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Following is the speech by the Financial Secretary, Mr Henry Tang, in a motion debate on "Increasing the Government's share in the Investment Income of the Exchange Fund" moved by the Hon Howard Young at the Legislative Council today (December 20): (English only)
Madame President,
I would like to thank the Hon Howard Young and the Hon Chan Kam-lam for moving this motion and the amendment respectively. I am also grateful to other Members for the views they have expressed today.
The enthusiasm Members have directed to the subject is palpable. It does credit to your sentiments. The seasonal spirit of generosity fills this chamber. It is a spirit to which I am not immune myself. But, the people of Hong Kong do not pay me to be carried away by the spirit of the season into short term generosity at the expense of their financial security. I have no doubt that, on the morning after, Members will appreciate why I must approach their suggestions with sobriety.
A major part of my duty to the people of Hong Kong is to ensure that in this season, and in every season, they can go about their lives and business with as little fear and as much freedom as possible. One of the major areas in which I have responsibility to discharge that duty is in maintaining their trust and confidence in the stability and integrity of the city's monetary and financial systems. One of the keys to achieving that is to provide assurance that we can cope with whatever shocks and strains the local, regional or global economy may confront us with.
That duty in crucial areas has been rightly entrenched in laws passed by this Council. The Exchange Fund Ordinance specifies that the primary purpose of the Fund is to regulate the exchange value of the Hong Kong Dollar, while allowing that it may also be used to maintain the stability and integrity of the monetary and financial systems and sustain Hong Kong's status as an international financial centre. The primary purpose is enshrined in Article 113 of the Basic Law. There is somewhat greater flexibility with the accumulated surplus of the Exchange Fund and the fiscal reserves placed with the Exchange Fund but even here the duty of care remains. I would fail in that duty were I to take actions with those monies that cast any shadow of doubt over our ability to maintain the integrity of the monetary and financial systems or that diminish our capacity to cushion the shocks of economic downturn. Measures which may seem easy and tolerable in prosperous times may become blocks of concrete on our legs when we have to swim through financial crises.
I really would like those who have been generous with accusations that I am playing Scrooge with Hong Kong's finances to remember that financial and monetary shocks are not hypothetical, or events that happen only in less fortunate economies than our own. There have been events - some of very recent memory - that have hurt us badly. They have required prompt action by my predecessors, calling on the resources of the Exchange Fund, to get us out of difficulty and enable us to move on. The extensiveness with which the Exchange Fund has been mobilised for this important, statutory purpose varies from event to event, with the most recent one recording a proportion that is much too high for comfort, although in that particular event the Exchange Fund ended up making a handsome profit rather than incurring significant expenses, as was the case of the bank rescues in the eighties. We also should not forget the high likelihood of the public finances being in considerable deficit coinciding with the occurrence of a financial crisis that requires the use of the Exchange Fund, with the substantial withdrawal of fiscal reserves from the Exchange Fund exacerbating the situation. Also, the globalisation of financial markets has been a great boon to Hong Kong but also exposes us to a global array of risks.
Globalisation of financial markets has increased the flow of international capital by leaps and bounds. Information technology has further increased the mobility of international capital, in terms of both speed and volatility. According to some estimates, there are now about 8 800 hedge funds with about US$1.2 trillion under management. The funds continue to be big, non-transparent and leveraged through borrowing or the use of derivatives. There is a potential risk that more institutions with more resources, all seeking rates of return higher than their benchmarks, will act in the same direction at the same time in their search for yield, making markets more volatile.
Hong Kong is an international financial centre sitting at the door step of the fastest growing and developing economy in the world, and being ourselves the freest economy in the world with no exchange control policies mandated by the Basic Law, and being large and liquid enough to attract international capital but small enough to be tossed around or subject to unscrupulous manipulation, our financial markets are more prone to sharp volatility than those of other centres. This is notwithstanding the robustness of our monetary and financial systems, and the strengths of the institutions, which are benchmarked, and measure well, against the best international standards. For many players in global finance, wherever they are domiciled, it is simply that it is much easier to pump water out of Hong Kong to put out fires in their own backyards. Consequently, it is much more difficult for a medium-sized, free and open international financial centre to maintain monetary and financial stability. Whether we like it or not, this is the reality of international finance and we have no option but to rise up to the challenge. And we have done it well, but clearly not without the occasional use of the Exchange Fund and unorthodox measures.
"Financial globalisation which has induced such dramatic increases in private capital flows has also exhibited significantly improved capacity to transmit ill advised investments", said Alan Greenspan. He went on to note: "Our productivity to create losses has improved measurably in recent years." Finance ministers and central bankers cannot, without undue intervention in the free market, prevent individuals from making investments that are often spectacular both in their value and the extent to which they are ill advised. But, when the consequences of those decisions hit the markets, the banks or the financial systems, it is the finance ministers and central bankers who have to be ready to shovel up the debris and put things back on a stable footing again. We have to have the tools ready to hand to do this job.
