REPORT ON THE FINANCIAL MARKET REVIEW TABLE OF CONTENTS

S OAT.i ?.sCV j CLASS NO, '

EXECUTIVE SUMMARY CHAPTER 1 INTRODUCTION AND OVERVIEW THE FINANCIAL TURMOIL COMMISSIONING OF THE REVIEW THE FUNDAMENTAL PRINCIPLES BACKDROP TO THE REGIONAL FINANCIAL TURMOIL VIEWS AND ADVICE TAKEN 1.1-1.2 1.3-1.6 1.7-1.8 1.9-1.12 1.13-1.17

CHAPTER 2 THE REGIONAL FINANCIAL TURMOIL SPREAD OF THE CONTAGION TURMOIL IN HONG KONG IMPACT ON HONG KONG AND THE REGION 2.1-2.3 2.4 - 2.6 2.7-2.12

CHAPTER 3 THE MONETARY SYSTEM AN ACCOUNT OF EVENTS IN THE MONETARY SECTOR Monetary Scene prior to October 1997 Events during the week of 20 October 1997 The Aftermath Measures Taken Characteristics of the October Currency Attack Post October Events #& * J t A S s i*
1 l *

31.-3.4 3.5-3.9 3.10-3.12 3.13-3.14 3.15 - 3.24 3.25 - 3.27

OPERATION OF THE LINKED EXCHANGE RATE SYSTEM Support for the Link Currency Board System Evolution of the Monetary Base in Hong Kong Mechanics of the Linked Exchange Rate System Clearing Balance of the Banking System Exchange Rate Level 3.28-3.29 3.30 3.31 - 3.33 3.34-3.35 3.36-3.41 3.42 - 3.45

PROPOSALS RECEIVED FROM THE ACADEMICS AND OTHERS Proposals for Reform US$LAF/HK$ Put Option Put Option - First Variation Put Option - Second Variation Put Option - Third Variation Dollarization AEL (Argentina, Estonia and Lithuania) Model Other Proposed Measures 3.46 3.47 - 3,49 3.50 - 3.53 3.54 - 3.58 3.59 3.60-3.63 3.64 - 3.65 3.66 - 3.69

IMPACT OF THE DEFENCE OF THE EXCHANGE RATE O N THE BANKING SECTOR Background The Impact on Banks' Liquidity and Funding The Impact on the Availability and Cost of Credit (Loan Growth) The Impact on Banks' Profitability The Impact on Banks' Asset Quality Public Perception of the Impact on the Banking Sector and on Individual Banks 3.70 - 3.73 3.74 - 3.79 3.80 - 3.88

3.89-3.95 3.96 - 3.98 3.99 - 3.102

REVIEW ON BANKING ISSUES Supervision and Transparency Lessons Learnt Consultancy Study The International Dimension 3.103-3.106 3.107 3.108 3.109

MACROECONOMIC ISSUES The Competitiveness Issue "The Interest Rate Pain" 3.110-3.114 3.115 - 3.125

CONCLUSION Background General Conclusions 3.126-3.127 3.128-3.141

CHAPTER 4 SECURITIES AND FUTURES MARKETS

THE MARKETS BEFORE AND DURING THE TURMOIL THE STOCK MARKET Short Selling and Stock Borrowing and Lending Margin Financing Relaxation of Takeovers Threshold Compliance of SEHK Listing Rules The Hang Seng Index 4.14 - 4.32 4.33 - 4.37 4.38 - 4.43 4.44 4.45 - 4.53 4.1-4.13

FUTURES AND DERIVATIVES MARKETS Introduction Trading System of Hong Kong Futures Exchange Margin Level for HSI Futures Contracts Derivative Warrants 4.54 - 4.66 4.67 - 4.79 4.80 - 4.85 4.86 - 4.103

MARKET SURVEILLANCE AND RISK MANAGEMENT Alleged Market Manipulation Surveillance of Trading and Member Conduct Link-up of CCASS and RTGS Investor Participation in CCASS Cross Margining Financial Resources Rules Stock Collateral 4.104 - 4.116 4.117-4.123 4.124 - 4.129 4.130-4.133 4.134-4.136 4.137-4.139 4.140 - 4.141

MARKET TRANSPARENCY, INVESTOR PROTECTION AND EDUCATION Introduction Disclosure of Information by Companies Listed on the SEHK Access to Corporate Information Fidelity and Compensation Schemes of Stock Market Investor Resources Centre Investor Education Programme Promotion of Use of Plain Language 4.142 4.143 - 4.145

4.146 - 4.147 4.148-4.150

4.151 4.152 - 4.153 4.154-4.155

THAPTER 5 SUMMARY OF RECOMMENDATIONS

THE TURMOIL IS PROGRESSING SUMMARY OF RECOMMENDATIONS 5.1-53 5.4

ANNEXES Annex 2.1 Annex 3.1 Chronicle of Events Circular announcing the establishment of the Liquidity Adjustment Facility (LAF) dated 27 May 1992 Circular on LAF borrowing dated 23 October 1997 Circular clarifying the definition of "repeated borrowers" dated 12 November 1997 Concluding statement of IMF Article IV Consultations A technical note on Hong Kong's linked exchange rate system Professor Goodhart's analysis on the recent events in Hong Kong and proposals received from the academics US$ LAF / HK$ put option proposed by Professor Chen Nai-fii and his colleagues Technical analysis of the US$ LAF/HK$ put option proposal Letter from Mr. David Goldsbrough of IMF dated 5 December 1997 commenting on the US$ LAF proposal Letter from Mr. David Goldsbrough of IMF dated 20 February 1998 commenting on the put option proposal AEL (Argentina, Estonia and Lithuania) model proposed by Professor Tsang Shu-ki

Annex 3.2 Annex 3.3

Annex 3.4 Annex 3.5

Annex 3.6

Annex 3.7

Annex 3.8 Annex 3.9

Annex 3.10

Annex 3.11

Annex 4.1

Performance of Major Overseas Stock Markets (table)

Annex 4.2

Short selling turnover - September 1997

Annex 4.3

Hong Kong Futures Exchange Limited Migration of Trading of Hang Seng Index Futures and Options Contracts to the Automated Trading System

EXECUTIVE SUMMARY INTRODUCTION

Affected by the contagion effect of the regional financial turbulence, the Hong Kong dollar came under speculative pressure on several occasions in the second half of 1997. Overnight interbank interest rate surged briefly to 280% on 23 October under the automatic adjustment mechanism of the currency board system. During that week and the following week, the securities and futures markets in Hong Kong also experienced the most severe volatility in history, recording a 1,438 points (13.7%) fall in the Hang Seng Index on 28 October and a 1,705 points (18.8%) rebound on the following day. 2. While we have ridden through this particularly stormy period with our currency remaining stable and the securities and futures markets operating orderly and efficiently, the combination of the interest rate hike and the asset price adjustments in both the securities and property sectors have caused serious concern among the local community. The Financial Affairs Panel of the Provisional Legislative Council called for a special briefing by the Administration on 31 October 1997. On 2 November 1997 the Financial Secretary made public his intention to call for a review of our currency defence. The Provisional Legislative Council further passed a motion on 26 November 1997. Among the Members who spoke during the motion debate, there was an overwhelming support that the linked exchange rate with the US dollar should be maintained to safeguard the well-being of the economy and investors' confidence in Hong Kong dollar. Nonetheless, they strongly urged the Administration to review the operation of the currency defence mechanism as well as the operation of the financial markets especially shortselling activities and the trading of derivatives. The motion also called for actions to enhance the Government's ability to withstand such volatility and strengthen investor education. Supporting the motion, the Secretary for Financial Services reiterated the Administration's commitment to launch a comprehensive review once the regional turmoil had settled.

CONTRIBUTION TO THE REVIEW 3. This Review covers the mechanism for defending the linked exchange rate system and the operating mechanisms of the securities and futures markets during this period of volatility. The major contributors to the Review were the Hong Kong Monetary Authority (HKMA) and the Securities and Futures Commission (SFC) in their respective ambits. 4. The HKMA had the benefit of the views from a wide spectrum of people with an interest and the capacity in technical issues of this nature, including those in the academic field, here in Hong Kong and elsewhere. In particular, the HKMA received the

expert advice from the International Monetary Fund (IMF) team which happened to be in Hong Kong for the annual Article IV Consultations in the second half of October, when the speculative attack on the currency occurred. Having watched closely how our linked exchange rate system worked to ensure exchange rate stability, the IMF experts provided objective advice and also gave specific opinion on a number of proposals that we received during this review. The HKMA also had the benefit of the advice of Professor Charles Goodhart of the London School of Economics who is also a member of the Monetary Policy Committee of the Bank of England. Professor Goodhart has long been associated with monetary developments in Hong Kong. 5. As regards the review on the securities and futures markets, we worked closely with the SFC and were assisted by the Stock Exchange of Hong Kong (SEHK), the Hong Kong Futures Exchange (HKFE) and the Hong Kong Securities Clearing Company (HKSCC). Throughout the financial turmoil, the SFC had also maintained close contact with its overseas regulatory counterparts, and discussed the appropriate measures to respond to the situation as it developed. 6. The review also took the benefit of advice from experts in the financial markets, including fund managers, securities brokers, and bank treasurers most of whom have extensive experience working in sophisticated international financial centres. Views were also widely sought from academics and the market participants. As the review progressed, the financial turmoil continued to affect the currency and the financial sectors of several regional economies. There were also isolated incidents of individual financial institutions in Hong Kong being affected, including the mini-run on the International Bank of Asia and the default of the Peregrine Group and the C A Pacific Group.

FUNDAMENTAL PRINCIPLES 7. The Review has been premised on two fundamental principles. First, consistent with the mandate in the Basic Law, and bearing in mind the long-term interest of Hong Kong as an open and externally-oriented economy, we must maintain and enhance the status of Hong Kong as an international financial centre. Secondly, consistent with the objective of maintaining the stability of the Hong Kong dollar, the linked exchange rate (LER) system which has served Hong Kong well must be preserved.

THE REVIEW 8. While we are not insensitive to the pain that has been inflicted on the economy by the interest rate hike and the asset price adjustments, we are pleased to note that the defence mechanism for the currency has very effectively preserved the stability of the exchange rate and the monetary system. The prudential regulatory framework for both the banking and the securities sectors which we have carefully built up over the

years have formed effective buffers against the recent shocks. Yet we have not been complacent. We have taken a thorough look at each facet of the currency defence mechanism and the securities and futures markets and have identified a number of areas where improvements can be made. Some of these measures have been immediately put in place to give prompt effect. Others may take some time to be examined in greater detail, for the targeted market to be developed, and for the necessary legislative and rule amendments to be formulated and put in place. In drawing the conclusions and the recommendations, we have been careful in striking a balance between the need for prudent regulation and the room necessary for free market development; and a balance between the need for improvements and the need for stability and certainty.

T H E REVIEW O N T H E C U R R E N C Y DEFENCE 9. In respect of the currency defence, we have examined the events in the monetary sector in detail, focusing on the currency attack in October 1997. We set out a discussion on the operation of the linked exchange rate system and evaluate the various proposals from academics which aimed at relieving pressures on interest rates. We have also conducted an assessment of the impact of the recent events on banks' liquidity, profitability and asset quality. The HKMA has drawn lessons on the banking side and has made recommendations regarding ways in which both the actual position of banks, and the public perception of their position can be improved. This Review also examines the wider implications of the link for the macro economy. 10. follows (I) The conclusions of the review on the defence of the currency are as

Role of interest rates (a) Under the automatic adjustment mechanism of the LER systems, it is the market which determines the level of interest rates required to maintain a fixed exchange rate. As exchange control or credit control is not an option in Hong Kong, there is little, if any, room for selective infliction of interest rate pain on the speculators under our LER system. Whilst one or two of the schemes proposed by the academics aiming at suppressing increases in interest rates may have some psychological value, they may carry the risk of undermining the credibility and self-adjusting mechanism of the LER system.

(b)

(c)

in

(II) Conduct of foreign exchange and money market operations bv the HKMA (a) Instead of rigidly buying and selling US dollars against Hong Kong dollars at the fixed exchange rate of 7.80, the HKMA should continue its existing practice of leaving the foreign exchange market very much alone. If there is risk of instability in the exchange rate, the HKMA should, as in the past and at undisclosed levels around 7.80, establish its passive presence in the foreign exchange market in accordance with the discipline of the currency board system. Operating under the rule-based currency board system, the clearing balance of the banking system, an important part of the monetary base, will vary in accordance with the flow of funds into and out of the Hong Kong dollars. Only in exceptional circumstances, such as Initial Public Offerings of shares and other large scale Hong Kong dollar transactions, will the HKMA consider directly varying the clearing balance temporarily without the corresponding change in its US dollar holdings. These operations are carried out for the benefit of promoting general market stability. In all other activities conducted by the HKMA which may have the effect of varying the clearing balance of the banking system such as a transfer of fiscal reserves and the issue of Exchange Fund Bills and Notes, the HKMA ensures that such effect is neutralized as the case may be, by recycling or sterilizing Hong Kong dollar liquidity. This practice should continue. For the purpose of facilitating the smooth functioning of the payment system, the HKMA should continue to provide intra-day liquidity as well as overnight liquidity through the Liquidity Adjustment Facility (LAF) by entering into the repurchase arrangements involving predominately Exchange Fund Bills and Notes. It should also continue to discourage repeated borrowings from LAF. The clarification of the definition of "repeated borrowers" enables the interbank market rates to rise in a less drastic manner, as was demonstrated during the week commencing 12 January 1998. This has contributed to a more orderly market reaction to the gradual shrinkage in the interbank liquidity. The present definition of a repeated borrower should be maintained.

(b)

(c)

(d)

(Ill) Banking system A sound and properly regulated banking system is essential to the maintenance of exchange rate stability. We should continue to reinforce our efforts in

IV

ensuring that banks in Hong Kong will manage prudently their risks, having regard to the special circumstances of Hong Kong's currency board system, and pay special attention to the quality of their assets so as not to be overly exposed to those which are vulnerable to interest rate volatility. It is recommended that strategic issues to further strengthen the resilience of Hong Kong's banking system to external and internal shocks be thoroughly considered in the consultancy study to be conducted in 1998.

(IV) Pain tolerance level of Hong Kong (a) In the defence of the Hong Kong dollar, sharp rises in interest rates will inevitably inflict pain not only on the currency speculators, but also on the home owners with floating rate mortgages and corporates with floating rate liabilities. One way to provide some insulation for the innocent parties from fluctuations in short term interest rates would be through borrowing fixed rate funds. It is recommended that steps should be taken for the Hong Kong Mortgage Corporation (HKMC) to play a greater role in developing the necessary market infrastructure to promote fixed rate mortgages as an additional financing option for home buyers. This can be achieved by the HKMC giving a clear indication of its intention to buy fixed rate mortgages from banks, thereby encouraging banks to originate such mortgages which they would otherwise be reluctant to grant because of the short term maturity and floating rate nature of banks' funding base. The HKMC may give a pre-commitment to banks to acquire those mortgages as they are originated. This will effectively protect banks from the market risk due to changes in interest rate after the origination of the mortgages as the banks can offload of those mortgages to the HKMC. It is recommended that steps be taken to develop the debt market, through encouraging the institutionalization of savings, especially the MPF, to promote the demand for fixed rate debt securities.

(b)

(c)

THE REVIEW ON THE SECURITIES AND FUTURES MARKETS 11. In respect of the review of the operation of the securities and futures markets, we have also examined the events prior to and during the market volatility in October 1997 to January 1998. We have considered in some detail the key issues of concern relating to the stock market, viz. risk management, shortselling and stock borrowing and lending; the regulation of margin financing activities which was a major factor in the default of the C A Pacific Group; the enforcement of compliance with SEHK

Listing Rules by company directors, financial advisors and sponsors; and the representativeness of the Hang Seng Index (HSI). We also discussed the role and function of the futures and derivative markets and their products, examining the trading system of the Hong Kong Futures Exchange especially in respect of the trading of HSI Futures contracts; the appropriateness of the margin level for HSI Futures contracts; and the function and market implications of derivative warrants. We have also addressed allegations of market manipulation; discussed ways to improve surveillance of trading and member conduct; and considered means to improve management of risk in the market at the investor, intermediary and market levels. Measures to improve market transparency, investor protection and education are also recommended. 12. The major conclusions and recommendations for the securities and futures sector are as follows tl) The market and regulatory systems (a) Throughout the period of volatility in the securities and futures markets, the trading, settlement and risk management systems continued to work well The institutional and regulatory framework put in place in the last ten years have proved to be effective in providing an open, fair and orderly market. In the two cases where provisional liquidators had to be appointed in respect of Peregrine and C A Pacific, the failure of these companies did not cause any substantive systemic problem, nor did they lead to further volatility in the market. Taking stock as of 31 March 1998, our market is among the least affected in the region. In US dollar terms, the stock market in Hong Kong shrank by 24% compared with the position at the end of June 19971.

(b)

(c)

(II) Issues of concern in the Stock Market (a) Shortselling, subject to regulation, is a widely accepted legitimate market activity in most major securities markets. The SEHK did not detect any improper activities in short selling reported to it during September to November 1997. Nor did SFC detect any link between improper short selling and market volatility during the period. Noting that market transparency is very important to the regime for shortselling, it is recommended that the reporting requirements for short open interest

When compared with end June 1997 and expressed in US dollar terms, the Taiwan market lost 15%. Tokyo and Singapore shrank by 31% and 27%, respectively. Others in South East Asia lost 45% (Philippines) to 79% (Indonesia).

VI

and other relevant information be enhanced to increase market transparency. On the other hand, a level playing field is important to the regime for stock lending and borrowing which complements short selling activities. We believe noted that the introduction of a central Stock Borrowing and Lending facility by HKSCC in early 1999 will provide equal access to stock borrowing and lending to all investors. (b) The C A Pacific incident made it clear that the largely unregulated margin financing activities by broker-related finance companies should be brought back into the regulatory fold. In this regard, the work of the cross-agency working group established in December 1997 was expedited with a view to publishing a consultation document in early May 1998 and to introducing the relevant legislative amendments to the first Legislative Council as soon as possible. It is recommended that these brokerrelated finance companies be subject to prudential regulation by the Securities and Futures Commission. The major areas of regulation include capital adequacy, risk management, and conduct of business. It is recommended that the SFC review the concept of Treasury Shares2 in the context < of the review of Share Repurchase Code which has just begun. It is recommended that the SFC and SEHK consider the introduction of measures such as application for court orders and mandatory remedies to strengthen the enforcement of compliance of SEHK Listing Rules. It is noted that the Hang Seng Index is a carefully constituted and largely representative index for the stock market in Hong Kong. We welcome the initiatives taken by Hang Seng Index Services Ltd (HSIS) to constantly review the various Hang Seng indices, and the introduction of the new Hang Seng 100 Index. It is further recommended that the SFC continue to discuss with HSIS on possible improvements to the representativeness of the related indices. We would also encourage the HKFE to launch the trading of futures contracts on the new HSI 100 as soon as possible.

(c)

(d)

(e)

"Treasury shares" refer to issued shares held by a company but not cancelled as a result of share repurchase. Such stock is available for reissue, but receives no dividends and carries no votes.

vn

(Ill) Issues concerning the Futures and Derivative Markets (a) Derivative products including index futures are important risk management tools in portfolio management. They add liquidity to the market and increase the diversity of the market product base. As such they are essential for the development of the Hong Kong market and to meet the needs of the local institutional fund industry. Such needs will grow with the introduction of Mandatory Provident Fund schemes. Without them the Hong Kong securities markets cannot remain competitive in the region. It is recommended that we continue to improve our market rules to maintain an effective regulatory regime. We welcome the HKFE's decision to migrate the trading of HSI Futures contracts to the Automated Trading System. Noting the lead time necessary to put the relevant systems in place both at the Exchange and for its broker members, we also welcome the HKFE's initiatives to improve the information dissemination system of the open outcry system in the interim. It is noted that the margin requirement of the HKFE on HSI Futures contracts is already among the highest in the world and has served the Exchange and its Clearing Company well during the turmoil. It is recommended that the SFC and HKFE continue to explore refinements to the calculation of margin level in order to maintain the flexibility to meet exceptional market volatility. There was substantial growth in the derivative warrant market following the relaxation of issue requirements in August 1996. There were indications that derivative warrants add to short term volatility as a result of the corresponding hedging activities by issuers. We welcome the SEHK initiatives to review the listing rules for derivative warrants with a view to reducing the impact of warrant issues and settlement on the cash market and improving transparency and investor's protection. We expect that the SEHK will submit the relevant changes to the Listing Rules to SFC before mid 1998.

(b)

(c)

(d)

(IV) Market Surveillance and Risk Management (a) There had been allegations that speculators had profited through market manipulation across the securities, futures and currency markets; that some had taken advantages of the expected interest rate surge following the attack on the currency, the ensuing liquidity squeeze and the selling pressure on the cash market; that certain brokerage houses had taken

vni

positions prior to the announcements of certain economic analysis by their own firms, and so on. The SFC investigations have found no evidence to substantiate any of these allegations of market manipulation. (b) Recognising the importance of market surveillance to ensure trading activities in the market are conducted in a fair and orderly manner, it is recommended that the capability of the SFC and the exchanges in the surveillance of trading and members' conduct be further enhanced. Where necessary, legislative amendments will be considered to strengthen the capability of the SFC and the exchanges in obtaining market information from the intermediaries. It is also recommended that measures to better manage and eliminate risks at various levels be introduced (i) (ii) link-up of CCASS and RTGS3 in May 1998; introduction of Direct Investor Participation in CCASS also in May 1998; detailed examination of the feasibility of cross margining between HKFE and SEHK; and promulgation of revised Financial Resources Rules in the second half of 1998.

(iii)

(iv)

We also welcome the acceptance of stock collateral by HKSCC since end December 1997 to alleviate part of the liquidity pressure on market intermediaries.

(V) Market Transparency. Investor Protection and Education (a) The heated activity in the market during the first half of 1997 and the volatility that followed both point to the importance of enhancing market transparency to enable investors to make their decisions based on equal and adequate knowledge about the fundamentals and prospects of the companies and investment products concerned. It is equally important to protect investors through regulations that protect their rights and opportunities and to educate them about the market.

This is a linkage between the Central Clearing and Settlement System (CCASS) of HKSCC which handles 99.5% of SEHK transactions and the Real Time Gross Settlement System (RTGS) of HKMA which is the money settlement system among banks. The linkage will further reduce the market risks of settlement for HKSCC and the parties to the trade.

IX

(b)

The following measures have either been introduced or are under study in order to achieve greater transparency and provide better protection and education to investors (i) revision to the financial disclosure provisions in the SEHK Listing Rules to improve the transparency of financial exposure of listed companies to their investors and the market; with effect from February 1998 a requirement on listed companies to provide corporate communications to all investors who deposit their shares with the CCASS; review of fidelity insurance and compensation schemes of SEHK to ensure the provision of cost-effective protection to investors and market practitioners; establishment of an Investor Resources Centre within 1998; provision of various investor education programmes and enquiry/complaint facilities; and a requirement of the use of plain language in company prospectuses and communications.

(ii)

(iii)

(iv) (v)

(vi)

THE BROADER PERSPECTIVE 13. The regional financial turmoil started off in Thailand in the middle of 1997 and quickly swept through to the rest of South East Asia. Then towards the year end, financial troubles in Japan and corporate bankruptcies in South Korea rocked North Asia. In early 1998, the fall-out in Indonesia gave a fiirther shock to South East Asia and the rest of the region. These events have tended to compound each other, resulting in serious regional crises with profound implications for the global financial markets. Hong Kong as a significant member of the global and regional financial community could not have been immune. 14. In all these events, the most conspicuous features of the turmoil were substantial downward pressure on the stock markets, upsurge in interest rates, rising inflation and, with the exception of Hong Kong, sharply depreciated and highly volatile exchange rates. Businesses experienced a widespread liquidity squeeze as the banking sectors exercised stringency on account of diminishing deposits, falling value in collateral and worsening quality of loans. These led to greatly increased corporate difficulties, with knock-on effects on local consumer and investment spending. Overall economic growth in the affected places dipped and unemployment correspondingly rose.

15. This region which is stricken by the financial turmoil was the region that was hailed not too long ago for its strong growth and economic dynamism. The crux of the problem, in many cases, lies in the structural and systemic weaknesses in the financial and corporate sectors which were overlooked at the times of exceptionally remarkable growth. In certain cases, these weaknesses were exacerbated by lax regulation, and deliberate policies favouring the growth of particular sectors and excessive exposure to particular sources of funding instead of being guided by competition and market efficiency. 16. Hong Kong generally has little of such structural and systemic problems. However, through a period of exceptional buoyancy in the economy and highly bullish outlook for the future, the stock and property markets in Hong Kong had gone to excessive heights. For example, residential property prices rose on average by as much as 80% to the peak during the two years prior to October 1997. The HSI gained by 1.4fold to reach the record high in August 1997 in slightly more than 2 1/2 years. At that record high, the P/E ratios for Blue Chips surged to an average of 17 times, while those for Red Chips and H shares were even more dramatic, at 52 and 30 times respectively. In retrospect, while the fundamentals of the economy at that time remained generally and basically sound, the sharp escalation in asset prices to unsustainable levels did expose a substantial weakness making our financial sector open to assault. It was against this background that the heavy speculative attack on the Hong Kong dollar took place in the latter part of October 1997. The subsequent adjustments, painful though they were, in hindsight was perhaps not only unavoidable but even necessary. 17. Going through this period of volatility, we continue to take comfort that our sound fundamentals, robust financial systems and market-oriented policies along with the flexibility of the economic structure have afforded us the best protection. To maintain our resilience against adversities, we must preserve all these underlying attributes. On top of this foundation, we would further refine our systems by the whole range of improvement measures outlined in this report. And they are by no means the end of our efforts. We must keep up our vigilance to ensure that we have the dynamism in the market as well as the vigour in our regulatory framework to ensure our long-term competitiveness. 18. Perhaps an important lesson for us to learn from the regional financial turmoil is exactly the saying of "staying vigilant while in peace". As we are riding out the storm and renewing our strengths, we must not forget the pains too quickly. Instead we should be watching out for the risk of any asset price bubbles, and make adequate preparations against possible market downturn in times of particular buoyancy. So is the need to watch out for any inherent imbalances in the economy and have them expeditiously and effectively addressed.
Red Chips are stocks which are mainly held by Chinese entities, including state-owned organisations, provincial and municipal authorities, whereas H shares are Chinese state-owned companies listed on SEHK.

XI

CHAPTER 1 INTRODUCTION AND OVERVIEW

THE FINANCIAL TURMOIL 1.1 In late May 1997, the Thai baht came under severe speculative attack. Selling pressure was also experienced by the Philippine peso and Malaysian ringgit As the Thai baht was attacked again in early July, the Bank of Thailand floated the baht which immediately fell from Bht 26 to the US$ to Bht 30. While the IMF pledged a rescue programme amounting to US$3.9 billion to assist the Thai government, the contagion spread to the neighbouring economies, including Malaysia, Indonesia and the Philippines. 1.2 In late October, the turmoil spread further. In the week preceding 20 October, the New Taiwan dollar depreciated sharply by 6.5% when the Taiwanese authorities decided not to defend its currency. However, the Hong Kong dollar remained unaffected. On 21 and 22 October, speculators launched massive short selling of Hong Kong dollar in the expectation that we would give up our linked exchange rate and join the row of competitive devaluation. They were joined by fund managers who decided to switch out of Hong Kong and sold in the stock market, as well as others who felt it prudent to hedge their Hong Kong dollar exposures and sold Hong Kong dollars forward. The defence mechanism for the Hong Kong dollar under the currency board system was automatically kicked in. In accordance with the currency board arrangement, the Hong Kong Monetary Authority (HKMA) sold a substantial amount of US dollar in the foreign exchange market in defence of the Hong Kong dollar exchange rate. As banks did not have sufficient Hong Kong dollars in their clearing balance with the HKMA to settle the foreign exchange deals done during these two days, they aggressively bid funds in the interbank market which did not actually exist. The HKMA also issued a statement discouraging licensed banks from repeated borrowings from the Liquidity Adjustment Facility (LAF). The market became so one-sided and trade so thin that the overnight interbank interest rate surged from 9% to 280% at around noon time on 23 October. On that day, the Hang Seng Index fell by 1,211 points (10.4%) to close at 10426 and stock markets world-wide also suffered severe loss. In the ensuing days, while the currency stabilised in the spot market, the liquidity eased and the overnight rate softened quickly to close to LAF bid rate, the term rate remained significantly higher than the Best Lending Rate, and the stock market experienced a period of high volatility and high turnover.

COMMISSIONING OF THE REVIEW 1.3 There was, understandably, considerable public concern at the high levels of interbank interest rates, however temporary as they turned out, as they drove asset prices sharply downwards, affecting considerably the wealth of the community, many of whom were innocent parties. Rather naturally then, as the high interest rates were for the purpose of defending the Hong Kong dollar, the blame was in turn put on the LER system, with renewed queries on the suitability of the system for Hong Kong. But as the Asian currencies succumbed to speculative attack, leading to devastation not only in the stock market, but also substantial corporate and banking losses, public opinion quickly realized the crucial importance of the stability of the Hong Kong dollar both in Hong Kong and the region. The attention of critics was then turned to the defence of the Hong Kong dollar itself, mounted by the HKMA. L4 The critics tended to ignore the fact that Hong Kong was the last and the least to be affected by the currency turmoil that has been sweeping through the region. There was, indeed, considerable pressure being felt even far beyond the region, as far as and as apparently unconnected as Latin America. The contagion also spread to most of the large, liquid, sophisticated and established markets. But the pain was obviously there locally and nobody liked it, regardless of how much worse the alternative might be. 1.5 At the same time, as the securities and futures markets experienced exceptional volatility when the regional currencies, especially Hong Kong dollar, were attacked, and there was a significant net fall in the market, there were concerns that certain aspects of the securities and futures markets were adversely affecting the market. The major issues of concern were volatility allegedly being exacerbated by shortselling of certain major shares in the market and trading related to derivative warrants. There were also allegations of market manipulation. These included suggestions of international participants taking advantage of the expected interest rate hike in the defence of the Hong Kong dollar, by first taking a short position in the index futures market and then launching an attack against the currency and of speculators reaping substantial profits from the futures market through manipulation across the futures and securities markets; and investment houses taking short positions in the market with a view to benefiting from anticipated announcements of their financial and economic analysts. 1.6 The Financial Affairs Panel of the Provisional Legislative Council called for a special briefing by the Administration on 31 October 1997. On 2 November 1997 the Financial Secretary made public his intention to call for a review of our currency defence. The Provisional Legislative Council further passed a motion1 on 26 November 1997. There was an overwhelming support among Members who spoke during the motion debate that the linked exchange rate with the US dollar should be maintained in order to safeguard the well-being of the economy and investors' confidence in Hong Kong dollar. Nonetheless, they also strongly urged the Administration to review the operation of the currency defence mechanism as well as the operation of the financial
The Motion reads "Review of the Operating Mechanism of Hong Kong's Financial Market".

markets especially shortselling activities and the trading of derivatives. The motion also called for actions to enhance the Government's ability to withstand such volatility and strengthen investor education. Supporting the motion, the Secretary for Financial Services reiterated the Administration's commitment to launch a comprehensive review once the regional turmoil had settled.

THE FUNDAMENTAL PRINCIPLES 1.7 The Review has been premised on two fundamental principles. First, we must maintain our position as an open, mature and liquid international financial centre. This is not only because of the mandate in the Basic Law that the Government of the Hong Kong Special Administrative Region shall provide an appropriate economic and legal environment for the maintenance of the status of Hong Kong as an international financial centre. It is also the only way that serves the long term interest of Hong Kong given our external orientation and enables Hong Kong to play our strategic role in the nation's economic development. Secondly, consistent with the object of maintaining the stability of the Hong Kong dollar which is essential for our trade-oriented economy, the linked exchange rate system must be preserved. 1.8 The Review therefore focuses on the technical and practical levels to see if the operation of the existing systems can be further refined or improved. With the exception of margin financing activities2 for which there is a demonstrable need for prudential regulation, we do not propose to introduce drastic changes just for the sake of change. The existing currency defence mechanism has proved effective in maintaining a stable currency. The regulated industries in the banking and securities sectors have withstood the exceptional volatility during this period, and have proven that the current regulatory regimes are functioning well. But we are not complacent. And we have not left a stone unturned in the conduct of this Review.

BACKDROP TO THE REGIONAL FINANCIAL TURMOIL 1.9 In addition to bearing in mind the major principles underlying our financial and monetary policies and fundamental to this Review, we should also see the volatility we experienced in the context of the developments in Hong Kong and in the region prior to the onslaught of the attack. 1.10 Starting from the end of the 1980s, the economic success of Asia became the headlines of international journals and publications. There was a bullish atmosphere all over the region. Strong export growth and ambitious infrastructure projects suggested an "Asian Miracle". Foreign capital poured into emerging economies in the region to reap a return impossible elsewhere. Beneath this track record of high growth, significant
"Share financing", or commonly referred to as "margin financing", refers to the provision of loans against stock collateral for the purpose of financing stock transactions.

structural and systemic weaknesses accumulated in the financial and corporate sectors over time but receiving little or no attention. Worse still, there existed deliberate policies and entrenched political settings stretching those strains. The government policies encouraging open borrowing by domestic enterprises in foreign currencies, the thrust of industrial policy prompting the banks to lend relentlessly to the conglomerates on projects of feeble viability and sometimes obscure and problematic business, and supervisory relationships amongst the corporations, the financial institutions and the regulators were sources of the problem. Then there were the lax supervision on banks, in respect of their excessive exposure to real estates, and the closely webbed linkage between political and business interests, thereby impeding competition and efficiency. Such examples can go on. In short, international speculators may not be singly blamed for destabilising the financial markets and the economy. The financial crises must be analysed for the root causes which are very often entrenched domestic malaise. (This is precisely the approach taken by the international financial institutions in constructing programmes to assist the stricken economies to come out of their crisis.) 1.11 Hong Kong generally has little of such structural and systemic problems. In particular, our monetary system is robust with a well constituted exchange rate regime underpinned by substantial foreign exchange reserves and effective monetary devices, our banking system is well-supervised to ensure prudent lending and decent balance sheet and collateral strength, and our securities markets are properly and smoothly run. The government budget is prudent and debt-free. We have non-interventionist policies whereby private enterprises are left to make their own business decisions, for which they are entirely accountable, and where the Government facilitates, not directs, the development of the economic sector. We have fair and transparent rules and a level playing field, as well as the protection accorded by a sound judicial system coupled with effective enforcement. We have a high degree of flexibility in the economic system, and a highly adaptable workforce. As experience over the years vindicates, all these positive attributes have enabled our economy to weather shocks and vicissitudes efficaciously as they occur. The same attributes should enable us to live through the impact of the regional financial turmoil. 1.12 However, through a period of exceptional buoyancy in the economy and highly bullish outlook for the future, the stock and property markets in Hong Kong had gone to excessive heights. For example, residential property prices rose on average by as much as 80% to the peak in October 1997 in just a matter of two years. The Hang Seng Index gained by 1.4 fold to reach the record high in August 1997 in slightly more than two and a half years, At that record high, the P/E ratios for Blue Chips surged to an average of 17 times, while those for Red Chips and H shares3 were even more dramatic, at 52 times and 30 times respectively. In retrospect, while the fundamentals of the economy at that time remained generally sound, the asset prices had escalated to an almost unsustainable level and well above the underlying fundamentals. This exposed a

Red Chips are stocks which are mainly held by Chinese entities, including state-owned organisations, provincial and municipal authorities, whereas H shares are Chinese state-owned companies listed on SEHK.

weakness making our financial sector so vulnerable to assault. This was particularly so when, amidst the regional financial turmoil, the asset prices and exchange rates of the affected economies around us had already come down so much. It was against this background that the heavy speculative attack on the Hong Kong dollar took place in the latter part of October 1997. It was also against this background that short positions had been accumulated by investors, especially institutional ones, in the futures market.

VIEWS AND ADVICE TAKEN 1.13 In conducting the review, the HKMA had the benefit of advice from a wide spectrum of people with an interest and the capacity in technical issues of this nature, including those in the academic field, here in Hong Kong and elsewhere. The HKMA have also had the benefit of advice from experts in the financial markets, in particular the fund managers and the bank treasurers who deal with currencies day in and day out and have extensive experience working in sophisticated international financial centres. 1.14 There are then the technical experts of the International Monetary Fund (IMF), who happened to be in Hong Kong for the annual Article IV Consultations in the second half of October, when the currency attack occurred. The IMF experts with wide international experience watched closely how our linked exchange rate system worked to ensure exchange rate stability and were thus in a very good position to give us objective advice. They also subsequently on their return to Washington gave useful advice on a number of proposals we had received during this Review. 1.15 Last but not the least, the HKMA had the valuable advice in person from Professor Charles Goodhart of the London School of Economics who is also a member of the Monetary Policy Committee of the Bank of England. Professor Goodhart has long been associated with monetary developments in Hong Kong. Way back in 1983 when the linked exchange rate system was first established, Professor Goodhart, who was then special economic advisor to the Governor of the Bank of England, travelled to Hong Kong, together with David Peretz of the UK Treasury, at the request of the then Financial Secretary, the late Sir John Bremridge, to give a critical examination of the viability of the linked exchange rate system for implementation in Hong Kong. He has kept in close touch with the Hong Kong monetary scene ever since. Indeed, Professor Goodhart served for a number of years as a member of the Exchange Fund Advisory Committee until March 1997 and he is now Special Advisor to the HKMA. 1.16 The review on the securities and futures markets is largely contributed by the Securities and Futures Commission (SFC) who in turn were assisted by the Stock Exchange of Hong Kong (SEHK), the Hong Kong Futures Exchange (HKFE) and the Hong Kong Securities Clearing Company (HKSCC). In the course of the Review, the SFC and the exchanges had widely sought the views and advice from people in the markets, including securities brokers and fund managers. Views expressed and conveyed by the media have also been taken into account. The SFC also had close contact with its

overseas regulatory counterparts throughout the financial turmoil and at several meetings of senior officials of the regulators of the major overseas markets, the SFC discussed, at length, the appropriate measures to respond to the situation as it developed. 1.17 As the Review was progressing, the financial turmoil continued in the region and to some extent in Hong Kong. We have taken into account the issues unravelled in the subsequent events, in particular the defaults of the Peregrine Group and the C A Pacific Securities and its related finance company.

