FINANCIAL AND MONETARY AFFAIRS
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indebtedness (CIs) issued by the Exchange Fund, which the note-issuing banks are required to hold as cover for the issue of Hong Kong dollar notes, are issued and redeemed against payments in US dollars at a fixed exchange rate of HK$7.80 to US$1. In practice, therefore, any increase in note circulation is matched by a US dollar payment to the Exchange Fund, and any decrease in note circulation is matched by a US dollar payment from the Exchange Fund. In the foreign exchange market, the exchange rate of the Hong Kong dollar continues to be determined by forces of supply and demand. Against the fixed exchange rate for the issue and redemption of CIS, the market exchange rate stays close to the rate of HK$7.80 to US$1. From January 24, 1994, banknotē transactions among banks are for Hong Kong dollar value (instead of US dollar value under the previous arrangement).
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 adjust automatically, over time, 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 changes will induce an inflow of funds to offset the original outflow arising from the balance of payments deficit, while reducing domestic demand and imports and enhancing export competitiveness, contributing 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 outflow of funds and, on the other hand, increase domestic demand and imports and erode export competitiveness, again restoring the external balance.
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. To ensure that the interest rate gap is large enough to produce the corrective inflows or outflows, there is 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, under which banks may impose deposit charges (negative interest rates) on large Hong Kong dollar credit balances maintained by their customers, if the need arises. The revised rules provided a tool to deter speculation on a revaluation of the Hong Kong dollar, which emerged in late 1987 and continued in early 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 authorised institutions under the Banking Ordinance
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