A Modern Day Currency Board System

Joseph Yam
Chief Executive
Hong Kong Monetary Authority

Contents

Foreword

A Modern Day Currency Board System

Glossary

Foreword

This summer I prepared a paper addressing the question of how a modern Currency Board system should be organized. This paper explores the core concepts involved in a Currency Board system, including the Monetary Rule, the Monetary Base, the Convertibility Undertaking, and the Adjustment Mechanism. One of the main aims of the paper was to provide a clear conceptual framework for facilitating a thorough examination of the Currency Board arrangements in Hong Kong. The paper became the basis for a productive discussion at a meeting with academics on 24 October. Those present at the meeting unanimously advised that a wider circulation of the paper would help to promote a greater understanding of the Currency Board system and form a useful basis for public discussion of monetary policy in Hong Kong. Taking this advice, we have decided to publish the paper.

As a guide to this rather technical paper, a glossary of terms has been included at the end of the paper. It may also be helpful for me to summarize the salient features of a model Currency Board system below :

1. the Currency Board should strictly observe the Monetary Rule which requires any change in the Monetary Base to be brought about only by a corresponding change in Foreign Reserves in a specified foreign currency at a fixed exchange rate;
2. the Monetary Base should be defined to include financial instruments which can be used for settling transactions. The Monetary Base should also appear on the balance sheet of the Currency Board to ensure effective control. In a modern monetary system, the Monetary Base should embrace three components: the Aggregate Balance of the banking system, currency notes and coins, and the pool of Currency Board debt paper used for the smooth settlement of interbank transactions;
3. the three components of the Monetary Base should be freely transferable amongst themselves at the initiative of the owner, and the Currency Board should facilitate this;
4. individual components of the Monetary Base may be changed against a corresponding change either in Foreign Reserves, in accordance with the Monetary Rule (resulting in an overall increase in the Monetary Base), or against a change in the other components of the Monetary Base in the opposite direction (resulting in a reconstitution of the Monetary Base);
5. in compliance with the Monetary Rule, the Currency Board should provide an undertaking to convert Domestic Currency into Foreign Reserves at the fixed exchange rate. While the precise scope and form of the Convertibility Undertaking may vary depending on the specific circumstances of each economy, transactions arising from the Convertibility Undertaking should be settled through the Aggregate Balance of the banking system; and
6. there should be a high degree of transparency and disclosure about how the Monetary Rule is strictly observed by the Currency Board. Up-to-date information should be regularly published on all three components of the Monetary Base.

Joseph Yam
Chief Executive
Hong Kong Monetary Authority

A Modern Day Currency Board System

There is some confusion as to how a Currency Board system should be structured nowadays, having regard to the technologically sophisticated arrangements of modern day finance, where money is transmitted electronically and transactions are settled largely without the use of cash. Unlike the days when transactions were predominantly cash based, a modern day Currency Board system has to cater for and cope with free and therefore volatile capital flows which can be voluminous, move around with high velocity and facilitated by a large variety of financial instruments including derivatives. This chapter attempts to outline a theoretical framework of a modern day Currency Board system.

Monetary Rule

Essential to the Currency Board system is a Monetary Rule that requires any change in the Monetary Base to be brought about only by a corresponding change in Foreign Reserves in a specified foreign currency at a fixed exchange rate. The Monetary Base and the Foreign Reserves should respectively be on the liability and asset sides of the balance sheet of the Currency Board. Operationally, this Monetary Rule often takes the form of a Convertibility Undertaking for the Currency Board to convert Domestic Currency into Foreign Reserves at the fixed exchange rate. The Convertibility Undertaking may be one that is triggered from time to time by the Currency Board or an evergreen one without discretion on the part of the Currency Board. Domestic Currency covered by the Convertibility Undertaking may just be the Monetary Base, or it may be some other definition of domestic money, whether or not including the Monetary Base. But it is essential that the settlement of transactions arising from the Convertibility Undertaking be effected through the Monetary Base in order that the automatic adjustment mechanism under a Currency Board system can function to ensure exchange rate stability.

The Monetary Rule of a Currency Board system is almost sacrosanct. Confidence in the Currency Board system hinges very much on the Monetary Rule being observed. It will be useful if the operator of the Currency Board is structured in such a way as to enhance the impression that the Monetary Rule is indeed strictly observed. A high degree of transparency and disclosure is essential, particularly in respect of changes in the various components of the Monetary Base and the corresponding changes in Foreign Reserves. Operational independence of the Currency Board is also essential. The Currency Board must not be influenced for political purposes into, for example, exercising discretion to deviate from the Monetary Rule, create money without the backing of Foreign Reserves and depress interest rates in order to ease the pain imposed by the discipline of the Monetary Rule on the economy.

