Economies with currency board systems are vulnerable to interest rate shocks, but there are ways of handling this risk.

This is the view of Monetary Authority Chief Executive Joseph Yam in the latest edition of his Viewpoint column on the authority's website.

He said that in an economy operating with a currency board system, where non-discretionary, non-sterilised foreign exchange intervention at a fixed exchange rate is automatically triggered by capital outflow, there will be a shrinking of the monetary base and a tightening of inter-bank liquidity.

In other words, to the extent that the shocks involve sudden capital outflow, they will be transformed into interest rate shocks. This can be painful and destabilising, Mr Yam said.

Those operating or contemplating the adoption of a currency board system, strategically, should pursue proactive policies that have the effect of lowering the probability of capital outflows, lowering the sensitivity of interest rates to capital outflows, and enhancing the pain tolerance threshold of the economy.

HK's net external assets 210% of GDP

"The fact that we have no public debt and substantial fiscal reserves has provided considerable comfort. In fact, the whole of Hong Kong has net external assets equivalent to 210% of GDP. This is by far the highest ratio in the world," Mr Yam said.

"The economic recovery and the substantial balance of payments surplus provide further support, to the extent that the probability of capital outflow seems now remote."

With no reserve requirement and a very efficient real time interbank payment system, there is no need for licensed banks to maintain substantial balances in their clearing accounts.

Consequently, the Aggregate Balance in the clearing accounts of licensed banks, that crucial element of the monetary base is very small compared with the volume of capital flows.

As a result, interest rates are ultra-sensitive to capital flows.

"This was the situation in Hong Kong before various technical measures were introduced in 1998 to reduce that sensitivity. The inclusion of the pool of Exchange Fund paper as part of the Monetary Base, involving the commitment of more foreign reserves backing the Monetary Base, has been helpful in reducing the probability of interest shocks," Mr Yam said.