Hong Kong Economic and Monetary Developments and Prospects

1
HONG KONG MONETARY AUTHORITY
Briefing to the Legislative Council Panel on
Financial Affairs
29 January 2008
2
DISCUSSION TOPICS

• Updates on
• Currency Stability
• Banking
• Financial Infrastructure
• Hong Kong as an International Financial Centre
• Exchange Fund

3
HONG KONG DOLLAR HAS WEAKENED
Hong Kong Dollar Exchange Rate
4
INTERBANK LIQUIDITY
Aggregate Balance
5
Hong Kong Dollar Spot and 12-month Forward
HONG KONG DOLLAR MARKET EXPECTATIONS
6
HONG KONG-DOLLAR AND US-DOLLAR INTEREST RATES
7
WIDENED YIELD SPREAD OF EXCHANGE FUND BILLS OVER
HIBORs
1-month EFB yields vs HIBOR
Up to mid-Dec 07
8
RAPIDLY GROWING RTGS TURNOVER
RTGS vs stock market turnover
9
INTRADAY REPO TURNOVER
10
ADDRESSING THE INCREASED DEMAND FOR EXCHANGE FUND
PAPER

• Increase the supply of Exchange Fund paper via
  tap issues
• Consistent with Currency Board principles as the
  Monetary Base remains fully backed by foreign
  reserves
• Primary objective is to meet the increased demand
  of Exchange Fund paper for managing intraday
  liquidity

11
YIELD SPREAD BETWEEN EXCHANGE FUND BILLS AND
HIBOR NARROWING
Note The Viewpoint article on 20 Dec 07
suggested that there might be a need for
additional Exchange Fund paper and the article on
3 Jan 08 indicated that the case for increasing
the supply of Exchange Fund paper has become
clearer.
12
FACTORS AFFECTING CURRENCY STABILITY

• Sub-prime crisis
• Monetary and financial conditions on the Mainland
• Inflation

13
THE US SUB-PRIME CRISIS CONTINUES

• Housing market continues to deteriorate

Depressed housing activity
Falling house prices
14
Increasing risks of a recession in the US

• There are increasing talks that the US economy
  might dip into or is already in a recession.

US GDP growth
Note Q4 07 growth figure is market forecast
(source Bloomberg)
15
CENTRAL BANKS IN ACTION

• Co-ordinated central bank actions to inject
  liquidity
• Major central banks cut policy rates

Interest rate spreads
Policy rates
16
FINANCIAL MARKET STILL IN TURBULENCE

• Weak US data, persistent credit crisis and fears
  that a US recession will likely drag down the
  global economy led to a renewed bout of risk
  aversion and global equity market sell-off

US commercial paper outstanding
Global equity markets
17
IMPACT OF THE SUB-PRIME PROBLEM ON HONG KONG

• Local financial markets have been more volatile
  but no systematic problem has emerged
• Individual banks in Hong Kong may suffer from
  their investment in asset-backed securities, but
  unlikely to affect their financial soundness

18
MONETARY AND FINANCIAL CONDITIONS ON THE MAINLAND

• Widening of balance-of-payments surplus
• Faster appreciation of the renminbi
• Continued capital inflows, and rapid accumulation
  of foreign-exchange reserves
• Continued increases in reserve requirement of the
  banking sector
• Large issuance of PBoC paper to sterilise excess
  liquidity created by the acquisition of foreign
  reserves

19
MONETARY AND FINANCIAL CONDITIONS ON THE MAINLAND

• Rising inflation
• Raising interest rates and using price controls
  to curb inflation
• Implementing policies to encourage orderly
  capital outflows
• Large demand for investment instruments by the
  non-state sector
• Development of capital markets against the
  background of supply-and-demand imbalance

20
Key Drivers of Inflation
HOUSING RENTS AND FOOD PRICES PUSH UP HONG
KONGS INFLATION
21
PRODUCTIVITY GROWTH HELPS CHECK HONG KONGS
INFLATION
Productivity Growth Remains Strong
22
CURRENCY NOTES

• HK10 Polymer Note
• Put into circulation in July 2007
• Extensive public education programme launched
• Public response favourable so far
• Additional 50 million notes to cater for Chinese
  New Year demand
• The HKMA will evaluate public acceptance and
  technical performance of the note in two years

23
BANKING SECTOR PERFORMANCE
Local AIs Remain Well Capitalised
Period-end figures
24
BANKING SECTOR PERFORMANCE
Liquidity Levels Remain High
25
BANKING SECTOR PERFORMANCE
Higher Domestic Loan Demand
Quarterly increases (in HK bn)
Trade financing Share financing Property lending Others Total domestic loans
Mar-07 0 127 10 9 146
Jun-07 18 47 25 21 111
Sep-07 3 43 28 26 100
Total up to Sep-07 21 217 63 56 357
26
BANKING SECTOR PERFORMANCE
Net Interest Margin Increasing
Period-average figures Annualised figure
27
BANKING SECTOR PERFORMANCE
Asset Quality Remains Sound
Annualised figure
28
BANKING SECTOR PERFORMANCE
Residential Mortgage Lending in Negative Equity
Declined Further
Period-end figures
29
BANKING SECTOR PERFORMANCE

