The case for increasing the supply of Exchange Fund paper has become clearer.
With stock market activity (Initial Public Offerings as well as secondary-market turnover) falling off as the calendar year drew to an end, the demand for liquidity in the interbank market eased considerably. But the demand for Exchange Fund paper has still been high enough to justify an unusually large discount in the yield of the paper, particularly the short-term bills, from the corresponding interbank interest rates. The discount, in the one-month area, was still about 140 basis points at the end of last year, having narrowed from about 400 basis points, although market anticipation of an increase in the supply of Exchange Fund bills following my earlier article on the subject may have contributed to this narrowing.
Thus, even in a relatively quiet period in the interbank market, the demand for Exchange Fund paper remains unusually high. Or rather the volume of interbank activity has grown so much, that even with a quiet interbank market the fixed supply of Exchange Fund paper seems to be inadequate. The supply of Exchange Fund paper – the instrument for acquiring intra-day liquidity from the HKMA for effecting interbank payments in our Real Time Gross Settlement (RTGS) system – being fixed was a consequence of the seven technical measures introduced in 1998 to make the Linked Exchange Rate system more robust. The then existing pool of Exchange Fund paper was defined as part of the Monetary Base, along with and transferable into the Aggregate Balance, to reduce the sensitivity of interbank interest rates (and therefore the prices of financial assets) to the flow of funds into and out of the Hong Kong dollar. Once this is done, any further increase in the pool of Exchange Fund paper has to be matched by a corresponding increase in US dollar reserves backing the Monetary Base. When we buy US dollars at the exchange rate of 7.75 defined by the Convertibility Undertaking in response to an inflow of funds, we have the choice of allowing the increase in the Monetary Base to take in the form of an increase in the volume of Exchange Fund paper rather than an increase in the Aggregate Balance. But we have chosen so far to allow inflows to be reflected in an increase in the Aggregate Balance, mainly to avoid giving the impression that we have an interest-rate policy independent of US interest rates or preventing inflows from depressing domestic interest rates and frustrating the built-in adjustment mechanism of the Currency Board system.
The shortage of Exchange Fund paper to facilitate smooth interbank RTGS clearing, to the extent that this explains the large discount in yield compared with HIBOR, now clearly points to the need for us to introduce flexibility in the supply of Exchange Fund paper. Comments from our market contacts also suggest that such an increase will be welcomed by the banks. What we have to decide is whether we treat the intended increase in Exchange Fund paper as an internal transfer between different components of the Monetary Base, in which case no additional US dollars are required for backing purposes; or an increase in the Monetary Base, in which case there will need to be a corresponding increase in US-dollar backing.
Given that there is quite a lot in the Aggregate Balance at the moment, we prefer the former; in other words, an internal transfer between different components of the Monetary Base. This will be done by debiting the clearing accounts of the successful bidders at a special tender of Exchange Fund paper. The reduction in the Aggregate Balance should not have significant effects on interbank interest rates or the exchange rate. In the unlikely event that the interbank market tightens and the exchange rate strengthens significantly as a result, we can counter these movements by using part (or even all) of the Hong Kong dollar proceeds of the special issue to purchase US dollars, thereby increasing the Aggregate Balance again. To the extent that this is the outcome, then the increase in Exchange Fund paper will mean an increase in the Monetary Base and the corresponding US-dollar backing.
All this is probably rather technical for those not familiar with our monetary system. But it is necessary to make our intentions clear to avoid misunderstandings. We do not have an interest rate policy, other than generally following the interest rates for the US dollar. And for those who are familiar with the functioning of our monetary system, the transferability of the Aggregate Balance into Exchange Fund paper makes a lot of sense, given that Exchange Fund paper is already transferable into the Aggregate Balance through intra-day repurchase arrangements and end-of-day discounting through the Discount Window.
Joseph Yam
3 January 2008
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