The Monetary Base

inSight

10 Oct 2002

The Monetary Base

The key to achieving any monetary policy objective is effective influence over the monetary base through a monetary mechanism. In Hong Kong the Monetary Base is well defined and amenable to the achievement of the monetary policy objective - whether through discretionary decisions or - under the currency board system chosen for Hong Kong - through rule-based arrangements.

Whatever the monetary policy objective might be, and in Hong Kong this is determined by the Financial Secretary on behalf of Government, achieving it requires a monetary management mechanism through which the responsible authority can exercise effective influence on the monetary base. Readers may not be aware of it, but, notwithstanding our status as an international financial centre, such a monetary management mechanism was virtually non-existent in Hong Kong until the late eighties. What happened then was that certain novel "Accounting Arrangements" were introduced (in 1988) between the responsible authority and the bank acting as the clearing-house of the banking system, which had the desired effect of creating such a mechanism. It was then that the Monetary Base of Hong Kong was first put on to the balance sheet of the Exchange Fund and therefore subject to government influence through activities dedicated to that purpose. Before that, the Monetary Base had been, for a long time, on the balance sheet of a commercial bank, which understandably would not necessarily put the achievement of the monetary policy objective, whatever that might be, ahead of its commercial interests.

It took another eight years before the novel Accounting Arrangements were eventually replaced in 1996 by the more traditional central banking arrangements whereby the HKMA assumed the role as the clearing-house of the banking system. The opportunity of introducing the robust and risk reducing payment arrangements of Real Time Gross Settlement (RTGS) for interbank transactions (this time among the first in the world) presented itself then. Although the Monetary Base and its control for achieving a monetary policy objective in Hong Kong are rather esoteric subjects, for those with an academic or professional interest in the monetary system of Hong Kong an awareness of this significant aspect of Hong Kong's monetary history is essential.

The monetary policy objective of Hong Kong has been, since 17 October 1983, a stable exchange rate against the US dollar at 7.80. The achievement of this objective over the period from 1983 to 1988 was in theory entirely dependent on the note issue arrangement. Bank notes, or rather the certificates of indebtedness giving the authority to the note issuing banks to issue bank notes, were issued and redeemed against US dollars at the fixed exchange rate of 7.80. As bank notes are only one element of the Monetary Base, and as the convertibility of large amounts of bank notes into other forms of money is not guaranteed, this arrangement was actually rather ineffective in the achievement of the monetary policy objective of a stable exchange rate. There was a lot of theoretical talk about bank notes arbitrage, but none in practice occurred on any significant scale. Quite a lot of intervention in the foreign exchange market was in fact needed to stabilise the exchange rate, but, as transparency in Exchange Fund operations was a lot lower then, this was not widely known.

From 1988 to the end of 1996, when the clearing balances of the banks were, through the Accounting Arrangements, held indirectly with the Monetary Affairs Branch and then the HKMA for the account of the Exchange Fund, less foreign exchange intervention was required. The crucial element of the Monetary Base - the clearing balance of the banking system - was indirectly managed, through influencing its size or its price (interbank interest rates), to help achieve the monetary policy objective of exchange rate stability, with notable success. But the discretionary nature in the management of the clearing balance did draw some criticism from academic circles, arguing that this was a departure from the rule-based arrangement of a currency board system. What they did not realise was that the indirect nature (through one commercial bank) of official control of the clearing balance meant that any rule-based arrangement would need also to be operated indirectly through that commercial bank. A convertibility undertaking of the type in force now (clearing balance against US dollars at the fixed rate) would have been open only to one bank and not the others. This would have been considered too unfair to be acceptable.

When RTGS was introduced and all banks started maintaining clearing accounts with the HKMA for the account of the Exchange Fund, the opportunity could have been taken to introduce a convertibility undertaking then. But this was not brought up in view of the need for caution during the sensitive period of political transition in not making too many fundamental changes to the monetary system, which could be misinterpreted. In the event, the Convertibility Undertaking was introduced in 1998 under the stressful circumstances of which we are all aware.

Monetary reform is never straightforward, and it tends, as the experience of other jurisdictions shows, to be crisis induced. In Hong Kong we have not done badly. We have built a proper monetary system, most of the reforms to which were not crisis induced. The Monetary Base is well defined and in the right place. There is a monetary management mechanism to control it effectively, through discretionary decisions or rule-based arrangements (we have chosen the latter) in the achievement of the monetary policy objective determined by the Financial Secretary.

 

Joseph Yam

10 October 2002

 

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Last revision date : 10 October 2002