ENG-1996 — Page 128

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FINANCIAL AND MONETARY AFFAIRS

Under the Linked Exchange Rate System, it is essential that interest rates should be flexible in order to minimise deviations of the exchange rate from the fixed level. This was why the lower limit for interest rates was eliminated when the HKAB introduced in January 1988 revised Interest Rate Rules, under which banks may impose deposit charges (negative interest rates) on large Hong Kong dollar credit balances maintained by their customers, if the need arises. The revised rules provided a tool to deter speculation on a revaluation of the Hong Kong dollar, which emerged in late 1987 and continued in early 1988. In practice, however, there has been no need to impose the deposit charges, as the mere threat of their imposition has been effective in deterring speculation.

The upper limit for interest rates was removed in July 1988, when the Money Lenders Ordinance was amended to exempt all authorised institutions under the Banking Ordinance from the restriction of lending money at an effective interest rate exceeding 60 per cent per annum.

To help the HKMA use the Exchange Fund to exercise more effective influence over liquidity and interest rates in the interbank market, and so to help it maintain exchange rate stability within the framework of the Linked Exchange Rate System, the Accounting Arrangements were entered into in July 1988 between the Financial Secretary and the Hongkong and Shanghai Banking Corporation Limited (HSBC) as the management bank of the clearing house of the HKAB.

Under the Accounting 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 penal interest to the HKMA.

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 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 downward pressure on 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 upward pressure on 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 (Exchange Fund Bills and Notes). The Exchange Fund paper is designed to complement the Accounting Arrangements by providing the HKMA with an additional instrument to conduct money market operations.

In June 1992, the Liquidity Adjustment Facility (LAF) was introduced to help banks make 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 rates appropriate for maintaining