Foreign Reserves

Theoretically, all that is required for the Currency Board to hold is the amount of Foreign Reserves adequate to meet comfortably the anticipated reduction in the Monetary Base in stressful conditions. The Monetary Rule focuses on the flow rather than the stock of the Monetary Base, although obviously if it is extended to the stock of the Monetary Base the Currency Board would have greater credibility. It would therefore be desirable, if only psychologically, for the Foreign Reserves held by the Currency Board to be larger than the Monetary Base and perhaps even larger than the amount of Domestic Currency covered by the Convertibility Undertaking. This is notwithstanding the requirement that transactions arising from the Convertibility Undertaking are to be settled through the Monetary Base.

Monetary Base - Definition

The Monetary Base, in layman terms, is money that can be used for settling transactions. As almost all transactions have to be somehow settled with the use of money in some form, monetary control is normally exercised through controlling the Monetary Base, by an automatic or discretionary mechanism determining its price, however measured, or its supply. In order that the control is effective, the definition of the Monetary Base should be a comprehensive one covering all money that can be used for settling transactions. It must also be practical, enabling control to be effectively exercised. This inevitably requires the Monetary Base to be on the balance sheet of the authorities responsible for monetary control, in this case, the Currency Board.

In Currency Board systems of the old days, the Monetary Base focuses very much only on Currency Notes as these were the predominant medium for the settlement of transactions. Nowadays, Currency Notes are only used for the settlement of day to day retail transactions in the economy. Large transactions are settled through the use of electronic and other forms of money. And the great majority of these transactions involve settlement through payments between banks on behalf of their customers, including the clearing of cheques. It is therefore no longer appropriate or adequate, and indeed theoretically no longer necessary, to focus only on Currency Notes.

In a modern day Currency Board system, the Monetary Base should, at the minimum, be the aggregate of the balances (the Aggregate Balance) held in the clearing accounts which banks maintain with the Currency Board. It is predominantly through the Aggregate Balance that the automatic interest rate adjustment mechanism of a Currency Board system, as described later in this chapter, works to ensure exchange rate stability. This realistically requires the Currency Board being responsible also for the running of the interbank clearing system, a function that may, if not carefully handled, involve departures from the Monetary Rule and undermine the credibility of the Currency Board. This is because of the need for the Currency Board to provide liquidity to facilitate the smooth clearing of interbank transactions, involving possibly the creation of additional money in the Aggregate Balance, or the Monetary Base, without additional Foreign Reserves.

This unavoidable downside risk can be managed, however, in either of two ways. First is to minimize the risk through appropriately structuring the interbank payment system. The use of Real Time Gross Settlement (RTGS) would minimize the need for day end liquidity support from the Currency Board. The consequently small amount of such day end liquidity, when required, can further be provided against collateral, in the form of obligations of the Currency Board that are already backed by Foreign Reserves held by the Currency Board. But this still involves an increase in the Monetary Base, if it is defined only to include the Aggregate Balance, without the corresponding increase in new Foreign Reserves held by the Currency Board. This may be seen as a departure from the Monetary Rule, and for the purists, a dangerous departure. That is why it should be kept to the minimum. It should also be provided only at adequately penal rates of interest to discourage the facility being inadvertently used for more permanent money creation that gets around the Monetary Rule of the Currency Board.

Second is to eliminate the risk altogether through expanding the definition of the Monetary Base. Assume that the Currency Board has indeed created a pool of Currency Board debt paper backed fully by Foreign Reserves. The Monetary Base can then be defined as the sum of the Aggregate Balance and the amount, perhaps a limited amount, of such debt paper outstanding. As the Currency Board debt paper provides the liquidity for banks to effect the settlement of transactions, it is indeed necessary to take account of it in the Monetary Base. In accepting the debt paper as collateral for intraday or day end liquidity, the Currency Board will merely be switching its liability in the form of the debt paper into the Aggregate Balance. No increase in the Monetary Base, as more widely defined, is involved. Neither is there any need for an increase in Foreign Reserves.

The Monetary Base may also include the amount of Currency Notes (and coins) issued in order psychologically to instill greater confidence on the part of the holders of Currency Notes. Traditionally this is the case, and indeed Currency Notes were probably the only element in the Monetary Base in the old days. It is a tranquilizing feeling to have for the community when the money in their hands, money that they can feel, is actually backed by and convertible into Foreign Reserves at the fixed exchange rate. It is as if the Domestic Currency is as good as the specified foreign currency.

But, desirable as it may be, this is strictly speaking not a necessary feature of a modern day Currency Board system. For as long as the Currency Notes are issued and redeemed against the Aggregate Balance, the banking system would be forced to surrender Foreign Reserves to the Currency Board indirectly to back the issue of Currency Notes through having to reconstitute the Aggregate Balance. Thus when the Currency Board issues Currency Notes to a particular bank, it should settle the required amount by debiting the balance in the clearing account of the bank concerned. As the Aggregate Balance falls, the banking system as a whole would soon find it necessary to sell Foreign Reserves to the Currency Board, so as to bring the Aggregate Balance back to its original level. This in effect means that the issue of Currency Notes is backed by Foreign Reserves, although there is no clear Convertibility Undertaking for the Currency Notes themselves.