And the task is likely to become more difficult as the much politicised global imbalance continues to loom large over international finance, threatening a disorderly adjustment of global dimension, as geo-political tension possibly intensifies and as our own country - now the fourth largest economy, the third largest trading entity and the largest foreign reserve holder in the world - continues on a path of reform and liberalisation. The application of information technology to international finance has considerably more room to make it even more potent in the years to come.
What happened in Thailand yesterday serves as a very good reminder for all of us the potency of international finance and the difficulty in the task of maintaining monetary and financial stability. Measures in Thailand to limit capital inflow produced a surprisingly sharp downward adjustment in the prices of financial assets there - the stock market fell by about 15% in one day, bond yields went up by 20 to 30 basis points, savagingly slashing bond prices, and the exchange rate of the Thai Baht depreciated. This sent shock waves through financial markets in Asia.
It is still too early to tell how this episode of financial shock will play out. Hopefully the reversal of the measures announced last night, insofar as non-resident investments in the Thai stock market are concerned, will have a stabilising effect and contain possible contagion. Indeed, this seems to have been the case in the last 20 hours or so, given the muted reaction in emerging markets in the West overnight and the rebound this morning in Asian markets - the Thai market rebounded 10%. But it is also possible that global investors may, quickly or in more measured time, take a fresh look at the risk profile of their international investments in the light of the changed probability of policy shifts in emerging markets. If so, there may be significant adjustments to the earlier liquidity driven compression of yield spreads and boosting of prices of financial assets in emerging markets, with possible implications for monetary and financial stability. These are issues that keep me and my colleagues in the front line alert and support my wish to keep our powder dry.
Each day I keep in mind the observation that "No-one, except perhaps for one or two very brave economists, predicted Japan's descent into an economic morass. Nobody predicted the South East Asian crisis and no-one predicted Russia's default in 1998."
Each day that I have to help Hong Kong find its path through the jungle of global finance I keep listening carefully for the brave economists, and I make sure I continue to carry a large stick to deal with anything that may jump out.
Madam President, we will continue to make every effort to make our monetary and financial systems more robust. We will act whenever we identify a case for doing so. We will act in advance wherever we can. The introduction of the three refinements to our Linked Exchange Rate system in May last year is a case in point. They were made ahead of the reform to the Renminbi exchange rate system announced in July last year, to anchor exchange rate expectations on the strong side of the Hong Kong Dollar link. But Hong Kong still needs the assurance of strong reserves available to support monetary and financial stability. Such stability is essential to the livelihood of the people of Hong Kong and to the maintenance of the status of Hong Kong as an international financial centre.
The question that can be easily asked is "how much do we need". A question that was asked several times in this Chamber today. But the provision of an authoritative answer is as difficult as it is market sensitive, possibly in a destabilising and self-defeating way, given the dynamics of financial market discipline. This is certainly not an excuse for not trying. We did, and quite extensively, though quietly, look into the matter, and the answer is inconclusive. The traditional models of reserve adequacy measured in terms of the number of months of retained imports or against the amount of external debt are simple but highly misleading, particularly for an international financial centre, because foreign reserves are not for paying for imports in case of a calamity imposed by nature, or for servicing external debt when external finance suddenly dries up.
There are many other models but none relevant to our circumstances. We even attempted to look for a sophisticated balance between the opportunity cost of holding liquid foreign reserves and its insurance value on the basis of past volatility of key monetary variables, using an option pricing methodology, but the result was not confidently convincing to the extent of convincing also the controller of the Exchange Fund.
Thus, this deceptively simple question on the adequacy of foreign reserves shall, for the time being, remain unanswered, which means that the contribution of the Exchange Fund to the general revenue shall continue to be limited to the investment income from the fiscal reserves deposited at the Exchange Fund in accordance with the sharing arrangement. The simple truth is: it is very hard to identify a level of reserves and say, with confidence, "this is enough". Even if you can do it, chances are that some unforeseen event will occur that will throw your calculations out of kilter. Neither is experience always a reliable guide.
Consider the events of 1998. The more than $100 billion deployed then to fend off the notorious double play in our stock and currency markets far exceeded, in absolute terms and as a proportion of the Exchange Fund, the amounts used to maintain stability on earlier occasions. If we had been relying solely on experience of those previous crises in 1998, we might have found ourselves dangerously short of resources.
