ENG-2006 — Page 125

Financial and Monetary Affairs | 97

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 is made against US dollars at the convertibility rate of $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 is conducted against US dollar 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 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 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 EFBNs 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 dollar) 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 or rise, respectively, creating the monetary conditions that automatically counteract the original capital movements, ensuring stability of the exchange rate.

In May 2005, the HKMA introduced three refinements to the operation of the linked exchange rate system to remove uncertainty about the extent to which the exchange rate may strengthen and promote the smooth functioning of the money and foreign exchange markets in accordance with currency board arrangements. The three refinements are: (a) the introduction with immediate effect of a strong-side