FINANCIAL AND MONETARY AFFAIRS
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The foreign exchange and money markets stayed calm when China resumed sovereignty over Hong Kong on July 1, but financial turmoil sparked off by the floating of the Thai Baht in early July swept across the East Asian economies in the second half of 1997. Affected by the contagion effect of the regional financial turbulence, the Hong Kong dollar came under selling pressure on a few occasions between July and October, and money market conditions tightened. On August 19, money market rates firmed up on rumours of a possible hike in the Best Lending Rate, with the overnight HIBOR briefly touching a high of 18 per cent. There was another brief tightening on August 28 due to renewed fears of a possible contagion effect from the sharp falls in the region's currency and stock markets. The overnight HIBOR then stabilised and hovered within a range of 4.8 per cent to 7.9 per cent until mid-October.
Selling pressure on the Hong Kong dollar intensified in the week preceding October 20 after the Taiwanese government decided not to defend the New Taiwan Dollar. In response, the HKMA bought a substantial amount of Hong Kong dollars on October 21 and 22. These foreign exchange transactions were due to settle on October 23 and 24. The settlement would involve the HKMA debiting the clearing accounts of the banks which had sold the Hong Kong dollars to the HKMA. On October 23, the HKMA issued a circular to all licensed banks reminding them of the need to organise their Hong Kong dollar funding prudently and not be overly dependent upon the LAF for last-resort liquidity support. The circular also warned them that the HKMA might impose penal LAF rates for repeated borrowers to discourage the use of the facility to fund a short Hong Kong dollar position.
As the banks collectively had sold more Hong Kong dollars to the HKMA than they could settle by using their credit balances in their clearing accounts with the HKMA, there was a shortage of interbank liquidity when these foreign exchange transactions were settled on October 23. As a result, short-term interest rates were driven up and the overnight interbank interest rate briefly touched 280 per cent. The high interest rate reversed the capital outflow and effectively fended off speculators.
When speculators began to unwind their short positions in Hong Kong dollar by selling US dollar, and some investors and corporates with US dollar funding switched into HK dollar to benefit from the high deposit rates, the HKMA picked up the US dollar and recycled the Hong Kong dollar into the banking system in the afternoon of October 23. Short-term interbank interest rates began to ease. By the close of day, the overnight interbank interest rate came down to 100 per cent and towards the end of the month, it eased further to around 7 per cent. On October 24, the savings deposit rate and Best Lending Rate of major banks were raised by 75 bps.
As the overnight HIBOR exhibited a higher degree of volatility during this episode, a wider LAF corridor was considered appropriate to give the overnight interbank interest rate more room to move and to reflect conditions in the interbank market. On October 25, the HKMA widened the band of the LAF corridor from 200 bps to 300 bps and adjusted the LAF bid and offer rates to 4 per cent and 7 per cent respectively.
While short-term interest rates came down quickly, term rates remained high in late October and early November as banks conserved liquidity for fear of another liquidity squeeze as a result of another currency attack. The Hong Kong dollar yield curve thus assumed an unusual inverted 'U-shape', with a very steep portion running