The choice of the appropriate definition for the Monetary Base depends on the characteristics of other domestic monetary arrangements and the circumstances under which the Currency Board system is established. Adequacy of Foreign Reserves is obviously a key factor. Confidence considerations would require Currency Notes being included along with the Aggregate Balance. If payment system responsibilities require the provision of liquidity by the Currency Board to facilitate the smooth settlement of transactions, then this should also be adequately dealt with in the Monetary Base. The inclusion of an amount of Currency Board debt paper that can be used as collateral for such liquidity, with properly structured arrangements, will be appropriate. But the paper, to the extent that it can be used for this purpose, will need to be backed by Foreign Reserves.

In any case, the absence of reserve requirements and the presence of an efficient interbank payment system mean that the size of the Aggregate Balance may be quite small relative to the normal day to day volume of the flow of funds. As a result, small flows of funds involving transactions with the Currency Board may lead to unnecessarily sharp fluctuations in interbank interest rates. In other words, the "leverage" of the Aggregate Balance, whilst effective in bringing about the necessary adjustments, may put too much pressure on the financial, particularly the banking, system. In such circumstances, a wider definition for the Monetary Base, enabling a degree of transferability of other components of it into the Aggregate Balance, may help to dampen unnecessary volatility in interest rates.

Monetary Base - Internal Transferability

Whatever the definition of the Monetary Base, the transferability between the different components of it should be carefully handled. Theoretically, transferability amongst them could be allowed given that all components of the Monetary Base have already been backed fully by Foreign Reserves. But it will be useful to examine carefully the implications of such transferability. For this purpose, it is assumed that the Monetary Base has been defined to include the Aggregate Balance, Currency Notes and a pool of Currency Board debt paper, all fully backed by Foreign Reserves.

Transferability between Currency Notes and the Aggregate Balance is a delicate matter. If this is allowed, then a bank could place Currency Notes with the Currency Board and receive value in its clearing account with the Currency Board, or withdraw Currency Notes and pay for them through the Currency Board debiting its clearing account. This arrangement has important implications. On the one hand, it may give people the impression that the issue and redemption of Currency Notes are not against, and therefore not fully backed by, Foreign Reserves. It may further affect confidence in the currency and in the robustness of the Currency Board system itself. On the other hand, such transferability would give the banks a choice in their transactions of Currency Notes with the Currency Board. They can obtain value either in Foreign Reserves at the fixed exchange rate or in Domestic Currency in the form of their clearing balances with the Currency Board, or draw Currency Notes against either their clearing balances or Foreign Reserves.

This choice for the banks would create opportunities for Currency Notes arbitrage when the market exchange rate deviates from the fixed exchange rate level. For example, when the exchange rate is weak, a bank can sell Foreign Reserves for the Domestic Currency in the market at the weak market exchange rate. It can then withdraw Currency Notes against its clearing balance with the Currency Board and return those Currency Notes to the Currency Board for Foreign Reserves at the fixed rate, thus recouping the Foreign Reserves sold earlier and make a profit. Such arbitrage, in effect, amounts to the Currency Board undertaking to convert the Aggregate Balance into Foreign Reserves at the fixed exchange rate. If this were explicitly stated as a Convertibility Undertaking, then there would be no need for the rather operationally tedious Currency Notes arbitrage to take place.

Transferability between Currency Notes and Currency Board debt is, by comparison, of less significance. There is no incentive for the holders of Currency Board debt paper to have it sold for Currency Notes, unless of course they could in doing so acquire Foreign Reserves at a cheaper rate than the exchange rate in the market. Neither is there any incentive for anybody to buy Currency Board debt paper by the use of Currency Notes, notwithstanding that the former carries interest and the latter do not. It would be a lot more convenient for the buyer to make use of deposit money and in the case of a bank to make use of its clearing balance with the Currency Board, particularly when Currency Notes are transferable into the Aggregate Balance.

Transferability between Currency Board debt paper and the Aggregate Balance is a tricky issue. When the Currency Board buys and sells its own debt, whether passively or actively, it could be seen to be conducting money market operations of a discretionary nature, typical of central banks operating with other monetary policy objectives. It could undermine credibility of the Currency Board system. This is notwithstanding that the Currency Board debt paper is defined as part of the Monetary Base and is already fully backed by Foreign Reserves. There is the unavoidable impression that the Currency Board is aiming at influencing the level of interest rates or the level of interbank liquidity on a discretionary basis.

To deny transferability between Currency Board debt paper and the Aggregate Balance would, however, mean greater volatility in interbank interest rates. The Aggregate Balance could frequently move up and down in response to small flows of Foreign Reserves into and out of the Currency Board, particularly for economies with a relatively large external sector involving quite large volumes of external transactions. The susceptibility of the system to such volatility may be considered undesirable for the economy. Indeed, this weakness could be exploited. It does not take much for speculators who have built up a long position in the Domestic Currency to dry up the Aggregate Balance or send it into negative territory, thereby producing a sharp hike in interest rates and benefit from it.

