Purpose

This paper briefs Members on the Administration's intention to apply a new formula, effective from 1 April 1999, for determining the concessionary interest rates for Government loans granted on the principle that there should be 'no gain' and also 'no loss' to the Government.

Background

2. When approving the introduction of the Home Purchase Scheme (HPS) and Housing Loan Scheme (HLS) for civil servants in 1981, Finance Committee (FC) noted that the interest rate for loans granted under these schemes would be set on the principle that Government should not seek to make a profit out of the loans. Equally Government should not incur a loss. When approving the Home Financing Scheme (HFS) for civil servants in 1990, FC noted that we would charge interest for loans granted under this scheme at the same rate as under the HPS and HLS.

3. The bases and rationale in setting the interest rate under the principle of 'no-gain, no-loss' from July 1981 up to now are set out in Annex A. In brief, for most of the period in question, the rate was set half way between the six-month bank deposit rate and the best lending rate. Since June 1995, we have linked the rate to the return on fiscal reserves, reflecting the opportunity cost to Government. The interest rates for housing loans during the past ten years are set out in Annex B.

4. Apart from civil service housing loans, the 'no-gain, no-loss' interest rate also applies to the following loan schemes -

1. loans to civil servants under Civil Service Regulation 633;
   
   
2. housing loans to eligible former Education Department lecturing staff who have transferred to the Hong Kong Institute of Education ;
   
   
3. the Non-means-tested Loan Scheme for eligible students of the Open University of Hong Kong and Government-funded tertiary institutions where interest is charged at the 'no-gain, no-loss' interest rate plus a risk adjustment factor of 1.5%; and
   
   
4. the Building Safety Improvement Loan Scheme.

The Existing Formula

5. With the implementation of a new investment arrangement for the fiscal reserves on 1 April 1998, which links the return of the fiscal reserves to that achieved by the entire Exchange Fund in order to maximise investment returns, we informed FC that the 'no-gain, no-loss' interest rate would be set based on an 18-month time-weighted average return of the Exchange Fund. The interest rate (from 1 October 1998) calculated under this formula is 6.748% per annum. This rate is subject to review every six months. The next review date is 1 April 1999. Prior to the next review, we have been taking stock of the methodology adopted.

Shortcomings of the Existing Formula

6. Given that the objective of the investment of the fiscal reserves is to maximise return on Government's assets, we believe that there is an inherent conflict in linking this to the interest rate payable under concessionary loan schemes. Though the existing formula may reflect the 'no-gain, no-loss' principle from Government's investment perspective in its purest terms, it causes conceptual and practical difficulties. This is borne out by the unaudited figures available from the Hong Kong Monetary Authority (HKMA) which suggest that the interest rate calculated under the existing formula may exceed 10% per annum as from 1 April 1999. Given the increased volatility in the financial markets, it is possible that the weighted return of the Exchange Fund and hence the interest rate on the concessionary loans may fluctuate further in line with market conditions. In general terms, there is also an inverse relation between investment return and interest rates, in that, when interest rates rise, investment returns fall, and vice versa.

The New Formula

7. We consider it not fair to ask borrowers to accept wide fluctuations in the interest rate arising from volatility in investment performance and which would trend in the opposite direction to market lending rates. We consider it appropriate, as a long term solution, to revert from the existing formula to a market lending-based formula by setting the interest rate at a fixed percentage 'X' below the average of the best lending rates of the note-issuing banks. Since the best lending rates incorporate a profit element for the banks, we consider it reasonable to discount the best lending rate by an appropriate amount to conform to the long standing principle that Government should not seek to make profit out of loan schemes which embody specific policy objectives.

8. On the other hand, we have been mindful that setting too high an 'X' could be to Government's disadvantage and could provide an opportunity for borrowers to make a profit by depositing the borrowed money with a bank to earn some interest.

