ENG-2015 — Page 113

4

Financial and Monetary Affairs

Monetary Policy

The city's monetary policy objective is currency stability, defined as a stable external exchange value of the HKD, in terms of its exchange rate in the foreign exchange market against the USD, at around HK$7.80 to US$1. This objective is achieved through the Linked Exchange Rate System introduced in 1983. The government is fully committed to maintaining this system, which is a cornerstone of the city's monetary and financial stability, and to the strict discipline of the system's currency board arrangements.

The Linked Exchange Rate System is characterised by currency board arrangements requiring the HKD 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 USD 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 Balance14, and the outstanding amount of EFBNs. Banks have unrestricted access to a Discount Window for overnight liquidity through repurchase agreements using EFBNs as collateral. Under the currency board system, HKD exchange rate stability is maintained through an interest rate adjustment mechanism and the HKMA's commitment to honour the Convertibility Undertaking. In particular, the HKMA undertakes to buy USD from licensed banks at HK$7.75 to US$1 (strong-side Convertibility Undertaking) and sell USD at HK$7.85 to US$1 (weak-side Convertibility Undertaking). The expansion or contraction in the monetary base arising from these currency board operations leads interest rates for the domestic currency to fall or rise respectively, creating the monetary conditions that automatically counteract the original capital movements and ensuring exchange rate stability.

A Currency Board Sub-Committee under the Exchange Fund Advisory Committee (EFAC) oversees the operation of the currency board system and recommends to the Financial Secretary through the EFAC measures to enhance the robustness and effectiveness of the currency board arrangements.

Monetary Situation

In 2015, the HKD exchange rate traded within a tight range of 7.750 to 7.767. The strong-side Convertibility Undertaking was triggered repeatedly in April, September and October. Net inflows of $71.5 billion were recorded in April amid strong equity-related demand for HKD, while combined net inflows of $155.7 billion were seen in September and October, driven by commercial demand for HKD and conversions of offshore RMB (CNH) into HKD. Separately, with yields of short-dated Exchange Fund Bills (EFBS) trading at very low levels amid abundant liquidity following the inflows, the HKMA issued a total of $75 billion worth of additional EFBs between August and December to meet banks' strong demand for the papers. The additional issuance brought about a corresponding decline in the Aggregate Balance. Nonetheless, as net inflows exceeded the additional issuance of EFBS during the year, the Aggregate Balance increased from $239.2 billion at the end of 2014 to $391.3 billion at the end of 2015.

14 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.

81