Legislative Council
Meeting on 17 December, 1998

HKMA's Response to Views of
Market Practitioners and Academics on the
Linked Exchange Rate System


1. The Legislative Council Panel on Financial Affairs held special meetings on the 7th and 14th of November, 1998 to discuss the mechanism for defending the linked exchange rate system and on the regulation of the securities and futures markets. Representatives of the financial services industry and relevant associations and local academics were invited to present their views at the meetings. Representatives of the HKMA were also invited to observe the meetings to take note of the views expressed. This document outlines the HKMA's response to the comments concerning the HKMA and the linked exchange rate system. A summary point-to-point response on comments relating to the linked exchange rate system is prepared in tabular form and is attached as an Annex to this document.

The Linked Exchange Rate System

(a) The performance of the link during the Asian financial turmoil

2. The Hong Kong dollar exchange rate has remained remarkably stable since the Asian financial crisis erupted in July 1997. In the past eighteen months, notwithstanding bouts of speculative attacks, the Hong Kong dollar exchange rate vis-a-vis US dollar moved within a narrow range of 7.725 to 7.752. It remains the only freely convertible currency in Asia that has not experienced devaluation.

3. Under Hong Kong's currency board arrangements, interest rates must rise to restore exchange rate stability whenever capital outflows place pressure on the Hong Kong dollar. The interest rate pain so inflicted on the economy has been the focal point of attack by many skeptics of the currency board system. A comparison of the interest rate fluctuations in the four rounds of currency attacks on the Hong Kong dollar during the Asian financial crisis, however, demonstrates that volatility in Hong Kong dollar interest rates has been reducing, despite deteriorating external and domestic economic conditions. (see Table 1).

Table 1

Overnight HIBOR
closing rate
1-month HIBOR
closing rate
First Round (23 Oct 97) 100%45%
Second Round (12 Jan 98) 13%19%
Third Round (15 Jun 98) 10%18.5%
Fourth Round (7 Aug 98) 7.5%13%

4. Interest rate increases, in terms of magnitude and duration, were greatest during the first attack in October 1997. The overnight and 1-month HIBOR rates rose to as high as 280% and 100% respectively on 23 October, and did not ease as quickly as in the subsequent rounds of attacks. The more moderate interest rate adjustments in the January and June rounds were mainly the result of the various improvement measures of the HKMA implemented in the midst of the financial turmoil. These include the clarification of the definition of 'Repeated Borrowings' under Liquidity Adjustment Facility (LAF) in November 1997, and the announcement of the forecast change in the Aggregate Balance on a real time basis since June this year.

5. When large hedge funds deployed the more sophisticated 'double-market' play in August with a view to creating extreme conditions in the money market so that they might gain from their substantial short positions in the stock and futures market, the HKMA took decisive steps to operate in the stock and futures market to frustrate their play and to restore the stability and integrity of financial markets. The decision has been controversial, but was well justified, as the hedge funds' manipulative play was threatening the systemic stability of our financial system. In the last two LegCo meetings, a number of market professionals and academics expressed their understanding and support of our market operations under such exceptional circumstances.

(b) The seven technical measures

6. To follow through on our market operations in August, a package of technical measures to strengthen our currency board system was introduced in early September. Underscoring the technical measures were two major planks: the provision of an explicit Convertibility Undertaking to the Aggregate Balance and the replacement of the LAF by a Discount Window. The explicit Convertibility Undertaking is a clear demonstration of the Government's commitment to the linked exchange rate system. The Discount Window facility provides a bigger cushion of interbank liquidity and helps to reduce excessive volatility in interest rates arising from the relatively small size of the Aggregate Balance of the banking system.

