(Approved for Issue by the Exchange Fund Advisory Committee on 31 July 2003)
Report on Currency Board Operations (29 May - 20 June 2003)
The Sub-Committee noted that the Hong Kong dollar and exchange markets had continued to be stable in June. Having risen to a near-term high of 182 pips on 17 June, following conjecture about a widening of the official trading band of the renminbi, Hong Kong dollar 12-month forward points had declined in late June. Interest spreads between the Hong Kong dollar and US dollar continued to decline with the winding down of the SARS episode.
Members noted the publication on 27 June of the letter from the Financial Secretary to the Monetary Authority, dated 25 June 2003, formally specifying the monetary policy objective and the structure of the monetary system of Hong Kong: this was defined in the letter as continuing to be a stable external exchange value of the currency of Hong Kong, in terms of its exchange rate in the foreign exchange market against the US dollar, at around HK$7.80 to US$1, maintained through a currency board system. These arrangements reflected the Linked Exchange Rate system in existence in Hong Kong since October 1983.
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 changes in the foreign reserves.
The report on Currency Board operations for the period under review is at Annex A.
Monitoring of Risks and Vulnerabilities
The Sub-Committee noted that, despite some signs of improvement in the latest data from the US, growth in the major economies continued to be sluggish. Equity markets had nevertheless continued to rally in expectation of better economic growth. In Hong Kong, financial conditions had improved with the end of the SARS episode, and merchandise exports had continued to perform strongly. However, domestic demand was generally expected to recover only gradually, given the high rate of unemployment.
The Sub-Committee noted a special analysis of the decline in the ratio of Hong Kong dollar deposits to total deposits. The analysis found that the decline was attributable to macroeconomic and financial market developments rather than to pressures on the currency. Specifically, the factors likely to have contributed to the decline were weaker economic growth relative to Hong Kong's main trading partners and a robust external trade performance, which had increased the demand for foreign currency. Members noted that the relatively low level of the ratio of domestic currency deposits to total deposits in Hong Kong was similar to that in other major international financial centres. Members observed that there appeared to be no consistent relationship between confidence in the Hong Kong dollar and the ratio of Hong Kong dollar deposits to total deposits.
The Profitability of the Banking Sector in Hong Kong
The Sub-Committee considered an information paper examining the various factors affecting the profitability of the banking sector in Hong Kong against a background of economic difficulty and a changing operating environment. The Sub-Committee noted that a profitable banking sector would be better able to withstand negative shocks and contribute to the stability of the financial system. The paper found that both macroeconomic and bank-specific factors were important determinants of bank profitability. Among macroeconomic variables, GDP growth, inflation and real interest rates were positively linked to profitability. Bank-specific variables indicated that operational efficiency was the most important factor in determining profitability. Members observed that deterioration in profitability in recent years was mainly attributable to macroeconomic factors, especially deflation, and that bank profitability should in general improve as the economy recovered.
The Causes of Inflation and Deflation on the Mainland
The Sub-Committee noted a study of inflation dynamics on the Mainland since the late 1980s. The study found that main factors behind deflation were the appreciation of the effective exchange rate of the renminbi and growth in productivity.
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Hong Kong Monetary Authority
4 August 2003