How time flies! It’s nearly five years since I first took up the position of Chief Executive of the HKMA in October 2009. Now, as my first term draws to a close, I would like to take this opportunity to reflect on my work over that period, and to explain further the challenges faced by the HKMA and the rationale behind the various policies and measures we have introduced.
Financial Stability – First Things First
The HKMA has five main functions: maintaining Hong Kong’s monetary stability; supervising the banks; monitoring and promoting the development of payment systems and other financial infrastructure; managing the Exchange Fund; and promoting the development of Hong Kong as an international financial centre. Of these, the performance of the Exchange Fund usually attracts considerable attention from the public as the Fund represents the largest pool of financial assets of the Government, thus the property of the Hong Kong people. As such, it’s natural the public is keenly interested in the Exchange Fund’s investment results. For me, the HKMA’s most important function is the maintenance of financial stability, in other words, our duty to uphold the integrity and safety of the monetary, banking and payment systems of Hong Kong. Financial stability is the cornerstone of all economic and commercial activities, without it economic development, people’s livelihood, as well as political and social stability is in jeopardy. Let me put it this way: if money was like blood flowing in our body, then banks would be our heart, and payment systems our blood vessels. Normally, we don’t notice the beating of our heart or the circulation of our blood. It’s only when our heart or blood circulation system begins to fail resulting in life-threatening illness do we realise their importance and our failure to take good care of our body. In recent years, the global financial crisis and the European sovereign debt crisis have shown that even the largest and most sophisticated economies cannot and should not take financial stability for granted and assume that it can be achieved with little or no effort. And Hong Kong, as a small and open economy, is no exception. If a banking or financial crisis occurred in Hong Kong, the resulting impact could be devastating, and even a windfall of tens of billions of dollars in the Exchange Fund would not help in these circumstances.
This was why the first thing I did when I became Chief Executive of the HKMA in 2009 was to introduce a series of countercyclical macro-prudential measures with the aim of reducing the risks to the banking system posed by an overheated property market. Back then, a countercyclical measure was a rather novel approach and one that most advanced economies had never implemented. However, systemic risks arising from our overheated property market were building up quickly as a result of an "experiment of the century" introduced by the US to help reflate the economy and support the labour market. The US lowered its short-term policy rate to near zero and implemented an "unconventional" monetary policy – quantitative easing. Setting aside the debate on the effectiveness of this policy to the US economy, it inevitably had an impact on Hong Kong. Between 2008 and 2009, some US$83 billion flowed into the Hong Kong dollar, resulting in a sharp expansion in the Monetary Base by about HK$700 billion to HK$1 trillion. This also explained the considerable corresponding increase in the asset size of the Exchange Fund because the Monetary Base constitutes the short-term liabilities of the Fund. While the US was experimenting with its accommodative monetary policy, I recognised our economy would face risks from inflationary pressures, negative interest rates and overheating in the property market. I was also doubtful of the potency of monetary easing in supporting the US economy, something that has now been proven to be far less effective than the Fed had expected. However, the side effects of this policy on other emerging markets, including Hong Kong, were much more obvious. With the repeated extension, and expansion, of the US monetary easing policy and asset purchases, the upward cycle of Hong Kong’s property market was also prolonged. Not until the introduction in February 2013 of the sixth round of countercyclical prudential measures by the HKMA and the demand management tax measures by the Government did the property market begin to show signs of cooling down. Recent years have seen increasing discussion on, and increasing recognition for, counter-cyclical macro-prudential measures at the international level. For example, the Bank of England recently required banks to tighten stress tests on mortgage borrowers and imposed a cap on mortgage lending by banks, which stipulated that banks must ensure 85% of their total number of new home mortgages do not exceed 4.5 times the borrowers’ annual income. The cap applies to banks with mortgage lending in excess of £100 million per year.