7. To date, this package of technical measures is operating smoothly. As pointed out by some market practitioners in the LegCo meeting on 7 November, the technical measures have served to stabilize market sentiment and improve investor confidence. There have been no significant capital outflows since the implementation of those measures in early September, with the Hong Kong dollar exchange rate remaining stable at around 7.741 - 7.748. There were a couple of incidents, in mid-September and late October respectively, when some capital outflows temporarily resulted in the Aggregate Balance becoming negative. Interest rates firmed up in response to the shortage of the liquidity, but the rise was much more moderate when compared with previous rounds of capital outflows. The calm reaction of the banks towards a shortage of interbank liquidity was partly explained by a bigger cushion of interbank liquidity made possible by the Discount Window facility. Reflecting improved investor confidence, the interest rate premium on Hong Kong dollar assets has declined significantly since early September. The spread between 3-month HIBOR and its US dollar counterpart fell from nearly 700 basis points (bp) in early September to around 50 bp in mid-December. At the longer end of the yield curve, the spread of the 10-year Exchange Fund Notes over the US Treasuries fell from around 490 bp to 190 bp over the same period.

8. Views have been expressed that the introduction of the package of technical measures before September might have averted the need for market operations. Up until the latest round of attack in August, the linked exchange rate system had worked well, and it was not necessary to introduce significant changes. More important still, while the package of technical measures would dampen interest rate volatility in the event of capital outflows, there would be greater volatility in the level of official foreign reserves. They would also, to some extent, have negative implications on debt market development in Hong Kong. The decision to implement these measures therefore was not taken lightly. Furthermore, to implement these reform measures at a time when HK$ is subject to immense pressure could also give rise to the misconception that we are changing the rules of the game in an unplanned and uncoordinated manner, which would not be conducive to financial market stability.

(c) Further measures to improve the currency board arrangements

9. To keep in step with changing market conditions and financial and technical innovations, the currency board system needs to be subject to constant review, and refinements should be introduced where appropriate to strengthen the system. Against such background, an EFAC Subcommittee on Currency Board Operations ('the Subcommittee') was set up in late August to oversee the operations of the Currency Board arrangements in Hong Kong and to recommend measures to enhance their robustness and effectiveness. Besides, the HKMA has been convening discussions with academics from different universities in Hong Kong to exchange views on the currency board arrangements.

(i) Proposals by academics

10. A number of academics put forth various proposals on the currency board arrangements in the 14 November LegCo meeting. Our responses to their proposals are as follows:

  • Professor Nai-fu Chen's proposal to link the monetary base to credit creation

    Professor Chen proposed to introduce a Base Ratio to "tie an important component of the monetary base to the credit creation in the banking system". The Base Ratio is defined as the ratio of the monetary base (i.e. clearing balance + cash + Exchange Fund Bills and Notes) to total HK$ financial asset. Professor Chen expects that under such a scheme, "interest rates depend on the aggregate demand (and not just the liquidity in the banking system's clearing balance) and act as the equilibrating mechanism to induce the proper (foreign reserves) supply response."

    As part of our ongoing discussion with the academics on the currency board arrangements, the HKMA will further discuss with Professor Chen and other academics on this proposal. Our preliminary assessment is that under the proposed scheme, an outflow of funds may trigger a significant decline in the Base Ratio, in response to which banks may curtail their lending activities to restore the ratio. This could have undesirable repercussions on economic growth, especially when the local economy is under severe contractionary pressure. The introduction of a Base Ratio on banks, which resembles the imposition of a reserve requirement on credit creation, will also impose additional costs on the banking system which are not needed for monetary control.

  • Professor Merton Miller's proposal of insurance/HK$ put option

    Professor Miller proposed some forms of insurance scheme or HK$ put options to signal the Government's strong determination to maintain the link. Some other academics (including Professor Tsang Shu-ki and Professor Sung Yun-wing) had reservation on the value-added of such schemes as the determination and ability of the government to uphold the link has been amply demonstrated in the past episodes when the Hong Kong dollar was under attack.

