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Letter to the Financial Secretary on hiving off the fund management arm of the Hong Kong Monetary Authority

4 November 2002

The Honourable Antony Leung
Financial Secretary
Government Secretariat
12/F, Central Government Offices
West Wing, Lower Albert Road
Central, Hong Kong

Dear Mr Leung,

We read recently in the press that you might be considering hiving off the fund management arm of the Hong Kong Monetary Authority into a separate institution. We are writing to express our wholehearted support for such idea.

The HKMA has over the years gathered to itself a remarkable collection of powers and roles. From 1983, the Exchange Fund was intended to operate as a currency board, i.e. a non-discretionary mechanism for administering the linked rate mechanism with the U.S. dollar. Yet, it introduced embellishments on the original design, including discretionary interventions into the currency market and the issuance of Exchange Fund Bills and Notes, that made it in some respects almost like a central bank, quite inconsistent with the currency board mechanism. In August 1998, the HKMA became the major player in the stock and index futures markets, spending HK$118 billion on what appeared to be an attempted short squeeze on speculators. Although some of the embellishments were withdrawn or tempered by the seven Technical Measures introduced in September 1998, recent anxieties over the Hong Kong dollar suggest that confidence has not been wholly restored.

In 1992, the Exchange Fund was merged with the former Office of the Commissioner of Banking to form the HKMA. Later the former Land Fund was merged into it. Now, in addition to operating the currency board and regulating the banks, the HKMA operates a depository system for the debt market and otherwise actively develops the financial markets, manages an investment portfolio of over HK$900 billion – by far the largest in Hong Kong – manages the Government’s fiscal reserves, issues debt, and manages the Mortgage Corporation. Given the vagueness of the governing legislation, the Exchange Fund Ordinance, it is difficult for the HKMA to be held to account for the way it disposes of its vast assets – witness the recent controversy over its purchase of prime office property at some HK$4 billion.

We believe that there are conflicts of interest among the various functions currently carried out by the HKMA. For example, the HKMA regulates the banks who issue securities, issues securities itself and through its subsidiary the Mortgage Corporation, and is Hong Kong’s major investor in securities. We believe that these functions should not all be carried out by a single institution. We therefore would encourage you to review the functions of the HKMA with a view to hiving off functions to appropriate bodies.

This would be a complex exercise requiring detailed study. However, we would like to share with you a few initial thoughts on the direction such restructuring might take. The core function of administering the linked rate mechanism and managing the backing of the currency issue should remain with the HKMA. However, the HKMA has very substantial retained earnings, of HK$316 billion. In principle, it does not need these reserves since the currency board mechanism is supposed to operate in an automatic self-balancing manner, i.e. without intervention or the need for reserves (the funds actually backing the issue of currency are not a matter of reserves but are represented by liabilities due to the note-issuing banks). We would not recommend reducing the reserves to zero, but the present HK$316 billion appears far too high an amount. Study should be made of an appropriate amount to retain within the Exchange Fund and the balance should be returned to the Government. We would also recommend clarifying in law the uses to which the Exchange Fund may be put.

The function of regulating the banks should probably remain in the HKMA until the Government is ready to consider the creation of a single financial regulator along the lines of Britain’s Financial Services Authority or Japan’s Financial Services Agency.

As already mentioned, the HKMA’s fund management arm should be hived off into an independent body, possibly under the direct control of the Financial Secretary. Firm guidelines should be established for the investment of these funds, and a suitable oversight and reporting mechanism established.

The Hong Kong Mortgage Corporation (HKMC) should be spun off as an independent private entity. At present, there is concern that the HKMC is being used to buy up the mortgage loans of the banks at favourable prices. Whether justified or not, such concern is difficult to refute given the current structure. An arm’s length structure would help boost confidence in the system.

We realise that the above would be a sensitive exercise from a number of points of view, not least from that of potential impact on confidence in the exchange rate. Such restructuring should be carefully handled. However, we would argue that confidence would in the long run be better served by arrangements that were more transparent, better structured and better governed by law than those presently in effect.

We hope that the above suggestions are helpful to you in drawing up your plans for the new government.

Yours sincerely,

Alan Lung Ka-lun

Chairman