As reported to the Legislative Council Panel on Financial Affairs earlier this week, the investment performance of the Exchange Fund in the first nine months of the year has exceeded the figure included in the Financial Secretary’s 2006-07 Budget for the full-year investment return of the fiscal reserves placed with the Exchange Fund. We are glad that the community and their representatives in the Legislative Council monitoring this and other areas of work of the HKMA have found this satisfactory.

Whether we can keep the investment income of the Exchange Fund in the first nine months to the end of the year remains to be seen. We have to mark everything to market, given the possibility, however remote, that we may need to sell Exchange Fund assets quickly to obtain liquidity for defending currency stability or more generally maintaining monetary and financial stability, as we are required to do by the Exchange Fund Ordinance. Marking to market is also a prudent international practice. Sharp, adverse adjustments in global financial markets are always a possibility, particularly when issues of global significance continue to affect financial stability. The US trade imbalance remains, as does the common view that it cannot be sustained indefinitely. Geopolitical tension has been building here and there, notably in this region. Closer to home, macro adjustment and control on the Mainland is still going on, and the effects of the administrative measures for macro-economic control are rather difficult to predict because of the distortions to resource allocation they entail. But the global economy seems to be robust, although greater concern now about inflation may lead to more monetary tightening.

We will continue to do our best to make investment decisions in the best interests of the Exchange Fund in accordance with the guidance given by the Exchange Fund Advisory Committee. But I must confess to having something of a conservative bias, at least as far as the money managed in-house by the HKMA is concerned, because we would like to keep what we have already made in the first nine months, in the hope that by the end of the year our performance really will meet the expectation of the Financial Secretary and the community. Appreciation by the community that we have done a good job in investment management is of course important to us. But I have to point out again that the true and fair measurement of investment performance is the differential between the rate of investment return and the rate of return of our benchmark portfolio – the alpha, as they call it in the investment management industry. We deviate from the benchmark portfolio in asset allocation, hoping to achieve better results than sticking to the benchmark allocation (meaning essentially doing nothing). If we are successful, the alpha will be positive: if not, it will be negative. Since benchmarking was introduced, the alpha has been positive in every year except 2004 when it was zero, meaning that our investment performance has been good. With two months to go, we are optimistic about achieving a positive alpha this year, but the world is an uncertain place and we cannot give any guarantee.

As I have mentioned before, investment management of the Exchange Fund represents about 10% of the work of the HKMA, measured in terms of the number of employees involved in this important area of work to which the community pays quite a lot of attention. The other 90% of our work is also important, although perhaps less high profile so that our performance is less noticeable. The maintenance of currency stability, for example, is of crucial importance to Hong Kong, although with little volatility in the exchange rate this might have become taken for granted. Some say that our Linked Exchange Rate system runs itself. I wish that were the case, although I believe that, other things being equal, a more rule-based system for the conduct of monetary policy, requiring fewer administrative decisions, is likely to command a higher degree of credibility. But then nothing is absolute, particularly in money and finance and for an international financial centre that embraces market freedom as enthusiastically as Hong Kong. Those familiar with monetary management will have noticed the differences between the technical arrangements in our Linked Exchange Rate system now and in 1983 when it was first established. I hope they also agree that the system, as originally designed in 1983, would not have survived the continuing uncertainties over the years: the signing of the Joint Declaration and promulgation of the Basic Law, the stock market crash in 1987, the sensitive period leading to the resumption of sovereignty in 1997, the Asian financial crisis immediately after, and the introduction of flexibility to the exchange rate of the renminbi. Making changes in response to problems is not easy. Doing so ahead of time to prevent problems from occurring is even more difficult. The ability to do so is, I think, a reliable foundation for confidence and credibility.

Our work involves other policy objectives too. We are responsible for banking supervision, establishing banking policy and supporting banking development, all of which underpin the efficiency and robustness of our banking system. Our other projects include Basel II, the Deposit Protection Scheme and the credit information systems. We are also responsible for the construction and operation of one of the best financial infrastructures in the world, and the part we play in the development of Hong Kong as an international financial centre. In these other important areas of work, we hope the apparent lack of public criticism is a good indication that the HKMA has been doing a reasonable job.

Joseph Yam
9 November 2006

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