    One of Professor Miller's suggestions involves the HKMA issuing special Exchange Fund papers, which is redeemable at the option of the holder either in Hong Kong dollars or US dollars at the exchange rate of 7.80. As Exchange Fund Bills and Notes have become a component of monetary base and are fully backed by the foreign reserves, it is our intention to review the case of extending the Convertibility Undertaking to Exchange Fund Bills and Notes, which may have similar effects as the proposed scheme.

    As regards other variations of the HK$ put option, to the extent that the size of the options offered is very substantial and/or the coverage of the option is outside the monetary base, the credibility of the scheme may be questioned as our foreign currency reserves, though sizable, would not be sufficient to cover the options. While a limited size of the options may help address the above concern, issues such as the pricing and allocation scheme and the limited effect of the scheme in boosting public confidence in the link will bound to arise.

  • Professor Tsang Shu-ki's proposal of two-way convertibility undertaking for the Aggregate Balance

    This is an important issue which will further be discussed in our meetings with academics, as well as in the Subcommittee meetings. Under the present market sentiment, there is greater concern about the pressure on the Hong Kong dollar to depreciate. Giving an undertaking to sell US dollars for Hong Kong dollars at a published exchange rate is more relevant in addressing these concerns. For the time being, we can continue to leave the foreign exchange market very much alone when the Hong Kong dollar is traded at a level stronger than 7.75. If circumstances warrant, we may in due course provide a bid rate also for the sale of the Hong Kong dollars against US dollar. But this will have important implications for foreign exchange activity.

(ii) Rule versus discretion on the part of the HKMA

11. There were diverse views as to the extent of the discretionary power that should be exercised by the HKMA. Operating under the currency board system which is a rule-based monetary regime, a change in the monetary base can only be brought about by a corresponding change in foreign reserves. The HKMA cannot therefore create unbacked monetary liabilities to influence the supply of liquidity in the financial system. Nor can the HKMA pursue an independent interest rate policy to affect the price of liquidity. The currency board operations are under close scrutiny by the Subcommittee, which works to ensure that the HKMA is in full compliance of the monetary rule. The exercise of any discretionary power, e.g. the temporary provision of liquidity in the interbank market under exceptional circumstances such as Initial Public Offering or the charging of penal Base Rate on individual banks (for example, banks believed to be facilitating market manipulation), will be reported to the Subcommittee, whose minutes are published regularly. Such arrangements provide proper checks and balances on the discretionary power of the HKMA. It is also worth noting that in the broader context, there is a need to balance between credibility, achieved through strict adherence to rules and regulations, and flexibility through the exercise of certain discretionary power.

(d) Cost of maintaining the link/alternative arrangements

(i) The link and economic competitiveness

12. There were concerns that the fixed exchange rate has eroded the competitiveness of Hong Kong. One common indicator of competitiveness from the cost-price perspective is the real effective exchange rate (REER), i.e. nominal exchange rate adjusted for price differentials. It is important to note that an appreciation in the REER could be attributed to a nominal exchange rate appreciation or high domestic inflation relative to the trading partners or both.

13. Under a fixed exchange rate regime, adjustments to regain competitiveness have to come from the domestic sector. In fact, domestic prices, wages and asset prices have already adjusted downwards. Composite CPI growth fell to a record-low of 0.1% in October. Wage increases have moderated markedly since the third quarter of last year. As of end-October, property prices have fallen by over 50% compared with the peak in 1997. Stock prices are still around 40% below the record-high in August last year, despite the rebound in the last three months. It is also important to note that the recent strengthening of the Japanese Yen and other Asian currencies has also contributed to some unwinding of the real appreciation of the Hong Kong dollar. We crudely estimate that the CPI-based REER appreciated by 9% during July 1997 to September 1998, but depreciated by about 5% in September to November, in part due to the US dollar's weakening.

