The HKMA has been refining the Linked Exchange Rate system over the years, trying to strike a fine balance among transparency, discretion and credibility.
There is a variety of models for fixing an exchange rate. The choice of the exchange rate anchor is a prime consideration. The currency of the major trading partner is often chosen as the anchor currency, although the use of a currency basket is also quite common. In the latter case, there is the additional choice of whether to be transparent about the anchor, in terms of, for example, the currencies included in the basket, the weightings assigned and the frequency with which the weightings are reviewed and altered. Transparency is a two-edged sword. It improves the credibility of the system but limits the scope and flexibility of the authorities to deal with anomalies for the public interest. The degree of discretion the authorities have in operating the system is another important consideration in designing a fixed exchange rate system; and discretion is a two-edged sword, in much the same way as transparency.
At one extreme, one can have a totally transparent and non-discretionary system for fixing the exchange rate (our Currency Board system is close to this model), or, at the other extreme, the exchange rate can be more or less fixed against an undisclosed basket of currencies. But interestingly, there is not a definite relationship, in monetary or exchange rate management, between transparency and discretion on the one hand, and transparency and credibility on the other. One can think of successful examples to support a particular way of doing things. In the end, the optimal model depends very much on domestic circumstances. These differ widely across jurisdictions. For example, transparency (at least operational transparency) and the degree of discretion in running the system are not particularly important in fixing an exchange rate if there is foreign exchange control, while they may be crucial for a free and open international financial centre.
But then, nothing is absolute. Even in Hong Kong's case, where transparency and (the lack of) discretion are almost at the extreme end, there is still a need to strike a fine balance and choices are involved. These choices may be of a structural or day-to-day discretionary nature. Readers will recall short-term interest rates being pushed to very high levels in 1997 when the Asian financial crisis began. The overnight interbank interest rate went above 200% per annum. While the HKMA was blamed for squeezing the interbank market, this was very much the result of the system being run by the book, without any discretion on our part to dampen interest rate volatility that might be damaging to the economy. When there is capital outflow, interest rates go up to stem and then reverse the outflow. If the authorities were to take discretionary action to dampen the interest rate adjustment and ease the pain of high interest rates, the credibility of the system, it is argued, might be undermined. Clearly, however, the community considered interest rate volatility as we saw it in 1997 to be excessive and, in response, action was taken in 1998 to re-define the Monetary Base and allow banks holding Exchange Fund papers to access to liquidity through the Discount Window. This structural change to the Currency Board arrangements has no precedent anywhere in the world.
Then there were the further structural changes made last year, also to limit interest rate volatility, this time on the low side, by anchoring exchange rate expectations on the strong side of the Linked Exchange Rate by introducing the strong-side Convertibility Undertaking at HK$7.75 per US dollar. Interest rates, having remained close to zero for 18 months preceding the change, returned to more normal levels afterwards, close to those of the US dollar, our anchor currency. There is one thing that we must, however, be very clear about. To maintain a fixed exchange rate in a free and open monetary system, interest rate volatility of the domestic currency around the policy interest rate of the anchor currency is inevitable. Although history has demonstrated that there is some scope for dampening interest rate volatility without undermining the credibility of the system, there are obviously limits to how far this can be done.
Under the current system, within the Convertibility Zone of 7.75 to 7.85, the exchange rate is allowed to fluctuate in response to supply and demand conditions in the foreign exchange market. If the exchange rate hits either of the Convertibility Undertakings, then there will be an interest rate response. For example, if the exchange rate strengthens to 7.75 and the strong-side Convertibility Undertaking is triggered, the Aggregate Balance will increase and interest rates in the interbank market will fall. When the exchange rate is within the Convertibility Zone, interbank interest rates will still fluctuate, and quite significantly, as a result of the interaction of supply and demand for liquidity. As the banking community is aware, the supply of interbank liquidity, as measured by the size of the Aggregate Balance, is constant when the exchange rate is within the Convertibility Zone, but the demand is not, since it is affected by factors such as IPO activities. While we at the HKMA are quite relaxed about this volatility from a macro-monetary point of view, as far as its effects on exchange rate stability are concerned, banks, particularly those dependent on interbank funding, should consider how these fluctuations in interbank interest rates would affect them and how they can best manage the risks arising from this.
Joseph Yam
30 March 2006
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