9. While there is no scientific method to calculate what 'X' should be, the historical average differential between the 'no-gain, no-loss' rates charged and the best lending rates should provide a reasonable indication of the suitable value of 'X'. As can be seen from Annex B, the average differential between the best lending rate and the interest rate for the Government housing loan schemes over the last ten-year period (1989 to 1998) was about 2%. It is also reasonable to compare our 'no-gain, no-loss' rate with the rates quoted in the inter-bank money market. According to HKMA's statistics set out in Annex C, the average differential between the 12-month Hong Kong Dollar Inter-Bank Offered Rates (HIBOR) and the best lending rates between 1993 and 1998 was also close to two percentage points. We therefore intend to set 'X' at 2%.

Consultation

10. We have consulted the four central staff consultative councils. Their reactions are mixed. Some of them agree to adopt the new formula while others accept the approach in principle but consider that 'X' should be greater than two percentage points in keeping with the trend rate in recent years. Since the new formula is straightforward and provides greater certainty of the interest rate, we anticipate that borrowers under the other schemes should not be opposed to the change.

Implementation

11. We plan to implement the new formula effective from 1 April 1999. The average best lending rate is currently 8.75%. Should this rate still hold true on 1 April 1999, the interest rate under the new formula would be 6.75%, as compared with the current rate under the existing formula of 6.748%.

Advice Sought

12. Members are invited to offer views on the proposed change of the formula for calculating the interest rate for the concessionary loan schemes.

Finance Bureau
26 January 1999

(LEPAN-IR/4.2.99)

Annex A

Period	Basis	Rationale
July 1981 to May 1995	Mean of Hongkong Banking Corporation's six-month deposit rate and best lending rate	The inclusion of best lending rate and bank deposit rate in the formula was based on the consideration that the two factors of market lending rate and yield on low risk investment (i.e. bank deposit) should be the basis for setting the 'no-gain, no-loss' interest rate.
June 1995 to March 1998	Mean of 1-year and 2-year yields of the Exchange Fund Bills/Notes (EFB/N)	Return on fiscal reserves was linked to the yields of the EFB/N. The yields of the EFB/N hence reflected the opportunity cost of Government funding.
April 1998 to now	Time-weighted average return of the Exchange Fund	Return on fiscal reserves is linked to that achieved by the entire Exchange Fund w.e.f. 1 April 1998. Again, this approach reflects the opportunity cost of Government funding. To smooth out fluctuations in the interest rate, the rate is based on a time -weighted average return of the Exchange Fund over a period of 18 months.

Annex B

Effective from	Government Best Rate (a)	Interest Lending Rate (b)	Differential (b)-(a)	Basis
1.1.89	7.875	10.00	2.125	Mean of Hong Kong Banking Corporation's 6-month deposit interest rate and Best Lending Rate.
1.3.89	8.875	10.50	1.625
1.5.89	9.875	11.50	1.625
1.8.89	8.875	10.50	1.625
1.2.90	8.375	10.00	1.625
1.5.90	9.500	11.00	1.500
1.12.90	8.500	10.00	1.500
1.9.91	7.750	9.50	1.750
1.12.91	6.750	8.50	1.750
1.7.92	5.250	7.00	1.750
1.2.93	4.750	6.50	1.750
1.7.94	5.875	7.25	1.375
1.1.95	7.6406	8.50	0.8594
1.6.95	6.285	9.00	2.715	Mean of 1-year and 2-year yields of HKMA Exchange Fund Bills/Notes.
1.12.95	5.765	9.00	3.235
1.6.96	5.800	8.50	2.700
1.12.96	5.685	8.50	2.815
1.6.97	6.075	8.75	2.675
1.12.97	7.955	9.50	1.545
1.1.98	9.475	9.50	0.025
1.3.98	10.650	10.25	(0.400)
1.4.98	6.262	10.00	3.738	Time-weighted average return of the Exchange Fund over a period of 18 months
1.10.98	6.748	10.00	3.252
19.10.98	6.748	9.75	3.002
11/23/98	6.748	9.50	2.752
7.12.98	6.748	9.25	2.502
12/21/98	6.748	9.00	2.252

Annex C