Record of Discussion of the Meeting of the Exchange Fund Advisory Committee Currency Board Sub-Committee held on 20 February 2008

(Approved for Issue by the Exchange Fund Advisory Committee by circulation on 7 March 2008)

Report on Currency Board Operations (5 January - 4 February 2008)

The Sub-Committee noted that the Hong Kong dollar exchange rate had been stable during the reporting period. Interbank interest rates had eased, while their negative spreads against US dollar interest rates had shown a diverse pattern. The Monetary Base had increased slightly from HK$319.71 billion to HK$344.28 billion.

2. The Sub-Committee noted that, in accordance with Currency Board Principles, changes in the Monetary Base 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 that global financial markets had been volatile and had weakened during the reporting period amid continuing weak US data, persistent credit concerns and central banks' highlighting of risks to growth. The slowing in economic growth was increasingly being felt by economies around the world.

5. The US Federal Reserve had cut interest rates by 75 basis points on 22 January, and the federal funds target rate by a further 50 basis points and the discount rate by 25 basis points a week later. While this had restored some confidence in markets, the credit problems had occurred on a very large scale and were outside the traditional banking channels. The troubles in the US could affect the East Asian economies through various financial channels. There was a risk that risk aversion and a flight to safety could dampen confidence in the region's markets leading to capital outflows.

6. In Hong Kong, inflationary pressures and expected further easing of US monetary policy were reducing real interest rates and probably stimulating the build-up of leveraged positions and asset-price inflation, particularly in the property market. Vigilance is warranted to guard against the risks such developments may pose to financial stability.

7. The Sub-Committee noted an analysis which concluded that, while market dynamics could make US assets less attractive and lead to a further depreciation of the dollar in the short term, a number of supporting factors remained and there were no strong reasons to expect the dollar to be in a long-term decline.

Exchange Rate Pass-Through to Domestic Inflation in Hong Kong

8. The Sub-Committee noted a paper analysing the pass-through of changes in exchange rates to domestic inflation in Hong Kong. The analysis estimated that a 10% depreciation in the US dollar against all currencies except the Hong Kong dollar would cause domestic inflation in Hong Kong to rise by about 0.82% in the short run and about 1.61% in the medium run.

Service Exports: The Next Engine of Growth for Hong Kong

9. The Sub-Committee noted a study of the importance of service exports to economic growth in Hong Kong. The paper noted that exports of trade-related, financial and travel services, especially those related to Mainland China, had all experienced significant growth and become an increasingly important contributor to economic growth.

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Hong Kong Monetary Authority
11 March 2008