(Approved for Issue by the Exchange Fund Advisory Committee on 31 March 2005)
Report on Currency Board Operations (28 January - 17 February 2005)
The Sub-Committee noted that the Hong Kong dollar exchange rate had stayed very close to the linked rate throughout the reporting period and that the Convertibility Undertaking had been triggered on several occasions. With the outflow of funds, the Aggregate Balance had declined during the period under review, and had continued to decline since, to around HK$8 billion on the day of the meeting. Members observed that, with the Aggregate Balance gradually returning to more normal levels, the relatively easy monetary conditions, which had generally prevailed since September 2003, would eventually come to an end.
2. The Sub-Committee noted that, in accordance with Currency Board principles, changes in the Monetary Base had been fully matched by corresponding changes in foreign reserves during the reporting period.
3. The report on Currency Board operations for the period under review is at Annex A.
Monitoring of Risks and Vulnerabilities
4. Members noted that the US economy had continued to show solid growth. Although the euro area and Japan had performed poorly in the last quarter of 2004, forward-looking indicators suggested improvements in early 2005. The situation on the Mainland had been less clear, as the different timing of Chinese New Year from year to year complicated data reading: growth momentum appeared to be strong, though inflation had continued to decline. In Hong Kong, the indicators pointed to slower, though still solid growth. Members noted that the main risks continued to be associated with US dollar and US interest rate movements; high oil prices; and the macroeconomic and financial conditions on the Mainland.
5. The Sub-Committee noted a special analysis on Hong Kong dollar fund flows in 2004. The analysis found that there had been an inflow of funds into the Hong Kong dollar in 2004. This inflow, however, reflected an increase in banks' demand for the Hong Kong dollar, while the non-bank sector had recorded an outflow. The reduction in the Hong Kong dollar position of the non-bank sector might be attributable to portfolio re-allocation prompted by a rise in asset prices and low interest rates. The increase in the banking sector's Hong Kong dollar position followed developments in the third quarter of 2003, when banks had begun to unwind their short Hong Kong dollar positions, which had been built up between 1998 and mid-2003.
Hang Seng Index Futures Open Interest and its Relationship with the Cash Market
6. The Sub-Committee considered a paper examining the question of whether the rise in large open positions in Hang Seng Index futures in the past three years should be a matter for concern, given the role that these positions played in the 1998 speculative attacks on Hong Kong's financial markets. The analysis considered in particular two adjusted indicators as a way of examining the level of open interest with reference to trend growth and cash market development: the de-trended open interest position, and the ratio of open interest to cash market turnover. These two indicators were found to be high in the last four months of 2004, but were not as alarming as the raw data on open interest would suggest. The Sub-Committee considered these indicators to be useful additional tools for monitoring markets, although Members observed that market intelligence was also critical in determining whether developments in the futures market were a cause for concern.
Money and Inflation in Mainland China
7. The Sub-Committee noted a paper which used formal modeling of the linkages between money and inflation to examine monetary conditions and inflation developments on the Mainland: these issues had important implications for Hong Kong, given the close economic integration between Hong Kong and the Mainland. The findings of the research indicated that periods of above-equilibrium money growth tended to increase inflation pressures in the economy. The derived money overhang, which was a useful early warning signal of future inflation, had shown a positive gap in recent years. But this positive gap had been much reduced by the end of 2004.
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Hong Kong Monetary Authority
4 April 2005