CHAPTER 2 THE REGIONAL FINANCIAL TITRMOTI

SPREAD OF THE CONTAGION 2.1 The regional financial turmoil started off in Thailand in the middle of 1997 and quickly swept through to the rest of South East Asia. In late May, Thai baht came under severe speculative attack. Selling pressure was also felt in the Philippine peso and Malaysian ringgit. On 2 July, the Bank of Thailand announced the adoption of a "managed float" regime for the Thai baht. The value of the baht immediately fell by more than 10%. In the two weeks that followed, the authorities in the Philippines allowed the peso to float and those in Indonesia and Malaysia allowed the rupiah and ringgit to depreciate. 2.2 In August 1997, a second wave of speculative attacks took place. All ASEAN currencies subsequently fell, with the baht, rupiah, and ringgit depreciating more sharply than in July. Major corrections set in across regional stock markets. 2.3 During this time, the Hong Kong dollar remained unaffected4. The stock market, however, experienced a significant fall as a consequence of the tumbling of other regional markets, partly due to the general atmosphere, and partly because Hong Kong remained the most liquid market which allowed fund managers to liquidate their positions in order to meet demands for redemption on regional funds. By 15 October 1997, Hang Seng Index (HSI) had fallen by 20% from its historical high in early August, closing at 13384.

TURMOIL IN HONG KONG 2.4 On 20 October, the New Taiwan dollar depreciated by 5.8%, as a result of the authorities' announcement of allowing the currency to float. This sparked off speculation on the resolve of Hong Kong authorities in maintaining the linked exchange rate with the US dollar. On the same day, Morgan Stanley published the recommendation of one of its analysts to unload Asian stock holdings, including Hong Kong shares.

2.5 On 21 and 22 October 1997, Hong Kong dollar was under heavy speculative attack. There was massive short selling as well as hedging in the forward

There were incidents of selling pressure on Hong Kong dollars in mid July and mid August, but this subsided somewhat in September and early October. See chapter 3 for further detail.

markets. With the ensuing liquidity squeeze and interest rate hike5, coupled with the market's reaction to the Morgan Stanley recommendation, the HSI plummeted 1211 points (10.4%) on 23 October in addition to the loss of 1963 cumulated during the previous three days, closing at 10426. At one point, the HSI was as low as 9766 (1871 points or 16% down). Daily turnover totalled $34 billion6. 2.6 HSI rebounded strongly by 718 points (6.9%) on the following day (24 October), mainly encouraged by the easing pressure on the dollar peg and the climb down of the interest rates. Turnover remained high at HK$30 billion. The market continued to remain highly volatile in the following couple of days. Led by the fall of the HSI, the Dow Jones Industrial Average (DJIA) plunged by a record of 554 points (7.2%) on 27 October, which in turn triggered the largest single day fall of the HSI on 28 October by 1438 points (13.7%). Following the rebound of the DJIA on 28 October, HSI also opened high on 29 October and closed with its largest single day gain by 1705 points (18.8%). The period of high volatility and high turnover continued up to 4 November.

IMPACT ON H O N G K O N G A N D T H E REGION 2.7 In the months that followed, the turmoil continued in the region. As illustrated in the chronicle of events in Annex 2.1, problems in Indonesia and Korea called for the approval of two more rescue programmes (after Thailand) amounting to US $23 billion and US $57 billion, respectively. Nonetheless, the announcement of Indonesia's 1998 budget deepened concerns as to the country's commitment to economic and financial reforms. This triggered further fall in rupiah and other South East Asian currencies, and another round of sell-off across Asian stock markets. 2.8 In all the affected economies, the most conspicuous features of the turmoil were a downslide in the stock markets, an upsurge in interest rates, and, with the exception of Hong Kong dollar, highly volatile exchange rates. The general business climate deteriorated as a result of increased stringency in the banking sector on account of falling collateral values and worsened loan qualities which led to a widespread liquidity squeeze on business. Corporations experienced various degree of difficulties. The knock on effects were exhibited in reduced consumer and investment spending, reduced economic growth and an increase in unemployment. While Hong Kong could not stay immune to this regional contagion, the effects on interest rates and stock market prices are among the lightest felt in the region while the exchange rate of our currency remained effectively unchanged (see Table 2.1 below).

As highlighted in para 1.2 and described in more detail in chapter 3, the overnight interbank rate surged to a record high of 280% for a short period of time on 23 October. Compared with an average daily turnover of $5.67 billion in 1996 and $12.63 billion in the first half of 1997.

Table 2.1: Changes in exchange rates, interest rates and stock market performance in regional markets
Market Exchange rates Short-term interest rates

Stock Market Performance

end 6/97 Hong Kong Taiwan Japan Singapore Philippines Malaysia Korea Thailand Indonesia 7.747

end 3/98 (change) 7.749 (-0.03%) 32.867 (-15%) 133.32 (-14%) 1.6145 (-11%) 38.08 (-31%) 3.665 (-31%) 1385 (-36%) 38.9 (-37%) 8575 (-72%)

end 6/97 6.06%

end 3/98 (change) 5.55% (-8%) 7.6% (-28%) 0.69% (+10%) 4.46 % (+25%) 18.88% (+72%) 10.91% (+48%) 21% (+75%) 24.5% (+55%) 47% (+222%)

Market end 6/97 15197

Indices end 3/98 11519

% Changes in in local uss term term -24% -24%

27.81 114.6 1.430 26.38 2.525 887.9 24.7 2432

10.5% 0.63% 3.56% 10.97% 7.35% 12% 15.81% 14.6%

9030 20605 1988 2809 1077 745 527 725

9091 16527 1629 2238 720 481 459 541

+1% -20% -18% -20% -33% -35% -13% -25%

-15% -31% -27% -45% -54% -59% -45% -79%

2.9 In Hong Kong, there were three incidents of individual financial institutions running into problems. In early November 1997, rumours on several local minor banks had been circulating in the stockbroking circle. This precipitated in a bank run on 10 November on the International Bank of Asia (IBA). The IBA had over the several days of rumours made preparation with its liquidity and was able to deal with the customers' demands. The stock market also reacted sensibly. In fact, on the day the bank run commenced, the Hang Seng Index went up by about 200 points. This had certainly assisted to contain the damage of the run. The ran did not spread to other banks, reflecting the general confidence in the strength of the banking system overall in Hong Kong.
The short term interest rates for Korea and the Philippines quoted are Korea Certificates of deposits 91 days middle rate and Philippine Treasury bill 91 days middle rate respectively. Others are 1-month interbank rates.

2.10 The second incident was the default of the Peregrine Group, one of the largest local investment firms. The Group took on a substantial exposure to certain fixed income investments in the region and the associating exchange risk of currency which became non-performing. This led to the insolvency of the Group and the eventual applications for provisional liquidation on 13 January 1998. 2.11 The third incident occurred with the CA Pacific Group. The default occurred when its finance company subsidiary exceeded its credit limit to the banks as a result of the default of its major debtors and its assets being tied up in a significant nonsecurities related loan. As a result of this financial problem of the finance company subsidiary, CA Pacific Securities, which was a regulated securities dealer and which relied on the former for finance to settle its trade could not perform its obligations with CCASS. This prompted the SFC to apply for the appointment of provisional liquidators in respect of the securities company on 19 January 1998 in order to safeguard the interests of its clients. 2.12 None of these incidents created systemic implications for Hong Kong. Even during and immediately following these incidents, the market reacted sensibly8. They also demonstrated that the regulated entities under both the banking and securities regimes had within themselves the necessary prudential management which provided the protection for their investors. The CA Pacific case, however, highlighted the need to bring hitherto unregulated margin financing activities from outside regulated entities into the regulatory regime.

The HSI dropped 8.7% on 12 January as a result of the announcement of interest rate on the previous Friday and breakdown of negotiation between Peregrine and a potential investor. The market rebounded strongly by 7.4% the next day because of performance in the US market overnight, despite the appointment of provisional liquidators in respect of Peregrine. On 19 January 1998 when the C A Pacific incident occurred, the HSI rose by 5.6%, and it remained at that level on the following day.

10

CHAPTER 3

THE MONETARY SYSTEM

AN ACCOUNT OF EVENTS IN THE MONETARY SECTOR Monetary Scene prior to October 1997 3.1 The monetary scene in Hong Kong was relatively quiet in the first half of 1997, with the foreign exchange and money markets reacting calmly to the death of Mr. Deng Xiao-ping in February and the resumption of the exercise of sovereignty by China over Hong Kong on 1 July. During this period, the Hong Kong dollar exchange rate moved within a narrow range of 7.73 to 7.75. Except on occasions due to IPO activities or month-end settlements, the interbank interest rate for overnight money stayed within the corridor set by the LAF Offer and Bid Rates. In respect of the longer term interest rates, there was a noticeable compression in the spread between the yields of Exchange Fund paper and the US Treasuries of corresponding maturity, partly reflecting the popular "carry-trade" undertaken by international funds in borrowing yen to invest in higher-yield paper. The yield spread in the ten-year area narrowed from around 90 basis points at the beginning of the year to 54 basis points at the end of June 1997. 3.2 Elsewhere in the region, problems were brewing. Balance of payment pressure was building up and the structural problem in financing long term investments with short term capital flows was attracting greater attention. With the US financial markets continuing to outperform many of the Asian financial markets, the balance of risk and return produced a sharp reversal of the capital inflow into the region. Weaknesses in the financial systems of some of the Asian economies, partly the result of inadequate supervision and development of the financial infrastructure, further inhibited the ability of those economies in dealing with the volatility in capital flows. 3.3 Thus financial turmoil in East Asia unfolded with the floating of the Thai Baht on 2 July. Amidst strong selling pressure, the Philippines Peso, Indonesian Rupiah, Malaysian Ringgit and to a lesser extent, the Singapore dollar experienced sharp depreciations in July and August (see the sequence of events in Annex 2.1). Affected by the contagion effect of the regional currency turmoil, the Hong Kong dollar came under speculative pressure on a couple of occasions in these two months. In addition to speculative shorting of the Hong Kong dollar, there were small and medium-sized selling orders, probably associated with equity-related hedging.

11

3.4 The selling pressure subsided somewhat in September and early October. The HKMA started to pick up US dollars as some speculators began to unwind their short positions built up earlier. Moreover, there was some inflow of funds as overseas subscribers and sponsoring banks positioned themselves for a major IPO exercise. However, as financial turbulence swept from Southeast Asia to Northeast Asia in midOctober, speculators mounted another raid against the Hong Kong dollar. Events during the week of 20 October 3.5 In the week preceding 20 October, the Taiwanese authorities decided not to defend the New Taiwan dollar, as a result of which it immediately depreciated sharply by 6.5%. There were rumours in the market that Hong Kong might, for competitive reasons or otherwise, also lose its willingness to defend the linked exchange rate system, encouraged by calls from individual politicians and industrialists to devalue the Hong Kong dollar, to float it or to determine a weaker level for the link. This triggered significant selling in the stock market as many foreign fund managers decided to switch out of Hong Kong. There were also others who felt it prudent to hedge their Hong Kong dollar exposures by selling Hong Kong dollars forward. There were obviously speculative shorting of the Hong Kong dollar as well. The selling pressure on the Hong Kong dollar became significant on Tuesday 21 October in Hong Kong, and throughout London and New York trading. It intensified on the following day (22 October) as further speculative and hedging positions were taken, and there were signs that the banks reportedly were also jumping onto the bandwagon, without bothering as to how they could fund these short positions, on their own accounts and on behalf of their customers. In these two days, the HKMA sold a substantial amount of US dollars in the foreign exchange market. 3.6 The foreign exchange transactions conducted on 21 and 22 October were due to be settled on 23 and 24 October respectively. Insofar as the sale of US dollars by the HKMA was concerned, the settlement would involve the HKMA debiting the clearing accounts of the banks which had sold the Hong Kong dollars to the HKMA. Surprisingly, the banking sector at large did not seem to be aware of the impending shortage of interbank liquidity, notwithstanding repeated reminders by the HKMA to the counterparties on the need to consider how they would make sure that they had adequate funds in their clearing accounts to effect settlement of the deals done with the HKMA. They were also reminded that, in accordance with the discipline of the currency board system, Hong Kong dollars sold to the HKMA could only be recycled on a permanent basis into the market through sales of US dollars to the HKMA. The alternative would be for banks to borrow through LAF on a repeated basis, which was not encouraged, as was clearly laid down in the circular announcing the establishment of LAF on 27 May 1992 (Annex 3.1). Yet overnight HIBOR remained fairly stable and closed at around 5.75% on 22 October.

12

3.7 In the morning of 23 October, the HKMA issued a circular to all licensed banks reminding them, in very much the same spirit as the earlier circular in 1992, of the need to organize their Hong Kong dollar funding prudently and not be overly dependent upon the LAF for last resort liquidity support. The circular also warned them that the HKMA might impose penal interest rates for repeated borrowers to discourage the use of LAF to fund a short Hong Kong dollar position (Annex 3.2). 3.8 As the banks collectively had sold more Hong Kong dollars to the HKMA than they could settle by using their credit balances in their clearing accounts with the HKMA, the banking system was seriously short of Hong Kong dollar liquidity for the purpose of interbank clearing. Given that the HKMA does not normally allow overdraft and the banks did not wish to resort to LAF on a repeated basis, interbank interest rates shot up very quickly as banks were bidding very aggressively for funds in the interbank market. The market was rather one-sided as the major interbank lenders held on to their surplus liquidity in such tense market conditions. There was also a rumour spreading in the market that the HKMA would charge an exorbitant penal rate of 1000% on LAF borrowing. In the absence of offers, the overnight interbank rate kept on rising and reached 280% around noon time in a nervous and thinly traded market. At that time, the Hong Kong dollar exchange rate began to rebound sharply as the exceptionally high interest rates forced many speculators, who required Hong Kong dollar funding, to unwind their short positions. There were also some local corporates selling US dollars to acquire Hong Kong dollar funding either to avoid borrowing at, or to take advantage of the high return available from, the high Hong Kong dollar interest rates. Some corporates also switched US dollars into Hong Kong dollars to buy back their shares in the stock market. 3.9 Under the influence of high interest rates and reversal of outflows, the spot Hong Kong dollar exchange rate rebounded sharply from 7.7500 in the late morning of 23 October to 7.60. Although the exchange rate in the forward market was still on the weaker side of 7.80, with the substantial interest rate premium, it was quite clear that the speculative tide was beginning to turn. The HKMA started picking up US dollars in the spot market. Some of these were for same day value which gave some immediate relief to the tightness in the interbank market. Thus, when the market reopened after lunch, interbank rates soon eased and overnight HIBOR came down to close at 100% - 150%. The HKMA continued to pick up US dollars during the night in London and New York, a clear indication that more speculators were closing out their short positions. On 24 October, the HKMA continued to buy US dollars spot and for same day value. As Hong Kong dollars were reinjected into the system, overnight HIBOR softened to around 7.0% by 10:00 a.m. and closed at 5.0% at the end of the day. The Best Lending Rate (BLR) and interest rates for deposits covered by the Interest Rate Rules of the Hong Kong Association of Banks (HKAB) were nevertheless adjusted upwards by 0.75% on this day. The Aftermath 3.10 After 23 October 1997 there was a steady inflow of funds in the rest of October and November. This can be attributed to three main factors :

13

(a) (b)

speculators reversing their short Hong Kong dollar positions; banks in Hong Kong selling US dollars for Hong Kong dollars to avoid paying the high interest during a period of tightness in the Hong Kong dollar interbank market; and depositors and corporates converting US dollars into Hong Kong dollars to benefit from the high Hong Kong dollar deposit rates.

(c)

3.11 Largely in accordance with the discipline of the currency board system, the purchase of US dollars by the HKMA entailed an increase in the supply of interbank liquidity, as the HKMA credited the clearing accounts of the banks concerned when the foreign exchange deals were settled. The aggregate Hong Kong dollar balance in the clearing accounts of licensed banks, before they made use of LAF to get rid of their excess liquidity, rose significantly from around HK$3-4 bn in mid-October to HK$12 bn by the end of the month, and further to HK$26 bn by end-November. 3.12 Overnight HIBOR quickly eased to just over the Bid Rate of LAF at 4%. Term rates also came down. However, the downward adjustment in the term rates was impeded by market fears of another sudden liquidity squeeze as a result of another currency attack as the financial turmoil in the region continued. One-month HIBOR, for instance, eased from a high of 45% on 23 October to 12% by the end of the month, but remained stubbornly at around that level in early November, notwithstanding a significant inflow into the Hong Kong dollar. The Hong Kong dollar yield curve thus assumed an unusual inverted "U-shape", with a very steep portion running from the overnight to the one-month area (Chart 3.1). Despite the wide gap between the overnight rate and the term rates (of around 5-6 percentage points), banks were conserving liquidity (by lending surplus liquidity short term and giving up yield) and refraining from gapping activities (borrowing short and lending long), which had apparently become highly profitable, because of the unsettling external environment and the alleged uncertainties concerning access to LAF.

14

% per annum
16

Chart 3.1 H K $ A N D U S $ YIELD C U R V E S (as at 7 November 1997)

14 ~ 12 ~ 10 8 6

EF Bills/Notes

US Treasuries
4

2 0

1 Week

1Y

2Y

3Y

4Y

5Y

7Y

8Y

9Y

10 Y

Chart 3.2 1 M o n t h A N D 3 M o n t h HIBOR

16 14 12 10 8
1MH1BOR

0 31 OCT

10NOV

20NOV

28NOV

15

Vo per annum

Chart 3 . 3 HK$ YIELD C U R V E S

October 31, 1997

September 30, 1997

5 1 Week

2Y

3Y

4Y

5Y

7Y

8Y

9Y

10Y

Measures Taken 3.13 With the term rates, crucially in the one-month area, staying at well above BLR, banks without a retail deposit base were finding it rather difficult to conduct their banking business normally. There was understandably great discontent, particularly for those who are relying heavily on interbank funding, and some pressure for pushing BLR higher. Given the continued inflow into the Hong Kong dollar, however, it was felt necessary first to address the anomaly in the interbank market. After consultation with market participants, the HKMA issued a circular to banks on 12 November clarifying the definition of "repeated borrowers" on the access to LAF. Repeated borrowers are defined as those which have borrowed through LAF on eight occasions in any period of 25 days or on four consecutive days in which LAF is open. If a repeated borrower fails to provide a satisfactory explanation of their repeated use of LAF and continues to borrow, a penal rate may be charged on future borrowing (Annex 3.3). This has removed uncertainty as well as anxiety within the banking sector regarding the availability of LAF. 3.14 Helped by the above measure, the term rates in the interbank market started to come down since the third week of November. One-month HIBOR eased to around 7.5% to 8% towards the end of November. Similarly three-month HIBOR declined from 12% at end-October to 9.5% at end-November (Chart 3.2). There remains, however, a considerable differential between the Hong Kong dollar and the US dollar interest rates, which reflects the Asia risk premium. At the longer end of the Hong Kong dollar yield curve, the yield on the ten-year Exchange Fund paper also firmed up during the October episode, but much more moderately when compared with the shorter term interest rates. This is a reflection of market confidence in the long-term stability of the exchange value of the Hong Kong dollar (Chart 3.3).

16

Characteristics of the October Currency Attack 3.15 There are a few characteristics of the October currency attack that are worth special mention. First is the severity of the attack. The magnitude of the selling pressure on the Hong Kong dollar was the largest ever encountered since the inception of the link in October 1983 and it came quickly. 3.16 Second, whilst the attack was largely speculative in nature, given that the Hong Kong dollar was (and still is) the only remaining major freely convertible currency in the region on a fixed exchange rate regime after all others had tumbled, there was a considerable amount of hedging, largely by overseas investors but also by some local corporates, out of Hong Kong dollar assets into foreign currencies to cover exchange risk, as they perceived it. But confidence on the Hong Kong dollar, particularly on the part of the Hong Kong general public, on the determination of the Government to maintain the linked exchange rate system, and on the ability of the HKMA in delivering exchange rate stability remained remarkably high. 3.17 Third, Hong Kong dollar deposits and the money supply did show some modest decline after the October currency attack. Our consultation with bankers revealed that this was not the result of any detectable loss of confidence by depositors. Rather this was the result of a fall in Hong Kong dollar loans (including overdrafts and loans secured upon Hong Kong dollar deposits) under the influence of higher Hong Kong dollar interest rates. Demand for new Hong Kong dollar loans also fell off as uncertainties in economic prospects for Hong Kong, seen in the wider context of the region, arouse greater cautiousness amongst businesses, consumers and home buyers. 3.18 Fourth, the form of the currency attack was a rather typical one through a forward sale of the Hong Kong dollar, which speculators did not have. And this was done by a spot sale of Hong Kong dollars matched by a TT swap for whatever period, typically three or six months, involving the exchange in the use of Hong Kong dollars for US dollars over that period. Thus, a speculator shorting the Hong Kong dollar did not really have to commit any resources other than the credibility of its name. The US dollars that he bought out of Hong Kong dollars were used to swap into the Hong Kong dollars that he was shorting and for settlement. With the spot exchange rate remaining stable, being supported rather passively by the HKMA, the focus of such activity is on the very active, liquid and deep TT swap market. 3.19 The TT swap market is also where the funding risks are priced and transferred. The HKMA had repeatedly been alerting banks operating in the market to be cautious in not inadvertently funding speculators cheaply, thereby exposing themselves to the risk of a liquidity squeeze. A defensive move for banks was to widen the bid and offer spread of the TT swaps. Their alertness or otherwise to this would be reflected in the speed with which the prices of the TT swaps, and correspondingly the interbank interest rates for term money, move. In the October currency attack the banks still appeared slow in attaining a full realization of what was coming, although the prices of the TT swaps did move up significantly at the beginning of the week of 20 October 1997.

17

3.20 Speculators also used to a much smaller extent put options in the Hong Kong dollar. These have the same effect on the markets as the institutions writing the options would "delta hedge" their exposure through a sale of the Hong Kong dollar in the forward or spot market. 3.21 In an attempt to undermine public confidence in the link, those with speculative positions also spread rumours in the market. Some financial institutions involved in these activities even went to the extent of advising their customers to hedge all their Hong Kong dollar assets and foreign currency liabilities, supporting their advice with "analyses" or rumours of one sort or another. A popular story line they deployed during the October episode was that the Government had lost its will to maintain the link as the economy had become uncompetitive in the face of the sharp depreciations of the regional currencies. This regrettably is an inevitable feature of financial markets, even in the most sophisticated financial centres, and it is always a task for the authorities to demonstrate determination and ability to pursue a policy that it believes to be in the best interest of the community. 3.22 Fifth, although widely reported in the press that some speculators operated simultaneously in the foreign exchange market and the Hang Seng Index futures market, there was no clear evidence of such coordinated and concerted effort on the occasion of the October currency attack. Clearly, as interest rates increased in the defence of the Hong Kong dollar, stock prices would tumble and the speculators would also gain from a short position in Hang Seng Index futures if they have one. While there is doubt as to whether individual speculators are big enough to move the markets in this manner, this is a possibility that the authorities must be fully alert to. Thus, the HKMA has since been keeping even closer contacts with the securities regulators in the exchange of information on irregular market activities. 3.23 Sixth, with globalized financial markets encouraged by rapid financial liberalization, financial turmoil has become highly contagious internationally, much more so than generally anticipated. Market corrections are also a lot sharper than expected. These are demonstrated by the fact that the interest rate hike on 23 October sent the Hang Seng Index down by 1,211 points (or 10.4%) on the same day and further by 646 points (or 5.8%) on 27 October. This triggered significant falls in New York and other stock markets around the world. Further in response, the Hang Seng Index shed 1,438 points (or 13.7%) on 28 October. 3-24 Seventh, nevertheless, a downward adjustment in asset markets has been anticipated for some time. They exhibited signs of "irrational exuberance" before the corrections in October. The Hang Seng Index rose by 24% from end-1996 to its peak in early August 1997, with the price earnings ratio increasing from 17.2 to around 19.5 during this period. Property prices on average increased by 43% during the first three quarters of the year, encouraged by rapid credit expansion. Thus when interest rates shot up on 23 October, the corrections in the asset markets, which were somewhat overdue, came sharply and abruptly.

18

Post October Events 3.25 Higher interest rates in Hong Kong and some flight to quality against the background of continued financial turmoil in the rest of Asia led to substantial inflows of funds into Hong Kong in November. Foreign reserves at US$96.5 bn were at a record high at the end of the month. But as interbank interest rates eased under the influence of ample liquidity in the interbank market, coupled with the seasonal increase in the demand for US dollars for backing additional issue of banknotes ahead of the festive season, in December there was a steady outflow of funds. The HKMA sold a considerable amount of US dollars in that month, and the level of interbank liquidity correspondingly fell, in accordance with the discipline of the currency board system, to HK$8.1 bn at the end of December. 3.26 These trends continued into the new year. As the level of interbank liquidity fell further to below zero on Friday, 9 January 1998, a number of banks had to borrow last resort liquidity from LAF and interbank interest rates firmed up, leading to an upward adjustment of HKAB deposit rate and BLR by 0.75%. Sentiment was also affected by sharp falls in stock markets and exchange rates throughout Asia. The weakening of the Yen to 135 against the US dollar triggered another round of sell-offs of Asian currencies. The exchange rate for the Indonesian Rupiah, for example, fell to a low of over 10,000 on 8 January 1998 compared with around 2,500 in the middle of 1997. Korean won depreciated from 890 to 1,800 during the same period. The Singapore dollar also fell, triggering substantial tightening in money market conditions there, with one month SIBOR touching 20%. 3.27 The outflow from the Hong Kong dollar was once again stemmed by the higher interest rate and the shortage of Hong Kong dollar liquidity. By the middle of January, US dollars were gradually sold back to the HKMA for Hong Kong dollars and interbank interest rates resumed its downtrend. Once again the linked exchange rate system has held up well and operated in exactly the manner that it was supposed to.

OPERATION OF THE LINKED EXCHANGE RATE SYSTEM Support for the Link 3.28 The successful defence of the Hong Kong dollar during the October episode has received very positive evaluations from the central banking community and international financial organizations. The IMF strongly endorses Hong Kong's continued commitment to the linked exchange rate system. The IMF team conducting the annual Article IV Consultations happened to be in Hong Kong in the second half of October 1997 and observed closely the events during the week of 20 October. In commenting on the HKMA's defence of the Hong Kong dollar in the concluding statement of the Consultation, the IMF team stated that "appropriately, the authorities have taken forceful action during the past two weeks to tighten significantly monetary conditions, and have successfully demonstrated their ability and commitment to defend the link It is

19

important to recognize that allowing interest rates to rise in response to exchange market pressures is an essential element of the currency board mechanism that lies at the heart of Hong Kong's monetary arrangements. Recent events demonstrate that the system is working exactly as intended ...." (see IMF Report at Annex 3.4). 3.29 Within the local community, there is also a widely held consensus that the linked exchange rate system should be maintained, as it has buttressed confidence in Hong Kong's monetary and financial system. Nevertheless, concerns have been raised as to whether the interest rate pain could have been less severe had the HKMA mounted the currency defence differently. These concerns are understandable given that higher interest rates affect all those who borrow Hong Kong dollars, including the innocent home mortgage payers and others not taking part in the currency speculation. To address these concerns and the proposals for alternative defence strategies that have so kindly been put forward, and encouraged also by the Financial Secretary's call for a review of currency defence, it would be useful to re-examine the framework for the operation of the linked exchange rate system and its development over the years. A detailed technical note on Hong Kong's monetary system is at Annex 3.5. The salient aspects are summarized in the paragraphs below. Currency Board System 3.30 The linked exchange rate system is what is known academically as a currency board system, which theoretically requires the monetary base to be backed by a foreign currency at a fixed exchange rate. The monetary base is normally defined as the sum of the amount of bank notes issued and the balance of the banking system (the reserve balance or the clearing balance) held with the currency board for the purpose of effecting the clearing and settlement of transactions between the banks themselves and also between the currency board and the banks. The monetary base would increase when the foreign currency (in Hong Kong's case, US dollars), to which the domestic currency is linked, is sold to the currency board for the domestic currency (capital inflow). It would contract when the foreign currency is bought from the currency board (capital outflow). The expansion or contraction in the monetary base would lead to interest rates for the domestic currency to fall or rise respectively, creating the monetary conditions that automatically counteract the original capital inflow or outflow respectively, ensuring stability of the exchange rate throughout the process. Evolution of the Monetary Base in Hong Kong 3.31 Insofar as banknotes are concerned, since the inception of the linked exchange rate system in October 1983, the issue and redemption of bank notes, through the note issuing banks, are required to be made against US dollars at the fixed exchange rate of HK$7.80 to US$1. Specifically, Certificates of Indebtedness, which give the authority to the note issuing banks to issue bank notes, are issued and redeemed against US dollar at that fixed rate and for the account of the Exchange Fund.

20

3.32 However, at the time when the linked exchange rate system was introduced, there was no institutional arrangement whereby banks in Hong Kong maintained clearing accounts with the currency board. Thus that part of the monetary base represented by the clearing balance of the banking system was initially not subject to the discipline imposed by a currency board system. Rather, it was subject to the actions of the Management Bank of the Clearing House of HKAB, The Hongkong and Shanghai Banking Corporation Limited (HSBC), in the interbank market, which are mostly dictated by commercial considerations. This anomaly was corrected in 1988 through the so-called Accounting Arrangements which required HSBC, as the Management Bank of the Clearing House of HKAB, to maintain a clearing account with the then Monetary Affairs Branch of Government for the account of the Exchange Fund. Thus the monetary base was only transparently defined then. The Accounting Arrangements were subsequently replaced by another arrangement, on the occasion of the introduction of Real Time Gross Settlement for interbank transactions in Hong Kong towards the end of 1996, requiring all licensed banks to maintain a clearing account with the HKMA for the account of the Exchange Fund. In operating the Accounting Arrangements (1988 - November 1996) and the settlement accounts (since December 1996), the Monetary Affairs Branch and subsequently the HKMA have ensured that the whole of the monetary base is subject to the discipline of the currency board arrangement. These reform measures have thus strengthened the linked exchange rate system of Hong Kong in ensuring exchange rate stability. 3.33 Whilst the HKMA is acutely aware of the need to observe strictly the discipline of the currency board system in respect of activities impacting upon the monetary base, the reform measures do put the HKMA in a position to vary the monetary base directly without the corresponding change in its US dollar holdings. But as demonstrated later on, when these operations are conducted, they are done for good reasons and in a way which does not undermine that important discipline. But this has been the subject of some controversy, notwithstanding the high degree of transparency in the relevant activities undertaken by the HKMA. Mechanics of the Linked Exchange Rate System 3.34 Some believe that the theoretical possibility of banknote arbitrage, taking advantage of any discrepancy between the fixed exchange rate for banknotes and the market exchange rate applicable for deposit balances, and the convertibility between deposit balances and banknotes, should ensure that the exchange rate remains close to the fixed level. However, in a financially sophisticated.economy like Hong Kong, where banknotes account for only a small proportion of the total money supply (5% of HK$M3 as at end-1997), banknote arbitrage has never been carried out on any significant scale ever since the link was introduced and thus had not played any significant role in ensuring exchange rate stability. Quite apart from the transaction costs involved in the cumbersome process of carrying the banknotes around, prior to the revised arrangements adopted in January 19949, a number of banks imposed banknote handling charges on
Prior to January 1994, banknote transactions among banks were settled in US dollars at a fixed

21

banknote transactions with their customers, which eradicated the arbitrage profits. These inhibited the convertibility between deposit balances and banknotes by making it costly. Furthermore, the present institutional framework in the issue of banknotes is such that the fixed exchange rate for banknotes is available only to the three note issuing banks. These factors together make banknote arbitrage impracticable. 3.35 As a matter of fact, the automaticity and potency of the currency board system do not rest in the banknote arbitrage mechanism. Rather, it lies in the interest rate adjustment mechanism mentioned in paragraph 3.30 above. This was evidenced during the October episode. The HKMA sold US dollars and picked up the Hong Kong dollar thrown at it by banks. On the settlement of the foreign exchange deals, the HKMA debited the clearing accounts of the banks concerned, leading to a shortage of interbank liquidity. To be precise, the shortage was created by the banking system selling Hong Kong dollars to the HKMA and not engineered by the HKMA. The resultant shooting up of interbank Interest rates was part and parcel of the auto-pilot mechanism of the currency board system, which proved to be a powerful means to restore exchange rate stability. Clearing Balance of the Banking System 3.36 As discussed in paragraph 3.32, the clearing balance of the banking system is a crucial part of the Hong Kong dollar monetary base. In line with the discipline of the currency board system, the clearing balance will be affected by the flow of funds into or out of the Hong Kong dollar. Specifically, when there is an inflow of funds involving the HKMA passively buying US dollars sold to it by the banks and providing the Hong Kong dollars, the clearing balance of the banking system will rise. This is the result of the HKMA, in the settlement of the deals, crediting the clearing accounts of the banks selling the US dollars to it with the Hong Kong dollars required for settlement. Conversely, when there is an outflow of funds involving the HKMA passively selling US dollars and buying Hong Kong dollars from the banks, the clearing balance of the banking system will fall This is the result of the HKMA, in the settlement of the deals, debiting the clearing accounts of the banks the Hong Kong dollars required for settlement. 3.37 The HKMA adheres strictly to this discipline which in effect involves the clearing balance of the banking system varying with the amount of US dollars sold to or bought from the HKMA at the initiative of the banks. There are, nevertheless, exceptional circumstances in which the HKMA may directly vary the clearing balance of the banking system temporarily without the corresponding change in its US dollar holdings. These operations, as set out in paragraphs 3.38-3.41 below, are carried out for
exchange rate of 7.80. When the exchange rate stayed on the strong side of the link, banks which were net takers of banknotes suffered an exchange rate loss (as HK$TT had a slightly higher value than 7.80). To recoup this exchange rate loss, banks imposed banknote handling charges, which were very unpopular among bank customers. In January 1994, the three note-issuing banks, following consultation with the HKMA, introduced revised arrangements under which banknote transactions among banks are settled in Hong Kong dollar value. In keeping with the discipline of the currency board system, the issue and redemption of banknotes has continued to be carried out in US$ at the fixed rate of 7.80.

22

the benefit of promoting general market stability, having regard to the level of sophistication of present day financial systems. 3.38 Firstly, on occasions when Initial Public Offerings (IPOs) of shares and other large scale Hong Kong dollar transactions risk creating extreme conditions in the interbank market and affecting the stability of the exchange rate, the HKMA may, as and when appropriate, lend to or borrow Hong Kong dollars from the interbank market temporarily to dampen such extreme conditions. This involvement of the HKMA is considered necessary. As there is no statutory reserve requirement on banks in Hong Kong, balances maintained by the banks in their clearing accounts with the HKMA ape solely for the purpose of interbank clearing and settlement. The aggregate clearing balance is small in relation to the Hong Kong dollar money supply (HK$M3 of around HK$1654 bn as at end-January 1998), Hence, a sudden surge in the demand for interbank liquidity caused by, say a large scale IPO, may give rise to unwarranted volatility in interbank interest rates, which may affect the stability of the Hong Kong dollar exchange rate. 3.39 Secondly, the HKMA may enter into intraday Repos of Exchange Fund Bills and Notes and other eligible paper and overnight Repos through the LAF to facilitate the smooth settlement of interbank transactions. The manner in which liquidity is provided through intraday Repos and overnight Repos through LAF does not involve any real conflict with the discipline of the currency board system. Such lending is organized largely through a repo arrangement of paper issued by the HKMA. Such paper, in the form of Exchange Fund Bills and Notes, are liabilities of the HKMA which are backed by foreign currency assets, as the proceeds of such debt issues have largely been switched into foreign currency assets. In any case, with a real time payment system, last resort overnight lending through the LAF though essential is infrequent and the money is to be repaid the first thing in the following morning. Further, the HKMA discourages the repeated use of the overnight facility by charging repeated borrowers, which is clearly defined, very high penal interest rates (see also paragraph 3.13). 3.40 In all other activities conducted by the HKMA which may have the effect of varying the clearing balance of the banking system, the HKMA ensures that such effect is neutralized as the case may be, by recycling or sterilizing Hong Kong dollar liquidity. For example, a transfer of fiscal surpluses from the Government held in commercial bank accounts to the HKMA for the account of the Exchange Fund will be recycled to ensure that there is no effect on the clearing balance of the banking system. This will be done either through the purchase of foreign assets when market conditions permit or through lending Hong Kong dollars in the interbank market. Similarly a drawdown of fiscal reserves by the Government will be sterilized to ensure that there is no effect on the clearing balance of the banking system. This will be done either through the sale of foreign assets when market conditions permit or through borrowing Hong Kong dollars in the interbank market.

23

3.41 In another example, proceeds from the issue of Exchange Fund Bills and Notes not for redemption of earlier issues will be recycled either through the purchase of foreign assets when market conditions permit or through lending Hong Kong dollars in the interbank market. Exchange Rate Level 3.42 Rather than being entirely transparent and passive by always adhering to the fixed level of the exchange rate (7.80) at which it buys or sells US dollars against Hong Kong dollars, the HKMA under normal circumstances leaves the foreign exchange market pretty well alone. This approach is considered appropriate as it allows the foreign exchange market as much freedom as is desirable without interference from the HKMA. 3.43 The consequence of adopting such an approach is that the HKMA will need to decide at which particular level to enter the foreign exchange market to support the exchange rate. This involves judgement by the HKMA as to whether or not the circumstances have become abnormal, for example, when there is speculation, although in practice the judgement is never difficult to make. Furthermore, the intervention level may not be exactly at 7.80, although very close to it. For instance, when there are signs of speculative pressure, the HKMA may establish its presence in the foreign exchange market even though the exchange rate is still on the strong side of the link. 3.44 An important issue to consider is whether the HKMA should continue the present mode of operation or should instead be entirely passive and undertake to buy and sell US dollars at the fixed exchange rate of 7.80. We believe a change to the latter would entail the following downside risks: (a) if the exchange rate is fixed at a single level, the foreign exchange market involving the Hong Kong dollar will largely disappear as trading among banks would be displaced by trading with the HKMA; since there is no scope for the exchange rate to move, the impact of the flows of funds will fall entirely upon interest rates, even though these flows are not related to speculative activities. The resultant greater volatility in interest rates will have important ramifications for financial and other economic activities; greater transparency will mean giving up. the surprise element which is often quite helpful in managing markets effectively as transparency and predictability often make it easy for speculators; and a sudden move to the 7.80 level engineered by the HKMA may be misinterpreted by the market as a weakening of resolve on the part of the Government to accept the interest rate pain.

(b)

. (c)

(d)

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3.45 In relation to the problems set out in (a) and (b) above, a possible alternative is to allow the exchange rate to move within a pre-determined band rather than fixing it at a single level. Once the exchange rate hits the limits defined by the "band", the HKMA would trigger the auto-pilot adjustment mechanism by passively buying and selling US dollars in the foreign exchange market and allow the full money market effects to be felt. However, a significant drawback of this system is that the exchange rate band, regardless of whether it is presented in the form of a spread or a commission rate, would provide clear target points for speculators to attack. The present practice provides no clear target for speculators.

