FINANCIAL AND MONETARY AFFAIRS
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the timely payment of principal and interest due on the securities, serves to make the MBS a safe and attractive investment for investors.
Monetary Policy
Hong Kong's monetary policy objective is currency stability. Given the highly externally oriented nature of the Hong Kong economy, this objective is further defined as a stable external value for the currency in terms of a fixed exchange rate against the US dollar at the rate of $7.80 to US$1. This clear monetary policy objective is achieved through the linked exchange rate system. This system was introduced in October 1983 after a nine-year period in which the Hong Kong dollar floated and the exchange rate was volatile.
The linked exchange rate system is in essence a currency board system with two distinctive features: i) full backing of the monetary base; and ii) convertibility between the monetary base and the reserve currency at the fixed exchange rate (i.e. HK$7.80 = US$1). In Hong Kong, the monetary base includes the amount of bank notes and coins issued, the Aggregate Balance (which is the sum of the clearing balances of the licensed banks held with the HKMA for the purpose of effecting the clearing and settlement of transactions between the banks themselves and also between the HKMA and the banks), and the outstanding amount of Exchange Fund Bills and Notes.
Since the inception of the linked exchange rate system in October 1983, the issuance and redemption of bank notes, through the note-issuing banks, are required to be made against US dollars at the fixed exchange rate of $7.80 to US$1. Specifically, Certificates of Indebtedness, which authorise note-issuing banks to issue banknotes, are issued and redeemed against US dollars at that fixed rate and for the account of the Exchange Fund. In other words, the Certificates of Indebtedness, which are cover for banknotes, are fully backed by US dollars and are convertible into US dollars at the fixed rate of HK$7.80 to US$1. Similarly, the issue and withdrawal of coins in circulation are conducted against US dollars at a fixed exchange rate of 7.80.
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 balances 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 Hong Kong Association of Banks 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. 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 prescribed convertibility rate. The convertibility rate was initially set at HK$7.75 to US$1, taking into account the then prevailing market exchange rate. Starting from April 1, 1999, the convertibility rate moved from 7.75 by 1 pip (i.e. HK$0.0001) per calendar day. It converged with the convertibility rate