The investment environment during the first six months of this year continued to be challenging. The Exchange Fund nevertheless managed to achieve a positive return during this period.
Readers will I hope be pleased to learn that the investment performance of the Exchange Fund in the second quarter of this year has improved. We managed to more than recoup the HK$2.1 billion loss made in the first quarter and for the first half of the year as a whole recorded an investment income of HK$11.5 billion. The detailed numbers are given in our press release issued today (28 July). Although the continuing strength of the US dollar into the second quarter has meant that we have incurred more exchange losses on our holdings of other foreign currencies, there has been a welcome recovery in equity prices both in Hong Kong and overseas. We also did well in the bond market in the second quarter, recording investment income from this source of HK$15.8 billion, following HK$5.3 billion in the first quarter. Thankfully the successive increases in short-term interest rates have not affected the long-term interest rates and so bond prices have held up well for us, although there is uncertainty as to how long this conundrum in the bond market will last.
It is helpful always to bear in mind that the Exchange Fund is not just an investment fund. It has clearly defined purposes laid down in the Exchange Fund Ordinance. It is to be used "primarily for such purposes as the Financial Secretary thinks fit affecting, either directly or indirectly the exchange value of the currency of Hong Kong and for other purposes incidental thereto". The Financial Secretary may also, "with a view to maintaining Hong Kong as an international financial centre, use the Fund as he thinks fit to maintain the stability and the integrity of the monetary and financial systems of Hong Kong". To achieve these purposes, the Fund has to be held in very liquid assets, and there is a strong emphasis on capital preservation in its management. An investment strategy is designed according to these needs, with the approval of the Financial Secretary after consultation with the Exchange Fund Advisory Committee and the Investment Sub-Committee which I chair. The strategy is therefore significantly different from the strategies of, for example, pension funds and other investment funds.
An example of the special requirement of the Exchange Fund is, of course, the need to hold US dollar liquid assets to provide for the full, foreign-exchange backing for the Monetary Base in accordance with the Currency Board rules of our Linked Exchange Rate system. The size of the Monetary Base at the end of June this year was HK$281.4 billion and with a Backing Ratio in the Currency Board Account now of over 110% we have to passively hold over HK$310 billion worth of highly liquid US dollar assets - US dollar call deposits and US Treasury securities. There is little room for manoeuvre in this Backing Portfolio, which represents almost 30% of the Exchange Fund, although short-term US dollar liquid assets have not done badly relative to other financial assets so far this year.
There is another special requirement of the Exchange Fund and this is our commitment to hold as a long-term investment the Hong Kong equities left over from the purchases in 1998 and the subsequent Hong Kong Tracker Fund disposal programme. The Hong Kong equity portfolio now represents about 8% of the Exchange Fund. We believe that this is a good, long-term investment, but the requirement to hold it regardless does constrain our ability to limit the effect of short-term fluctuations in Hong Kong equity on the investment performance of the Exchange Fund.
While we always do our best to achieve as good a return as possible for the Exchange Fund and for the people of Hong Kong, I hope the constraints we face, including also the maintenance of some Hong Kong dollar liquidity to meet drawdowns of fiscal reserves, are well understood. I also hope that the community will understand that whether or not we can meet the budgeted investment return on the fiscal reserves under the sharing arrangement depends very much on financial market conditions. While the budgeted figure may be reasonable as an average over a longish period, it is bound to be different from the actual out-turn, possibly quite significantly given financial market volatility. Indeed, as I mentioned at a recent meeting with the Legislative Council Panel on Financial Affairs, in four out of seven years in which the sharing arrangement applied, we managed to achieve a higher return than budgeted. It is highly likely that we shall by the end of the year see the expected long-term outcome of 50-50, in terms of the number of years of higher and lower returns relative to budget, although I hope that the average annual return would still be higher.
Joseph Yam
28 July 2005
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