Our work in maintaining monetary stability has also been challenging. The experiment with the "unconventional" monetary policy by the US led to very unusual monetary and financial conditions around the world. Over the past few years in Hong Kong, we have faced rising inflation, negative interest rates, surging property prices and rents, which have adversely affected people’s livelihood and the cost of doing business. More importantly, as the US dollar continued to weaken against the renminbi, the price of daily necessities imported from the Mainland increased, thus eroding Hong Kong people’s purchasing power on the Mainland. So, it’s understandable that some people began questioning whether Hong Kong should continue with the Linked Exchange Rate System (LERS). There were also suggestions the Hong Kong dollar should be pegged to the appreciating renminbi. Nevertheless, the HKMA and the HKSAR Government’s commitment to maintaining the LERS is clear and unwavering. Despite its imperfections, the LERS is still the most suitable regime for Hong Kong after thorough consideration of all the related factors and analyses, and our views are shared by the International Monetary Fund, the most authoritative organisation on monetary issues in the international financial community. For those readers interested, I refer them to the detailed arguments in my article published in October last year on the 30th Anniversary of the LERS together with a set of frequently asked questions and answers, which can be found at (http://www.hkma.gov.hk/eng/key-information/insight/20131014.shtml).
With the US already beginning to exit from quantitative easing by tapering its monthly asset purchases, funds have begun flowing out of emerging markets notwithstanding a distant prospect of a rate rise by the Fed. Other currencies have weakened against the US dollar with the renminbi depreciating by as much as over 3% against the US dollar during the first half of this year, a rebuff to the widely held belief that the renminbi would only appreciate against the US dollar and, therefore, the Hong Kong dollar. This confirms my often repeated comment that the long-term trend of the relative exchange rates of the major world currencies is cyclical and will not remain a one-way bet indefinitely. In the process of the normalisation of interest rates in the US, funds that previously flowed into emerging markets may flow out, exerting downward pressure on their asset markets and currency exchange rates. Looking ahead, the US dollar is likely to reverse its depreciating trend of the past few years, and, consequentially, the Hong Kong dollar, through the LERS, will face a quite different set of circumstances.
Prudential Supervision and Conduct Supervision – a Two-Pronged Approach to Banking Supervision
Another grave challenge the HKMA faced five years ago was the numerous claims from investors of Lehman minibonds and other wealth management products. At the time, we received more than 20,000 complaints. Each case required follow-up and investigation to determine whether the banks concerned were involved in mis-selling. We were under enormous internal and external pressure, compounded by inadequate manpower and intense political pressure at that time. Fortunately, through the concerted efforts of the HKMA and the banking industry, the majority of cases were resolved through settlement, thus avoiding prolonged and expensive legal proceedings between the complainants and the banks. As a result of this challenge, I decided to realign the HKMA’s banking supervision functions in 2010, creating two new departments – the Banking Conduct Department and the Enforcement Department – to take over the responsibility of regulating banks’ business practices and conduct from the Banking Supervision Department. The initiative gave us a two-pronged approach towards the supervision of banks, separating the prudential supervision of banks’ assets and liabilities from the regulation of banks’ business practices and conduct. By doing this, the departments are able to focus on their respective supervisory responsibilities which are quite different in nature and require different supervisory skills.
Exchange Fund – Last Line of Defense for Financial Stability
The Exchange Fund is not an ordinary investment fund, nor is it an enterprise which involves commercial sales and turnover. As such, the usual performance indicators for a company are not entirely appropriate in measuring the performance of the Exchange Fund. While the Exchange Fund’s investment performance is published quarterly, like usual companies, it is more appropriate to adopt a longer-term perspective for the Exchange Fund. First and foremost, it is a statutory government fund. Its primary purpose, as prescribed by the Exchange Fund Ordinance, is to maintain the monetary and financial stability of Hong Kong. The rule of law is fundamental to Hong Kong. Therefore, the HKMA must act in accordance with the law and the management of the Exchange Fund must comply with the overriding principles of preserving capital and ensuring a high degree of liquidity. This dictates that the Fund must build a relatively safe and liquid portfolio and avoid taking excessive risks and impairing its ability to meet contingent needs for the sake of seeking higher returns. Subject to this, we recognise that a small portion of the Exchange Fund can be more actively invested to enhance returns in the medium and long term. This was the backdrop against which the Long-Term Growth Portfolio (LTGP) was created in 2008.
