(Approved for Issue by the Exchange Fund Advisory Committee on 23 November 2000)
Currency Board Operations for the Period 1 - 21 October 2000
1. The Sub-Committee observed that the period under review had been a generally quiet and stable one: Hong Kong had not been adversely affected by the weaknesses elsewhere in the region, which, if anything, appeared to have led to a flow of funds into Hong Kong as a safe haven. As a result of strong demand for Hong Kong dollar assets, which was reportedly equity related, the Hong Kong dollar had appreciated in early October. The HKMA had, in response to bank offers, sold a total of HK$0.39 bn. The Aggregate Balance had risen to HK$0.79 bn, leading to a softening of local interest rates and an easing of the exchange rate, which had remained generally steady throughout the rest of the period.
2. Members noted that the negative spreads between Hong Kong dollar and US dollar interest rates had widened during the reporting period. They also noted that, largely as a result of net interest income, the backing ratio had seen a moderate increase, from 111.47% to 111.66%.
3. The Sub-Committee noted that, in accordance with the currency board principles, changes in the monetary base during the reporting period had been fully matched by corresponding changes in foreign reserves.
4. The report on Currency Board operations for the period under review is at Annex A.
Monitoring of Risks and Vulnerabilities
5. The Sub-Committee noted an information paper assessing risks and vulnerabilities in the external and domestic environments that might have an adverse impact on Hong Kong's financial stability. The assessment examined, among other scenarios, the risk of sharp reversals of capital flows, particularly in association with major realignments of international currencies; threats posed by higher oil prices; vulnerabilities in Asia's recovery; and the possibility of a scaling back of growth momentum within Hong Kong. The general conclusions of the assessment were that Hong Kong's economy was in good shape, that the recovery was well entrenched, and that, on present indications, the risks identified were unlikely to reach crisis dimensions.
Reserve Requirements as a Liquidity Buffer
6. The Sub-Committee considered a paper setting out the arguments for and against using reserve requirements as a tool for reducing interest rate volatility in Hong Kong. Members observed that, while the use of reserve requirements (whether for liquidity management, monetary control, prudential regulation, or central bank income) had markedly declined throughout the world, a thorough examination of this subject formed a useful part of the Sub-Committee's continuing consideration of the question of liquidity management.
7. Members noted that reserve requirements, even if set at a quite modest percentage of bank deposits, would add substantially to the Aggregate Balance, thus expanding the liquidity buffer available for reducing interest rate volatility. Members observed, however, that there were a number of analytical and practical problems associated with the use of reserve requirements for liquidity management. First, in order for reserve requirements to work effectively as a flexible buffer, an averaging provision would be necessary to enable the requirements to be met on average over a specified maintenance period: this arrangement might well add to interest rate volatility under certain conditions by encouraging banks to over- or under-react to market movements that changed expectations about the overnight interest rate. In addition, the room for manoeuvre in the reserve position would become increasingly inelastic towards the end of the maintenance period. As a result, the extent to which reserve requirements could effectively act as a liquidity buffer would decline during the period, thus risking additional interest rate volatility, particularly near the end of the period.
8. Members noted that a second problem arose from the fact that reserve requirements would be, in effect, a substantial tax on the banking system: this could well undermine Hong Kong's competitiveness as an international financial centre. Thirdly, Members observed that the increasing globalisation of financial markets and financial innovation had made it much easier for banks to circumvent reserve requirements in jurisdictions where reserve requirements were still imposed. There was no reason to expect that Hong Kong would avoid these difficulties.
9. The Sub-Committee concluded that, since the practical difficulties considerably outweighed any benefits, reserve requirements were not appropriate as a liquidity buffer for Hong Kong, particularly in view of the fact that the current system was working well.
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