FINANCIAL AND MONETARY AFFAIRS
In October 1983, when the linked exchange rate system was introduced, there was no institutional arrangement whereby banks in Hong Kong maintained clearing accounts with the currency board. Thus that part of the monetary base represented by the clearing balance of the banking system was initially not subject to the discipline imposed by a currency board system. Action was taken to correct this in 1988 through arrangements that required the Management Bank of the Clearing House of the HKAB to maintain a clearing account with the Government's then Monetary Affairs Branch for the account of the Exchange Fund. This was replaced by another arrangement, when the RTGS system was introduced for interbank transactions in Hong Kong towards the end of 1996. Since then, all licensed banks have had to maintain direct clearing accounts with the Exchange Fund. These reform measures subjected this crucial part of the monetary base to the discipline of the currency board arrangement and strengthened the linked exchange rate system. As part of a package of technical measures introduced in September 1998 to strengthen the currency board arrangements, a clear undertaking was made by the HKMA to licensed banks to convert Hong Kong dollars in their clearing accounts into US dollars at the fixed exchange rate of $7.75 to US$1. This represents an explicit Convertibility Undertaking in respect of the Aggregate Balance. Starting from April 1, 1999, the exchange rate under this Convertibility Undertaking has been moving from 7.75 to 7.80 by 1 pip (i.e. $0.0001) each calendar day. It will take 500 calendar days to complete the move of the rate to 7.80, where it will converge with the convertibility rate for Certificates of Indebtedness and remain at that level thereafter.
By assuming responsibility for the interbank clearing system, the HKMA also became responsible for the provision of lending to any banks experiencing day-to-day shortages of liquidity. A Liquidity Adjustment Facility (LAF) was set up in 1992 for this purpose. This was replaced in September 1998 by the Discount Window arrangement under which banks have unrestricted access to day-end liquidity through repurchase agreements using Exchange Fund Bills and Notes as collateral. A two-tier structure of Discount Rates has been adopted to ensure that interest rates are adequately responsive to capital flows, while avoiding excessive interest rate volatility if liquidity shortages are only modest. Banks are charged the Base Rate with respect to the first 50 per cent of their holding of Exchange Fund Bills and Notes. For the next 50 per cent, however, the charge is the Base Rate plus 5 per cent, or the overnight Hong Kong Interbank Offer Rate (HIBOR) of the day, whichever is higher. The Base Rate is set at the higher of the simple average of the five-day moving averages of overnight and one-month HIBORS, and the US Federal Funds Target Rate plus an adjustment factor, currently set at 150 basis points.
Under the currency board system, Hong Kong dollar exchange rate stability is maintained through an interest rate adjustment mechanism. The monetary base increases when the foreign currency (in Hong Kong's case, US dollars) to which the domestic currency is linked is sold to the currency board for the domestic currency (inflow into Hong Kong dollars). It contracts when the foreign currency is bought from the currency board (outflow from Hong Kong dollars). The expansion or contraction in the monetary base leads interest rates for the domestic currency to fall or rise respectively, creating the monetary conditions that automatically counteract the original capital movement, ensuring stability of the exchange rate.
The Government is fully committed to maintaining the linked exchange rate system. and adheres to the strict discipline under the currency board system. Operation of the
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