14. Competitiveness covers more than cost-price measures such as the REER. Other factors are also important in determining Hong Kong's competitive edge over other economies. With regard to exports, Hong Kong has the benefit of having the Mainland as its hinterland, which provides our manufacturers with low-cost labour and land. Average wages in the Mainland are still substantially lower than those of the other Asian countries even after the sharp depreciation of their currencies. In addition, Hong Kong possesses a well-established financial infrastructure and a sound financial supervisory framework that ranks with the best internationally. Our banking system remains strong, with local banks having a high capital adequacy ratio of over 18%. In sum, both domestic price adjustments as well as continued improvements in other areas will help Hong Kong regain its competitive edge under the linked exchange rate system. In fact, the link itself provides a pillar for strengthening Hong Kong's role as an international financial centre.

(ii) Impact on the debt market and Hong Kong's status as an international financial centre

15. There were views that the ineligibility of new private sector debt instruments for Discount Window purpose and the request for multilateral agencies to withhold their issuance of debt papers of less than three years will hamper debt market development. Admittedly, the above measures will have some negative implications on debt market development in the short run. Nevertheless, the resultant interest rate and exchange rate stability will be conducive to debt market activities in the long run. The view is shared by the Hong Kong Capital Markets Association (HKCMA). We shall also review the present arrangements of encouraging multilateral agencies to issue debt instruments of three years or more when market conditions become settled. The HKMA will continue to work closely with the HKCMA on measures to foster local debt market development. Measures to be considered include a review of the tax treatment of debt instruments and the promotion of investor education.

16. More generally, there were concerns that interest rate volatility in the defence of the link will undermine Hong Kong's status as an international financial centre. It is, however, worth noting that the absence of capital controls, coupled with a stable exchange rate and interest rate environment will enhance rather than undermine our status as an international financial centre. With our banking system remaining strong and robust in the midst of the Asian financial turmoil, Hong Kong remains one of the most prominent international banking centres. There are signs of partial recovery and revived interest from overseas investors in local capital markets after September. Hong Kong will also maintain its important role as an international centre for currency trading, as Hong Kong has an advanced financial infrastructure, simple and transparent regulations and the strategic advantage of being the financial services centre for China. We also concur with the views of some market professionals that downward price adjustments in Hong Kong help reduce the cost of operations here and make Hong Kong more competitive as an international financial centre.

(iii) Reduce the internationalization of the HK dollar and dollarization

17. There was a recommendation that a greater use of US$ to denominate financial activities may help insulate Hong Kong from financial instability arising from currency attacks. At present, there is no restriction on the use of foreign currencies in conducting economic activities in Hong Kong. For market development purpose, the HKMA , the SFC and the SEHK are jointly studying the proposal of trading and settling 'H' shares in US$ or other foreign currencies or in dual currencies. The initial assessment was that the viability of introducing US$ denominated 'H' shares or dual listing depends on the availability of an efficient and robust clearing and settlement market infrastructure. Further study on the feasibility of such an infrastructure is required.

18. Regarding the viability of full dollarization as an exit option, the Report on Financial Market Review has highlighted several issues of concern (para. 3.63):

  1. Transitional issues: huge legal problems are envisaged as some of the contracts will automatically become void under the force majeure clause. Moreover, at a time when public confidence in the monetary system is waning, depositors may become "extra cautious" and shift their deposits (which have been re-denominated into US dollars) out of Hong Kong, leading to a leakage of bank deposits. Furthermore, because of the risk premium caused by the disruptions in the monetary and banking systems, the interest cost of financing economic activities in Hong Kong is unlikely to come down to the levels in the USA, even though the borrowing is denominated in US dollars.

  2. Loss of seigniorage: the HKMA is earning a seigniorage on Hong Kong dollar currency notes in circulation, which is derived from the interest income on the US dollars surrendered by the note-issuing banks as backing for their banknote issue. The amount of seigniorage is presently estimated to be around HK$4.2 bn per annum (outstanding currency in circulation: HK$89.2 bn; assumed rate of return on US dollar assets: 4.75%) and this figure will increase along with the growth in currency in circulation. If the Hong Kong dollar were to be replaced by the US dollar, US dollar notes will circulate instead of Hong Kong dollar banknotes and so the seigniorage of the note issue would accrue to the US rather than Hong Kong.