PROPOSALS RECEIVED FROM THE ACADEMICS AND OTHERS Proposals for Reform 3.46 Proposals for reform have been quite forthcoming, no doubt encouraged by the crisis sentiment prevailing, sparked off by financial turmoil in the region, the interest rate pain being a lot greater than expected and the Financial Secretary's public call for a review. There were many proposals received, mainly from the academics, both orally and in writing, with some quite well articulated, privately to us or through the mass media. The main ones include the US$LAF/HK$ put option and dollarization developed by Professor ChenNai-fu and his colleagues in the Hong Kong University of Science and Technology, the insurance scheme proposed by Nobel Laureate Professor Merton Miller and the AEL (Argentina, Estonia and Lithuania) model proposed by Professor Tsang Shu-ki of the Baptist University. The HKMA has convened several technical discussions with the academics to understand the objectives and technicalities of their proposals. We have also consulted Professor Goodhart as well as experts in the IMF on these proposals (see the analysis by Professor Goodhart at Annex 3.6 and letters from IMF at Annex 3.9 & 3.10). This section examines each of the proposals received. US$LAF/HK$ Put Option 3.47 The proposed scheme is designed to achieve exchange rate stability without the use of high interest rates even in the face of a speculative attack on the Hong Kong dollar. Under the proposal, banks may borrow US dollars at LIBOR (plus a small spread) from the LAF using Exchange Fund Bills and Notes as collateral. Furthermore, banks are given an option to repay the US dollars borrowed either in US dollar or in Hong Kong dollar at a fixed exchange rate of 7.80 (see Annex 3.7 for details). 3.48 According to Professor Chen, the scheme achieves both exchange rate and interest rate stability through the following : (a) banks can sell the US dollars obtained through LAF for Hong Kong dollars, thus obviating the need for them to borrow Hong Kong dollars aggressively in the interbank market or at penal rates from LAF to fund a

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short Hong Kong dollar position, and therefore preventing a sharp rise in Hong Kong dollar interest rates; (b) as banks are provided with an option to repay the US dollars borrowed in Hong Kong dollar at a fixed rate of 7.80, the downside risk of currency devaluation is minimized. The efficiency of the interest rate arbitrage mechanism will therefore be enhanced to close the gap between the Hong Kong dollar and US dollar interest rates; and the scheme will give a strong signal to market participants that the Government is firmly committed to the link, as the Exchange Fund will incur a loss when the Hong Kong dollar devalues.

(c)

3.49 The HKMA's assessment, which is supported by Professor Goodhart and experts in the IMF, is that the scheme is unlikely to achieve its stated objective. A technical analysis using the balance sheet approach is at Annex 3.8 and IMF's comments are at Annex 3.9. Our main reservations are summarized below: (a) the scheme may require the greater use of foreign reserves - on top of the sale of US dollars in the foreign exchange market which has the desired effect, in accordance with the discipline of the currency board arrangement, of creating a shortage of Hong Kong dollar liquidity, there will be a further depletion of US dollar reserves as these are lent to the banks through LAF with the possibility that they may be repaid in Hong Kong dollars instead, to the extent that these are not sold back to the HKMA for Hong Kong dollars; the scheme commits the HKMA to providing Hong Kong dollars at LIBOR - when the banks sell the US dollars borrowed through LAF for Hong Kong dollars so as to fund their short Hong Kong dollar position, assuming that they could do so for same day value, it is likely that part of the US dollars may be sold back to the HKMA. Indeed, for the banking system as a whole this is the only avenue of acquiring any net increase in Hong Kong dollar liquidity, particularly when the whole market is already short of liquidity. So the proposal, to a large extent, amounts to the HKMA lending Hong Kong dollars on the security of the collateral, i.e. Exchange Fund paper, as in the normal operation of LAF, except that the interest rate applicable will not be a penal one but a cheap one at LIBOR. In other words, the HKMA will be providing cheap Hong Kong dollar funding to the banks to fund their customers' or their own short Hong Kong dollar positions. The initial shrinkage in the monetary base due to an outflow of funds will be partly or wholly offset, for the duration of the US dollar loans through LAF, which could of course be renewed, and the rise in Hong Kong dollar interest rates will be suppressed. Thus, the self correcting mechanism under a currency board system for interest rates to go up to support the exchange rate when the currency is under selling

(b)

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pressure will not be triggered for as long as the banks could still use the US dollar LAF; (c) the interest rate pain is nevertheless only delayed rather than obviated - the amount of US dollar loans through LAF is limited to the amount of available collateral which is the total of Exchange Fund paper outstanding (around HK$100 bn or US$13 bn). When there is no more collateral, the interest rate effect will set in. The scheme amounts to the HKMA providing cheap Hong Kong dollar funding to the banking system, to the tune of HK$100 bn, or whatever value of Exchange Fund paper outstanding, before allowing the interest rate tool to become operative; public perception - whilst the put option may be seen as a demonstration of strength and confidence in the Administration's commitment on the link, the skilled operators in financial markets will be able to see through the scheme and recognize it as a show of weakness in accepting the inevitable interest rate pain. Further, depending on the tenor of the US dollar loans through LAF, when the loans are drawn the published figures on foreign reserves may show a sharp depletion as the US dollars lent out could no longer be treated as foreign reserves in view of the option to repay in Hong Kong dollars; and the option to repay in Hong Kong dollar will not deter selling pressure the option for banks to repay the US dollars borrowed in Hong Kong dollar at a fixed rate of 7.80 effectively means that HKMA will be writing a put option on the Hong Kong dollar, with a strike price at 7.80, at no cost to the banks holding the Exchange Fund Bills and Notes. However, since the put option is limited in supply and covers only a tiny proportion of total Hong Kong dollar assets, it is unlikely to deflect selling pressure on the Hong Kong dollar. If, on the other hand, the option is issued for an unlimited amount, then the scheme would not be credible because even the sizable foreign currency reserves would not be adequate to cover all Hong Kong dollar assets. In fact, the put option lays all the downside risk of currency devaluation upon the Exchange Fund. It is worse than a forward purchase of the Hong Kong dollars whereby the Exchange Fund can enjoy a profit when the exchange rate is successfully defended and the forward exchange rate of the Hong Kong dollar appreciates.

(d)

(e)

Put Option - First Variation 3.50 A variation of the put option idea which has been put forward requires the offering of currency put options by the HKMA on the open market underwriting the linked exchange rate of 7.8 for, say, up to a year. It is believed that this would provide the strongest proof that the HKMA would not move the link so that interest rates would then return to the normal range, and speculators might give up on the Hong Kong dollar.

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3.51 This indeed would be a very strong and clear policy commitment because the options are legally enforceable contract. But then the question is whether the Government, or any government, is in a position to honour such a commitment when called upon to do so, and therefore whether such a commitment would have credibility beyond challenge. This depends on how the option is structured, in particular whether there is any limit to the amount involved and its pricing. If the purpose is to bring down interest rates, then it should be free and for unlimited amounts. Furthermore, in order not to create a privileged class that could enjoy the facility, it should as suggested be open to everybody. If this is the case, then it would be difficult to establish credibility as the demand for such options would be well beyond what the Government could supply given limited, albeit substantial, foreign reserves, 3.52 Limiting the supply of the options to a credible amount supported by foreign reserves would create a price for the options which could be established through an open auction process. But that auction price or the secondary market price thereafter, would in all likelihood reflect largely the interest rate differential between the Hong Kong dollar and the US dollar in the absence of the options, in which case the intention to bring down interest rates would be defeated. 3.53 It could be made clear that the settlement of the Hong Kong dollars put to the Government must be made through the HKMA debiting the clearing accounts of licensed banks, in which case the adequacy of foreign reserves may be less of a concern. As the options are exercised, the level of interbank liquidity would shrink, at the initiative of whoever that exercises the option, and interbank interest rates would shoot up, as the currency board system dictates (unless the Hong Kong dollar liquidity is recycled by the HKMA), thus strengthening the exchange rate making it unnecessary for the options to be exercised and foreign reserves depleted. But then this would also call into question as whether the options are required in the first place if there is a clear commitment, albeit without the force of law, for the discipline of the currency board system to be adhered to. Put Option - Second Variation 3.54 Yet another variation of the put option idea put forward by Professor Merton Miller is for the HKMA to issue special Hong Kong dollar Exchange Fund paper, involving an issue size of HK$40 bn to HK$80 bn, which is to be redeemable at the option of the holder either in Hong Kong dollars or US dollars at the exchange rate of 7.80. Professor Miller is of the view that the issue of such an instrument may have a significant psychological effect on interbank interest rates as it is a clear demonstration of the Government's commitment to maintaining the linked exchange rate system. 3.55 Indeed, the interest rate that needs to be paid for such special Exchange Fund paper would be close to US dollar interest rates of the same term to maturity. But this does not necessarily mean that other existing Exchange Fund paper not redeemable in US dollars and therefore Hong Kong dollar interbank interest rates would come down. One is talking about creating a new market for a new financial instrument that in practice has no bearing on the existing Hong Kong dollar money market. As discussed in

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paragraph 3.51 the objective of writing the option is to buttress confidence in the Hong Kong dollar exchange rate, the issue size of the special notes should be sufficiently large if not unlimited. To place a cap upon the issue size (HK$40 bn - $80 bn) would only lead to competitive bidding which ends up in the option price reflecting the interest rate differential between the Hong Kong dollar and the US dollar. This will not help to narrow the interest rate spreads and relieve the interest rate pain, other than perhaps the psychological and temporary impact arising from the public perception of an additional demonstration of commitment to the link. Alternatively, the HKMA may fix the price of option. Nevertheless, the determination of the option price and the allocation of the options will inevitably give rise to issues on social equity and complex problems in the implementation of the scheme. 3.56 On the other hand, to offer an unlimited amount of such notes with a limited size of foreign exchange reserves would only put the credibility of the government at risk and further undermine the effectiveness of the scheme in enhancing public confidence in the Government's determination to maintain the link. 3.57 In the final analysis, the interest rate basically adjusts the economy to the level that equilibrates the internal balance and the external balance. Derivatives only shift risk, but do not eliminate risks. Writing options would only shift the risks to HKMA. 3.58 IMF experts concur with our analysis on the proposal. They have stressed the unavoidable use of interest rates to defend the linked exchange rate system and pointed out that "experience of other economics strongly suggests that it is imprudent for the monetary authorities to engage in derivative transactions. Such activities transfer significant risks to the public sector, which can have extremely adverse consequences during periods of market pressure" (Annex 3.10). Put Option - Third Variation 3.59 Another variation suggested in the discussion with the academics is for all the existing Exchange Fund debt to be made redeemable also in US dollars at the exchange rate of 7.80. To the extent that the amount of Exchange Fund debt outstanding is limited (now at around HK$100 bn) and that the foreign reserves held in the Exchange Fund is adequate for redeeming all this debt in US dollars at the exchange rate of 7.80, the yield curve of Exchange Fund debt will come down and track closely that for US Treasuries, at least at the shorter end. But again this may not have any real significance in pulling down the Hong Kong dollar interbank interest rates. The supply of interbank liquidity, and hence its price, under our currency board system is dependent upon the willingness of the banks to sell US dollars to, or buy from, the HKMA. Any depressing effect on the interbank rate would be psychological and possibly temporary, arising from what could be seen as a clear and strong additional demonstration of commitment to the link. But the proposal would give a windfall gain to those holding the existing Exchange Fund paper and is likely to be strongly criticized. Further, to safeguard against a depletion of the foreign reserves of the Exchange Fund, the proceeds of future issues of Exchange

29

Fund paper not replacing redemptions in Hong Kong dollar of earlier issues should not be recycled unless through US dollar purchases. DoUarization 3.60 Professor Chen and his colleagues have further proposed that if the US$LAF/HK$ put option scheme cannot hold back the outflow of funds, the HKSAR Government should enforce doUarization through passing legislation to replace the Hong Kong dollar by the US dollar by re-denominating assets, liabilities, contracts, etc, involving the Hong Kong dollar into US dollar. 3.61 in simple terms, doUarization means a substitution of domestic currency by a foreign currency (which is often the US dollar). It has evolved over a period of time in some central and Latin American countries such as Panama as a response to a loss of confidence over the domestic currency. Inflicted by hyperinflation and persistent currency devaluation, businessmen denominate their goods and services in US dollars; workers demand their salaries be paid in US dollars; and banks offer much lower interest rates for loans extended in US dollars. Over time, the US dollar assumes a predominant role as a medium of exchange and a unit of denominating goods and assets. In another example, the Hong Kong dollar is extensively used in Macau because I long Kong is a much stronger economy and the most important source of its earnings, 3.62 Enforcing doUarization by law is a draconian measure. Recent examples resembling this are the replacement of East German marks by DM and the introduction of the Euro. The former was predicated on political objectives while the latter has taken years of preparatory work and the transitional issues involved have not been fully resolved. 3.63 A number of complex issues will arise if Hong Kong were to pursue the doUarization route: (a) transitional issues - huge legal problems are envisaged as some of the contracts will automatically become void under the force majeure clause. Moreover, at a time when public confidence in the monetary system is waning, depositors may become "extra cautious" and shift their deposits (which have been re-denominated into US dollars) out of Hong Kong, leading to a leakage of bank deposits. Furthermore, because of the risk premium caused by the disruptions in the monetary and banking systems, the interest cost of financing economic activities in Hong Kong is unlikely to come down to the levels in the USA, even though the borrowing is denominated in US dollars; loss of seignior^.- the HKMA is earning a seigniorage on Hong Kong dollar currency notes and coins in circulation, which is derived from the interest income on the US dollars surrendered by the note-issuing banks as backing for their banknote issue. The amount of seigniorage is presently

0>)

30

estimated to be around HK$5.1 bn per annum (outstanding currency in circulation: HK$92.2 bn; assumed rate of return on US dollar assets: 5.5%) and this figure will increase along with the growth in currency in circulation. If the Hong Kong dollar were to be replaced by the US dollar, US dollar notes will circulate instead of Hong Kong dollar banknotes and so the seigniorage of the note issue would accrue to the US rather than Hong Kong; (c) operational issues - as most of the banking transactions would be denominated in US dollars, banks would need to adjust their US dollar liquidity position from time to time. Operationally this will be difficult as the US Fed Funds market, the deepest market in overnight US dollars funds, is closed during the business hours in Hong Kong. Theoretically, it should be possible for the banks to maintain US dollar clearing accounts with the HKMA for the purpose of settling interbank and other transactions. But it is doubtful whether the US authorities would allow US dollar clearing to be conducted by a foreign monetary authority in another time zone; and implications for -"one country two currencies" - the Basic Law provides that the Hong Kong dollar shall continue to be legal tender in Hong Kong after 1997 as an important demonstration of the principle of "one country, two systems". The demise of the Hong Kong currency may contravene the Basic Law.

(d)

AEL (Argentina, Estonia and Lithuania) model 3.64 In contrast to the US$ LAF/HK$ put option scheme which aims at modifying the currency board arrangements to ameliorate the interest rate pain, Professor Tsang Shu-ki of Baptist University suggests that Hong Kong should follow the classical currency board system as practised in Argentina, Estonia and Lithuania (see Annex 3.11 for details). Specifically: (a) Professor Tsang proposes that the convertibility at the fixed rate of 7.80 should be extended from banknotes to the entire monetary base. In other words, the exchange rate at which the HKMA undertakes to buy and sell US dollars against the Hong Kong dollar clearing balances of licensed banks will be entirely transparent, passive and be fixed at 7.80; and as the aggregate clearing balance maintained by licensed banks with the HKMA is very small, given in particular an efficient real time interbank payment system, even small flows of funds into or out of Hong Kong dollar, which are likely all to be conducted with the HKMA as there will be no deviation in the exchange rate from 7.80, would cause sharp volatility in interest rates if the measure set out in (a) is implemented (see also paragraph 3.44). Recognizing this, Professor Tsang also proposes

(b)

31

creating a cushion for the management of interbank liquidity, by the introduction of statutory reserve requirements with averaging provisions over a period of time. 3.65 The HKMA's view, which is supported by Professor Goodhart and experts in the IMF, is that the distinction between monetary arrangements in Hong Kong and the "classical" currency board system are relatively minor (see, for example, the letter from Mr. David Goldsbrough of IMF at Annex 3.9). In relation to the two measures suggested above, the following are worthy of note : (a) the proposed arrangements will not protect the economy from the interest rate pain - as evidenced in the case of Argentina in 1995, the AEL model would not protect the local currency from speculative attack; nor would it minimize the economy from the pain of high interest rates when there is a large-scale outflow. Foreign currency reserves in Argentina dropped by 43% from around US$14 bn in December 1994 to a low of US$8 bn by the end of March 1995. Money supply contracted by more than 13% during this period. Short-term interbank interest rates shot up to 70% in early March and the prime rate almost doubled from 12.4% to 23%; transitional problems in moving the exchange rate from the present levql to 7.80 should not be underestimated - see paragraph 3.44 for a detailed discussion on this issue; the proposed statutory reserve requirement will b$ very unpopular among banks - the statutory reserve requirement amounts to a tax on the banking system (unless market interest rate is paid on the reserves). In recent years, a number of economies (e.g. Switzerland and Canada) have abolished such a requirement. In some other economies, it has been retained mainly for the purpose of controlling the money supply. However, under a fixed exchange rate system, money supply is endogenously determined by balance of payments situation, rather than controlled by the central bank; and the LAF has already provided a cushion to prevent sharp interest rate movements - the concern over an overshooting of interest rate due to the small size of the aggregate clearing balance has been addressed by the provision of liquidity through the LAF. Presently, the outstanding amount of Exchange Fund paper and other eligible private sector debt securities amounted to HK$101 bn and HK$100 bn respectively. About 70% of these papers are held by the banking sector. With the clarification on the definition of "repeated borrowings" in the use of LAF, uncertainty regarding the access to LAF has been removed.

(b)

(c)

(d)

32

Other Proposed Measures 3.66 A number of other suggestions have been received, including an improvement in the coordination among the regulatory authorities in monitoring the activities of the speculators in the foreign exchange, stock and futures markets, more frequent reporting of foreign exchange deals by banks and some drastic proposals such as measures to reduce non-trade related foreign exchange trading. 3.67 The HKMA has long recognized the significance of a close monitoring of the foreign exchange market. For that purpose3 we have constantly been strengthening the monitoring capability of our dealing room and have set up a representative office in New York to keep a close watch of the foreign exchange markets outside the Hong Kong time zone. The HKMA has also required banks active in the foreign exchange market to submit a weekly report on their foreign currency position. Following the implementation of the Real Time Gross Settlement interbank payment system in December 1996, the HKMA can monitor interbank liquidity on a real time basis and is able to ascertain promptly whether a bank has become significantly short in Hong Kong dollars. 3.68 As an international financial centre and a major foreign exchange market, buying and selling of Hong Kong dollar against foreign currencies is a normal part of banks' business. It is not easy for the HKMA and the banks to differentiate between foreign exchange trades for hedging purposes or for supporting normal commercial transactions and trades associated with speculation. Hence, administering selective pain is easier said than done. Moreover, as an open financial system with an absence of foreign exchange controls, it is certainly not advisable to contemplate measures to curtail non-trade related foreign exchange transactions. This would drive financial business out of Hong Kong and undermine our position as an international financial centre. 3.69 The HKMA will remain vigilant of the developments in the financial markets. We will also monitor closely the development of new financial products (including derivatives) and assess their implications for monetary management. As and when appropriate, the HKMA will share market intelligence with other regulatory authorities to ensure prudential supervision of financial markets and financial institutions in Hong Kong.

IMPACT OF THE DEFENCE OF EXCHANGE RATE ON THE BANKING SECTOR Background 3.70 It is important to draw a distinction between the impact on the banking sector as a whole, and the impact on individual banks or groups of banks. While it is true to say, for example, that for the sector as a whole, liquidity, loan growth and profitability have been adversely affected by the currency attack and the defence, not all banks have been affected in the same way and to the same degree. For example, the rise in interbank

33

rates will have adversely affected the profitability of those banks which are net borrowers from the interbank market, but will have had less effect on those which are net lenders to the interbank market. 3.71 A further distinction that needs to be made is between the perception and the reality, the subjective and the objective. Banking is about confidence. It is not enough to satisfy those who are "in the know" that the system and individual banks are sound. It is also necessary to satisfy a number of other parties - depositors, the general public, investors, the press, ratings agencies and other commentators - who may take an excessively cautious or more alarmist view than is warranted by the facts. 3.72 This section looks at the main ways in which banks have been affected by the currency turmoil, differentiating where possible between how different types of banks (e.g. local/foreign, retail/wholesale) have been affected. The areas covered are liquidity, e.g. the availability and cost of funding, the availability and cost of credit (loan growth), profitability, and asset quality. The section concludes with some thoughts on how the public perception of the impact on the banking sector and on individual banks may differ from the reality. 3.73 Before considering the various forms of impact on the banking system, it would be useful to look at the interest rate environment during the period right after the attack on the Hong Kong dollar. On 23 October, overnight interbank rates shot up to an unprecedented level of 280% p.a. at the height of the attack on the Hong Kong dollar. When the attack was over, Hong Kong dollar interbank rates experienced a period of steep yield curve for about two to three weeks. During this period, while the overnight rate was low at 4-5% p.a., term rates for one-month and three-month money were high at around 10-15% p.a., compared with a prime rate of 9.5% p.a. This had considerable adverse impact on banks5 liquidity, funding and profitability. The Impact on Banks9 Liquidity and Funding 3.74 Apart from the need to meet the legal liquidity requirement, banks have to maintain the level of liquidity they feel necessary having regard to current market conditions. Given the uncertainties during the currency crisis, banks have in general reacted by seeking to increase (or at the very least conserve) their holdings of liquidity so as to give them a cushion to guard against any unforeseen events or problems. 3.75 In the case of banks (mainly foreign banks) which have to rely on the interbank market for funding, the initial response of many was to try to insulate themselves from the volatility in the interbank market by extending the maturity of their borrowings from, say, overnight/one week to one month or three months. However, at the same time as the demand for term money was increasing, its supply was contracting, as the local banks, which are the main suppliers of Hong Kong dollar funding, decided also to take a cautious approach and to retain more liquidity by lending out only short term funds, mainly in the form of overnight money. The increased demand (and hence competition) for term money, coupled with a reduced supply, led to the bidding up of

34

term interbank rates, making it prohibitively expensive for many banks to achieve their desired aim of reducing their reliance on short term funding. 3.76 Many foreign banks, therefore, have remained uncomfortable about their funding position, as they continue to have to rely on overnight/one week money to fund their operations. Reliance on short term borrowing, moreover, has caused these banks' liquidity ratio to fall. In order to protect their own position, some foreign banks have bid very aggressively not only for term money in the interbank market but also for term customer deposits. Such behaviour has driven up both term interbank rates and customer deposit rates. The impact on the banking sector has been significant. Not only has the interest cost of foreign banks gone up, but also the local banks have been affected. First, local banks which are net placers of funds in the interbank market have not benefited as much as they might have done from the attractive term interbank rates, because they have wanted to keep themselves liquid and have therefore refrained from lending term money. Second, they were forced to raise their term deposit rates in order to prevent an outflow of deposits. Thus both local and foreign banks have been under a very difficult operating environment during the currency crisis, and this has necessitated that they pay very close attention to their funding and liquidity positions. 3.77 Against the background of high interest rates as mentioned above, the perception arose that banks, and local banks in particular, were suffering from funding problems and incurring losses. No doubt this adversely affected the public's general confidence in the banking system, and later developed into a mini-run on one bank, which was the subject of unfounded rumours. The run was short-lived and subsided quickly due to the strong backing of the parent bank and the Government. 3.78 Banks' liquidity management has been made more difficult by the fact that current market conditions make it difficult (or at least more costly) to make issues of floating rate certificates of deposits (FRCDs). Similarly, plans by a number of banks to securitize residential mortgages and other assets (which would help to improve liquidity) have been placed on hold until market sentiment improves. The liquidity position of the banking sector remains good despite these problems. There has been no evidence of a "flight to quality" by depositors, 3.79 The HKMA continues to monitor the banks' liquidity position closely. The monitoring of local banks' positions is now being done on a weekly basis in order to ensure that any emerging problems are identified early and appropriate remedial action can be taken before a crisis develops. The Impact on the Availability and Cost of Credit (Loan Growth) 3.80 It is apparent that most banks have been reining back loan growth particularly residential mortgage lending - in the current circumstances. There are a number of reasons for this. One is the desire to conserve liquidity, discussed above. Another is that the change in the spread between prime and HIBOR has adversely affected the profitability of lending, and banks are therefore wary of entering into new

35

lending commitments while they are uncertain of the returns on such lending. A third is that banks are anticipating a downturn in the economy and in property prices, and are cautious about lending at the cusp of a downturn, when bad debts can be expected to increase. 3.81 This reduction in the availability of credit has to some extent coincided with a reduction in demand (e.g. demand for mortgage finance has fallen as property prices have shown signs of weakening), and this has lessened the "credit crunch" effect. But demand has not fallen as much as supply, and this has been reflected in a hardening in lending rates, particularly on mortgage lending (rates on which were already increasing as banks became "full" on mortgage lending), and also on other forms of lending. 3.82 The price of lending - the cost to the borrower - has two elements. The first is the "base", generally the prime rate. The second is the "spread" over the base, which reflects the bank's perception of the riskiness of the product and the borrower. The price of both of these elements has increased recently. The base, the prime rate, has increased by 150 basis points (reflecting - although not fully - the increase in cost of funding), while the add-on, the spread, has also increased as a result of banks' perception of the increased riskiness of lending in current circumstances (over 65% of new mortgage loans were priced at 0.75% or more above BLR in December compared with 25% in October). At the same time, competition to lend (which tends to drive down rates) has lessened substantially. Together, these factors have combined to increase the cost of borrowing for most borrowers, both individuals and corporates. 3.83 As regards the outlook for loan growth, with an expected downturn in property prices and turnover, the growth of property lending of the banking sector is expected to slow substantially in 1998 - perhaps from around 30% to around 10-15% (according to preliminary forecasts supplied by the banks to HKMA). In a similar vein, growth of loans related to share financing is also expected to decline in 1998. 3.84 The trade financing business of banks is also likely to be affected. First, as the Hong Kong dollar remains firm relative to the ASEAN currencies, the demand for our exports may diminish somewhat. Second, the weakening of the ASEAN exchange rates might encourage intra-ASEAN trade at the expense of Hong Kong. However, as the ASEANs have to rely on imported raw materials for their export production, the depreciation of their currencies could raise the domestic costs of production and thus offset some of the gain in competitiveness. 3.85 The corporate sector's likely demand for finance is difficult to assess. On the one hand, with market conditions becoming more difficult they may run down inventories and may also delay investment, both of which would tend to reduce their demand for finance. On the other hand, if cashflows deteriorate and if access to funds from alternative sources such as the stock market dries up, there may be greater recourse to bank financing. In such circumstances, however, the banks are likely to be very wary of increasing their exposure.

36

3.86 Although the full implications for loan growth are difficult to assess, it seems likely that there will be a substantial slowdown of growth in 1998 - perhaps to around 10-15%. 3.87 As regards pricing, everything points to a further hardening of borrowing rates. Banks will be more wary of lending, so there will be less competition on rates. Banks will seek to pass on to borrowers their increased cost of funding. And the "risk premium" factored into the price is also likely to increase. 3.88 It should be borne in mind, however, that though the "spread" element of the cost of credit - particularly on residential mortgage lending - has increased sharply of late, this merely represents a return to the more "normal" margins of the recent past, rates having been driven down to historically very low levels by fierce competition over the last year. The Impact on Banks' Profitability 3.89 Obviously the impact on profitability varies from bank to bank depending on the nature of their business and the structure of their balance sheets. Despite the recent problems, the profitability of the local banks for 1997 will, on average, continue to be reasonably good, as the very good performance in the first nine months of the year will help reduce the effect on profitability of the crisis in the region. At an individual bank level, it is our belief that the 1997 profit figures for the local banks will, on average, be both reasonably good and better than expected. 3.90 As regards the foreign banks, the position varies greatly from bank to bank. A small number are likely to suffer not just a drop in profits but an actual loss for the year, due to a combination of factors, including increased funding costs and losses on exposures to regional currencies and economies which are booked in Hong Kong. 3.91 Looking ahead to 1998, the operating environment will clearly be much more difficult, and the profitability of the local banks, particularly the small to mediumsized ones, is likely to be affected. How the banks fare will depend on three factors: interest rate movements; the performance of the local economy ; and the external environment. 3.92 Unless interbank rates return to more normal levels - and stay there - the increased cost of funding will squeeze the banks' profit margins. The effect of this over a full year will be felt in a lower net interest margin and hence in lower operating profits. 3.93 The performance of the local economy is a key factor in two respects. First, a slowdown in growth and downturn in loan demand will adversely affect banks' lending volumes, and hence their income. Secondly, it is likely that there will be some increase in bad debts. The lack of any significant historical loan loss experience makes it extremely difficult to predict how substantial the increase in bad debts will be, but we consider that it is very unlikely to reach the 10-20% of loans which a credit rating agency

37

thinks is possible (the current percentage of problem loans is less than 2% of loans for the local banks). This issue is considered in more detail below. 3.94 The external environment is also key, because to a very large extent the problems being encountered in the Hong Kong banking sector are duejM to the defence of the Hong Kong dollar, but to the fallout onto Hong Kong of problems elsewhere in the region. For example, interbank rates remained high not mainly because of speculative pressure, but because of uncertainties regarding the region as a whole, and particularly its banking systems, as a result of which a premium is now demanded of all banks in the region. Hong Kong banks have been caught up in the regional problems not because they share the same fundamental weaknesses as some other banks in the region, or have large exposures to regional currencies or economies, (which they do not), but simply because they are Asian. As a consequence, any further worsening of the external environment is likely to continue to have a significant knock-on effect on Hong Kong banks - in terms of their cost of funding, and of external/public perception. 3.95 All in all, it is difficult to be too optimistic about the banks*1 profitability for 1998. However, a falloff in profitability is not in itself a significant problem, as the banks have a large capital cushion, and a drop in profits (or even losses) would not place them in immediatefinancialdifficulties. The problem, though, is more one of perception. Everyone has become used to Hong Kong banks increasing their profits year after year which is certainly not the case in most other banking sectors - and so any downturn in profits is likely to be quite negatively received. The Impact on Banks' Asset Quality 3.96 Weaker asset quality will inevitably begin to emerge over time in a situation of higher nominal and real interest rates, a general slowdown in the economy, and tighter cash flows (particularly for marginal borrowers). The question, however, is how severe the deterioration in asset quality and increase in bad debts will be in the current circumstances. There are some grounds for optimism here: (a) Hong Kong banks are going into the downturn in a much stronger position than banks in many other economies. Hong Kong banks' non-performing loans were 2.7% of total loans at end-1996 (and have since fallen to less than 2.0%), compared to 8.8% for Indonesian banks and 7.7% (at end1995) for Thai banks. Hong Kong banks are run on a free-market basis, and are not burdened by policy lending. Hong Kong banks have very prudent lending criteria.

(b)

(c)

38

3.97 Given these factors, the effect of the slowdown in the economy may not be too debilitating - assuming that there is no further deterioration in the environment, and in particular no further increase in interest rates, and that any downturn in the economy is not too protracted or severe. 3.98 There are perhaps four main types of exposure which might be expected to lead to banks incurring some amount of losses in the current environment. (a) First - an obvious one - is exposure to regional currencies and regional economies. However - contrary to popular opinion - the local banks actually have comparatively little exposure of this nature. Local banks' open positions in regional currencies are minimal, and their regional exposure is modest. Moreover, attention has been paid to ensuring that these exposures are valued realistically. Second is exposure to the stock market. There is a little more cause for concern here, as loans to stockbrokers and for share purchase have grown rapidly in the first three quarters of 1997 on the back of the buoyant stock market before the eruption of the currency crisis. However, due to their generally very prudent margin limits and their practice of marking-tomarket and making margin calls on a daily basis, banks have not so fax experienced significant problems arising from the recent decline in stock prices. Most loans continue to be well covered by collateral. In a few cases where the value of collateral has been eroded, the banks have either required the collateral to be topped up or have sold the shares concerned. Even if the stock market falls further, as long as banks remain alert, there is no reason why they should suffer significant losses on such exposure. The HKMA is monitoring banks' margin lending very closely to ensure that such lending is made on a prudent basis. It is worth noting that local banks had little exposure to Peregrine. Third is property-related loans. This is clearly an area of potential concern in the somewhat longer term. Total property lending as a percentage of loans for use in Hong Kong reached 43.3% in the third quarter, of which 23.2% was residential mortgage lending and 20.1% was for property development and investment. Although banks should be protected to a certain degree by their conservative loan-to-value ratios (60% for more expensive properties valued at HK$12 mn or over and 70% for other properties), it is reasonable to expect that non-performing loans will increase in 1998. The degree of impact will depend on interest rate movements and how far and how quickly property prices fall Some comfort is provided by the evidence from previous falls in property prices that borrowers in Hong Kong tend not to default in great numbers, even if they are in a negative equity situation. As long as this holds true for the current downturn in the

(b)

(c)

39

property market, any losses suffered by the banks should not be too alarming. However, while the track record of residential mortgages has been very good, loans for property investment and lending to some smaller property developers may be more vulnerable to an economic downturn. Loans to the large developers should not cause any problems to the banks in view of the strong financials of these developers. (d) The fourth risk area is general commercial and personal lending. One would certainly expect to see the losses on this type of lending to increase in an economic downturn, and there can be little doubt that this will be the case in the current circumstances. But, again, it is difficult to say with any certainty how significant the losses will be. Hong Kong banks' loan loss record is historically particularly good, in large part because their lending practices allow for the fact that a certain amount of volatility in the economy, in the stock market, and in the property market is a cyclical feature of the Hong Kong market. For example, banks pay close attention to borrowers' repayment capability, e.g. to borrowers' income/cashflow when advancing loans, and are not generally too reliant on borrowers providing security - although security is of course taken as a fallback, second source of repayment. This applies to both individual and corporate borrowers. All in all, while some deterioration in asset quality is to be expected, along with some increase in provisions for bad and doubtful debts, there is no sign of an imminent collapse in asset quality. Public Perception of the Impact on the Banking Sector and on Individual Banks 3.99 (a) As mentioned above, Hong Kong banks; do not share the same fundamental weaknesses as the region's problem banks; are subject to more effective supervision and market discipline than the region's problem banks; operate within a legal framework of business laws which, among other things, allows for enforceability of contracts and the realization of collateral; do not have significant financial exposures to the region's problem banks, economies and currencies; do not have significant exposure to the Hong Kong stock market; and

(b)

(c)

(d)

(e)

40

(f)

are reasonably well insulated from the effects of a downturn in the stock market (because of their prudent lending criteria) and in the economy in general, and as long as the situation does not deteriorate further significantly), although there will clearly be some negative effect on their profitability, asset growth and asset quality.

3.100 The picture, therefore, is one of a banking sector which is strong, well capitalized and liquid, and which is coping well in somewhat difficult circumstances. 3.101 The external and public perception, however, can sometimes be somewhat different. In large part this is because people fail to appreciate how different the situation is in Hong Kong compared with that in other parts of the region. There is a tendency to lump all the Asian economies together, and to jump to the conclusion that if there are problems with the Thai and Korean banks, there must also be problems with the Hong Kong banks. This is not in fact the case. However, this misconception, if uncorrected, could in fact precipitate genuine problems for Hong Kong banks. We have already seen two examples of this: the difficult domestic monetary conditions (a regional phenomenon), which have driven up the cost of term funding; and the mini-run on one bank, which was fueled by entirely spurious rumours about the bank being in financial difficulties - not true, but in the circumstances, easy to believe. 3.102 Thus, although the financial position of the banks genuinely remains quite stable, and all the indications are that while there is likely to be some deterioration in their position, this should not be severe, maintenance of confidence in the sector remains a key issue.

REVIEW OF BANKING ISSUES Supervision and Transparency 3.103 Despite the extremely volatile external environment and the internal shock caused by the speculative attack on the Hong Kong dollar, the Hong Kong banking sector has so far emerged relatively unscathed. Indeed, currency stability could not have been maintained without a fundamentally strong and well supervised banking system which is the linchpin of a stable and resilient macroeconomic environment. 3.104 Since the 1980s, Hong Kong has been working on establishing a sound and effective legal and supervisory framework under which banks operate. Over the years, this framework has been constantly updated to ensure that it complies with the highest international standards. This has contributed to the strength and resilience of the local banking system which has weathered many severe tests including the 1989 Beijing events, the 1991 BCCI crisis and the 1994/95 economic downturn. Even the death of Deng Xiao-ping and the resumption in the exercise of sovereignty over Hong Kong in 1997 did not cause any apparent shock to the system.