Given also the responsibility of the Currency Board in ensuring the smooth operation of the interbank payment system, some transferability between Currency Board debt paper and the Aggregate Balance will have to be carefully prescribed. The Currency Board could allow the use of its debt paper as collateral for intraday liquidity in the case of an RTGS system as well as day end liquidity through a discount window. It will be useful if it could do so passively to avoid the impression that it is conducting discretionary money market operations, although the Currency Board will still have to determine a discount rate.

Convertibility Undertaking - Settlement

Three aspects of the Convertibility Undertaking can usefully be distinguished. First and arguably more importantly is how transactions arising from the Convertibility Undertaking are to be settled. The second aspect is the coverage and the third aspect is the form of the Convertibility Undertaking.

Whatever the coverage and the form of the Convertibility Undertaking, it is crucially important for the success of the Currency Board that transactions arising from the Convertibility Undertaking are settled through the Aggregate Balance. For example, in taking in Domestic Currency from (and providing Foreign Reserves to) a counterpart, pursuant to the Convertibility Undertaking, the Currency Board should debit the clearing account of the counterpart's bank the required amount of Domestic Currency. The bank should in turn debit the counterpart's deposit account the same amount of Domestic Currency or effect the payment through other means of their own choice. The counterpart could of course be the bank itself, in which case the settlement arrangements are simpler.

Convertibility Undertaking - Scope

Concerning the scope of the Convertibility Undertaking there are a number of choices. First, a simple and bold choice may be for the Currency Board to undertake to buy or sell Domestic Currency against Foreign Reserves at any time at the fixed exchange rate with whoever that wants to do so. But operationally this can be rather tedious for the Currency Board as it may not have the capacity physically to cope with the demands for conversion. Credibility of the Convertibility Undertaking may also be a concern. No matter how substantial Foreign Reserves are, the volume of international capital is enormous, so is the amount of Domestic Currency and assets denominated in it. And the leverage of the Aggregate Balance is not something that one can expect the community fully to comprehend.

It may therefore be necessary to limit the counterparts that the Currency Board wishes to deal with. As the Aggregate Balance is the sum of the balances (or assets) of the banks clearing with the Currency Board, it may be convenient, as a second choice, for the Convertibility Undertaking to be given only to the banks and for the Currency Board only to deal with the banks. As long as the banks have money in their clearing accounts, the Currency Board undertakes to convert it into Foreign Reserves and have their clearing accounts debited. Similarly, as long as the banks have Foreign Reserves, the Currency Board undertakes to provide Domestic Currency through crediting their clearing balances, thereby increasing the Aggregate Balance.

In practice, the banks enjoying the Convertibility Undertaking should be in a position to extend it more widely to non-bank customers, and it would be beneficial to confidence in the currency for them to do so. But in doing so they may incur a funding risk in that a non-bank customer taking advantage of the Convertibility Undertaking through them may put them in a difficult position of having to borrow interbank funds at expensive interest rates to cover the resultant shortage of interbank funds. Nevertheless this risk is not a lot different from that they would incur in servicing the normal day to day activities of their customers. The only difference is that these other day to day activities would not normally lead to a fall in the Aggregate Balance, but that taking on the Currency Board through the Convertibility Undertaking would. This may be adequate disincentive for the banks not to extend the Convertibility Undertaking to non-bank customers or to charge a fee for the service. If this extension is considered desirable, having regard to the specific circumstances of each economy, the Currency Board will have to ensure that the banks comply with the requirements of the system and possibly regulate or prohibit the charging of any fees.

Alternatively, the Currency Board, as a third choice, may wish to target the non-bank customers, as they are the ones that matter. They are holders of the Domestic Currency and assets so denominated. Their confidence in the currency is crucial and not that of speculators without the Domestic Currency but funded by the banks. Thus the Currency Board may wish specifically to give the Convertibility Undertaking to all non-bank holders of the Domestic Currency and in whatever form it is being held and require the cooperation of the banks in effecting settlement arising from the Convertibility Undertaking through the Aggregate Balance. Again the banks may be reluctant, but they will just have to be made to comply and be sensible about the charging of fees.

As in the first choice, the wide scope may carry a downside risk in that there may be doubts on the ability of the Currency Board to honour the Convertibility Undertaking. Members of the public are typically not familiar with the fine technicalities of monetary affairs generally and the leverage of the Aggregate Balance in a Currency Board system specifically. If the Foreign Reserves are only a small fraction of the amount of Domestic Currency covered by the Convertibility Undertaking, there may be a credibility problem. Covering the Aggregate Balance, which is small in relation to Foreign Reserves, is fine. But they may feel that it is a little too much for the Currency Board to handle if the Convertibility Undertaking is to cover every bit of the Domestic Currency under the sun. Even for an economy with very large Foreign Reserves, they would only be a fraction of the total deposit base or the money supply.

