Record of Discussion of the Meeting of the Exchange Fund Advisory Committee Sub-Committee on Currency Board Operations held on 7 March 2003
(Approved for Issue by the Exchange Fund Advisory Committee on 27 March 2003)
Currency Board Operations for the Period 30 January - 21 February 2003
1. The Sub-Committee noted that monetary conditions continued to
be stable during the period under review. The Monetary Base
contracted by around HK$13 billion, largely as a result of the
reduced public demand for cash after the Chinese New Year. Interest
rates continued to be low and close to their US dollar
12-month forward points for the Hong Kong dollar remained generally stable, at below 200 pips.
2. The Sub-Committee noted that, in accordance with Currency Board principles, changes in the Monetary Base during the reporting period had been fully matched by changes in foreign reserves.
3. The report on Currency Board operations for the period under review is at Annex A.
Monitoring of Risks and Vulnerabilities
4. The Sub-Committee noted that global growth had moderated and that the near-term outlook was clouded by international tensions. Further signs of weakness had emerged in Japan and Europe, where the European Central Bank had revised downwards its growth forecast for 2003 and had cut its refinance rate from 2.75% to 2.5%, the lowest level in four years. Members noted an analysis that suggested that the risk of deflation in the US was low, particularly in view of the weakening US dollar and the rise in oil prices.
5. The Sub-Committee noted that, domestically, Hong Kong's exports had continued to grow strongly, and there were signs of improvement in domestic demand. This momentum was expected to continue, with domestic demand being helped by continued strong growth in export earnings, which would benefit from external trade growth in Mainland China and the weakening of the US dollar. The outlook was, however, subject to a number of uncertainties, including the impact on the global economy of the current international tensions.
6. The Sub-Committee noted a preliminary assessment of the macro-economic impact of the Government budget. Members noted that the budget implied a continued expansionary stance in fiscal policy for the financial year 2003-04, with the fiscal impulse estimated to raise real GDP growth by 0.7 of a percentage point. Members also noted that, over the medium term, the specification of a number of concrete measures on both the revenue and expenditure side should help increase the credibility of the Government's medium-term consolidation strategy. The Sub-Committee noted that the response of the market to the budget had been generally calm, with 1-year forward points for the Hong Kong dollar remaining stable at below 200 pips.
The Impact of the Hong Kong Dollar Risk Premium on the Performance of the Banking Sector
7. The Sub-Committee noted a paper assessing the effects of a rise in the Hong Kong dollar risk premium on the banking sector's performance, based on the experience of the last decade and using the aggregated profit position of retail banks as a measure of performance. The findings of the paper suggested that an increase in the risk premium (as measured by the spread of the Hong Kong dollar interest rate over the US dollar rate) by 125 bps tended to reduce the net interest margin of banks by 6 bps in the same quarter and by a cumulative 16 bps in the long run. In contrast, a similar increase resulting from a change in the US dollar interest rate had no material impact on profitability. The paper also found that an increase in the risk premium would impact on banks' profitability through a negative effect on the asset quality. Members observed that performance would vary from bank to bank depending, for example, on whether a bank was a net lender or a net borrower in the interbank market.
Comparing Inflation Dynamics of Hong Kong and Singapore
8. The Sub-Committee considered a paper comparing inflation dynamics in Hong Kong and Singapore, both of which were small and open economies but with key differences in their monetary policies. In Hong Kong, under the Linked Exchange Rate system, any adjustment in the real effective exchange rate would fall entirely on domestic prices. In Singapore, where the Singapore dollar floated against a basket of currencies within an undisclosed band that was subject to regular review and adjustment with a view to promoting price stability and sustainable growth, both the nominal exchange rate and domestic prices could adjust in the face of a shock. The empirical analysis related CPI inflation to cost factors including import prices, unit labour cost and property rentals. The results suggested that the CPI adjusted more quickly to shocks in cost variables in Hong Kong than in Singapore. This appeared to support the hypothesis that the rational response of firms under a macroeconomic policy centred on price instead of exchange rate stability tended to perceive any changes in costs as transitory and likely to be offset by exchange rate movements, and therefore generally to refrain from immediately passing increases or decreases in them on to consumers. Nevertheless, the estimates suggested complete import price passthrough to retail prices of imported consumer goods in the long run in both economies.
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Hong Kong Monetary Authority
28 March 2003