Opportunity to implement necessary reforms of Hong Kong Monetary Authority
7 September 2009
Mr Freely K Cheng
Administrative Assistant to Financial Secretary
Financial Secretary's Office
Government of the HKSAR, People's Republic of China
5/F, Central Government Offices, Main Wing
Lower Albert Road, Central, Hong Kong
Dear Mr Cheng,
Opportunity to implement necessary reforms of
Hong Kong Monetary Authority
Thank you for your letter of 30 July 2009 responding to our own letter of 10 July 2009 on the above subject. We appreciate your effort to respond to our suggestions; however, as several of our points appear to have been missed, we would like to further clarify our position.
1. Purpose of Exchange Fund not adequately specified
In accordance with Section 3(1) of the Exchange Fund Ordinance, the Exchange Fund shall be used primarily for such purposes affecting, either directly or indirectly, the exchange value of the currency of Hong Kong and for other purposes incidental thereto. Section 3(1A) provides that the Financial Secretary, while having regard to the primary purpose of the fund, with a view to maintaining Hong Kong as an international financial centre may use the Fund as he thinks fit to maintain the stability and the integrity of the monetary and financial systems of Hong Kong.
In practice, the Exchange Fund has been used to conduct a very wide range of transactions, such as the acquisition of substantial premises for the Hong Kong Monetary Authority, intervening in the stock and futures markets, making strategic investment in the stock market operating company, and committing HK$33 billion to China's contribution to the Chiang Mai Initiative Multilateralisation (CMIM).
We suppose that none of the above actions were in breach of the Exchange Fund Ordinance. If so, the wording of the ordinance is so loose as to permit the Financial Secretary to do almost anything. In effect, the Exchange Fund has become a kind of gigantic ‘slush fund', through which the Government can conduct enormous financial transactions without proper accountability. This is highly unsatisfactory. We strongly recommend that the purposes of the Exchange Fund be more tightly specified in legislation, so that accountability to the community can be restored.
2. Amount of Exchange Fund excessive
We note your observation that it is difficult to foresee the nature of the crises that the Exchange Fund might have to deal with. However, we respectfully submit that it is the responsibility of those charged with, and paid by the taxpayer for, maintaining the stability of the financial system to do precisely that - to anticipate possible crisis scenarios and make plans and preparations accordingly. Happily, Hong Kong has a great deal of recent experience from the Asian Financial Crisis, SARS and the Global Financial Crisis, which should provide guidance and illustration to the officials charged with this task. In particular, the Global Financial Crisis has provided a once-in-a-century object lesson that through the experience of the involved countries explores almost every imaginable financial scenario.
Hong Kong has come through these various crises in relatively good shape. In particular, thanks in great part to the supervision of the HKMA, Hong Kong's banks have remained sound. We submit that this soundness has more to do with prudent supervision under a conservative policy framework, and technical improvements to the administration of the linked rate mechanism, than to the accumulation of vast assets in the Exchange Fund.
We cannot accept that the Exchange Fund should accumulate assets without limit. These assets are not cost-free: there is an opportunity cost to the resources withdrawn from the community in this manner. Most of the developed economies manage well enough without substantial foreign exchange reserves. Hong Kong, which has merely to maintain the linked rate mechanism, not manage a freely-floating currency, and should need less reserves - not more. We strongly recommend that a debate be commenced on the purposes for which the Exchange Fund needs assets, quantification of those needs, and return of the unneeded assets to the community.
3. Sovereign wealth fund preferred to ‘slush fund'
As stated in 2 above, our preference is for the purposes of the Exchange Fund to be specified narrowly, and the size of the fund reduced commensurate with the specified purposes. If the Government will not do this, then our second preference is for the part of the fund with is not needed for monetary stabilisation purposes (when these are properly defined) to be hived off into a fully-fledged sovereign wealth fund, perhaps along the lines of China's CIC. Such SWF could then be set objectives of its own, and in turn be subject to proper accountability.
4. Spin off reserve management function
We note that the Government has no plan to spin of the HKMA's reserve management function. However, while on the surface it may seem to make sense for the Exchange Fund to act as ‘the Government's banker', there are drawbacks. For example, are the fiscal reserves banked with the Exchange Fund still fiscal reserves or are they now foreign exchange reserves? At the moment, they seem to be performing both functions, and we seem to be having our cake and eating it. But this state of affairs may not last. Supposing, for example, that a much larger proportion of the Exchange Fund were committed to the CMIM or its successor? Then the fiscal reserves might not be available to meet future government deficits. Or if the government were to substantially draw down the fiscal reserves, this would reduce the foreign exchange reserves and perhaps impact confidence there (albeit that we consider the reserves much too high in any event).
Our point is that we may not be able to have our cake and eat it indefinitely, at least not without massive over-allocation of assets to the Exchange Fund at substantial opportunity cost (which is, in fact, the present state of affairs). We believe that serious consideration should be given to managing the fiscal reserves and the foreign exchange reserves separately.
5. Over-concentration of functions in HKMA
You state that there are well-established arrangements separating the supervisory and investment management functions within the HKMA. However, while this may be the case at operational level, it is hardly the case at macro level. The HKMA is operator of debt securities market infrastructure, issues debt securities, is a major portfolio investor in securities, undertakes ‘strategic' investments in securities, regulates the banks who are themselves issuers of securities, and through a subsidiary repackages mortgages for issuance as securities. There are obvious conflict among these functions. It is hardly possible for the HKMA to conduct this wide range of activities within the confines of the law. In fact, the HKMA claims it is exempt from the disclosure of interests provisions of the Securities and Futures Ordinance (albeit making the disclosures voluntarily), which is surely not setting a good example to the market.
We strongly recommend that a review be conducted of the HKMA's functions, in order to achieve a more rational, transparent and lawful allocation of the functions, if necessary among one or more other institutions.
6. Inadequate supervision of banks' conduct of business
As we acknowledge above and in our letter of 10 July 2009, the HKMA has done a good job supervising the banks' capital adequacy. However, the minibond incident, and other similar incidents, has shown that the HKMA has done a very poor job as supervisor of the banks' conduct of business. We strongly believe that change to the existing regulatory system is needed to avoid a repeat of minibond-style problems and other conduct of business issues.
We are currently working with another group examining possible alternative regulatory models, and believe that the Twin Peaks model may be suitable for Hong Kong. We will revert in due course on this matter.
7. Hong Kong Mortgage Corporation (HKMC) not needed
We understand that the HKMC has embarked on programmes of purchasing mortgages outside Hong Kong, for example in Korea and Shenzhen. This is far outside any possible mission for a Hong Kong public corporation. We doubt that there is a need even for the HKMC to perform its original function of purchasing and securitising Hong Kong mortgages, since this function, if required, could be performed by private sector. We recommend that consideration be given to winding up the HKMC and selling off its assets.
We hope that these clarifications will be helpful to you.
George W H Cautherley
Reproduction of this paper is permitted with proper attribution to the Hong Kong Democratic Foundation