Despite a very difficult year, the Exchange Fund continues to serve its primary purpose effectively.
Readers will be aware of the position of the Exchange Fund at the end of 2008 which we announced yesterday: an investment loss for the year of $74.9 billion. While this is obviously a very large sum and nobody, least of all we at the HKMA, likes to record losses, I hope readers will agree that, in a year that saw what many are calling the biggest financial crisis in a century, an investment loss of 5.6% is not such a terrible result. Certainly there are many other funds around the world that have experienced much worse losses, although few, if any, of them have the same purpose and objectives as the Exchange Fund. And that is an important point: the statutory purpose of the Exchange Fund is to support the exchange value of the Hong Kong dollar and thus to ensure monetary stability. This means that the Exchange Fund is managed conservatively and I believe this has stood us in very good stead over the last year. Despite the investment loss, the Fund remains available and sufficient for that primary purpose and, amid all the turmoil of recent months, the one number that has been reassuringly stable has been the exchange rate of the Hong Kong dollar to its US counterpart. We have also been able to draw on the resources of the Fund to support the financial system, by providing liquidity, contingent capital and the 100% deposit guarantee, without any questions about whether we have the wherewithal to do so. Conservatism, of course, also means a less attractive trend rate of investment return in good times, but there is obviously a price to pay for the ability to sustain confidence through more difficult times.
Looking back at what I wrote at this time last year when announcing a near-record positive investment return in 2007, I notice that I mentioned that a significant part of that return came from gains in Hong Kong equities and warned that we could not expect the very strong performance of the local stock market to be repeated every year. That clearly turned out to be the case given the fall in the Hang Seng Index last year, especially in the last quarter. If the Hong Kong equities, which readers will recall we hold long term, are excluded, the Fund would actually have made a small positive return in 2008.
Also important is the role that the Fund plays in providing a stable source of fiscal income. Through the fee arrangement, which I am sure readers are familiar with by now, the fiscal reserves are protected from the damaging short-term effects of the financial crisis. Instead of sharing in the loss, as would have been the case under the earlier sharing arrangement, and having to pay the Exchange Fund about $29 billion, the fiscal reserves are guaranteed a fee, amounting to $46.4 billion, in accordance with the fee rate determined at the beginning of the year as the moving average of the rate of return of the investment portfolio of the Exchange Fund in the previous six years. So there is a favourable swing of about $75.4 billion in the fiscal balance for the financial year 2008-09. Readers will I’m sure appreciate the significance of this if they think in terms of the fiscal deficit being $75.4 billion bigger than whatever figure is likely to be announced by the Financial Secretary as he reviews the public finances in the coming budget, and the implications of such a large budget deficit for government expenditure and taxation.
The investment loss, the fee payment to the fiscal reserves, a decline of $8.9 billion in the value of the Strategic Portfolio (which contains the shares in Hong Kong Exchanges and Clearing Ltd. purchased by the Financial Secretary for strategic purposes), together with other factors such as interest charges and other expenses, resulted in a decline in the Accumulated Surplus of the Exchange Fund of $136.3 billion.
This has to be seen in the light of another point readers may have noticed, which is the growth in the size of the Exchange Fund, by about 10% for the year, to $1,557.7 billion, at the end of the year. At the risk of over simplifying the matter, the amount of money available for maintaining monetary and financial stability in Hong Kong has increased, notwithstanding the financial crisis. This reflects the inflow of funds into the Hong Kong dollar, which results in an expansion of the Aggregate Balance and the US-dollar assets backing it. Some will of course correctly point out that, corresponding to the assets of the Fund, there are liabilities. I certainly agree but the growth in the total assets of the Exchange Fund takes the form of liquid US-dollar assets, mostly US Treasuries, rather than the doubtful or even toxic financial assets that central banks in other parts of the world have had to buy in support of their financial systems.
But readers should be prepared for possible sharp adjustments in the structure of the balance sheet of the Exchange Fund, as we manage it in accordance with what is required of the Fund for the maintenance of monetary and financial stability. A reversal of capital inflows into Hong Kong, for whatever reason, is a possibility – although we do not see any reason why this should occur in the near term. Such a reversal would be manifested in a fall in the Aggregate Balance and the corresponding US dollar assets backing it. The performance of global financial markets might also continue to disappoint. If so, this and the fee arrangement might result in further downward adjustments in the Accumulated Surplus of the Fund.
The Exchange Fund continues to play a very effective role in accordance with its legal mandate to maintain monetary and financial stability through the worst financial crisis for years. We in the HKMA will continue to manage the Fund prudently, in line with the policy determined by the Financial Secretary with the advice of the Exchange Fund Advisory Committee.
Joseph Yam
22 January 2009
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