CONFIDENTIAL
3
high wage and price increases without undermining external competitiveness.
While structural changes are likely to continue for some time, the high
degree of openness of long Kong's economy should work to moderate inflation
as the process of structural transformation gradually slows down. Our
concern, however, is that strong private demand fueled by low interest
rates, combined with substantial infrastructural investments for the new
airport by both che public and private sectors, would further push aggregate
demand beyond the economy's supply capacity. In the absence of corrective
measures, such excess demand pressures could lead to an acceleration of
inflation. An increasing entrenchment of inflation expectations would
inevitably reduce the traditional flexibility of Hong Kong's economy and
Increase the subsequent cost of re-establishing an appropriate wage-price
structure.
Against this background, monetary policy has been oriented towards
maintaining the fixed exchange rate vis-a-vis the U.S. dollar. The linked
exchange rate system is a transparent policy that has served as the linchpin
of financial confidence and stability since its introduction in 1983. In
view of Hong Kong's generally successful performance and the high degree of
uncertainty leading up to the transfer of authority to China in 1997, we
fully support your continued commitment to the exchange rate anchor.
At the same time, the exchange rate link rules out the effective use of
monetary policy in containing inflation. Indeed, with the decline in
interest rates In the United States during the past year, monetary
conditions in Hong Kong have loosened substantially at the time of a
cyclical upswing in the economy. The increasingly negative real interest
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