  3. Operational issues: as most of the banking transactions would be denominated in US dollars, banks would need to adjust their US dollar liquidity position from time to time. Operationally this will be difficult as the US Fed Funds market, the deepest market in overnight US dollar funds, is closed during the business hours in Hong Kong. Theoretically, it should be possible for the banks to maintain US dollar clearing accounts with the HKMA for the purpose of settling interbank and other transactions. But it is doubtful whether the US authorities would allow US dollar clearing to be conducted by a foreign monetary authority in another time zone.

  4. Implications for "one country two currencies": the Basic Law provides that the Hong Kong dollar shall continue to be legal tender in Hong Kong after 1997 as an important demonstration of the principle of "one country two systems". The demise of the Hong Kong currency may contravene the Basic Law.

Accountability of the HKMA

19. In strictly legal terms, the Monetary Authority is accountable to other parties, including the Legislative Council, through the Financial Secretary. The Monetary Authority, under the arrangements passed by the Legislative Council in 1992, is appointed by the Financial Secretary to assist him in his duties under the Exchange Ordinance. The Monetary Authority is accountable to the Financial Secretary for all his actions when exercising the authority delegated to him under the Exchange Fund Ordinance. In the performance of his functions in connection with the Exchange Fund, the Financial Secretary is advised by the Exchange Fund Advisory Committee (EFAC), whose members are appointed by the Chief Executive of the Hong Kong SAR under the Exchange Fund Ordinance. The Government of the Hong Kong SAR, of which the Financial Secretary is a principal official, is accountable to the Legislative Council under Article 64 of the Basic Law.

20. The HKMA recognizes that it has a wider responsibility to seek to promote an understanding of its role and objectives, and to keep itself both informed of public concerns and open to public debate. In its day-to-day operations and in its broader contacts with the community, the HKMA pursues a policy of transparency and accessibility. The objective of this policy is to ensure that the financial industry and the wider public are as fully informed of the HKMA's work as possible, subject to the limitations imposed by considerations of market sensitivity and commercial confidentiality. The HKMA is one of the most transparent institutions of its kind in the world and has, since its establishment in 1993, made special efforts to increase its transparency.

21. Recent initiatives to raise transparency include the decision in 1996 to disclose information about the Aggregate Balance on virtually a real-time basis (a facility which is unique among central banks), the daily publication of the size of the monetary base and the publication of the minutes of meetings of the EFAC Subcommittee on Currency Board Operations, which began in November 1998. The HKMA issues monthly and quarterly bulletins and a variety of other topical materials, including, for example, the recent 'Review of Currency Board Arrangements'. The HKMA maintains a programme of workshops for journalists and secondary school teachers and holds regular meetings with academics, market practitioners and other groups. The HKMA's 1997 Annual Report won a gold award in the Hong Kong Management Association's annual competition, and its website is one of the most visited websites of any government department or agency: a new, expanded website, together with a public resource centre, will be launched early next year.

22. An important part of the HKMA's policy of transparency includes ensuring that Members of the Legislative Council Financial Affairs Panel, and Legislators in general, are extensively briefed on monetary affairs and that their views are taken into account in the broad development of monetary policy. HKMA representatives have attended eight Panel meetings since January 1998, in addition to holding a variety of briefings and informal meetings with Members. The HKMA is committed to developing its policy of transparency and accessibility and to fully explaining its work to the community and its representatives.

Handling the shares acquired during the market operation

23. The Exchange Fund Investment Limited (EFIL) was set up in October to manage the Hang Seng Index (HSI) constituent stocks acquired by the Exchange Fund in the stock market operation in August. The Board of EFIL is chaired by Mr. T. L. Yang and the majority of the directors of EFIL are drawn from distinguished members of the community, including members of the Legislative Council.