41

3.105 Transparency of the banking system, which was achieved by the effort in enhancing financial disclosure by authorized institutions since 1994, has also enabled local banks to better deal with the crisis. Such transparency not only has improved the international perception of the Hong Kong banking sector, but also has made the financial strength of local banks widely known to the professional communities. Wliile rumours on several local banks had been circulating in the stockbroking circle for a few days before the run on IBA, analysts and journalists have been very disciplined in not broadcasting the rumours as they were fully apprised of the financial position of these institutions. By the time the rumours reached the general public, IBA had several days to make preparation and was in a much better position to deal with the rumours. The stock market also reacted sensibly. In fact, on the day the bank run commenced, the Hang Seng Index went up by about 200 points. This had certainly assisted to contain the damage of the run. The run also did not spread to other banks in contrast to the case in the 1991 crisis. 3.106 Of course supervision and transparency would not have helped if the banks were not fundamentally sound at a time of crisis. Bank soundness has many aspects. One prominent distinction between Hong Kong banks and many other banks in Asia is the lack of any policy loans. In Hong Kong, banks operate on the basis of commercial principles and are not used to achieve public policy objectives. This means that corporations are not likely to over extend themselves because of the availability of cheap credit, and are therefore less likely to fail in an economic turmoil Market force will also ensure that banks' lending goes mainly into commercially viable uses, thus enhancing the quality of bank assets. Lessons Learnt 3.107 One of the lessons to be learnt from the crisis is that Hong Kong has been working in the right direction overall in respect of the effort to improve the soundness and robustness of its banking sector and such efforts must continue. Having said that, there are other valuable lessons to be learnt from the episode which can help to further improve the working of the banking system and strengthen it against external shocks. While a thorough evaluation can only be done after the turmoil is over, the following preliminary observations may be relevant (a) it is important to maintain a sound, liquid and well capitalized banking system that can withstand short term interest rate shocks which are unavoidable under the currency board mechanism to maintain exchange rate stability. Public confidence in the banking system can deteriorate quickly in such circumstances. The main way for banks, particularly the smaller ones, to withstand such deterioration is to demonstrate that they have strong capital adequacy and liquidity ratios, as well as good asset quality; strong and effective prudential supervision is vital In markets where asset prices rise rapidly, it is important for supervisors to monitor closely the quality of banks' loan portfolios and take relevant prudential measures

(b)

42

where appropriate. Excessive lending to finance overheated asset markets will undermine the resilience of banks in adverse market conditions; (c) it is important to recognize that allowing interest rates to rise in response to exchange rate pressures is an essential element of the currency board mechanism that lies at the heart of Hong Kong's monetary arrangements. Banks should therefore take care not to expose themselves to interest rate risk by providing cheap funding to speculators to short the local currency. Banks which are mainly reliant on time deposits or the interbank market for funding also need to address the interest rate risk of HIBOR-related liabilities and BLR-related assets. While the former can fluctuate wildly, the latter may not adjust in tandem, thus causing margin squeeze on the banks. This may require banks to be more active in their use of interest rate derivatives to fix the cost of their funding (although the limited size of the interest rate derivatives market in Hong Kong makes this difficult). There may also be a shift to greater use of HIBOR-based lending, although the appetite of the personal sector for such products as HIBOR-linked residential mortgages is likely to be limited; enhancement in disclosure and transparency of banks' financial condition should help reduce market uncertainty, thereby limiting the risk of unwarranted contagion. The IMF recommends that we should continue to build on the considerable progress already achieved in this area to include new measures such as increasing the disclosure of banks1 non-performing loans and adopting more specific guidelines for provisioning and income recognition; liquidity management is a critical and crucial aspect of a bankfs operations in a volatile market as the banking system is susceptible to influences of market rumours regardless of whether these are unfounded. We intend to review again the workings of the current liquidity ratio system to determine for example whether more focus should be placed on liquidity in Hong Kong dollars and to further increase the quality of the liquid assets held. The possible need for this is illustrated by the fact that a significant amount of debt securities issued by regional borrowers which would previously have qualified as liquid assets are now unmarketable; and the lack of a safety net, e.g. deposit insurance, has exacerbated the effect of market rumours. While the soundness and transparency of banks are important for decision making by professionals, they may be less meaningful for small depositors, particularly at a time of panic. Even healthy banks are therefore vulnerable to the contagious effect of a run on other banks, whether or not the latter are themselves healthy. The first line of defence, as set out in (a) above, is to be able to display undoubted financial strength and to build customer loyalty. However, deposit

(d)

(e)

(f)

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insurance may also help to reduce the risk of bank runs by providing assurance to small depositors that they will be repaid if a bank fails. It may also give banking supervisors greater freedom to allow problem banks to fail because the impact on small depositors of a liquidation is softened. Finally, a system of deposit insurance makes explicit the cost of protecting depositors and may therefore reduce the risk that the Government implicitly underwrites the banking system. There are however drawbacks. Deposit insurance may give rise to moral hazard, encouraging irresponsible behaviour by both banks and depositors. Insurance also has to be paid for and even if the cost is borne initially by the banks, it will be passed on to consumers. Large banks will also be reluctant to participate in a scheme from which they themselves will not directly benefit. It was for these reasons that the proposal for deposit insurance in Hong Kong was not proceeded with when the issue was last addressed in 1992, However, it has re-surfaced again following the run on IBA and it may be appropriate to revisit the pros and cons of introducing a scheme for deposit insurance in Hong Kong. Consultancy Study 3.108 A thorough and systematic review of these issues will be a top priority for the HKMA in 1998. The issues are complex and will involve both domestic and international dimensions. In Hong Kong, apart from internal review, we will commission a consultancy study early in 1998 to evaluate the strategic outlook for the banking sector for the next five years. The study has been considered well before the current turmoil in regional financial markets. It is intended to enable the HKMA to plan more strategically, proactively and in the longer term, but the recent upheavals have given added emphasis to its necessity and timeliness. The consultants will definitely touch on some of the above identified issues in conducting the study. The International Dimension 3.109 On the international front, Hong Kong will also have a role to play. For example, Hong Kong may need to assist the others in the region to deal with the longer term issues such as improving their banking supervisory systems through the international fora such as EMEAP. Hong Kong has published a self-assessment of its compliance with the 25 Core Principles for effective banking supervision recently published by the Basle Committee. It is hoped that this will induce others to follow suit and indirectly enhance the level of banking supervision in the region. This is obviously necessary for Hong Kong's own benefit as the current turmoil is, at least partly, stimulated by weaknesses in the banking systems elsewhere.

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MACROECONOMIC ISSUES The Competitiveness Issue 3.110 While the stability of the Hong Kong dollar is certainly a welcome development as compared with the sharp depreciation of the regional currencies, there are concerns as to whether Hong Kong is losing its competitiveness by abstaining from competitive devaluation. It is, however, a mistaken view that Hong Kong could improve its competitiveness through a devaluation of its nominal exchange rate. Quite the contrary, allowing the Hong Kong dollar to devalue would entail significant downside risk to the Hong Kong economy. In the first place, as Hong Kong has to import almost all raw materials and equipment, inflationary pressure would accelerate as a result of higher import prices. This would in turn raise the cost of producing goods and services in Hong Kong. More importantly, the uncertainty and disturbance caused by the change in the linked exchange rate system would significantly weaken investment sentiment. Interest rate was likely to stay at a high level as a result of the high risk premium associated with exchange rate uncertainty. The erosion of confidence in the monetary system might also bring irreparable damage to Hong Kong's position as an international financial centre. In short, the price and pain of breaking the link would be much higher. According to an analysis conducted by a major bank in Hong Kong, a switch to a floating exchange rate regime would lead to a sharp rise in inflation to a double digit of 11% and a marked deceleration in GDP growth to 1.5% in 1998. 3.111 During the past 14 years under the link, the Hong Kong dollar has fluctuated along with the US dollar against other major currencies such as the Japanese yen and the Deutschemark. The economy has never lost its flexibility to adjust to changes in the external environment and maintained its competitiveness. Hong Kong has been churning out stable economic growth which averaged 6.1% in real terms per annum between 1983 and 1996. As the economy has now moved into a high value-added services centre, with the manufacturing sector contributing only around 8% of GDP, it should be relatively less affected by the depreciation of the regional currencies. Moreover, stable non-inflationary growth in Mainland China would continue to provide ample business opportunities for Hong Kong. 3.112 It is also important to note that exchange rate is a discipline on both the public and private sector. Under the strong form currency board arrangement in Hong Kong, the government cannot "print money" through fiscal deficits. Indeed, with the single exception of 1994, the Hong Kong government has run a fiscal surplus averaging more than 2% of GDP since the establishment of the link in 1983. The fiscal surplus in 1997/98 was estimated at over 5% of GDP. The discipline on the private sector is also important. The private sector cannot pressure the government to use the exchange rate to gain external trade competitiveness under the fixed exchange rate regime. This ensures that the private sector must adjust to external shocks through productivity and quality, rather than nominal exchange rate adjustments.

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3.113 Various calculations of real effective exchange rates in Hong Kong demonstrate clearly that despite a rising nominal effective exchange rate due to higher domestic inflation, the real effective exchange rate index, as deflated by prices of tradeable goods, adjusts very quickly so that in the trade account, the Hong Kong dollar is not overvalued. Nevertheless, while tradeable goods prices may adjust rapidly to that of the anchor currency, differential in inflation rates may be accounted for by the slowness in adjustment in non-tradeable goods prices. As Hong Kong is now a service economy (with services accounting for 84% of GDP), there is a real challenge for the service sector to adjust to greater external competitiveness. 3.114 Nevertheless, with the correction in property prices and in due course rentals and with the easing in the labour market, the cost of doing business in Hong Kong will be contained. This should help to improve competitiveness. "The Interest Rate Pain" 3.115 There are also concerns as to whether the cost of defending the link is too high, as evidenced in the sharp corrections in the asset markets triggered by the high interest rate. However, it would be unrealistic to assume that the sharp falls in the asset markets could have been avoided had Hong Kong adopted a floating exchange rate regime. The financial turbulence in the neighbouring economies is a regional or even global problem from which Hong Kong cannot be immune. Economies adopting a floating exchange rate regime have seen similar, or even sharper fells in their asset markets, and certainly higher interest rates. Stock indices End-1996 End-1997

%.change Tin local qurrencv fin US$ term')

Thailand Indonesia Korea Malaysia Philippines Singapore Taiwan Hong Kong

831.6 637.4 651.2 1238.0 3170.6 2216.8 6933.9 13451.5

370.0 401.7 351.5 587.9 1869.2 1529.8 8187.3 10722.8

term)
-55 -37 -46 -53 -41 -31 +18
-20

-76 -66 -73 -69 -61 -43

-0.6 -20

3.116 Reflecting the Asia risk premium, term rates in Hong Kong had firmed up. One month HIBOR, for instance, stayed at around 7.5% in late December, as compared with 5.8% in early July. But a similar phenomenon is observed in Singapore which practises a floating exchange rate regime. Singapore's one month interbank rate rose by almost 5 times to 11.9% on 27 October. Though it eased to around 7.5% in late December, it was still significantly higher than the level of around 3.6% in early July (Chart 3.4). This clearly shows that it is incorrect to assume that Hong Kong interest

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rates would remain stable in the face of external shocks if we were under a floating exchange rate regime. Chart 3.4 1-month Hong Kong & Singapore interbank Interest Rates
40 j 353025201510-5f 0 7-97 8-97 9-97 10-97 1-month SIBOR 11-97 12-97 1-98 2-98 1-month HIBOR

3.117 With excessive global market liquidity, the spreads or risk premium in Asia had been driven to excessively low levels. However, once Asian currencies were floated, the exchange rate risk, and the domestic inflation expectations, credit risks and political risks all escalated, requiring massive hedging. This hedging "doubles" the previous over-leveraging in the economy, thus exacerbating the interest rate pressure. 3.118 In some Asian economies, domestic bank credit was equivalent to as much as 60% of GDP and foreign external debt as much as 40% of GDP. Once the currency was floated, the corporate sector wished to borrow domestic currency to hedge the external debt, thus increasing the domestic bank credit demand by potentially the same value. If the central bank defends the interest rate, the pressure is put on the exchange rate. If the central bank defends the exchange rate, the interest rate must rise sufficiently to match the supply and demand. Thus the interest rate went through the roof once the currency was floated. Domestic interest rates must therefore reflect that element of dynamic hedging in an economy that we see from time to time. 3.119 With a fixed exchange rate as a policy target, all the adjustments in the economy would come through interest rates and asset prices. This is unavoidable. While some factors are under our control or supervision, such as the level of fiscal surplus and the solvency of domestic banks, the political risks and the international environment are not. Even though Hong Kong is a victim and not an originator of the Asian crisis, it has

47

been lumped together indiscriminately with some other Asian economies hit by macroeconomic imbalance and the lack of a transparent and rigorous system of prudential financial supervision. Hong Kong's exceptional financial strengths, such as a foreign exchange reserve of USD98.1 billion (the third largest in the world at end-January 1998), a fiscal reserve of about HK$300 billion (USD 38.7 billion), and the absence of any sovereign debt, are often ignored. There is also a great deal of misunderstanding, especially abroad, of Hong Kong dollar's link to the US dollar. It is widely assumed that this is just another form of the conventional fixed exchange rate regime, and is therefore subject to the same weaknesses. The fact that the linked exchange rate is a form of currency board arrangement, with a built-in stabilising mechanism already explained earlier, is often brushed aside. 3.120 To a large extent, the current level of high Hong Kong dollar interest rates are due to the regional uncertainties creating the market perception that the exchange rate risk of the Hong Kong dollar may be significant. As an international financial centre, we cannot insulate ourselves completely against external shocks and we will have to ride those shocks. 3.121 We believe the Hong Kong economy should be resilient enough to absorb the impact of higher interest rates due to the "Asia premium". The economy has been on a strong cyclical upswing in the first three quarters of 1997, with the unemployment rate at a low level of 2.2% and inflation beginning to edge up. At the same time, stock and property markets, until the corrections in October, had been buoyant, with substantial price escalation and rapid expansion of bank credit. The higher interest rates result in a lower growth rate. But on the positive side, the pressure on prices and wages will ease, allowing inflation to ease. The stock and property markets, after the correction, are better underpinned by economic fundamentals. In fact, the lower inflation and property prices will help restore Hong Kong's competitiveness vis-a-vis our neighbouring economies which have experienced sharp currency depreciation. 3.122 It is nevertheless recognized that sharp interest rate movements do impact upon the economy, particularly when the profitability and income generating ability of its activities are dependent upon, perhaps to a larger extent than in other economies, asset prices which are sensitive to interest rate changes and the level of interest rate itself. For example, for the typical household in Hong Kong, the main liability item is mortgage borrowing. As a predominant proportion of those loans are arranged on floating rate terms, the mortgage servicing burden of the borrowers increases when interest rate rises. 3.123 Consideration has already been given to reducing the vulnerability of the economy to interest rate hikes or the ability of the economy to tolerate the interest rate pain through the promotion of fixed interest rate borrowing and lending. Those borrowing money with interest rate fixed for a long period will not be affected by hikes in short term interest rates. Such insulation enhances the pain tolerance level of the economy and hence the resilience of the linked exchange rate system.

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3.124 The creation of the Exchange Fund debt market has provided the market with a benchmark yield curve against which to price long term fixed money. But private sector issuers have not been very forthcoming perhaps because of the lack of interest amongst small savers on investing in long term fixed rate debt instruments. But the forthcoming greater institutionalization of savings through the Mandatory Provident Fund (MPF) should generate more demand to stimulate greater interest in the fixed rate market. 3.125 A useful avenue has also been created on the establishment of the Hong Kong Mortgage Corporation (HKMC). It has all along been the intention for the HKMC to develop the necessary infrastructure to promote fixed rate mortgages as an additional financing option for home buyers. The Corporation is well placed to tap fixed rate funds from long term investors in the capital market to fund the purchase of fixed rate mortgages,, This preference for purchasing fixed rate mortgages by the HKMC should hopefully stimulate banks to consider extending fixed rate mortgages. These efforts should continue and new initiatives explored.

CONCLUSION Background 3.126 Whilst this review was considered timely, it should nevertheless be pointed out that the HKMA, and its predecessors the Office of the Exchange Fund and the Monetary Affairs Branch of Government, had over a long period often years or so in fact been conducting, on a continuous basis, reviews on monetary issues of Hong Kong. Obviously, a currency crisis at any point of time over the highly sensitive period of political transition and beyond was something that all concerned had worked exceedingly hard to avoid. Having regard to this background, any responsible organization in charge of delivering currency stability must operate on the prudent assumption that a currency attack, however unlikely, will occur, for whatever reasons, whether or not connected with political transition. With this mentality, considerable efforts had been spent over the years to strengthen Hong Kong's monetary system to ensure that, as far as possible, a currency attack could be dealt with effectively and decisively without undermining confidence on Hong Kong, in particular on the Hong Kong dollar. The products of this continuous review were in the form of monetary reform measures introduced over the past ten years, largely in quiet times, in preparation for, rather than in response to, crises on the monetary front. As a result, thankfully, the exchange rate remained very stable, notwithstanding an abundance of events in the past ten years or so which could have knocked our currency around. 3.127 It is against this background that the following conclusions of the current review were drawn. They may come as a disappointment to those who have spent quite a lot of their precious time in drawing up proposals which, useful and interesting as they are, had to be rejected for technical reasons or otherwise and in the light of the circumstances that we face. Their efforts are, however, very much appreciated. One aspect of this review which will prove to be of great benefit to the conduct of monetary

49

affairs in Hong Kong in the future is the degree of interest on the subject that it has generated, particularly in academic circles in Hong Kong. Monetary affairs are so esoteric a subject that it has perhaps not been given as much attention as it deserves other than within Government. There will, from now on, hopefully be greater scrutiny on the actions of the HKMA which will only be in the public interest. General Conclusions 3.128 There are, first of all, four general conclusions. The first is perhaps a rather theoretical one concerning the role of interest rates in the .operation of a fixed exchange rate system. Whatever form the fixed exchange rate system takes, be it in the form of a pegged exchange rate system, requiring intervention by the central bank or monetary authority to maintain the exchange rate within pre-determined bands, or a currency board system, as in the case of Hong Kong, requiring largely passive and foil backing of the monetary base, however defined, by foreign currency reserves, the use of interest rates as the stabilizer, whether or not an automatic one, cannot be avoided. This is more so when there are no exchange controls and when foreign reserves, however abundant, are understandably limited in comparison to the amount of funds flowing through financial markets on a global basis and to the value of disposable assets in the domestic currency. While the interest rate is a major and necessary tool, it is not a sufficient one. It needs to be aided by supervisory tools (as discussed in the previous two sub-sections - "impact of the defence of exchange rate on the banking sector" and "review of banking issues") and the need for fiscal prudence which Hong Kong clearly has. 3.129 It is simply not possible for both the exchange rate and interest rates to be fixed. Any attempt to fix the interest rate adjustment, through the use of forwards or derivatives, would lead to a loss in the foreign exchange reserves, as the experience of some Asian economies shows. Higher interest rates are the natural adjustment to match both the supply and demand for domestic currency as well as the equilibrating mechanism between aggregate demand and supply in the currency. When the demand for money temporarily increases due to an external shock (such as the high perceived Asian risks and the need for hedging) and supply of domestic funds remains the same, high interest rates are part of the natural self-adjusting mechanism under a fixed exchange rate regime. But clearly higher interest rates will not be welcomed by those who have to borrow money in the domestic currency, for whatever purposes. It is therefore understandable that there will always be political pressures to keep interest rates down. Such political pressures, particularly when the institutional framework for monetary management is such that they could be effectively applied, are often detrimental to the credibility of monetary arrangements, no matter how theoretically sound such arrangements may be, and there is an abundance of central banking literature and practical examples on the subject in other monetary systems. Political pressures or justifications notwithstanding, it must be realized that shying away from the use of the interest rate tool or not allowing interest rates to rise in response to market forces as the fixed exchange rate system dictates will, in all likelihood, damage the credibility of that system and the organization managing that system. It is often seen as a show of political weakness or lack of resolve in bearing the interest rate pain that was necessary to ensure

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exchange rate stability. Furthermore, any attempt to lower or relieve the interest rate pain requires the use of, or a commitment to make use of, more foreign reserves than was required under the currency board system. This could be counter-productive as foreign reserves are always limited. And the effect will merely be postponing the problem rather than solving it. 3.130 The second general conclusion concerns the manner in which the HKMA conducts TT and Hong Kong dollar money market operations. The linked exchange rate system is of course a rule-based exchange rate system that theoretically does not require the exercise of any discretion in monetary management. Indeed, a rule-based monetary system is designed precisely for the purpose of ensuring that monetary management is not subject to the influence of short term political considerations, as a system that requires discretionary monetary management would. 3.131 However, given the very much monetized nature of modern day economies, particularly for an international financial centre like Hong Kong where the "gearing" of the monetary base to monetary transactions of the economy is very much higher than that in the old days when currency board systems were more widely practised, there are exceptional circumstances under which money market operations to smooth the sharp gyrations in monetary conditions are beneficial to market stability. An example is the IPO activities which in some cases entail a significant upsurge in the demand for interbank liquidity. The question then is whether smoothing operations should be undertaken by the HKMA to inject additional liquidity into the system temporarily to forestall sharp rises in interbank interest rates. 3.132 There is yet another complication in view of the role that the HKMA plays as lender of last resort of the banking system. This is a necessary role, given that all licensed banks maintain clearing accounts with the HKMA - a feature of robust, modem day large value payment systems which has supervisory and systemic implications, and given that the clearing balance of the banking system, which is the essential part of the monetary base, must be on the balance sheet of the currency board - the HKMA. However, the way in which last resort liquidity is provided can be easily misinterpreted as involving the creation or drainage of liquidity through money market operations which deviate from the discipline of the currency board system. 3.133 But perhaps the most debatable issue is whether or not the HKMA should, rather than being totally passive in buying and selling US dollars against Hong Kong dollars in the foreign exchange market at the fixed exchange rate, leave the foreign exchange market alone, as it has been doing so, so that the market exchange rate in practice is allowed to deviate within undefined margins acceptable to the HKMA around the fixed exchange rate level of HK$7.80 to US$1 in accordance with the forces of supply and demand in the foreign exchange market. On this point, the conclusion of the review is that the present mode of operation, which retains a surprise element in the precise exchange rate level the HKMA enters into the market, would actually make it more difficult for the speculators to attack the Hong Kong dollar.

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3.134 The impression we got from the discussion with various groups is that the rationale behind HKMA's occasional presence in the foreign exchange and money markets does not seem to be clearly understood. Certain of its actions in the markets have been subject to all sorts of interpretations. 3.135 As far as is practicable, therefore, the HKMA will ensure a high degree of transparency in its involvement in the markets and for this purpose, paragraphs 3.36 3.43 of this Report sets out the manner in which the HKMA conducts its TT operations and the circumstances in which the clearing balance of the banking system, the crucial part of the monetary base, will be affected. 3.136 The third general conclusion of this review concerns the implications of the operation of a currency board system on the maintenance of banking stability, particularly in times of financial turmoil which, with globalized financial markets and rapid financial liberalization, can be highly contagious internationally. Although the empirical evidence in the history of Hong Kong's monetary system probably does not bear this out in any definitive sense, it can theoretically be argued that a fixed exchange rate system involves greater volatility in interest rates, asset prices and more generally the level of economic activity. This has implications for the stability of the banking system and also the approach to banking supervision in Hong Kong. 3.137 There is obviously a need for great care on the part of the banks operating in Hong Kong to identify and understand the risks involved, having regard to the special circumstances of Hong Kong's monetary arrangements, and manage them prudently. They need to pay special attention to their Hong Kong dollar liquidity and funding, the availability of which under conditions of stress could well be non-existent other than either on a temporary basis through LAF secured upon Exchange Fund bills and notes, and other eligible paper, or from the sale of their US dollar resources. They need also to pay special attention to the quality of assets on their books and not be overly exposed to those which are vulnerable to interest rate volatility, such as property loans. They need to be aware of how their profitability, having regard to their own business profile, could be affected by the type of monetary conditions that may prevail, when there is pressure on the currency, and position themselves correspondingly, with appropriate contingent and defensive strategies in place. And on a more macro level, they need individually to guard against excessive credit growth which may collectively contribute to the development of asset price bubbles detrimental to their long term interest. 3.138 As banking supervisor the HKMA also has an important role to play in working with the banks to promote all these. The fact that Hong Kong's banking system has weathered the storm of financial turmoil in the region so well is a demonstration that all concerned have been working in the right direction overall in respect of the effort to improve the soundness and robustness of the banking sector, Such efforts must continue. 3.139 . The fourth general conclusion of this review concerns how the tolerance level of the economy to the interest rate pain could be enhanced, thus also strengthening the resilience of the linked exchange rate system. It is regrettable that the interest rate

52

pain has to be borne by all borrowers of Hong Kong dollars, including those conducting normal business and the home mortgage payers. Yet it would not be practicable for a system operating largely on auto-pilot to be selective in administering pain. The system is not capable of distinguishing between the innocent parties and the culprits of currency speculation. 3.140 One obvious way for borrowers to be insulated from fluctuations in short term interest rates is to borrow fixed rate long term funds. While the banks do not really have significant fixed rate funding sources, borrowers will need to look to the fixed rate debt market. The development of that market has been well documented and characterized by the Exchange Fund debt issuance programme which started early in the year 1990. A benchmark yield curve for fixed rate Hong Kong dollar for up to ten years has been established, but the enthusiasm with which private sector borrowers in tapping the fixed rate market, pricing their debt against the benchmark, has not been impressive. It is hoped that the institutionalization of savings through the creation of the Mandatory Provident Fund would generate adequate demand for fixed rate Hong Kong dollar paper to make it attractive to prospective borrowers in arranging such issues. Meanwhile, the market development effort of the past eight years should be sustained. 3.141 In this context, the mortgage payers deserve special attention. Clearly they are not currency speculators, but the banks are reluctant to offer fixed rate mortgages because of the lack of long term fixed rate funding. Here the Hong Kong Mortgage Corporation (HKMC) should have a role to play in promoting fixed rate mortgages by expressing a preference to buy such mortgages from banks, thus allowing the banks to off load fixed rate mortgages that are not supported by long term fixed rate liabilities and be more willing to offer this facility to home buyers.

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THAPTER4 SECURITIES AND FUTURES MARKETS

THE MARKETS BEFORE AND DURING THE TURMOIL Market performance prior to financial turmoil 4.1 The extreme market volatility between September and November 1997 was preceded by a period of substantial rises in market turnover and capitalisation and a very significant rise in the Hang Seng Index (HSI) dating as far back as mid-1996. 4.2 1996, particularly its second half, was a bull market for the securities market of Hong Kong. The HSI surged by 26% from 10,681 recorded at end-July to close nearly at its highest level of the year (13,530) at 13,451. Total market capitalisation increased by almost 50% over year-end 1995 to $3,476 billion. Average daily turnover also increased significantly by nearly 70% from $3.3 billion to $5.7 billion. 4.3 The bullish trend continued into the first seven months of 1997, taking the HSI to its life record high on 7 August at 16,673. By the end of August, market capitalisation had increased by a further 25% over 1996 year-end to $4,335 billion. During the period, average daily turnover jumped by nearly two times to $15,9 billion, reflecting that the market had been extremely active before it was hit by the financial turmoil. 4.4 There was, at the same time, a very significant, visible and substantial shift in market interest from "blue chips" to "H-shares", "red chips", and other non-HSI shares. Retail investor participation in the market had also apparently increased substantially since mid-1996, as reflected by the increasing market share of small stockbrokers in terms of market turnover (from 26% in June 1996 to 44% in August 1997) and the corresponding decrease in the market share of large stockbrokers (from 42% to 23% over the same period). The stock market, in effect, changed from a predominantly institutional market to a pre-dominantly retail market from about March to end October 1997. 4.5 During these 22 months since January 1996, the cumulative increase in HSI was over 4,000 index points, or 40%, outperforming by far all major overseas markets10 with the exception of New York, Frankfurt and Paris (see Annex 4.1).

Including Frankfort, London, New York, Paris, Singapore, Sydney and Tokyo.

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The market during the financial turmoil 4.6 On 23 October, coinciding with an attack on the Hong Kong dollar LER and a surge in overnight interest rate (to as high as 280% at one point), the HSI plunged by 1,211 points, or 10.4%, to 10,426. The total trading on that day amounted to $34 billion, which almost doubled the average of the first eight months of 1997. HSI then rebounded strongly by 718 points (6.9%) on the following day (24 October) with a sustained active trading of $30 billion, mainly encouraged by the easing pressure on the LER and the climb down of the interest rates. The market continued to remain highly volatile in the following couple of days. Following the fall of the HSI, the US Dow Jones Industrial Average (DJIA) index plunged by a record of 554 points (7.2%) on 27 October, which in turn triggered the largest single day fall of the HSI on 28 October by 1,483 points (13.7%). Following the rebound of the DJIA that night Hong Kong time, HSI opened high on the following day (29 October) and closed with its single largest day gain by 1,705 points (18.8%). The period of high volatility and high turnover continued into early November. Market movements subsequently settled down and turnover shrank (averaged at $12 billion per day) in the following two weeks from 5 to 19 November. 4.7 Separately on the Hong Kong Futures Exchange (HKFE), a total of 816,615 and 610,632 HSI futures contracts were traded in October and November respectively, representing an increase of 64% and 23% respectively over the average in the first nine months of 1997. 4.8 The market stabilized in the rest of November and the following month. However in early January 1998, because of the economic and political instability in Indonesia, the rupiah devalued dramatically, leading to another round of financial turmoil in the region. The Hong Kong stock market became more volatile again and the HSI fluctuated substantially within the range of 7,900 to 10,800 levels, whereas the average daily turnover was moderate at HK$9 billion. Operation of the market 4.9 Notwithstanding the exceptional volatility and high turnover, the market had been able to continue to operate efficiently and orderly throughout the period. Neither exchanges had reported significant delay in order execution or any problem in transactions processing. While there were increases in incidents of failed trades of SEHK that could not be completed within two days from trade (the so-called "T+2" rule), 99% of the trades could still be settled within four days from trade (T+4). The Hong Kong Securities Clearing Company (HKSCC) also experienced a number of delays in the payment of intra-day marks but no significant problem was resulted. Overall, the settlement and clearing systems of HKSCC continued to function efficiently and effectively and provided a solid foundation for the risk management system of the securities market.

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4.10 The system and risk management procedures of the HKFE and its clearing house worked well during the period. Between September and November 1997, over $36.5 billion in marked-to-market payment was collected from Clearing Members of the HKFE and in addition, the Hong Kong Futures Exchange Clearing Company (HKCC), issued intra-day margin calls in 69 incidences to Clearing Members totalling over $19.2 billion. All calls were met in full before the designated time. Relative performance vis-a-vis other regional markets 4.11 Although Hong Kong has been hard hit by the financial turmoil, our market has weathered the storm strongly and confidently. On a relative basis, we fare strongly vis-a-vis other regional economies11 in terms of the impact of the financial turmoil on the market. Between June 1997 and March 1998, market capitalisation of the SEHK shrunk by 24% while that of other regional securities markets have lost from 15% to 79% in US dollar terms. Peregrine Investment Holdings 4.12 The Peregrine Group was one of the few local financial conglomerates that had successfully established itself in the local as well as overseas markets. Unfortunately, the Group took on a substantial exposure to certain fixed income investments in the region, which, as the regional monetary market became non-performing, leading to the insolvency of the Group, and the eventual appointment of provisional liquidators. The registered business of Peregrine under supervision by the SFC had apparently remained properly run but the Group's failure has prompted the SFC and the SEHK to review the need for more disclosure requirements for investment information of financial conglomerates (see paragraphs 4.143 to 4.145). CA Pacific Group 4.13 Financial problems also led to the default of the CA Pacific Group, which occurred when its finance company subsidiary exceeded its credit limit to the banks as a result of the default of its major debtors and its assets being tied up in a significant nonsecurities related loan. To better protect the interests of the clients, the SFC applied for the winding up of the securities dealing subsidiary of the Group on 19 January 1998. While the incident did not lead to significant impact on the market, it has nonetheless raised general concerns about margin financing (see paragraphs 4,33 to 4.37).

Including Indonesia, Japan, Korea, Malaysia, Philippines, Singapore and Thailand. Please see Annex 2.1.

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THE STOCK MARKET Short Selling and Stock Borrowing and Lending Short selling 4.14 Short selling is a regular and common practice in major international financial centres. While there may be a wide spectrum of views regarding what type of regulation is appropriate, there are two commonly acknowledged points. The first is that the industry, including brokers of all sizes in Hong Kong, generally accepts that short selling is an integral part of a well developed securities market. The second is that there should be sufficient prudential and surveillance measures to ensure the fairness and transparency of such activities and the market efficiency they provide. Short Selling Practices in Major Markets 4.15 Currently, regulators in most major markets have accepted that short selling, subject to regulation, is a legitimate market activity. Of the 12 major overseas markets12 covered by a study by the SEHK, only two (Japan and Singapore) have prohibited short selling entirely. In most of the remaining markets where short selling is permitted, such activity is subject to a partial regulatory regime. In the case of the USA, short selling activities are regulated by the Securities and Exchange Commission (SEC). In Australia and New Zealand, the major regulations include a pre-determined cap on the maximum level of shares that could be sold short and a 20% short selling margin requirement. In exchanges in Canada and the US, short selling is subject to an up-tick rule and is prohibited before secondary offers. On the other hand, Taiwan's short selling activities are restricted to domestic investors only. In the case of France and the UK, short selling is subject to minimal rules or is largely unregulated. Stock Borrowing and Lending 4.16 Stock borrowing and lending (SBL) is an important complementary activity to short selling. A borrower borrows stocks from a lender usually with collateral with an obligation to return the stocks to the lender in future. In a short selling transaction, the short seller can borrow from a lender the stocks required to settle the transaction and deliver them to the ultimate buyer who receives full title of the stocks. At a later time, the borrower must purchase like shares on the market to return to the lender.

12

13

Australia, Canada, France, Germany, Japan, Korea, Malaysia, New Zealand, Singapore, Taiwan, UK, US. The up-tick rules have many variations on the theme that prohibits short sales at a price below current best market ask price. The SEHK had until 1995 a rule based on the best nbid price" but taking the view that an uptick rule is a "clog" on market efficiency, the SEHK has decided to relinquish the rule.

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4.17 SBL is regarded as a cornerstone of the short selling regime because it facilitates the short seller to acquire stocks to cover his short position. This protects not only the short seller, but also his trading counterpart and the market. According to the study by the SEHK mentioned above, in five out of the 10 markets where regulated short selling is permitted, SBL is a pre-requisite for short selling. 4.18 A centralised SBL agency would be helpful in the further development of the SBL business as it improves access of all stockbrokers and investors to short selling, Clearing houses are best placed to serve as this central intermediary given their knowledge of who has uncommitted stocks available for lending and possibly who has the need for them. Their transaction and settlement systems can also help reduce transaction costs involved in a SBL for both the borrowers and the lenders. As in the case of bond securities, the two largest international clearing houses, Euroclear and Cedel, now arrange an average of nearly US$4.2 billion and US$1 billion of loans per day respectively. The intermediation role played by a clearing house also helps address the concern on the part of securities lenders about the creditworthiness of securities borrowers and provides the capability to return the securities upon lenders' demand at any time. Short Selling in Hong Kong 4.19 In 1988, the Report of the Securities Review Committee (SRC Report) recommended that regulated short selling (as opposed to '"naked"" short selling) should be permitted provided that necessary safeguards were in place. Since 1992, submissions had been received from market practitioners for developing short selling in Hong Kong, Subsequently, the SEHK introduced short selling on a limited basis in January 1994. 4.20 "Naked" or uncovered short sales are prohibited in the Stock Exchange of Hong Kong (SEHK) under the Securities Ordinance. Section 80 of the Ordinance provides that a person shall not sell securities at, or through the SEHK unless, at the time he sells them, he or his client (if he is acting as an agent) has a presently exerciseable and unconditional right to vest the securities in the purchaser thereof 4.21 Currently, all short selling activities at the SEHK are subject to the Rules of the Exchange and, in particular, the Short Selling Regulations contained in the Eleventh Schedule to the Rules of the Exchange. The Regulations provide that a short selling transaction can only be made in respect of securities so designated by the SEHK ("Designated Securities"). A SEHK Member selling short either for his own account or on behalf of a client has an obligation to ensure when placing a short sales order that arrangements have been made to ensure that the short sold security will be available upon settlement. The short selling member also has to indicate every short selling transaction when inputting a short selling order as well as on the contract note, and maintain an upto-date ledger for inspection by the SFC, SEHK or HKSCC upon request. Such regulations are intended to enable the SFC and SEHK to closely monitor all exchangebased short selling activities, and to detect, and where appropriate, take action in the

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event of violation of market rules, such as manipulation and/or "short squeeze". The SEHK publishes information relating to short sales in each Designated Security twice a day and also a market summary at the end of each month. 4.22 At the moment, more than 300 securities are designated as eligible for short selling, including all Hang Seng Index (HSI), MidCap 50 Index and "Red Chip" Index constituent stocks, stocks with an associated derivative product and stocks within the "50 non-HSI largest capitalised stocks" category. During the 12-month period ending December 1997, the SEHK recorded a swift increase in short selling activities by almost 6 times of that in the preceding 12-month period in terms of value transacted. It was believed that the increase was partly due to a booming stock market during that period. That notwithstanding, the aggregate value of short selling transactions remained insignificant as compared to the total trading in the stock market (1.2%). Stock Borrowing and Lending Activities in Hong Kong 4.23 In the absence of a centralised stock borrowing and lending facility, institutional brokers and investors have comparative advantage in access to sources of stock lending. As there is a substantial pool of Hong Kong stocks held by international fund managers and custodians outside Hong Kong, and since the overseas SBL market runs a more efficient and less costly service, it is believed that stock borrowing and lending of Hong Kong stocks off-shore is more active than on-shore. The SEHK understands from market practitioners that unreported short selling of Hong Kong stocks based on off-shore borrowing exists both in Hong Kong or overseas. The extent of such practice is however unknown. Stamp Duty Relief for Local Stock Borrowing and Lending Transactions 4.24 In Hong Kong, stamp duty relief for SBL was first introduced in 1989 to help resolve settlement problems caused by temporary delays in delivering stock sold on the stock exchange, for instance, where stock was held overseas. The stamp duty relief scheme was subsequently expanded in mid 1994 to help develop the short selling market introduced earlier that year. That expanded scheme remains effective as of today. 4.25 In essence, stamp duty relief is available in relation to borrowing securities pursuant to a stock borrowing and lending agreement, which is to be used for specified purposes14 and which is returned to the lender within 12 months.

Such specified purposes include, among others, (i) the settling of a sale of Hong Kong stock wherever effected, whether by a borrower himself or another person; (ii) the settling of a future sale of Hong Kong stock, whether agreed or not when such stock borrowing is effected and whether by a borrower himself or another; (iii) the replacement, in whole or in part, of Hong Kong stock obtained by a borrower under another stock borrowing; and (iv) the on-lending of the borrowed stock to another borrower who effects a stock borrowing in respect of such stock on-lent.

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Short Selling During Market Turmoil 4.26 There has been a great deal of conjecture about the connection between short selling and recent market volatility, for example, the allegation that there were some who followed a deliberate strategy of short selling and price manipulation to drive the market down. 4.27 The SEHK reported that it did not detect any improper activities in the short selling transactions reported to it during the period September to November 199715. The SFC also has not detected any link between improper short selling and market volatility during that period. 4.28 In fact, during the two days when HSI declined by over 10%, i.e. on 23 and 28 October 199716, the turnover attributable to shortselling was only 0.4% and 1.6% respectively. 4.29 The current rules which require the reporting of short sales and the restriction of short sales to more liquid and designated stocks appear to be working quite well. The SFC will continue to work with SEHK to make this an area of focus in inspection visits for 1998. 4.30 In some jurisdictions, notably the USA, intermediaries are required to report short positions and these are then aggregated and form the subject of a public report of total short open interest. The SFC will consider this and other reporting mechanisms which will improve information on short selling in the market. Further Development of On-shore Stock Borrowing and Lending ; Stock Borrowing and Lending programme to be provided by HKSCC 431 Notwithstanding some conjecture and rumour, there does not appear to be any reason to believe that short selling and related SBL activities made any material contribution to recent market volatility. It is, however, opportune to review the current arrangements, particularly in light of the repeated complaint that there is not a level playing field due to an under-developed domestic SBL market and the lack of access of some local market participants to overseas lenders. We should address the apparent "imbalance" in terms of access and transparency by bringing more of the SBL activities on-shore.

