Despite a difficult investment environment, the Exchange Fund will continue to meet its primary purpose.
We announced today the position of the Exchange Fund at the end of the first half of the year. The Fund recorded an investment loss of $35 billion, or about 2.5% of the Fund's total assets.
Of course, nobody likes to see a loss, and this is certainly a change from the substantial investment gains the Exchange Fund has enjoyed in recent years – including the $142.2 billion return recorded for 2007. But it is important to keep these figures in proper perspective. The investment environment in the first half of this year has been an extremely challenging one, especially in the equities markets. The Hang Seng Index is down over 20% in the first half compared with a gain of nearly 40% in the whole of 2007. And markets around the world have all seen declines in the first six months of the year: the S&P 500 in the US by 12.8% and the MSCI World Index by 14%.
It should therefore come as no surprise that local and foreign equities accounted for a valuation loss of $57.5 billion. This was offset by an exchange valuation gain of $11.6 billion and a return from bonds and other investments of $10.9 billion. I believe this demonstrates that the prudent investment policy of the Exchange Fund, set by the Financial Secretary on the advice of the Exchange Fund Advisory Committee, is the correct one: it has helped to keep losses to a minimum in a very uncertain and volatile situation. The latest figures should also be viewed against the average 7% annual investment return of the Exchange Fund since 1994.
The other thing to remember is that the Exchange Fund is not primarily an investment fund: its primary purpose under the Exchange Fund Ordinance is to affect, directly or indirectly, the exchange value of the Hong Kong dollar to ensure the exchange-rate stability that is so essential to the economic well-being of Hong Kong and its people. With total assets of $1,409.2 billion at the end of June (a slight reduction of $5.2 billion, or 0.37%, from the end of 2007), the Fund continues to be available and in good shape for this purpose.
The fee payment to the Treasury for the fiscal reserves deposited with the Exchange Fund was $23.6 billion in the first six months of 2008 based on the rate of 9.4%, which is the six-year moving average of the rate of return for the Investment Portfolio of the Fund. This illustrates the benefits of the fee arrangement introduced on 1 April last year for the Financial Secretary’s budgetary planning. The tough and volatile investment environment does not immediately affect the Government’s revenue, as it would have done under the previous arrangement. Of course, the other side of this coin is that the Accumulated Surplus saw a total reduction of $68.4 billion, comprising the investment loss, the fee payment to the fiscal reserves, a reduction in the value of the Strategic Portfolio (established to hold the Government’s strategic holding of shares in Hong Kong Exchanges and Clearing Ltd) and interest and other expenses.
As far as the second half of the year is concerned, we are all of course hoping for a turnaround. But we should be cautious. The factors that affected markets in the first half – the deepening of the sub-prime crisis and the spread of problems to other asset classes, the ensuing credit crunch, fears of recession in the major economies, high commodity prices, and concerns about inflation – have not gone away. The problems in the US housing market continue and may be getting worse, with implications for the resilience of the US consumer and the wider economy. The credit squeeze persists. Commodity prices – especially the price of oil - remain elevated despite some recent declines. We are clearly not out of the woods yet: I recently wrote about taking the rough with the smooth in the financial markets and we should all be prepared for more rough to come.
As always, we at the HKMA will continue to do our best to manage the Exchange Fund prudently, in accordance with the investment policies set by the Financial Secretary, and always keeping in mind the statutory purpose of the Fund.
Joseph Yam
31 July 2008
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