102 Financial and Monetary Affairs
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.
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 the Hong Kong dollar). It contracts when the foreign currency is bought from the currency board (outflow from the Hong Kong dollar). 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 movements, ensuring stability of the exchange rate.
In May 2005, the HKMA introduced three refinements to the operation of the linked exchange rate system to remove uncertainty about the extent to which the exchange rate may strengthen and promote the smooth functioning of the money and foreign exchange markets in accordance with currency board arrangements. The three refinements are: (a) the introduction with immediate effect of a strong-side convertibility undertaking by the HKMA to buy US dollars from licensed banks at 7.75; (b) the shifting of the existing weak-side convertibility undertaking by the HKMA to sell US dollars to licensed banks from $7.80 to $7.85; and (c) within the zone defined by the levels of the convertibility undertakings, the HKMA may choose to conduct market operations consistent with currency board principles.
To strengthen the institutional framework for the operation of the currency board system in Hong Kong, the Subcommittee on Currency Board Operations was established under the Exchange Fund Advisory Committee (EFAC) in August 1998. The subcommittee has been entrusted with the responsibility of overseeing the operation of the currency board system in Hong Kong and may, where appropriate, recommend to the Financial Secretary through the EFAC measures to enhance the robustness and effectiveness of Hong Kong's currency board arrangements.
The HKMA pursues a policy of transparency to ensure that the financial industry and the wider public are fully informed of the currency board operations. To this end, the Aggregate Balance and forecast changes to the Aggregate Balance attributable to the currency board's foreign exchange transactions are disclosed on a real-time basis. In addition, the size of the monetary base and its components are published on a daily basis, while the Currency Board Account is published on a monthly basis. The records of the meetings of the Subcommittee on Currency Board Operations are also published within six weeks of each meeting.
The Government is fully committed to the maintenance of the linked exchange rate system, which is a cornerstone of Hong Kong's monetary and financial stability, and to the strict discipline of the currency board arrangement under that system.