The investment environment remains difficult.
The third quarter has come and gone. Readers can hardly fail to be aware that it was a very tough one in the investment field. At the end of September, the Hang Seng Index was down more than 40% from its peak in 2007. A recent press article was accompanied by a map of the world showing how far various stock indexes had declined in the year to mid-October. The smallest decline was in Saudi Arabia and even that was 26%. Of the larger indexes, the Dow Jones had declined by 40%, the FTSE by 42%, the Nikkei by 52% and the China Shanghai Composite Index by 66%. All this, of course happened against the background of a financial crisis that has been described as a once-in-a-century event and which has seen some of the best known names in the financial industry having to be rescued or ceasing to exist altogether. At the same time, the US dollar, perhaps surprisingly, strengthened substantially, presumably because funds have been repatriated to the US to provide partial relief to the intense stress in the financial system there. This has adversely affected the value of non US-dollar assets, including those held by the Exchange Fund.
It will therefore not come as a surprise that the Exchange Fund will not escape mark-to-market losses when the final figures for the third-quarter position of the Fund are published shortly. However, I hope the people of Hong Kong will view them as I do: disappointing but not unduly alarming given the current investment environment and the nature and purposes of the Fund.
Readers will be well aware that the primary purpose of the Exchange Fund under the Exchange Fund Ordinance is to affect the exchange value of the Hong Kong dollar. In that, I am pleased to say that we have been successful: the one number that has remained very stable in Hong Kong amid the turmoil of recent months has been the exchange rate of the Hong Kong dollar with its US counterpart. This primary objective means that the Exchange Fund is not managed like a conventional investment fund: its investment objectives stress liquidity and capital preservation because the assets of the Fund must be available to support the local currency at short notice if required. These objectives, and an emphasis on prudence and risk management, have stood us in good stead.
Effective risk management has meant that the Exchange Fund has not been exposed to some of the "toxic" assets that have caused problems in the markets. Our exposure to financial institutions that have failed has also been either zero or very small through passive investments that track the indexes of the stock markets on which those institutions were quoted. We were also able to reduce exposures in good time, where it seemed prudent to do so.
Another factor that I have pointed out before is that a significant part of the loss, about 60%, is due to our holding of Hong Kong equities. Readers will no doubt recall that this holding comprises the remainder of the stocks purchased ten years ago as a major - and successful - part of our response to an earlier financial crisis. It is in effect involuntary because we have given undertakings that we will not dispose of these stocks because of obvious sensitivity about the effect of doing so on the market.
It is also essential that we keep in view the long-term performance of the Exchange Fund given its primary purpose. The Exchange Fund generated a compounded annual return of 7.0% between 1994 and 2007, which compares favourably with the compounded annual inflation rate of 1.5% over the period. It shows that we have done a reasonable job of maintaining and growing the value of the Fund and ensuring that it continues to be available and adequate for its statutory purposes. A related point is that, from April last year, the fee paid by the Exchange Fund to the Treasury for the use of the Government's fiscal reserves deposited with the Fund is calculated based on a six-year moving average of the investment return. This means that the contribution to the general revenue from this source is smoothed out and not affected immediately by fluctuations in the investment return. In fact, the Government will benefit from last year's high return in this year's contribution. However, this does mean that the Accumulated Surplus will decline this year, in part because of the need to make this payment.
Finally, I think it goes without saying that the investment environment remains very volatile and is likely to be so for some time yet. A slowdown or recession in the major economies looks more or less certain and it is difficult to see light at the end of the tunnel. We at the HKMA will, as always, do our very best to manage the Exchange Fund prudently in accordance with the benchmark set by the Financial Secretary on the advice of the Exchange Fund Advisory Committee.
Joseph Yam
30 October 2008
Click here for previous articles in this column.
Document in Word format
