TNAG-2466-FCO40-3590-Economic-situation-in-Hong-Kong-1992 — Page 28

Under these arrangements HSBC maintains a Hong Kong dollar account with the Exchange Fund. The government uses the account, at its discretion, to effect settlement of its Hong Kong dollar transactions

with the HSBC or with other banks. HSBC is required to ensure that the net clearing balance (NCB) of the rest of the banking system does

not exceed the balance in the account and that the NCB is not in

debit, otherwise it will have to pay interest to the Exchange Fund.

5. As a consequence of these accounting arrangements the Exchange

Fund effectively became the ultimate provider of liquidity in the interbank market, a role which until mid-July 1988 was performed by

HSBC. Through its borrowing Hong Kong dollars in the inter-bank market

or selling foreign currencies for Hong Kong dollars in the foreign exchange market, the Fund is able to reduce the supply of Hong Kong dollars and hence raise interest rates in the interbank market,

thereby offsetting a weakening of the exchange rate of the Hong Kong

dollar against the US dollar. Similarly, it may increase interbank liquidity and lower interest rates by taking action in the opposite direction, thereby offsetting a strengthening of the exchange rate. The size of the NCB is of the order of HK$500million which is small relative to the size of the banking system. However, it is sufficiently large for effective management of the inter-bank money market by the Exchange Fund, and indirectly of the market exchange

rate around the fixed rate of HKD7.80 to the USD.

VIEWS ON THE LINK

6. There has over the last year or so been some criticism of the

linked exchange rate system based on the proposition that it partly responsible for Hong Kong's double digit inflation. I attach a minute by Mr Broadbent (Chief Economic Adviser) which discusses the possible relationship between the "link" and inflation. One of his conclusions