ENG-1997 — Page 128

FINANCIAL AND MONETARY AFFAIRS

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Banking Ordinance. Its business will be developed in two phases. Initially the corporation will purchase mortgage loans for its own portfolio and fund the purchases largely through the issuance of unsecured debt securities. In the second phase, the HKMC will securitise the mortgages into mortgage-backed securities and offer them for sale to investors.

The HKMC commenced business in October 1997. The first block of mortgage purchase, involving a total of $650 million, was purchased in November.

Monetary Policy

Hong Kong's monetary policy objective is currency stability. Given the highly externally oriented nature of the Hong Kong economy, this objective is further defined as a stable external value for the currency in terms of a fixed exchange rate against the US dollar at the rate of $7.80 to US$1.

This clear monetary policy objective is achieved through what has been referred to as the linked exchange rate system. This system was introduced in October 1983 after a nine-year period in which the Hong Kong dollar floated and the exchange rate was volatile. Without an effective monetary anchor or any mechanism for monetary control, due to the absence of any institutional arrangement that enabled the authorities to influence the supply or price of money, there was sharp depreciation in the exchange rate towards the end of the nine-year period when uncertainties about the political future of Hong Kong affected confidence in the currency. The linked exchange rate system introduced an external anchor for the currency and restored confidence in it.

The linked exchange rate system, as structured in 1983, required the issue and redemption of bank notes, through the note-issuing banks, to be made against US dollars at the fixed exchange rate of $7.80 to US$1. Certificates of Indebtedness, which authorise the note-issuing banks to issue bank notes, are issued and redeemed against the US dollar at that fixed rate and for the account of the Exchange Fund. Under this influence, and the fact that deposit money is convertible to bank notes, the exchange rate for the Hong Kong dollar in the foreign exchange market stays close to the level of the fixed rate.

The linked exchange rate system is what is known academically as a currency board system which theoretically requires the monetary base to be backed by a foreign currency at a fixed exchange rate. The monetary base is normally defined as the sum of the amount of bank notes issued and the balance of the banking system (the reserve balance or the clearing balance) held with the currency board for the purpose of effecting the clearing and settlement of transactions between the banks themselves, and also between the currency board and the banks. The monetary base increases when the foreign currency (in Hong Kong's case, US dollars), to which the domestic currency is linked, is sold to the currency board for the domestic currency (capital inflow). It contracts when the foreign currency is bought from the currency board (capital outflow). The expansion or contraction in the monetary base leads interest rates for the domestic currency to fall or rise, respectively, creating the monetary conditions that automatically counteract the original capital movement, ensuring stability of the exchange rate throughout the process.

In October 1983, when the linked exchange rate system was introduced, there was no institutional arrangement whereby banks in Hong Kong maintained clearing