The Hong Kong dollar has been showing a tendency to strengthen in recent months, although it has weakened somewhat in the past few days. Hong Kong's Currency Board system has been able to handle this well.
Shortly before the Lunar New Year holidays, on 19 January, I gave a speech on some of the issues in monetary policy that Hong Kong now faces. It was an attempt to answer many of the queries and doubts raised concerning the operation of the Currency Board system at a time when the exchange rate was exhibiting a tendency to strengthen.
Although there was in 1987 a similar episode of strength in the Hong Kong dollar, when the US dollar weakened sharply against other foreign currencies, the structure of our system has since undergone significant modifications, which make quite a difference to the way in which our system handles such a tendency. Then, the monetary base was yet undefined. The HKMA was not yet in existence. The banks were not yet required to operate clearing accounts with the authorities. Then, the only mechanisms for dealing with the substantial inflow of funds into the Hong Kong dollar were exchange market intervention and the threat of negative interest rates. And without the HKMA operating the clearing system, any negative interest rates would have had to be promulgated through rules made by the Hong Kong Association of Banks.
Now, with all the licensed banks maintaining Hong Kong dollar clearing accounts with the HKMA, and the Monetary Base consequently well defined, when there are inflows into the Hong Kong dollar to the extent that US dollars are put to the HKMA, the Aggregate Balance in the clearing accounts of the banks (a key component of the Monetary Base) will increase. The size of the Aggregate Balance is determined by the amount of US dollars put to the HKMA. In line with the Currency Board mechanism, the role of the HKMA is to take those US dollars and create the corresponding Hong Kong dollars by crediting the clearing accounts of the banks selling US dollars the required amounts in Hong Kong dollars. This is a mechanical process involving no discretion on the part of the HKMA, other than the determination of the level of the exchange rate at which to accept offers in US dollars.
Thus the use of the word "intervention" is in fact rather inappropriate, in view of its connotation that deliberate action on the part of the HKMA is involved. A much more accurate description is the sale of US dollars by banks in Hong Kong, for whatever reason, to the HKMA under the Currency Board arrangements. I am glad that, with more explanation from the HKMA, and greater understanding by commentators on the mechanics of the Linked Exchange Rate system when the exchange rate is on the strong side, there is now more accurate reporting of what is going on. Consequently, I hope that there is less anxiety over the increase in the size of the Aggregate Balance. Indeed, the Aggregate Balance can become very large if there is continuous inflow into the Hong Kong dollar and US dollar is put to the HKMA.
To the HKMA, the passive purchase of US dollars from the banks through the creation of Hong Kong dollars will mean an increase in US dollar assets that earn some interest and a corresponding increase in Hong Kong dollar liabilities that cost no interest. The HKMA will thus be making profits for the account of the Exchange Fund. The larger the Aggregate Balance, the larger will be the profits. With an interest rate differential of one per cent and an Aggregate Balance of, say, HK$50 billion, the HKMA makes a profit of HK$1.37 million a day or HK$500 million a year for the account of the Exchange Fund.
To be sure, a large Aggregate Balance does mean very loose monetary conditions, which may encourage monetary expansion to the extent of generating inflationary pressures. At a time when credit demand is still depressed, and there is still high unemployment and substantial deflation (measured by the year-on-year changes in the consumer price indices), they are not of immediate concern. But obviously we should all bear in mind the possibility of another bubble developing. I hope that the lessons learnt from the past are still fresh in our minds: we have all seen how the bursting of a bubble can be very damaging on the economy as a whole.
Joseph Yam
5 February 2004
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