ENG-2004 — Page 140

110 Financial and Monetary Affairs

The linked exchange rate system is characterised by currency board arrangements, requiring the Hong Kong dollar monetary base to be at least 100 per cent backed by, and changes in it to be 100 per cent matched by corresponding changes in US dollar reserves held in the Exchange Fund at the fixed exchange rate of HK$7.80 to US$1. In Hong Kong, the monetary base includes the amount of currency notes and coins issued, the Aggregate Balance (the sum of the clearing balances of banks held with the HKMA for the purpose of effecting the clearing and settlement of transactions between banks themselves and also between the HKMA and banks), and the outstanding amount of Exchange Fund Bills and Notes.

Since the inception of the linked exchange rate system in October 1983, note-issuing banks are required to hold Certificates of Indebtedness (CIs) issued by the Exchange Fund to provide backing for bank note issuance. The issuance and redemption of Cls are made against US dollars at the convertibility rate of HK$7.80 to US$1 for the account of the Exchange Fund. Similarly, the issue and withdrawal of government-issued currency notes and coins in circulation are conducted against US dollars at the fixed exchange rate of 7.80.

When the linked exchange rate system was introduced in October 1983, there was no institutional arrangement whereby banks in Hong Kong maintained clearing accounts with the currency board. Thus, that part of the monetary base represented by the clearing balances of the banking system was initially not subject to the discipline imposed by a currency board system. Action was taken to correct this in 1988 through arrangements that required the Management Bank of the Clearing House of the Hong Kong Association of Banks (HKAB) to maintain a clearing account with the Government's then Monetary Affairs Branch for the account of the Exchange Fund. This was replaced by another arrangement, when the RTGS system was introduced for interbank transactions in Hong Kong towards the end of 1996. Since then, all licensed banks have had to maintain direct clearing accounts with the Exchange Fund.

By assuming responsibility for the interbank clearing system, the HKMA also became responsible for the provision of lending to any banks experiencing day-to-day shortages of liquidity. A Liquidity Adjustment Facility (LAF) was set up in 1992 for this 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.

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 (inflow into the Hong Kong dollar). It contracts when the foreign currency is bought from the currency board (outflow from the Hong Kong dollar). The expansion or contraction in the monetary base leads interest rates for the domestic currency to fall