FINANCIAL AND MONETARY AFFAIRS
between banks ensures that the market exchange rate stays close to the rate of HK$7.80 to US$1 fixed for the CIS.
With the adoption of the linked rate system, the exchange rate is no longer a variable in the economy's adjustment process. Interest rates, the money supply and the level of economic activity over time adjust automatically to balance of payments pressures. If there is an outflow of money, caused for example by a tendency for the balance of payments to be in deficit, there will be a contraction in the money supply and higher interest rates. These will, on the one hand, induce an inflow of funds to offset the original outflow arising from the balance of payments deficit and, on the other hand, reduce domestic demand, restrain imports and enhance export competitiveness, and thereby also contribute to restoring the external balance. Alternatively, if there is an inflow of money, caused for example by a tendency for the balance of payments to be in surplus, there will be an expansion in the money supply and lower interest rates. These will, on the one hand, induce an outflow of funds and, on the other hand, increase domestic demand and imports, and erode export competitiveness, again restoring the external imbalance.
When there is a tendency for the Hong Kong dollar to weaken relative to the US dollar, Hong Kong dollar interest rates will rise relative to US dollar interest rates. They may rise to a level where the interest rate gap between the Hong Kong dollar and the US dollar is large enough to stem or reverse the outflow from the Hong Kong dollar. Similarly, when there is a tendency for the Hong Kong dollar to strengthen relative to the US dollar, Hong Kong dollar interest rates will fall relative to US dollar interest rates. They may fall to a level where the interest rate gap between the Hong Kong dollar and the US dollar is large enough to stem or reverse the inflow into the Hong Kong dollar. From the monetary policy point of view, it is sometimes desirable to expedite this adjustment process in order that the economy is not unduly disrupted by speculative flows of funds aimed at manipulating the value of the Hong Kong dollar. So that the interest rate gap is large enough to produce the corrective inflows or outflows, there should therefore ideally be no limit on how low or high interest rates can move.
The lower limit for interest rates was eliminated when the Hong Kong Association of Banks, after consultation with the Financial Secretary, introduced in January 1988 revised interest rate rules whereby banks may impose deposit charges ("negative interest rates') on large Hong Kong dollar credit balances maintained by their customers, if the need arises. The purpose of the revised rules was to deter persistent speculation on a revaluation of the Hong Kong dollar which emerged in late 1987 and continued early in 1988. In practice, however, there has been no need to impose the deposit charges, as the mere threat of their imposition has been effective in deterring speculation.
The upper limit for interest rates was removed in July 1988 when the Money Lenders Ordinance was amended to exempt all institutions authorised under the Banking Ordin- ance from the restriction in the ordinance on lending money at an effective interest rate exceeding 60 per cent per annum.
To enable the government, through the use of the Exchange Fund, to exercise more effective influence over liquidity and interest rates in the interbank market and thus to assist it to maintain exchange rate stability within the framework of the linked exchange rate system, Accounting Arrangements were entered into in mid-July 1988 between the Exchange Fund and The Hongkong and Shanghai Banking Corporation Limited (HSBC) as the Management Bank of the Clearing House of the Hong Kong Association of Banks.
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