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Annex A

EXCHANGE FUND ADVISORY COMMITTEE Currency Board Sub-Committee

Report on Currency Board Operations (9 July 2009 – 30 September 2009)

The Hong Kong dollar exchange rate stayed close to the strong-side Convertibility Undertaking (CU) of 7.75 during the reporting period. The strong-side CU was repeatedly triggered between mid-July and early August amid buoyant stock market activities. Hong Kong dollar interbank interest rates generally edged down and their negative spreads against US dollar interest rates narrowed. The Monetary Base increased from HK$720.31 billion to HK$804.08 billion and the market value of outstanding Exchange Fund paper continued to expand due to additional issuance of Exchange Fund Bills. These operations were in line with Currency Board principles, with changes in the Monetary Base fully matched by changes in foreign reserves. - 2 -

Hong Kong dollar exchange rate

1. The Hong Kong dollar exchange Chart 1 Hong Kong dollar exchange rate HK$/US$ rate moved within a narrow range of 7.89 (closing rate) 7.89 Weak-side Convertibility Undertaking 7.7500 and 7.7520 during the review 7.87 7.87 period (Chart 1). The strong-side 7.85 7.85 7.83 7.83 Convertibility Undertaking (CU) 7.81 7.81 was repeatedly triggered between 17 7.79 7.79 7.77 7.77 July and 5 August. Strong inflows 7.75 7.75 into the Hong Kong dollar probably 7.73 Strong-side Convertibility Undertaking 7.73 7.71 7.71 reflected equity-related demand, which 31/03 20/04 10/05 30/05 19/06 09/07 29/07 18/08 07/09 27/09 was boosted by activities arising from equity initial public offerings (IPO) and the better prospects for recovery in Jan 2000=100 Chart 2 the Mainland and Hong Kong 102 Effective Exchange Rate Index 102 100 100 economies. On 15, 16 and 30 98 98 September, licensed banks triggered 96 96 94 94 the strong-side CU again. The 92 92 exchange rate closed at 7.7502 at the 90 90 88 88 end of the review period. Meanwhile, 86 86 the effective exchange rate index of the 84 84 82 82 Hong Kong dollar declined from 88.2 Jan 05 Jul 05 Jan 06 Jul 06 Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 to 86.7 during the review period, as the US dollar weakened against other major currencies (Chart 2). - 3 -

Interest rates

2. Reflecting ample liquidity Chart 3 % p.a. HIBORs in the banking system, Hong 2.0 2.0 1-month 3-month 12-month Kong dollar interbank interest 1.5 1.5 rates remained below 1% during the reporting period (Chart 3). 1.0 1.0 The one-month and three-month HIBORs were near zero, with small 0.5 0.5 fluctuations due to short-term funding 0.0 0.0 demand associated with IPO 31/03 20/04 10/05 30/05 19/06 09/07 29/07 18/08 07/09 27/09 activities. During the review period, the three-month HIBOR declined from 0.18% to 0.12%, and the 12- month HIBOR from 0.95% to 0.85%, in line with the downward movements in their US dollar counterparts.

3. Interest rate volatility, measured by the standard deviation Chart 4 Interest rate volatility of daily changes in one-month 0.5 0.5 Standard deviation of daily HIBOR, decreased in July and 0.4 changes in 1-month HIBOR 0.4 August, but increased slightly in 0.3 Standard deviation of daily 0.3 September partly because of IPO changes in 1-month HIBOR relative to its monthly average activities. The standard deviation as 0.2 0.2 a ratio of the average one-month 0.1 0.1

HIBOR also showed similar pattern 0.0 0.0 (Chart 4).1 Jan 05 Jul 05 Jan 06 Jul 06 Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09

1 The ratio of the standard deviation of daily changes in the one-month HIBOR to its monthly average measures the extent of interest rate fluctuations relative to the average level of interest rates. - 4 -

4. The negative spreads of Chart 5 Hong Kong dollar - US dollar Hong Kong dollar interest rates % p.a. 0.5 interest rate spreads 0.5 against their US dollar 1-month 3-month 12-month counterparts narrowed slightly 0.0 0.0 during the review period (Chart 5), partly reflecting US dollar -0.5 -0.5 interest rates decreasing more -1.0 -1.0 than Hong Kong dollar interest rates. The one-month and three- -1.5 -1.5 31/03 20/04 10/05 30/05 19/06 09/07 29/07 18/08 07/09 27/09 month negative spreads contracted by 28 and 14 basis points to -39 and -63 basis points respectively. The 12-month negative spread also narrowed from -70 basis points to -40 basis points during the review period.