24. EFIL will act as an external manager of the Exchange Fund and manage the Hong Kong equity portfolio in accordance with the guidelines issued by the Hong Kong Monetary Authority. According to the investment guidelines, EFIL is responsible for safeguarding the interests and rights of the Government in these shareholdings. EFIL is not allowed to conduct active trading of the portfolio, however EFIL is responsible for identifying value added opportunities for the eventual disposal of the shares with minimum disruption of the market.

25. EFIL will be subject to the full regulation by the Securities and Futures Commission and is in the process of applying for an Investment Adviser licence. The Administration intends to designate EFIL as a "public body" under the Prevention of Bribery Ordinance (PBO), which means that the directors and staff of the company will become public servants for the purpose of the PBO. This will ensure that EFIL staff and directors will comply with the high standard of conduct imposed on public servants. All directors of EFIL have already declared their interests in Hong Kong equities and such declarations have also been filed with the HKMA. Directors are also required to report all future transactions as and when they occur. Staff of EFIL have made similar declarations and they are prohibited from buying and selling any of the 33 HSI constituent stocks. In addition, a Code of Conduct has been prepared in consultation with the ICAC.

26. Following the first meeting of the Board, directors have concluded that it would be appropriate for the Government to disclose, on a voluntary basis, in full the 33 HSI constituent stocks acquired by the Exchange Fund in its market operation in August.

27. The Financial Secretary announced in November to include the Hong Kong equities transferred from the Land Fund to the Exchange Fund in the portfolio to be managed by EFIL. Following the second meeting of the Board on 15 December, the additional Hong Kong equity holdings to be placed under EFIL's management was disclosed in full. The Board also discussed a number of possible approaches for the orderly disposal of the Hong Kong equity portfolio of the Exchange Fund were received by EFIL. These approaches include share placements, public auction, unitization and structured convertible bond issues. These different approaches are not mutually exclusive and EFIL will keep an open mind and respond flexibly to changing market conditions and investor appetite. Given the sheer size of the portfolio, it will not be realistic to expect that the disposal programme would be completed over a short period of time. Nor will it be meaningful for EFIL to devise a very specific or rigid timetable for the disposal programme. EFIL has reiterated that its primary objective is to dispose of the shares in an orderly manner without disrupting the stability of the market.

28. EFIL believes that it will be useful to adopt a proactive approach in reaching out to potential investors. In this connection, EFIL will proceed to appoint a panel of financial advisers to assist in the design and implementation of a detailed framework for disposal. The financial advisers will be selected having regard to their technical expertise, placement capabilities and their presence and commitment to Hong Kong. The selection process will commence straight away and should hopefully be finalized by early next year.


Summary of the HKMA's responses to suggestions raised by academics in the 14 November Special Meeting of the LegCo Panel on Financial Affairs

Item1Comments/ProposalsHKMA responses
Discount Window and Base Rate
1Hong Kong Monetary Authority (HKMA) should issue new Exchange Fund papers when there is an inflow of funds.

In one of the seven technical measures announced on 5 September, the HKMA has undertaken to issue additional Exchange Fund Bills and Notes only when there is an inflow of capital. This ensures that all new Exchange Fund paper will be fully backed by foreign currency reserves.

2Hong Kong Monetary Authority (HKMA) should only issue new Exchange Fund papers when there is an inflow of funds.

3It is necessary to reconstruct the currency board according to the current technology in electronic banking to make sure that the market interest rate is determined by demand and supply for currency in the economy so that interest rate fluctuations will induce the correct currency supply changes in response to the currency demand.

See our assessment in para. 10 of the main response.
4The 'risk-premium targeting' approach should be adopted in determining the Base Rate. The US Federal Funds Target Rate should be used as a benchmark and a premium should be added to it to reflect the Hong Kong dollar risk. The premium may be adjusted according to the average differential between overnight HIBOR and LIBOR in the previous month.

