BIS Review 28/1998  ˝  -5-  18. The latter point needs some further elaboration. As you will be aware, Hong Kong’s monetary policy is built around exchange rate stability in the form of the link between the Hong Kong dollar and the US dollar. This is backed up by the currency board system which requires the monetary base of the banking sector - the notes and coins in circulation and the clearing balances held with the HKMA - to be fully backed by foreign currency. When the Hong Kong dollar is under pressure as it was at the end of October 1997 and again in January of this year, the HKMA buys Hong Kong dollars from the banks in exchange for US dollars and the monetary base shrinks. This tightening of liquidity will in turn cause interest rates to rise, perhaps sharply so. This will choke off the inflows and restore stability to the exchange rate. 19. It is important to realize that this is an automatic process and that the HKMA has no room to maneuver to prevent the rise in interest rates from taking place. To do so would run counter to the basic principle of the currency board and would risk prolonging any attack on the Hong Kong dollar. 20. I think that there is now a better understanding of how the currency board system works. In addition, our determination to adhere to the system and to defend the linked exchange rate has been clearly demonstrated.
The Asian economies were certainly not fault-free, but in general they not exhibit the classic signs of gross macroeconomic weakness that normally lead to a balance of payments crisis. Governments ran fairly prudent fiscal policies, savings were high and inflation rates reasonably low. Even if policy mistakes were made, the punishment does not really seem to fit the crime. 3. Why then have exchange rates fallen by as much as they have and why have economies in the region been so severely crippled? It is generally agreed that a large part of the answer lies in the weakness of financial and banking systems in the region, which have amplified the initial effects of external shocks and economic downturn. In essence, banking systems that were already in weak health before the crisis broke were not up to the task of intermediating large inflows of capital. They have been part of a vicious circle whereby loss of confidence in the currency leads to loss of confidence in the banking system that further undermines the currency. This is the “run on the country” syndrome. It therefore follows that strengthening of the banking system must be part of the cure of the Asian disease and the means of preventing a recurrence. Banking supervision has an important part to play in this strengthening - hence the topic of my speech today. The weaknesses in Asian banking systems 4.