Exchange Fund position for the first half of 2009

inSight

30 Jul 2009

Exchange Fund position for the first half of 2009

A better first half, but markets remain uncertain.

Readers may recall that in my last briefing to the Financial Affairs Panel of the Legislative Council on 21 May 2009, I said that the Exchange Fund had incurred an investment loss of $33.5 billion in the first quarter of the year. Obviously this was a large figure, although, as a percentage of the Exchange Fund, the loss was not very large given the very adverse market conditions in the first quarter. We are fully aware of the importance that the community places on the investment performance of the Exchange Fund and this is part of the reason we have always adopted a conservative investment strategy. There are stringent controls over the investment management of the Exchange Fund, giving us only limited leeway, which is approved by the Financial Secretary on the advice of the Exchange Fund Advisory Committee, to deviate from the benchmark positions. And we pay a lot of attention to maintaining a high degree of transparency in the investment management of the Exchange Fund, providing as much explanation of our work as possible — given the market-sensitivity of this information — to the people we serve, directly and through the Legislative Council.

Fortunately, I was also able to report to the Panel at the briefing that the loss in the first quarter, which mainly reflected mark-to-market losses in the period, had all been recouped half way into the second quarter, mainly because of the mark-to-market gain arising from the rebound in the Hong Kong equity market.

As announced in our press release today the Exchange Fund recorded an investment gain of $25 billion in the first half of the year. This reflects mainly a recovery in equity markets in the second quarter. The mark-to-market gain of our Hong Kong equity portfolio in the first half amounted to $26.1 billion and that of the foreign equity portfolios to $9.2 billion. Together with an exchange gain of $2 billion, these gains more than offset the mark-to-market loss of $12.3 billion in our bond holdings caused by the rise in long-term US interest rates (and therefore long-term bond yields) as the market grew concerned about the sustainability of the US fiscal position.

On several occasions (including in this column) in the past couple of months I have drawn attention to the possible disconnection between financial-market performance and economic performance, and pointed to the risk that, as economic reality (in the form of continued economic weakness and a slow recovery) sinks in, we may see disappointments in the financial markets in the months ahead. We of course do not wish to see this happen; but realistically we cannot take it for granted that the positive investment results in the first half of the year will be repeated in the second half. We will, of course, continue to do our best.

The investment performance of the Exchange Fund, which inevitably varies over time, will not affect the stability of the investment income of the Government. The fee arrangement between the Exchange Fund and the general revenue that has been in place now for more than two years ensures a high degree of predictability for the "investment" return on the accumulated fiscal reserves deposited with the Exchange Fund. We saw the benefits of the arrangement quite clearly in 2008. While the Exchange Fund incurred a loss of 5.6%, which incidentally was much smaller than the percentage of loss incurred by the great majority of investment funds, the fiscal reserves still enjoyed a 9.4% return. However, I must point out an inevitable feature of the fee arrangement arising from its moving-average nature: the fee (in percentage terms) paid by the Exchange Fund for the use of the fiscal reserves may at times be less than the actual rate of investment return of the Fund. Yet we still consider the fee arrangement is in the best interests of the people of Hong Kong because stability and predictability are key considerations in the management of public finances and there is no doubt that the fee arrangement helps to achieve these goals.

A consequence of the fee arrangement, however, is that the Accumulated Surplus of the Exchange Fund has become more volatile. Readers will have observed the large fall of $136.5 billion recorded in 2008, as we paid a fee of 9.4% to the fiscal reserves, even though the Exchange Fund had recorded an investment loss. In the first half of this year, the Accumulated Surplus of the Exchange Fund increased only by $8.5 billion, after paying a fee of $17.9 billion to the general revenue.

Joseph Yam
30 July 2009

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