LC Paper No. CB(1)1137/98-99
(These minutes have been seen by the Administration)

Ref : CB1/PL/FA/1

Legislative Council
Panel on Financial Affairs

Minutes of special meeting held on Thursday, 17 December 1998, at 10:45 am in the Chamber of the Legislative Council Building

Members present :

Hon Ambrose LAU Hon-chuen, JP (Chairman)
Hon Eric LI Ka-cheung, JP (Deputy Chairman)
Hon James TIEN Pei-chun, JP
Hon Cyd HO Sau-lan
Hon Albert HO Chun-yan
Hon NG Leung-sing
Hon James TO Kun-sun
Hon CHEUNG Man-kwong
Hon HUI Cheung-ching
Hon Bernard CHAN
Hon SIN Chung-kai
Dr Hon Philip WONG Yu-hong
Hon FUNG Chi-kin

Member attending :

Hon Martin LEE Chu-ming, SC, JP

Members absent :

Hon Kenneth TING Woo-shou, JP
Hon David CHU Yu-lin
Dr Hon David LI Kwok-po, JP
Hon Margaret NG
Hon Ronald ARCULLI, JP
Hon Ambrose CHEUNG Wing-sum, JP
Hon Jasper TSANG Yok-sing, JP
Hon Timothy FOK Tsun-ting, JP

Public officers attending:

Agenda items I and II

Mr Joseph YAM

Chief Executive
Hong Kong Monetary Authority

Agenda item II

Miss Denise YUE

Secretary for the Treasury

Mrs Lesley WONG

Principal Assistant Secretary for the Treasury

Miss Clara TANG

Principal Assistant Secretary for Financial Services

Clerk in attendance :

Ms Estella CHAN

Chief Assistant Secretary (1)4

Staff in attendance :

Ms Connie SZETO

Senior Assistant Secretary (1)1

I The Administration's response to views of market practitioners and academics on the mechanism for defending the linked exchange rate system (Part II)
(LC Paper Nos. CB(1)636/98-99(01), 570/98-99, 571/98-99 and 647/98-99)

At the Chairman's invitation, the Chief Executive, Hong Kong Monetary Authority (CE/HKMA) briefed members on HKMA's information paper and referred them to one of its recent publication, "Review of Currency Board Arrangements in Hong Kong", which provided a useful theoretical framework for the discussion of monetary issues relating to the currency board (CB) system. CE/HKMA highlighted in his presentation the broad support of market practitioners and academics to the linked exchange rate (LER) system and the seven technical measures introduced since early September 1998 to strengthen the CB arrangements in Hong Kong. He also advised that HKMA would continue the discussion with academics on proposals to further improve the CB system including, inter alia, Professor CHEN Nai-fu's proposal to link the monetary base to credit creation and Professor Tsang Shu-ki's proposal of two-way convertibility undertaking (CU) for the aggregate balance.

Proposal of insurance/Hong Kong dollar put option

2. Mr Albert HO Chun-yan pointed out that Professor Merton Miller's proposal of insurance/Hong Kong dollar put option scheme and some other academics' suggestion of allocating the foreign currency reserves into functional categories, such as for backing the notes and coins in circulation and for backing the monetary base, etc., would clearly demonstrate the Government's strong determination to maintain the link and fully utilize the function of the substantial amount of foreign currency reserves for defending the Hong Kong dollar, hence instilling public confidence in the local currency. Indeed, HKMA's measure to allow banks to use Exchange Fund Bills and Notes to obtain Hong Kong dollar liquidity through the Discount Window was seen as a similar move in the same direction. By expanding the monetary base to include the Exchange Fund Bills and Notes, the shock of large capital outflow during speculative attacks on the Hong Kong dollar would be offset by a corresponding fall in foreign currency reserves rather than an interest rate hike inflicting much pain on the local economy. Mr HO opined that the above proposals should be further pursued. He also sought HKMA's views on the extent of volatility that the foreign currency reserves were able to withstand for defending the Hong Kong dollar.

3. In response, CE/HKMA said that although the put option scheme and the mechanism of allowing the level of foreign currency reserves to vary with capital outflow received support from some academics, market practitioners, in general, had the concern that these would be seen as an indication of inability, hence a sign of weakness, to withstand the inevitable interest rate pain. Moreover, there were issues concerning the appropriate size and allocation of put options to be offered in order to sustain the required level of confidence. For the scheme to be effective in stabilizing the exchange rate, the options should be available to everybody and the amount offered could be virtually unlimited. Notwithstanding the substantial amount of foreign currency reserves accumulated, to offer an unlimited amount of put option with a limited size of foreign currency reserves would inevitably put the credibility of the Government at risk and further undermine the effectiveness of the scheme in enhancing public confidence in the Government's determination to maintain the LER system.

