The purchase of government bonds by the Exchange Fund would risk giving the impression of monetising the budget deficit.
In connection with the issue by the Government of a total of HK$20 billion of bonds, some of our media friends asked me the simple question of whether or not the Exchange Fund would invest in the bonds. As with many simple questions in monetary affairs, there is no simple answer to this. And so I prefaced the negative answer that I eventually gave by supporting the Government's efforts in bringing these bonds to the market and then qualified it by pointing to the undesirable possibility of being seen to be monetising budget deficits. This created some interest in the concept of monetisation of budget deficits, and a number of journalists have asked me to write a simple piece on it.
To exercise effective monetary policy, whatever the objective of such policy and the form of monetary operations conducted to achieve it, a central bank or a monetary authority must have control over the monetary base. An effective mechanism for exercising this control comes from the interbank payment and settlement of the domestic currency, with the central bank or monetary authority being the settlement institution. All banks maintain a clearing account with the central bank for the purpose of effecting electronic payments between themselves and between their customers, and the total of the balances in the clearing accounts - what we call the Aggregate Balance in Hong Kong - is the crucial element of the monetary base. A payment from Bank A to Bank B is effected through the central bank by debiting the clearing account of Bank A and crediting the clearing account of Bank B for the same amount. As the settlement institution, the central bank is endowed with the power to create money by crediting the clearing account of banks with whatever amounts are paid in settlement of the purchase of whatever assets by the central bank. The central bank can, of course, sterilise the money created by borrowing it back from banks or by selling assets of an equivalent amount, and settling these transactions by debiting the clearing accounts of the banks.
Thus, if the government runs short of money in the public finances, the central bank, which in most cases is the banker to the government, has the choice of financing that shortfall through the creation of money (or by printing money, when money was still predominantly in physical form). While the central bank can sterilise the money so created, in which case effectively the government will be borrowing, through but not from, the central bank to finance budget deficits, there are limits to the central bank's capacity to do so and market confidence about monetary stability can be undermined. The consequences of the monetisation of budget deficits are, immediately, a larger monetary base and, subsequently, according to economic textbooks, lower interbank interest rates, easier monetary conditions, higher growth in bank credit and the money supply, and higher inflation. This, of course, is a slippery slope for macro-economic management, and so we have examples of jurisdictions forbidding, by law, the central bank to lend to government.
In Hong Kong the HKMA is the settlement institution of the interbank payment and settlement system for the domestic currency and so we are in a position to create money. But, through adopting Currency Board arrangements, we have committed ourselves to creating money (Hong Kong dollars) and increasing the Aggregate Balance, the crucial element of the Monetary Base, only through the purchase of US dollars and to doing so transparently, with information disclosed real-time. This is the monetary rule that underpins the confidence in the Hong Kong dollar. The purchase of the bonds issued by the Government through the creation of money - the monetisation of budget deficits - is against the monetary rule and undermines confidence in the Hong Kong dollar. Even if we were to sterilise the money created through certain funding arrangements, we would still be lending to the Government, which could be misunderstood.
To eliminate the possibility of any misunderstanding, I have also determined that the government bonds will not be eligible for access to the Discount Window. Even though the provision of liquidity through the Discount Window is typically for very short-term money, the acceptance of the government bonds, apart from being seen to be lending to the Government, involves the creation of Hong Kong dollars against a Hong Kong-dollar, rather than a US-dollar, asset. This is also against the Currency Board rule, however short-term the transaction through the Discount Window. The integrity of the Currency Board system, and the confidence in Linked Exchange Rate of the Hong Kong dollar, cannot be compromised.
Joseph Yam
12 August 2004
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