ENG-2004 — Page 141

Financial and Monetary Affairs | 111

or rise, respectively, creating the monetary conditions that automatically counteract the original capital movements, ensuring stability of the exchange rate.

Under the present arrangement, the HKMA undertakes to convert the Hong Kong dollar balances held by banks into US dollars at the convertibility rate of 7.80. However, there is no explicit convertibility undertaking on the strong side of the linked rate. This arrangement is considered optimal mainly because the constructive ambiguity on the strong side helps deter speculative pressures against the Hong Kong dollar on the weak side by making it difficult for speculators to calculate the cost of shorting the Hong Kong dollar. This arrangement increases the resilience of the system to weak-side pressures, thereby improving the sustainability of the system as a whole. In choosing the exact level of the exchange rate to sell the Hong Kong dollar, the HKMA has mainly responded to bank offers of the US dollar in a passive manner. Nevertheless, when there are strong speculative pressures or the exchange rate appreciates sharply, a proactive approach is adopted to counter possible strategic behaviour of large market players, and to provide an anchor for the exchange rate.

To strengthen the institutional framework for the operation of the currency board system in Hong Kong, a Sub-committee on Currency Board Operations was established under the Exchange Fund Advisory Committee (EFAC) in August 1998. The sub-committee has been entrusted with the responsibility of overseeing the operation of the currency board system in Hong Kong and may, where appropriate, recommend to the Financial Secretary through the EFAC 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. To this end, the Aggregate Balance and forecast changes to the Aggregate Balance attributable to the currency board's foreign exchange transactions are disclosed on a real-time basis. In addition, the size of the monetary base and its components are published on a daily basis, while the Currency Board Account is published on a monthly basis. The records of the meetings of the Sub-committee on Currency Board Operations are also published within six weeks of each meeting.

The Government is fully committed to the maintenance of the linked exchange rate system, which is a cornerstone of Hong Kong's monetary and financial stability, and to the strict discipline of the currency board arrangement under that system.

Monetary Situation

The Hong Kong dollar exchange rate gradually depreciated to the linked rate of 7.80 during the first four months of 2004, as appreciation pressures slowly subsided and the HKMA conducted a number of strong-side operations (i.e. selling Hong Kong dollars for US dollars). Thereafter, the Hong Kong dollar exchange rate stayed close to the linked rate and the Convertibility Undertaking was triggered occasionally between April and September. The Hong Kong dollar exchange rate strengthened again in October, prompting the HKMA to conduct a number of strong-side operations in response to banks' bids. The exchange rate finally closed at 7.7745 at the end of the year. The renewed strength in the Hong Kong dollar reflected several