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 of the currency of Hong Kong, in terms of its exchange rate in the foreign exchange market against the US dollar at around HK$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 characterised by currency board arrangements, requiring the Hong Kong dollar monetary base to be at least 100 per cent backed by, and changes in it to be 100 per cent matched by corresponding changes in US dollar reserves held in the Exchange Fund at the fixed exchange rate of HK$7.80 to US$1. In Hong Kong, the monetary base includes the amount of currency notes and coins issued, the Aggregate Balance (the sum of the clearing balances of banks held with the HKMA for the purpose of effecting the clearing and settlement of transactions between banks themselves and also between the HKMA and banks), and the outstanding amount of Exchange Fund Bills and Notes.

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 HK$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 Hong Kong Association of Banks (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.

Under the present arrangement, the HKMA undertakes to convert the Hong Kong dollar balances held by banks into US dollars at the convertibility rate of 7.80. However, there is no explicit convertibility undertaking on the strong side of the linked rate. This arrangement is considered optimal mainly because the constructive ambiguity on the strong side helps deter speculative pressures against the Hong Kong dollar on the weak side by making it difficult for speculators to calculate the cost of shorting the Hong Kong dollar. This arrangement increases the resilience of the system to weak-side pressures, thereby improving the sustainability of the system as a whole. In choosing the exact level of the exchange rate to sell the Hong Kong dollar, the HKMA has mainly responded to bank offers of the US dollar in a passive manner. Nevertheless, when there are strong speculative pressures or the exchange rate appreciates sharply, a proactive approach is adopted to counter possible strategic behaviour of large market players, and to provide an anchor for the exchange rate.

To strengthen the institutional framework for the operation of the currency board system in Hong Kong, a Sub-committee on Currency Board Operations was established under the Exchange Fund Advisory Committee (EFAC) in August 1998. The sub-committee 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 Sub-committee 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.