ENG-1987 — Page 81

THE ECONOMY

Government's Involvement in the Economy

Economic Policy

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Economic policy in Hong Kong is to a large extent dictated, and constrained, by the special circumstances of the Hong Kong economy. Owing to its small and open nature, the economy is vulnerable to external factors, and government actions designed to offset unfavourable external influences are of limited effectiveness. Further, the government is of the view that, except where social considerations are regarded as over-riding, the allocation of resources in the economy will normally be most efficient if market forces are relied on and if government intervention in the private sector is kept to a minimum.

This basically free-enterprise, market-disciplined system has contributed to Hong Kong's economic success. The narrowly-based tax structure with relatively low tax rates provides incentives for workers to work and for entrepreneurs to invest. Both workers and entrepreneurs are highly motivated, given that all individuals have equal opportunity to pursue the goals of individual betterment and the accumulation of wealth. The primary role of the government is to provide the necessary infrastructure and a stable legal and administrative framework conducive to economic growth and prosperity.

Monetary Policy

The government has consistently worked towards providing a favourable environment in the financial sector, with sufficient regulation to ensure, as far as possible, sound business standards and confidence in the institutional framework, but without unnecessary im- pediments of a bureaucratic or fiscal nature.

Unlike most major economies, Hong Kong has no central bank. Most of the functions which might normally be performed by one such as prudential supervision of financial institutions, managing official foreign exchange reserves, undertaking certain types of open market operations, issuing banknotes, and providing banking services to the government – are carried out by different government offices under the Monetary Affairs Branch of the Government Secretariat or by selected commercial banks.

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

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On October 17, 1983, after a period of much instability in the exchange rate of the Hong Kong dollar, a revised exchange rate 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 notes, are issued and redeemed against payments in US dollars at a fixed exchange rate of HK$7.80=US$1. In practice, therefore, any increase in note circulation is matched by a US dollar payment to the Exchange Fund, and any fall in note circulation is matched by a US dollar payment from the Exchange Fund. The two note-issuing banks in turn extend this fixed exchange rate to their note transactions with all other banks in Hong Kong. The market exchange rate of the Hong Kong dollar against the US dollar has remained stable and close to the fixed rate for banknotes since October 1983.

This important aspect of Hong Kong's monetary framework means that the exchange rate is no longer a variable in the economy's adjustment process. Under the linked exchange rate system, interest rates, the money supply and the level of economic activity tend to