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Record of Discussion of the Meeting of the Exchange Fund Advisory Committee Sub-Committee on Currency Board Operations held on May 4 2001

(Approved for Issue by the Exchange Fund Advisory Committee on 31 May 2001)

Currency Board Operations for the Period 1 April - 23 April 2001

The Sub-Committee noted that, despite the more volatile external environment, this had been a period of stability for the Hong Kong dollar. The 50 basis point cut in the US Fed Funds Target Rate on 18 April had prompted a sharp drop in interbank interest rates. In mid-April, the spreads between US dollar and Hong Kong dollar interest rates had narrowed at the longer end and had returned to negative at the shorter end. Members noted that there had been no significant movement in the Aggregate Balance, and that the Convertibility Undertaking had not been triggered during the period under review.

2. The Sub-Committee noted that, in accordance with Currency Board principles, changes in the monetary base during the period under review had been fully matched by corresponding changes in foreign reserves.

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

Monitoring of Risks and Vulnerabilities

4. The Sub-Committee noted the regular information paper on external and internal risks facing Hong Kong. The Sub-Committee noted that the more volatile and uncertain external environment presented certain risks. Members focused in particular on the continuing weakness of the Japanese economy. They observed that, while the economic ties in terms of investment and bank lending between regional economies and Japan had substantially decreased since the Asian financial crisis, Japan was still an important influence in the region. The main risk from Japan appeared to be the possibility that any sharp weakening in the yen might trigger a round of competitive depreciation among regional currencies. Although Hong Kong's currency board arrangements had amply demonstrated the resilience of the exchange rate to such events, there might nevertheless be temporary upward pressure on local interest rates, and any lasting depreciation of the region's currencies against the dollar would be likely to spark renewed deflationary pressures within Hong Kong.

5. Within Hong Kong, Members noted an analysis of the impact of stock market developments on the economy, particularly in the light of the sharp corrections in March and early April. Members noted the assessment that the declines so far should have only modest negative effects on economic growth and that the impact on the banking system was likely to be minimal.

Policy on Foreign Exchange Reserves

6. The Sub-Committee considered a discussion paper on the desirability and feasibility of determining the optimal level of foreign exchange reserves for Hong Kong. Members agreed that this was too complex an issue to be dealt with conclusively in a single session and recommended that further research and deliberation on the subject should be carried out.

Use of Interest Rate Swaps

7. The Sub-Committee considered a proposal for using Hong Kong dollar interest rate swaps as a means of reducing the cost of issuing more long-dated Exchange Fund Notes. Members noted that, under the technical measures to strengthen the Currency Board arrangements in September 1998, restrictions had been imposed on the issue of new Exchange Fund paper. In the interests of facilitating market development, however, the HKMA had in June 1999 resumed the issue of ten-year paper through the displacement of shorter Exchange Fund paper. Because of the positively sloping Hong Kong dollar yield curve, and the tendency of the yield margin over US Treasuries to rise along the curve, the increasing proportion of longer paper tended to incur higher interest costs. One way of reducing the cost would be for the HKMA to enter into a set of Hong Kong dollar interest rate swap transactions the maturity of which would correspond to that of the Exchange Fund Notes issued.

8. Having considered the likely gains and the possible risks associated with such a practice, the Sub-Committee supported the proposal to use Hong Kong dollar interest rate swaps as a means of reducing the cost of issuing Exchange Fund Notes. Members observed that such transactions would be unlikely to be large enough to materially influence market yields. The Sub-Committee also recommended that the net interest payable or receivable and revaluation gains or losses on interest rate swaps should be included in the Currency Board Account.

Review of Fungibility Arrangements between Exchange Fund Bills & Notes and Specified Instruments

9. The Sub-Committee considered the question of whether the current fungibility arrangements between Exchange Fund Bills and Notes and Specified Instruments should be either abolished or capped. Members noted that Specified Instruments consisted of paper issued by the Mass Transit Railway Corporation, the Airport Authority, the Kowloon-Canton Railway Corporation and the Hong Kong Mortgage Corporation under a Notes Issuance programme initiated by the HKMA. Under the technical measures introduced to strengthen the Currency Board arrangements in September 1998, Specified Instruments newly issued since then became ineligible for access to the Discount Window, since, unlike the components of the Monetary Base, they were not backed by US dollar assets. But because of the fungibility between Specified Instruments and Exchange Fund Bills and Notes, a loophole existed in that there was a possibility that holders of Specified Instruments could create additional Exchange Fund paper (without the normal backing arrangements) for discounting at the Discount Window. The Sub-Committee agreed that, in view of the rapid growth in the total Specified Instruments outstanding, it was timely to review the fungibility arrangements.

10. The Sub-Committee recommended that a cap should be placed on the total of fungible Specified Instruments. Members were of the view that the total outstanding amount of fungible Specified Instruments should be capped at the current level (of around HK$15 bn). The pool of fungible Specified Instruments would diminish over time as they mature. Members noted that the amount of Exchange Fund paper so created could be backed by the cushion in the existing Backing Portfolio.


For further enquiries, please contact:

Jasmin Fung, Manager (Press), at 2878 8246 or
Thomas Chan, Senior Manager (Press), at 2878 1480

Hong Kong Monetary Authority
4 June 2001

Last revision date: 1 August 2011
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