The ratio between the Backing Portfolio of the Exchange Fund and the Monetary Base has declined in recent months. Capital inflows into the Hong Kong dollar are the root cause of this.
In the Report on Currency Board Operations that we publish every month, there is at the end commentary concerning the movements of the "Backing Ratio" over the period covered by the Report. The Backing Ratio refers to the extent to which the Monetary Base is backed by foreign currency assets held in the Currency Board Account of the Exchange Fund. Although all of the one trillion Hong Kong dollars of assets of the Exchange Fund can be used to ensure the stability of the exchange value of the currency of Hong Kong, in transparently operating the Currency Board system, we prepare for analytical purposes a specific Currency Board Account. On the asset side of this Account are liquid US dollar assets - the Backing Portfolio - providing specific backing for the Monetary Base (the rest of the assets of the Exchange Fund are referred to as the Investment Portfolio). On the liability side are the four components of the Monetary Base, namely, (i) Certificates of Indebtedness issued to the note issuing banks in support of the banknotes they have issued, (ii) currency notes and coins issued for the account of the Exchange Fund, (iii) the Aggregate Balance and (iv) Exchange Fund paper outstanding.
The US dollar assets backing the Monetary Base are managed in the most liquid form, in US dollar call deposits and US Treasury securities. Because the value of securities, including those of the Exchange Fund paper on the liability side, fluctuate in response to changes in interest rates, we have a practice of keeping in the Currency Board Account US dollar assets that exceed the Monetary Base by a safe margin. Take the situation in which US dollar interest rates rise more than Hong Kong dollar interest rates. The value of the US Treasury securities may fall, in absolute terms, more than that of the Exchange Fund paper, so that the backing may become insufficient if there is no safety margin. Thus we have the Backing Ratio of US dollar assets over the Monetary Base, which we monitor daily. We have also set upper and lower "Trigger Levels" for the Backing Ratio, at 112.5% and 105% respectively, beyond which transfers can be made out of or into the Backing Portfolio into and from the Investment Portfolio of the Exchange Fund.
Since, in normal circumstances, we are earning investment income from all of the US dollar assets in the Backing Portfolio but are paying interest on only about 40% of the liabilities constituting the Monetary Base, there is a tendency for the assets to accumulate faster than the liabilities. In other words, the Backing Ratio tends to increase over time. Indeed, from the time when the Trigger Levels were first established in 2000, the Backing Ratio reached the upper Trigger Level of 112.5% twice and assets were transferred from the Backing Portfolio to the Investment Portfolio and the Backing Ratio brought down to 110%.
But the Backing Ratio can drift down for a number of reasons. The first is when Hong Kong dollar interest rates fall below US dollar rates. Marking the value of securities to market, there may be an increase in the Monetary Base relative to the Backing Portfolio. The second is when the Hong Kong dollar strengthens, however slightly, against the US dollar, so that the US dollar assets in the Backing Portfolio are worth less in Hong Kong dollars. The third is when there is a sudden increase in the Monetary Base, for example in the Aggregate Balance. While this is matched by a corresponding increase in the Backing Portfolio in absolute terms, the fact that the Backing Portfolio is, by design, bigger than the Monetary Base will lead to a fall in the Backing Ratio.
Capital inflows into the Hong Kong dollar in the past few months have led exactly to this happening. Hong Kong dollar interest rates have become significantly lower than US dollar interest rates. Although we are paying less interest for the money borrowed through the issue of Exchange Fund paper than the interest we receive on US Treasury securities, this is offset by the differential market valuation effect. More significantly are the exchange rate valuation effect, as a result of a stronger exchange rate, and the unusual increase in the Monetary Base (HK$54 billion or about 20% more than otherwise would be the case). As a result, the Backing Ratio has fallen from around 112% in September last year to below 109% in late January this year, before edging up again as the exchange rate weakened to nearer 7.80. But, at 109%, the Backing Ratio is still very much above the Lower Trigger Level of 105% that requires a transfer from the Investment Portfolio to bring it up to 107.5%. Thus the backing arrangements have been working as designed.
Joseph Yam
1 April 2004
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