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Record of Discussion of the Meeting of the Exchange Fund Advisory Committee Sub-Committee on Currency Board Operations held on July 6 2001

(Approved for Issue by the Exchange Fund Advisory Committee on 26 July 2001)

Currency Board Operations for the Period 1 June - 21 June 2001

The Sub-Committee noted that the Hong Kong dollar exchange rate had remained stable during the period under review. Interbank interest rates had eased in the latter part of the period, reflecting in part market expectations of a rate cut in the US in late June. The negative spreads between Hong Kong dollar and US dollar interest rates had narrowed, and had turned positive for 12-month maturity. 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.

2. Members observed that developments in Argentina had had no negative repercussions on markets in Hong Kong, and that market participants continued to differentiate between the economic fundamentals on which the two currency board systems rested. Members noted that, following approval by the Financial Secretary for the use of interest rate swaps to manage the cost of issuing long-dated Exchange Fund Notes, the first such transactions had taken place in mid-June.

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. Members noted that a number of risks and uncertainties were creating considerable concern about the outlook for the global economic environment. Among these were the general global slowdown, especially more recently in Europe, and the declining demand for technology-related products, which had contributed to the decline in equity markets. Although some analysis suggested that the slowdown in the US had been arrested, the outlook was by no means clear. Members observed that Japan continued to be a key concern, and that a tension had arisen there between the long-term benefits of the policy measures recently proposed by the new government and the short-term effects of restructuring under those measures.

5. Members noted that monetary and financial conditions in Hong Kong remained stable, although the broader economy was slowing. Given the importance of external factors to Hong Kong's economy, it was difficult to assess future developments, although it was noted that the external uncertainties affecting Hong Kong were common to most economies.

Monetary and Financial Stability

6. The Sub-Committee considered a paper on the relationship between monetary and financial stability under a fixed exchange rate regime. The paper explored in particular the types of risks that a fixed exchange rate system should pay special attention to, and how far the various policy instruments available were able to manage these risks.

7. Members noted that the risks to financial stability under a fixed exchange system, particularly a currency board system, included the greater exposure to interest rate volatility from speculative inflows and outflows and the possibility that the economic cycles for the linked currency and the reserve currency may not be perfectly synchronised, thus exacerbating economic swings and increasing the scope for unstable dynamics to develop. Members noted that imperfect synchronisation between economic cycles had in the past created the risk of excessive optimism, which had contributed to asset market bubbles.

8. Members noted the various policy tools that had been introduced to manage the risks to financial stability in Hong Kong. Among these were the additional cushioning of interest rates provided under the technical measures to strengthen the Currency Board system in September 1998, and the clear policy statement made by the HKMA in 1999 on its role as lender of last resort. Members also noted the use of various prudential supervision methods to identify and manage risks. These included the monitoring of banks' exposure to the property and equity sectors, and the rule capping the maximum loan-to-value ratio at 70% for residential mortgages, as well as the development of a risk-based supervisory approach.

9. Discussion focused on the question of whether a more formal approach could be adopted towards managing the risks under a counter-cyclical system, not only in the light of excessive optimism during times of economic growth but also in the light of banks' reluctance to lend during downturns. Among the tools used in other jurisdictions were higher capital adequacy requirements during upswings and lower capital adequacy requirements during downswings, and dynamic provisioning requirements to provide for greater loan provisioning during downswings. Members noted, however, that the difficulties in applying these tools to Hong Kong included the fact that capital adequacy among banks was already very high and certain technical objections to dynamic provisioning among the accounting profession. More broadly, Members also considered that it would not be easy to assess objectively whether asset prices were reflecting economic fundamentals and that frequent changes to prudential requirements could be perceived as policy inconsistency or as intervention in the market by the government.

Argentina's Basket Peg Proposal

10. The Sub-Committee noted an information paper on the proposed basket peg in Argentina.


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

Hong Kong Monetary Authority
30 July 2001

Last revision date: 1 August 2011
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