Annex 4.2 sets out the details of reported short selling during the period September - November 1997. * The HSI declined by 1211 and 1438 points on 23 and 28 October respectively. The total turnover on these two days was $34 billion and $25 billion.

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4.32 To help develop a local SBL market, the HKSCC will introduce its SBL service in early 1999. This centralised SBL service will make on-shore stock borrowing and lending services much more attractive and accessible. By pooling together a much bigger stock of shares than in the overseas SBL market, the HKSCC will provide a more level-playing field for all market participants. It will also help improve the transparency and surveillance of SBL activities in the market. Margin Financing 4.33 Those who rely on margin financing in their securities trading seek to realise larger gain from limited investments on the anticipation of an upward market or price increase of certain stocks. In a free and open market, margin trading, like any other legitimate trading activity, facilitates the price discovery process of the market and contributes to liquidity. Subject to certain regulations, margin trading is permitted in most major overseas markets. 4.34 Investors engaged in margin trading pay a portion of the price of the stock they buy, with the outstanding balance being financed by another source. In Hong Kong, some stockbrokers provide share financing services directly to their clients, but many others do so through a related finance company licensed under the Money Lenders Ordinance but otherwise not subject to regulation by the SFC, HKMA or the SEHK. The practice of using a licensed money lender to operate margin financing business has been in existence in Hong Kong for over a decade but with the introduction of higher financial resources requirements and tighter regulatory standards for securities dealers in the late 1980's and early 1990's, such practice has become more widely used, apparently to take advantage of the much less stringent capital requirements and virtually non-existent regulation and supervision under the Money Lenders regime. 4.35 The absence of regulations, particularly prudential controls, over margin financing operations carried on by companies that are neither Authorised Institutions regulated by the HKMA nor securities dealers regulated by the SFC has generated considerable concerns about the soundness of such operations and their potential impact on the securities market as a whole. The increase in retail participation in the market as well as in trading on margin since early 1997 had prompted the SFC and the SEHK to conduct a series of audit inspections on broker-related finance companies to determine whether the regulated securities dealer continued to be in compliance with all applicable Codes, Rules and Ordinances. 4.36 Notwithstanding the efforts of the SFC and SEHK, one securities dealer, CA Pacific Securities Limited, was so affected by the activities of a related finance company, CA Pacific Finance Limited, that in January 1998 application was made to appoint a Provisional Liquidator. Although the financial problems of the CA Pacific companies were, in large part, caused by non-securities related loans and exposures, their failure has raised general concerns about margin financing.

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437 The incident has affected investor confidence in margin finance companies and led to concerns about the wider financial impact that unregulated and poorly managed margin financing could have on the market. Back in late December 1997, the government had set up an inter-agencies working Group under the Financial Services Bureau to find a long term solution to the problem. Its membership includes the SFC, the HKMA, the SEHK, the Companies Registry and the Department of Justice. The Working Group is mandated to consider whether margin financing operations should be made subject to regulation and, if so, how. In drawing up its recommendation, the Working Group is required to balance between investor protection and market integrity on the one hand and the continuing viability of the securities market on the other. The Working Group has concluded that it is necessary and appropriate from both investors protection and market integrity points of view that margin financing should be subject to regulation. The Working Group considers that the activity of margin financing to investors should be brought within the securities regulatory framework and required to be registered like other market intermediaries. The Working Group has also considered necessary amendments to the Financial Resources Rules to ensure that there would be proper prudential measures commensurate with the liquidity requirements and risk features of margin financing operations and sufficient disclosure requirements. The Working Group also proposes that a code of business conduct be introduced to enhance professional conduct and improve investors protection. Details of the recommendations are contained in the Working Group's report to be published shortly after this report. Relaxation of Takeovers Threshold 4.38 At present, the Hong Kong Code on Takeovers and Mergers requires a party to make a general offer when such party's shareholding in a listed company and the shareholdings of parties connected to him exceed 35%, unless a waiver is granted by the Takeovers Panel. 4.39 There has been suggestion that at such times as last October when the market fell rapidly, and when the prices were driven down by extensive selling, it would be in the interests of both the market and the controlling shareholders of listed companies that the latter be allowed to increase their shareholding without having to make a general offer even if such acquisition increases their shareholding to over the 35% threshold under the Takeovers Code. It was suggested that the controlling shareholders could then place down their holding when market conditions improve and that the acquisitions would have a stabilising effect on a downward market. 4.40 It should be noted that the temporary waiver of the general offer obligation given to controlling shareholders in the post-crash market of 1987 was criticised by the SRC Report, which indicated that "such ad hoc departures from a fundamental principle create undesirable precedents and, in the long term, tend to undermine the credibility of the entire body of rules".

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4.41 The SFC has considered the proposal to temporarily relax the takeovers threshold during a short term market downturn but believe it would not be in the interest of the market to do so. Besides technical issues such as the degree of downturn that would trigger the relaxation, it would also send the message that the regulator was prepared to change the rules of the game in favour of the controlling shareholders even though the shares could be bought back by the companies (under the Share Repurchase Code introduced in 1991) in a manner which is fairer to all shareholders of the company concerned. 4.42 However, under existing company law, shares bought back by listed companies represent a reduction in capital and have to be cancelled. The SFC noted that companies would be more prepared to buy back their shares in the market if such shares could be treated as treasury stock17, and need not be cancelled. 4.43 The SFC has commenced a review of the Share Repurchase Code and the concept of treasury shares* It is anticipated that the proposal will be submitted to public consultation later this year. Amendments to the Companies Ordinance would be necessary if it is decided to introduce treasury shares. Compliance with SEHK Listing Rules 4.44 The Listing Rules of the SEHK (the Rules) have specified functions and responsibilities of different parties and people including directors, professional advisers and sponsors in relation to the initial application for and the continuing listing of the securities of a company. To ensure that the Rules are fully observed and that the listing and continuing listing of the securities satisfy the requirements set out in the Rules, it is essential that such parties discharge their functions and responsibilities properly. To ensure their compliance with the Rules, the present sanctions, which comprise public reprimand or at best, "cold shouldering' have become inadequate. We welcome the initiative by the SEHK and SFC to embark on a study to put 'teeth' in the listing rules and look forward to their specific recommendations in this regard. Options under consideration include seeking powers to apply to the courts for injunctions and mandatory orders to enforce the listing rules. Where statutory backing is required for these measures, we are prepared to work on necessary legislative proposals for submission to the first Legislative Council as soon as possible. The Hang Seng Index 4.45 The Hang Seng Index (HSI) is compiled and managed by the HSI Services Limited (HSIS), which is a private company wholly-owned by the Hang Seng Bank. It is a market value weighted index in which the contribution of each individual stock to the index is weighted against the total market value of all stocks in the HSI. Currently, the

"Treasury shares" refer to issued shares held by a company but not cancelled as a result of share repurchase. Such stock is available for reissue, but receives no dividends and carries no votes.

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HSI has 33 constituent stocks, comprising companies of the finance sector, utilities sector, properties sector and commerce and industry sector. Selection Criteria for the HSI Constituent Stocks 4.46 Constituent stocks of the HSI are selected by a rigorous process of detailed analysis, supported by extensive external consultation. To be eligible for selection, a company: must be among those that constitute the top 90% of the total market value of all ordinary shares listed on the SEHK; must be among those that constitute the top 90% of the total turnover on the SEHK;

15 i
should have a listing history of 24 months ; and should not be a foreign company as defined by the SEHK.

From the many eligible candidates, final selections are based on the following factors of consideration: the market value and turnover rankings of the companies; the representation of the sub-sectors within the HSI directly reflecting that of the market; and the financial performance of the companies.

Representativeness of the HSI 4.47 The representativeness of the HSI can be measured by its coverage of the market capitalisation and turnover of the whole stock market. In the past years, the aggregate market value of the HSI constituent stocks has been maintained at approximately 70% of the total market value. The turnover of HSI also tends to cover over 60% of the total market turnover but the ratio can be much lower, or higher, at times of heavy trading depending upon increasing retail or institutional investor participation. 4.48 The representativeness of the HSI can also be reflected by its resemblance with the movements of the All Ordinaries Index (AOI) compiled by the SEHK, which includes all listed stocks on the SEHK. For the whole year of 1997, the correlation coefficient between the HSI and the AOI was 0.97. Even during the October market turmoil, the daily change of the HSI still closely matched that of the AOI.
This has since been relaxed. See paragraph 4.49 below.

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Review of the HSI 4.49 HSIS reviews the HSI on a regular basis. The HSI was last reviewed on an overall basis in the last quarter of 1997, taking into account many views expressed during the financial turmoil. The review has considered the composition of the HSI and concluded that, with a market capitalisation coverage of about 70%, the HSI had been able to achieve its prime objective of reflecting the performance of the Hong Kong stock market. However, in light of the structural changes to the local stock market with more listings of H shares and China-affiliated corporations (or so-called "red chips"), the HSIS has decided that the constituent stocks will no longer be required to have a substantial business presence in Hong Kong, but they should not be a foreign company as defined by the SEHK. Moreover, the rule of 24-month listing history will be flexibly applied in order to permit companies meeting all other selection criteria to be included in the HSI. As a result of this policy, China Telecom (HK) and Shanghai Industrial Holdings Ltd. were added to the HSI with effect from 27 January 1998, which has increased the HSFs market capitalisation coverage to above 70%. 4.50 To meet the increasingly divergent and sophisticated needs of different investors and taking into account the experience in overseas stock markets, the HSIS review also recommended the introduction of a wider-based index called the Hang Seng 100 Index (HSI00). The HSI00 will select, from all listed companies on the SEHK, the top 100 ones in terms of both market capitalisation and turnover to be its constituent stocks. The Hang Seng MidCap 50 Index will also be revised to cover the next 50 top stocks outside the HSI00. The HSI00 is expected to achieve a market capitalisation coverage of more than 80% and a turnover coverage of close to 80%. Both the HSI00 and the New Hang Seng MidCap 50 Index have recently been launched in April 1998. The HKFE has indicated that they would conduct a market feasibility study on the introduction new index derivatives based on the HSI00 similar to the current HSI futures and options. Weighting ofHSBC 4.51 With a market value of over HK$500 billion, which doubles the size of the second largest HSI constituent company, it is inevitable that the weighting of HSBC Holdings in the HSI will by far be larger than the rest of the constituent stocks. However, as HSBC Holdings is extensively traded and commands a wide investor base, it would be problematic to remove it from the HSI. Nor is it appropriate and justified to arbitrarily reduce its weighting. Cross-ownership 4.52 The HSIS review also studied the issue of cross-ownership. The review acknowledged that cross-ownership among HSI constituent stocks may lead to doublecounting of market capitalisation and affect the number of shares actually available for public trading. However, it also recognised that it is a phenomenon which reflects the

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realities of the stock market. The HSIS review examined various proposals to reduce the extent of cross ownership but considered none would be viable without upsetting the continuity of the HSI as a reference point for stock market performance. Nonetheless, the HSIS has undertaken to continue to consider the issue and take into account a stock's corporate relationship in the selection of HSI constituent stocks. SFC's Observation 4.53 HSI has been widely used by local and overseas financial institutions and fund managers as a benchmark indicator of the Hong Kong market performance and is the underlying instrument of a number of derivative products both traded on the exchanges and the over-the-counter market. As the underlying index for exchangetraded derivatives, the HSI meets international standards of size, diversity, and representativeness. Stock indices being a commercial product, the market is free to develop new indices should there be such market demands. With due respect to the fact that the HSIS and the HSI are commercial entities outside the supervision of both the SFC and the Exchange, the SFC will continue to discuss with the HSIS on possible improvement to the HSI in the future. Futures and Derivative Markets 4.54 One of the major developments in the financial markets in recent years has been the growth of derivative markets. A derivative product derives its value from the underlying asset. In the case of financial derivatives, such underlying assets may include stocks, bonds, interest rates, currencies and stock indices. Usually the trading of derivatives is conducted through a mechanism involving deposit and margins which facilitate the leverage of high value return with the outlay of minimal capital. 4.55 The leveraged and future nature of derivative products make them an effective and popular instrument for hedging. As the awareness of the usefulness of derivatives as risk management tools has grown, so have the derivative markets themselves. Apart from being an important risk control instrument in portfolio management, derivatives also add liquidity to the underlying cash market and increase the diversity of its product base to satisfy the needs of different investors, The availability of derivative instruments enables the market to allocate risk better by allowing risks to be priced as reflected in the market value of those derivative instruments. The importance of derivative markets in the whole financial sector and the economy often reflects the extent to which the market has developed. As the economy becomes more advanced, the role of institutional investors in the market will also become more important and the demand for efficient risk management investment instruments will increase. 4.56 Derivative warrants and HSI futures are the two most successful exchange-based derivative products in Hong Kong's markets. Like the other derivative products, their history is relatively short. The HSI futures were traded for the first time in

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the HKFE in May 1986 and derivative warrants were not introduced to the SEHK until 1989. Now, both of them are traded actively in Hong Kong. 4.57 During the financial turmoil, there were concerns about the role that derivative products played in the local market and the relationship between the derivative market and the cash market. 4.58 Bearing in mind the risk management principles of most institutional investors, there are reasons to believe that index-based derivative contracts actually reduced volatility on the cash market during the most volatile of trading days by providing a means to market participants to reduce their exposure to stocks at times when the stock market had become relatively illiquid but extremely volatile. 4.59 There are also suggestions that the "derivative market drove the cash market". The question of the relationship between the derivative market and the cash market is a complicated one. 4.60 Indeed, there are a number of interrelationships between the derivatives and the underlying "cash" markets. 4.61 First of all, both act as price discovery markets but with concerns at different point of time: the cash market establishes a price for individual stocks or other items for the present while the derivative market establishes a price in relation to the underlying item on a future date. The future aspect in derivative markets means the price will often vary from that on the underlying market to reflect the time factor in settlement and other cost factors such as intervening dividends or interest payments concerning the underlying. 4.62 In the case of stock index futures, due to their leveraged nature, a single transaction can create a long or short position for a basket of stocks comprising the index. These futures are used by market participants who, for example, wish to quickly hedge a portfolio of stocks, or create the near equivalent of a portfolio of stocks, or who believe the entire market may move up or down due to changes in economic fundamentals or simply because of the participants' expectations. At the same time, the underlying market reflects the activity of buyers and sellers who want physical delivery in a short time. At any given time, one market may "lead" the other. 4.63 When the two markets diverge, arbitrage trading will close the gap to a large extent. This is because the two markets will eventually converge to the same value when the futures expire and there is no longer a difference in cost of carry or in the time frame when the transaction must be completed. This activity causes the two markets to converge, but may still leave a gap which reflects the costs for arbitrage transactions such as the cost of finance, stamp duty, exchange and clearing fees, as well as the market risk between transaction and settlement. These last factors mean that in Hong Kong there

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could be several hundred index points difference between the futures and cash markets depending on prevailing market situations. 4.64 Both stock and derivatives markets reflect the interactions of buyers and sellers, some of whom want delivery now and others who wish to deliver in future or not at all There are many additional factors at work in the markets and many of these might be described as involuntary. For example, a mutual fund or unit trust manager may be forced to sell stocks to meet redemption requests. He or she may also be required to invest newly received funds into the market. In the case of margin accounts, the margin lender will demand that a margin call be met if the market falls and if this is not met the stocks in the account will be liquidated. This may also be done by banks who hold stock as collateral for loans. Some investors place so-called stop loss orders to be acted upon if the market falls a certain amount. When the market falls these are automatically executed without further instructions from the investor. Also significant are the hedging activities of futures and options market makers and warrant issuers who according to their own risk management models must buy or sell shares in response to market moves. In addition, there are also arbitrageurs, as described above, who profit from very short intervals of imperfections between and across markets. Thus, a move in the market may trigger additional moves even though this may not in itself have changed investors'' expectations. 4.65 Hong Kong has probably the most developed and active derivative market in Asia, commensurate with the advanced status of our financial market and our overall economy. This is also in line with our status as an international financial centre where institutional investors play an important role in market activity. With the development of the local institutional fond industry particularly with the establishment of the mandatory provident fund system, efficient hedging instruments such as the financial derivatives will play an even more important role in the future development of our financial market. 4.66 A mature, developed and well regulated derivative market has already been and will continue to be an indispensable sector of our financial market. While we still maintain a leading edge over other regional markets, competition to become the regional derivative market centre has become more intense and a number of regional markets such as Taiwan and Singapore have already declared their ambition to further develop and open up their derivative markets. Hong Kong cannot afford to take a backward step at this juncture if we are to maintain our reputation as the regional financial centre and a major derivative market. It is however important that we take the opportunity of the financial turmoil to review the operation of the derivative market with a view to identifying areas where improvements are warranted. In the rest of this section, the Report will separately address the key issues raised during the financial turmoil concerning the two major derivative products in Hong Kong, namely the HSI futures and derivative warrants.

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Trading System of Hong Kong Futures Exchange 4.67 Over 20 products are being traded at the HKFE. HSI futures and options are the two major HKFE products that are traded on the open outcry system and the rest on the Automated Trading System (ATS). 4.68 Open outcry system is an auction system used by futures and options exchanges under which all bids and offers are made openly by public, competitive, shouted prices, assisted by hand signals. A transaction is completed if a buy and a sell match in price and quantity. This method is favoured by many derivatives exchanges including the largest financial futures exchange of the world, the Chicago Board of Trade19, since it allows all concurrent bids and offers to be heard at the same time and provides liquid, efficient order execution mechanisms for the market. 4.69 In November 1995, the HKFE introduced the Automatic Trading System (ATS) for its currency futures product, the Rolling Forex. The system has proved to be effective. A total of 24 products of the HKFE, including Red Chip Index futures and options, are now traded on the ATS. 4.70 The ATS is a real-time computerised trading network allowing all subscribing HKFE members to interact with the system simultaneously through off site workstations at the members' premises. It is widely acknowledged that ATS has the capacity to provide spontaneous price dissemination and superior audit trails. In addition, automated trading provides standards for order execution that are based exclusively on time and price priority. It further enables better risk management especially in a scenario of growing volumes. 4.71 During the financial turmoil, some of the views were expressed with regard to the futures and option markets operated by the HKFE. Some of the views suggested that the current open outcry trading system, under which HKFE's HSI products are traded, did not provide sufficient transparency and did not support efficient market monitoring functions essential for the Exchange to keep track of market activities, especially at times of exceptional volatility and heavy trading. 4.72 In the Review, the SFC has considered those concerns. It believes that transparency on the HKFE compares well with other open outcry markets around the world, including the major derivatives futures markets. It is also satisfied that volatility during the period of September to November 1997 was not made more extreme by the open outcry system at the HKFE.

Although at present the Exchange is actively considering the comparative merits of an open outcry system and an automated trading system

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4.73 The Review has further examined various factors pertinent to the choice of trading system for a market, including system fairness, liquidity, efficiency, transparency and market development. The trading system will to a large extent dictate the promptness and comprehensiveness of information dissemination in the market, which in turn will affect market transparency, efficiency and fairness. A trading system which enhances and facilitates deal matching will also improve liquidity and thereby contribute to the efficiency of the price discovery process. In an increasingly complicated and busy market, there will also be increasing demands on the trading system. 4.74 In considering the case of the HKFE, the Review has made reference to the previous experience on automation of the HKFE, including the migration of stock futures and HIBOR futures from open outcry to ATS, and the trading on ATS of Rolling Forex and more recently the Red Chip index futures and options. The Review noted that experience so far has been positive and suggested that the ATS environment has worked well and there have been no complaints that trading or market operations have been adversely affected by the migration to the ATS., 4.75 At the same time, we acknowledge that there are practical issues to be fully considered in any decision of full automation of HKFE trading, i.e. to "migrate" the trading of HSI futures and options, from open outcry to ATS, These practical considerations in particular include: the capacity and robustness of the ATS hardware and software; and the capability of members to integrate into the new system.

4.76 In conclusion, We believe that trade automation is the right direction to which the Hong Kong securities markets including the HKFE should move and supports the policy decision of the HKFE Board of Directors in April 1997 to introduce all its future products on the ATS. We also welcome the recent decision of the HKFE to migrate its HSI futures and options trading from open outcry to ATS. It is estimated that the preparation for migration will take a period of 18 to 24 months to allow sufficient lead time for system development and staff training by HKFE members. A recent paper submitted by the HKFE to the Financial Affairs Panel of the Provisional Legislative Council at Annex 4.3 provides further information on the consideration of the system migration project and costs and operations involved. 4.77 As a near term objective to improve its efficiency in reporting bids, offers and transaction prices for existing HSI products, the HKFE has allocated more than $10 million for a project to enhance the price dissemination system that supports open outcry trading before the migration takes place. The first phase of the project to increase the computer capacity for price dissemination has already been completed. Futures-related price information can now be disseminated to members more speedily. The second phase of the project involves the upgrading of the clearing and trade reporting system . The HKFE aims to implement the second phase by mid-summer 1998.

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4.78 The HKFE has also engaged consultants to review the operations of its technology systems. The review will include, in particular, a risk assessment of vital operating systems and their back-up. 4.79 Separately, in response to market suggestion, the HKFE also extended the trading hours of stock futures from 3:55 pm to 4:00 pm with effect from 2 February 1998. The extension will align the trading hours of both the SEHK and the HKFE and preserve the symmetry of the trading hours of related products in the two markets20. Margin Level for HSI Futures Contracts 4.80 The margining system is an important component of the overall risk management system of the Hong Kong Futures Exchange. A client buying or selling a HSI futures contract is required to place a minimum deposit (initial margin) with his/her broker and to maintain it at a minimum level (maintenance margin) for as long as his/her position remains open. The objective of margin is to provide proper level of protection to the brokers as well as the clearing house against market risks. 4.81 Working with the other risk management features such as daily mark-tomarket and continuing monitoring of account position, margining seeks to cover the daily market risk up to a certain theoretical level of safety. At times of exceptional market volatility such as the period during last October and November, additional marks would be collected within a day, known as intra-day marks, to maintain the clients' margin level. 4.82 The determination of the margin level is essentially a statistical process based on past volatilities derived from the underlying HSI, usually over a period of 60 days. Under a normal statistical distribution, the margin is set at a level sufficient to cover over 99% of the previous daily movements within the 60-day period. In addition to past market volatilities, a number of other factors are also taken into account, such as: divergence between historical and implied volatilities market liquidity market open interest in futures and options intra-day price changes in the cash and futures markets imminent and known price-sensitive events

20

As a result of the extension of the trading hours by HKFE in respect of the stock futures market as well as the same operation by the SEHK in respect of its stock and stock options markets (from 3:55pm to 4:00pm), the trading hours of the major related products of the two Exchanges are now synchronised.

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impending market holidays

4.83 The margin level is routinely reviewed by the HKFE. In feet, between September and November 1997, the margin level for HSI futures had been revised upward four times, from $50,000 (initial margin) per contract to $90,000 per contract, sufficient to cover a movement of 1800 points or about 17% of the HSI futures level at the closing of November 1997. 4.84 We have examined how the margining system had worked during the financial turmoil. We noted that (a) all margin calls including intra-day marks were met in full by Clearing Members of the HKFE within the designated time of one hour; the margin level has been revised upwards four times according to the existing adjustment formula Initial Margin/HSF movement covered Maintenance Margin/IISF movement covered Average HSF movement during the preceding 60 days" 237 points 255 points 326 points 434 points

(b)

Date of revision

3 September 30 September 24 October 7 November

$60000/1200 points $70000/1400 points $75000/1500 points $90000/1800 points

$48000/960 points $56000/1120 points $60000/1200 points $72000/1440 points

(c)

HKCC, unlike clearing houses in London and New York, requires margins on gross positions. For example, a Clearing Member holding 999 long futures contracts and 1,000 short futures contract is required to deposit margin for 1,999 contracts, instead of one. This provides greater immediate assurance that market participants have the financial ability to support their market activity; and The margin level charged in Hong Kong is among the highest when compared with the other major overseas markets. For example, a $80,000 margin with effect from 1 April is equivalent to 14% of the HSI futures level at the close of market on 31 March. The margin level charged in London is about 6%, Sydney 6%, New York 5% and Tokyo 16%.

(d)

21

The maximum HSF movement was 2160 recorded on 29 October 1997,

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4.85 While we are generally satisfied with the mechanism for the determination of the margin level, we consider it also important that, at times of exceptional market volatility, flexibility must be maintained to ensure that swift adjustments to the margin level are possible. We have also taken note of certain views which argued for a higher margin level for HSI futures trading and invited the SFC and the HKFE to consider them. We have also asked SFC and HKFE to continue to explore refinements to the mathematical models by capturing factors such as using a shorter time period (e.g. 15 days or 20 days) to enable faster reactions to market conditions; intra-day movement (instead of close-to-close movement); and increase in the range of intra-day and close-to-close movements and exceptional volatility in the recent past; and

Derivative Warrants 4.86 The emergence of derivative securities including derivative warrants in the world financial market in recent years has made sophisticated investment planning possible for institutional and specialised investors. They also contribute to market liquidity and provide efficient instruments for risk control in portfolio management. 4.87 Derivative warrants give its holders the right, but not the obligation, to purchase (call warrant) from or to sell (put warrant) to the issuer at a predetermined price (exercise price or strike price) a specified number of specified securities (the underlying securities). A derivative warrant may also be settled in cash instead of physical stocks if its terms so permit. 4.88 In Hong Kong, the derivative warrant market was first established in 1989 on the SEHK. It is under the supervision of the Listing Division and the terms of a derivative warrant are governed by a listing document. The issuer of the warrant provides its own capital or its parent company guarantees to support its obligations. 4.89 In line with its overall policy to develop the derivative products market in Hong Kong, in August 1996 the SEHK revised the Listing Rules including relaxation of the issuing criteria for both single share and basket derivative warrants. The requirements on the market capitalisation of the underlying shares were relaxed. 4.90 Coupled with a rising market, the one year period following the revision of the listing rules saw substantial growth in the market. The number of listings of derivative warrants on the SEHK and their market value compared as follows -

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Date August 1996 September 1996 August 1997 September 1997 March 1998

No. listed

135 152 378 423 252

Market Value (HK$bn) 12.9 16.5 57.0 49.3

5.5

4.91 Since the financial turmoil, the number of listings of derivative warrants on the SEHK and their market value has decreased. This is a natural development as the majority of derivative warrants in Hong Kong are call warrants. These call warrants enable investors to profit from a rise in prices of the underlying securities. The current downturn of the market does not favour the issue of call warrants. This relatively quiet period also gives room for the SEHK and SFC to review the regulation of the derivative warrants market. 4.92 The listing of derivative warrants on the SEHK is principally subject to Chapter 15A of the SEHK Listing Rules. The Rules set out the suitability and "qualifications" of issuers, derivative warrants and underlying securities, as well as the application procedures and requirements involved. 4.93 During the financial turmoil, there were suggestions that the hedging strategies of issuers of derivative warrants had increased volatility and exaggerated the fall of the prices of the underlying stocks. 4.94 The SEHK Listing Rules require that issuers of derivative warrants satisfy the Exchange that they are "financially suitable" to issue derivative warrants and have sufficient risk management measures in place to cover their obligations. One of the common hedging strategies used by issuers is the buying or selling of the underlying stocks, either in the cash market or over-the-counter. According to these hedging strategies, when prices on the cash market go up, the chances of call warrant holders to exercise their warrants increase and the issuers of call derivative warrants are likely to increase their holding of the underlying shares to cover their positions. When prices drop, the issuers are likely to undertake an opposite transaction, i.e. to unload their holdings that are no longer needed. During the recent market turmoil, prices dropped so significantly that the buying demand in the market became very thin. Consequently, issuers would have found it difficult or even been unable to sell the underlying stocks. In the circumstances, they might use other derivative instruments such as HSI futures for hedging purposes. 4.95 Depending on market conditions, the impact of warrant-related hedging activities by issuers on the cash market of the underlying stocks could vary and under certain situation, such as that over the financial turmoil, such activities could have contributed partly to short term volatility.

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4.96 This Review believes that measures are called for to improve the listing mechanism of the derivative warrants with a view to reducing the impact on the cash market. We however do not share some of the more extreme views expressed in the market that derivative warrants should as a result be banned altogether. 4.97 In January 1998, the SEHK formed a Working Group to review and draw up recommendations with regard to the current listing rules and practices for derivative warrants to further develop the market in a way consistent with the requirement of a sound regulatory framework. 4.98 The Working Group has identified a number of areas for review and consideration, including: the financial suitability and other requirements for issuers and guarantors; ways and means to reduce the impact of the issue of a derivative warrant on the cash market, if any, at the time of launch and expiry; other criteria in addition to fulfilling a minimum public float by which stocks are considered as being suitable underlying stocks for the issue of derivative warrants and basket derivative warrants; the listing process and placing guidelines; introducing standard terms and conditions of warrants to better protect warrant holders interests; the transparency of the warrant market; and comparison study with international practices. The principal recommendations made by the Working Group include: requiring of warrant issuers to be either regulated entities or institutions with acceptable credit ratings; increasing the net asset requirement for regulated issuers from $1 billion to $2 billion; requiring an issuer to demonstrate its capability of issuing and managing derivative warrants;

4.99

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maintaining the existing balloting system22 on the launching of derivative warrants and further spreading out the expiry dates of derivative warrants of the same underlying stocks to reduce the possible impact of the related hedging activities by the issuers on the cash market; requiring the method of settlement, in share or in cash, to be specified at the time of launch and shortening the period for physical settlement as far as possible; establishing disclosure requirements regarding the placement of the warrant by issuers; and increasing transparency of the derivative warrants market, including information relating to basket warrants, distribution of warrants upon placement and removal of inactive warrants from listing,,

4.100 The Working Group has considered whether there should be a limit on the value of derivative warrants issued by an issuer in relation to its net asset value but concluded on the basis of reference to international practices and local market structure that such limit is neither meaningful nor practical. However, consideration is being given to the feasibility of some quantitative and qualitative criteria to serve as early warning signals to facilitate regular monitoring by the SEHK, 4.101 The Working Group has also recommended to repeal the existing rule that would permit, albeit on an exceptional basis, the issue of derivative warrants in respect of stocks that fall short of the minimum public float capitalisation requirement but have exceptionally high turnover. Further consideration will be given to possible improvements to the rules governing the suitability of the underlying stocks. 4.102 Separately, the SEHK has commenced displaying information relating to basket warrants on the trading terminals since early April. Such information may include (a) details of the underlying stocks; (b) basket value; (c) premium; (d) gearing; and (e) a reference index for each derivative warrant. The SEHK will continue to work on measures that could contribute to increased transparency of the derivative warrant market. 4.103 The SFC has considered the recommendations of the SEHK Working Group and is in agreements on matters of principles. The SEHK and SFC will further examine some of the specific recommendations more closely. In parallel;, possible changes in the Listing Rules necessary for implementing some of the above

2 2

Under this system, whenever conditions are satisfied to permit more than five issues of derivative warrants on the same underlying shares, a maximum of five issues (selected by ballot) will be launched in every 7-day launch period, subject to the requirement that the warrants issued in each of these launch periods do not exceed 10% of the public float of the underlying securities. Inactive warrants refer to those either already fully exercised or bought back by the issuers.

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recommendations are also being proposed. We expect the SEHK will submit the relevant changes to the Listing Rules to SFC before mid 1998.

MARKET SURVEILLANCE AND RISK MANAGEMENT Alleged Market Manipulation 4.104 During the financial turmoil, there were allegations that speculators had reaped substantial profits from the futures market through manipulation across the cash, futures and currency markets. Some alleged that international participants in the Hong Kong market had used the futures market to manipulate prices on the SEHK. Others suggested that international participants took advantage of the expected HKMA reaction to an attack against the Hong Kong dollar, and the impact this would have on liquidity and interest rates, which in turn would be reflected in stock prices, by first taking a short position in the index futures market and then launching an attack against the currency. Still some other allegations suggested that some brokerage houses had taken short positions in the market with a view to benefiting from anticipated announcements of their financial and economic analysts to liquidate or reduce Hong Kong stock holdings. 4.105 In the reporting of these allegations in the financial press and in general discussion in the community, the terms 'speculation and manipulation' have been used very loosely. Before we can proceed with a fruitful discussion therefore we must be clear as to the contexts under which these terms are used. 4.106 It is in the nature of financial markets that present and future prices are in a constant state of flux. Provided that this state of flux is driven by the ordinary forces of demand and supply based upon fair and complete dissemination of underlying information, then regulation should not interfere. 4.107 Thus, no system of financial regulation regards it as wrong for a person to buy or sell any financial instrument in any amount either simply or in any combination as long as that person does not distort the ordinary forces of demand and supply . So, it is perfectly legal in our jurisdiction to speculate, which is no more than taking a view on the eventual direction of a market. Similarly, it is perfectly legal to arbitrage between cash and futures markets - which is no more than taking advantage of a temporary difference of perceptions between the traders of one market as against the other. Further, it is perfectly legal to hedge, which is no more than to insure against a rise or fall in a cash market by taking an opposite direction in a futures market or vice versa.

24

Of course other obligations of disclosure of interests and the requirement to make a general offer may arise.

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4.108 The concern from a regulatory perspective is whether information is made accurately and efficiently available to all market participants, so that the financial risks associated with any investment can be detected and managed in time; and whether investors have sufficient information to allow them to understand the risks associated with each investment product and are capable of bearing these risks. At the same time, we are also concerned whether the market as a whole, and the regulated entities themselves, are able to withstand the accumulated risks of the market. 4.109 Where, however, a person seeks to deliberately distort the forces of demand or supply in a market or seeks to exploit confidential "inside" information or otherwise attempts to manipulate a market in order to profit from trading there or in another market (or possibly in the over the counter markets), regulatory action will be called for. The SFC has analysed the allegations that manipulative actions of this type partly contributed to the volatility in late October, Whilst not entirely ruling out such conduct as a possibility, the SFC believes that neither was a significant contributor to volatility on the SEHK or the HKFE. 4.110 The IMF, in its World Economic Outlook Interim Assessment published in December 1997 also notes that it does not believe that speculators had been major contributors to the recent market volatility in this region. The report in particular pointed out that "[P]erhaps [the speculators] determined the timing of the eruption of crisis in some countries, but investors who profited did so primarily by correctly perceiving unsustainable and inconsistent economic policies, financial sector fragilities, and overvalued property and stock markets", 4.111 The SFC had inquired into the above mentioned allegations and reviewed the trading activities, open cash and futures positions and securities holdings with the HKSCC of the most active firms in Hong Kong. Evidence available to the SFC does not support the allegations that they had acted, either in concert or alone, to manipulate the market by selling in the cash market on 23 October 1997 so as to profit in the futures market. Nor does the evidence support the allegation that the objective of the currency speculators was primarily to benefit from the "expected" impact of their attack on the stock market. 4.112 The following findings from SFC's analysis show that there was no basis for the allegation of intermediaries, local or international, manipulating the market through the futures market and that of correlation between currency speculators and fixtures market participants (a) the bulk of the short positions in HSI Futures as at 23 October was quite evenly spread among the members, with the largest short position being 4,440 contracts or 16% of the market open interest. As for this particular investment house, the value of its short position in HSI futures and its cash position with the securities clearing was such that any "profits" reaped

78

from a fall in HSI would cost it a loss of at least five times the amount in the market value of its securities; (b) the bulk of the short futures position were built up around My 1997 when the stock market was at its all time high. This resembles more of riskcapping or profit-locking hedging strategy at a time when the market was challenging its record high, instead of positioning for profit from manipulation in three to four months' time; there was no build-up of positions in the run-up to 23 October and these positions have remained largely intact since. For example, the change in aggregate short positions held by the top five firms remained within a 10% margin in the week before and after 23 October, showing no evidence that these firms liquidated their positions to profit from the market fall; and the majority of these houses were issuers of covered warrants. Analysis showed that if their risk management strategies were allowed to play according to theoretical models, they would have sold down more heavily than their actual trading activities in the market.

(c)

(d)

4.113 Likewise, evidence revealed by SFC's inquiries also lends no support to the claims that a major stock brokerage house had taken advantage of the anticipated announcement of the negative recommendation on Hong Kong stocks by its own analysts. 4.114 At the moment, the SFC is still inquiring into media allegation of insider dealing in connection with the heavy short-selling on HSBC in the SEHK on 29 and 30 October 1997 before the announcement by Moody's Investors Service on 30 October downgrading the outlook of Hong Kong's banks and placing the ranking of HSBC and Hang Seng Bank on review for possible downgrading. While the investigation has yet to be completed, the SFC has established that almost all of the short selling was caused by the need for Hong Kong-based entities to reduce their large exposures to the Hong Kong market and not related to Moody's announcement, 4.115 During the financial turmoil, Hong Kong had experienced exceptional volatility in both its cash market and futures market. Invariably, exceptional volatility always lead to exceptional losses and profits and invites suspicion of market manipulation. It is the responsibility of the SFC as the principal market regulator to ensure that the market continues to operate on a level playing field. 4.116 Market integrity is among the most important qualities vital to the maintenance of Hong Kong's status as a major international financial centre. Under the SFC Ordinance and other related legislation, the SFC is empowered to conduct investigations, either on its own initiative, or at the direction of the Financial Secretary, or upon public application, into suspected market malpractice including insider dealing and

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market manipulation. The SFC is committed to exercising its power whenever a case is demonstrated. And at times of exceptional volatility like October and November last year, it is particularly important that the market be served by a regulator which is guided by professionalism and respect for evidence, rather than market sentiment. Surveillance of Trading and Member Conduct 4.117 The SEHK takes primary responsibility for the supervision of listed companies and for the routine surveillance of the conduct of Exchange members. In addition to its routine inspection visit, the SEHK also conducted focus visits to members with respect to different scenarios of risks associated with the fast changing and turbulent market conditions, both local and overseas. The scope of these focus visits to members included review of their trading practices, their financial soundness and the adequacy of their risk management and credit control measures. This surveillance is vital to the protection of investors and is also important to systemic stability of the market. The SFC has regular liaison meetings with SEHK at the staff level and receives reports on the outcomes of SEHK inspection visits. In addition, the SFC itself undertakes a limited inspection program of SEHK members and conducts periodic review of the operations of the compliance function within the SEHK. 4.118 In the period leading up to September 1997, the SFC detected a significant increase in improper activities including suspect price manipulation and trading and as a result, an increased number of investigations were instigated and companies suspended from trading. The SFC however found no evidence that these problems worsened during the period offinancialturmoil. 4.119 In a period of market downturn there is an increased risk of certain forms of misconduct on the part of brokers, their employees and their clients. The SFC and the SEHK are mindful of that risk and have discussed at their regular liaison meetings strategies for addressing that risk as part of the cycle of surveillance visits planned for 1998. Both the SFC and the SEHK will focus their attention on the internal controls of intermediaries, particularly as they relate to risk management and fraud prevention. 4.120 The SFC and the SEHK have also undertaken a review of their surveillance capacity. Whilst satisfied that the present system of surveillance works well, the two organizations believe that improvement is possible. 4.121 Within this year, The SFC and SEHK will further develop their surveillance capacities by installing an enhanced real-time surveillance and analytical software for their computer system. Assessment has been undertaken of an overseas developed system which will be modified to meet the user needs of the SFC and SEHK,

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The SFC will build an early warning system by establishing linkages with SEHK, HKFE and Hong Kong Clearing on the basis of line feeds and clearing tape. The SFC will also strengthen its capability in market information research to better identify market trends.

