We have to take the rough with the smooth in the financial markets. It is the long-term performance of the Exchange Fund that matters.
The respite in financial-market performance that began in April turned out to be short-lived, as equity markets in most jurisdictions resumed the downward trend that started in the fourth quarter of last year. Recent press reports1 have suggested that global equities markets (measured by the MSCI world equity index) would see their worst first-half decline in 26 years; the FTSE Eurofirst index its worst first-half decline since it was launched in 1986; and the S&P 500 its worst first half since 2002. As far as the Hong Kong market is concerned two main factors contributed to the decline. The first was the persistent tension in credit markets in the US and Europe, with financial institutions continuing to make large write-downs with consequential strains on liquidity and capital adequacy. The stimulus for these problems – the decline in housing prices in the US – has intensified. At the same time, the market seemed to sense a possible shift of emphasis in US monetary policy towards tackling inflation expectation, perhaps signalling an end to interest-rate cuts and possibly the arrival of interest-rate increases.
The second factor is the clearer determination of the Mainland authorities to curb inflation, through stronger macro-economic controls, using both market and administrative means. These weighed on the Mainland equity market, which has declined further since the beginning of the year than other markets in the region (except Vietnam). There is, for obvious reasons, a high degree of correlation between the Mainland and Hong Kong equity markets, and so a more bearish sentiment has set in since April.
Readers will by now be familiar with the statutory purposes of the Exchange Fund, primarily affecting the exchange value of the Hong Kong dollar, through the Linked Exchange Rate system, to maintain monetary stability. This is reflected in the investment objectives of the Exchange Fund, which are conservative and emphasise high levels of liquidity. This sets the Exchange Fund apart from most investment funds. Despite the unusually rough period currently being experienced by global financial markets, the conservative investment approach of the Exchange Fund, reflected in the investment benchmark approved by the Financial Secretary with the advice of the Exchange Fund Advisory Committee, has helped to keep losses to a minimum. The investment performance of the Exchange Fund has to be judged over the longer term. Short-term fluctuations are inevitable, but the investment return of the Fund has averaged 7% since 1994 and reached a near record of 11.8%, a gross investment income of $142.2 billion, in 2007. As I mentioned when announcing that figure, we cannot expect such good results every year.
I also pointed out at that time that a significant part of last year’s investment return - some $55.8 billion – came from gains on Hong Kong equities. Readers may recall the action we took ten years ago to safeguard monetary and financial stability in Hong Kong. Using the Exchange Fund, we purchased $118.1 billion of the stocks that made up the Hang Seng Index in August 1998. The details are well documented, as is the subsequent disposal of most of those stocks through the Tracker Fund, which has since become a popular investment product in the stock market. The sale proceeds, plus dividends received in the meantime, amounted to $165.2 billion. On top of this, some $51.5 billion of Hong Kong equities was retained as a long-term investment of the Exchange Fund, representing about 5% of the Fund’s total investment assets at the time. An announcement was made in September 2002 that we would not dispose of this holding for the foreseeable future but retain it as a long-term investment.
This investment in Hong Kong equities grew rapidly with the economic recovery of the past few years. By the end of last year, it had grown to $170.7 billion (excluding shares in Hong Kong Exchanges and Clearing Ltd., most of which were acquired for strategic purposes in 2007). Equities are of course more subject to volatility than other asset classes such as bonds, and readers will not need me to tell them what has happened in the Hong Kong equities market since the end of last year. On 31 December the Hang Seng Index stood at 27,813. Since then, it has fallen by around 6,000 points. A movement of one point in the Index means a valuation gain or loss of about $6 to $7 million for the Exchange Fund, assuming that the composition of the holdings tracks that of the Index. A movement of 1,000 points means a valuation gain or loss of about $6 to $7 billion. The stabilising effect usually provided by the much larger bond portfolio of the Exchange Fund was not much help in the second quarter of this year, as bond prices reacted to the possibility that interest rates might start to increase again.
The longer-term approach to the investment return of the Exchange Fund is reflected in the revised income-sharing arrangement between the Fund and the fiscal reserves placed with it by the Government introduced from 1 April last year. Under the arrangement, the Exchange Fund pays a fee to the fiscal reserves based on the six-year moving average of the investment return of the Investment Portfolio of the Fund2 The Government’s investment income from the fiscal reserves in 2008 will therefore not be immediately affected by the performance of the Fund during the year. The system spreads out the effects of good and not-so-good years making the Government’s income from the fiscal reserves more stable and predictable. This year the fee will be about $40 billion, depending on the actual amount of fiscal reserves deposited with the Exchange Fund during the year, or a 9.4% rate of return, which is the six-year (2002 to 2007) moving average already fixed for 2008.
We have to take the rough with the smooth and should not be surprised by short-term losses at times of high market volatility and uncertainty. The important thing is the long-term performance of the Fund and its ability to fulfil its primary purpose. We are finalising the preliminary half-year accounts of the Exchange Fund, and will, as usual, publish them as soon as they are available. As always, we at the HKMA will continue to do our best to manage the Exchange Fund prudently in accordance with the investment strategy established with the advice of the Exchange Fund Advisory Committee.
Joseph Yam
10 July 2008
1 Financial Times: 29 June 2008
2 Or the average annual yield of 3-year Exchange Fund Notes in the preceding year subject to a minimum of zero percent, whichever is the higher
Click here for previous articles in this column.
Document in Word format
