ENG-1994 — Page 121

FINANCIAL AND MONETARY AFFAIRS

from the restriction of lending money at an effective interest rate exceeding 60 per cent per

annum.

To enable the HKMA, through the use of the Exchange Fund, to exercise more effective influence over liquidity and interest rates in the interbank market and so assist it in maintaining exchange rate stability within the framework of the linked exchange rate system, accounting arrangements were entered into in July 1988 between the 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, the HSBC maintains a Hong Kong dollar account with the Exchange Fund. The HKMA uses the account at its discretion to effect settlement of its Hong Kong dollar transactions with the HSBC or with other banks. The 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 HKMA for the account of the Exchange Fund.

Consequently, the HKMA, through the use of the Exchange Fund, has effectively become the ultimate provider of liquidity in the interbank market, a role which was previously performed by the HSBC. Through the borrowing of Hong Kong dollars in the interbank market, or selling foreign currencies for Hong Kong dollars in the foreign exchange market, the HKMA is able to reduce the supply of Hong Kong dollars and so raise interest rates in the interbank market, in this way 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, offsetting a strengthening of the exchange rate.

Under the accounting arrangements, the HKMA 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 HKMA has developed a programme for the issue of short-term and longer-term paper for the account of the Exchange Fund (the Exchange Fund Bills and Notes). The Exchange Fund paper is designed to complement the accounting arrangements by providing the HKMA with an additional instrument for conducting money market operations.

In June 1992, the Liquidity Adjustment Facility (LAF) was introduced to assist banks in making late adjustments to their liquidity positions. The bid rate (for taking overnight deposits from banks) and offer rate (for lending overnight money to banks) are set having regard to the level of interest rate appropriate for maintaining exchange rate stability. These rates provide an additional tool for the HKMA to influence the movements of the interbank interest rates.

The Monetary Situation

Since the end of February, increases in US interest rates have been closely followed by increases in the comparable Hong Kong interest rates. Notably, the LAF rates, Hong Kong's version of the discount rates, have followed their US dollar counterparts almost immediately and to an identical extent. Since May 18, the LAF bid and offer rates have been revised upwards by a total of 175 basis points (bps) and stood at 3.75 per cent and 5.75 per cent, respectively, at the end of 1994.

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