The methodology of Base Rate determination was announced on 26 November. The floor to the Base Rate is set by reference to the US Fed Funds Target Rate, adjusted by a factor which is a premium of 150 basis points. The adjustment factor will be reviewed by the EFAC Subcommittee on Currency Board Operations from time to time. Subject to the floor, the Base Rate will be derived by taking the simple average of the 5-day moving averages of overnight and 1-month HIBORs.

Convertibility Undertaking
5The Convertibility Undertaking should be two-way allowing the conversion from HK$ into US$ or vice versa at the fixed exchange rate.

See our comments in para. 10 of the main response.
6Government should offer guarantees in the form of put options in order to instil confidence in the local currency. The 'puts' is equivalent to an exchange rate insurance providing guarantee for the Convertibility Undertaking.

Foreign currency reserves
7A comprehensive and transparent allocation of the foreign currency reserves into function categories, say, for backing the notes and coins in circulation, for backing the monetary base, for contingencies and as cushion against capital outflow, will help to build confidence in the Hong Kong dollar. By doing so the function of the foreign currency reserves for defending Hong Kong dollars will be fully utilised.

When announcing the package of technical measures on 5 September, the HKMA undertook to work towards identifying clearly that part of the Exchange Fund balance sheet showing Currency Board operations. The relevant information will be published as frequently as it is technically feasible. It should however be pointed out that the whole of the Exchange Fund assets is available for defending the external value of Hong Kong dollar.

8There should be a gradual transition of the exchange rate from 7.75 to 7.8 in 500 calendar days. The scheme to move the Convertibility Undertaking in respect of the Aggregate Balance from the present level of 7.75 to 7.80 was announced on 26 November. As from 1 April 1999, the exchange rate under the Convertibility Undertaking in respect of the Aggregate Balance will move by 1 pip (i.e. HK$ 0.0001) per calendar day. It will then take 500 calendar days to complete the move to 7.80.



There should be as little discretion as possible for Hong Kong Monetary Authority (HKMA) in implementing the seven measures aiming at strengthening the currency board arrangements in Hong Kong.

A greater degree transparency and disclosure on HKMA's operations will improve its accountability and help to enhance investor confidence. However, HKMA should have discretion to adjust the interest rate appropriately in tackling currency attack.

Promotion of a greater understanding of the currency board system and operation of the HKMA's seven technical measures is useful in instilling public confidence in the linked exchange rate system.

See our comments in para. 11 of the main response.

In determining the Base Rate, the HKMA will follow the methodology announced on 26 November. The HKMA, however, reserves the right, in exceptional cases, to apply a different Base Rate to individual banks, for example, banks believed to be facilitating market manipulation. The HKMA will report exceptions to the EFAC Sub-committee on Currency Board Operations and the EFAC. This represents proper checks and balances on the discretionary power of the HKMA.

To move towards greater transparency, the HKMA has started to publish the monetary base and its components, on a daily basis since November. Minutes of meeting of the EFAC Subcommittee on Currency Board Operations have been published within six weeks after each meeting.

Apart from our regular publications such as the quarterly bulletins in which our monetary and banking policies are clearly explained, the HKMA has been promoting the general understanding of currency board system in Hong Kong through technical briefings to reporters and seminars to students and market practitioners. Recently, we have published a booklet on 'Review of Currency Board Arrangements in Hong Kong' which provides an elaborate discussion of the conceptual framework of modern day currency board system and the case of Hong Kong.

Handling of securities acquired by the Administration in the operations in August


Government should dispose of its shareholdings as soon as possible to restore international confidence on Hong Kong's non-intervention policy.

A public auction to sell off the shares is recommended as the operation will be transparent and the shares will be sold close to the market price.

The Exchange Fund Investment Company Limited should dispose of the shares in an orderly manner without disrupting the market.

See our comment in para. 23- 28 of the main response.

Alternatives to the linked exchange rate system



Dollarization is the last line of defence against future attacks on the HK$. More studies on the feasibility and technical implementation of this option should be undertaken.

