ENG-1998 — Page 124

FINANCIAL AND MONETARY AFFAIRS

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calendar days to complete the move of the rate to 7.80, where it will converge with the convertibility rate for Certificates of Indebtedness and stay thereafter.

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By assuming responsibility over the interbank clearing system, the HKMA also became responsible for the provision of last-resort lending to any banks experiencing day-to-day shortages of liquidity. A Liquidity Adjustment Facility (LAF) was set up in 1992 for such purpose. This was replaced in September 1998 by the Discount Window arrangement under which banks have unrestricted access to day-end liquidity through repurchase agreements using Exchange Fund Bills and Notes as collateral. A two-tier structure of Discount Rates has been adopted to ensure that interest rates are adequately responsive to capital flows, while avoiding excessive interest rate volatility if liquidity shortages are only modest. Banks are charged the Base Rate with respect to the first 50 per cent of their holding of Exchange Fund Bills and Notes, but, for the next 50 per cent, Base Rate plus 5 per cent, or the overnight Hong Kong Interbank Offer Rate (HIBOR) of the day, whichever is the higher. In November 1998, the methodology for determining the Base Rate was announced: it is set as the simple five-day average of overnight and one-month HIBORS, or the US Federal Funds Target Rate plus a premium of 150 basis points, whichever is the higher.

Under the currency board system, Hong Kong dollar exchange rate stability is maintained through an interest rate adjustment mechanism. 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.

The government is fully committed to maintaining the linked exchange rate system and adheres to the strict discipline under the currency board system. Operation of the system is overseen by the Sub-committee on Currency Board Operations of the Exchange Fund Advisory Committee (the sub-committee) which was established in late August 1998. The sub-committee may also recommend to the Financial Secretary, where appropriate, measures to enhance the robustness and effectiveness of Hong Kong's currency board arrangements.

The HKMA pursues a policy of transparency to ensure that the financial industry and the wider public are fully informed of the currency board operations and to instil public confidence on the link. The Aggregate Balance has been disclosed on a virtually real time basis since December 1996 when the RTGS system was launched. Forecast changes to the Aggregate Balance due to foreign exchange transactions have also been published on a daily basis since June 1998. Furthermore, starting from November 1998, the size of the monetary base and its components is published daily, and the records of the meetings of the Sub-committee on Currency Board Operations are published within six weeks after each meeting.

Asian Financial Turmoil

The contagion of the Asian financial turmoil reached Hong Kong in late 1997 and remained a concern in the year that followed. While the overall financial market and