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.
This situation was rectified in 1988 through the so-called Accounting Arrangements which required the Hongkong and Shanghai Banking Corporation Limited, as the Management Bank of the Clearing House of Hong Kong Association of Banks, to maintain a clearing account with the then Monetary Affairs Branch of Government for the account of the Exchange Fund. Thus the monetary base was only clearly defined then. The Accounting Arrangements were subsequently replaced by another arrangement, on the occasion of the introduction of Real Time Gross Settlement for interbank transactions in Hong Kong BIS Review 19/1998  -6any change in the monetary base has to be matched by a corresponding change in the amount of US dollar reserves held by the HKMA, and the change brought about by the HKMA rather passively converting Hong Kong dollars in the monetary base into US dollar reserves and vice versa at much the initiative of the banks. 19. The advantage of such a requirement is that whenever there is capital outflow, which would take the form of the sale by the banks of Hong Kong dollars to the HKMA for US dollars at the fixed exchange rate, there will, on settlement of the deals, be a shrinkage of the clearing balance of the banking system. This will lead to Hong Kong dollar interest rates in the interbank market increasing. The greater the outflow, the larger will be the fall in the clearing balance of the banking system and the higher will be the interest rates in the interbank market.