The Convertibility Zone

inSight

26 May 2005

The Convertibility Zone

This second article on the recent refinements to Hong Kong's Currency Board system explains the purpose of the Convertibility Zone that lies between the two Convertibility Undertakings and around the Linked Rate.

The interactive relationship between the money and foreign exchange markets for a particular currency is a complex one. As a general rule, and other things being equal, a premium on the interest rates for the domestic currency over those for foreign currencies leads to capital inflow and appreciation in the exchange rate. Conversely, a discount on interest rates for the domestic currency below those for foreign currencies leads to capital outflow and depreciation in the exchange rate. In practice, however, this is often not the case. The economic prospects in various jurisdictions may differ to such an extent as to justify a significant interest rate differential, premium or discount, without the counteracting flows of funds through the foreign exchange market. Where such differences are telescoped into rather more short-term financial market performances, and possibly magnified in their intensity, the effect of this general rule could be easily overwhelmed. And there is of course the speculative element that is always present, at times leading to large and sharp distortions.

As readers are aware, in Hong Kong we have had over eighteen months of interest rates being at a substantial discount below those for the US dollar, as a result of capital inflow. The capital inflow is understandable. We did have quite a strong economic recovery, and this is likely to be sustained. We have a balance-of-payments surplus. There is also expectation, whether justified or not, that the Hong Kong dollar may strengthen along with the renminbi when exchange rate reform for the latter is implemented. However, the long-standing objective of our monetary policy is a Linked Exchange Rate, and this is achieved through a rule-based monetary system that requires non-sterilised foreign exchange market intervention at around the Linked Rate. Non-sterilised foreign exchange market intervention involves the HKMA buying or selling US dollars and, in settlement, injecting or withdrawing the corresponding Hong Kong dollar amounts into or from the Aggregate Balance. Capital inflow has, therefore, led to our interest rates falling quickly and the appearance of a substantial discount on our interest rates below those for the US dollar. What is less readily understood is why the substantial interest rate discount, which has, if anything, widened, has not reversed the capital inflow entirely, allowing monetary conditions to return to normal.

We have, in fact, identified two reasons that needed to be addressed. The first one is the constructive ambiguity we have on the strong side of the Link. As I said last week, constructive ambiguity that helpfully inhibits speculative shorting of the Hong Kong dollar represents also uncertainty about the extent with which the exchange rate may strengthen. And when market sentiment is influenced by the possibility of the exchange rate's strengthening, this becomes unhelpful. And so we removed this uncertainty last week by introducing the Convertibility Undertaking on the strong side of the Link.

The second reason is that the passivity of the Convertibility Undertakings might affect the efficiency of the adjustments in the money and foreign exchange markets under the Currency Board system. Our experience in the past 18 months suggests that the Aggregate Balance has been slow to adjust even with the exchange rate drifting to very near the weak-side Convertibility Undertaking. If the market rate does not reach the Convertibility Undertaking rate and if the Undertaking is not triggered by banks, the Aggregate Balance will remain high and interest rates will remain low. This passivity imposes a rigidity in the system making it difficult to address market anomalies such as this. The market operations within the Convertibility Zone by the HKMA will help address this and similar anomalies, thus promoting the smooth functioning of the money and foreign exchange markets in accordance with Currency Board arrangements. Readers may already be aware that the HKMA carried out its first operation within the Convertibility Zone earlier this week, on 25 May. The Hong Kong dollar strengthened and Hong Kong dollar term rates rose across the board. This reflected the increased liquidity demand for Hong Kong dollars ahead of a number of large-scale IPOs. Taking into account market conditions, we purchased US dollars against Hong Kong dollars. Needless to say, this operation was carried out in strict conformity with Currency Board principles: the increase in the Monetary Base was matched by an equivalent increase in the foreign reserves.

 

Joseph Yam

26 May 2005

 

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