4.122 SEHK being the front-line market regulators plays a vital role in ensuring compliance of their members with the Exchange rules. The above efforts will reinforce the surveillance functions of the SEHK and strengthen its co-operation with SFC. Additional resources may be required to implement these initiatives in the next couple of years. We will also urge the SEHK to consider institutionalising their authority to obtain client and market information from its members and appropriate sanctions should such authority not be respected. Where deemed appropriate, we are prepared to incorporate necessary legislative amendments in the Composite Securities and Futures Bill currently under consideration. 4.123 Notwithstanding all these efforts, the surveillance work of the SFC and the SEHK will not totally eliminate the risk of malpractice or negligence within member firms. Ultimately, management of those firms must take responsibility for the adequacy of operational controls. The existence of good internal controls is the first line of defence in periods of extreme market movements. Good internal controls help to ensure that firms do not have an inappropriate risk concentration, that there is a proper protection of client assets and that there are checks and balances to ensure that losses are recognised early and that staff are not able to conceal improper, imprudent or loss making activity. During 1997 and 1998, the SFC and the SEHK respectively introduced a new set of Internal Control Guidelines that made more explicit the their views on the requirements of management to ensure adequate systems and controls. Link-up of CCASS and RTGS 4.124 Currently, over 99.5% of all transactions concluded in the SEHK are settled through the Central Clearing and Settlement System (CCASS) of the HKSCC. The vast majority of those trades are settled by way of the Continuous Net Settlement (CNS) System, in which CCASS automatically nets the purchases and sales of each broker in each stock on a trading day and calculates the net position for settlement with CCASS. Some trades, either at the request of the trading brokers or at the discretion of the HKSCC for risk management purposes for instance, are settled in isolation from the bulk of the trades. Apart from Exchange-based transactions, the CCASS also provides settlement functions for over-the-counter trades or other stock transactions between CCASS participants, such as stock borrowing and lending and portfolio movements. These transactions are settled through Settlement Instructions (SI) issued directly by the parties to the transactions concerned. In these cases, the CCASS does not act as counterparty to the transactions, a function it performs for the exchange-based trades.

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4.125 Under CNS, delivery of stocks to the net buyers follows payment of money normally on the day after settlement (i.e. three days after trading, or T+3). Payments by the net buyers are effected overnight on T+2 and when confirmed by the bankers of HKSCC in the next morning (T +3), stocks will be credited to their accounts in CCASS. An overnight time gap is incurred between payment and delivery. When a broker wants to get hold of the purchased stocks earlier than T+3, special arrangement will have to be made to notify HKSCC of the payment made. For SI, stocks may be delivered free of payment or payment may be processed overnight, and the two operations are usually independent to each other. 4.126 In order to make delivery and payment (DvP) close together in time for settlement of securities transactions, the HKSCC has been working in conjunction with the HKMA, Hong Kong Association of Banks and Hongkong Interbank Clearing Limited (HKICL) to establish a message link between CCASS and the RTGS, the money settlement system among banks, so that confirmation of money payment can be communicated from the RTGS to CCASS spontaneously. A real time DvP can further reduce market risks of settlement for both HKSCC in respect of CNS and the parties to other transactions in respect of SI. It can also protect the parties to SI from default risks of its trading partner. For market participants who wish to use it, DvP will be more costeffective and bring greater certainty. However, as real-time DvP will operate to accelerate the timing of some payments, it may also exacerbate liquidity demand. 4.127 HKSCC is now at the final stage of finalising and testing the functional specifications for the interface between CCASS &nd RTGS and expects to be able to introduce real time DvP in early May 1998, 4.128 Real time DvP will initially be available for SI transactions only. The facility will be considered for expansion to CNS transactions and other non-SI transactions, such as intra-day marks, cash prepayment etc. at a later stage. 4.129 In mid-1998, HKSCC will also conduct a feasibility study to enhance coordination of settlements between brokers and custodians to help improve liquidity and relieve credit burden for brokers in intertwined CNS and SI transactions. Investor Participation in CCASS 4.130 HKSCC was established in June 1992 following the recommendation of the SRC Report 1988 to provide central clearing services for SEEK trades. It was originally designed to settle transactions among market intermediaries including brokers and custodians, who in turn act as mini-clearing houses for their clients. While the Report also envisages the possibility of expansion of the settlement services to cover also brokerclient trades25, access to HKSCC's services for retail investors is currently limited to the form of segregated account under the broker or custodian CCASS participants. While the
25

Para.5.101 of the SRC Report 1988 refers.

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stock segregated account service provides evidence of movements of such holdings through daily and monthly account statements, it does not however permit direct control by the investors over the movements of their shares. 4.131 To provide a more comprehensive service for the market and to answer the need of investors, the HKSCC has recently decided to extend its service to enable individual and corporate investors to participate directly in CCASS through individual accounts. Under the Investor Participation Scheme, individual and corporate investors can open individual investor accounts with CCASS. Through the account, they could, in respect of their shares deposited in CCASS, control movements of their shares, receive evidence of their shareholdings and enjoy better protection of their shareholdings. Although under this Scheme, transfer of investors' stocks still has to be initiated by their broker agents or custodians, such transfers must be confirmed by the investors themselves, which is not required for stock movements under the client segregated accounts. 4.132 Investor Participation Scheme provides an additional choice for investors to safekeep their shares and represents the continuing effort of the HKSCC in the improvement of risk management of the market. The Scheme is also expected to help enhance investor confidence in Hong Kong's securities market by permitting them a better control over their shareholdings deposited with CCASS. 4.133 The Investor Participation Scheme will be introduced in May 1998 with the initial set-up to accommodate 5,000 investor accounts but to take on 1,000 accounts first for the pilot run of three to four weeks, and to take on the remaining applications, if any, progressively and within nine to twelve months. Cross Margining 4.134 Currently, the securities and futures markets are segmented in terms of trades settlement. All trades on the SEHK are settled through the HKSCC, with the exception of stock options which are settled through the Stock Exchange Options Clearing House, SEOCH, which is a wholly-owned subsidiary of the SEHK. On the other hand, the Hong Kong Futures Exchange Clearing Company, or HKCC, is responsible for settling the trades based on HKFE. As a result of the segmentation, each exchange and its clearing house(s) will only have partial access to the overall position of the market and individual brokers, which will in turn limit their assessment of the overall exposures. 4.135 In order to improve overall risk management at the market level, the SFC is reviewing the feasibility of having cross margining between related products traded on the SEHK and HKFE, such as a specific stock and its derivative products. Cross margining has the potential to reduce overall risk within the clearing and settlement system. It will also allow for a more efficient use of capital for the intermediaries. The result of the review may also contribute to the longer term project to study the feasibility

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of integrating the three separate clearing systems currently serving the various segments of the securities and futures markets. 4.136 It is envisaged that the study will be completed in mid-1998 and implementation by product commenced in late 1998. Financial Resources Rules 4.137 The Financial Resources Rules were first introduced in 1993 to ensure that registered intermediaries have sufficient capital to cover the expected risks associated with the trading activities that they undertake. During the volatile period of the market, the general compliance with FRR has provided a sound cushion to both investors and market intermediaries themselves and has helped in preventing undue systemic risk, 4.138 In fact, since the introduction of the FRR, the SFC has conducted an extensive review of the FRR. In March 1997 the SFC launched a public consultation on its proposals to amend the existing Financial Resources Rules (subsidiary legislation of SFC Ordinance) which provides for the net capital and liquidity margin requirements for securities dealers, futures dealers, and securities and/or futures advisers. The proposed amendments take into account the development of new risk management techniques; the diversification into new products; and anomalies and deficiencies identified in operating the current set of rules. The proposals include the standardising of liquid capital requirement for all registered dealers, irrespective of whether they are corporations or sole proprietors; adopting a progressive reduction in total liabilities requirement for large portfolio; adopting a more flexible haircut structure; excluding from liquid assets all assets held in a currency subject to exchange control; and a number of technical amendments to the existing rules. 4.139 Public consultation was completed in April last year but the legislative amendments have not been introduced to the then Legislative Council, nor the Provisional Legislative Council largely due to timing constraints, We recommend that the proposed amendments, together with the necessary amendments relating to the proposed regulatory regime for share margin financing activities, be introduced to the first Legislative Council as soon as possible after its coming into force. The modified Financial Resources Rules will further enhance the ability of the securities and future dealers in withstanding unexpected market risks. Stock Collateral 4.140 Under the existing clearing arrangements, the Hong Kong Clearing marks to market the open positions held by the individual broker and collects the net marks on a daily basis. Brokers are required to meet the marks or default procedures will be triggered otherwise. In time of market volatility and heavy turnover, the arrangement may create considerable credit burden and liquidity problem on brokers, especially on the small ones and when there is a liquidity squeeze.

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4.141 In order to relieve the credit burden borne by brokers and provide extra flexibility to brokers' funding arrangement, the Hong Kong Clearing, with the approval of the SFC, had amended the CCASS rules to enable it to accept stock collateral in payment of mark-to-market obligations which could previously be settled with cash only. The new service was introduced on 29 December 1997. Under the new arrangement, brokers are permitted to meet up to 70% of mark obligations with stock instead of cash. For prudential considerations, only 33 constituent stocks of Hang Seng Index are accepted and a 50% haircut ratio will be applied in valuing the stocks collateralised.

MARKET TRANSPARENCY, INVESTOR PROTECTION AND EDUCATION Introduction 4.142 Efficient and appropriate disclosure of information and the accessibility of such information to investors are crucial elements of market transparency. The Review has addressed these issues and has recommended ways for improvement. Furthermore, we will also discuss our current effort in enhancing investor protection in respect of more efficient indemnity measures and effective investor education programmes in the rest of this section. Disclosure of Information by Companies Listed on the SEHK 4.143 The failure of Peregrine and financial problems of other listed companies have demonstrated the need of more financial disclosure by listed companies and greater transparency in respect of the exposure of financial conglomerates so that shareholders can make their investment assessment on a better informed basis. 4.144 The SEHK and the SFC have studied the issues and considered whether additional guidelines should be devised for listed companies to ensure timely and appropriate disclosure of relevant information. They recommend that transparency should be enhanced in respect of the following information: exposures to single group (where these exceed certain thresholds); significant exposure to countries or markets experiencing financial upheavals; commitments to provide finance to associated companies and joint ventures (where this exceeds certain thresholds); and conditions in loan agreement that are outside the control of a listed company. This would include an obligation for a major shareholder to maintain a minimum shareholding in the company.

85

4.145 In the medium term, the SEHK and SFC are considering other amendments to the financial disclosure provisions in the SEHK Listing Rules. The factors under consideration include: whether to require listed companies to disclose profit and loss account, balance sheet and cash flow information in their interim reports; and whether to require financial conglomerates to adopt some of the disclosure requirements that apply to banks under the Hong Kong Monetary Authority's Best Practice Guide on Financial Disclosure,

Access to Corporate Information 4.146 Since the introduction of the CCASS in 1992, the number and value of securities held in custody by the CCASS Depository have substantially increased, Currently, CCASS holds in custody more than 50% by number of shares and 30% by value of securities listed on the SEHK. The immobilised share certificates are registered in the name of the HKSCC Nominees Limited instead of the underlying beneficial owners and the latter as a result would not receive from the listed companies the corporate information which is distributed according to record on the share registrars.

4.147 In order to ensure that these non-registered shareholders would receive corporate communications from the companies the shares of which they hold through the CCASS Depository, the SEHK had changed its Listing Rules to place an obligation on the listed companies to send corporate communications to all non-registered holders behind CCASS Depository. The change has taken effect since 23 February 1998. Fidelity and Compensation Schemes of Stock Market 4.148 Fidelity insurance and investor compensation schemes are common features in most major securities markets as a safety net to investors in the event of defaults by brokers or misfeasance of their staff. They aim to offer safeguards for investors' interests in the case of, for instance, stockbroker defaults. An indemnity scheme which is efficient and balance will enhance investors confidence and yet stop short of creating a problem of moral hazard in the market. 4.149 Currently, the SEHK operates the Brokers' Fidelity Insurance (BFI) Scheme and the Fidelity Fund and Guarantee Scheme. There is also the Unified Exchange Compensation Fund (UECF), which is different from the other schemes as a statutory scheme established under the Securities Ordinance. These schemes provide successive layers of protection for both market practitioners and investors. As Hong Kong's financial markets have grown to become increasingly sophisticated and complicated and turnover significantly increased, there is a need to review whether current schemes could be further improved to offer better and more cost-effective protection to investors and

86

market practitioners, SFC and the SEHK have been working together on such a review, with input from an external consultant. An option under consideration in the review is to marry Fidelity Insurance with the UECF into an insurance scheme which should be able to provide much greater flexibility than present arrangements. 4.150 A conclusion of the review is expected to be ready by [mid-1998]. Existing Fidelity and Compensation Schemesr-of Hong Kong's Stock Market The Brokers' Fidelity Insurance Scheme (BFI) is compulsory for all SEHK members. The scheme provides a annual limited indemnity on a per member basis. Protection is given principally in respect of physical loss of securities, counterfeit securities, infidelity of employees, computer crime and errors and omissions. Coverage is placed into the Lloyd's and London market, with the premium shared between the SEHK and its members. The Fidelity Fund and Guarantee Scheme is only available to SEHK members who suffer financial loss as a result of default of a SEHK member in connection with dealing in securities listed on SEHK. The maximum payment in respect of a defaulting member is $2 million for each share the defaulting member holds. The compensation however is not available in respect of stock borroMnng and lending, transactions settled under the CCASS CNS system and trade options on SEHK. Unified Exchange Compensation Fund CUECF) is established under the Securities Ordinance (Cap. 333) to review and pay claims for compensation from any person other than a stockbroker who has suffered financial loss relating to money, securities or other property in their dealing with a stockbroker relating to stockbroking business, including options trading business. The maximum payment out of the UECF in respect of any one stockbroker member is $8 million, regardless of the number of claimants although the upper limit could be raised under certain circumstances, A Compensation Committee will decide and allocate the amount to be paid out of the Fund. Investor Resources Centre 4.151 The SFC, the Stock Exchange, the Futures Exchange and the Hong Kong Investment Fund Association, with the support of the government, will set up an Investor Resources Centre which is expected to come into operation within 1998. The purpose of the Centre is to provide facilities for access to the database and materials related to investment and financial markets. The Centre can also provide venue for investor education activities such as seminars and exhibitions for the general public on a nonprofit basis. These education programmes will furnish the investors with the necessary knowledge in the increasingly complicated and sophisticated securities and futures markets.

87

Investor Education Programme 4.152 Retail participation is one prominent characteristic of the stock market, To enhance the basic knowledge of the investing public on the operation of the market, the market regulators have devoted resources to investor education programmes in the last 18 months. Information booklets focusing on specific areas of interest have been published by the SFC, the Stock Exchange, the Futures Exchange, the Hong Kong Clearing and the Investment Fund Association. These booklets are designed to help the investors understand some basic issues of the respective areas. The most recent ones included the booklets about the rights of investors and funds investments issued by the SFC in December 1997. Besides printed materials, both SFC and SEHK have administered an investor hotline to answer questions and complaints from investors. During 1997, the SFC also sponsored the production of a series of investor education TV programmes and launched new announcements of public interest on both television and radio to remind investors of the importance of "doing homework" and '""asking the right questions" for their investment. 4.153 Separately, the Stock Exchange, in co-ordination with the SFC, has organised a series of investor education seminars ranging from introductory to advanced levels to meet the needs of different investors. Since September 1997, a total of 63 investors seminars have been held, attended by over 7,000 people. In addition, more than 10,000 people have taken part in the options-related seminars organised by the SEHK in the past three years. In the forthcoming year, the focus of the programme will be on derivatives and futures products, as well as the right of investors. Similarly, the Futures Exchange has also held a number of seminars to introduce to investors the operations and risks of its products. Promotion of Use of Plain Language 4.154 One important aspect of investor protection is to ensure that the information delivered to investors is clear and easily understood. In order to promote the use of plain language, the SFC set up a Working Group on this last year. The Working Group comprises representatives from the Stock Exchange and leading market practitioners, and its objective is to encourage issuers to make their documents more readable and easier to understand, in particular in relation to public announcements and prospectuses. 4.155 The Working Group concluded its first phase of work in last July and issued a set of guidelines for issuers called "How to Create Clear Announcement". The recommendations made by it were well received by the market and issuers are now required to have public announcements drafted in plain language. The second phase focused on improving the format, language and content of the prospectuses and was completed in January 1998. To help the issuers incorporate these improvements into a prospectus, the Working Group created a plain language sample prospectus and a handbook called "How to Create a Clear Prospectus". Changes to the content of

prospectus were also recommended. It is expected that all prospectuses to be issued after 31 July 1998 will appear in the plain language format.

89

CHAPTERS SUMMARY OF RECOMMENDATIONS

THE TURMOIL IS PROGRESSING 5.1 As the Review report is being written, the financial turmoil in the region continues. It was only on 8 April that Indonesia announced the signing of its third agreement with the IMF in seven months, aimed at reviving the economy. In Japan, Prime Minister Hashimoto further announced on 9 April a package of US$30 billion income tax cuts and other measures to revive the economy,, Various international financial institutions and analysts published different forecast of economic growth for economies in the region. It is therefore premature to draw a conclusion from the turmoil which started in mid 1997. 5.2 In Hong Kong, which is an open economy with intricate linkage with the region and the rest of the world, we cannot escape the impact of major external shocks and the temptation of assault on the Hong Kong dollar by international speculators, However, our sound fundamentals, robust financial systems and market-oriented policies along with the flexibility of the economic structure afford us the best protection against adversities. Experience over the years, especially during the recent months, demonstrates our remarkable resilience. To maintain it, all the underlying attributes must be consciously preserved and nurtured. The Government is fully committed to do precisely that. 5.3 Perhaps an important lesson for us to learn from the regional financial turmoil is exactly the saying of "staying vigilant while in peace". As we are riding out the storm and renewing our strengths, we must not forget the pains too quickly. Instead we should be watching out for the risk of any asset price bubbles, and make adequate preparations against possible market downturn in times of particular buoyancy. So is the m^d to watch out for any inherent imbalances in the economy and have them expeditiously and effectively addressed. SUMMARY OF RECOMMENDATIONS 5-4 The following is a summary of the specific recommendations from the Review conducted conclusions and

Regarding the Monetary System (I) Role of interest rates

90

(a)

Under the automatic adjustment mechanism of the LER systems, it is the market which determines the level of interest rates required to maintain a fixed exchange rate, and interest rates remain the most potent weapon in the defence of a fixed exchange rate. As exchange control or credit control is not an option in Hong Kong, there is little, if any, room for selective infliction of interest rate pain on the speculators under our LER system. Whilst one or two of the schemes proposed by the academics aiming at suppressing increases in interest rates may have some psychological value, they may carry the risk of undermining the credibility and self-adjusting mechanism of the LER system.

(b)

(c)

(II) Conduct of foreign exchange and money market operations by the HKMA (a) Instead of rigidly buying and selling US dollars against Hong Kong dollars at the fixed exchange rate of 7.80, the HKMA should continue its existing practice of leaving the foreign exchange market very much alone. If there is risk of instability in the exchange rate, the HKMA should, as in the past and at undisclosed levels around 7.80, establish its passive presence in the foreign exchange market in accordance with the discipline of the currency board system. Operating under the rule-based currency board system, the clearing balance of the banking system, an important part of the monetary base, will vary in accordance with the flow of funds into and out of the Hong Kong dollars. Only in exceptional circumstances, such as Initial Public Offerings of shares and other large scale Hong Kong dollar transactions, will the HKMA consider directly varying the clearing balance temporarily without the corresponding change in its US dollar holdings. These operations are carried out for the benefit of promoting general market stability. In all other activities conducted by the HKMA which may have the effect of varying the clearing balance of the banking system such as a transfer of fiscal reserves and the issue of Exchange Fund Bills and Notes, the HKMA ensures that such effect is neutralized as the case may be, by recycling or sterilizing Hong Kong dollar liquidity. This practice should continue. For the purpose of facilitating the smooth functioning of the payment system, the HKMA should continue to provide intra-day liquidity as well as overnight liquidity through the Liquidity Adjustment Facility (LAF) by

(b)

(c)

91

entering into the repurchase arrangements involving predominately Exchange Fund Bills and Notes. It should also continue to discourage repeated borrowings from LAF. (d) The clarification of the definition of "repeated borrowers" enables the interbank market rates to rise in a less drastic manner, as was demonstrated during the week commencing 12 January 1998. This has contributed to a more orderly market reaction to the gradual shrinkage in the interbank liquidity. The present definition of a repeated borrower should be maintained.

(Ill) Banking system A sound and properly regulated banking system is essential to the maintenance of exchange rate stability. We should continue to reinforce our efforts in ensuring that banks in Hong Kong will manage prudently their risks, having regard to the special circumstances of Hong Kong's currency board system, and pay special attention to the quality of their assets so as not to be overly exposed to those which are vulnerable to interest rate volatility. It is recommended that strategic issues to further strengthen the resilience of Hong Kong's banking system to external and internal shocks be thoroughly considered in the consultancy study to be conducted in 1998.

(IV) Pain tolerance level of Hong Kong (a) In the defence of the Hong Kong dollar, sharp rises in interest rates will inevitably inflict pain not only on the currency speculators, but also on the home owners with floating rate mortgages and corporates with floating rate liabilities. One way to provide some insulation for the innocent parties from fluctuations in short term interest rates would be through borrowing fixed rate funds.

(b). It is recommended that steps should be taken for the Hong Kong Mortgage Corporation (HKMC) to play a greater role in developing the necessary market infrastructure to promote fixed rate mortgages as an additional financing option for home buyers. This can be achieved by the HKMC giving a clear indication of its intention to buy fixed rate mortgages from banks, thereby encouraging banks to originate such mortgages which they would otherwise be reluctant to grant because of the short term maturity and floating rate nature of banks' funding base. The HKMC may give a pre-commitment to banks to acquire those mortgages as they are originated. This will effectively protect banks from the market risk due to

92

changes in interest rate after the origination of the mortgages as the banks can offload of those mortgages to the HKMC. (c) It is recommended that steps be taken to develop the debt market, through encouraging the institutionalization of savings, especially the MPF, to promote the demand for fixed rate debt securities.

Regarding the Securities and Futures Markets (I) The market and regulatory systems (a) Throughout the period of volatility in the securities and futures markets, the trading, settlement and risk management systems continued to work well. The institutional and regulatory framework put in place in the last ten years have proved to be effective in providing an open, fair and orderly market. In the two cases where provisional liquidators had to be appointed in respect of Peregrine and C A Pacific, the failure of these companies did not cause any substantive systemic problem, nor did they lead to further volatility in the market. Taking stock as of 31 March 1998, our market is among the least affected in the region. In US dollar terms, the stock market in Hong Kong shrank by 24% compared with the position at the end of June 199725.

(b)

(c)

(II) Issues of concern in the Stock Market (a) Shortselling, subject to regulation, is a widely accepted legitimate market activity in most major securities markets. The SEHK did not detect any improper activities in short selling reported to it during September to November 1997. Nor did SFC detect any link between improper short selling and market volatility during the period. Noting that market transparency is very important to the regime for shortselling, it is recommended that the reporting requirements for short open interest and other relevant information be enhanced to increase market transparency. On the other hand, a level playing field is important to the regime for stock lending and borrowing which complements short selling activities. We believe noted that the introduction of a central Stock

25

When compared with end June 1997 and expressed in US dollar terms, the Taiwan market lost 15%. Tokyo and Singapore shrank by 3 1 % and 27%, respectively. Others in South East Asia lost
45% (Philippines) to 79% (Indonesia).

93

Borrowing and Lending facility by HKSCC in early 1999 will provide equal access to stock borrowing and lending to all investors. (b) The C A Pacific incident made it clear that the largely unregulated margin financing activities by broker-related finance companies should be brought back into the regulatory fold. In this regard, the work of the cross-agency working group established in December 1997 was expedited with a view to publishing a consultation document in early May 1998 and to introducing the relevant legislative amendments to the first Legislative Council as soon as possible. It is recommended that these brokerrelated finance companies be subject to prudential regulation by the Securities and Futures Commission. The major areas of regulation include capital adequacy, risk management, and conduct of business, It is recommended that the SFC review the concept of Treasury Shares26 in the context of the review of Share Repurchase Code which has just begun. It is recommended that the SFC and SEHK consider the introduction of measures such as application for court orders and mandatory remedies to strengthen the enforcement of compliance of SEHK Listing Rules. It is noted that the Hang Seng Index is a carefully constituted and largely representative index for the stock market in Hong Kong, We welcome the initiatives taken by Hang Seng Index Services Ltd (HSIS) to constantly review the various Hang Seng indices, and the introduction of the new Hang Seng 100 Index. It is further recommended that the SFC continue to discuss with HSIS on possible improvements to the representativeness of the related indices. We would also encourage the HKFE to launch the trading of futures contracts on the new HSI 100 as soon as possible.

(c)

(d)

(e)

(Ill) Issues concerning the Futures and Derivative Markets (a) Derivative products including index futures are important risk management tools in portfolio management, They add liquidity to the market and increase the diversity of the market product base. As such they are essential for the development of the Hong Kong market and to meet the needs of the local institutional fund industry. Such needs will grow with the introduction of Mandatory Provident Fund schemes. Without

26

"Treasury shares" refer to issued shares held by a company but not cancelled as a result of share repurchase. Such stock is available for reissue, but receives no dividends and carries no votes.

94

them the Hong Kong securities markets cannot remain competitive in the region. It is recommended that we continue to improve our market rules to maintain an effective regulatory regime. (b) We welcome the HKFE's decision to migrate the trading of HSI Futures contracts to the Automated Trading System. Noting the lead time necessary to put the relevant systems in place both at the Exchange and for its broker members, we also welcome the HKFE's initiatives to improve the information dissemination system of the open outcry system in the interim. It is noted that the margin requirement of the HKFE on HSI Futures contracts is already among the highest in the world and has served the Exchange and its Clearing Company well during the turmoil. It is recommended that the SFC and HKFE continue to explore refinements to the calculation of margin level in order to maintain the flexibility to meet exceptional market volatility. There was substantial growth in the derivative warrant market following the relaxation of issue requirements in August 1996. There were indications that derivative warrants add to short term volatility as a result of the corresponding hedging activities by issuers. We welcome the SEHK initiatives to review the listing rules for derivative warrants with a view to reducing the impact of warrant issues and settlement on the cash market and improving transparency and investor's protection. We expect that the SEHK will submit the relevant changes to the Listing Rules to SFC before mid 1998,

(c)

(d)

(IV) Market Surveillance and Risk Management (a) There had been allegations that speculators had profited through market manipulation across the securities, futures and currency markets; that some had taken advantages of the expected interest rate surge following the attack on the currency, the ensuing liquidity squeeze and the selling pressure on the cash market; that certain brokerage houses had taken positions prior, to the announcements of certain economic analysis by their own firms, and so on. The SFC investigations have found no evidence to substantiate any of these allegations of market manipulation. Recognising the importance of market surveillance to ensure trading activities in the market are conducted in a fair and orderly manner, it is recommended that the capability of the SFC and the exchanges in the surveillance of trading and members' conduct be further enhanced.

(b)

95

Where necessary, legislative amendments will be considered to strengthen the capability of the SFC and the exchanges in obtaining market information from the intermediaries. It is also recommended that measures to better manage and eliminate risks at various levels be introduced (i) (ii)
2/ .2 7 in May 1998; link-up of CCASS and RTGS

introduction of Direct Investor Participation in CCASS also in May 1998; detailed examination of the feasibility of cross margining between HKFE and SEHK; and promulgation of revised Financial Resources Rules in the second half of 1998.

(iii)

(iv)

We also welcome the acceptance of stock collateral by HKSCC since end December 1997 to alleviate part of the liquidity pressure on market intermediaries.

(V) Market Transparency. Investor Protection and Education (a) The heated activity in the market during the first half of 1997 and the volatility that followed both point to the importance of enhancing market transparency to enable investors to make their decisions based on equal and adequate knowledge about the fundamentals and prospects of the companies and investment products concerned. It is equally important to protect investors through regulations that protect their rights and opportunities and to educate them about the market, The following measures have either been introduced or are under study in order to achieve greater transparency and provide better protection and education to investors (i) revision to the financial disclosure provisions in the SEHK Listing Rules to improve the transparency of financial exposure of listed companies to their investors and the market;

(b)

This is a linkage between the Central Clearing and Settlement System (CCASS) of HKSCC which handles 99.5% of SEHK transactions and the Real Time Gross Settlement System (RTGS) of HKMA which is the money settlement system among banks. The linkage will further reduce the market risks of settlement for HKSCC and the parties to the trade.

96

(ii)

with effect from February 1998 a requirement on listed companies to provide corporate communications to all investors who deposit their shares with the CCASS; review of fidelity insurance and compensation schemes of SEHK to ensure the provision of cost-effective protection to investors and market practitioners; establishment of an Investor Resources Centre within 1998; provision of various investor education programmes and enquiry/complaint facilities; and a requirement of the use of plain language in company prospectuses and communications.

(iii)

(iv) (v)

(vi)

97

Annex 2.1

Chronology Of Events
Date Late May 1997 2.7.97 Events Thai baht came under severe speculative attack. Selling pressure was also seen in the Philippine peso and Malaysian ringgit. The Bank of Thailand floated the Thai baht which immediately dropped to Bht 30 to the USS from Bht 26 before the float. The Central Bank of Philippines widened its intervention band of peso which fell from 27 peso to the USS to 29 peso. Bank of Indonesia also widened its intervention band for mpiah against the US dollar from 8% to 12%. The rapiah fell to 2443 to the USS, a drop of 0.9%. 14.7.97 7.8.97 20.8.97 Bank Negara Malaysia allowed theringgitto depreciate by nearly 2%. HSI reached its life record high of 16,673 points. The IMF approved a stand-by creidt facility for Thailand, authorizing drawings of up to US$3.9 billion over the next 34 months to support the government's economic reform. HSI plummeted 634 points (4.3%) as a consequence of the tumbling of other regional markets and the rise in interbank rates.

11.7.97

29.8.97

August to HSI slided downwards amidst strongfluctuationsduring the period. On October 1997 15 October 1997, HSI closed at 13384. A 20% dropfromthe historical high in early August. 20.1.0.97 The New Taiwan doflar depreciated, sparking off speculation on the resolve of Hong Kong authorities m maintaining the lint. Massive short selling of HK$, amounting to HK$4 to 5 billion. HKMA bought the equivalent amount of HK$fromthe market. Morgan Stanley made a recommendation to unload Asian holdings. 22.10.97 23.10.97 More short selling of HK$. HKMA sold US$ and bought HK$. HSI plunged 765 points (6.2%) and closed at 11637. HKMA issued a statement discouraging licensed banks from repeated borrowings from LAfl Banks rushed to bid for HK$ and raised the overnight HDBOR from 9% to touched 280% briefly. In the afternoon, speculators began to sell USS to buy HK1

21.10.97

HSI plummeted 1211 points (10.4%) to close at 10426. As a result of the contagion, stock markets world-wide suffered severe loss (see Table A). HSI futures transaction volume hit a record high of 83445 contracts. 24.10.97 HSI rebounded 718 point (6.9%) to close at 11144. Dow Jones recorded a further loss of 132 points (1.7%). Morgan Stanley clarified that they remained positive on the economic outlook of Hong Kong and Mainland. 25.10.97 HKMA adjusted the bid and offer rates under LAF from 4.25% and 6.25% to 4% and 7% respectively. HSI plunged 646 point (5.8%) which led the Dow Jones down by a historical record of 554 points (7.2%). HSI recorded the biggest point fall of 1438 points (13.7%) and closed at 9060. Dow Jones, on the contrary, recorded its biggest single-day point gain of 337 points (4.7%). US Federal Reserves Chairman Alan Greenspan said in the US Congress's Joint Economic Committee hearing that the Asian cuirency crisis and global stock market fall would directly affect American corporations' profits. Stimulated by the ratty of Dow Jones, HSI surged 1705 points (18.8%) to close at 10765. A heavy short-selling of the HSBC Holdings (12% of the total turnover of that share). 30.10.97 Moody's downgraded the outlook of Hong Kong's banks from stable to negative. HKMA issued a statement saying that Hong Kong's banks were robust. HSI tumbled by 402 points (3.7%) to 10363, 31.10.97 Standard & Poor's (S&P's) affirmed Hong Kong A-plus long-term foreign currency and AA-mkus long-term local currency ratings. IMF gave a very positive assessment of Hong Kong's economic fiindatnentals and a firm and clear endorsement of the territory's economic policy framework. Korean won dropped to 999 to US$L Bank run on the International Bank of Asia. In a press release, HKMA said that Hong Kong's banking system was highly capitalised and strong.

27.10.97

28.10.97

29.10.97

7.11.97

10.11.97

11.11.97

HKMA requested banks to submit returns on assets and liabilities and liquidity ratios on a daily, instead of the usual monthly, basis. Thomson BankWatch agreed with S & P's that there was no need to downgrade Hong Kong banks's ratings. However, it would consider reviewing Hong Kong banks' ratings if the interest rates stood high for two more months. HKMA clarified the meaning of repeated use of LAF. HBBOR lowered to 10-11%. US Federal Reserves Chairman Alan Greenspan spoke at the House Banking and Financial Services Committee hearing on 'Monetary Instability in Asia".

12.11.97

13.11.97

14.11.97

The Financial Secretary met academics to listen to their views on the financial crisis. The Korean government announced the widening of the intervention band in which the won was traded from 2.5% to 10%. The won fell by more than 8% the following day. Hong Kong University of Science and Technology academics introduced their US$ LAF system in a press conference.

17.11.97

24.11.97 2.12.97

Yamaichi Securities Co. Ltd. in Japan went bankrupt. The Financial Secretary suggested in Kuala Lumpur the setting up of a mature regional debt market enabling companies to raise money through bonds and reduce their reliance on bank borrowings. Hong Kong offered to host a meeting for technical experts and regional officials to discuss the proposal in more detail. IMF agreed on a US$57 billion bailout aimed at restructuring Korea's economy. Conditions include strengthening fiscal and monetary policies, implementing far-reaching financial reform, liberalising trade and capital-flow laws, changing the structure of corporations. IMF's interim Economic Outlook slashed its combined growth forecasts for Thailand, Indonesia, Malaysia and the Philippines from 3.7% to 1.7% in 1998. Forecast for Japan's growth was only 1.1% while S. Korea down from 6% to 2.5% growth in 1998. Thai baht dropped 2.6%; Indonesian rupiah 8%; Malaysian ringgit 6% and Singapore dollar 2.4%. HSI plunged 597 point (5.9%) to close at 9539 as a result of the tumbling of regional currencies.

3.12.1997

20.12.1997

7.1.98

8.1.98

The announcement of Indonesia's 1998 budget deepened concerns that the country was backing away from pledged reforms and austerity measures. Reflecting market worries that the IMF might suspend its US$23 billion bailout package, the rupiah fell at one point to 11050 against the US$, triggering another round of sell-offs across Asian financial markets. Liquidation of the Peregrine Group. HSI plunged to 7909 before closing at 8121, down by 8.7%. Moody's put Hong Kong's Prime-1 short-term foreign currency rating on review for possible downgrade. Japan Bond Reserach Institute put Hong Kong's various ratings on reappraisal. Liquidation of the C A Pacific Securities. Japan Credit Rating Agency put Hong Kong's UAA" long-term rating on credit monitor. Nobel laureate Merton Miller suggested HKMA issuing Structured Notes to strengthen the Link Exchange Rate System

12.1.98

13.1.98

19.1.98

2.2.98

HSI surged by 14.3% to above 10000 point level, closing at 10579 on the first trading day after the Lunar New Year holidays. Moody's downgraded Hong Kong's short-term foreign currency rating to Prime-2 from Prime-1. Japan Credit Rating Agency affirmed Hong Kong's UAA" long term rating.

19.2.98

19.3.98

31.3.98

Table A: Performance of other stock markets on 23 October 1997

Market Hong Kong Brazil Mexico Frankfurt Manila Singapore Russia Paris Kuala Lumpur London Tokyo Sydney New York Jakarta Toronto Taiwan

Change -10.4% -7.2% -5.1% -5.0% -5.0% -4.7% -3.9% -3.4% -3.4% -3.1% -3.0% -2.5% -2.3% -2.0% -1.3% +1.7%

$MMfa
ft m '* m w n P

DIRECTOR OFFl
T H E EXCHANGE 1 3
H

ONG K O N G

OUR?

it

3 Tel.: S 2 9 0021 O u r Rel.:

M :

27 May 1992 Chief Executives of Licensed Banks

To:

Dear Sir, Liquidity Adjustment Faciljt;v

t o lnform +u u n g K ~Q n Y u t h a t / following consultation g ^L ? Association of Banks (HKAB), t h e Office of the Exchange Fund has decided t o introduce a Liquidity Adjustment Facility (LAF) with effect from 8 June 1992 Uv^n^ ain i J u r p o ^ o f L A F i s ^0 a s s i s t licensed banks in

5S?SL + K i^ustments their liquidity positions, h e b a l a n c e ito n ? J ? 2 1, 5 ^ e i r clearing accounts with their Settlement Banks.
VUA
L k

S S J ?-f Y
*-K

i l 1 b e o p e n froiQ * Zr W pm t o 5 pm on Monday to m 1 1 # 3 am t o 1 2 n 4 oon on

u'

Ll( ensed

banks may approach this Office

Saturday other than

. A1? . ^ l d l t y Positions in a manner described in n A nnex A In l i ? ^ > v SUPP :J" . W i U* the ^ case of overnight :/ norm side t n / P ? ^ A eei ^ Y be provided through a ^^ ^ e n t (Repo) of a bank's banks holding o Exthanae S S ^ ent f XS ^ Iund Bills and Government G o v e r n t Bonds. B d th A copy of the ched a t r e a H SS- a t t aa Annex B. Liquidity support o n y alS be ext i ^ f l ^ d e d at iay discretion, Svtoo r i iay d i s c , e revai 3? ^ P ^ g market conditions a n d credit S S3? , P g a n 3 ? ^ , 1Ved The

lt ^ n unletured ?en^ S?fer Rate ri2

to

?/ ?f

t charged h d o ; u n d e r s Merest rate n T!?i tandably be higher toan the by a R e p O Under LAF office is

"*

' Y

- 2 -

3. Both the Bid Rate and the Offer R a t e under LAF will be d e t e r m i n e d in advance and published on Reuters (page H K E F ) and Telerate (page 9 9 0 8 ) . The rates may be varied from t i m e to time at my discretion, although they w i l l not n o r m a l l y be changed while LAF is open, I reserve the r i g h t , h o w e v e r , to take off either the Bid Rate or the Offer Rate at any time should this be considered a p p r o p r i a t e , having regard t o the need to ensure exchange rate s t a b i l i t y . HKAB has suggested that the spread between the Bid R a t e and the Offer Rate should be t w o percentage points I h a v e no difficulty with this as something to start w i t h and b e reviewed in the light of practical experience.