• Implications of the sub-prime crisis
• Aggregate sub-prime or sub-prime-related
  exposures of local banks are not material
  relative to their total assets
• No systemic impact on the banking sector
• However, profitability of individual banks with
  sub-prime or sub-prime-related exposures is
  likely to be affected

30
REVIEW OF HKMAS WORK ON BANKING STABILITY

• Aims to make recommendations on focus and
  priorities of the HKMAs banking supervisory
  functions and policies to be developed in the
  next five years
• Takes into account
• globalisation of finance and banking business
• increasing integration of the financial systems
  of Hong Kong and Mainland China
• growing complexity of banking products
• increasing reliance of banks on information
  technology
• increasing need to combat financial crime
• changing nature of supervision
• expectations of the community
• To be completed in second quarter of 2008

31
COMMERCIAL CREDIT REFERENCE AGENCY

• The Commercial Credit Reference Agency (CCRA)
  will be expanded to cover sole proprietorships
  and partnerships on 1 March 2008.

32
ANTI-MONEY LAUNDERING COUNTER TERRORIST
FINANCING

• The Financial Action Task Force on Money
  Laundering visited Hong Kong as part of a mutual
  evaluation of anti-money-laundering and
  counter-terrorist-financing measures. The report
  will be finalised in mid-2008.
• The HKMA amended its Supplement to the Guideline
  on Prevention of Money Laundering in November
  2007 to take into account recent developments.
• The Industry Working Group on Prevention of Money
  Laundering and Terrorist Financing has prepared
  several guidance papers on politically exposed
  persons, offshore companies, and address proof.

33
MARKET INFRASTRUCTURE

• To develop Hong Kong into a regional payment and
  settlement hub, enhancing Hong Kongs role and
  status as an international financial centre
• New project development
• Electronic trading platform for Exchange Fund
  Bills and Notes
• Migration to SWIFTNet

34
DEVELOPMENT STRATEGY

• Strategy for development of market infrastructure
• Adding new functions to payment systems
• promoting links and use of financial
  infrastructure
• Success in increasing turnover of RTGS systems
  and links with overseas systems
• Will continue to further strengthen Hong Kongs
  multi-currency, multi-dimensional payment and
  settlement platform

35
EFFICIENT OPERATION OF THE PAYMENT SYSTEM
HK Bn
36
MARKET INFRASTRUCTURE

• Oversight of the clearing and settlement systems
• All local designated systems remain in compliance
  with the safety and efficiency requirements of
  the Clearing and Settlement Systems Ordinance
• Continued support rendered to the Process Review
  Committee in preparing the third Annual Report to
  the Financial Secretary.

37
HONG KONG AS AN INTERNATIONAL FINANCIAL CENTRE

• Regional co-operation
• Developing bond market in Asia
• Promoting regional financial stability through
  active participation in an enhanced monitoring
  mechanism of Asia-Pacific central banks
• Providing input to regional financial
  co-operation initiatives
• Strengthening crisis management

38
HONG KONG AS AN INTERNATIONAL FINANCIAL CENTRE

• To continue the implementation of the Action
  Agenda of Chinas 11th Five-Year Plan and the
  Development of Hong Kong, focussing on
• (1) Renminbi business in HK
• promote continuous development of the renminbi
  bond market
• work further on the proposal for settlement of
  imports from the Mainland in renminbi
• (2) Use of HKs platform for the orderly outflow
  of Mainland funds
• work closely with Mainland authorities on
  implementation of pilot scheme for direct foreign
  portfolio investments by Mainland individuals and
  further development of QDII schemes.

39
Investment Objectives ofThe Exchange Fund

• Investment objectives of the Exchange Fund
• (1) to preserve capital
• (2) to ensure that the entire Monetary Base at
  all times will be fully backed by highly liquid
  US dollar denominated assets
• (3) to ensure sufficient liquidity for the
  purpose of maintaining monetary and financial
  stability and
• (4) subject to (1) (3), to achieve an
  investment return that will preserve the
  long-term purchasing power of the Fund.