4. As regards the allocation of a certain portion of foreign currency reserves for the sole purpose of defending the Hong Kong dollar, CE/HKMA stressed that all of the foreign currency assets held in the Exchange Fund were available for defending the external value of the Hong Kong dollar. Among the total of about US$90 billion foreign currency reserves which included fiscal reserves accumulated in the past, about US$30 billion was used to provide backing for the monetary base. If a definite amount was to be set aside for backing the Hong Kong dollar and the "excess" was used to counteract selling pressure without invoking the automatic interest rate adjustment mechanism, the foreign currency reserves could be depleted quickly when the Hong Kong dollar was under attack and this might further trigger a confidence crisis on the Hong Kong dollar. Hence, it was necessary to consider the proposal prudently to avoid possible adverse consequences. On the other hand, since Exchange Fund Bills and Notes (currently amounting to about HK$100 billion, around 70% - 80% of which were held by banks), which were fully backed by foreign currency reserves, had become a component of the monetary base by virtue of the technical measures introduced since September 1998, HKMA would review the case of extending the Convertibility Undertaking (CU) to these Exchange Fund paper, which might have similar effects as the put option scheme. Over time, HKMA would also consider issuing new Exchange Fund Bills and Notes in compliance with the CB principle that any new paper introduced should be fully backed by foreign currency reserves when there was inflow of capital.

5. CE/HKMA further said that it was difficult to ascertain the safety margin of foreign currency reserves required to withstand volatility and attacks, the authority needed to be conservative and cautious in taking such steps as issuing Exchange Fund paper only when there was capital inflow. He also remarked that if all Exchange Fund paper were used up at the Discount Window, interest rates would rise inevitably as a result of the triggering of the automatic interst rate adjustment mechanism.

The scope of the Convertibility Undertaking

6. Mr Fung Chi-kin opined that the effectiveness of the seven technical measures had not been subjected to test as there had been no speculative attack on the Hong Kong dollar since the measures were introduced. Hence, he was concerned about the possible risks of allowing the gradual migration of the CU rate from 7.75 to 7.8 over a long process of 500 calendar days. He also asked whether it was possible for banks to take up the CU to cover deposits of their customers since banks were allowed to convert Hong Kong dollars in their clearing accounts into US dollars at the fixed exchange rate of 7.75.

7. In response, CE/HKMA explained that CU was provided to banks to cover the Hong Kong dollar balance in their clearing accounts with HKMA. Generally, bank transactions affecting the clearing balance would offset each other leaving the aggregate balance unchanged. On the other hand, since banks enjoyed the CU offered by HKMA, they could offer their own CU to their customers. But this would be a matter between the banks and their customers.

8. On the movement of the CU rate from 7.75 to 7.80, CE/HKMA explained that no risk should be involved in the process as it only represented the convergence of the rate with the exchange rate of the LER system applicable to the issue and redemption of Certificate of Indebtedness backing the Hong Kong dollar. The gradual transition of the rate over a 500-day period was aimed to minimize disruption to the foreign exchange and money markets.

Dollarization

9. Miss Cyd HO Sau-lan opined that dollarization or a dual-currency system was an alternative to LER system for achieving momentary stability. Moreover, having financial activities denominated in US dollars would help enhancing Hong Kong's status as an international financial centre and better prepare Hong Kong in meeting the development of globalization in the financial industry. As regards the issues concerning the viability of dollarization as detailed in paragraph 18 of the paper, Miss HO opined that whilst the problem of loss of seigniorage was a concern, transitional and legal issues could be overcome. On operational issues, such as the setting up of clearing and settlement systems for US dollars, HKMA should step up effort in this respect.

10. Whilst concurring with Miss HO that a greater use of US dollars in financial activities would be a positive step in enhancing Hong Kong's position as an international financial centre, CE/HKMA remarked that this should be distinguished from dollarization in the sense that the domestic currency was substituted by the US dollar, which would be a draconian measure giving rise to complex political and operational issues. He pointed out that the very notion of dollarization already had a negative connotation for the Hong Kong dollar. To promote the internationalization of Hong Kong's financial market, HKMA in collaboration with SFC and the Stock Exchange of Hong Kong were studying the proposal of trading and settling "H" shares in US dollars or other foreign currencies or in dual currencies. The success of the proposal would depend on the availability of an efficient and robust clearing and settlement market infrastructure, which HKMA and concerned parties would pursue and further study. A major obstacle to be cleared would be US authorities" concern about allowing US dollar clearing to be conducted by HKMA operating in another time zone, with the possibility of the US dollar monetary base being expanded outside the US authorities" control.