4. Notwithstanding the establishment of LAF, l i q u i d i t y m a n a g e m e n t is still the primary responsibility of the m a n a g e m e n t of a b a n k . LAF should not be regarded as a substitute f o r . prudent liquidity management. For this r e a s o n , b a n k s are not expected to make use of LAF on a regular basis

5. S h o u l d you have any queries on the details of LAF, p l e a s e c o n t a c t M r Y K Choi of this Office at 529 0204 or Mr Barry Y i p at 866 3286.

Yours faithfully,

( Joseph Yam ) Director Office of the Exchange Fund

Hong Kong Monetary Authority

To

All Licensed Bank Chief Executive Officer

23 October I997

The HKMA would like to remind licensed banks that it does not encourage repeated borrowings by licensed banks through the Liquidity Adjustment Facility (LAF). Each licensed bank must organize their Hong Kong dollar fund prudently and not be overly dependent upon the LAF for last resort liquidity support. In order to discourage licensed banks from repeated borrowings from LAF, penal LAF offer rates different from the advertised LAF offer rate will be determined on a case by case basis and at the absolute discretion of the HKMA for repeated borrowers. These will be communicated to the individual licensed banks concerned.

P e t e r Pang Executive Director

Hong Kong Monetary Authority

Joseph C K Yam, JP
Chief Executive

f 3g 91 JP
i&M

12 November, 1997 To: Chief Executive All Licensed Banks

Dear Sir/Madam,

Liquidity Adjustment Facility (Lk?)

In response to enquiries from banks, I would like to reassure licensed banks that the purpose of the Liquidity Adjustment Facility (LAF) is to provide last resort Hong Kong dollar liquidity support to licensed banks in Hong Kong for their normal day-to-day operations. But banks should always do their best to organize their Hong Kong dollar fanding prudently and not be overly dependent on LAF. Clearly, LAF should not be abused by banks for the purpose of funding speculative short Hong Kong dollar positions. I am sure you will appreciate that it is inappropriate for the HKMA to provide cheap Hong Kong dollar funding to those shorting the Hong Kong dollar* I would also like to make the following clarifications on the policy concerning the use of LAF : (a) The HKMA has the discretion, mentioned in the letter dated 27 May 1992 from the then Director of Office of the Exchange Fund when LAF was introduced, to take off the Offer or Bid rate of LAF under unusual circumstances. However, in order that banks are assured that last resort liquidity from

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HKMA through LAF is always available, albeit at a price, the HKMA for the time being undertakes not to exercise this discretion. (b) The HKMA does not encourage repeated borrowings by licensed banks through LAF since banks should manage their liquidity adequately without reliance on HKMA funding. Penal LAF Offer rates different from the advertised LAF Offer rate will be determined on a case by case basis and at the absolute discretion of the HKMA for repeated borrowers. Repeated borrowers will, however, be given a prior warning and an opportunity by the HKMA to explain the reason for their repeated use of LAF before such discretion is exercised. Repeated borrowers are defined as those licensed banks which have borrowed through LAF on eight occasions in any period of 25 days or on four consecutive days in which LAF is open. If repeated borrowers fail to provide a satisfactory explanation of their repeated use of LAF and continue to borrow, a penal rate will be charged on any such future borrowing. For repeated borrowers, the HKMA may also impose a limit on the amount of LAF borrowings that they can obtain by using their holdings of private sector LAF eligible paper*

(c)

Yours faithfully,

ex.

Chairman, HKAB Chairman, HKCMA

Annex 3 A

INTERNATIONAL MONETARY FUND * HONG KONG SPECIAL ADMINISTRATIVE REGION Concluding Statement for the Article IV Consultation Discussions with the People's Republic of China in respect of the Hong Kong Special Administrative Region November 4,1997

1.

Economic prospects and the policy environment in Hong Kong SAR have been

overshadowed recently by the disruptions in many of the Southeast Asian economies, as well as by volatility within local financial markets. Despite these events, we continue to be of the view that the underlying fundamentals in Hong Kong SAR are sound. Moreover, the resumption of sovereignty by the People's Republic of China was accomplished smoothly, and we have been impressed by the confidence that market participants place in the continued commitment to the existing economic policyframeworkand the rule of law. 2. Looking ahead, the key policy challenge will be to ensure that financial and other

policies remain supportive of the economy's historical resilience and flexibility, so that the adverse impact of the present financial market volatility is relatively modest and short-lived. While this may require some adjustment of factor pricesincluding in property marketsin order to maintain competitiveness, the willingness in Hong Kong to let this process work is impressive. Indeed, with the recent tightening of liquidity, the policy framework has responded as envisaged to pressures on the Hong Kong dollar, and has provided a welcome element of stability* domestically and within the region.

-2-

A. NEAR-TERM ECONOMIC DEVELOPMENTS AND PROSPECTS

3.

Recent data provide evidence that the economy continues to recover from tie

growth slowdown of 1994-95. Real GDP growth accelerated further to an annual rate o f 6Vipercent during the first six months of 1997, from 5 percent in 1996, This reflecteda pickup in consumption, which seems to have been boosted by strengthened confidence^! well as higher investment spending. While inflation remains broadly unchangedfromits level last year, in large part because of low import prices, pressures on resource utilization appeared to emerge and the unemployment rate has dipped to 2% percent. 4. We expect that activity will slow to a more sustainable pace during the second

half of the year. Household consumption appears to have been strong in the third quarter, but is likely to decelerate thereafter due to the volatility in domestic financial markets, and investment growth also should moderate in late 1997. Nonetheless, given the strength in the first half, growth is expected to average 5V4-5V4 percent for the year as a whole. This would leave output at close to capacity, which we estimate to be growing at a n annual rate of about 5 percent. 5. The unsettled state of financial markets makes it unusually difficult to assess

prospects for 1998. Howevereven on the assumption of a relatively earlyfirmingo f market sentimenta persistence of somewhat higher interest rates, the drop in stock prices, and turbulence within the region could slow growth to about 4lA percent in 1998. Household consumption and private investment are likely to be adversely affected by t h e rise in lending rates and the wealth effect of stock price declines. The significant slowdown that is expected among many of the Southeast Asian economies, as well as* devaluations within the region, also would negatively affect Hong Kong's external trade.

-3-

However, the impact should be moderate, since these countries represent a relatively small share of Hong Kong's trade, and the product composition of their exports means that their direct competition in third markets is relatively limited. Thus, we project a moderate improvement in Hong Kong's overall trade position, partly owing to an expected pickup in imports by the mainland.
B. POLICY ISSUES

6.

The authorities' commitmeat to a rules-based and noninterventionist

approach should enhance the economy's ability to withstand the recent regional and financial market turmoil. In our view, the existing policy frameworkwhich includes the linked exchange rate system, a prudent fiscal policy, the careful supervision of the financial sector, and a noninterventionist approach to factor marketshas been extremely successful in fostering strong and sustainable growth in the past. We are encouraged by the authorities' steadfast adherence to this framework, which provides an environment that facilitates the flexible adjustment of costs and prices to external shocks, and which should reassure markets that the impact of recent events on Hong Kong will be relatively short lived. 7. As in the past, the mission strongly endorses the authorities' continued

commitment to the linked exchange rate system. The system has proven its ability as an anchor for economic stability since 1983. Looking ahead, the fundamentals indicate that the link can continue to successfully play this role. Foreign exchange reserves are large and the fiscal situation is sound. Moreover, there is little or no pressure on the current account of the balance of payments, since the goods and services trade deficit is largely offset by net factor income inflows. The link also plays a critical role in maintaining confidence in Hong Kongfs role as an international financial center, to a

-4-

significant degree because it demonstrates the continued commitment to free-market policies and monetary autonomy under the "one country, two systems" approach, 8. Nonetheless, recent events have illustrated that the openness of the domestic

financial market means that Hong Kong can be subject to external pressures arising from sudden shifts in market sentiment. Appropriately, the authorities have taken forceful action during the past two weeks to tighten significantly monetary conditions, and have successfully demonstrated their ability and commitment to defend the link. It is important to recognize that allowing interest rates to rise in response to exchange market pressures is an essential element of the currency boaid mechanism that lies at the heart of Hong Kong's monetary arrangements. Recent events demonstrate that the system is working exactly as intended, and there are encouraging signs that speculative pressures axe easing. However, confidence could still be easily buffeted by events within the region that are beyond the authorities' control. We are confident that the authorities will be cautious and avoid a premature loosening of monetary conditions, despite the short-term pain that high interest rates bring. Indeed, a period of tighter monetary conditions may help facilitate a desirable unwinding of the asset price inflation, rapid credit growth, and labor market tightness that emerged during the past year. 9. Our discussions with market participants have indicated a widely-held

consensus that the prudential and regulatory oversight of the financial sector is strong, which has helped underpin confidence in the system. Conservative loan-tovalue ratios and high levels of capital adequacy provide reassurance that the banking system will be able to withstand the effects of the recent financial market volatility. Nonetheless, further steps to enhance disclosure and transparency could help reduce market uncertainty, thereby limiting the risk of unwarranted contagion. Measures that

-5-

could build on the considerable progress already achieved in this area include increasing the disclosure of individual banks1 problem loanswhich on average are relatively lowand adopting more specific guidelines for provisioning and income recognition. In addition, further improvements in financial disclosure by foreign and mainland-related banks and nonbanks would also be beneficial, particularly given the growing financial integration between Hong Kong and the mainland. Development of a market for mortgage-backed securities will allow banks to enhance their liquidity and risk management, but it will be important to ensure that the Mortgage Corporation does not create a significant contingent liability for the public sector. 10. The mission strongly endorses the commitment to prudent fiscal policies,

including the commitment under the Basic Law to avoid fiscal deficits. We expect the FY 1997 fiscal surplus to be significantly higher than projected in the budget, mainly due to the unusual surge in land-related receipts during the first quarter of the fiscal year. As these receipts are expected to moderate, the surplus would narrow automatically in the coming fiscal year, but remain at a comfortable level. Despite the strong fiscal position, and the possibility of a growth slowdown next year, we would caution against the introduction of substantial expansionary measures in the FY 1998 budget. Particularly in view of the recent turmoil in financial markets, this would not be a propitious moment to signal a shift away from the traditional policy of significant surpluses. Moreover, a discretionary easing of fiscal policy could impede a desirable unwinding of demand pressures. 11. There remains the issue of the longer-term objective for fiscal policy,

especially with regard to the appropriate size of the fiscal surplus and reserves. In our view, a number of factors argue in favor of maintaining a substantial level of fiscal

reserves over the medium term. Large fiscal reserves will play an important role in ensuring that confidence in the authorities' policy frameworkincluding the exchange rate linkis sustained. They would also appear to be prudent in view of the heavy dependence of the revenue* system on relatively volatile land-related revenues. Demographic trends also argue in favor of maintaining a significant fiscal reserve. The expected rise in the old-age dependency ratio during the next 20 years could result in a substantial increase in the burden on the government for social welfare payments and medical care. While the Mandatory Provident Fund(MPF) will assist in providing for an aging society, there will still likely be significant fiscal costs associated with a rapid increase in the elderly population. 12. We support the government's effort to address the chronic undersupply of

housing, especially the emphasis on rationalizing housing policy and streamlining its implementation. However, public sector intervention in the housing market is targeroughly half the population lives in public housing or receives some form of housing assistanceand there appears to be substantial scope for improved targeting of subsidies. In our view, therefore, the emphasis should be on reducing government intervention in the housing market, particularly by increasing the supply of land for private sector development and more strictly targeting subsidies to the truly needy0

13.

While the near-term outlook is inevitably subject to risks, Hong Kong's

medium-term economic prospects are favorable. Productivity is high, particularly within the tradable goods and services sectors, and Hong Kong is in a unique position to benefit from the growing demand by the mainland for financial, business, and traderelated services. Moreover, the continued flexibility of goods and labor markets gives confidence that the necessaiy adjustments will be made as needed to changing economic

-7-

circumstances. Thus, we would support the intention to avoid an expansion of programs designed to promote specific industries. Rather, the emphasis should be on measures to increase the competitive environment in the nontraded services sector as a means of reducing business costs. The ongoing deregulation of the telecommunications sector is an important example of the potential benefits from such efforts. We also welcome the government's intentions to streamline administrative procedures, carefully assess the cost of compliance with new regulations, and transfer the provision of services out of the public sector. 14. Finally, the availability of timely and accurate economic data for Hong Kong

SAR, including Hong Kong's subscription to the Fund's Special Data Dissemination Standard, is consistent with the authorities' commitment to open and transparent policy making. We would encourage continued improvement in this area, especially with regard to the timely provision of external current and capital account data.

Hong Kong's Linked Exchange Rate System

Monetary Policy in Hong Kong The objective of monetary policy in Hong Kong is currency stability, Given the highly externally oriented nature of the Hong Kong economy, this monetary policy objective is further defined as a stable external value for the currency in terms of a fixed exchange rate against the US dollar at the rate of HKS7.80 to US$ 1. 2. This clear monetary policy objective is achieved through what has been referred to as the linked exchange rate system. This system was introduced in October 1983 after a nine-year period in which the Hong Kong dollar had been floating. During that earlier period of floating, the Hong Kong dollar exchange rate had been volatile, Without an effective monetary anchor or any mechanism for monetary control, due to the absence of any institutional arrangement that enabled the authorities to influence the supply or price of money, there had been sharp depreciation in the exchange rate towards the end of the nine-year period of floating when uncertainties about the political future of Hong Kong affected confidence in the currency. The linked exchange rate system, through introducing an external anchor for the currency, restored confidence in the currency. 3. The linked exchange rate system, as structured in 1983, required the issue and redemption of bank notes, through the note issuing banks, to be made against US dollars at the fixed exchange rate of HK$7.80 to US$1. Certificates of Indebtedness, which give the authority to the note issuing banks to issue bank notes, are issued and redeemed against US dollar at that fixed rate and for the account of he Exchange Fund, Under this influence, and the fact that deposit money is convertible to bank notes, the exchange rate for the Hong Kong dollar in the foreign exchange market stays close to the level of the fixed rate. 4. The linked exchange rate system is what is known academically as a currency board system which theoretically requires the monetary base to be backed by a foreign currency at a fixed exchange rate. The monetary base is normally defined as the sum of the amount of bank notes issued and the balance of the banking system (the reserve balance or the clearing balance) held with the currency board for the purpose of effecting the clearing and settlement of transactions between the banks themselves, and also between the currency board and the banks. The monetary base would increase when the foreign currency (in Hong Kong's case, US dollars), to which the domestic currency is linked, is sold to the currency board for the domestic currency (capital inflow). It would contract when the foreign currency is bought from the currency board (capital outflow). The expansion or contraction in the monetary base would lead to interest rates for the domestic currency to fall or rise respectively, creating the monetary conditions that automatically counteract the original capital inflow or outflow respectively, ensuring stability of the exchange rate through out the process.

5. In October 1983 when the linked exchange rate system was introduced, there was no institutional arrangement whereby banks in Hong Kong maintained clearing accounts with the currency board. Thus that part of the monetary base represented by the clearing balance of the banking system was initially not subject to the discipline imposed by a currency board system. Action was taken to correct this in 1988 through the socalled Accounting Arrangements which required the Management Bank of the Clearing House of the Hong Kong Association of Banks to maintain a clearing account with the then Monetary Affairs Branch of Government for the account of the Exchange Fund. This was subsequently replaced by another arrangement, on the occasion of the introduction of Real Time Gross Settlement for interbank transactions in Hong Kong towards the end of 1996, requiring all licensed banks to maintain a clearing account with the Hong Kong Monetary Authority for the account of the Exchange Fund. These reform measures had the effect of subjecting the whole of the monetary base to the discipline of the currency board arrangement and strengthened the linked exchange rate system of Hong Kong in ensuring exchange rate stability. 6. By assuming responsibility over the clearing system for money, the Hong Kong Monetary Authority also became responsible for the provision of last resort lending for banks with day to day shortage of liquidity. A mechanism to facilitate the performance of this important role was put in place through the Exchange Fund Bills and Notes Programme which started in 1990 and the introduction of a Liquidity Adjustment Facility in 1992. The former served, amongst other things, to provide a money market instrument which banks could use in times of need to obtain liquidity by selling them in an active secondary market or pledge them for liquidity from the Hong Kong Monetary Authority at the end of the day through the latter. 7. The Hong Kong Monetary Authority maintains the strict discipline of the currency board system both when engaging in any activity that has the effect of altering that part of the monetary base represented by the clearing balance of the banking system, and when issuing and redeeming Certificates of Indebtedness that give authority to the note issuing banks to issue bank notes. Mechanics of the Linked Exchange Rate System 8. The academics often referred to the theoretical possibility of bank notes arbitrage which they argue would ensure that the exchange rate remains close to the fixed level. This arbitrage process, which involves the movement of large amounts of bank notes, does not work effectively in practice under Hong Kong's monetary framework and in modern day financial systems. 9. Instead, the clearing balance of the banking system is the crucial element in the operation of our linked exchange rate system. 10. When a bank has surplus money in its clearing balance, it lends the money through the interbank market to other banks who are short of money; and, in settlement

of the deal, money is transferred from the clearing account of the lending bank to the clearing account of the borrowing bank maintained with the HKMA, leaving the clearing balance of the banking system as a whole unchanged. 11. But whenever banks carry out transactions with the HKMA, settlement.. is effected through the HKMA debiting or crediting their clearing accounts. As a result the clearing balance decreases and increases correspondingly. 12. When the clearing balance of the banking system as a whole falls, there is less money amongst the banks to trade with each other in the interbank market. Those in need of money will find it more difficult to borrow and may have to bid higher interest rates to acquire the money they need. Hence the smaller the clearing balance the higher the interest rates in the interbank market. 13. Under the linked exchange rate system, there is a general rule that the clearing balance of the banking system should be varied by the HKMA normally in settlement of US dollar transactions with the banking system. 14. Thus when US dollars were sold to the HKMA and Hong Kong dollars were credited by the HKMA to the clearing accounts of the banks, the clearing balance of the banking system increases and interbank interest rates fell Conversely, when US dollars were bought from the HKMA and Hong Kong dollars were debited by the HKMA from the clearing accounts of the banks, the clearing balance of the banking system falls and interbank interest rates rise. 15. Typically in a currency attack, the banks, on their own account or acting on behalf of their customers, would suddenly buy quite a lot of US dollars which, under the circumstances, would come largely from the HKMA who basically stands ready to sell US dollars at around the fixed exchange rate level in order to keep it stable. 16. In settlement of these deals involving the HKMA, which is in two days, large amounts of Hong Kong dollars would be debited from the clearing accounts of the banks who have sold Hong Kong dollars to the HKMA for US dollars. As a consequence, the clearing balance of the banking system falls sharply and may even become negative. 17On the settlement day, therefore, interbank interest rates would rise, as banks bid for the money in the interbank market which has become scarce. When interbank interest rates rise, it would become more expensive to maintain a short position in Hong Kong dollars. When this becomes too expensive, it pays to sell US dollars back to the HKMA for Hong Kong dollars and close out the short Hong Kong dollar position. This will result in an increase in the clearing balance of the banking system and a fall in interbank interest rates back to more normal levels.

18. The levels of interbank interest rates are determined by the borrowing and lending activity of the banks and not dictated by the HKMA. 19. The HKMA stands there largely passively to buy and sell US dollars from banks at around the level which the exchange rate is fixed under the linked exchange rate system. 20. The system therefore operates largely on auto-pilot without much discretion needed to be exercised by the HKMA. The necessity for monetary reforms 21. The monetary reforms introduced since 1988 have considerably enhanced the HKMA's capability in monetary management and improved the robustness of Hong Kong's linked exchange rate system. The volatility of the exchange rate, as measured by the standard deviation, has improved from 0.7% in 1983-91 to 0.1% since 1992. The robustness of the system is also demonstrated by its resilience against speculative attacks following the Mexican crisis and in the past few weeks amid Asian currency market turmoil. 22. There are several reasons why monetary reforms were necessary: First, the monetary reforms, such as the removal of the floor (under the Interest Rate Rules in 1987) and the ceiling for interest rates (under the Money Lenders Ordinance) would allow interest rates to be fully flexible in both directions. Second, the introduction of Exchange Fund Bills and Notes was designed to create a benchmark yield curve in Hong Kong, so that there is a clear term structure of interest rates for financial institutions to price their products more efficiently. Third, the creation of robust and efficient financial infrastructure, such as RTGS, and the paperless debt clearing and settlement system, Central MoneyMarkets Unit (CMU) are designed to make the market function more perfectly and sound. Fourth, Hong Kong is an international financial center with substantial flows of funds into and out of the Hong Kong dollar on a daily basis. The BIS 1995 foreign exchange market survey indicated that the average daily foreign exchange transactions involving the Hong Kong dollar amounted to over US$15 billion. The stock market is one of the most active and liquid market in the world, with daily turnover averaging [HK$15 billion] in the first three quarters of 1997. Interbank payments amount to more than $400 bh daily.

Differences from a "pure" currency board 23. There are some who question the wisdom to develop monetary tools to defend the Link since they believe such policies would be a deviation from a "pure" currency board. These commentators argue that a pure currency board does not perform central banking functions such as influencing interest rates, conducting open market operations, rediscounting, or acting as lender of last resort. Thus, a "pure" currency board has no discretion on monetary policy but merely issues and redeems domestic currency upon demand. 24 However, the HKMA is also responsible, under Section 3(1 A) to maintain the stability and the integrity of the monetary and financial systems of Hong Kong. For reasons explained above, the HKMA may have to provide from time to time liquidity of last resort for the banking system, which are fully secured against Exchange Fund Bills and Notes. Since such paper are fully backed also by US dollar assets, there is no compromise of the currency board principle. 25. This is the purpose of the Liquidity Adjustment Facility (LAF) operated by the HKMA. But this is not supposed to serve as a cheap bailout, particularly for those who were shorting the Hong Kong dollar or were assisting speculators in shorting the Hong Kong dollar, hence the discretion on the part of the HKMA to impose penal interest rates on the repeated borrowers of money through LAF. 26. The linked exchange rate system rather automatically produces higher interbank interest rates when there is capital outflow involving a depletion of foreign reserves. The larger the outflow the higher the interest rates, making Hong Kong dollars more expensive to borrow and more attractive in terms of the interest return, thus reversing the capital outflow in a self correcting process. 27. In a modern deposit based economy with sophisticated financial industry and large cross-border financial and trade flows, however, a currency board in its "pure" form, may not be adequate to ensure the smooth functioning of the domestic monetary and financial system. More specifically, given that the monetary base is small relative to the large financial sector and that the relationship between base money and broad money is not always stable, stability in the value of currency as provided by the currency board, although important, cannot guarantee the stability in the much larger financial and foreign exchange markets. Rules versus discretion 28The debate over a pure or modified currency board system hinges on the question of rules versus discretion. The concept of a monetary rule was originally built on the foundation that there is a stable relationship between money and other economic variables such as the price level A monetary rule to control, for example, the growth rate of the money supply, however defined, was considered the most effective mechanism for

monetary policy in the long run since empirically it has proved extremely difficult to establish a stable relationship between money and prices, due in part, to growing financial intermediation and innovation. 29. The main attraction of a monetary rule is that it prevents the government, for short term political expediency, to compromise the integrity and credibility of monetary policy. Flexibility or discretion in the determination of monetary policy objectives, however well intended, would do more harm than good, creating uncertainty of policy direction, possibly increasing the leads and lags with which the policy takes effect in the economy. 30. The other school of thought favours discretionary monetary management by monetary authorities. It argues that the relationship between money and other economic variables is never stable for monetary targets to be meaningfully pursued (Goodhart's Law), although there is no objection to the use of the exchange rate as an intermediary target. As long as the objective of monetary policy is clearly defined and central banks are given the necessary autonomy, if necessary through legislation, to pursue that objective, the risk of political interference in monetary management can as effectively be minimised or eliminated. 31. Hong Kong's monetary rule, the linked exchange rate system has brought stability to the exchange rate and therefore general monetary stability. Money supply growth has exhibited a higher degree of stability in the 13-year period 1983 to 1996. Particularly since 1989, our board money (HK$M3) has been growing at a steady annual rate of around 17%, broadly in line with the growth rate of nominal GDP. This stands in stark contrast to the high and variable money supply growth rates, of from 15% to 40%, during the nine-year period of floating exchange rate from 1974 to 1983. 32. The advantage of discretionary monetary management is flexibility in monetary policy operations rather than the monetary policy objective itself. Through varying the timing and extent of the discretionary intervention in the money and foreign exchange markets, monetary authorities can achieve a "smoothing" operation, particularly taking into account non-conflicting monetary objectives such as those at the micro level concerning the stability and integrity of the banking and payments systems. Thus, we adhere strictly to the currency board discipline of full backing against currency creation at all times, and would only intervene in special circumstances where the stability of the financial system and the payment system is at stake. Differences with other currency boards 33. While it is useful to compare Hong Kong's linked exchange rate system with other currency boards, notably in Argentina and the Baltic economies, major differences should be borne in mind. The first is the question of size. Hong Kong, as an international financial centre, has a based money supply of US$220 bn, compared to US$69 bn for Argentina, US$1.8 bn for Lithuania and $1.2 bn for Estonia. The Hong

Kong dollar is an actively traded international currency for trade, finance and investments, whereas the other currencies are used primarily for domestic transactions. 34. The second relates to the existence of statutory reserves, the variation of which can constitute controls on the mobility of funds. As Hong Kong is an international financial centre with constitutional guarantees against exchange controls, there are no statutory reserves requirements on banks in Hong Kong. In the defence of their currencies against speculative attacks, the other currency boards varied the statutory reserves ratios to quantitatively control the availability of funds for speculation. This tool is not available to Hong Kong. 35. The third issue is the strength of the banking system. The other currency boards are still rebuilding this banking systems, some with state-owned banks and others emerging from transitional economies. Hong Kong has one of the largest communities of foreign banks in the world and has a sound, well managed and well capitalized local banking system that is both profitable and fully market oriented. The market adjustments in Hong Kong through the banking system operate much more efficiently than elsewhere, 36. Finally, another important difference is that foreign currency backing for some currency boards is not necessarily 100% since they allow part of the reserves be held in US dollar denominated government debts. In Hong Kong, however, the note issuing mechanism ensures that backing is at least 100%. Indeed, the over US$90 bn reserves held by the HKMA at the end of 1997 are net reserves in that the HKMA does not have any foreign liabilities and the Government has no foreign debts. Hong Kong therefore operates a much more robust currency board system than others.

Hong Kong Monetary Authority

Annex 3.6

fot of Prof. Gonrihart

This brief note is intended to record my personal impression of recent events relating to the operations of HKMA, and the alternative monetary measures that have been suggested by various academics. Some parts of it may be extremely familiar to various readers, moreover my visit was brief, and I cannot guarantee the accuracy of some of the statements. A. Some background history of recent etents At the outset I note that Hong Kong has had greater success in avoiding the turmoil that has swept over Asia than any neighbouring countries, with the exception of Mainland China. A table [to be done] records the relative changes in exchange rates and in Stock Exchanges since 1st July. Moreover, the current forecast for Hong Kong for 1998, with growth of over 4%, inflation slowing, and no significant increase in unemployment, compares extremely well both with its Asian neighbours and mat of Western industrial countries, even though slightly down on previous projections. Again, the decline in property and equity prices, although somewhat abrupt, is not necessarily disadvantageous, and now appears to be rebuilding on a more secure level. Against this, it might, however, be argued that Hong Kong should always have done better, since economic fundamentals and policy were stronger. Although the events of October were not excessively severe, they cannot be described as helpful. Going back to the week starting in October 20th, a speculative attack on the exchange rate began early in mat week, following the decision of Taiwan authorities to allow exchange rates to depredate in the previous week. On Tuesday, October 21st there were sufficient sales of HK dollars to HKMA to force sizable system shortages on Thursday, October 23rd. Although these must have been obvious to the market and to the banks in Hong Kong, nevertheless there was no sign of rising interest rates on Wednesday, October 22nd. rather surprisingly and evea possibly worrying. It was felt that this might have

been due to the HK banks relying unduly on their access to LAP fund, and so, on the morning of October 23rd a notice was issued to HK banks warning them that they should not rely on the LAF if they were u repeated borrowers", in which case they might face an unstated penalty rate. Alongside the shortage from settlement of foreign exchange deals, the cash shortage in the HK money market was then unexpectedly and severely worsened by a large volume of cash being caught up within the banks. That shortage, plus the uncertain position relating to LAF access, then drove up overnight money very sharply, to a point at which the banks, and others, were induced to sell US dollars to HKMA; at which point HKMA injected liquidity against the future settlements for such FX purchases by HKMA. These actions had the effect of routing the speculators, who have not returned on any scale, but did have the effect of leaving the banks, and to some extent, other capital markets, more nervous about the likely future course of interest rates. To some extent those concerns have been reduced by the subsequent definitions and reassurance to the "repeated borrowers" in the subsequent LAF circular on November 12th. Even so, such nervousness has remained evident in the sharply upward sloping yield curve, so that overnight rate of about 4 to 5% has been consistent with term rates on one to three months HIBOR several percentage points higher; the three months HBOR rate remaining over 9%. These upward sloping yield curves have led to problems for many HK banks, in that the margin between HIBOR and BLR has narrowed to a point where their profitability has become a matter of public concern. B. Some Structural Problems The sharp, but short-lived, spike in overnight HK interest rates on October 23rd, and the resultant cessation, and reversal, of the speculative attack exemplified how a Currency Board system is typically meant to react to an external outflow (speculative attack). Nevertheless the pain of interest rate increases in HK is (structurally) magnified by the unusually high weighting of property-related business in both equity markets and banks* loan books. There are various measures that can be reviewed to reduce such concentration. The establishment of The Mortgage Corporation should be helpful, and more may, perhaps, be done (eg a Special Purpose Vehicle) in this field. In the longer term I would hope and expect that

credit derivatives, eg default swaps, could help HK banks to diversify their credit risk exposure more widely. The other structural concern, already noted, relates to the interaction between BLR (or Prime rate) and HEBOR. Because BLR is sticky (and cartelised), it often has too vary too late, and hence too much, which makes it even more politically visible, and thus evea stickier. The relationship, then, between BLR and HIBOR can become extremely difficult for some HK banks, causing public concern about their profitability. This issue also needs to be recognised, and, if possible, addressed. C. Alternative Monetary Measures Although the overnight spike in overnight rates was extremely short-lived (only one day), concern about its possible recurrence served to keep medium term (one week - one year) risk premia high. Moreover the occasion of the spike itself was clearly traumatic for markets. In several respects the effects have been favourable. FX Reserves have continued to build slowly, above June - October levels. Money market conditions, of high desired (by banks) short-term HK liquidity and medium-term risk premia, are conducive to caution and stability in asset markets. Nevertheless the pain in these events has led to a number of suggestions for revising the operations of HKMA, generally with a view towards reducing the interest rate pain of defending the system. Few, if any, commentators want either to abandon or to revise the link. It has served as a successful anchor. "There is no evidence, eg from trade figures, that HK, (essentially now a service economy) is having any fundamental problems in living with the link. Virtually everyone recognizes that dropping, or amending the link, would so enhance uncertainty that the subsequent interest rate pain would worsen (not reduce). One set of proposals is, to increase the automaticity, and transparency, of the Currency Board system, eg by having HKMA intervening continuously at, and only at, the fixed rate of HK$7.8(h

Sometimes its proponents, eg Prof Tsang, appear to argue that this would reduce interest rate volatility under current conditions, (sometimes they retreat into the argument that it would do so under idealised, classical conditions which do not now pertain). The evidence from Argentina (1995), though too short for proper econometric conclusions, does not suggest that automaticity, ipso facto, reduces volatility. In any case Argentina may, if events turn out badly in Latin America, find itself in the firing line again. It is conceivable that the tactical need in future could be to seek to distance the HK from the Argentinian system in public. Moreover, the distinction between a more discretionary and a more automatic Currency Board system is quite fine, and a change of operational form at this juncture could mislead the public about the scale and nature of changes involved. A more radical, and complex, proposal to reduce the interest rate 'pain' was proposed by Profs Nai-fu Chen and Leonard Cheng, plus colleagues from the HKUST. They argue that (too) high interest rates can reduce confidence, and that a public commitment to the link by HKMA in the form of HKMA writing US$ put options on $LAF loans would not only reduce HK interest rates but also increase confidence. There are, however, in my view both practical and technical problems with this proposal. It is in many ways akin to HKMA buying $HK forward, except mat HKMA bears all the risk and HK banks, who get the options, would get all the profits, (unlike the forward purchase when HKMA has both the risk and the returns). As with the forward purchases, the put option/LAF exercise assumes that no event will/can alter the link; if the link should be overtaken by events, the scheme would, of course, be a disaster. More seriously, the sight of HKMA acting in a way that reduces HK interest rates during a speculative attack - albeit by a mechanism that exposes itself to greater loss if the attack should in the event succeed - is not one that, I believe, wouid limit, halt or reverse that attack, (by all those other players, ie not HK banks, not offered such options); as the attack was halted on October 23rd in reality. The authors of this scheme recognize that if the initial shock to confidence is very large, then their scheme will not suffice; they would then protect the link, and HKMA by 'dollarising' Hong Kong. In my own view trying to hold HK interest rates by their US$ LAF/put option scheme would cause HKMA to run short of reserves quite quickly, as speculators piled in to take advantage of continuing low rates, at which

point a decision either to abandon the link or doilarise might appear to become forced on HK, (with perhaps a third possible course of raising interest rates by much more/longer than if done at the outset). 'Dollarisation' was not properly discussed at the academic seminar, owing to lack of time. It does have the obvious advantage of removing exchange rate risk, but not of course other types of risk (eg default risk, political risk). Against this it has numerous disadvantages, of which the loss of seignorage from the HK to the US taxpayer is both obvious and large. Besides this there are operational problems (eg how would HK$ reserve cash needs be arranged when the US Fed and money markets were shut), transitional problems, (at what rate would one switch 7.80, or current market rate; either choice creates arbitrary gainers and losers), and 'political* problems, (how would Beijing see it; would it be seen as a 'defeat'). It would not be an appetising move. D. Conclusion Although HK weathered the speculative attack in October, the process was painful. Nevertheless such a painful process is inherent in the manner that Currency Boards, in reality, have to work. The various academic proposals for seeking to lessen that pain have not been convincing to me, as I have tried to assimilate them over the course of the last couple of days.

Annex 3.7 Idea of USS I igtddirv Adjustment

P r e l i m i n a r y D r a f t Idea of A U S $ L i q u i d i t y A d j u s t m e n t (For Discussion on Recent Hong Kong Market Situation)

Facility

Prepared bv

Professor Nai-fu Chen Dr Alex Chan

(HKUST) (HKUST)

/. Establishing a new LAF System

Liquid Adjustment Facility in U.S. Dollar

Similar to the existing KKS LAF system, our proposed USS LAF provides a discount window function to the Hong Kong banking system. However, in the proposed USS LAF system, banks are allowed to borrow USS loans from HKMA by the collateral of Exchange Fund Bill under the following special terms: If a bank borrows USS loan (says 1-week ban of US$1 Billion) from HKMA through the proposed US$ LAF at she loan maturity, the bank can choose to l (!) repay (USS1 Billion + Interest payment for USS LAF) or (2) repay Hong Kong Dollar equivalent calculated by a pre-specified exchange rate HKS7.8/USS The interest rate of the USS LAF should be set to a level slightly higher than the Euro-dollar borrowing rate consistent with the credit rating of the borrowing bank.

IL Functioning of the USS LAF System

Under the existing system, when speculators attack the HKS/USS exchange rate, HKMA sometimes controls the HKS money supply through some restrictive policy in the-HKS LAF in order to protect the strength of HKS. It is true that this measure can protect the HKS exchange rate in some scenarios; but the HKS money supply becomes very tight Banks find it difficult to borrow HKS through the inter-bank market, and the HIBOR will rise dramatically; in turn the liquidity problem in the banking system will create harmful effect on our economy. With the proposed USS LAF, when the above situation (high HIBOR) happens, banks will be induced to borrow USS LAF from the HKMA and then sell the USS at spot Forex market directly for HKS. The receipt of HKS can alleviate their HKS borrowing demand and push down the HIBOR. Moreover, the overall HKS money supply in the economy remains the same. Suppose the HKS money supply becomes very tight (HIBOR is very high), Euro-dollar borrowing rate of the borrowing bank < Interest rate of USS LAF < the "high" HIBOR < Interest rate of the HKS LAF Why Banks Do Not Borrow USS to Fund the HK$ Demand under Existing System? Banks currently do not do this because of the potential exchange rate risk between HKS/USS. If a bank borrows USS to fund the HKS lending, it can suffer a significant loss should the HKS link be suddenly broken. An obvious evidence is the huge interest rate differential between HKS and USS during these weeks. Our proposed USS LAF does not only lend out USS loan to banks for alleviate their liquidity problem, but if also provides an option to the borrowing bank to choose between USS repayment and HKS repayment at the loan maturity. The bank is protected from any exchange rate risk through borrowing USS loan to fiind HKS lendmgfcash demand.