40
Markets in 2007

• Exchange rates
• US dollar weakened against the euro and yen
• Equity markets
• Foreign equities market rose in the 1H but
  retreated in the 2H as the US subprime mortgage
  crisis intensified
• Local equities market gained significantly on the
  back of ample liquidity but correction set in
  during Nov-Dec
• Interest rates
• Monetary easing by major central banks
• Bond yields fell in general as risk appetite
  declined but money market rates rose on concerns
  about credit availability
• Credit spread widened significantly

41
Investment Income
I 2007 I 2006 2005 2004 2003
(HK billion) Full year Q4 Q3 Q2 Q1 Full year Full year Full year Full year
Gain on Hong Kong equities 55.8 5.7 35.0 14.9 0.2 35.9 7.0 12.0 21.2
Gain/(Loss) on other equities 6.7 (4.4) (1.0) 9.9 2.2 18.7 20.5 11.2 26.8
Exchange gain/(loss) 18.7 8.2 3.0 1.5 6.0 17.3 (19.5) 8.5 22.9
Return from bonds 61.0 23.9 24.8 0.0 12.3 31.9 29.8 25.0 18.8
Investment income 142.2 33.4 61.8 26.3 20.7 103.8 37.8 56.7 89.7
Unaudited figures Including dividends
Including interest
42
Change in Investment Income, Treasurys Shareand
Accumulated Surplus
I 2007 I 2006
(HK billion) Full year (unaudited) Q4 Q3 Q2 Q1 Full year
Investment income 142.2 33.4 61.8 26.3 20.7 103.8
Other income 0.2 0.1 0.0 0.1 0.0 0.2
Interest and other expenses (10.2) (2.2) (2.8) (2.9) (2.3) (10.5)
Net investment income 132.2 31.3 59.0 23.5 18.4 93.5
Payment to Treasury (27.6) (7.4) (6.9) (6.9) (6.4) (28.9)
Valuation change of Strategic Portfolio 4.7 (1.1) 5.8 N/A N/A N/A
Increase in EF accumulated surplus 109.3 22.8 57.9 16.6 12.0 64.6
The fixed rate of fee payment to Treasury for
2007 (w.e.f. 1 April 2007) is 7.
Including dividends
43
Historical Change in Investment Income,
Treasurys Share and Accumulated Surplus
(HK billion) 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997
Investment income 142.2 103.8 37.8 56.7 89.7 47.0 7.4 45.1 103.8 93.8 35.6
Other income 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2
Interest and other expenses (10.2) (10.5) (7.6) (4.8) (5.6) (7.0) (10.5) (11.0) (10.0) (16.0) (18.4)
Net investment income 132.2 93.5 30.4 52.1 84.3 40.2 (2.9) 34.3 94.0 78.0 17.4
Payment to Treasury (27.6) (28.9) (10.1) (14.5) (25.7) (15.6) (1.6) (18.1) (45.4) (26.0) N/A
Valuation change of Strategic Portfolio 4.7 N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A
Revaluation gain/(loss) on premises N/A N/A N/A 0.9 (0.9) N/A N/A N/A N/A N/A N/A
Carry to accumulated surplus 109.3 64.6 20.3 38.5 57.7 24.6 (4.5) 16.2 48.6 52.0 17.4
Adjustment to accumulated surplus Adjustment to accumulated surplus
Effect of implementation of HKAS 39 N/A N/A (0.6) N/A N/A N/A N/A N/A N/A N/A N/A
Increase/(Decrease) in EF accumulated surplus 109.3 64.6 19.7 38.5 57.7 24.6 (4.5) 16.2 48.6 52.0 17.4
unaudited figures including dividends
44
Exchange FundAbridged Balance Sheet
(HK billion) At 31 Dec 2007 (unaudited) At 31 Dec 2006 Change
ASSETS
Deposits 133.9 62.4 71.5
Debt securities 922.3 828.4 93.9
Hong Kong equities 184.6 122.4 62.2
Other equities 145.6 137.4 8.2
Other assets 30.6 25.8 4.8
Total assets 1,417.0 1,176.4 240.6
LIABILITIES AND FUND EQUITY
Certificates of Indebtedness 163.4 156.9 6.5
Government-issued currency notes coins in circulation 7.5 6.9 0.6
Balance of the banking system 10.6 2.0 8.6
Exchange Fund Bills and Notes 141.8 129.2 12.6
Fiscal Reserves Account1 464.6 324.5 140.1
Other liabilities1 12.1 49.2 (37.1)
Total liabilities 800.0 668.7 131.3
Accumulated surplus 617.0 507.7 109.3
Total liabilities and fund equity 1,417.0 1,176.4 240.6
Note 1 Under the new fee arrangement, the
payment of 27.6 billion has been included in
Fiscal Reserves Account balance of 464.6
billion. With the old arrangement, the return on
Fiscal Reserves of 28.9 billion in 2006 was
accrued under Other liabilities of 49.2 billion.
45
Exchange Fund Performance Against Investment
Benchmark
46
Investment Returnof the Exchange Fund
47
Treasury Return Against Estimate