Record of Discussion of the Meeting of
the Exchange Fund Advisory Committee
Sub-Committee on Currency Board Operations held on 31 August
(Approved for Issue by the Exchange Fund Advisory Committee on 21 September 2000)
Currency Board Operations for the Period 1 - 20 August 2000
1. The Sub-Committee noted that, during the period under review, the Hong Kong dollar exchange rate remained stable. The main highlight of this period was the convergence, on 12 August, of the Convertibility Undertaking in respect of the Aggregate Balance with the Convertibility Undertaking for Certificates of Indebtedness, completing the 500-day transition period. Members observed that in early August there had been a considerable widening of the differentials between Hong Kong dollar and US dollar interest rates, with historically large negative spreads in the first week of August. This was understood to reflect an underlying demand for Hong Kong dollar assets, particularly equities, and some uncertainty in the market about the strategy the HKMA would follow after the convergence of the Convertibility Undertakings on 12 August, which had encouraged some banks to reduce their US dollar positions. As the Aggregate Balance shrank to a negative level on 17 August, the negative spreads between Hong Kong dollar and US dollar interest rates had substantially narrowed. Members noted that during this period the backing ratio had increased from 110.76% to 111.07%. They also noted that, in accordance with the Currency Board principle, all changes in the monetary base were fully matched by corresponding changes in foreign reserves.
2. The report on Currency Board operations for the period under review is at Annex A.
Strong-Side Operation Strategy
3. The Sub-Committee considered a paper outlining the HKMA's strategy in conducting foreign exchange operations on the strong side of the linked exchange rate. Members agreed that the complex interaction of a number of different circumstances that could trigger the sale by the HKMA of Hong Kong dollars for US dollars tended to preclude the prescription of any specific rule for intervention on the strong side. Among these circumstances were: speculative inflows into the Hong Kong dollar; a significant, non-speculative increase in the demand for Hong Kong dollars; a sharp shrinkage in the aggregate balance arising from speculative outflows or large commercial selling orders; and individual banks offering to sell US dollars to the HKMA to meet their liquidity needs or to adjust their portfolios. Members observed that the difficulty of devising a precise framework for deciding how these and other factors should be weighed in different circumstances, coupled with the lack of operational experience of the system and of how the market might interpret the HKMA's actions, added to the arguments against introducing specific rules to govern operations on the strong side.
4. Members noted, however, the dangers both of injecting liquidity too quickly into the system when the Aggregate Balance dipped below zero, which could give rise to perceptions that the HKMA was seeking to suppress the working of the interest rate adjustment mechanism and reduce the incentive for banks to obtain Hong Kong dollars on their own initiative, and of acting too slowly, which could lead to unnecessarily large fluctuations in the exchange rate and interest rates. They agreed that, in simple, conceptual terms, the HKMA should take account of three main factors, working in synergy, in formulating an appropriate response. These factors were: the spread of the exchange rate from the level of 7.8000, the interest rate differential between the Hong Kong dollar and the US dollar, and the level of the Aggregate Balance. The courses of action open to the HKMA on the strong side of the link could be categorised in the following way:
|No action : the HKMA normally would not accept offers to sell US dollars|
|Passive : the HKMA is prepared to consider offers from banks|
|Discretionary : the HKMA may adopt a more active approach in purchasing US dollars|
Having noted this conceptual framework, Members agreed that the HKMA should continue to exercise flexibility in its operations on the strong side, in view of the complexity of circumstances giving rise to market conditions.
Decomposing Changes in the Backing Ratio
5. The Sub-Committee noted an information paper on certain refinements to the methodology for decomposing past changes in the backing ratio into three components: autonomous changes in the monetary base, net interest income from investments, and revaluation gains (or losses). The main aim of the refinements was to correct significant distortions arising out of an accounting practice of including interest earned on discount paper (mainly US Treasury bills) in revaluation gains or losses. The refined method provided a more accurate analysis of the factors contributing to the movements in the ratio: it showed that the rise in the ratio over the past year had been almost entirely attributable to net investment income, which suggested that the introduction of the 112.5% trigger level was a prudent measure. Members noted that similar decomposition exercises would be conducted in the future.
A Monetary Conditions Index for Hong Kong
6. Members considered an information paper that presented an estimate of a Monetary Conditions Index (MCI) for Hong Kong, which was a weighted sum of the real interest rate and the real effective exchange rate (REER), with weights reflecting the relative effects of the two variables on aggregate demand. Members noted that the MCI was a simplified, composite indicator, and one of a number of indicators of monetary and financial conditions. They further noted that under the linked exchange rate system, movements in both interest rates and the effective exchange rate were exogenous. They therefore observed that the MCI should be viewed exclusively as an indicator of monetary and financial conditions, rather than a measure of monetary policy stance. Members also remarked that, while an MCI had uses for academic purposes, there were a number of problems in using it as an instrument for deciding monetary policy, even in floating exchange rate regimes. The Sub-Committee noted that analysis using the MCI suggested that swings in the REER resulting from the Asian financial crisis had led to tighter, and subsequently easier, financial conditions than were indicated by changes in the real interest rate alone.
Seasonal Adjustment of Hong Kong's Monetary Statistics
7. The Sub-Committee noted an information paper on the seasonal adjustment of Hong Kong's monetary statistics, using special high-frequency filtering to take account of increased currency holdings in the Chinese New Year season and an adjustment for the increase in cash demand associated with Y2K as well as increases in demand deposits due to initial public offers (IPOs), in addition to conventional techniques. Members noted that seasonally adjusted currency, demand deposits and Hong Kong dollar M1 series would be published in the HKMA's Monthly Statistical Bulletin in the near future.
Exchange Fund Bills and Notes Programme
8. Members noted a consultation paper issued to the Hong Kong Capital Markets Association on possible measures to promote primary and secondary market activities in Exchange Fund Notes, and outlining a proposed scheme to reduce the concentration of Exchange Fund paper at the short end through the replacement of some Exchange Fund Bills issues by longer-term Exchange Fund Note issues.
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Hong Kong Monetary Authority
28 September 2000