We were just sitting there passively, on settlement day, waiting for the banks to give us the Hong Kong dollars that they had sold to us - Hong Kong dollars that they did not have. 22. In the circumstances, the banks had only two alternatives. First is for them to borrow Hong Kong dollars from the HKMA at the end of the settlement day, through the Liquidity Adjustment Facility (LAF), Hong Kong’s version of a discount window. This would obviously not be cheap, particularly for repeated borrowers, as the HKMA is not in the business of providing cheap Hong Kong dollar funding to those shorting the Hong Kong dollar. And this would only be for overnight money. Second is for the banks to obtain Hong Kong dollars more permanently from the HKMA by selling US dollars back to the HKMA, which the HKMA again takes passively in accordance with the discipline of the currency board system. This is exactly what happened on 23 October 1997 and the speculative capital outflow then was as quickly reversed as it had started, in a matter of only two days, with the system operating very much on auto-pilot. Interest Rates 23.
And indeed, the demand for M3 in the euro area has shown clear signs of instability since 2001 and a break in the income velocity of M3 occurred at the same time. Most remarkably, instead of delivering some erratic pattern, a new velocity trend seemed to emerge with liquidity expanding much more rapidly 6 . It is fair to say that the precise role of financial innovation in this regard is still unknown but we have all the reasons to believe that, taking it into account should help explain this change in money demand, and better gauge its consequences for future inflationary pressures. Let me elaborate further. First of all, the introduction of the euro in itself a major financial innovation, had many effects on the financial behaviour of economic agents. The introduction of the euro immediately resulted in: •  the removal of any exchange rate risk between participating countries;  •  the introduction of a new system of remunerated reserve requirements;  •  and the creation of an integrated money market – thanks in particular to the setting up of a new large-value payment system (TARGET). Furthermore, thanks to the introduction of the euro and to the successful monetary policy conducted by the ECB, all member countries now benefit from an environment of well-anchored inflation expectations and, as a result, low interest rates.