ENG-1985 — Page 62

THE ECONOMY

Monetary Policy

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There are few monetary instruments available to the government for monetary policy purposes. From 1974 until October 1983, the Hong Kong dollar was a conventional floating currency and during this period the Exchange Fund's role in directly influencing the exchange rate through intervention in the foreign exchange market was limited at most to ironing out short-term fluctuations.

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On October 17, 1983, after a period of much instability in the exchange rate, a revised system was introduced. Under the new arrangement, certificates of indebtedness issued by 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 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 interest rates as an instru- ment 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 a statutory obligation to consult the government on these interest rates. This procedure is designed to ensure that the association takes account of the wider public interest in its decisions, including 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 expenditure by those organisations in which the government has only an equity position,