ENG-1993 — Page 105

FINANCIAL AND MONETARY AFFAIRS

Monetary Policy

A linked exchange rate system was introduced on October 17, 1983, after a period of much instability in the exchange rate of the Hong Kong dollar. Under the system, certificates of indebtedness (CIs) 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 to US$1. In practice, therefore, any increase in note circulation is matched by a US dollar payment to the Exchange Fund, and any decrease 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. In the foreign exchange market, the exchange rate of the Hong Kong dollar continues to be determined by forces of supply and demand. Against the fixed exchange rate for the issue and redemption of CIs, the market exchange rate stays close to the rate of HK$7.80 to US$1. In the last few years, the Hong Kong dollar has stayed on the strong side of the link. As a result, some banks have levied charges on large cash deposits to avoid the exchange rate loss on banknote transactions. Discussions are being held with the note-issuing banks on a new arrangement under which all banknote transactions among banks will be for Hong Kong dollar value. This arrangement will make cash-handling charges unnecessary. Exchange rate stability will not be adversely affected. Hong Kong dollar banknotes will continue to be 100 per cent backed by US dollars at the fixed rate of HK$7.80 to US$1. Note-issuing banks will continue to place US dollars with the Exchange Fund in order to acquire the CIs necessary for backing the banknotes they issue.

With the adoption of the linked rate system, the exchange rate is no longer a variable in the economy's adjustment process. Interest rates, the money supply and the level of economic activity over time adjust automatically to balance of payments pressures. If there is an outflow of money, caused, for example, by a tendency for the balance of payments to be in deficit, there will be a contraction in the money supply and higher interest rates. These will induce an inflow of funds to offset the original outflow arising from the balance of payments deficit while reducing domestic demand and imports and enhancing export competitiveness, contributing to restoring the external balance. Alternatively, if there is an inflow of money, caused, for example, by a tendency for the balance of payments to be in surplus, there will be an expansion in the money supply and lower interest rates. These will, on the one hand, induce outflow of funds and, on the other hand, increase domestic demand and imports and erode export competitiveness, again restoring the external balance.

When there is a tendency for the Hong Kong dollar to weaken relative to the US dollar, Hong Kong dollar interest rates will rise relative to US dollar interest rates. They may rise to a level where the interest rate gap between the Hong Kong dollar and the US dollar is large enough to stem or reverse the outflow from the Hong Kong dollar. Similarly, when there is a tendency for the Hong Kong dollar to strengthen relative to the US dollar, Hong Kong dollar interest rates will fall relative to US dollar interest rates. They may fall to a level where the interest rate gap between the Hong Kong dollar and the US dollar is large enough to stem or reverse the inflow into the Hong Kong dollar. From the monetary policy point of view, it is sometimes desirable to expedite this adjustment process in order that the economy is not unduly disrupted by speculative flows of funds aimed at manipulating the value of the Hong Kong dollar. To ensure that the interest rate gap is large enough to produce the corrective inflows or outflows, there is no limit on how low or high interest rates can move.

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