Hong Kong Democratic Foundation

Opportunity to implement necessary reforms to Hong Kong Monetary Authority

10 July 2009

The Honourable John Tsang Chun-wah, JP
Financial Secretary
Financial Secretary's Office
Government Secretariat
5/F, Central Government Offices, Main Wing
Lower Albert Road, Central
Hong Kong

Dear Mr Tsang,

Opportunity to implement necessary reforms to Hong Kong Monetary Authority

The retirement of the present head of the Hong Kong Monetary Authority (HKMA) presents an opportunity to review and make necessary reforms to the institution.  We are writing to make proposals in this regard.

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 recent years these embellishments have been reined back and the currency mechanism has been operated in a more stable manner.

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 for the debt market and otherwise actively develops the financial markets, manages an investment portfolio of some HK$1.6 trillion (including the Government's fiscal reserves) - by far the largest in Hong Kong - issues debt securities, and operates the Mortgage Corporation. We understand that if the Government goes ahead with its planned bond issue, the HKMA will also be given these funds to manage.  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.

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. To take another example, the HKMA is at the same time the regulator of banks' capital adequacy and the regulator of banks' conduct of business.  To take a third example, the HKMA is a financial regulator, but also the vehicle used for certain of the Government's strategic investments, such as that in the stock exchange company.

The HKMA appears to have discharged well its function of regulating banks capital adequacy - as demonstrated by the relative stability of Hong Kong banks through the recent crisis - but the minibond scandal, in which banks are alleged to have mis-sold substantial amounts of complex derivatives to retail investors, reveals its substantial failure in its second regulatory role.

We believe that the HKMA is simply overburdened with functions.  The functions, some of which conflict with one another, 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.

  • The function of regulating banks' capital adequacy should remain with the HKMA.

  • The function of regulating banks' conduct of business should be transferred to the SFC.  (We would support the adoption in Hong Kong of the ‘Twin Peaks' model, under which one regulator - the HKMA - is responsible for supervising financial institution capital adequacy and a second regulator - the SFC - is responsible for supervising financial institution conduct of business.)

  • The Exchange Fund has very substantial retained earnings, of HK$455 billion. In principle, it is doubtful that these reserves are needed 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). We would not recommend reducing the reserves to zero, but the present HK$480 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 HKMA's fund management function should be hived off into an independent body, possibly under the direct control of the Financial Secretary. This body should be constituted as a sovereign wealth fund, perhaps along the lines of China's CIC.  Firm guidelines should be established for the investment of these funds, and a suitable oversight and reporting mechanism established.

  • We question whether there is a need for the Hong Kong Mortgage Corporation, as we note that it has been buying up mortgages in Shenzhen and Korea, which seems far from its original mission of supporting the mortgage market in Hong Kong.  If retained, the HKMC should be spun off as an independent private entity.

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 are more transparent, more logical and better governed by law than those presently in effect.

We hope that the above suggestions are helpful to you in considering the future structure of the HKMA.

Yours sincerely,

George W H Cautherley
Vice Chairman