Disposal of shares

11. Mr CHEUNG Man-kwong commented that despite Government's repeated assurance on maintaining its non-interventionist economic policy subsequent to its operation in the securities and futures markets in August 1998, the credit rating on Hong Kong had been downgraded by international rating agencies. He questioned whether this was attributable to the lack of a definite timetable for disposing the shares acquired in the operation.

12. In response, CE/HKMA clarified that there was only one international survey pointing out that Hong Kong would drop from its first position as the world's freest economy in 1999 subsequent to the Government"s market operation in August. Whilst the downgrading of ratings on the outlook of Hong Kong's economy might not be related to the Government's market operation, some international rating agencies and financial organizations had indeed given positive assessments on Hong Kong's economic fundamentals and policies, and affirmed its ability to recover quickly in the wake of the Asian financial turmoil. He stressed that despite short-term concerns of the international financial community, the operation had not damaged Hong Kong's reputation as a free-market economy and would not adversely affect its economic activities in the long run. Moreover, the Government had been successful in explaining to the overseas governments and financial communities its stance and the purpose of the operation, which was to frustrate the double-play of currency speculators to reap profit from the stock market and restore order in the market with a view to protecting the interest of the investing public at large.

Discretion of the Hong Kong Monetary Authority

13. Mr Albert HO Chun-yan expressed concern about the discretionary power vested with HKMA and whether such power would be more clearly defined so as to enhance transparency of CB operation and credibility of the system. CE/HKMA responded that whilst a rule-based CB regime would increase the transparency and enhance the credibility of the system, the lack of discretionary power of HKMA would reduce its flexibility in coping with unforeseen circumstances, making the system more susceptible to manipulative attacks. Recognizing that there was a need to balance between credibility and flexibility, he believed that HKMA should be provided with certain discretionary power while raising its transparency and accountability to the public through disclosure of information, full explanation of its work to the community and scrutiny by monitoring bodies. He further stressed that as it was necessary to maintain constructive ambiguity for coping with urgent and exceptional circumstances, it would be difficult to clearly define the areas of discretionary power. However, he assured members that HKMA was committed to a policy of transparency and accessibility. Besides providing various monetary information and publication on a regular basis, the Subcommittee on Currency Board Operations was set up under the Exchange Fund Advisory Committee (EFAC) in late August 1998 to oversee and improve the CB arrangements in Hong Kong. The exercise of any discretionary power by HKMA would be reported to the Subcommittee, whose minutes of meetings were published regularly. On the other hand, HKMA endeavoured to promote better understanding of monetary affairs by the Legislative Council and ensure that legislators' views were taken into consideration in the broad development of monetary polices.

International co-operation in monitoring capital flows

14. On monitoring and regulating cross-border capital flows, CE/HKMA advised that since the emergence of financial problems of some large hedge funds, there had been a general consensus among the international financial community on the need to regulate large scale capital flows recognizing that the highly leveraged capital flows, if un-monitored, would have important implications for systemic stability. Responding to Mr HO Chun-yan's enquiry on the Administration's efforts in this respect, CE/HKMA remarked that whilst it would be a difficult task to seek co-operation from governments and market regulatory bodies to concur on implementing joint measures, HKMA supported the view of the major economies to improve transparency of the private sector. By enhancing information disclosure on the international exposures of investment banks, hedge funds and other institutional investors, their operations could be indirectly monitored.

II Alignment of investment policies of Land Fund and Exchange Fund
(LC Paper No. CB(1)636/98-99)

15. In briefing members on the merger of assets of the Land Fund (LF) into the Exchange Fund (EF), the Secretary for Treasury (S for T) stressed that this would not change the statutory position of LF, which would continue to remain as a separate government fund. As the merger was an investment decision made by the Financial Secretary (FS) pursuant to Clause 7 of the Land Fund Resolution passed on 1 July 1997, further LegCo approval was not required for the merger to take place. She further clarified that the alignment exercise would not pre-empt consideration of the long-term use of LF, and any proposal in this regard was subject to LegCo approval in accordance with the Land Fund Resolution.

16. While Mr Albert HO Chun-yan remarked that he was not opposed to the merger of LF and EF and agreed that merging the assets of the two funds would enhance operational efficiency, he sought the Administration's explanation on why the advantages of stable investment return and special dividend as pointed out in paragraph 6 of the paper could not be achieved when these funds were separately managed.