Chart 6 5. Broadly in line with the pips 100 Hong Kong dollar forward points 100 movements in the interest rate 50 50 spreads, the Hong Kong dollar 0 0 three-month and 12-month -50 -50 forward discounts narrowed -100 3-month -100 -150 -150 towards the end of the review -200 -200 12-month period. The three-month and 12- -250 -250 month forward discounts contracted -300 -300 31/03 20/04 10/05 30/05 19/06 09/07 29/07 18/08 07/09 27/09 by 16 and 3 pips to close at -48 and -175 pips respectively (Chart 6). - 5 -

Chart 7 6. Yields of Exchange Fund % p.a. paper, excluding those of tenors 8 Exchange Fund paper yield curves 8 7 7 end-Jun 97 between one week and two years, 6 6 declined (Chart 7). The decline in the 5 5 yields of longer-term Exchange Fund 4 4 3 8 Jul 09 3 paper was partly driven by decreases 2 30 Sep 09 2 in the yields of US government bonds 1 1 in August and September. In 0 0 1W 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y 12Y 13Y 14Y 15Y particular, the yield of 15-year Exchange Fund Note decreased by 24 basis points to 2.46% at the end of the reporting period. On the other hand, Table 1 the implied yields of one-week and Yield spreads of Exchange Fund paper over one-month Exchange Fund Bills US Treasuries (basis points) 27 Jun 97 8 Jul 09 30 Sep 09 turned positive, to 0.02% and 0.03% 3-month 56 -17 -5 respectively on 30 September, 1-year 21 -38 -21 compared with -0.01% on 8 July. 3-year 3 -36 -48 5-year 27 -43 -64 Meanwhile, the negative yield 10-year 54 -90 -97 spreads against US Treasuries 15-year - -135 -146 widened, except for those of tenors shorter than three years (Table 1).

7. The HKMA Base Rate remained unchanged at 0.5%, as Chart 8 the US Federal Open Market % p.a. 0.6 Base Rate and overnight HIBOR 0.6 Committee (FOMC) kept the Federal Federal funds target rate +50bps 0.5 0.5 Funds Target Rate (FFTR) at 0- 0.4 Closing O/N HIBOR 0.4 0.25% at the meetings in August and 0.3 Simple average of 5-day moving 0.3 September (Chart 8). The Base Rate averages of O/N & 1M HIBORs continued to be set at 50 basis points 0.2 0.2 above the lower boundary of the 0.1 0.1 target range according to the revised 0 0 31/03 20/04 10/05 30/05 19/06 09/07 29/07 18/08 07/09 27/09 Base Rate formula announced on 26 March. - 6 -

8. In line with the stable US

FFTR, banks continued to keep % p.a. Chart 9 Effective Hong Kong dollar deposit rate their Best Lending Rates 2.8 2.8 unchanged. There continued to be 2.4 2.4 2.0 2.0 two Best Lending Rates of 5.00% 1.6 1.6 and 5.25% at the end of the reporting 1.2 1.2 period. The average one-month 0.8 0.8 time deposit rate offered by major 0.4 0.4 authorized institutions remained 0.0 0.0 virtually unchanged at 0.01%. 2 The Jan 05 Jul 05 Jan 06 Jul 06 Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 effective deposit rate decreased to 0.05% in August from 0.08% in June (Chart 9).3 The composite interest rate, which indicates the average cost of funds of banks, edged down to 0.15% at the end of August from 0.19% at the end of June. 4 The lower average cost of funds partly reflected downward adjustments in interbank interest rates.

2 The figures refer to the average of interest rates offered by major authorized institutions for one-month time deposits of less than HK$100,000. 3 This is the average of the interest rates on demand, savings and time deposits. As the banking statistics classify deposits by remaining maturities, we have made certain assumptions regarding the maturity distribution in computing the effective deposit rate. 4 This is a weighted average interest rate of all Hong Kong dollar interest bearing liabilities, which include deposits from customers, amounts due to banks, negotiable certificates of deposit and other debt instruments, and Hong Kong dollar non-interest bearing demand deposits on the books of banks. Data from retail banks, which account for about 90% of the total customers’ deposits in the banking sector, are used in the calculation. - 7 -

Monetary Base

Table2 9. The Monetary Base, which Monetary Base consists of Certificates of (HK$bn) 9 Jul 09 30 Sep 09 Indebtedness (CIs), government- CIs 186.21 194.05 Government-issued 8.59 8.64 issued currency notes and coins in Currency Notes and Coins in Circulation circulation, the Aggregate Balance Aggregate Balance 208.17 184.18 and Exchange Fund Bills and Outstanding EFBNs 317.34 417.22 Notes, rose from HK$720.31 Monetary Base 720.31 804.08 billion to HK$804.08 billion during the reporting period (Table 2), mainly reflecting the additional supply of Exchange Fund Paper through a corresponding reduction of the Aggregate Balance.

Chart 10 Certificates of Indebtedness HK$ bn 200 Certificates of Indebtedness 200

10. During the reporting 195 195 period, the three note-issuing 190 190 banks submitted a total of US$1 billion to the HKMA in exchange 185 185 for HK$7.84 billion worth of CIs. 180 180 As a result, the outstanding CIs 175 175 climbed from HK$186.21 billion 31/03 20/04 10/05 30/05 19/06 09/07 29/07 18/08 07/09 27/09 to HK$194.05 billion (Chart 10).

