TNAG-2749-FCO40-3964-Economic-situation-in-Hong-Kong-1993 — Page 15

.4.

consolidation of monetary functions unger its auspices facilitates enhancements to the financial

system, such as the proposed new clearing system for domestic debt.

The exchange rate link has provided a transparent anchor that minimizes the scope for

destabilizing, discretionary actions. This has had the beneficial effect of placing responsibility on

the private sector to ensure the consistency of its actions with market signals, in keeping with the

authorities' non-intervenuonist approach to economic management. The need for a firm policy

anchor will remain of central importance in the period leading up to 1997. Alternative rules for

monetary policy each have their own drawbacks, and the staff agrees with the authorities that the

linked rate system remains the best option.

Of course, the link also implies constraints on the ability to set domestic monetary

conditions independently of those determined abroad. This issue would be of greater concern if

there were evidence of an upward spiral in inflationary expectations and cost pressures, or of a

speculative, unsustainable boom in asset prices. In the event, neither risk currently appears to be

significant Inflation has stabilized, while increases in asset prices have been associated with an

awakened recognition of the strength of Hong Kong's prospects and its ties to the booming

Chinese economy.

Concerning the mechanics of the linked rate system, the market rate has remained about 1

percent higher than the linked rate over the past year, in part due to strong capital inflows. While

such a spread is not of macroeconomic significance, its size--and related bank charges on cash

transactions--indicate some inefficiencies in the cash arbitrage process. Thus we support your

proposal that Hong Kong dollar credit be given for the excess receipts of note-receiving banks,

which should reduce these distortions. The Liquidity Adjustment Facility has played a useful role

in smoothing the impact on financial markets of temporary disturbances. While credit to the

banking system through this facility has been small relative to the overall assets of the HKMA, it

would be useful to establish a formal constraint that credit extended through the LAF not exceed

the outstanding value of Exchange Fund bills and collateralized foreign exchange assets. While

not of operational significance at the moment in this way the HKMA could not in the future

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