To ensure credibility of the Convertibility Undertaking, and give the impression of targeting a group of beneficiaries that is worth the while, the Currency Board may wish, as a fourth choice, to be rather more selective in defining the scope of the Convertibility Undertaking. But it must be realized that it will be impossible and indeed unnecessary to prevent shifts of Domestic Currency from outside of the scope to inside it. One such target group may be the small savers.

Convertibility Undertaking - Form

The exact form of the Convertibility Undertaking is also important. There may be room to choose between flexibility and rigidity, and between (constructive) ambiguity and clarity. The Convertibility Undertaking may be a rigid evergreen undertaking that can be invoked anytime at the initiative of the beneficiaries at the fixed exchange rate with no discretion on the part of the Currency Board. Alternatively, having regard to other considerations, this may be a rather more flexible undertaking to be brought into play by the Currency Board only when there is a perceived need to do so at or around the level of the fixed exchange rate, for example when there is currency speculation. It should be noted that this more flexible approach does not involve any departure from the Monetary Rule, in that when the Convertibility Undertaking is not in force, the Aggregate Balance simply does not change at all.

When confidence in the currency is an issue, then a rigid Convertibility Undertaking with no discretion on the part of the Currency Board may be the correct form. But when Foreign Reserves are substantial and confidence in the currency is not really an issue, some flexibility can be tolerated, if this is considered desirable for whatever reasons. In this connection, it should be noted that a Currency Board system inhibits the development of the foreign exchange market. In the case where the Convertibility Undertaking is rigid, at a fixed rate, has a universal coverage and can be invoked any time at the discretion of holders of Domestic Currency, there will be no need for a foreign exchange market. Everybody will just convert Domestic Currency into Foreign Reserves, or vice versa, with the Currency Board, when they have a need to do so.

Hence if the foreign exchange market is considered to be a beneficial feature of the economy, there may need to be some flexibility in the Convertibility Undertaking. Flexibility may take the following form. Under normal circumstances, the Currency Board leaves the foreign exchange market alone to find its level at around the fixed exchange rate specified. Meanwhile, the Currency Board reserves the right anytime to trigger and offer convertibility at the fixed rate or at a particular level of the exchange rate close to the fixed level should it consider that the circumstances justify so doing. Needless to say, however, flexibility, even with total transparency, can undermine credibility. Discretion is involved, in the sense that the Convertibility Undertaking is there only when the Currency Board feels that it is needed. This may bring into question whether the Currency Board is adequately committed to the Monetary Rule. The decision on the part of the Currency Board may also cause market operators profits and losses, and hence aggravation and distrust.

In circumstances when the Convertibility Undertaking is for whatever reason in doubt, it may be useful for the Currency Board somehow to exact a price for it so that it is seen to be worth something. More importantly, the Convertibility Undertaking is then no longer an empty promise of the Currency Board but a contract enforceable in court. This can take the form of an insurance premium for the target group of beneficiaries, for example the small savers, who should also be given the choice whether to buy such insurance. The price, or the insurance premium, however, may be manifested as a built-in interest rate premium for the Domestic Currency over the foreign currency.

The Adjustment Mechanism

Whatever are the specific features of the Currency Board system in terms of the definition of the Monetary Base, the transferability of its components, and the scope and form of the Convertibility Undertaking, theoretically two rather distinct adjustment mechanisms can be distinguished. There is Currency Notes arbitrage on the one hand and interest rate adjustment on the other.

With a Convertibility Undertaking for Currency Notes at the fixed exchange rate, any deviation of the market exchange rate from the fixed exchange rate would theoretically create opportunities for arbitrage, thus keeping the market exchange rate close to the fixed level. Assume, for example, that the market exchange rate is weaker than the fixed exchange rate. A person carrying out arbitrage can sell Foreign Reserves for Domestic Currency at the market rate and withdraw from his bank Currency Notes against the deposit balance which he got from the transaction. He can then take advantage of the Convertibility Undertaking to recoup from the Currency Board the Foreign Reserves that he has sold earlier at the more favourable fixed exchange rate and therefore make a profit.

It is not difficult to see that the feasibility or otherwise of Currency Notes arbitrage hinges upon quite a number of factors. First, the Convertibility Undertaking is obviously crucial, but as this is a clear commitment on the part of the Currency Board there should not be any difficulty in honouring it.

Second, there is however doubt as to whether or not banks would allow their customers to obtain a large amount of Currency Notes against their deposit balances. This is particularly so when the banks have to acquire Foreign Reserves in the market at the weaker exchange rate in order to submit them to the Currency Board to obtain the necessary Currency Notes for their customers. This may lead to banks charging a fee for the handling of large amounts of Currency Notes, with the fee, in percentage terms, reflecting the differential between the market exchange rate and the fixed exchange rate. This would inhibit the effectiveness of Currency Notes arbitrage in ensuring exchange rate stability.

Third, transaction costs may also be involved in moving large amounts of Currency Notes around, from a commercial bank to the Currency Board, or vice versa, thus further inhibiting Currency Notes arbitrage as an effective adjustment mechanism.

