(Approved for Issue by the Exchange Fund Advisory Committee on 27 July 2000)
Currency Board Operations for the Period 25 May - 26 June 2000
1. The Sub-Committee observed that, during much of the period under review, the Hong Kong dollar exchange rate had closely tracked the movement of the convertibility rate in respect of the Aggregate Balance. In mid-June, the Convertibility Undertaking had been triggered and the Aggregate Balance had shrunk into negative territory. This had led to a firming of interest rates: combined with more buoyant equity market conditions and a consequent rise in the demand for Hong Kong dollar assets, the exchange rate had strengthened markedly. Sales of Hong Kong dollars by the Hong Kong Monetary Athority caused the Aggregate Balance to rise towards the end of the reporting period. Members noted that interest rates had followed a general downward trend during the reporting period: this was due partly to alleviated concerns over another US dollar interest rate increase and partly to a revival of buying interest in the local equity market.
2. The Sub-Committee noted that, following the transfer of assets from the Backing Portfolio to the Investment Portfolio, after the upper trigger level of 112.5% in the Backing Ratio had been reached in late May, the backing ratio had gradually increased from 110% on 25 May to 110.47% on 26 June. The Sub-Committee also noted that changes in the monetary base during the reporting period had been fully matched by corresponding changes in foreign reserves in accordance with the Currency Board arrangements.
3. The report on Currency Board operations for the period under review is at Annex A.
Proposed Scope of the Review of Currency Board Arrangements
4. The Sub-Committee considered a paper on the proposed scope of its continuing review of the Currency Board arrangements.
5. The Sub-Committee noted that the scheme to move the convertibility rate in respect of the Aggregate Balance from 7.75 to 7.80 by one pip per calendar day had been progressing smoothly, and that, as scheduled, the convertibility rate would converge with the linked rate of 7.80 on 12 August. The Sub-Committee agreed that it was desirable to continue to keep under review the operation of the Currency Board system, and that the scope of the review should cover mainly the question of convertibility and transferability of the four components of the monetary base. In particular, this included a revisiting of the following issues, which had been examined in previous Sub-Committee meetings:
(a) Two-way convertibility undertaking for the Aggregate Balance (8 October 1999)
(b) Transferability between Certificates of Indebtedness and the Aggregate Balance (9 April 1999)
(c) Transferability between the Aggregate Balance and Exchange Fund Bills and Notes (8 January 1999)
(d) Extending the Convertibility Undertaking to Exchange Fund Bills and Notes (5 March 1999)
Members also agreed that the question of liquidity management and its relationship with foreign exchange transactions, particularly in the light of the experience of the currency board systems of Argentina and Estonia, should be examined.
6. Item (a) was to be discussed in the present meeting, while other items would be reviewed on future occasions.
Convertibility Undertaking in Respect of the Aggregate Balance
7. The Sub-Committee considered a paper reviewing the current policy and discussing options for HKMA operations on the strong side of the linked exchange rate. The Sub-Committee noted that, when it had previously examined this issue at its meeting in October 1999, its conclusion had been that the current policy should remain unchanged. Since then, however, two factors that had a bearing on that conclusion had ceased to be relevant: these were the Year 2000 issue, which had made it desirable for the HKMA to retain flexibility in its operations on the strong side for the time being, and the movement to 7.80 of the convertibility rate on the weak side in respect of the Aggregate Balance, which would be completed on 12 August.
8. Members considered a number of options for HKMA operations on the strong side, ranging from the current generally passive approach to an explicit two-way convertibility undertaking at the limits of a narrow band, either centred on 7.80 or bounded on the weak side at 7.80. Members observed that the advantages of a two-way convertibility undertaking included greater transparency and predictability, and a tidier, more symmetrical arrangement. The disadvantages included the possibility that too rigid an arrangement would play into the hands of speculators, and the possibility that too narrow a bid-offer band would displace a substantial part of foreign exchange business involving the Hong Kong dollar. Too wide a band, in contrast, might result in undue volatility in the exchange rate and other market variables. Members noted that the present system, in which the HKMA managed its foreign exchange operations on the bid side by responding to offers from banks according to prevailing market conditions, was working well and was accepted by the market. They concluded that on balance the present system should be maintained. It provided the HKMA with some flexibility in responding to bank offers, while nevertheless obliging the HKMA to be fully accountable by immediately publicising any currency board operations. Members agreed that there would be scope to review this arrangement again, should the need arise. Members confirmed, for the avoidance of doubt, that the CU rate on the weak side would remain at 7.80 from 12 August.
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Hong Kong Monetary Authority
2 August 2000