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A Record of Discussion of
the Exchange Fund Advisory Committee
Sub-Committee on Currency Board Operations on 9 April 1999

(Approved for Issue by the Exchange Fund Advisory Committee on 22 April 1999)

Operations of the Currency Board Arrangements

The Sub-Committee noted that during the review period from 1 to 26 March 1999, changes in the size of the monetary base were fully matched by corresponding changes in the foreign reserves in accordance with the rules of the Currency Board arrangements. It was also noted that the HK dollar exchange rate strengthened slightly in early March, and the HKMA sold some HK dollars for US dollars in response to offers by a few banks. This increased the Aggregate Balance, which in turn led to an easing in interbank interest rates. The exchange rate weakened briefly in mid-March to touch the convertibility rate of 7.7500 and the HKMA bought HK dollars under the Convertibility Undertaking, after which the exchange rate strengthened to 7.7490 and stayed around that level until the end of the review period. The report on currency board operations for the period under review is at Annex A.

2. Members further noted that the convertibility rate in respect of the Aggregate Balance began to move by 1 pip per calendar day with effect from 1 April 1999 in order to gradually bring the rate, originally at 7.75, in line with that applicable to Certificates of Indebtedness which was fixed at 7.80. In the first few days of April, there had been some selling of HK dollars in the market in an attempt to exploit short-term arbitrage opportunities, and the HKMA sold some US dollars under the Convertibility Undertaking. Thereafter, there had been some capital inflows that contributed to an increase in interbank liquidity and a drop in interbank interest rates. HK$ interest rate spreads over US$ rates had narrowed accordingly.

Transferability between Certificates of Indebtedness and Aggregate Balance

3. The Sub-Committee noted that under the existing system, Certificates of Indebtedness ("CIs") were issued and redeemed against US$ at the rate of US$1 to HK$ 7.80. The system did not allow direct transferability between CIs and the Aggregate Balance and the feasibility and desirability of allowing such a transferability had to be examined. It was nevertheless noted that the convertibility rates applicable to CIs and the Aggregate Balance were different at present, and the two rates would only be aligned in August 2000. So long as the rates remained different, allowing transferability between CIs and the Aggregate Balance would give the note issuing banks an option to convert the two components into US dollars at different convertibility rates, leading to arbitrage opportunities. Such arbitrage opportunities, however, would not close the gap between the market exchange rate and the linked rate of 7.80, since the HKMA would stand ready to convert the Aggregate Balance at a rate stronger than 7.80 until the convertibility rate converged to 7.80. If, on the other hand, CIs were only issued and redeemed against the Aggregate Balance in HK$, the convertibility rate for CIs would effectively become that applicable to the Aggregate Balance, which would remain stronger than 7.80 prior to August 2000. In other words, before the convertibility rates for CIs and the Aggregate Balance were aligned, there would not be scope for considering transferability between CIs and the Aggregate Balance.

4. In the circumstances, the Sub-Committee agreed that the existing arrangements should continue, although such transferability was considered as a desirable long-run goal. This issue should be revisited when the convertibility rate for the Aggregate Balance converged to 7.80.


Provision of Lender of Last Resort under the Currency Board System

5. The Sub-Committee noted that the Banking Sector Consultancy Study had raised, among other issues, the need to clarify the role of the HKMA as the Lender of Last Resort. The rules of the currency board arrangements required that any increment to the monetary base be fully backed by an increase in foreign currency reserves. This imposed a constraint on the ability of the HKMA to accommodate a demand for short-term liquidity by banks through increasing the monetary base. Members nevertheless noted that there were a number of channels through which Lender of Last Resort support could be effected in a manner consistent with the rules of the currency board arrangements. For example, the HKMA might fund liquidity support to banks through borrowing in the interbank market, uplifting its HK dollar deposits/selling HK dollar assets, or selling foreign currency assets outside those earmarked for the Backing Portfolio. These operations would leave the Aggregate Balance unchanged. The HKMA could also provide liquidity support through repos involving Exchange Fund paper or US$ denominated assets as collateral, or extend US dollar loans to the banks concerned.

6. The Sub-Committee further noted that, under extreme market conditions not directly related to pressure on the exchange rate, there might be justification for the HKMA to inject liquidity into the interbank market temporarily to ensure systemic stability. Nevertheless, adequate checks and balances would need to be put in place to ensure that the extension of liquidity support in this manner would enhance rather than undermine the resilience and credibility of the currency board arrangements.

7. Members agreed that all these options for providing Lender of Last Resort support to banks facing short-term liquidity problems should be left open. It was noted that, for practical reasons, the need for currency board systems to perform the role of Lender of Last Resort was gaining increasing acceptance.

Hong Kong Monetary Authority

26 April 1999

Last revision date: 1 August 2011
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