C H A P T E R 11 INTERVENTION REPLACES ARBITRAGE The July Package of Monetary Measures July–August 1988 The July 1988 package of new accounting arrangements for the Hong Kong monetary system represented the first major change in the design of the system since 1983. These measures were the official response to some of the defects in the original template as set out in AMM, but they also set a new direction. In the early years after 1983 the authorities and the Hongkong and Shanghai Banking Corporation (HSBC) had cooperated in intervening to support the HK$ market exchange rate, but if the design of the system had been adequate in the first place, such intervention should not have been necessary. In retrospect AMM had paid insufficient attention to one of the key problems that the July package sought to address — namely the potential leakage of funds into the system from the inter-bank clearing arrangements. In effect the AMM design had concentrated on only one element of the monetary base, namely the banknote issue and its backing. As mentioned earlier, this was based on the idea, derived from the operation of gold and silver specie standards, that if banknotes and deposits were interchangeable, then market arbitrage could be relied upon to bring the convertibility rate for banknotes and the exchange rate for wholesale funds into line. In practice this never happened, and the July 1988 package of measures was the first step to tackling this problem by moving in a different direction. Looking back on these events from the perspective of 2006 one can see that the new direction implied, but not articulated, by the July 1988 measures was to start to extend gradually the authorities’ control over all the elements in the monetary base, not simply the currency issue. Only then would any tightening or easing, whether market-induced or deliberately induced by the authorities, be transmitted to all parts of the system in such a way that interest rate movements reinforced the tendency of the market exchange rate to appreciate or depreciate. It was obvious (as pointed out in Chapter 5) that Hong Kong’s banks did not maintain reserves at the monetary authority, but the fact that Hong Kong’s banks had maintained a private clearing and settlement system obscured the fact that the ultimate settlement bank (HSBC) in fact had the power to operate like a central bank in the sense of granting credit to any bank in the system that might become overdrawn on its settlement account. Such credits were equivalent to the creation of high-powered or base money, and therefore undermined the ability of either the authorities or any auto-pilot mechanism in the currency board to exercise monetary control. 228 Hong Kong’s Link to the US Dollar It is important that students of the Hong Kong monetary system understand the significance of this shift, and see that this was a first logical step on the way to the “seven technical measures” of September1998 that finally made the system much more robust. The text provides a full explanation of the new measures (pp. 229–236), including two pages of T-form balance sheets setting out the mechanics of the new arrangements, together with a key historical document (the press release announcing the new measures and their effect) as an appendix (pp. 242–247). At the end of the article there is some mild criticism (pp. 238–239 and 241) of the measures, though it is more suspicion of the authorities’ motives than any view that the measures would not work. The central contribution of the article is a detailed explanation of how any mandated changes in the size of the account to be held by HSBC at the Exchange Fund would enable interest rates to support desired changes in the market exchange rate. This mechanism remained the core of the system from July 1988 until December 1996 when a new clearing system (real time gross settlement, or RTGS) was introduced, and all licensed banks were required to maintain clearing accounts with the Exchange Fund or the Hong Kong Monetary Authority (HKMA) as it became known following its merger with the Office of the Commissioner of Banking in April 1993. A S I A N M O N E T A R Y M O N I T O R Vo l . 1 2 N o . 4 J u l y – A u g u s t...
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