The Strong-Side Convertibility Undertaking


19 May 2005

The Strong-Side Convertibility Undertaking

This first of two articles explains the background to the introduction this week of measures to strengthen Hong Kong's Currency Board system.

Those interested in the structure of our monetary system will notice that we have always maintained an open mind on the need for an explicit convertibility undertaking on the strong side of 7.80 (to buy US dollars) to mirror the one on the weak side (to sell US dollars) introduced in 1998. As the published records of the Sub-Committee show, this is indeed a matter that has been under constant review at the Currency Board Sub-Committee (CBC) of the Exchange Fund Advisory Committee, which I chair. I have also addressed the matter in this column and in public speeches, in particular the one on 19 January 2004. In that speech I said that "it may also be that a more formal convertibility undertaking on the strong side of the Link, mirroring the one that already exists on the weak side, becomes necessary". I then went on to discuss the pros and cons in some detail.

At the meeting of CBC held on Friday 13 May 2005, the matter was discussed again in full. The pros and cons have tilted considerably in favour of introducing a convertibility undertaking on the strong side as well. Basically, constructive ambiguity on the strong side, while helpful in inhibiting speculative shorting of the Hong Kong dollar, is clearly unhelpful when, for whatever reason, there is pressure for the currency to appreciate. The ambiguity represents a degree of uncertainty about the extent to which the exchange rate can strengthen, which is precisely one factor that generates speculative inflow into the Hong Kong dollar if there is a shock to the exchange rate on the strong side. This uncertainty also lowers the sensitivity of the flow of funds into and out of the Hong Kong dollar in response to the interest rate differential between the Hong Kong dollar and the US dollar when the exchange rate is stronger than 7.80. The experience of the last eighteen months bears this out. We persistently had Hong Kong dollar interest rates below those of the US dollar, as the amount of liquidity in the interbank market, as measured by the size of the Aggregate Balance, stayed at levels in multiples (from about 5 times to 100 times) of what is normally required as engine oil for our very efficient interbank payment system.

To be sure, the consequential easy monetary conditions have been very helpful to the economy. In the third quarter of 2003, when all this started, we were still recuperating from SARS and many aspects of the economy were still at their lowest point, including of course deflation, negative equity mortgages and personal bankruptcies. Easy monetary conditions were therefore a godsend. And so we had quite an impressive economic recovery, which has continued to the present. Meanwhile, however, along with the strong economy recovery and higher world commodity prices, our domestic prices have been on the rise since August 2003, as I pointed out in this column at the beginning of 2004. As we come out of deflation, and we all should rejoice over it, we should not of course ignore the risks of inflation returning: hence my comments when I last appeared in front of the Legislative Council's Panel on Financial Affairs. It is of course too early to talk about inflation, but it is appropriate now, having regard to the objective of monetary policy that has been clearly laid down by the Financial Secretary, to ensure that our Currency Board arrangements do not unnecessarily encourage inflation, particularly at the wrong time.

The strong-side Convertibility Undertaking to buy US dollars will remove the uncertainty about the extent to which the exchange rate may strengthen. Consequently, it should increase the sensitivity of the flow of funds into and out of the Hong Kong dollar to the interest rate differential between the Hong Kong dollar and the US dollar. So far, the markets have accepted the refinements calmly and positively. There will, I am sure, continue to be large flows in and out, for as long as the reform of the renminbi exchange rate system is still on the agenda. And I am sure there will be other shocks that will generate similar flows in either direction. With the latest refinements to the Linked Exchange Rate system, we will be in an even better position than before to cope with such shocks and achieve the monetary policy objective of exchange rate stability laid down by the Financial Secretary.


Joseph Yam

19 May 2005


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Last revision date : 19 May 2005