(Approved for Issue by the Exchange Fund Advisory Committee on 25 July 2002)
Currency Board Operations for the Period 28 May - 21 June 2002
1. The Sub-Committee noted that the period under review had been stable. The Hong Kong dollar exchange rate had stayed very close to the Convertibility Undertaking rate. Interbank interest rates had remained soft, with short-term rates falling below their US counterparts. After rising in the first half of the period, Hong Kong dollar 12-month forward points had declined to a very low level of 21 pips at the end of the period. Members observed that, reflecting expansion in the backing assets following rises in the outstanding amount of Certificates of Indebtedness, the backing ratio had increase from 111.94% to 112.19%, bringing it closer to the upper trigger point of 112.5%.
2. The Sub-Committee noted that, in accordance with Currency Board principles, changes in the monetary base during the reporting period had been fully matched by corresponding changes in the foreign reserves.
3. The report on Currency Board operations for the period under review is at Annex A.
Monitoring of Risks and Vulnerabilities
4. The Sub-Committee noted that the external situation continued to present difficulties and uncertainties. The US economy continued to recover, though at a more moderate pace. There were signs of revival in major economies outside of the US, including Japan. The financial markets, however, had seen significant declines, largely as a result of concerns about corporate governance issues in the US. The main concern was how far economic recovery would be affected by the turbulence in markets. Members noted that in Hong Kong financial markets continued to be stable but economic activity remained weak.
5. The Sub-Committee noted a special study of the prospects for the US dollar and its implications for Hong Kong. One of the conclusions of the research was that an orderly depreciation of the US dollar would benefit the Hong Kong economy by strengthening the competitiveness of exports in the short term. In the long run, however, domestic prices would probably rise to offset the initial gains. Members observed that the study estimated the current real effective exchange rate of the Hong Kong dollar might now be undervalued relative to its estimated long-run equilibrium, possibly by as much as 5-10% (in contrast to an overvaluation by an estimated 12% in 1998). This suggested that Hong Kong's competitiveness had improved substantially over the past few years, largely as a result of sizeable downward adjustments in domestic costs and prices.
Price Convergence Between Hong Kong and the Mainland
6. The Sub-Committee considered a paper reporting on research aimed at ascertaining how far the deflation that Hong Kong had experienced over the past five years could be attributed to price convergence between Hong Kong and Mainland cities. The general conclusion of the research was that price convergence appeared to be less important in explaining deflation than may have been thought to be the case. The findings noted that price convergence had been taking place and that it had accelerated in recent years, but that it varied considerably among a broad spectrum of products and services. The research also noted that price convergence among cities within the Mainland was occurring at a much faster pace than was convergence between the Mainland and Hong Kong. The conclusions were that price convergence between Hong Kong and the Mainland had accounted for about 2% of the decline in the composite consumer price index over the past four years, and that the decline in property prices, cyclical factors, and shocks had played a more important role in driving deflation. The conclusions tended to support the view that Hong Kong's recent economic difficulties were the product more of cyclical than of structural factors.
Bank Lending and Property Prices in Hong Kong
7. The Sub-Committee considered a paper assessing the relationship between bank lending and property prices in Hong Kong against the general international experience pointing to an accelerator role played by the banking sector in the supply of credit when property prices rose. The research pointed to the existence of a stable long-term relationship between lending, property prices and gross domestic product, and concluded that the direction of influence went from property to bank credit, rather than the other way around: in other words, bank lending appeared to have responded to, rather than to have fuelled, rising property prices. Members noted that, among other changes, regulatory changes in the early 1990s, such as the limit on loan-to-value ratio, tended to limit the responses of credit to property price changes, thus limiting the vulnerability of the banking sector to property price swings.
What Drives Property Prices in Hong Kong?
8. The Sub-Committee considered two empirical models of property prices to explore the role of fundamental variables and speculative bubbles. The estimates derived from the model suggested that about half of the swings in property prices in Hong Kong since the early 1990s could be attributed to changes in fundamental variables, such as macro-economic activity, monetary conditions, demographic movement and public housing supply. The other half was explained by the build-up of a bubble and its sudden collapse.
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Hong Kong Monetary Authority
29 July 2002
