Hong Kong's monetary policy objective is to maintain currency stability. Given the highly externally oriented nature of the Hong Kong economy, this objective is further defined as a stable external value for the currency in terms of a fixed exchange rate against the US dollar at the rate of $7.80 to US$1. This clear monetary policy objective is achieved through the linked exchange rate system, which was introduced in October 1983 after a nine-year period during which the Hong Kong dollar floated and the exchange rate was volatile.

    The linked exchange rate system is in essence a currency board system with two distinctive features: first, full backing of the monetary base; and second, convertibility between the monetary base and the reserve currency at the fixed exchange rate (i.e. $7.80 = US$1). In Hong Kong, the monetary base includes the amount of bank notes and coins issued, the Aggregate Balance (which is the sum of the clearing balances of the licensed banks held with the HKMA for the purpose of effecting the clearing and settlement of transactions between the banks themselves and also between the HKMA and the banks), and the outstanding amount of Exchange Fund Bills and Notes.

    In Hong Kong, bank notes are issued by three note-issuing banks. In addition, a new $10 note, which is issued by the Government, has been put into circulation since September. Since the inception of the linked exchange rate system in October 1983, note-issuing banks are required to hold Certificates of Indebtedness (CIs) issued by the Exchange Fund to provide backing for bank note issuance. The issuance and redemption of CIs are made against US dollars at the convertibility rate of $7.80 to US$1 for the account of the Exchange Fund. Similarly, the issue and withdrawal of government-issued currency notes and coins in circulation are conducted against US dollars at the fixed exchange rate of 7.80.

    When the linked exchange rate system was introduced in October 1983, there was no institutional arrangement whereby banks in Hong Kong maintained clearing accounts with the currency board. Thus, that part of the monetary base represented by the clearing balances of the banking system was initially not subject to the discipline imposed by a currency board system. Action was taken to correct this in 1988 through arrangements that required the Management Bank of the Clearing House of the HKAB to maintain a clearing account with the Government's then Monetary Affairs Branch for the account of the Exchange Fund. This was replaced by another arrangement, when the RTGS system was introduced, for interbank transactions in Hong Kong towards the end of 1996. Since then, all licensed banks have had to maintain direct clearing accounts with the Exchange Fund.

    By assuming responsibility for the interbank clearing system, the HKMA also became responsible for the provision of lending to any banks experiencing day-to-day shortages of liquidity. A Liquidity Adjustment Facility (LAF) was set up in 1992 for this purpose. This was replaced in September 1998 by the Discount Window arrangement under which banks have unrestricted access to day-end liquidity through repurchase agreements using Exchange Fund Bills and Notes as collateral. A two-tier structure of Discount Rates has been adopted to ensure that interest rates are adequately responsive to capital flows, while avoiding excessive interest rate volatility if liquidity shortages are only modest.

    Under the currency board system, Hong Kong dollar exchange rate stability is maintained through an interest rate adjustment mechanism. The monetary base increases when the foreign currency (in Hong Kong's case, US dollars) to which the domestic currency is linked is sold to the currency board for the domestic currency (inflow into the Hong Kong dollar). It contracts when the foreign currency is bought from the currency board (outflow from the Hong Kong dollar). The expansion or contraction in the monetary base leads interest rates for the domestic currency to fall or rise, respectively, creating the monetary conditions that automatically counteract the original capital movements, ensuring stability of the exchange rate.

    To strengthen the institutional framework for the operation of the currency board system in Hong Kong, a Subcommittee on Currency Board Operations was established under the Exchange Fund Advisory Committee (EFAC) in August 1998. The subcommittee has been entrusted with the responsibility of overseeing the operation of the currency board system in Hong Kong and may, where appropriate, recommend to the Financial Secretary through the EFAC measures to enhance the robustness and effectiveness of Hong Kong's currency board arrangements.

    The HKMA pursues a policy of transparency to ensure that the financial industry and the wider public are fully informed of the currency board operations. To this end, the Aggregate Balance and forecast changes to the Aggregate Balance attributable to the currency board's foreign exchange transactions are disclosed on a real-time basis. In addition, the size of the monetary base and its components are published on a daily basis, while the Currency Board Account is published on a monthly basis. The records of the meetings of the Subcommittee on Currency Board Operations are also published within six weeks of each meeting.

    The Government is fully committed to the maintenance of the linked exchange rate system, which is a cornerstone of Hong Kong's monetary and financial stability, and to the strict discipline of the currency board arrangement under that system.