Fourth, foreign exchange transactions are typically for value spot, that is, for settlement two days hence and not for same day value. The two-day time lag between the taking of the decision to conduct Currency Notes arbitrage and its completion is probably too long for the comfort of those involved. This is particularly so at a time when the market exchange rate is weak and understandably rumours abound concerning the possibility of the Currency Board not being able to hold. Thus it is doubtful whether Currency Notes arbitrage is an effective adjustment mechanism to ensure exchange rate stability under a Currency Board system.

Fifth, in any case, if there is transferability between the Aggregate Balance and Currency Notes, and if the Convertibility Undertaking covers the Aggregate Balance at the fixed exchange rate, there is no need for Currency Notes arbitrage to take place.

The more effective adjustment mechanism of a modern day Currency Board system works through interest rates. With the Convertibility Undertaking for Domestic Currency working through the Aggregate Balance, capital inflows or outflows will lead to corresponding changes in the Aggregate Balance and therefore interbank interest rates. Within the limit of credibility, the resultant interest rate differential would create interest rate arbitrage opportunities and therefore generate offsetting capital flows. Meanwhile, the market exchange rate, if there is one, depending on the form of the Convertibility Undertaking, remains close to the fixed exchange rate level.

This adjustment mechanism, which works through interest rates, obviously involves pain for all borrowers of the Domestic Currency and thus for the economy as a whole, not just the speculators shorting the Domestic Currency for short-term gains. Depending on the level of confidence and the severity of the attack on the Domestic Currency, the pain can be quite sharp and prolonged. In this context, a number of factors are relevant. These include, but obviously not limited to, the determination of the government in adhering to the Currency Board system; the credibility of fiscal and other economic policies; the external environment including sentiment in the regional and global financial system; the domestic social, economic and political environment; the ability of the domestic economy to adjust, etc. Confidence may also be affected by the technical details of how the Currency Board system is structured. A clear and credible Convertibility Undertaking without discretion on the part of the Currency Board that is also legally enforceable will of course be more favourable to confidence, particularly amongst the holders of the Domestic Currency, than one with flexibility. When the community is in pain, they are likely to try and find someone to blame and the Currency Board responsible for inflicting the pain, albeit not so much at its initiative, is a very good target. But changes to the technical details should not lightly be considered precisely for the purpose of avoiding confidence being undermined. This is a delicate issue that can only be dealt with in the light of domestic circumstances.

No matter how a Currency Board system is structured, whether there is a rigid or a flexible Convertibility Undertaking, it will always be useful to ensure a high degree of transparency that the Monetary Rule is adhered to. To achieve this, it will be useful to provide up to date information on the Aggregate Balance and the other components of the Monetary Base. Given foreign exchange deals are typically for value spot and money market transactions are for value the same day, forecasts on the Aggregate Balance should also be provided. These will enable banks to prepare themselves well for any sharp changes in the Aggregate Balance, thus possibly avoiding market panic when any shortage occurs, dampening the sharp hikes in the short-term interbank interest rates and preventing overshooting of the interest rate pain.

Tolerance of Pain

For economies operating with Currency Board systems, it will be useful to pay attention to enhancing the ability of the economy generally to tolerate the interest rate pain. It will obviously be advisable for the innocent borrowers of the Domestic Currency, for example, those conducting their businesses or paying their mortgages, to be insulated as much as possible from the interest rate pain. This would help to prevent political pressures from building up against the Currency Board and calling for painkillers, notwithstanding that these would damage the health of the system in the long term. One way of doing so would be to promote the use of fixed interest rates, particularly for home mortgages and where borrowers are less able to protect themselves from interest rate fluctuations.

It is important also to realize that the leverage of the Aggregate Balance, whilst very strong, transmits the pressure of adjustment onto the banking system. When there is capital outflow, whether or not initiated by the banks or by the bank customers, leading to the Aggregate Balance shrinking or even going into debit, the banks are forced to surrender Foreign Reserves to the Currency Board in order to reconstitute the Aggregate Balance. Failure to do so will mean that their interbank obligations may not be settled and their going into default. Under the influence of higher interest rates, there may hopefully be offsetting capital inflows, but this is never guaranteed particularly when there is panic. And the banking system, in the meantime, may be forced into running down their Foreign Reserves and thereby incurring a short foreign currency position. The settlement risk and foreign exchange risk specific to a Currency Board system will need to be carefully managed. Furthermore, under a Currency Board system the banks may be exposed to sharper interest rate fluctuations and therefore greater interest rate risk than would otherwise be the case. There is a need for banks to pay special attention to managing these risks, working closely with the supervisory authorities, who will also have to promote better understanding amongst banks and provide suitable guidance.

