ENG-2011 — Page 136

100 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 $7.80 to US$1. In Hong Kong, the monetary base includes the amount of currency notes and coins issued, the Aggregate Balance11, and the outstanding amount of EFBNs.

Banks have unrestricted access to a Discount Window for day-end liquidity through repurchase agreements using EFBNs as collateral. Under the currency board system, Hong Kong dollar exchange rate stability is maintained through an interest rate adjustment mechanism.

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.

A Currency Board Sub-Committee under the EFAC was established in August 1998 to oversee the operation of the currency board system in Hong Kong and recommend to the Financial Secretary through 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.

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

Notwithstanding the market volatilities arising from the European sovereign debt crisis and the historic downgrading of the United States' sovereign credit rating by the Standard & Poor's, currency stability in Hong Kong was well maintained during the year. Between January and March, the market exchange rate softened slightly from around 7.77 to 7.80, partly reflecting some repatriation of funds raised in the equity market. With the US dollar depreciating against other major currencies, the Hong Kong dollar exchange rate strengthened somewhat against the US dollar in April. From May to July the bilateral exchange rate weakened again as growing worries about the European sovereign debt problems weighed on market sentiment. In the five months to December, the exchange rate largely mirrored the swings in the US dollar against other major currencies, either strengthening amid a weaker US dollar or weakening alongside a stronger US dollar. Overall, the market exchange rate traded within a narrow range of between 7.7671 and 7.8097 during the year.

11 Aggregate Balance is 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.