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(Approved for Issue by the Exchange Fund Advisory Committee on March 19 1999)

Operations of the Currency Board Arrangements

The Sub-Committee noted that during the period from January 27 to February 26 1999, changes in the size of the monetary base were fully matched by corresponding changes in the foreign reserves in accordance with the rules of the Currency Board arrangements. It was further noted that, before the Chinese New Year, the exchange rate weakened briefly to touch the Convertibility rate of 7.75 in mid-February partly due to the Note Issuing Banks having to provide backing for additional banknote issuance. The HKMA bought a total of HK$3.41 bn for US$440 mn under the Convertibility Undertaking. The Aggregate Balance shrank correspondingly and was at one point forecasted to drop to a negative level of HK$0.97 bn on February 22. In response, 1-month HIBOR firmed up moderately to 6.38% on February 19. The situation was however quickly reversed after the Chinese New Year holidays, with the HKMA selling HK$3.64 bn for US$ on February 19. As a result, the Aggregate Balance rose to HK$2.68 billion on February 22. 1-month HIBOR also quickly eased to 5.88% on February 25. The Sub-Committee further noted that, as liquidity conditions tightened towards the end of the month and the exchange rate strengthened, the HKMA sold HK$775 mn for US$ during February 25-26.

The report on currency board operations for the period under review is at Annex A.

Extending the Convertibility Undertaking to Exchange Fund Bills and Notes

The Sub-Committee noted that of the four components of the monetary base, separate Convertibility Undertakings ("CUs") already covered Certificates of Indebtedness ("CIs") and the Aggregate Balance of the banking system. The CU rate applicable to the latter would be gradually realigned with that for the former starting from April 1 1999. With effect from April 1 1999, the issue and withdrawal of coins would also be conducted against US$ at a fixed rate of 7.80. It was therefore for consideration whether Exchange Fund Bills and Notes should also be covered by an explicit CU.

Members noted that, as far as Exchange Fund paper was concerned, licensed banks in Hong Kong already enjoyed an indirect CU. At the maturity of such paper, the HKMA would credit the clearing accounts of banks either as holder of such paper or as agent banks for investors. Banks could then convert the proceeds into US$ under the CU in respect of the Aggregate Balance.

Members considered that to extend the CU arrangement to Exchange Fund paper would not strengthen significantly the Currency Board arrangements. At the same time, practical issues had to be addressed such as the determination of an appropriate CU rate applicable to Exchange Fund paper before the rates in respect of the Aggregate Balance and CIs converged in August 2000. Furthermore, with Exchange Fund paper settled in HK$ only at issue, to provide a CU at maturity for such paper would result in an asymmetric arrangement.

Members agreed that, since the benefits that could be derived from introducing a CU for Exchange Fund paper were not obvious, it would be prudent to maintain the status quo and to review the matter later in the light of more experience.

Movements in the Backing Ratio: Various Scenarios

The Sub-Committee noted that when the Backing Portfolio was set up in October 1998, the amount of US$ assets transferred into the Portfolio was 105% of the monetary base. The backing ratio subsequently rose to the current level of slightly above 108%. The ratio was expected to fluctuate over time as circumstances changed, and it was appropriate to consider whether assets should be transferred into or out of the Backing Portfolio if the ratio reached certain pre-determined trigger points.

Members noted that three factors could lead to movements in the backing ratio: incremental changes in the monetary base; revaluation effects from changes in market interest rates; and net interest earnings. Under the monetary rule of the currency board operations, incremental changes in the monetary base would be 100% backed by changes in foreign currency assets. Thus, in situations when the monetary base expanded, the backing ratio would drop, since the backing ratio for marginal changes was 100% while the backing ratio for the whole portfolio was over 108%. Conversely, the backing ratio would rise when the monetary base contracted, other things being equal. As for the second factor, interest rate movements would affect the backing ratio via their impact on the market valuation of backing assets and the Exchange Fund paper component of the monetary base. Nevertheless, the impact that HK$ and/or US$ interest rate fluctuations would have on the backing ratio should be small, since the duration of the Backing Portfolio was relatively short. The third factor that would affect the backing ratio was net interest earnings. To the extent that interest income arising from the US$ assets in the Backing Portfolio exceeded interest payments on Exchange Fund paper, the backing ratio would rise over time.

It was agreed that a rising backing ratio would generally cause less concern than a falling one, although too high a backing ratio might give rise to a perception that additional base money could be created. It could also be argued that excess assets in the Backing Portfolio should be transferred out of the portfolio and invested in higher return instruments. Members were of the view, however, that with the Backing Portfolio having only been established for about six months, it was too early to consider the question of asset transfers. It was agreed that evolution of the ratio should be monitored closely and the question of asset transfers reviewed in the light of more experience.

Exchange Rate under the Convertibility Undertaking and the Market Exchange Rate

The Sub-Committee noted that under the Convertibility Undertaking ("CU") in respect of the Aggregate Balance, the CU rate had been set at 7.75 initially and would be moved by 1 pip per calendar day from HK$7.75 to HK$7.80 per US$ over a period of 500 days starting on April 1 1999. With the market exchange rate trading on the strong side of the CU rate, the Sub-Committee considered it necessary to remind the market about the imminent change in order to avoid any confusion on or after April 1, and to facilitate the market in planning for the gradual move.

Papers Tabled for Information

Members noted two papers tabled for information. They dealt with an analysis of currency board regimes outside of Hong Kong, and the effects of the Brazilian crisis on Argentina.

END/Monday, March 22 1999

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