The Monetary Authority has introduced the composite interest rate as a tool for banks to manage their interest rate risks. But the authority's chief executive Joseph Yam says it is still for the banks to determine their own interest rates.

In his latest Viewpoint column, Mr Yam clarified confusion over the role of the authority in determining interest rates in Hong Kong, by explaining its monetary policy and efforts in maintaining the banking system's stability and effectiveness.

Mr Yam said as the clearly stated objective of monetary policy in Hong Kong is exchange rate stability, the authority should not play any role in determining interest rates. But he said monetary management is more complicated than that in practice, particularly when Hong Kong is an international financial centre embracing the free flow of capital.

Because the size of the monetary base is allowed to be determined by the inflow and outflow of capital, through a clear and non-discretionary undertaking to buy and sell Hong Kong dollars for US dollars at a fixed exchange rate, Hong Kong must be prepared for volatility in interbank interest rates and, as a result, volatility in deposit and lending rates for consumers.

Mr Yam said the authority has developed ways to dampen interest rate volatility. Including the large pool of Exchange Fund paper as part of the monetary base, and allowing banks which hold the paper to acquire liquidity through the discount window, there is a welcome cushion against upward pressure on interest rates arising from capital outflow.

The introduction of the strong-side convertibility undertaking, in addition to the existing weak-side convertibility undertaking, and the 10-cent convertibility zone provided a cushion against downward pressure on interest rates arising from capital inflow.

"But that really is as far as we go in the monetary-policy context. Setting deposit and lending rates is still entirely a matter for the individual banks, which operate in a freely competitive environment," Mr Yam said.

As interest rate volatility can undermine the stability of the banking system, Mr Yam said the authority always encourages banks to manage prudently the risks arising from interest rate volatility.

"One obvious way for them to do this is to price their lending. In other words to determine lending rates by making reference to the cost of funds. After the full liberalisation of interest rates, deposit rates, except perhaps those for savings deposits, are now more closely related to interbank rates, which as I mentioned earlier can be quite volatile," he said.

On the lending side, Mr Yam said a larger proportion of loans than before is admittedly priced against the interbank rates, but the bulk are still prime-based and the prime rate normally only changes when there is a change in the Federal funds target rate.

Mr Yam said he had, in the interests of the stability and integrity of the financial system, exceptionally made comments in public to try to dampen the potentially adverse impact of the leap-frogging.

But he said it is still for individual banks to determine their deposit and lending rates, adding his suggestion on the use of the composite interest rate is simply encouraging the banks to manage their interest rate risks and not trying to influence the setting of deposit and lending rates.

"There was no intention to get into consumer issues, on which the authority does not have a mandate," he said.