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The Exchange Fund and Hong Kong's Currency and Financial Stability

The recent global financial crisis has caused substantial damages on the world's financial and economic systems. It has also taught us a few lessons. One of the key lessons is that potentially there are inherent weaknesses and vulnerabilities in the global financial system, and even the largest and most advanced economies in the world cannot be immune. To prevent future crises from recurring, the Group of Twenty (G20) is now working very hard in introducing fundamental reforms to strengthen the global financial system, including the enhancement of banks' capital and liquidity requirements as well as restricting leverage. While these reforms are comprehensive and well designed, it is too optimistic to rule out the recurrence of large scale financial crises in the future.

Another key lesson we have learnt is that during a financial crisis, the government has to step in to rescue distressed financial institutions and stabilise financial markets. Nevertheless, the effectiveness of the government's rescue operations largely hinges on its financial strength. The bigger or more sophisticated a financial system is, the greater amount of financial resources would be needed in such rescue operations. For example, the US and the UK committed hundreds of billion dollars to save troubled financial institutions and to stabilise their financial systems. As for those economies with weaker financial strength, such as Iceland and Ireland, their governments' indebtedness has risen to very dangerous levels after committing huge amount of funds to rescue their banking systems. As a result, these economies are now facing rather gloomy prospects for their fiscal and economic outlook.

What about Hong Kong? The global financial crisis broke out following the collapse of Lehman Brothers in mid-September 2008. While Hong Kong's banking system was robust, we were nevertheless affected by the global credit crunch and repatriation of funds by US and European investors at that time. In October 2008, the HKSAR Government announced the use of the Exchange Fund to provide a 100% guarantee for all Hong Kong dollar and foreign-currency bank deposits in Hong Kong. The Government also introduced a Contingent Bank Capital Facility as a precautionary measure in case any bank required capital injection. These two measures, which were extraordinary measures launched in an exceptionally unusual time, had contributed to the maintenance of banking and financial stability in Hong Kong. Since the total deposits in the Hong Kong banking sector amounted to HK$6 trillion, it was an enormous financial undertaking by the Exchange Fund to provide this special blanket guarantee for all bank deposits. We were able to provide such an undertaking not only because we are confident in the soundness of Hong Kong banks, which managed to avoid the kind of bad debt problems that battered their US and European counterparts, but also because we have a sizeable Exchange Fund, whose high-quality, highly liquid foreign-currency assets could be deployed quickly for use in Hong Kong in case of need. With the solid backing of the Exchange Fund, the people of Hong Kong as well as the international investors abroad have maintained a high level of confidence in our banking system, even during the peak of the global financial crisis. In December 2010, Standard and Poor's assigned the highest "AAA" rating to Hong Kong for the first time, which is an international vote of confidence in the strength and soundness of Hong Kong's fiscal and financial conditions.

The Exchange Fund is the HKSAR Government's most important financial asset. It is not a sovereign wealth fund that focuses mainly on investment returns. The Exchange Fund Ordinance stipulates that the Fund can only be used to support the Hong Kong dollar and financial stability. To maintain public confidence in Hong Kong dollar and to protect monetary stability, Hong Kong has since 1983 adopted a Currency Board regime by pegging the Hong Kong dollar to the US dollar (i.e. the Linked Exchange Rate System). The entire Hong Kong dollar Monetary Base (comprising all legal tender notes and coins issued, the aggregate balance of the clearing accounts of banks kept with the HKMA and the total amount of Exchange Fund Bills and Notes) must be more than 100% backed by a Backing Portfolio comprising liquid assets denominated in US dollar. As at the end of 2010, foreign-currency assets of the Exchange Fund reached HK$2.2 trillion, of which the Backing Portfolio accounted for HK$1.1 trillion. But as its name suggests, the Backing Portfolio is used exclusively for the backing of the Hong Kong dollar Monetary Base. Whenever there is an outflow of funds from the Hong Kong dollar, US dollars have to be drawn from the Backing Portfolio to pay for these outflows. This means that the Backing Portfolio cannot be deployed for any purposes other than backing the Monetary Base, which has become rather volatile since the eruption of the global financial crisis.

Excluding the Backing Portfolio, the Exchange Fund's main source of funds comprises the Exchange Fund's investment surpluses accumulated after many years of prudent management as well as the fiscal reserves placed with the Exchange Fund by the Treasury of the Government. Currently, the sum of the accumulated surplus of the Exchange Fund and the fiscal reserve is HK$1.2 trillion. It is a big sum of money, which has increased significantly from HK$720 billion 10 years ago. However, it is worth noting this increase was accompanied by a phenomenal growth in the size of Hong Kong's banking system and financial markets in the same period. Total assets of our banking system have nearly doubled from HK$6.7 trillion in 2000 to HK$12.3 trillion by the end of 2010; and our stock market capitalisation has more than quadrupled from HK$4.8 trillion to HK$21 trillion in the same period. The rapid growth in the depth and breadth of our financial system in the past ten years is a welcome reflection of the success of Hong Kong's development as Asia's premier international financial centre.

As we strive to further develop Hong Kong as an international financial centre, we are acutely aware of the need to strengthen the risk management of our financial system. The Exchange Fund, as the ultimate backing for Hong Kong's banking and financial systems, is crucial in maintaining market confidence and financial stability. We are confident that banks in Hong Kong will continue to be prudent in running their businesses, and the HKMA will continue to upgrade our prudential supervision standards. But no one can say for sure that Hong Kong's financial system would be immune from the shockwaves of the next global financial turmoil. It is therefore essential that Hong Kong maintains an Exchange Fund commensurate with the scale of Hong Kong's financial system. During the Asian financial crisis, the Exchange Fund played a critical role in stabilising Hong Kong's monetary and financial systems, and the Exchange Fund has achieved the mission again in the recent global financial crisis.

There have been calls that the Government should try to quantify the optimal size of the Exchange Fund. I believe it is difficult, if not impossible, to arrive at a credible estimate, both in theory and in practice. We witnessed during the global financial tsunami that financial crises are hard to foresee or prevent. It would be even more difficult to predict the amount of resources needed when a crisis actually hits. Even though we cannot be too precise in quantifying in advance the amount of financial resources we will need in a crisis situation, we can certainly shore up our defence capability and resilience in good times. Only with the comfort of a powerful backstop, in the form of a sizable Exchange Fund, to protect Hong Kong's monetary and financial stability that we can feel at ease in making continued efforts to further develop Hong Kong as an international financial centre.


Norman T. L. Chan
Chief Executive
Hong Kong Monetary Authority

18 February 2011

Last revision date: 1 August 2011
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