ENG-1984 — Page 124

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THE ECONOMY

the Exchange Fund, which the two note-issuing banks are required to hold as cover for the issue of Hong Kong dollar banknotes, are issued and redeemed against payments in US dollars at the fixed exchange rate of US$1 = HK$7.80. In practice, therefore, any rise in the note circulation has to be matched by a US dollar payment to the Exchange Fund and any fall in circulation is matched by a similar payment from the fund. The note-issuing banks in turn extend this fixed rate to their note transactions with all other banks in Hong Kong. The forces of competition and arbitrage, aided by a largely favourable psychological impact, have ensured that the market exchange rate has been stable at a level close to the fixed rate of US$1 = HK$7.80 since October 1983.

This important change in Hong Kong's monetary framework means that the exchange rate is, in effect, no longer a major variable element in the economy's adjustment process. Factors such as interest rates, money supply and the level of economic activity, rather than the exchange rate, now tend to adjust automatically to balance of payments pressures, without government intervention being necessary. The role of money market interest rates as an instrument of monetary policy has therefore altered. They now assume a more passive role, changing, more frequently perhaps, in response to balance of payments inflows and outflows.

The Hong Kong Association of Banks, which sets the maximum rates of interest payable on deposits with licensed banks, still has the statutory obligation to consult the government on these interest rates. This procedure was designed to ensure that the association took account of the wider public interest in its decisions, including, of course, their effect on the exchange rate. Under the new exchange rate system, however, it is neither so necessary nor so desirable for the government to play an active role in this process.

Through its bankers, the Exchange Fund has operated a scheme which enables it to draw funds out of the local interbank market and to ensure that these funds are not directly recycled into that market. This arrangement is capable of tightening up the money market and putting upward pressure on market interest rates in the short term. Thus, despite the change in the monetary framework which took place in October 1983, the arrangements whereby the government may influence interest rates through the Hong Kong Association of Banks or the money market remain in place.

Public Sector and Public Finances

For the purpose of formulating annual budgetary policies, the public sector is defined in terms of the deployment of funds under the government's control. Thus public sector expenditure is conventionally taken to include expenditure on the General Revenue Account, expenditure by the Urban Council and the Housing Authority, expenditure financed from certain statutory funds, and expenditure on public works projects financed with loans from the Asian Development Bank. Expenditure by institutions in the private or quasi-private sector is included to the extent that it is met by government subventions but not included is expenditure by those organisations in which the government has only an equity position, such as the Mass Transit Railway Corporation and the Kowloon- Canton Railway Corporation.

As an indication of the size of public sector spending, expenditure on the Consolidated Account rose from $6,703 million in 1974-5 to an estimated $44,024 million in 1984-5. The average annual growth rate for these years taken together was 20.7 per cent in money terms. Over this period, the relative size of the public sector (defined as the ratio of expenditure on the Consolidated Account to the GDP at current prices) rose from 15 per cent to around 16.5 per cent.