Dollarization

Hopefully the necessary adjustments arising from a domestic or an external shock, including a currency attack, would be temporary. But the process may be sustained, involving a breakdown of confidence in the Domestic Currency, notwithstanding the Convertibility Undertaking of the Currency Board. In that case the adjustment pressures centering around high domestic interest rates may lead borrowers to seek the agreement of the lenders to re-denominate loans in foreign currency. The banks themselves may, in view of the risk profile of their balance sheets, seek to do the same with their customers. And in turn, or at the same time, providers of goods and services may demand receipts, and workers may demand remuneration, in foreign currency. Legislation may need to be put in place to facilitate this. The process would in effect amount to "dollarization" if the foreign currency to which the Currency Board is anchored is indeed the US dollar, and a gradual and orderly demonetization of the Domestic Currency, with the exchange rate remaining fairly stable throughout.

The Model System

On the basis of the theoretical discussions earlier in this chapter, a model modern day Currency Board system is outlined below. It is assumed that there is an abundance of Foreign Reserves and no lack of confidence in the currency. This is asking a lot, given particularly that with these conditions there may not be a need for a Currency Board system in the first place. But this model system may be used as reference for structuring a new system or for modifying an existing one in the light of domestic circumstances.

1. The Monetary Base should include the Aggregate Balance, the Currency Notes and a pool of Currency Board debt paper to an extent adequate to facilitate the smooth settlement of interbank transactions.
2. The Monetary Base should be backed fully by Foreign Reserves and, as a whole, be subject to the Monetary Rule.
3. The three components of the Monetary Base should be fully transferable amongst themselves at the initiative of the owner and the Currency Board should facilitate this.
4. Individual components of the Monetary Base could be changed against a corresponding change either in Foreign Reserves, in accordance with the Monetary Rule, or against a change in the other components of the Monetary Base in the opposite direction.
5. The Convertibility Undertaking should be an evergreen one for all Domestic Currency held by anybody at the fixed exchange rate, and passive on the part of the Currency Board, with transactions arising from the Convertibility Undertaking settled through the Aggregate Balance.
6. There should be a high degree of transparency and disclosure on how the Monetary Rule is being strictly observed by the Currency Board.
7. Up to date information should be published on all three components of the Monetary Base with possibly real time updating of the Aggregate Balance and forecasts thereon, and on the Foreign Reserves held by the Currency Board.

Glossary

Aggregate Balance

The sum of balances in the clearing accounts and reserve accounts maintained by commercial banks with the central bank. In Hong Kong, this refers to the sum of the balances in the clearing accounts maintained by the licensed banks with the Hong Kong Monetary Authority (HKMA) for settling interbank payments and payments between banks and the HKMA. This represents the level of interbank liquidity.

Arbitrage

Interest rate arbitrage: Activities that seek to profit from the deviation between the interest rate differential and interest equivalent of the spread between the forward exchange rate and spot exchange rate.

Currency Notes arbitrage: The mechanism through which economic agents seek to profit from the deviation between the official exchange rate applicable to the issue and redemption of banknotes and the market exchange rate. For example, when the market exchange rate is stronger than the official exchange rate, banks can buy foreign currency in the foreign exchange market, surrender it to the Currency Board in exchange for domestic currency at the fixed exchange rate, and thereby make a profit from the differential between the two rates.

Automatic/Autopilot Adjustment Mechanism

Under Hong Kong's Currency Board system, when there is an inflow of funds involving the HKMA buying the US dollars sold to it by the banks at their initiative, the clearing balance and hence the Monetary Base will expand. This is so because in settling the deals the HKMA credits the clearing accounts of the banks selling the US dollars to it with the Hong Kong dollars required for settlement. In the other direction, when there is an outflow of funds involving the banks selling the Hong Kong dollars to the HKMA at their initiative, the clearing balance and hence the Monetary Base will shrink when the HKMA debits the clearing accounts of the banks concerned in the settlement of the deals. The expansion and contraction of the Monetary Base will cause domestic interest rates to fall or rise respectively, creating the market condition necessary to counteract the initial capital flows to restore exchange rate stability.

Base Rate

The interest rate which forms the foundation upon which different Discount Rates for repo transactions through the Discount Window are computed. The HKMA announces the Base Rate everyday before the interbank market opens in Hong Kong.

Certificate of Indebtedness (CIs)

Under the Exchange Fund Ordinance, note-issuing banks are required to obtain Certificates of Indebtedness from the Exchange Fund as cover for the banknotes they issue.

Convertibility Undertaking

An undertaking by a central bank or Currency Board to convert domestic currency into foreign currency at a fixed exchange rate. In the case of Hong Kong, the HKMA undertakes to convert the Hong Kong dollar balances held by the licensed banks in their clearing accounts with the HKMA into US dollars at the fixed exchange rate of HK$7.75 to US$1. It is the HKMA's intention to move the rate to 7.80 (the rate applicable to Certificates of Indebtedness) when market circumstances permit.

Currency Board Accounts

Currency Board Accounts list the various liability and asset items relating to the operations of the Currency Board arrangements. On the asset side, it shows Foreign Reserves designated to back the Monetary Base and other liabilities of the Currency Board. On the liability side, it shows the Monetary Base (which includes banks notes and coins issued, and the Aggregate Balance) and the outstanding amount of debt paper issued by the Currency Board.