Chart 11 Government-issued currency notes Government-issued currency HK$ bn and coins in circulation notes and coins in circulation 10 10

9 9 11. The amount of 8 8 government-issued currency notes and coins in circulation 7 7 edged up from HK$8.59 billion 6 6 to HK$8.64 billion at the end of 31/03 20/04 10/05 30/05 19/06 09/07 29/07 18/08 07/09 27/09 the reporting period (Chart 11). - 8 -

Aggregate Balance

Chart 12 12. The Aggregate Balance Aggregate Balance HK$ bn (before Discount Window activities) expanded from HK$188.21 billion 280 280 on 22 July to HK$234.24 billion on 240 240 4 August (Chart 12), due to the repeated triggerings of the strong- 200 200 side CU (Table 3). Because 160 160 additional Exchange Fund Bills were issued to meet banks’ demand, the 120 120 31/03 20/04 10/05 30/05 19/06 09/07 29/07 18/08 07/09 27/09 Aggregate Balance declined and closed at HK$184.18 billion on 30 September. The increase in the supply of Exchange Fund paper is Table 3 consistent with Currency Board HKMA HK$/US$ FX Transactions principles, as the additional issuance (9 Jul 09 – 30 Sep 09) Trade Date Net HK$ purchase (+) represents a change in the (HK$mn) composition of the Monetary Base, 17 Jul 2009 -3,487.50 from the Aggregate Balance to 20 Jul 2009 -1,937.50 21 Jul 2009 -4,262.50 Exchange Fund Paper. 22 Jul 2009 -2,325.00 23 Jul 2009 -6,975.00 24 Jul 2009 -14,725.00 27 Jul 2009 -6,200.00 28 Jul 2009 -5,037.50 29 Jul 2009 -5,037.50 30 Jul 2009 -6,975.00 31 Jul 2009 -6,200.00 3 Aug 2009 -2,325.00 4 Aug 2009 -3,100.00 5 Aug 2009 -2,325.00 15 Sep 2009 -1,550.00 16 Sep 2009 -3,100.00 30 Sep 2009 -1,550.00* Total -77,112.50 * Figure will be shown in the Aggregate Balance on 5 October. - 9 -

Outstanding Exchange Fund Bills and Notes

13. The market value of Chart 13 outstanding Exchange Fund Bills Exchange Fund paper held HK$ bn by licensed banks and Notes rose markedly from 400 400

HK$317.34 billion to HK$417.22 350 350 billion during the reporting 300 300 period, mainly because of the 250 250 additional supply of Exchange 200 200 Fund Bills. Holdings of Exchange 150 150 Fund paper by the banking 100 100 31/03 20/04 10/05 30/05 19/06 09/07 29/07 18/08 07/09 27/09 sector (before Discount Window activities) also expanded considerably from HK$270.32 billion (85.2% of total) to HK$364.66 billion (87.4% of total) (Chart 13).

14. During the reporting period, Table 4 HK$435.74 million of interest Issuance of Exchange Fund Bills and Notes payments on Exchange Fund (9 Jul 09 – 30 Sep 09) paper were made. Taking into No. of Over- issues subscription ratio account interest payments brought launched forward from the last reporting 1-month EFB 2 2.00-2.75 3-month EFB 12 0.38-4.31 period, an additional HK$468.86 6-month EFB 8 0.93-8.62 million (in market value) of 12-month EFB 3 2.29-8.84 2-year EFN 1 4.03 Exchange Fund paper was 5-year EFN 2 2.12-2.14 issued to absorb these interest 15-year EFN 1 4.87 payments. The Exchange Fund papers issued were well received by the market (Table 4). - 10 -

Discount Window activities Chart 14 HK$ bn Discount Window borrowing 3.0 3.0 15. During the reporting 2.5 2.5 period, banks did not borrow 2.0 2.0 from the Discount Window 1.5 1.5 (Chart 14). 1.0 1.0 0.5 0.5

0.0 0.0

-0.5 -0.5 Backing Portfolio 31/0330/03 19/04 09/05 29/05 18/06 08/07 28/07 17/08 06/09 26/09

16. Backing assets expanded Chart 15 during the reporting period, % 114 Daily movement of the Backing Ratio 114 mainly reflecting the rise in the Upper Trigger Level Monetary Base. The Backing 112 112 Ratio decreased from 106.25% 110 110 on 9 July to 105.80% on 30 108 108 September (Chart 15), because 106 106 the backing assets rose Lower Trigger Level proportionally less than the 104 104 Jan 05 Jul 05 Jan 06 Jul 06 Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Monetary Base. Under the Linked Exchange Rate system, while specific Exchange Fund assets have been designated for the Backing Portfolio, all Exchange Fund assets are available to support the Hong Kong dollar exchange rate.

Hong Kong Monetary Authority 12 November 2009