Since departing from the Strong-side Convertibility Undertaking level of 7.75 against the US dollar at the beginning of the year, the Hong Kong-dollar exchange rate has been fluctuating within the Convertibility Zone of 7.75 and 7.85, reflecting the changes in demand for Hong Kong dollars caused by external factors. Some time ago, the Hong Kong dollar exchange rate softened to a level beyond 7.80. At that time, some reports described it as a substantial fall and attributed it to sharp outflows of funds. Perhaps the fact that the Hong Kong dollar had stayed at 7.75 for a large part of last year leads to some concerns when the exchange rate moves away from that level. But the truth is, since the HKMA introduced the three refinements to the Linked Exchange Rate system in 2005, the Hong Kong dollar is allowed to fluctuate within a small band between 7.75 and 7.85, with a band width of only 1.3%. Movements within such a narrow band are hardly "substantial". Whether the exchange rate strengthens to 7.75 or weakens to 7.85, it should be considered normal as long as the movements take place in an orderly way.
There has not been any net inflow into or outflow from the Hong Kong-dollar Monetary Base so far this year. Fewer equity fund-raising activities in Hong Kong might explain the absence of large inflows of funds. Amid corrections in the Hong Kong stock market and those around the world, there has been a decrease in the amount of capital raised in the equity market in the first half of this year, leading to a drop in demand for Hong Kong dollars. At the same time, some Mainland corporations that were listed in Hong Kong last year are gradually converting the Hong Kong dollars they raised into other currencies. We pointed out at the meeting of the Legislative Council Panel on Financial Affairs in February that there might have been as much as HK$260 billion raised by Mainland corporations listed in Hong Kong still being held as Hong Kong-dollar deposits in the Hong Kong or Mainland banking systems. It is very likely that these Hong Kong dollar funds will gradually be converted into other currencies.
Concerns over the sovereign debt crisis in Europe have also heightened investors' risk aversion and prompted funds to flow into US-dollar assets, particularly US treasuries. Against this backdrop, the Hong Kong dollar did soften mildly.
Looking ahead, there continue to be uncertainties over the flows of funds in the next six months. On the one hand, a number of large Mainland banks are planning to raise funds through rights issues or IPOs in the coming six months. While these activities may attract funds to flow into the Hong Kong dollar, their effects on the exchange rate may not last long, depending on how quickly the fund raisers switch the Hong Kong dollars that they raised into renminbi or other foreign currencies.
On the other hand, Europe's debt crisis, economic adjustment measures on the Mainland and a possible slowdown in the global economy may affect investor sentiment or even cause a sudden reversal of fund flows. But despite all these, Hong Kong's fundamentals remain strong. Unlike some other economies that are suffering from the latest financial crises, Hong Kong has a sound fiscal position, substantial fiscal reserves and a robust banking sector with strong capital, sufficient liquidity and high-quality assets. These strengths will help our economy withstand the volatility in exchange rate and interest rates brought about by sudden reversals of fund flows.
It is normal to see funds flowing in and out of an open economy and international financial centre like Hong Kong. History has shown that Hong Kong's Currency Board arrangements have served us well in coping with fund flows and maintaining monetary and financial stability. The inflows of funds in 2009 have led to substantial growth in US-dollar reserves held by the Exchange Fund, providing a useful buffer against net outflows of funds in the future. Hong Kong is also totally capable of managing net outflows of funds from the Hong Kong-dollar Monetary Base caused by the triggering of the Weak-Side Convertibility Undertaking at 7.85. If that happens, the Aggregate Balance will decrease from its current high level of HK$149 billion. But this is exactly how the Linked Exchange Rate system is supposed to work: when funds flow in, the Aggregate Balance expands; when funds flow out, the Aggregate Balance shrinks. If the Aggregate Balance continues to decline, Hong Kong's monetary environment will gradually move from a very loose state to a more normal state.
We pointed out in an inSight article last November that while Hong Kong could not change the monetary policies in the US, Europe and the Mainland, or predict the future directions of fund flows, we should prepare ourselves for the impact of global fund flows. The Hong Kong-dollar exchange rate can move up or down within the Convertibility Zone, and interest rates can increase or decrease depending on market developments. The loose monetary environment will not last forever. Banks, businesses and the general public should be mindful of the associated risks in making investment or borrowing decisions.
Eddie Yue
Deputy Chief Executive
24 June 2010
