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LCQ2: Strategies for managing reserve assets

     Following is a question by Ir Dr Hon Raymond Ho Chung-tai and a reply by the acting Secretary for Financial Services and the Treasury, Ms Julia Leung, in the Legislative Council today (October 19):


     According to the relevant reports in August this year, the value of the United States (US) Treasuries held by Hong Kong amounted to US$121.9 billion and Hong Kong ranked eighth in the world in terms of total holdings. In this connection, will the Government inform this Council:

(a) given that the sovereign credit ratings of the US and some member states of the European Union have been downgraded one after another, whether the future prospects of their sovereign credit ratings will affect the decisions of Hong Kong's Exchange Fund (EF) on investing in the debt securities of these countries (particularly the US); apart from the sovereign credit ratings of the relevant countries, what other factors will affect EF's investment decisions;

(b) given that in recent years, quite a number of countries and regions have established sovereign wealth funds (SWFs) to manage reserve assets in order to seek higher returns, of the major differences between the investment management and operation of EF and that of SWFs at present; and

(c) whether it has assessed if the approach of managing reserve assets by an SWF is suitable for Hong Kong; if the outcome of assessment is in the negative, of the reasons for that?



(a) In managing the investments of the Exchange Fund (EF), we have to take into account statutory purposes for and the uses of setting up the EF. Under section 3(1) of the Exchange Fund Ordinance, the EF shall be used primarily for such purposes as the Financial Secretary thinks fit affecting, either directly or indirectly, the exchange value of the currency of Hong Kong and may also be used to maintain the stability and the integrity of the monetary and financial systems of Hong Kong with a view to maintaining Hong Kong as an international financial centre.

     As the EF is to maintain the monetary and financial stability of Hong Kong, investment decisions must be made to ensure its overall investment safety and liquidity.

     The assets of the EF are primarily managed as two distinct portfolios: the Backing Portfolio, which backs up the Monetary Base, and the Investment Portfolio. At present, the Monetary Base roughly totals HK$1.1 trillion.  Under the Currency Board arrangements, its size may vary greatly. For example, there were inflows of over HK$600 billion during the fourth quarter of 2008 and 2009. Since we must provide full backing to the Monetary Base with US dollar-denominated assets as required under the Currency Board arrangements, the Backing Portfolio can only be invested in high quality, very short-term and highly liquid US dollar-denominated debt instruments. Therefore, the Backing Portfolio must hold a considerable amount of short-term US Treasuries. While the Investment Portfolio may comprise more diversified assets than the Backing Portfolio, it must also maintain a high degree of safety and liquidity so that the EF has sufficient liquidity to achieve its statutory purpose of maintaining monetary and financial stability.  The Hong Kong Monetary Authority (HKMA) will review its investment strategies from time to time under the guidance of the Exchange Fund Advisory Committee and manage prudently the assets of the EF.

     While the credit rating agency Standard & Poor's downgraded the US credit rating by one notch to AA+ in August, other international credit rating agencies, including Moody's Investors Service and Fitch Ratings, maintain their AAA credit ratings for the US. Taking into account the recent developments, we are of the view that the possibility of a default on US Treasuries is very slim. The dollar is by far the world's most dominant, most traded and liquid reserve currency. It is not matched by any other major currencies in terms of safety and liquidity. Thus, we have no intention for the time being to adjust the share of holdings in US assets by the EF in response to the downgrading of the US credit rating by Standard & Poor's.

     We also noted the downgrading of the sovereign credit ratings of some members states of the European Union. With stringent risk management measures in place, the EF reviews and adjusts as and when appropriate its investments in individual countries or debt instrument issuers in the light of developments in the financial markets, such as changes in credit ratings, economic outlook or regulatory rules, to ensure the overall asset safety and liquidity.

(b) Regarding the differences between the management and operation of the EF and that of sovereign wealth fund (SWF) as mentioned in part (b) of the question, I would like to point out that the EF is not an SWF. It is different from an SWF in investment goals, strategies and performance. As mentioned above, the EF is established under the Exchange Fund Ordinance with the statutory purpose to maintain monetary and financial stability. Investments of the EF are required to preserve capital and ensure that the entire Monetary Base will at all times be fully backed by highly liquid US dollar-denominated assets. They are also aimed at ensuring that sufficient liquidity will be available for the purpose of maintaining Hong Kong's monetary and financial stability.  Subject to the above principles, we will also strive to achieve a medium to long-term investment return that will preserve the long-term purchasing power of the EF. Given that the safety and liquidity of assets are of high importance to the EF, what it pursues is a relatively stable investment performance.

     On the contrary, there is no need in general for SWFs to encash their investments in the short term.  To secure higher long-term, or even cross-generational, investment return, SWFs tend to invest in higher risk and longer term assets with very low liquidity.  As a result, the return performance is often more volatile. For example, some SWFs invest heavily in stock markets and new listings; their investment performance will inevitably be subject to high volatility due to the ebb and flow of stock markets. These SWFs will certainly make a considerable investment return when the markets are vibrant, but will suffer substantial losses at times of crash.

(c) Part (c) of the question is on whether the SWF approach is suitable for Hong Kong.  As mentioned earlier in my reply, the EF was set up for statutory purposes. We consider the existing operation model of the EF, which is in line with the principle of prudent management, an effective tool to maintain the monetary and financial stability of Hong Kong. Under this operation model and on the premise that adequate liquidity will be maintained to uphold monetary and financial stability, the HKMA has been diversifying part of the EF investment, in a prudent and incremental manner, into a greater variety of asset classes, including emerging market bonds and equities, private equity funds, overseas investment properties and Mainland bonds and equities. This will serve the purpose of diversifying risks and enhancing investment returns in the medium and long term for the preservation of the long-term purchasing power of the EF. The HKMA will continue to adopt a prudent and pragmatic approach in implementing investment diversification in a cautious and gradual manner.

Ends/Wednesday, October 19, 2011
Issued at HKT 15:06


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