The Exchange Fund

inSight

11 Jul 2002

The Exchange Fund

The Exchange Fund has improved its performance for the first half of this year. But the prospects for the second half are uncertain.

The first half of the year has just past and it is time again to report results on the investment management of the Exchange Fund. We are still preparing the preliminary figures, but early indications are that the first half of the year has been a profitable one. We have most probably, once again, beaten the return of the benchmark asset allocation portfolio (benchmark return) set for us by the Exchange Fund Advisory Committee.

Despite the very low interest rates, the bond market experienced exceptionally high volatility in the first half of the year. This volatility is evident in the substantial gains recorded in the first half of the year, all of which came in the second quarter, and which offset significant losses in the first quarter. Interest income received in the first half, together with appreciation in bond prices when the bonds are marked to market, amounted to about HK$20.9 billion.

Equities, however, have not done well at all. The S&P500 fell in the first half of the year by 13.8% and the Hang Seng Index correspondingly by 7%. The Exchange Fund therefore incurred losses in both foreign equities, amounting to HK$10.9 billion, and in Hong Kong equities, amounting to HK$4.6 billion, after adjusting for dividend income.

But the Exchange Fund's exposure to foreign currencies other than the US dollar has benefited from the US dollar's recent weakness, particularly against the euro. Exchange gains for the first half of the year (although unrealised) amounted to HK$17.4 billion, which is more than the exchange loss for the whole of last year of HK$13 billion, when the US dollar was strong.

Overall, therefore, when the preliminary figures are published later this month, they will probably show total investment income for the first half of the year at about HK$22.8 billion. This is more than three times the corresponding figure for the whole of last year. Deducting, as usual, interest and the relatively small amount of administrative expenses, totalling about HK$3.2 billion, the net investment income for the Exchange Fund in the first half of the year is about HK$19.6 billion. The share of this accruing to the fiscal reserves, in accordance with the agreed methodology for sharing, is estimated to be about HK$8.1 billion.

Readers will I am sure compare this with the budgeted figure on the investment return for the fiscal reserves of nearly HK$13 billion for the whole of the financial year 2002-03. They may go on to say that the investment return is currently running at a rate that will enable the budgeted figure to be achieved or even exceeded. But I have to remind them again of two points.

The first is that the HK$8.1 billion refers to the investment return for the fiscal reserves in the first half of the calendar year 2002 and not the first half of the financial year 2002-03. How the investment return for the fiscal reserves is accounted for is a matter for the Treasury. Given that figures for a particular period can only be available and accounted for after the expiry of that period, there will necessarily be discrepancies between figures prepared on the basis of accrual accounting and of cash flow accounting.

Secondly, and more importantly, the investment environment in the second half of the year will most probably be different from that in the first half. Market sentiment points to the possibility of higher interest rates, given the recent weakness of the US dollar and the economic recovery in the US, if it is in the event sustainable, although there are some doubts on this score. This would adversely affect bond prices and possibly result in losses in the bond portfolio, no matter how defensively we have positioned the portfolio in order to minimise the losses. More difficult to predict, as always, is the likely performance of equity markets and exchange rate movements. All in all, the investment outlook for the rest of this year looks very uncertain - even by the standards of recent years. It is too early to say whether the improved performance so far this year will continue.

 

Joseph Yam

11 July 2002

 

More information about the Exchange Fund can be found here.

 

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