Monetary Authority Chief Executive Joseph Yam says the authority has been refining the Linked Exchange Rate system over the years, trying to strike a fine balance among transparency, discretion and credibility.

In his Viewpoint column published today on the authority's website, Mr Yam said there is a variety of models for fixing an exchange rate and the choice of the exchange-rate anchor is a prime consideration.

He said there is a need to strike a fine balance that involves choices. These choices may be of a structural or day-to-day discretionary nature.

Interest rates in 1997

"Readers will recall short-term interest rates being pushed to very high levels in 1997 when the Asian financial crisis began. The overnight interbank interest rate went above 200% per annum.

"While the HKMA was blamed for squeezing the interbank market, this was very much the result of the system being run by the book, without any discretion on our part to dampen interest-rate volatility that might be damaging to the economy."

When there is capital outflow, interest rates go up to stem and then reverse the outflow, Mr Yam said. If the authorities were to take discretionary action to dampen the interest-rate adjustment and ease the pain of high interest rates, the credibility of the system, it is argued, might be undermined.

"However, the community considered interest-rate volatility as we saw it in 1997 to be excessive and, in response, action was taken in 1998 to re-define the Monetary Base and allow banks holding Exchange Fund papers to access liquidity through the Discount Window. This structural change to the Currency Board arrangements has no precedent anywhere in the world."

Structural changes made

There were the further structural changes made last year, also to limit interest-rate volatility, this time on the low side, by anchoring exchange-rate expectations on the strong side of the Linked Exchange Rate by introducing the strong-side Convertibility Undertaking at $7.75 per US dollar.

"Interest rates, having remained close to zero for 18 months preceding the change, returned to more normal levels afterwards, close to those of the US dollar, our anchor currency.

"There is one thing that we must, however, be very clear about. To maintain a fixed exchange rate in a free and open monetary system, interest-rate volatility of the domestic currency around the policy interest rate of the anchor currency is inevitable.

"Although history has demonstrated there is some scope for dampening interest-rate volatility without undermining the credibility of the system, there are obviously limits to how far this can be done."

Under the current system, within the Convertibility Zone of 7.75 to 7.85, the exchange rate is allowed to fluctuate in response to supply and demand conditions in the foreign-exchange market. If the exchange rate hits either of the Convertibility Undertakings, then there will be an interest-rate response, Mr Yam added.

For example, if the exchange rate strengthens to 7.75 and the strong-side Convertibility Undertaking is triggered, the Aggregate Balance will increase and interest rates in the interbank market will fall.

Interbank interest rates fluctuate

When the exchange rate is within the Convertibility Zone, interbank interest rates will still fluctuate, and quite significantly, as a result of the interaction of supply and demand for liquidity.

The supply of interbank liquidity, as measured by the size of the Aggregate Balance, is constant when the exchange rate is within the Convertibility Zone, but the demand is not, since it is affected by factors such as IPO activities.

"While we at the HKMA are quite relaxed about this volatility from a macro-monetary point of view, as far as its effects on exchange-rate stability are concerned, banks, particularly those dependent on interbank funding, should consider how these fluctuations in interbank interest rates would affect them and how they can best manage the risks arising from this."