Investment return

inSight

24 Feb 2000

Investment return

The impressive rate of investment return on the Exchange Fund, shared by the fiscal reserves, has helped to reduce the budget deficit. But it is unlikely that the windfall gains will be repeated in the coming year.

Readers will recall the new arrangements introduced in April 1998 to enable the fiscal reserves deposited with the Exchange Fund to enjoy the same rate of investment return as that of the Exchange Fund as a whole.

I am happy to report here that the rate of return of the Exchange Fund in the calendar year 1999 has been significantly higher than expected. This also means that the investment return for the fiscal reserves for the financial year 1999-2000 is likely to be surpassed, perhaps by a quite a large margin. For the period from April to December 1999, that is to say the first nine months of the financial year 1999-2000, the total amount of investment return actually paid over or accruing to the fiscal reserves has already greatly exceeded the budgeted return on the whole financial year.

However, market developments so far in the first quarter of the calendar year 2000 (or the last quarter of the financial year 1999-2000) suggest possible losses, as in the case of the third calendar quarter of 1999. Interest rates have moved higher in the US and Europe, leading to lower bond prices. Equity markets have also been particularly volatile. And the US dollar has been strong, so that the Exchange Fund's exposures to the euro and the yen have suffered exchange losses. So, regrettably, the impressive investment return for the fiscal reserves for the financial year 1999-2000 is likely to be pared down somewhat.

Nevertheless, it will still be possible for the higher than expected investment return for the fiscal reserves to contribute significantly to reducing the budget deficit originally put at $36.5 billion. This happy result was mainly made possible by the highly profitable "investment" made by the Exchange Fund in Hong Kong equities in 1998 as a result of the controversial but justifiable decision taken to prevent market dislocation from destabilising the monetary and financial systems of Hong Kong. I am sure readers need no reminder of the reasons behind that decision. Furthermore, whether this extraordinary investment has contributed to, or merely coincided with the strong recovery of the equity market is of no real significance. The fact of the matter is that the people of Hong Kong have benefited, and this is what counts.

But the recent high rates of return for the Exchange Fund, and hence for the fiscal reserves, are unlikely to be sustainable over the longer term. Even if the equity market continues to record substantial gains, the extent to which the Exchange Fund will benefit from it is likely to be reduced. The exposure of the Exchange Fund to Hong Kong equities has been considered, in the elaborate strategic review undertaken at the end of 1998 to optimise asset allocation for the Exchange Fund, to be far too high. As this relatively more risky portfolio continues to be reduced, through further tap issues of TraHK and other disposal schemes that may be designed by Exchange Fund Investment Limited (EFIL), the rate of return of the Exchange Fund will increasingly depend upon bond market performance.

In an environment in which interest rates, in particular those in the US, are on an increasing trend, bond prices are likely to be adversely affected. Although the Exchange Fund will continue to receive steady interest income from the bond portfolio, valuation effects will almost certainly produce a low, if not negative, rate of return. It will, therefore, be unrealistic to expect another windfall in the coming financial year from the investment returns on the fiscal reserves, let alone the kind of substantial contribution to funding public sector expenditure or budget deficit that we have been used to in the past two years.

Joseph Yam
24 February 2000

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