Marking the assets of the Exchange Fund to their market values is an accounting requirement related to the Fund's need for liquidity.
It is useful, every now and then, to remind ourselves of the purpose of the Exchange Fund. This is laid down very clearly in both Article 113 of the Basic Law and the Exchange Fund Ordinance. The former says that the Fund shall be managed and controlled by the government of the HKSAR, "primarily for regulating the exchange value of the Hong Kong dollar". The latter lays down in greater detail that the Fund "shall be under the control of the Financial Secretary and shall 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". It also specifies that "in addition to using the Fund for its primary purpose, the Financial Secretary may, 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".
In a long period of monetary and financial stability, particularly exchange rate stability, despite highly volatile international financial conditions, there is an understandable tendency for the community to overlook the fact that this stability is underpinned by, among other things, a substantial Exchange Fund with a clear statutory purpose. Although the Asian financial crisis of 1997-98 occurred only a few years ago when the Financial Secretary had to use the Exchange Fund extensively to maintain exchange rate and financial stability, some appear to have forgotten this important role of the Exchange Fund, and have come to regard the Exchange Fund as a pure investment fund. This perhaps reflects a certain complacency on the part of the community, something that, in my opinion, we can ill afford.
While making sure the Fund is ready for use for its statutory purpose, we understand the need to invest the Fund properly and not just let it sit idly. Indeed, we should all hope that the Fund need not be used at all. In the HKMA we try our best to make sure that this is more than just a hope by introducing reforms to our monetary system whenever necessary, in many cases to prevent problems before they arise as far as possible. Members of the community are probably familiar with how the HKMA every now and then comes up with a few innovative "jiu" ( "招" or "measures"), which even those working in the financial system are not expecting. But unforeseeable monetary shocks that require the use of the Exchange Fund can never be ruled out. The investment of the Fund therefore places a lot of emphasis on liquidity, so that its assets, possibly in large volumes, can be readily turned into liquid funds when necessary.
When evaluating a fund with a high liquidity requirement, there is an accounting requirement that all the assets must be marked to their market values. This is one of the requirements of the new International Accounting Standards. In fact, we have been marking both the financial assets and liabilities of the Exchange Fund to market since 1994, long before the new accounting standards came into effect. When we hold, say, 10-year US Treasuries paying annual interest at 4.25%, we cannot ignore the effect of increasing interest rates on the bond price and claim that our rate of return is 4.25%. When interest rates rise, bond prices fall. If the price of the bonds has fallen from, say, 100.22 at the beginning to 98.83 at the end of the year, the loss of capital, amounting to 139 basis points, must be deducted from the interest income of about 430 basis points (due to the compounding of interest). In other words, the true return should be about 291 basis points (430 - 139 = 291), or a rate of 2.89%. The reason why the financial assets of the Exchange Fund must be marked to market is that there may be a need to sell them at market prices to raise cash during the year.
Of course, if there is no liquidity requirement and the bonds are intended to be held to maturity, the international accounting standards do allow them not to be marked to market, subject to certain disclosure requirements. The annual rate of investment return would then be 4.25%. But 4.25% is still less than the 6.3% average rate of return of the Exchange Fund in the past twelve years or the 5.7% average rate of return in the past seven years (excluding the effect of the stock market intervention in 1998), just as 2.89% is less than the Exchange Fund's investment return of 3.1% in 2005.
Joseph Yam
22 June 2006
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