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Following is a question by the Hon Sin Chung-kai and a written reply by the Secretary for Financial Services, Mr Rafael Hui, at the Legislative Council today (Wednesday):

Question :

It is learnt that the Hong Kong Monetary Authority (HKMA)'s seven measures to strengthen the currency board system had been on the drawing board for quite a while. However, considering external factors and objective circumstances, the HKMA announced and implemented the measures only after the Government had ceased intervening in the stock and futures markets. In this connection, will the Government inform this Council:

(a) when the HKMA started and finished working out the seven measures;

(b) of the external factors and objective circumstances involved;

(c) of a detailed comparison of such external factors and objective circumstances before and after the Government's intervention in the markets; and

(d) whether it has assessed what consequences might have arisen if the seven measures had been implemented by the HKMA before or during the Government's intervention?

Reply :

(a) The HKMA has been constantly strengthening the currency board arrangements in Hong Kong in the light of changing market conditions. The seven technical measures introduced in early September were part of HKMA's ongoing efforts to enhance the resilience and robustness of the linked exchange rate system. Some of these measures had been considered previously as contingency measures. But as we will explain in part (b), these measures have certain downside risks and the market conditions before August 1998 did not justify their introduction. When there was clear indication of double market play in the August episode threatening systemic stability, the Administration immediately launched market operation to dampen manipulation activities and at the same time proceeded to finalize the proposals. We consulted the Exchange Fund Advisory Committee (EFAC) on 4 September and with its endorsement, announced the measures on 5 September.

(b) The seven technical measures have both advantages as well as disadvantages. For example, while the measures would dampen interest rate volatility in the event of capital outflows, it could possibly be misinterpreted by the international financial community as a sign of Hong Kong's unwillingness to bear the pain of interest rate adjustments under the currency board discipline. This would in turn undermine the market's confidence in the Linked Exchange Rate . Moreover, there could be greater volatility in the level of official foreign reserves. Making explicit the passive convertibility of the Aggregate Balance of the banking system into US dollars may also dampen activity in the foreign exchange market. The measures could also, to some extent, affect the development of the Hong Kong debt market. In considering when to implement these measures, the Administration has to assess whether they are necessary to achieve our aim of maintaining the stability of the monetary and financial systems, in the light of the latest developments in the market and external factors.

The circumstances prior to the August 1998 did not justify the introduction of the seven technical measures. In the first place, there was no clear indication of double market play before the August episode. Secondly, in the previous speculative attacks, most of the market manipulators had not acquired sufficient Hong Kong dollar beforehand. Hence the rise in interest rate under the auto pilot mechanism of the currency board system effectively fended them off. Thirdly, the HKMA introduced two measures prior to August 1998 to facilitate a more orderly and efficient interest rate adjustment and prevent an overshooting of market reaction to changes in the liquidity conditions. They included the clarification of the definition of repeated borrowers in the access to the Liquidity Adjustment Facility in November 1997 and the announcement of the forecast changes in the level of interbank liquidity since June 1998. These measures helped to reduce excessive interest rate volatility. The 1-month Hong Kong dollar interbank rate only stayed above the Best Lending Rate for 10 days after the attack in January 1998 and for only three days in June 1998.

(c) In late July this year, pressure on the Asian financial markets intensified. The yen fell to a new low of 147 against the US dollar and there was growing instability in Russia and Latin America. There were also widespread rumours of imminent depreciation of the Renminbi and delink of the Hong Kong dollar. Unlike the earlier episodes, the market manipulators had acquired sufficient Hong Kong dollars beforehand by swapping US dollars through intermediaries with multilateral institutions which had issued Hong Kong dollar debt paper (such issues amounted to over HK$30 billion up to end July this year). On the securities side, the cash market was very thin while the stock index futures market grew disproportionately. Against such unusual circumstances, had the government not acted to frustrate the double market play of the hedge funds, there would have been serious dislocations in the securities market and a sustained period of excessively high interest rates.

Through the market operations, the Government has successfully forced the market manipulators to leave the markets. The securities and futures as well as money markets also stabilized . To follow through the market operation, we had immediately implemented the package of technical measures to strengthen the defence against market manipulation.

The money and equity markets continue to stabilize after the introduction of the seven technical measures on 7 September. Interbank interest rates have eased substantially across the board. The one-month interbank rate has eased from 10.5 per cent on 4 September to 5.25 per cent on 20 October. The Hang Seng Index has also rebounded sharply from 7,489 to 9,642 in the same period.

(d) Given the rapid deterioration in market conditions as explained in part (c), we do not believe that the package of measures alone would turn around market sentiment and obviate the need for the Government's operations in the stock and futures markets. The possible downside risks of the seven technical measures have been explained in part (b). More importantly, had the measures been introduced before or during the market operations, the international financial community might have conjectured that we were not determined to bear the interest rate pain under the currency board discipline, thus weakening their confidence on our commitment to maintain the link. This is contrary to the ultimate objective of introducing these measures - strengthening confidence on our system.

End/Wednesday, October 21, 1998

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