Additional issuance of Exchange Fund paper

The HKMA has been issuing additional Exchange Fund Paper to meet market demand.

Readers may have noted that the HKMA has been expanding the issuance of the Exchange Fund Bills recently. In early 2008, the HKMA launched an ad hoc issue of $6 billion Exchange Fund Bills. This was mainly to address demand for the paper for intraday liquidity to meet settlement obligations through the Real Time Gross Settlement system, largely driven by the increase in equity-market transactions. At that time, the demand for the paper was so strong that the yield of short-dated Exchange Fund Bills actually dipped into negative territory at one point.

After the collapse of Lehman Brothers last September, banks' demand for short-dated Exchange Fund paper surged again, but this time it was due more to a flight to safety caused by heightened credit and liquidity concerns. Given their concern about counterparty risks, banks preferred to park their surplus funds in short-dated Exchange Fund paper. Such holdings also helped them manage their liquidity, allowing them to use the Exchange Fund paper to conduct repurchase (or "repo") transactions to obtain Hong Kong-dollar funds from the HKMA through the Discount Window.

To meet this increased demand, the HKMA has been issuing more Exchange Fund Bills since October last year with the increased issuance reaching a total of $72.8 billion by the end of March 2009, on top of the stock of Exchange Fund Bills and Notes of about $145 billion at the end of September 2008. The expansion of the issuance of Exchange Fund paper is consistent with the principles of our Currency Board in that the Monetary Base remains fully backed by foreign reserves. The backing of the additional issuance can be achieved in two ways: a back-to-back purchase of US dollars against Hong Kong dollars, or a transfer within the Monetary Base from the Aggregate Balance to Exchange Fund paper. No matter which method is used for the additional issuance, the primary objective is to satisfy the increased demand for the short-dated paper without unduly affecting monetary conditions.

So far, the bulk of the additional Exchange Fund paper has been issued making use of the Aggregate Balance. While the additional issuance leads to a reduction in the Aggregate Balance, the impact on interbank interest rates has been negligible because the Aggregate Balance — which is the sum of the balances in the banks' clearing accounts with the HKMA — remains very large: it was $168 billion on 23 April. This means that there is still ample liquidity in the market.

That the expansion has been smooth is also shown by the continuing low yields of short-dated Exchange Fund Bills, with three-month Bills currently yielding only a few basis points. This suggests that demand for the paper for liquidity management remains strong. Although the yields are low, it is still preferable for the banks to hold the paper than to maintain non-interest-bearing balances in their clearing accounts.

We will continue to monitor developments in the Exchange Fund-paper market and consider the need to issue more paper if there is demand for it and such issuance will not affect monetary conditions.

Edmond Lau
Executive Director (Monetary Management)
23 April 2009

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