The renminbi has been trading at below RMB8 yuan to the US dollar for some time now. There is nothing significant about the number eight, other than that it is a round number and one that rhymes with "fortune" in Chinese. But it was, as those working in the foreign exchange market often tell us, one of those psychological levels that might trigger unusual market reaction, not just in the forward exchange rate of the renminbi, but also in the spot and forward exchange rates of the currencies of jurisdictions having a close economic relationship with the Mainland, notably the Hong Kong dollar. Thankfully, no significant market movement occurred when the psychological level was breached. The Hong Kong dollar exchange rate remained stable, although it has been trading at close to the strong-side Convertibility Undertaking for some time. There was no capital inflow into the Hong Kong dollar, at least not to the extent that we needed to buy US dollars for the account of the Exchange Fund in accordance with the Convertibility Undertaking.

The interbank rates for the Hong Kong dollar have also remained stable, although a significant discount relative to the US interest rates continues to exist. This is partly because the Aggregate Balance, or the supply of interbank liquidity to oil the interbank payment system, has been somewhat larger than necessary except when there are large initial public offerings of shares, and partly because the liquidity in our banking system has been ample as reflected by a rather low loan-to-deposit ratio. The three refinements introduced last May allow the HKMA to conduct market operations within the Convertibility Zone to remove any excess liquidity in the interbank market or provide more liquidity in response to any temporary increase in demand for liquidity. But it has not been normal practice for us to engage in this type of money market fine-tuning, mainly to avoid its being misunderstood as an unorthodox attempt to pursue an independent interest rate policy for a freely convertible currency with a fixed exchange rate – an attempt that has a low probability of success. Nevertheless, the structure of our monetary system is such that, within the constraint of exchange rate stability defined by the Convertibility Undertakings, there is some scope for influencing the size of the interest rate differential between the Hong Kong dollar and the US dollar. The Currency Board Sub-Committee has published, through its record of the meeting on 4 July 2005, four broad principles governing these operations:

• the operations should be in accordance with the Currency Board rule that any change in the Monetary Base is matched by a corresponding change in the foreign currency assets backing it
  
  

• the primary objective of any operations should be to preserve exchange rate stability
  
  

• operations might be undertaken to support such interest rate adjustments as would maintain exchange rate stability
  
  

• operations might be undertaken to remove market anomalies.
  
  

This obviously is not an independent interest rate policy as such, although it may be misconstrued to be, given our special circumstances and the traditional understanding of how currency boards work.

Perhaps of greater interest to the market now are the market expectations that the renminbi exchange rate will appreciate towards 7.80, again, not because there is anything of real significance about that other auspicious number, but because of the market perception of it as a psychological level similar to the number eight. While market psychology can never be ignored, it should not be an important factor in the determination of an exchange rate policy. Psychological levels, once breached, dissipate quickly in terms of their market influence, as we saw when the exchange rate of the renminbi breached eight. We should not, of course, underestimate the reaction of the public when one day they see that their HK$100, which used to buy more than RMB100 yuan, now buy less. In layman’s terms, the renminbi appreciates from being "smaller" to "bigger" than the Hong Kong dollar. People might sense that they are losing something, or the Hong Kong dollar is losing its attraction, or even that Hong Kong is losing out, somehow. It is hard to counter this. We can, of course, point out that the Hong Kong dollar, or indeed the renminbi or the US dollar or the euro, are "bigger" than the Japanese yen. Or we can explain that, as the economic development of Mainland China catches up with the rest of the world through reform and liberalisation, its goods and services will inevitably become more expensive, either through a more expensive currency or through faster increases in domestic prices.

But it is very much our duty to explain as best as we can to the public the significance, or really the lack of it, of the matter because this psychological level is likely to be breached soon. There is no need, and there is no intention, for any change in our exchange rate policy in response to the breaching of any psychological level in the renminbi exchange rate. There will be comments, here and there, about the future of the Hong Kong dollar, or the future relationship between the Hong Kong dollar and the renminbi, and they will be quite well articulated. But we can be quite sure that life will go on as usual. I can still remember the many questions asked before the political handover about the future of Hong Kong, or its monetary system, after 1997. One favourite answer that I gave was: "We can be quite sure of what comes after 1997. It must be 1998. Life goes on. "

Joseph Yam

24 August 2006

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