Currency Board System

A monetary system that complies with the Monetary Rule requiring any change in the Monetary Base to be brought about only by a corresponding change in Foreign Reserves in a specified foreign currency at a fixed exchange rate. Operationally, the Rule often takes the form of an undertaking by the Currency Board to convert Domestic Currency into Foreign Reserves at the fixed exchange rate.

Currency Note

A note issued by a bank or Currency Board promising to pay the bearer the par value of the note on demand. In the case of Hong Kong, currency notes are issued by the note-issuing banks.

Discount Rate

The interest rate at which licensed banks obtain overnight Hong Kong dollar liquidity from the HKMA through repurchase agreements involving Exchange Fund paper or other eligible papers under the Discount Window. The Discount Rate consists of two tiers :

Discount Window

In Hong Kong, the facility through which licensed banks can borrow Hong Kong dollar funds overnight from the HKMA through repurchase agreements using eligible securities as collateral.

Dollarization

The replacement of a domestic currency by a foreign currency as a store of value, unit of account and medium of exchange.

Exchange Fund Advisory Committee (EFAC)

Under section 3(1) of the Exchange Fund Ordinance, the Financial Secretary's control of the Fund is exercised in consultation with an Exchange Fund Advisory Committee of which the Financial Secretary is the ex-officio chairman and of which the other members are appointed by the Chief Executive of the Hong Kong Special Administrative Region. The Committee advises the Financial Secretary on general policy on the uses and the investment of the Exchange Fund.

Exchange Fund Bills and Notes

Debt instruments issued by the HKMA for the account of the Exchange Fund. Introduced in March 1990, the Exchange Fund Bills and Notes programme has expanded progressively over the years. At present, the total outstanding size is around HK$97.5 bn and the maturity profile extends from 3 months to 10 years. These instruments are fully backed by Foreign Reserves. The HKMA has also undertaken that new Exchange Fund paper will only be issued when there is an inflow of funds, thus enabling the additional paper to be fully backed by Foreign Reserves.

Foreign Reserves

Stock of foreign assets, held primarily for making foreign payments without the need to sell domestic currency in the market. In most economies, Foreign Reserves are primarily used to support the exchange rate of the domestic currency.

Liquidity Adjustment Facility (LAF)

The Hong Kong version of a Discount Window, established in 1992. Under the facility, licensed banks can borrow overnight funds from the HKMA through repurchase agreements of eligible securities at the Offer Rate and can place surplus funds overnight with the HKMA at the Bid Rate. The LAF was replaced by the Discount Window in September 1998.

Monetary Base

Money that can be used for settling transactions. To enable effective control, financial instruments constituting the Monetary Base generally appear on the balance sheet of the authorities responsible for monetary control. In a modern day monetary system, the Monetary Base is, at the minimum, defined as the sum of the currency in circulation (banknotes and coins) and the balance of the banking system held with the central bank (the reserve balance or the clearing balance). In Hong Kong, the Monetary Base comprises the Certificate of Indebtedness (for backing the currency notes) and coins issued and the balance of the clearing accounts of licensed banks kept with the HKMA for the account of the Exchange Fund. The Monetary Base can arguably be expanded to include Exchange Fund Bills and Notes since they can be used under the Discount Window to facilitate the smooth settlement of interbank transactions.

Monetary Rule

Under the Currency Board system, the Monetary Rule requires changes in the Monetary Base (liabilities of Currency Board) to be brought about only by corresponding changes in Foreign Reserves in a specified foreign currency (assets of the Currency Board) at a fixed exchange rate.

Real Time Gross Settlement (RTGS)

The continuous settlement of payments on an individual order basis without netting debits with credits across the books of the central bank.

Subcommittee on Currency Board Operations

A Subcommittee established under the Exchange Fund Advisory Committee in late August 1998 to oversee the operation of the Currency Board in Hong Kong and to recommend to the Financial Secretary, where appropriate, measures to enhance the robustness and effectiveness of Hong Kong's Currency Board arrangements. The Subcommittee is chaired by the Chief Executive of the HKMA. Other members include professionals in the financial industry, academics and senior officials of the HKMA.

US Fed Funds Target Rate

In the US, depository institutions can trade their reserves held by the Federal Reserve among themselves in the Fed funds market. The Fed Funds Rate is the cost for the overnight borrowing of these reserves. The Fed Funds Target Rate is the Federal Reserve's desired target rate for the Fed Funds Rate. The Federal Reserve conducts money market operations to influence the Fed Funds Rate if it considers the rate to be deviating too much from the target rate.

US Federal Open Market Committee (FOMC)

Chaired by the Chairman of the Board of Governors of the Federal Reserve System in the US, the Committee meets eight times a year to set Federal Reserve guidelines in the open market as a means of influencing the volume of bank credit and money in the economy. It also establishes policies relating to system operations in the foreign exchange markets.