The recent refinements to Hong Kong's Linked Exchange Rate system have had their intended effect.
It has been a little over four weeks now since the introduction of the three refinements to the operation of the Linked Exchange Rate system. So far the refinements seem to have achieved the purposes they were designed for. Expectation about the extent to which the exchange rate may appreciate has been well anchored and limited by the new, strong-side Convertibility Undertaking (CU) at 7.75. The residual "hot money" that had come into and stubbornly stayed in Hong Kong, using the Hong Kong dollar as an instrument for betting on a revaluation of the renminbi exchange rate, has departed quickly. Monetary conditions in Hong Kong have returned to normal, with Hong Kong dollar interest rates closely tracking those for the US dollar. It may be that this would have happened anyway without the three refinements, given the reduced, short-term prospects of any move in the renminbi exchange rate, but then, without clearly limiting the movement of the exchange rate on the strong side, the hot money could have stayed, as it had done in the previous eighteen months.
It is important for all concerned to understand that the three refinements do not preclude the continuing use, by some, of the Hong Kong dollar as an instrument for speculating on the renminbi, or significant inflows into the Hong Kong dollar in response to the implementation of the expected reform to the renminbi exchange rate system. It is hoped, however, that the clarity of the two-way CU may reduce significantly the extent of these possibilities. Furthermore, even if they occur, their sustainability may be greatly reduced, in that the refinements will have increased the sensitivity of capital flows to the interest rate differential between the Hong Kong dollar and the US dollar. Ultimately, it is confidence in the determination of the Hong Kong Special Administrative Region Government in adhering to the Linked Exchange Rate system that is of key importance.
With the three refinements, the exchange rate will be stable within the rather narrow Convertibility Zone of 1,000 points, or 10 cents, defined by the two-way CU. We feel quite relaxed about possible fluctuations of the exchange rate within the 1,000 points under normal circumstances. It is unlikely that members of the public will even notice these fluctuations. In any case, before the three refinements, the strongest level recorded recently in the exchange rate was 7.70, which is also 1,000 point away from 7.80, where the weak-side CU used to be. But I can understand the anxiety of those active in the foreign exchange market about what our stance might be within the Convertibility Zone. While it would be counter-productive to disclose all our strategies, for indeed they depend very much on prevailing circumstances, it should not be difficult to understand our thinking.
Exchange rate stability is, of course, the monetary policy objective. We therefore have no interest rate policy. In normal circumstances our interest rates track those of the US dollar. However, short-term capital flows, specifically into or out of the Aggregate Balance, given that we have to conduct non-sterilised foreign exchange intervention at levels bounded by the two-way CU, create interest rate volatility. Indeed, temporary deviations of Hong Kong dollar interest rates from US rates are part of the adjustment process under the Currency Board system in response to fund flows to maintain exchange rate stability. However, at times, such volatility can be destabilising and can be manipulated for speculative gains, as we have learnt from the experiences of 1997-98. And so, to the extent that we have the resources to do so and in a manner that does not undermine the credibility of the Linked Exchange Rate system, we would like also to avoid a situation where interest rate differentials become so large and persistent as to possibly jeopardise monetary and financial stability. Hence in 1998 we included Exchange Fund paper as part of the Monetary Base and made it transferable into the Aggregate Balance through the Discount Window. Overall, we would like our interest rates to behave in a manner consistent with the all-important objective of exchange rate stability and with how the Linked Exchange Rate system is supposed to operate. For most of the time we have this, without the need for our presence in the market. But, for one reason or other, market anomalies do occur, from time to time, to an extent that requires our presence to smooth things out. The new measures allow us to do this.
It is a matter of judgement what constitutes market anomalies. It also depends on circumstances, taking account of market dynamics. While it would not be wise to attempt to lay down criteria for making these judgements, it would be unreasonable to expect us to stand on the sidelines if credible evidence emerges of mounting instability in the market or conditions that prevent smooth interest rate adjustments. But we would not attempt to define quantitatively the combination of exchange rate and interest rate conditions which we may cause us concern. Nor is it practicable to describe the exact forms of our possible presence, should we not feel convinced that the anomalies are reasonable. Our intentions are, nevertheless, crystal clear: to preserve exchange rate stability implied by the Linked Exchange Rate System and to promote smooth interest rate adjustments implied by that system.
Joseph Yam
16 June 2005
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