17. Elaborating on the two advantages of the merger, S for T explained that due to various reasons, the investment strategy of LF had been different from that of EF, achieving different rates of return on investment. For the period from July 1997 to September 1998 during which the market had been exceptionally volatile due to the Asian financial turmoil, the return of EF was higher than that of LF. For instance, from April to September 1998, EF achieved an average rate of return of 7.43% while the return for LF was only 2.94%. It was expected that the merger would reduce the volatility of returns and help to achieve a more optimal and stable return for LF. Furthermore, as LF had become part of the fiscal reserves, the merger would ensure management of the assets in exactly the same way as other fiscal reserves placed with EF. LF would then enjoy the same rate of return achieved by EF as a whole after the merger. Under the existing arrangement, FS could declare a special dividend from EF if necessary to maintain the real value of that portion of the fiscal reserves which was kept for monetary purposes. The merger would enlarge the fiscal reserves for special dividend calculation purposes.

(Post-meeting note: The Finance Bureau subsequently clarified that the yield of 7.43% for EF was for the period from January to June 1998. The return achieved by EF for the period of April to September 1998 was 9.72% and the corresponding return for LF was 2.94%.)

18. Mr NG Leung-sing, being one of the trustees of the then Hong Kong Special Administrative Region Government (HKSARG) Land Fund Trust, remarked that as LF and EF had different investment objectives and policies, it would be unfair to compare their investment returns. As far as he re-called, performance of LF since its establishment in 1986 had been quite satisfactory and at times the returns of LF were higher than those of EF. It might be an over-generalization to conclude that volatility of returns for EF was lower than that of LF by only comparing the returns of the two funds during the period of the Asian Financial turmoil. He enquired about the specific objectives expected to be achieved in terms of returns on investment after the merger.

19. In view of the different investment strategies of LF and EF, Mr FUNG Chi-kin concurred that there should be no direct comparison between the investment returns of the two funds. He opined that the merger would have limited advantage in enhancing operational efficiency further as given the substantial assets of the funds, external investment professionals were already employed to undertake investment activities anyway. He was more concerned about the impact of alignment of investment strategies of the funds on the overall investment return.

• On the past performance of LF and EF, S for T recognised that the comparative information available since the establishment of LF in July 1997 was exceptional due to the unusual circumstances in the past year or so, hence it was not to be used as a long term reference. CE/HKMA supplemented that due to different investment policies and strategies for the two funds, it was logical that returns would be different. He pointed out that for a certain period before July 1997, LF did record higher returns than EF. However, due to higher exposure of LF to the Asian equity markets, even though HKMA had reduced the holdings in these markets after it had taken over the management of LF from July 1997, LF returns suffered from higher volatility than that of EF amidst the financial turmoil.

20. In view of the increasing volatility of the financial markets worldwide, S for T explained that the merger was expected to enable the two funds to continue to achieve an optimal return steadily under such circumstances. She re-iterated that as LF had become part of the fiscal reserves, it was necessary for the Administration to strike an appropriate balance between its prudent investment and the aim of achieving an optimal return. Moreover, as a result of the merger, the fiscal reserves for special dividend calculation purpose would be enlarged and this was in line with the policy of securing better rate of return for fiscal reserves. CE/HKMA remarked that besides the several perceived advantages as mentioned in the information paper, the merger was also a logical and reasonable decision. The only reason why LF had been managed in the form of a separate investment portfolio was due to special circumstances of the transition in July 1997. There was no reason to maintain this arrangement after LF had become part of the fiscal reserves and investment management should therefore be streamlined. In order to achieve administrative efficiency and economies of scale, FS had announced in the Budget speech in February 1998 his intention to align the asset allocation and investment policies of the two funds by 1 April 1999.

21. Concerning the long-term investment policy following the merging of the two funds, CE/HKMA advised that this would be reviewed by the EFAC as one of its duties of advising FS on reserves management. As the Hong Kong equity portfolio in LF would also be managed by Exchange Fund Investment Limited (EFIL) which had been managing the equity portfolio acquired by EF in the August market operation, the review would include the investment components of EF, such as the appropriate weightings of equity, if any, in the investment portfolio. He assured members that HKMA managed EF under the direction of FS, who pursuant to the Exchange Fund Ordinance (Cap 66) should exercise his control of the Fund in consultation with EFAC.

22. On the enquiry about the resultant staffing arrangement of the Land Fund Office after the merger, CE/HKMA advised that staff of the former HKSARG Land Fund Secretariat had been transferred to HKMA to continue management of the asset portfolio on a contract basis when LF was taken over by the HKSARG in July 1997. The staff of the Land Fund Office would welcome early conversion into permanent terms of employment with HKMA, which could only take place after the merger of the two investment portfolios. HKMA had undertaken that there would be no redundancy as a result of the alignment exercise. Furthermore, as HKMA continued to develop and took up new functions, such as providing support for EFIL, it did not envisage any problem in re-deploying surplus staff of the Land Fund Office.

VI Any other business

23. The meeting ended at 12:35 pm.

Legislative Council Secretariat
16 April 1999