HKMA market operations

inSight

13 Nov 2008

HKMA market operations

Recent actions by the HKMA have begun to have the desired effect.

Readers will have seen reports of market operations by the HKMA in the press in recent weeks and may be interested in what we have been doing and why, and what effects our actions have had.

Readers may recall that we introduced three refinements to the operation of the Linked Exchange Rate system on 18 May 2005. Among other things, these introduced a strong-side Convertibility Undertaking at the rate of 7.75 Hong Kong dollars to one US dollar. When this strong-side Convertibility Undertaking is triggered – that is, when the exchange rate reaches 7.75 – the HKMA will sell Hong Kong dollars against US dollars in response to demand from banks. In addition, the refinements allowed the HKMA to conduct market operations within the Convertibility Zone of 7.75 to 7.85 Hong Kong dollars to one US dollar, taking into account market conditions.

Since September, the HKMA has injected HK$44.2 billion into the Aggregate Balance – the sum of the clearing-account balances held by banks kept with the HKMA - by buying US dollars against Hong Kong dollars. Some of these operations were conducted within the Convertibility Zone and some when the strong-side Convertibility Undertaking was triggered. The nature of these operations is different but both result in a larger Aggregate Balance.

After Lehman Brothers filed for bankruptcy in the US on 15 September, global money markets seized up, reflecting increased concern about credit and liquidity conditions. This led to uncertainty about whether funding could be obtained through the usual channel of the interbank money markets and banks began to refrain from lending to each other, and to other sectors, and their demand for liquidity increased markedly as they held on to funding to meet their obligations. At the same time in Hong Kong, a brief run on a local bank, resulting from unfounded rumours about its stability, led to further tightness in the money market as banks became concerned that possible withdrawals by nervous depositors might increase pressure on their funding.

Against this background, local interest rates rose, narrowing the gap between Hong Kong-dollar and US-dollar interest rates; this in turn led to a strengthening of the Hong Kong-dollar exchange rate. In view of the strong liquidity demand for Hong Kong dollars, the HKMA conducted a number of market operations involving the purchase of US dollars against Hong Kong dollars, consistent with Currency Board principles. Such operations caused the Aggregate Balance to increase by HK$24.8 billion. In fact it was the strengthening of the Hong Kong-dollar exchange rate that provided room for us to operate within the Convertibility Zone without affecting exchange-rate stability. In the event of any weakening of the exchange rate, the scope to inject liquidity would be greatly limited, since any such injection could put further downward pressure on the exchange rate.

The Hong Kong dollar exchange rate remained strong in late October and again firmed to near the strong-side Convertibility Undertaking rate. The strong demand for Hong Kong dollars was probably due to repatriation of funds and unwinding of interest carry trades as global financial jitters led market participants to deleverage and reduce their exposure to risk. The CU has been triggered 10 times since 31 October, obliging the HKMA to sell Hong Kong dollars against US dollars and leading the Aggregate Balance to increase by a further HK$19.4 billion. All these operations were in response to the strong-side pressure on the exchange rate under the currency-board arrangement.

In response to the much larger Aggregate Balance and the HKMA's measures to improve liquidity, local interbank rates eased across the board. For example, overnight HIBOR rose to 4% on 18 September but has eased to 0.2% lately, while one-month HIBOR rose to a high of 6% and has retreated to 1.1%. This process was also helped by efforts around the world to provide liquidity to the markets, coupled with an improvement in market sentiment. Lower interbank short-term rates should provide a more accommodative monetary environment and allow banks to pass on lower funding costs to sound borrowers, although this may not happen straight away.

The interbank money market is showing signs of gradual improvement, although interbank lending for longer tenors remains limited as credit risks persist. It will take time - and the absence of any further nasty surprises - for the money market to return to normal functioning. In the meantime, interest-rate volatility may continue given fragile sentiment and market uncertainties. There is thus a need for all parties concerned – banks and their customers – to remain prudent in the management of interest-rate risk under the current market conditions. We at the HKMA will of course continue to monitor the markets and stand ready to take further measures if necessary in the light of developments.

Joseph Yam
13 November 2008

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Last revision date : 13 November 2008