(Approved for Issue by the Exchange Fund Advisory Committee on 25 March 2004)
Report on Currency Board Operations (29 January - 20 February 2004)
The Sub-Committee noted that the Hong Kong dollar had continued to be stable during the reporting period, and that the difference between the market rate of the dollar and the Linked rate had narrowed further since the reporting period. Interest rates had risen briefly in early February on concerns about avian influenza, but they had subsequently softened. The Aggregate Balance had remained largely flat, at around $55 bn, following the substantial increases in January. Members observed that the Currency Board arrangements were working effectively.
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 the foreign reserves.
The report on Currency Board operations for the period under review is at Annex A.
Monitoring of Risks and Vulnerabilities
The Sub-Committee noted that growth in the US continued to gather momentum, and that Japan had shown exceptionally strong growth in the fourth quarter of 2003. Recent indicators showed that the recovery in Hong Kong was deepening, and Members noted that some private institutions had revised upwards their growth projections for 2004. The risks to Hong Kong's monetary system appeared to have declined, as the economy improved, the balance of payments continued to show a large surplus, and the Hong Kong dollar exchange rate remained on the strong side.
Issuance of Exchange Fund Paper to Reduce the Aggregate Balance
The Sub-Committee considered a paper examining the need, consistency with Currency Board principles, effectiveness, and technical considerations of issuing Exchange Fund paper to mop up interbank liquidity in the light of the substantial increase in the size of the Aggregate Balance in recent months. Members noted that such a measure could be undertaken in one of a number of possible scenarios under which the current strength of the Hong Kong dollar might unfold, that is, the size of the Aggregate Balance and the associated loose monetary conditions became a matter of concern. Other scenarios included the Aggregate Balance increasing to a size where the total opportunity cost to the banking sector exceeded the perceived risk of the alternative (i.e. appreciation of the Hong Kong dollar), resulting in banks switching out of Hong Kong dollars; the imposition of charges on large balances maintained by banks in their clearing accounts held with the HKMA; and allowing low nominal and real interest rates to continue to play their role in facilitating economic recovery until, through the normal operation of the Currency Board system, equilibrium was gradually restored.
Members agreed that the issue of Exchange Fund paper to mop up interbank liquidity would be consistent with Currency Board principles: Exchange Fund paper was a component of the Monetary Base, and such a measure would involve no change in the size of the Monetary Base. Members noted, however, that there was a possibility that the measure might be perceived in the market as a form of sterilised intervention.
Members had doubts about whether there was a need, in present circumstances, to reduce the Aggregate Balance in this way. Members observed that under the Currency Board system low interest rates, resulting from inflow of funds, were the only monetary tool available for facilitating economic recovery, and that asset price increases were a legitimate channel through which monetary expansion could be transmitted to achieve economic recovery. Members observed that Hong Kong was currently experiencing economic recovery and a normalisation in asset prices. It was too early to conclude if there was an asset price bubble. A large Aggregate Balance was a symptom, rather than a cause, of current monetary conditions.
Members also had some doubts about the effectiveness of such a measure. While noting that the issue of additional Exchange Fund paper could provide a buffer in dealing with the monetary consequences of inflows of funds, Members noted the small scope of interest rate tightening and the limited effect of interest rates on asset prices. Members also expressed concerns that in certain circumstances the opposite might be achieved. By tightening interbank liquidity and putting upward pressure on Hong Kong dollar interest rates, the issue of Exchange Fund paper could lead to further inflows of funds.
The Sub-Committee advised that there was no need in present circumstances to issue additional Exchange Fund paper to mop up interbank liquidity.
Movements in the Backing Ratio
The Sub-Committee noted an information paper analysing the factors in the steady decline in the level of the Backing Ratio (i.e. the ratio of the Backing Assets to the Monetary Base) since September 2003. Members noted that in the first eight months of 2003 the Backing Ratio had been at around 112%, which was close to the upper trigger of 112.5% (at which assets would be transferred out of the backing portfolio to the investment portfolio of the Exchange Fund assets to bring the ratio to 110%). Since September the Backing Ratio had gradually declined to 109.2% on 13 February 2004.
Members noted the analysis in the paper that the main reason for the decline in the Backing Ratio was the increase in the Aggregate Balance. Even though the sales of Hong Kong dollars had led to matched increases in the Backing Assets and the Monetary Base, the fractional increase in the former was smaller owing to its being larger than the latter.
Sources of Unemployment
The Sub-Committee noted an information paper examining the underlying sources of the relatively high rate of unemployment seen in Hong Kong in recent years. Consistent with research carried out for the Sub-Committee in 2001, the paper found that the main drivers of unemployment were cyclical, although there were signs that the natural rate of unemployment may have risen, from 2-3% in the late 1980s to 3-4% in recent years, as a result of the considerable structural changes taking place in the economy.
Members noted that the 15-19 age group had a markedly higher rate of unemployment than other age groups and that the construction sector had suffered most from unemployment, while the services sector had fared better.
A Simple Measure of Underlying Inflation: Estimates for Hong Kong and the Mainland
The Sub-Committee noted an information paper on measures of underlying inflation for Hong Kong and Mainland China. The analysis in the paper used a simple measure made by means of a statistical model that decomposed the monthly change in the CPI into the underlying rate of inflation and changes due to price-level shocks. The paper found that, under this model, deflation in Hong Kong had ended in the second half of 2003 but that inflation had not yet taken hold, and that inflationary pressures were rising on the Mainland.
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Kevin Ip, Manager (Press), at 2878 1687 or
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Hong Kong Monetary Authority
26 March 2004
