The investment results for 2007 were good but the prospects for 2008 are uncertain.
As expected, the year-end numbers of the Exchange Fund drew considerable interest from the community, judging from the press reports. The investment income of $142.2 billion, quoted in many headlines, is the highest on record in absolute terms, far exceeding the previous record set in 1999 (and repeated in 2006) of $103.8 billion. The rate of return was 11.8%, which I think is pretty respectable by any standards. These numbers are of course gratifying, although I think I should point out that a significant part of the return - some $55.8 billion - came from gains on Hong Kong equities. I am sure readers will understand that the strong performance of the Hong Kong stock market in 2007, despite a partial reversal towards the end of the year, is not something we can expect to be repeated every year. Indeed, we have already seen further sharp volatility so far this year and, while we all hope this will be temporary, a degree of caution about the prospects for 2008 is obviously called for.
I would also like to remind everyone that, as encouraging as the 2007 results are, investment is not the primary purpose of the Exchange Fund. The purposes for which the Fund must be used are laid down in law and are, first, backing the Hong Kong dollar, and, second, maintaining the stability and integrity of Hong Kong’s monetary and financial systems. These purposes determine the investment objectives of the Fund, set by the Financial Secretary on the advice of the Exchange Fund Advisory Committee: capital preservation; ensuring that the Monetary Base is at all times fully backed by highly liquid US dollar-denominated assets; ensuring sufficient liquidity; and, subject to the first three, achieving an investment return that will preserve the long-term purchasing power of the Fund. These factors set the Exchange Fund apart from pure investment funds, which typically put investment return first. I have said before that the best way to assess the performance of the Exchange Fund is to compare its return with that of the benchmark set by the Financial Secretary: in 2007 the Fund outperformed the benchmark by 126 basis points, compared with 63 basis points - a good result in itself - in 2006.
The investment return on the Exchange Fund for 2007 was achieved despite some developments that made it a difficult year for investors around the world. In the first half of the year, we saw investors chasing higher yields through innovative financial instruments, only to rush back into safer assets in the second half, as the emerging sub-prime crisis in the US and the ensuing credit crunch made investors more risk averse. Of course, no one should be surprised by fluctuations in markets, but last year was exceptional. For example, few would have predicted at the beginning of the year the kind of volatility in the fixed-income, equity and foreign exchange markets that we actually saw, with markets here and around the world fluctuating by large amounts, in many cases swinging back and forth several times during the year with little or no warning. Experience during the year also underlined how the increased inter-connectedness of global markets, coupled with the complexity of some new financial products, can transmit risks rapidly from one market to another, sometimes catching market participants and policy makers by surprise. Although some analysts were expressing concerns at the start of last year about whether the rise of the US and other housing markets was sustainable, no one was predicting that problems in one sector of the US mortgage market - I recall it being described as "a piece of a piece" of a very large market – would lead to a credit crunch and central banks acting singly and together to inject liquidity into credit markets.
Another figure that attracted attention this week was the payment to the Treasury of $27.6 billion under the new fee arrangement, introduced on 1 April last year, for determining the investment return for the fiscal reserves. This new arrangement is of considerable benefit to the community in that it provides a stable and predictable source of income for the Government. The fee of $27.6 billion for the calendar year 2007 is very close to the figure of $26 billion used in the Government budget for the financial year 2007-08. The rate at which the fee is set is calculated as a moving average of the rate of investment return of the Investment Portfolio of the Exchange Fund over the previous six years. For the 2008 calendar year, 2001 will drop out and 2007 will be added to the calculation. Because of the higher rate of investment return achieved in 2007 compared with 2001, and because the fiscal reserves have grown substantially meanwhile, the fee for inclusion in the 2008-09 budget should be higher.
It is by now something of a tradition for me to sound a cautious note about the prospects for the year ahead. But given the extreme volatility in financial markets that we have seen already in 2008, with January not even over, I am sure readers will agree that caution is particularly justified this time. Global markets are clearly unsettled; the odds on a recession in the world’s largest economy, although not yet a certainty, are believed by many to have lengthened; the sub-prime crisis in the US, and its ramifications elsewhere, are still not fully played out. The turbulence we have seen in the latter part of 2007 and so far in 2008 appears set to continue for at least a while. I have described the investment environment for this year as difficult, and I stand by that characterisation. Everyone will need to manage their risks carefully in the months ahead. We in the HKMA will of course continue to do our best to manage the Exchange Fund prudently in accordance with the strategy determined by the Exchange Fund Advisory Committee. But I hope the community will understand that it is impossible to keep breaking records year after year.
Joseph Yam
24 January 2008
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