This process of re-intermediation put considerable  2  BIS Review 139/2007  pressure on the profitability, asset quality and capital adequacy, to the extent of creating great tension in the inter-bank market, as financial institutions hoarded liquid funds. Ninth, as you all know, major central banks had to step in to provide liquidity in order to ease tightness in the money market. They have been doing so for about three months now, which is not a good sign, because of the implication of a continuing lack of trust among financial institutions in lending to each other. In one particular jurisdiction, a problem at the wholesale money market level triggered a breakdown of depositors’ confidence at the retail level, resulting in a bank run. In the United States, the Fed further responded with a shift in monetary policy, notwithstanding continuing concerns over rising inflation, and cut interest rates twice, presumably to pre-empt credit tightness from adversely affecting economic prospects generally and the property market in particular. Tenth, meanwhile, financial institutions in the United States are writing off large amounts quarter after quarter and this is affecting the general availability of credit and prospects of the economy, notwithstanding lower interest rates, and increasing the probability of a recession, although many still put this at less than 50-50. This seems to be the general sentiment currently reflected in financial market performance in the United States. There has also been much greater short-term volatility, as new information is absorbed by the market, indicating considerable nervousness.
I should of course start by re-iterating the firm HKSARG policy of keeping our exchange rate to the US dollar within the range of 7.75 to 7.85 through the linked exchange rate system, characterised by currency board arrangements that require our monetary base, and any changes in it, to be 100% backed by US dollars. With the weakening US dollar and the strengthening renminbi; with the local inflation rate, excluding the temporary effects of tax relief, edging higher; with an “asset bubble” on the lips of many commentators; with the exchange rate hitting the strong side Convertibility Undertaking late last month, requiring our passive and un-sterilised foreign exchange intervention, injecting quite a lot of Hong Kong dollar liquidity into the inter-bank market; and with current US monetary policy possibly becoming inappropriate for Hong Kong; questions have understandably been raised on the appropriateness of the system. Let me provide answers to these questions. First, the appropriateness of the linked exchange rate system should be judged by its ability to deliver monetary and financial stability in Hong Kong through economic cycles, and should not be judged by the short-term cyclical conditions of the economy relative to that of the US economy. The linked exchange rate system has served Hong Kong extremely well since its establishment.