The Linked Exchange Rate system is working as intended to safeguard monetary stability.
I hope readers will not mind if I describe again how our Linked Exchange Rate system works. At the exchange-rate levels defined by the strong-side and weak-side Convertibility Undertakings, 7.75 and 7.85, the HKMA stands ready to exchange any amount of US dollars against Hong Kong dollars with licensed banks maintaining Hong Kong-dollar clearing accounts with the HKMA. At those levels, action is initiated by the banks and not by the HKMA. When the exchange rate is within the two Convertibility Undertakings, in other words within the Convertibility Zone, the HKMA occasionally takes the initiative to buy or sell US dollars against the Hong Kong dollar, when in our opinion the monetary environment justifies our doing so. Such operations within the Convertibility Zone have occurred only twice since the introduction in May 2005 of the three refinements made to the Linked Exchange Rate system, which, among other things, defined the Convertibility Zone. These actions are taken to normalise the relationship between the exchange rate and interest rates in the interbank market.
With the exchange rate fixed at 7.80 to the US dollar (for the Monetary Base), the theoretical relationship between the market exchange rate and interest rates in the interbank market should be one of an interest rate premium over the US dollar when the exchange rate is on the weak side of 7.80, or an interest rate discount when the exchange rate is on the strong side of 7.80. However, because the supply of liquid funds in the interbank market, defined by the Aggregate Balance of the Hong Kong-dollar clearing accounts maintained by the licensed banks with the HKMA, remains constant in the absence of market action taken by us but the demand fluctuates along with general economic activity, particularly financial market activity, anomalies do occur in the relationship between the exchange rate and interest rates.
We have in the past seen periods in which the exchange rate was stronger than 7.80 but there was a significant interest-rate premium for the Hong Kong dollar over the US dollar. Conversely, there were periods in which the exchange rate was weaker than 7.80 but there was a significant interest-rate discount. Such anomalies may be quite temporary and the market may adjust, without the need for us to take action. But they may be quite persistent, to the extent of creating the possibility of sharp interest-rate adjustments when the Convertibility Undertaking is eventually triggered, causing similarly sharp and possibly destabilising reactions in financial markets. There may therefore be a case for action within the Convertibility Zone to normalise the relationship between the exchange rate and interest rates so as to minimise the possibility of abrupt adjustments in the latter.
It is, of course, a matter of judgement for us whether or not there is a need to take action within the Convertibility Zone. As a matter of routine we monitor closely market conditions, talking frequently with significant players in the money and foreign-exchange markets. One can argue that there should be flexibility in varying the size of the Aggregate Balance, that is the supply of liquidity in the interbank market in response to fluctuating demand, to deliver a greater degree of stability in interest rates around those for the US dollar and hence for the exchange rate. On the other hand, one can also argue that interest rates could deviate temporarily from those of the anchor currency to reflect the fund flows at the time. And the banking system seems quite relaxed about small fluctuations in interest rates in the interbank market around those for the US dollar, although the possibility of sharp changes when the exchange rate hits the levels defined by the Convertibility Undertakings is something they do not want to see.
On 23 October, we operated within the Convertibility Zone, buying about HK$775 million worth of US dollars when there was a significant interest-rate premium for the Hong Kong dollar over the US dollar at a time when the exchange rate was near the strong-side Convertibility Undertaking. This had the effect of normalising the relationship between the exchange rate and interest rates in the interbank market, in that the interest-rate premium at least disappeared, although one would hope that a discount could emerge. And when the exchange rate strengthened further to 7.75, under the influence of equity-related demand for Hong Kong dollars, we passively took in another HK$775 million worth of US dollars on 26 October, when the Convertibility Undertaking was triggered. Subsequently on 31 October, a series of strong-side Convertibility Undertaking operations was undertaken, which involved the purchase of a total of about US$1 billion against the Hong Kong dollar, under the influence of persistent equity-related inflow as well as speculative demand arising from a number of unfounded rumours regarding the peg. As a result of these events, we estimate that the size of the Aggregate Balance will have increased from around HK$1.3 billion on 23 October to HK$10.6 billion on 2 November, and a larger interest rate discount has appeared.
It may be that the strong-side Convertibility Undertaking will further be triggered, requiring us to buy in more US dollars passively and inject more Hong Kong-dollar liquidity. Alternatively, the interest rate discount that has emerged may be enough to generate the counter-balancing outflow. Whatever the case, and whether or not action within the Convertibility Zone is taken, the Linked Exchange Rate system has been functioning well to deliver exchange-rate stability. The Government has also reiterated that there is no plan or intention to change the system in any way (such as re-pegging at a different level or widening the Convertibility Zone).
Joseph Yam
1 November 2007
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