In a possibly deteriorating external economic environment, it will be the appropriateness of the fixed exchange rate of 7.80, rather than the intention and ability of the government to defend it, that is cast in doubt. Insurance instruments to show the intention and ability will be irrelevant as a strengthening measure.

Possible options in the long run for replacing the linked exchange rate system in stabilizing the HK$ are dollarization and the Singaporean model.

Rapid growth in trading volume in HK's equity market will make HK$ more vulnerable to attacks. To conduct trading in US$ could be a solution to the problem.

See our comment in para. 10, 17-18 of the main response.

Regarding the Singaporean model of segregating the onshore and offshore markets, it is worth noting that Singapore has recently started to move away from its dichotomy model by encouraging internationalization of the S$. Besides, the segregation of economic activities into onshore and offshore activities may involve administrative controls which may be construed as foreign exchange controls.

Regaining Hong Kong's Competitiveness




To uphold the non-intervention free-market policy in Hong Kong.

While maintaining the linked exchange rate system, Hong Kong has to regain its competitiveness through market adjustment in domestic prices and production costs. Increasing local productivity by means of technological advancement is also necessary.

Hong Kong should develop itself further as an international financial centre. Government should put more effort in this regard and devise comprehensive policies to facilitate this.

It is the Government's task to stimulate economic recovery and growth without jeopardizing currency stability. Options for stimulating the economy include appropriately expansionary fiscal policy like tax concessions and increasing spending on infrastructure, labor policy to increase labor productivity, incomes policy to contain wage increase and housing policy to stabilize property prices.

It will be more effective for Hong Kong to improve its own competitiveness instead of banning competition from other centres. A special task force comprising representatives of HKMA, SFC, professional and trade bodies, scholars and experts should be set up to study measures for strengthening HK's position and reputation as an international financial centre.

Regarding our assessment of the link and HK's competitiveness, please see our comments in para. 12-14 of the main response. We believe both domestic price adjustments and continued improvements in other areas are needed to help Hong Kong regain its competitiveness, and the link itself provides a pillar for strengthening HK's role as an international financial centre.

To enhance HK's role as an IFC, the 1998 Policy Address unveiled that regulatory systems will be strengthened while new products, such as a venture board for the trade of shares in smaller and emerging companies will be developed. Furthermore, to enhance the research capability of HK as a leading player in the region in relation to research and policy analysis in the monetary and banking fields, a monetary research institute will be established. Further studies will be conducted by the HKSARG on measures to promote Hong Kong's status as an international financial centre.

30Asia should consider adopting a Euro-style single currency for the region in the long run as a way to avoid the damage inflicted by the fluctuating US dollar-yen rates.The HKMA has been one of the most active among the Asian monetary authorities in promoting regional cooperation. While the use of a single Asian currency would have the advantage of reflecting the strong trade linkages in the region and help to address problems of intermediating financial resources within Asia, we envisage tremendous difficulties in the setting up of an institution to administer the currency and monetary and fiscal policy co-ordination throughout the region. We expect there will be more discussion and consideration on this challenging concept among the Asian economies in the coming years.

31The interest rate cartel in HK should be lifted. Opening up the banking business to more foreign banks may be beneficial in removing the cartel.This issue is being covered by an independent review of the banking industry to be released for consultation in the near future.

32"Hedge funds" is one of the various kinds of investment instruments. Strict regulations targetted at hedge funds are unnecessary.Unmonitored, highly leveraged cross-border capital flows have important implications for systemic stability. We support the view of the G7 and G22 to improve transparency and accountability of the private sector. In particular, we support the G22's recommendation to form a working party comprising private sector representatives, international groups and national authorities to examine the modalities of compiling and publishing data on the international exposures of investment banks, hedge funds and other institutional investors.

Hong Kong Monetary Authority
15 December 1998

1.Same item number as set out in the letter from LegCo secretariat dated 15 Dec. 1998