The new arrangement makes the estimated investment income of the fiscal reserves more stable and helps with budgeting.
The arrangement under which the fiscal reserves placed with the Exchange Fund share in the investment return of the Fund as a whole has been in use since 1998. Compared with the previous arrangement whereby the fiscal reserves received interest from the Exchange Fund as if the money was placed on deposit with the Fund, the sharing arrangement has, over the last nine years, improved considerably the investment return for the fiscal reserves as a source of government revenue. But, because financial market performance differs from year to year, there has also been considerable volatility in the amount of investment income for the government accounts. This presented considerable difficulty in the annual budgeting of this significant source of government revenue.
Although it is obviously necessary to put a figure in the government budget for the investment income from the fiscal reserves, the sharing arrangement and financial market volatility mean that the budget figure often turns out to be wrong by a fairly wide margin. This is understandable for those familiar with financial markets, but for the general public the discrepancy that occurs every year between the budget figure and the actual out-turn inevitably becomes a kind of measure of the performance of the HKMA in investment management. This is certainly not what the existing sharing arrangement is intended to be. For a number of good reasons, it is desirable to work out an alternative arrangement that gives greater predictability and lower volatility in the estimated investment income for the annual budget.
We therefore welcome very much the decision by the Financial Secretary, announced in the Government's 2007-08 Budget yesterday, to change the sharing arrangement. Starting from this year the Exchange Fund is to pay a fee for the use of the fiscal reserves placed with the Exchange Fund to achieve the purposes of the Fund, as defined in the Exchange Fund Ordinance. The fee is to be calculated by applying the average annual rate of investment return of the Investment Portfolio of the Exchange Fund (the whole of the Fund less the part of it dedicated to backing the Monetary Base – the Backing Portfolio) for the last six years to the time-weighted amount of fiscal reserves placed with the Exchange Fund during the year.
The new arrangement achieves three things: greater stability of investment income as a source of government revenue; greater predictability of the revenue stream for budgeting; and, hopefully, a higher investment return on the fiscal reserves. The greater predictability comes from applying a pre-determined, fixed fee rate to an estimate of the (time-weighted) amount of fiscal reserves placed with the Exchange Fund during the year. Any variation between the budget number and the out-turn number should be small and attributable to the extent that the total amount of fiscal reserves placed with the Exchange Fund during the year may be different from the estimate. The greater stability will be achieved through the use of the six-year moving average, which obviously is a lot less volatile than the actual year-to-year fluctuations, six years being the best estimate of the duration of an investment cycle of this type of portfolio. The investment return should be higher in the long run because the fiscal reserves will only share in the Investment Portfolio of the Exchange Fund and not the Backing Portfolio, which has to be invested in very liquid US dollar assets in order to provide full backing for the Hong Kong dollar Monetary Base, and would therefore normally achieve a somewhat lower investment return over time, although of course there will be variations from year to year.
I think the new arrangement suits our circumstances well, but it does have one important implication. The use of the six-year moving average almost inevitably means that, in any particular year, the investment return of the Investment Portfolio will be higher or lower than the calculated fee rate. These differences will be for the account of the Exchange Fund: in years when the Investment Portfolio achieves a higher rate of return, the amount above the fee rate will be credited to the Fund; in years when the actual return is lower than the fee rate, the Fund will still pay the calculated fee rate to the Treasury. This is, of course, how the new arrangement makes the investment return of the fiscal reserves more stable, and the Financial Secretary’s budgeting more predictable.
Joseph Yam
1 March 2007
Click here for previous articles in this column.
Document in Word format