This is not to say that we cannot afford to be a little more aggressive in the investment of even a small part of the Exchange Fund. This is in fact a matter under constant review by the Investment Sub-Committee of the Exchange Fund Advisory Committee. There is a fine balance to be struck among risk, liquidity and return, having regard to the overall objective of the Exchange Fund: from time to time modifications are made to the investment strategy, although not necessarily to the overall risk appetite of the Exchange Fund. Such adjustments are made in the hope of improving the overall rate of investment return of the Exchange Fund and therefore the investment income for the fiscal reserves.
The present sharing arrangement introduced in 1998 has served the general revenue very well. Although there has been higher year on year volatility in investment income for the fiscal reserves, on average the rate of return has been higher than that under the previous arrangement when the fiscal reserves were placed with the Exchange Fund as if they were bank deposits. Obviously, the rate of return on assets of a bank is on average higher than the interest rate paid for deposits, except that it is more volatile. But short term volatility is fine as long as we take a long term view. However, it will obviously be useful for the proper management of the public finances if such volatility could be dampened, and this source of government revenue made more stable and predictable, without conceding on the average rate of investment return over a period of time.
I have listened with interest to Members' views on options for the sharing arrangement. These range from some form of fixed fee, either in the form of a percentage or an absolute amount each year; through various forms of bonus sharing with the government taking the whole amount or a higher share; to sharing based on a fixed or moving average of returns over the previous few years. All of these have advantages and disadvantages. Fixed fees offer stability but mean that higher returns in good years may be forgone. More flexible arrangements are likely to mean greater volatility, although some of the volatility under the current arrangement is caused by the need to mark to market and the fact that the Exchange Fund has to record unrealised gains and losses. Prices of equities fluctuate. Even for bonds, changes in interest rates - or in expectations about interest rates - cause yields, and hence prices, to rise and fall: when this happens, the resulting mark-to-market gains or losses depend on the duration of the portfolio and a host of other factors. Along with these are international accounting standards that the Exchange Fund, with its commitment to full transparency, must follow.
I am not opposed to exploring how we might improve the balance between the desire for higher returns to fund government spending and stability of income, subject to the overriding need to ensure monetary and financial stability. It is, I suppose, a bit like trying to have your cake and eat it too, but I am ready to consider suggestions for improvement that may have merit in them.
For stable and sufficient revenues to provide sustainable finance to meet public needs, broadly based taxation is the direction we must look. The Exchange Fund is not a revenue raising implement. It is our bulwark for stabilising the exchange rate of the Hong Kong Dollar and a firm foundation stone for the continued healthy development of Hong KongĄ¯s economy. I am not as sanguine as a number of Members who have spoken today that taking money out of the Fund, thereby weakening our ability to resist external attacks, would be wise at this time.
Reviewing the arrangement for sharing revenue between the Exchange Fund and the fiscal reserves is one thing. The use of the Exchange Fund to subsidise general revenue is an entirely different matter. Crediting to general revenue an income more than the share attributable to the fiscal reserves would amount to a transfer for the Fund under section 8 of the Exchange Fund Ordinance. Any such transfer would have to be explicit, transparent and in accordance with the provisions of the Ordinance. These require that the Financial Secretary be "satisfied that such transfer is not likely to affect adversely his ability to fulfil the purpose for which the Exchange Fund is required to be or may be used". From what I have said about the risks to which we are open, and from my understanding of the importance of monetary and financial stability to the well being of the citizens of Hong Kong, I must take great care and must not be satisfied easily before making any such decision.
I understand that it is Members' hope that the Government will have more income and more stable sources of income to support various items of public expenditure they desire. I can assure Members that the Government will adhere to the fiscal principles of the Government, as laid down in Article 107 of the Basic Law, that is, keeping expenditure within the limits of revenues in drawing up the Budget; striving to achieve a fiscal balance; avoiding deficits; and, keeping the Budget commensurate with the growth rate of the Gross Domestic Product.
Putting the Exchange Fund and public expenditure together in one bag will violate the principle of keeping expenditure within the limits of revenues. Indeed, it appears to turn it on its head by looking for revenue to meet expenditure. This will not meet the public expectation for the Government to manage public finance prudently and leave as much economic choice and freedom to the community as possible. The call for restraint in Government spending has been heard loudly in this Chamber. In response, through hard work across the public sector the Government has managed for two consecutive years in 2004-05 and 2005-06 to reverse the previous trend for continual increase in public expenditure. In preparing the 2006-07 Budget, we have planned for a modest growth in expenditure in the coming five years while, at the same time, aiming to maintain an overall surplus. We will continue to stress prudence and value for money in daily public expenditure while being ready to make long term investments that will benefit our economy and our society.
Madam President, I am grateful to Members for their suggestions. As I have said, I will continue to keep the income sharing arrangement with the Exchange Fund under review and to consider measures that are commensurate with my duty to protect the monetary and financial stability on which our present prosperity and future prospects so heavily depend.
Thank you.
Ends/Wednesday, December 20, 2006
Issued at HKT 18:21
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