ENG-1991 — Page 103

FINANCIAL AND MONETARY AFFAIRS

Exchange Fund and The Hongkong and Shanghai Banking Corporation Limited (HSBC) as the Management Bank of the Clearing House of the Hong Kong Association of Banks. Under these arrangements, HSBC maintains a Hong Kong dollar account with the Exchange Fund. The government uses the account, at its discretion, to effect settlement of its Hong Kong dollar transactions with HSBC or with other banks. HSBC is required to ensure that the net clearing balance (NCB) of the rest of the banking system does not exceed its balance in the account and that the NCB is not in debit. Otherwise it will have to pay interest to the Exchange Fund.

Consequently, the Exchange Fund effectively became the ultimate provider of liquidity in the interbank market, a role which until mid-July 1988 was performed by HSBC. Through its borrowing Hong Kong dollars in the interbank market, or selling foreign currencies for Hong Kong dollars in the foreign exchange market, the fund is able to reduce the supply of Hong Kong dollars and hence raise interest rates in the interbank market, thereby offsetting a weakening of the exchange rate of the Hong Kong dollar against the US dollar. Similarly, it may increase interbank liquidity and lower interest rates by taking action in the opposite direction, thereby offsetting a strengthening of the exchange rate.

As well as these accounting arrangements between the fund and HSBC, the Treasury maintains a Hong Kong dollar account with the fund where money transferred from the General Revenue to the fund in return for interest bearing 'debt certificates' is accounted for. Through the issuance and redemption of debt certificates, the Exchange Fund has an additional tool to affect interbank liquidity.

Under these accounting arrangements, the government can also influence monetary conditions in the interbank market through its buying or selling of Hong Kong dollar financial assets of acceptable quality. For this purpose, the government has developed a programme for the issue of short-term paper for the account of the Exchange Fund (the so-called Exchange Fund bills). The bills are designed to complement the accounting arrangements by providing the Exchange Fund with an additional instrument for conducting money market operations.

The Exchange Fund

The Hong Kong Government's Exchange Fund was established by the Currency Ordinance of 1935 (later renamed the Exchange Fund Ordinance). Since its inception, the fund has held the backing to the note issue. In 1976, its role was expanded, with the assets of the Coinage Security Fund (which held the backing for coins issued by the government) as well as the bulk of foreign currency assets held in the government's General Revenue Account, being transferred to the fund. In both cases, the transfer was made against the issue by the fund of interest-bearing debt certificates denominated in Hong Kong dollars. On December 31, 1978, the Coinage Security Fund was merged with the Exchange Fund and all the debt certificates held by the Coinage Security Fund redeemed.

In 1976, the government began to transfer the fiscal reserves of its General Revenue Account (apart from the working balances) to the fund, against the issue of interest- bearing debt certificates. This arrangement was introduced for the safety, economy and advantage of these monies so as to avoid fiscal reserves having to bear the exchange risk arising from investments in foreign currency assets and to centralise the management of the government's financial assets. The fiscal reserves are not permanently appropriated for the

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