Indeed, the LTGP was in its infancy when I took office, with a total market value of $2.3 billion in private equity investments and outstanding undrawn investments of $13.9 billion (at that stage we had not begun to invest in real estate). Since those early days, the Portfolio has made good progress. At the end of 2013, the aggregate market value of the investments in private equity and real estate increased to $88.6 billion and outstanding undrawn investments amounted to $80.2 billion, for a combined total of $168.8 billion. Because they are medium- to long-term investment projects, spanning five to eight years, it’s not advisable to focus on their short-term performance, but understandably this is of concern to the general public, that’s why we also publish the Portfolio’s investment performance each year. At the end of 2013, the Long-Term Growth Portfolio had recorded an annualised internal rate of return of around 16% since its inception. The Portfolio now holds private equity and real estate investments, an approach that is similar to some sovereign wealth funds. However, I again emphasise the Exchange Fund is not an investment fund or a sovereign wealth fund. Its investment objective is not simply driven by the pursuit of high returns. For this reason, the diversification of the Fund’s investment was capped at one-third of its Accumulated Surplus, which is around HK$210 billion. The purpose of the cap is to ensure the Exchange Fund holds enough highly liquid assets that can be readily liquidated to meet short-term obligations (for example, when there are capital outflows from the Hong Kong dollar) or to address financial disruptions or crisis that may arise.
Offshore Renminbi – Unlimited Business Potential
Finally, Hong Kong’s financial sector has achieved significant progress in the past years. Our banking system and capital markets have emerged relatively unscathed from the disruptions of the global financial crisis. This speaks volumes for the robustness of Hong Kong's financial supervision and its financial infrastructure and systems. Indeed, it is no small feat that Hong Kong has continued to develop and enhance its status as an international financial centre against a broad backdrop of turmoil and disruption. Hong Kong’s ascendancy as the world’s largest and most competitive offshore renminbi business centre in just a few years should escape no one’s attention. When I took office in October 2009, the pilot scheme for cross-border renminbi trade settlement was just announced, while the essential policies and financial infrastructure were not yet in place, and the renminbi trade settlement amount was insignificant. Renminbi bank deposits were only RMB58.2 billion, with the vast majority being the personal deposits of Hong Kong residents which had built up gradually since 2004. Thanks to the efforts of the HKMA and the banking industry, Hong Kong’s inherent strengths and "first-mover" advantage, as well as the strong support from the Central People’s Government, the People's Bank of China and relevant Mainland ministries, Hong Kong’s offshore renminbi market has grown in breadth and depth. We can now look back with pride at the remarkable progress. Total deposits have surpassed the RMB1 trillion mark for the first time; cross-border trade settlement exceeded RMB3.8 trillion last year; and the average daily turnover of payments handled by Hong Kong banks has increased rapidly to about RMB700 billion. This is in addition to a growing range of renminbi financial intermediation activities and products in Hong Kong, providing an unparalleled one-stop financing, investment and wealth management platform for individuals and enterprises.
So, in summary, this is my quick review of the past five years. Over the coming weeks I plan to share with you more on the rationale and principles behind the policies and work of the HKMA. My subsequent articles will cover:
• Countercyclical supervisory measures and financial stability
• The approach to banking supervision
• Management of the Exchange Fund, and
• Hong Kong’s competitiveness as a financial centre.
To round off the series, I will discuss the objectives and the vision for my second five-year term in office.
Norman T.L. Chan
Hong Kong Monetary Authority
7 July 2014