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Record of Discussion of the Meeting of
the Exchange Fund Advisory Committee
Sub-Committee on Currency Board Operations held on 7 January 2000

(Approved for Issue by the Exchange Fund Advisory Committee on 20 January 2000)

Note: The Financial Secretary, on the advice of the Exchange Fund Advisory Committee (EFAC), has approved the arrangements for the transfer of funds between the backing and investment portfolios recommended by the Sub-Committee in paragraphs 6 to 10 of this Record.

Currency Board Operations for the Period 25 November - 30 December 1999

The Sub-Committee noted that during the period covered by the report there was continued strong demand for Hong Kong dollar investments as a result of positive economic news, increased activity in the equity market, and perceptions of Hong Kong as a Year 2000 safe haven. The market exchange rate for the Hong Kong dollar strengthened moderately relative to the convertibility rate in respect of the Aggregate Balance. Interbank interest rates moved on a general up trend to the last business day of 1999, reflecting partly a premium on interbank borrowing straddling 1 January 2000. The monetary base increased from HK$200.18 bn to HK$234.63 bn during this period, reflecting seasonal demand for cash during the holiday period and an increase in cash holdings as the Year 2000 drew near. Members noted that the Aggregate Balance was as high as HK$7.96 bn on 30 December, its highest level since the introduction of the seven technical measures in September 1998.

2. The report on Currency Board operations for the period under review is at Annex A.

Report on Selected Millennium Indicators for the period 25 November - 30 December 1999

3. The Sub-Committee noted the last of the regular monthly reports on selected millennium indicators, which covered the period from 25 November to 30 December 1999. Members observed that the smooth transition of Hong Kong's financial sector into the Year 2000 had been accompanied by a generally confident and rational approach to the issue in the markets and among the general public. Banknotes in circulation had increased significantly during the period under review, with the outstanding amount of Certificates of Indebtedness rising from HK$91.7 bn at the end of November, to HK$109.2 bn ahead of the Christmas holidays, and further to HK$118.2 bn at the end of December. This increase of HK$26.5 bn during the month of December compared with a usual increase of around HK$5 bn during the Christmas period over the past few years. The increase in banknotes in circulation reflected an increase in cash holdings by both banks and the general public.

4. The Sub-Committee noted an increase during the period under review in the proportion of Exchange Fund paper held by banks (from 82% to 87%) and a moderate widening of the differential between HIBOR and the yields on Exchange Fund Bills and Notes. This reflected the strong demand for Exchange Fund paper from banks resulting from both the high liquidity in the banking system and the demand for Exchange Fund paper for the purpose of liquidity management as the Year 2000 drew near. Members observed that the differential had narrowed since the passage into the new year. Members further noted a kink in the Hong Kong dollar yield curve in the 1-week area in late December, a phenomenon that was also observable for other major currencies.

5. The Sub-Committee noted that no use had so far been made of the enlarged Discount Window facility or of the term repo facility introduced in the context of the Year 2000 issue, and that even borrowing under the regular Discount Window had declined substantially as a result of the increased liquidity in the banking system.

Movement of the backing ratio

6. Further to its consideration of various scenarios relating to movements in the backing ratio at its meeting in March 1999, the Sub-Committee considered a paper on policy issues relating to the movement of the backing ratio. Members noted the analyses in the paper of past movements and future projections of the backing ratio. In general, the backing ratio had been gradually rising from around 108% at the end of 1998 to 111% at the end of November 1999. According to projections, the backing ratio was expected to continue to rise over the course of the next twelve months. Members noted that, in general, three factors affected the movement of the backing ratio: autonomous changes in the monetary base; net investment income; and revaluation gains and losses. Of these factors, net investment income was the main driving force behind the rise.

7. Given the continuing rise in the backing ratio, and the fact that the assets in the backing portfolio, because of the requirement that they be highly liquid, generally earn a lower rate of return than do those in the investment portfolio, the Sub-Committee considered various options for containing or reducing the ratio, through either expanding the monetary base or transferring excess assets out of the backing portfolio.

8. With regard to the option of enlarging the monetary base, Members concluded that the only practical way of achieving this would be through deliberate issuance of additional Exchange Fund paper (which would, via market forces, attract roughly equivalent inflows, thereby increasing the monetary base and lowering the backing ratio). Members noted, however, that there were already clear guidelines for issuance of Exchange Fund paper, which were operating smoothly, and that there was no economic rationale for allowing movements in the backing ratio to determine adjustments to the monetary base. It was also noted that in some circumstances private sector debt issuance might be crowded out by additional Exchange Fund paper. In sum, Members were not attracted by this option.

9. Members preferred that a framework should be established whereby surplus assets in the backing portfolio could be transferred to the investment portfolio. They concluded that it would be desirable to establish a trigger point for the backing ratio that would stop it rising above a particular level; and that, in the event of the ratio falling rather than rising, there should similarly be a lower trigger point at which assets would be injected into the backing portfolio.

10. Specifically, the Sub-Committee recommended that on the high side the trigger point should be set at 112.5%; normally, when the backing ratio reached this point, assets should be moved out of the backing portfolio, sufficient to reduce the ratio to 110%. On the other side, it was recommended that 105% be set as the trigger point at which, normally, assets would be transferred into the backing portfolio, sufficient to restore the ratio to 107.5%. This formula provided symmetry and the arrangements would ensure that there would always be adequate, liquid assets in the backing portfolio, while allowing assets which were clearly surplus to the narrow needs of that portfolio to be managed more flexibly in the investment portfolio. Moreover, there would be no effect on the monetary base.

Settlement of Foreign Exchange Transactions Conducted by the HKMA

11. The Sub-Committee considered a paper on the settlement of foreign exchange transactions conducted by the HKMA. Members explored the question of whether, in order possibly to improve the interest rate adjustment mechanism, there was a need to offer the Convertibility Undertaking on a T+0 rather than a T+2 basis. The Sub-Committee also considered the question of whether the practice of retaining flexibility to sell Hong Kong dollars on the strong side on a T+0 basis should continue. Members advised that, while it would be technically feasible to move the Convertibility Undertaking to a T+0 basis, the status quo should continue because it reflected market convention and because no clear benefits were apparent in a proposed change in the arrangements. Members also advised that the flexibility to sell Hong Kong dollars on the strong side on a T+0 basis should also continue and that the T+0 rate quoted in such cases should continue to be determined by reference to the spot (T+2) rate in the market and the differential between the Hong Kong dollar rate at which two-day funding might have been available to the counterparty and US dollar short-term market interest rates. Members considered, however, that changing circumstances (such as changing market conventions or the introduction of a two-way Convertibility Undertaking) could warrant a revisiting of the present arrangements.

Future meetings

12. The Sub-Committee considered its schedule of meetings for the coming year and decided that, in the absence of any urgent issues for which special meetings might need to be arranged, future meetings should take place once every two months.

Last revision date: 1 August 2011
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