Technically speaking. HKMA offers * USS ban to the banks and gives them a put option to sell HKS for P USS at a prt-specified rap (HKS7AUSS]. "

Idea of USS Liquidity Adjustment Facility November 14, 1997 ///. Illustration of the Operation

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IV. Major Advantages: 1. HKS money supply will not be increased through the USS LAF; hence, it will not create any additional pressure on the HKSAJSS exchange rate. If anything, HKS strengthens as the local bank converts USS to HKS, counter to the wish of speculators. 2. The proposed USS LAF induces banks to borrow USS from HKMA to buy HKS and then lend out HKS to clients that demand HKS loan. (If clients demand USS loan, this scheme facilitates the local banks in injecting liquidity in USS when liquidity is tight in HKS). As liquidity is the lubricant for the economy, this allows the quick introduction of lubricant in tight market without flooding the market with HKS which might inadvertently help speculators. 3. Offering optional repayment scheme is a strong signal of your rigorous exchange rate policy (HKS7.8/USS system); it, in turn, provides strong confidence to the public. 4. Will not drain out the reserve. Theoretically, the put option is a "ZERO value" off-balance sheet item. The loan is almost a pass-through from Euro-dollar market to local banks. 5. Banks can solve their liquidity problems through borrowing USS from the USS LAF-to fund their HKS cash demand. Hence, HKMA can maintain the HKS link without creating high interest rates affecting the economy. It can stabilise the interest rate differential between HKS and Euro-dollar to a reasonable level. HIBOR will be more stable and stays reasonably close to the Euro-dollar interest rate.

Proposed by Nai-fu Chen & Alex Chan

Proposal for US dollar discount window dismissed as being too risky for Government P E T E RC H A N
Suggestions by academics last week to install a US dollar discount window to help push interbank market rates down have met with scepticism among market traders, . Academics from the Hong Kong University of Science and Technology who were part of a group of 10 academics who met Financial Secretary Sir Donald Tsang in recent days - have proposed creating a liquidity adjustment facility (LAP) denominated in US dollars, which would give banks access to cheap Hong Kong dollars in a high interest rate environment. While Hong Kong has successfully defended the. dollar against currency speculators, the price it has paid higher interest rates - h expected to. hurt economic growth. Under the proposal, when interest rates go up as a result of the Hong Kong Monetary .Authority's intervention, a | bank can pledge Exchange Fund bills to the "US dollar LAP" for US dollar loans with maturities shorter thnn one year. The bank can then sell the US dollar in the spot market directly for Hong Kong dollars, which will soothe demand for the local currency. On maturity the bank can choose to repay the loan in US dollars plus interest, or the equivalent in Hong Kong dollars at the rate of HKS7.8 per US dollar. Market participants are sceptical about the suggestion, saying it is difficult to get Hong Kong dollars to cover a short position \t\ times of crisis. The suggestion effectively requires the SAR government to use the Exchange Fund to bear all the exchange risks of commercial banks operating in Hong Kong-an * idea unlikely to be adopted by the Government. Standard Chartered Bank forex and money markets manager Stephen Yau Chinfat said it normally required two days for a typical "sell

said the existing LAF did not US for Hong Kong'* transac- from the MUS dollar LAF", have a problem. tion to settle. selling them for HKS7.90 The huge spike in the inThe bank still has to either and repaying only $7.80 to terbank rate - up to 300 per the Government.. borrow from the market -or cent for overnight funds on Citibank money markets resort to the Hong Kong dolmanager Chordio Chan said , October 23 - stemmed from lar LAF for funding. a lack of clarity in the rules the suggestion might wqrk Commonwealth Bank of governing the use of the LAF well if it was used as a longerAustralia treasurer Andrew announced that day. term risk management tool Fung^Hau-chung argued that He said banks were worrather than an emergency faif a bank had holdings of Exried that they might be mischange Fund bills, it could go cility. taken as a "repeated He points out under a straight to the Hong Kong borrower" by the authority if dollar LAF for overnight as- high interest rate environthey used the LAF for emerment the mechanism might sistance. gency funds. . He said there was. ample encourage banks to borrow .Mr Yau of Standard supply of US dollars as it was US dollars from the US dolChartered Bank has prolar LAFf Vscll US for Hong an international currency and posed that the Government Kong dollars" and then lend procuring US dollars had take an active role in calming the Hong Kong dollar pronever posed any problems. long-term rates down. ceeds to parn higher interest Mr Fung said the proposal "When the prevailing rate rates. " I essentially asked the SAR stays Jiigh at .13 per cent and It is essentially an interest I 1 government to write curren- j I cy options to banks -guaran* j.rate ^arbitrage opportunity . you want it to ease to below 10 per cent-, there's no use rej teeing to exchange US dollar j and-can help to case interleasing funds at ^percent," j borrowing for Hong Kong I bank rates back to their.norMr Yau said. I dollars at HKS7.8 - at zero mal levels. Mr Chan said the Gov"The effect could be more premium. visible and the authority's * Problems occur when the ernment was unlikely to addpt the suggestion because determination to defend the Hong Kong dollar is traded on the weak side of HKS7.80 I it would expose the Govern- peg more comprehensible if j'ment to undue exchange rate It was ready to lend at 9.5 per to the dollar, say $7.90. cent in such a situation, takBy then a bank car^ easily * risks. ing the risk of a minor run in pocket the 10-cent difference International Bank of Hong Kong's reserves." by borrowing US dollars Asia treasurer Davy Kwan
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Reply to " Proposal for US dollar discount window dismissed as being too risky for Government 57 I am very grateful to the feedback we received in the aforemendoaed article published in the business section of SCPM on November 24, 1997. It is this type of feedback that will help us understand the concerns from all angles. Mr. Stephen Yau Chin-fai and Mr, Chordio Chan took the words out of our month when they felt that our idea was to address the longer teim interest rate differential between the domestic interest rate (KEBOR) and the international US dollar interest rate (TLJBOR). The main idea behind our proposal (see SCMP p.18 , November 22) is for the government to facilitate the private sector* s arbitrage between HUB OR and LIBQR to bring down the longer term domestic interest rates. After all, it is the long term high domestic interest rates that 3dQl the economy slowly but surely. On the technical side of the 2-day settlement period, our proposal does not address directly the short term interest rate spike as voiced by Mr. Davy Kwan. It is a technical issue that we are working on to make sure that the same panicky situations would not occur again in the future, whether the short term pressure comes from unanticipated loan demand, sudden coatraction of money supply or speculative attacks. Mr, Andrew Fung Hau-chung' s concerns touched on the heart of our proposal In times of crisis, banks are reluctant to sell US dollais to get Hong Kong dollars because they are afraid of sudden devaluation. Our idea is just an intertemporal version of the existing currency board arrangement We would like the HKMA to enter into a business contract right now (via the put options) guaranteeing that the currency board arrangement will be honored in the future, at least up to the expiry of the put options. The risk (value-at-risk) to the government is minimal if it is merely acting as a middleman to unleash the debt capacity of the entire Hong Kong banking system to keep the domestic interest rate down- This is especially true if the final defense is a dollarizztiori of the Hong Kong financial system. Our proposal will address the confidence issue confronting Hong Kong: its term structure curve (or eqmvalcntly its currency forward curve) deviates from the US term structure curve even though the two currencies arc linked. This reminds me of the lyrics of a pop song " To-night you' re mine completely, . . will you still love me to-morrow?11 With the put options, the HKMA is merely converting the sequential one-night stands into a marriage vow. For better, for worse,.., l e t ' s sec if the HKMA is willing to walk down the aisle.

To Defend the Hong Kong Dollar in Times of Crisis Nai~fuChen

The Hong Kong dollar was under attack in August after the devaluation of the Thai Baht and other Asian currencies in July 1997; and again in October after thefloatof the Taiwan and South Korean currencies. The Hong Kong dollar has been linked to the US dollar at 7.8HKD to 1 USD through a currency board arrangement since October 1983. In other words, the government promises to pay 1 USD for every 7.8HKD in currency surrendered. To back this up, Hong Kong now has foreign currency reserve of about US$88 billion (mostly in USD denominated liquid Investments such as T-bilis), which is about 5 times the coverage of its ML In that sense, it is somewhat curious why speculators should pick oa a cunency with such strong backing* A common strategy of currency speculators is that they will sell a large amount of currency in the forward market, perhaps with a knock on the door at the spot market to start the " panic" Using the HKD-USD as an example, they will commit to sell, say, 100 billion HKD in 3 months- This forward contract is equivalent to 3 steps: 1. Borrow HKD at HIBOR (the Hong Kong Interbank Offer Rate), 2. Sell the borrowed HKD at the spot foreign exchange market for USD, and 3, Lend the received USD at the UBOR rate. (In normal tircES, the UBOR and HIBOR art just a few basis points apart because of the lint) There is no money changing hands at the time of inception of the forward contract. The speculators gain if cither (a) HKD loses value relative to USD, or (b) HEBORnte (domestic interest rate) increases relative to UBOR- In either case, the speculators gain in their short positions in forward contracts since the contracts are now worth less. A simple numerical example illustrates the point Suppose the current UBOR rate is 6%, the HBOR rate is 65% and the exchange rate is 7.75HXD/USD. The 1-yeax forward price for HKD is therefore 7.7S66. (a). If HIBOR goes up to 9% and UBOR remains at 67c, even if the spot exchange rate strengthens to 7 J0 the forward price will drop to 7.9179. (b) If the spot exchange rate remains at 7.75, the forward price will drop wen further to 7.9693. Thus using forwards becomes a favorite strategy for currency attacks because it is attacking simultaneously the exchange rate and the interest rate. Speculators do not even have to come up with money up front when they take short positions since these are forward contracts. But if either the exchange rate or the domestic interest breaks, speculators simply unwind their positions and gain. The fallacy of using high domestic interest rates to defend Many nughty currencies have fallm when central banks resorted to high domestic interest rates and tight money supply to defend their curoncies. The traditional wisdom is that the international speculators must borrow the domestic currency and dump it in the foreign exchange market to drive down the exchange rate in order to gain. Consequently, the defense xecipe for the central banks is to limit the money supply and increase the domestic interest mes to make it

borrow the domestic currency. As one can easily seefromdie above discussion,
speculators can reap enormous profits when the domestic interest rates go up. If

central banks consistently use this interest rate mechanism, it will invite speculators to come back over and over again and the locals may be forced to join the speculators to protect themselvesWhat is worse is that by tightening the money supply and increasing interest rates, it hurts the domestic economy and further erodes confidence. When the locals lose confidence in their central bank and start switching their local currency into, say, USD, the battle is lost Luckily, in spite of the recent turmoil Hong Kong still has a strong economy and abundant foreign reserves. Unless the locals lose faith, the link between HKD-USD can be easily maintained- As long as the government does not do anything counter productive to generate further panics, the battle is largely won before it starts.

The classical currency board system in times of crisis The classical currency board is an excellent system in normal times. It has two built-in self-adjustment mechanisms. The first one is pore arbitrage. If HKD should drop to 13 per USD, banks can exchange 1 USD for 7.9 HKD in the foreign exchange market and exchange 7.8 back into 1 USD with the currency board. The second one is the increase in domestic interest rate due to shrinkage in the domestic money supply as HKD arc turned in for USD, The high domestic interest rate makes the HKD more attractive. But in times of crisisf the high domestic interest may be interpreted as a sign of weakness- People will ask: why should HKD interest rate be so much higher than" USD interest when the currencies arc linked? The obvious answer is that the difference between HEBOR rate and LEBOR rate is ariskpremium reflecting the possibility of de-linking. The higher this differential, the higher the likelihood of delinking. If a local faces the choice of switching his lifetime HKD deposit into USD right now versus accepting a high domestic interest rate of, say, 100%/year (or about 3% a day) overnight and risking the possibility of devaluation of, say, 10% when he wakes up, he might choose to switch and sleep better- This win open up a flood gate that cannot be stopped People do not even bother to arbitrage. Thus there is a that the d^sical currency beard may not function as intended in times of crisis. A proposal to liandle the crisis situation in a strong economy: an intertemporal currency board with commitments There are times when exogenous situations precipitate a crisis in confidence. A case in point is the fell of cunendes aD around Hong Kong in the summer and fall of 1997. One can witness a sharprisein the HD3OR rate relative to the UBORrate- This represents the risk p r e m i e the future. The arbitrage between HBOR and LffiOR breaks down because investors have doubts about the resolve of the Hong Kong Monetary Authority (HKMA) in keeping the link for the foreseeable future. Ihave woiked oat (with Dr. Alex WH Chan of the Hong Kong University of Science and Technology) a proposal to handlesuch acrisis. The proposal is complex in its actual mechanics but simple in concept I will explain the general idea below.

With the strong banking system in Hong Kong, local banks arc overly well funded and have direct access to UBOR- If they can be induced to restore the congruence between HTBOR and LXBOR, it will keep the domestic interest rates down (to the level of UBOR) aixl simultaneously neutralize the pressing coming from the forward contracts to sellHKD for USD (conceptually, these are just the reverse 3 steps induced by the forward contracts). Here, the HKMA can play a key role. It can issue (frec-of-charge) what amounts to a ourency put option at the exercise price of 7.8HKD/USD to banks engaged in the HEBOR-L3BOR arbitrage. In economics, this is equivalent to " costly signaling." The put has zero value if HKMA keeps to its link of 7.8HKD/USD. With a 6-month put (associated with a 6-month UBOR loan), HKMA promises with ACTION (put option) that it wiH mainMn the link for the next 6 months. Ic will be cosily to HKMA if it should break: its promise. With this guarantee from HKMA, banks can quickly bring the HIBOR down kt congruence with UBOR. There are at least four xtasons why HKMA should facilitate rather than do it itself- L HKMA is not using its reserves directly in iniervention. Its huge reserves are used as a guarantee (of its existing promise) in order to unleash the debt capacity of the entire banking system in Hong Kong to neutralize the effort of any speculative attack on the HKD and keep the domestic interest rate down- When speculators4< borrow" HKD, then HKMA, teamed with the induced local banks, wiU act as a middleman to transmit the speculators* loan request to the mtemational money market 1 A put option is an explicit commitment that gives the market confidence, without which the market can only infer the commitment of HKMA from marketplaces and interest rates, 3. As a regulate^ author involved in operations that compete with private banks in generating profits, Its monetary operations should befecDIt&tingand providing incentives for the private sector to carry out the normal banking operations* 4 Hundreds of traders in commercial banks are better suited to trade, take risks and commiKiteate the needs of millions of clients. In all these, keeping domestic interest rate down is the ultimate medicine in keeping the ' local economyfrompanics. With local confMeoce intact, no spooilative attack can shake the BSWJSD link One waytolook at this idea is limit is an ^ emxency board guaranteeing the link overtimewith conunltnaeat It will defend not only the spot maxket link, but also the entire forward currency curve up to the apiiy of the put options. Let me emphasize that this is not the itcipt for a weak currency mda attack because their problems lie in a weak economy. This proposal will-work well for Hong Kong because of the strong Hong Kong economy (a benefidary of the strong Chinese economy), overly well funded banks, soundfiscalpolicies and a huge forelp cunency reserve. Even if the Hong Kong real estate prices should crash, the banks will remain well funded There is uo doubt that this strategy wffishteMth*^ m times of crisis, butithasto be k^lemented bdfow the stirrauiadiBg eoonauie* deteriorate any further. Once wo have this additional shkM* there is less chance of navmg ^ invoke the last defense - (totalization of the Hong Kong economy (U* using USD rather than HKD in the local economy, an option well suited in Hoog Kong because of its huge USD reserves). With these mechanisms in place* they will act as I

natural deterrent to any speculative attacks* We can all sleep better knowing that tomorrow the Hong Kongfinancialmarket system will still be in good shape, Nai-fu Chen is a professor offinanceat the University of California, Irvine and the Hong Kong University of Science andTecknotogy.

Annex 3.8

A Technical Analysis on the US$ LAF Proposal

This note analyses the US$ LAF Proposal with the use of the Exchange Fund's Balance Sheet (See ApyeatiK ). It shows why the scheme will not achieve its intended objective of reducing the pain resulting from a rise in interest rate when the HK$ is under selling pressure. Suppose the HK$ weakens from 7.73 to 7.78 due to speculative pressure and in response, the HKMA sells US$ for HK$ to support the exchange rate, la settling these US$ deals, the HKMA debits the clearing accounts of the banks concerned and the monetary base will shrink and interbank interest rates will go up (Step 1 in Appendix ). Under the proposed US$ LAF, a bank may obtain liquidity support by borrowing US$ from the LAF and selling it for HK$ (Step 2). Assuming other banks do not wish to incur a short HK$ position at a time when the supply of HK$ liquidity is shrinking, the HKMA will at the end become the counterparty of the deal. It will buy the US$ and create HK$ (Step 3). This transaction means the Mowing : (i) the HKMA gets back the US$ it has lent out. There has not been an increase in the foreign currency reserves (the US$ loan is not counted as reserves because it cannot be liquidated to support the exchange rate in time of need); when the bank attempts to sell the US$ for HK$ in the forex market, it does give some support to the HK$ exchange rate. However, the same effect can be achieved if the HKMA itself sells the US$ for HK$, rather than lending the US$ to the bank first, and then for it to sell the US$ in the market; and the HKMA creates HK$ when it purchases the US$ from the bank. This has two important implications. First, netting off the transactions in Steps 2 & 3, the HKMA is in fact creating HK$ on the back of the US$ loan, which is lent out at LIBOR (plus a small spread). We believe that the US$ LAF has the effect of the HKMA providing HK$ at LIBOR. Secondly, the cheap HK$ funding obtained by the bank (up to the total outstanding amount of Exchange Fund Bills and Notes, which is around HK$100 bn) may be used to fbnd its or others* short positions in the HK$. The decline in the clearing balance in Step 1 is offset, and the rise in interest rate is suppressed. This obviously runs counter to the design of the currency board system, which is embedded with a self correcting mechanism for interest rates to go up to support the exchange rate when the currency is under selling pressure.

(ii)

(iii)

Even assuming that there is no further outflow of funds, it is interesting to see what happens when the US$ loan matures (say one week or one month later). If the HK$ exchange rate is still stronger than 7.80, the bank will repay in US$. This will entail a sale of HK$ for US$. Other things being equal, this will put downward pressure on the HK$ exchange rate. Assuming other banks are not willing to pick up

the HK$, it will eventually be sold to the HKMA. This will lead to a contraction of the clearing balance, which is a recurrence of the situation one week or one month ago (Steps 4 & 5). Supposing the exchange rate weakens to below 7.80 as a result of intensified selling pressure (say to 7.85), the bank will exercise the option to repay the US$ loan in HK$ at the fixed rate of 7.80. The HKMA will debit the dealing account of the bank; supply of HK$ liquidity will shrink and interest rate will go up (Step 4A). It follows from the above analysis that the proposed US$ LAF only postpones rather than obviates the need for the self-correcting mechanism under the currency board system. Ultimately there is no escape from the interest rate pain. The very fact that the self-correcting mechanism of the currency board system is deferred may be perceived as a loss of resolve on the part of the government to maintain the link. It is also useful to note that apart from those banks which go to the US$ LAF for liquidity purpose, some banks may play safe by borrowing US$ and sitting on it when there are signs that HK$ is in trouble or under pressure. The cost to the banks is the spread between the cost of borrowing p g the US$ from LAF and the return from placing it out. But if the HK$ does weaken to below 7.80, they can exercise the put option and repay the US$ borrowing in HK$ at 7.80. This implies that the HKMA will be parting with its liquid US$ assets (up to HKS100 bn or around US$13 bn), at least until the repayment of the loan. This occurs at a time when the HKMA is facing speculative pressure and is most in need of strong reserves to back up its operations in the foreign exchange market. In the event that the HK$ exchange rate weakens to below 7.80, the US$ loan will be repaid in HK$, and the effect is analogous to a sudden switching out of the HK$.

Analysis of the Bnlnncc Sheet Effects of the US$ LAE Effect on Exchange Fund's Balance sheet A Step 1 HKMA sells US$ for HK$ US$ assets -US$1 bn Step 2 A bank borrows, say US$1 bn, from the US$ LAF US$ assets -US$1bn US$ loan +US$lbn . Step 3 The US$ is picked up by the HKMA, and assuming the exchange rate has strengthened slightly to 7.75 US$ assets +US$lbn CB +HK$7.75bn The decline in clearing balance in Step 1 is offset by [he creation of HK$ liquidity Clearing balance of the banking system (CB) -HK$7.78bn L As a result of the decline in the clearing balance, interbank interest rate will go up. Liquid US$ assets of the Exchange Fund is reduced by USSlbn,

Action

Remarks

Step 4

On maturity of the loan, the bank sells HK$ for US$ to repay the HKMA. The HK$ is picked up by the HKMA, and assuming the exchange rate has weakened to 7.78. The bank repays the loan in US$.

US$ assets -US$1 bn

-HK$7.78bn

StepS

US$ assets +US$lbn US$ loan -US$1 bn

Netting off the transactions in Steps 1-5, we are almost in the same position as Step 1.

Step 4A

The bank exercises the option and repays the loan in HK$

US$ loan -US$1bn

-HK$7.8bn

Netting off the transactions in Steps 1-3 and 4A, we are almost in the same position as Step 1.

I N T E R N A T I O N A L MONETARY WASHINGTON. O. C 20431

FUND

December 5, 1997

Mr. Norman T. L. Chan Deputy Chief Executive Hong Kong Monetary Authority Hong Kong

Dear Norman, 1 am replying to your letter of December 3 seeking my views on the proposal for a "U.S. Dollar Liquidity Adjustment FadEty". I can be brie since I agree with the points you make in your letter of December 1 to Professor Chen. l a my view, the proposed facility is a very bad idea. Indeed, I can think of few more effective means of undermining the credibility of the exchange rate link. Tnere is no need for me to repeat a detailed analysis of the technical implications of the proposal, since you have done this yourself in your December 1 letter and I have nothing to add to your analysis. But let me underscore two fundamental points: 1. It is wishful thinking to believe that the exchange rate link can be defended without. an active use of interest rates. Of course> interest rates can be kept lowtemporarilyduring a speculative attack if theHKMAis prepared, one way or another, to offset the domestic liquidity impact of any-foreign exchange outflow. This can be done through direct injections of liquidity or more complicated schemes of the type being proposed in the USSLAF. But the end result will be the same: the foreign exchange outflow will continue and at some point the HKMA would have to call a halt to the game by allowing interest rates to rise or by abandoning the link. 2. Postponing the necessary use of the "interest rate tool is likely to increase speculative pressures. We have ample recent evidence on this from around the Asia region, and it must be especially true in Hong Kong where the no-discretionaiy nature of the currency board arrangement is at the heart of policy credibility.1 MateoveffO- ^speculators, and HKS asset holders generally, are given the impression that the "gain" oif higher interest rates is not tolerable politically, then they are more likely to=teuach new speculative attacks. So pursuit of the illusion that there are imaginative axtangements that can maintain the benefits of the currency board mechanism and the

Incidentally, like Professor Goodhart, I find the distinction between the "classical1" currency board and Hong Kong's arrangements zs relatively minor.

-2-

exchange n t c link without the inevitable consequences for domestic liquidity could be very damaging. I hope this is hdpfuL With best personal regards, Yours sincerely,

David Goldsbrough " Senior Advisor Asia and Pacific Department

cc:

Mr. Towe

I N T E R N A T I O N A L MONETARY WASHINGTON. 0. C. 20431

FUND

February 20,1998

Mr. Norman T. L. Chan Deputy Chief Executive Hong Kong Monetary Authority Hong Kong Special Administrative Region

Dear Norman, Thank you for your letter of February 18 seeking my views on Professor Miller's proposal to issue special Exchange Fund notes that may be redeemed in U.S. dollars. We continue to be highly skeptical about such schemes. In particular, Professor Miller's proposal seems unlikely to have any significant effect on domestic interest rates. While interest rates on the special Exchange Fund notes would presumably trade closer to U.S. interest rates, it is hard to see how this would have a significant effect on rates for other Hong Kong dollar securities that do not have the put option attached. Proponents of these schemes argue that they can increase the credibility of the exchange rate commitment by increasing thefinancialcosts to the Exchange Fund were the link to be abandoned. However, such a strategy would be extremely risky, and could result in Hong Kong's version of Mexico's Tesobonos. Indeed, the experience of other economies strongly suggests that it is imprudent for the monetary authorities to engage in derivative . transactions. Such activities transfer significant risks to the public sector, which can have extremely adverse consequences during periods of market pressure, A proper accounting of these risks would require reducing the Exchange Fund's available foreign exchange assets, in order to reserve against the possibility that the option would be exercised. More fundamentally, it must be stressed that the exchange rate link cannot be defended without an active use of interest rates, which is the essence of the currency board arrangement, not something to be attenuated by various imaginative schemes. Efforts to

-2-

minimize the necessary adjustment in rates is more likely to fuel rather than attenuate speculative pressures. If speculators are given the impression that the "pain" of high interest rates is not tolerable politicallyan impression that could easily be conveyed with any tinkering of the present systemthey are more likely to launch new speculative attacks. I hope this is helpful With best personal regards,

Yours sincerely,

David Goldsbrough Senior Advisor Asia and Pacific Department

cc. Mr. Zhang, Executive Director

3 1 OCT mi

HE recent "currency attacks" in Southeast Asia have heightened concerns about the Hong Kong dollar, pegffed to die US currency at ihc rate of 7.SQ since 19SS under the "UnV. WUi the Hong Kortg doilar face the same fate as the Thai baht or the Malaysian ringgit? * Many have analysed the "lessons" for Hong Kong. Unfortunately, neglecting the exact mechanism of the link, there is not much to learn. Officials and commentators point to sound economic fundamentals and huge reserves. Hong Kong's economic fundamentals cannot be that sound, or Mr Tung Chee-hwa would not be enjoining everyone to work for **a new era**. And no reserves arc sufficiently large io withstand an onslaught , that erodes bank cieposits substantially. An exchange ate cannot be pinned for long by sound fundamentals or sufficient reserves. It ;can however"'be fixed fer arrangements thai appeal m the self-interest of market pa*>

The link belongs to a genre called "currency board"*, first set \tp in Mauritius in the last century- to be exact 1841. like the gold standard, it was an ingenious invention. Dozens of economics many former colonies of Briain have adopted the system. It has worked well in fixing exchange rates. Hong Kong actually used it between 1935 and 1972, tying the dollar to the British pound. There are now over ten countries in the world employing it, but none in Southeast Asia except Hong Kong, This fact should have been stressed. The idea is surprisingly simple. A "currency board" issues currenq* notes (paper money) -with a 100 per cent foreign reserves backing at a fixed exchange rate. Any holder of paper money therefore rests assured that he can exchange his notes into foreign currency at the fixed rate. In a modern financial system, people hold much more

Strangely. Hong Kong of^ bfdl m ficials choose not to empha- ^ ^ ^ ^ g ^ ^ fu|1 g fu|1 S SC ie ! Imk. v vu u Whric I T f Southeast c iC deposits deposits. Hong the * Kong's" (f sd th I country k Whri try S to h keep h * u Asian ** b ; exchan rates stable bl the if exchange (but not fixed) through market intervention and aditiinistrativc control, ihc link is fixed for totally different reasons.

one dittd of its ctoilar deposits. How Js the exchange rate of bank deposits ftxcu? Like ihc gold standard, it is through arbitrage. Since ihc exchange rate of paper money is fitted, the rate of bank deposit has to follow suit. Any rate differential gives rise to profitable activity tint closes tiie gap^ Take Hong Kong as**an example. Iftiic market rate of deposit weakens to say 8.00 against the US dollar, anyone can withdraw cash from his Hong Kong dollar deposit account* surrender the paper money to the "currency board** (the Exchange Fund) and get US dollars at the fixed but stronger rate of 7.S0. With HKS7.S million in cash, he will be given USSI million. By selling the USS I million in the market* he fetches HK58 million. So he obtains a profit of HKS2OO.O0O. That is arbitrage, risklcss. The selling pressure on the US dollar will push the market raic backto/.SO. Under the gold standard, gold bullion was shipped across countries to ensure that exchange rates converged to their gold panties. In a currency board system, people move currency notes to keep the market exchange rate in line. Ooih systems appeal to the self-interest of the arbitrageur, and are distinct from regimes thai "fix" the exchange nue through nan-market meum.

Why arc Hong Kong of. ficialx shy of highlighting the link as a currency board system? The truth *i$ that Hong Kong has been a "black sheep" in the family. From the beginning, I935t there was no currency board. Because of colonial tradition, dollar no:cs were issued by designated banks. There are now three of them: the Hong Kon^ Bank, ihc Standard Chartered Bank, and the Bank of China. When issuing currencynotes, the notes, the noteissuing banks (NIBs) deposit an equivalent amount of US dollars with the Exchange Fund (EF) at the rate of 7.80. That follows the principle of the cur* renq* board. However, besides the NIBs, other banks, financial institutions and the depositors at large have no direct access to the EF to perform arbitrage. This is a crucial weakness of the link. In the 1980s, the market exchange rate was on the weak side of the official rate (above 7.80). In the 1990s. it swung to the strong side, staying belowr.7.S0. Deviation so far averaged I per cent. Such a price differentia! should nave invoked arbitrage activities. But they have hardly been observed. A key reason is.ihat banks do not like to have large amounts of their deport* converted imo cash for the pursuit of arbitrage promA kirgc-scalc conversion will be equivalent to a bank nw< The NIBs and indeed in* whole financial sccwr *r*

H o n g K.on^_Stand;irJ

3 I OCT 1997

less than three months; G O banks folded; economic growth rate was a negative -\ per cent; and unemployment shot up to id per cent. Yet the market exchange rate adhered strictly to the official rate (of ortc peso against USS1). The same "miracle" occurred in Lithuania. A not interested in facilitating They have instituted a banking crisis broke out in arbitrage. Hence, the mar- reserves system whereby December 1995. The ket rate has persistently each bank has an account nation's two largest banks strayed from 7.80. .. with the central bank, in were closed. Deposits fell toy Moving gold around an- which the reserves for notes 15 per cent in the first noys relatively few people, as well as the monetary quarter of 1996. Yet the moving cash around is a reserves are kept. The cen- official rate of four litas different story. That Is a tral bank guarantees the against USS1 was noi chalminus for currency board full convertibility of all the lenged at all. vis-a-vis the gold standard. reserves of each bank, at die I visited Argentina in Because of the absence of a fixed exchange rate. This April 1996 and the Baltics genuine currency board ingenious set-up bypasses in June 1996. The amazing of their and the lack of universal the problem of moving cash robustness exchange rates drove me to access to it by market par- around for arbitrage. Suppose Hong Kong only one conclusion: Hong ticipants. Hong Kong's multi-layer system adds to adopted such a system, no Kong's currency board the problems of die classi- banks would dare quote an regime, having started cal board. It has failed to exchange rate that deviated earlier, has performed fully enforce the fixed rate from 7.80. If Bank A quoted rather poorly. a rate of say 8,00. Bank B Hong Kong should cat of 7.3.0. could immediately sell the humble pic and learn When the local dollar is US$1 million to it, fetching the real lesson from the under pressure, Hong HK$8 million, with an in- experience of the AEL Kong's central bank, the struction that Bank A trans- countries < our "junior" Hong Kong Monetary Auth- ferred the amount to its members in the currency ority {HKMA). has to account with the central board camp. This is not a tighten liquidity and raise bank. time for indulging in self interest rates, on top of The HKMA would con- congratulation over sound shouting at speculators and vert HKSS million into fundamentals and huge rebanks that accommodate US$1.03 million for Bank B serves. them. This is not the way at the fixed rate of There is already a central that a currency board is HKS7.80. A profit of bank in Hong Kong, the supposed to work. Doubts U$$26.OOO then went to HKMA. h is not a very big linger on the long-cun vi- Bank B. Banks C and D step to institute a direct ability of the link. would be jumping at the banking reserves system. Hong Kong's foreign In any case, there is a real arbitrage opportunity. lesson for Hong Kong to Note mat no cash "exchange reserves arc learn. Argentina, Estonia movements were .involved much larger in relative size and Lithuania adopted the in all these transactions, as than those of the AEL currency board system in the central bank played the countries, k is a shame that 1991. 1992 and 1994 re- role of settling arbitrage the territory cannot guarantee a 100 per cent stability spectively. ! have dubbed activities. them as the AEL modef. With this improved cur- in the exchange rate, as Though latecomers, all rency board system. they can. Why should Hong three AEL countries use an Argentina. Estonia and Knr&3 be bothered about improved version of the Lithuania have been able to the fate of the Thai baht or system.' It overcomes the ensure 100 per cent stability the Malaysian ringgit? They problem of cash move- in their exchange rates. In .ire different animals! ments for arbitrage, with 1995. Argentina faced H Tsnng Shu-ki i$ professor which Hong Kong is strug- serious crises: 20 per cem of of ettmomkrs at ths Hong Kmf gling. H bank deposits were lost in 6*i[*t$i University

Anne* Performance of Major Overseas Stock Markets

Market Hong Kong Paris Frankfurt New York London Sydney Tokyo Singapore

As at 1 Jan 1996 As at 1 Oct 1997 10073 2261 2359 5117 3689 2203 19868 2267 15049 4263 4039 7945 5244 2767 17888 1955

% change +49% +89% +71% +55% +42% +26% -10% -14%

Annex 4.2
Short selling turnover - S e p t e m b e r 1997

101 1135 23 293 13S l )2 1 !03X 25 31 670 2 688 1109 291 308 267 1199 440 223 231 142 41 270 1203 525 123 1063 10 11 97 12 535 655 480 3 45 8 156 6 54 5 13 14 1182 368 173 183 683 190 488 323 17 301 318 230 438 304 988 90 1122 566 78 1138 363 338 69 218 103 697 521 242 83 1166 583 409 16 19 87 511 322 268 247 349 757 4 20 302 1033 1128

jiSf^SJ! ffi #N fir 8* SESffiff !!^3a3ii c P&'4t#'. /3S-I4I5 JkiELItM HOI Jt KHI$$ ^n[^l4S tpmM7iW-HB. tpM'Stt] ^WMW^ktfk 31 $Ui1JF, 3ife SiHfi!IJ ifJlf^'SS ^fS&S dp*M'# fciffiikM. i l 'FS&fT ,liS.5S ^yfc^F JMBMB ##S;8:ifif MM&M HiSEffcBHK 8 3 f l&'jSf %WLWk \EM ts^ilfifT fMsSS^fSlJIiJii MS^iifel ^81 UK # ?i * A ^MMMMWk iffi^WS^R JzMBi #?i'Wift ipiife &ttM1Bk C 3 fQHH ?IBSK SlffilTO #HCH'li *&# ^ft-ftlHK

fifT

Amoy Properties Asia Satellite Telecom Bank of East Asia Cathay Pacific Airways CCT Telecom Holdings Champion Technology " Cheung Kong (Hodings) Cheung Kong Infrastructure Chevalier lnt'1 Holdings China Aerospace Int'l China Eastern Airlines - H Shs China Light China Overseas Land China Resources Beijing Land China Resources Enterprise China Travel CITIC Pacific COSCO Pacific Dah Sing Financial Dao Heng Bank Fairyoung Holdings First Pacific Great Eagle Holding Guangdong Investment Guangnan (HoldingsJ Guangshen Railway - H Shares Guangzhou Investment HB Int'l Holdings Hang Lung Development Hang Seng Bank Henderson Investment Henderson Land Hing Kong Holdings HKCB Bank Holding HKR Int'l HK& China Gas Hong Kong Hotels Hong Kong Telecom Hong Kong China Hongkong Electric Hopewell Holdings HSBC Holdings Hutchison Whampoa Hysan Development Ideal Pacific Holdings Ltd Jilin Chemical - H Shares

Mmmm
SM8f? MMMWi. J&#ffi ffiffSS Jlfefc UjMIK fftJMfcR #Mk JJ-36& 2xMf? IC^F Wfe yfc^Ft&IQ X t t l l J (MM) ?ISjHII ll'tt'I&ISlJff Ml^^^H3S $Li&3im *S/ jftlHlteHK #5HH JbifitHrfi'fbXHK S # S & (353H) ^ftffa "if Jk H fii H H ITftHRR "i*H$4t fiflSUn 'flr'fnSI!! HSIJUX; ffi^-?-fg E3flrt-=F fflillifeJS ^fc^i&'^i'A' fctifcJQ'B *M9tft H ^ (M ft A) n$IBlK ^ ^ I t l #^l^;SISffifT 41 P ^ H AHA US 'SOI *^fT fcff fbHHK UMMfbitJLHK

K. Wan Int'l
Ka Wah Bank Kerry Properties Kumagai Gumi (HK) Lai Sun Development Maanshan Iron & Steel - H Shares New World Development New World Infrastructure Ng Fung Hong Ltd ONFEM Holdings Pacific Concord Peace Mark (Holdings) Pearl Orental Holdings Peregrine Investments Qingling Motors - H Shares RBI Holdings Regal Hotels Infl Shanghai Hai Xing - H Shares Shanghai Industrial Holdings Shanghai Petrochemical -H Shares Shangri-La Asia Shenyin Wanguo (HK) Shougang Concord Century Shougang Concord Int'l Shougang Copncord Technology Shun Tak Holdings Sino Land Solartech Int'l South China Morning Post Stone Electronic Technology Sun Hung Kai Properties Swire Pacific'A" Swire Pacific 'B1 Television Broadcasts Tingyi (Cayman Islands) Top Glory Int'l Holdings TST Properties Union Bank Vanda Systems & Communications Wharf (Holdings) Wheelock&Co Wing Hang Bank Yizheng Chemical - H Shares Zhenhai Reftning - H Shares

2.478.000 70,000 2,130,400 2.745,000 1.288.1HM) lOO.tKK) 4,St)5.()()<) 2.023.000 1.984.000 1.715,400 250.000 1.966,500 35.250,000 5,648.000 3.724.000 6,452.000 2,632,000 2,604,000 12.800 668,500 290,000 4,112.000 285,000 6,410.000 984.000 4,334,000 3,812,000 6,182,000 1,790,000 1,652,200 2.526.000 958,000 80,000 246,000 496,000 6,063,000 478,000 8,810,800 1,336,000 1.736,500 8,862,000 2,824,000 3,422,000 1,590,000 250,000 4,082,000 102,000 2,139,000 389,000 218.000 681,000 1,966.000 1,765,000 15,000 968.000 890,000 100,000 1,268,000 7,130,000 400,000 6,592,000 510,000 4,564,000 300,000 2,153,000 7,090,000 554,000 55,000 182,000 350,000 128,000 596,000 3,580,000 100,000 454,000 660,000 2,333,000 563,500 1,655,000 58.000 3J92DO0 2,880.000 2.000 164,000 30,000 2J27.000 2,042,000 150.000 42,000 48.000

141.476,419 10,764,350 68,331,609 134.692.500 3.692.388.046 661.029.71! 143.569.063 47.388.140 66,052.031 580.215.966 875.506.300 U5.104.U7 699.713.261 71.792.450 148.321.542 607.273.024 159.272,412 ! 247.356.501 10,516.010 23,802,637 80.388,445 105,427.935 18,457,988 278,562,960 68,444,841 184,624,500 366,889.254 542,144,000 29,366,122 70,923.592 41,742.810 54,728,177 292,341,046 658,380.278 35,284,517 164,208,803 31.433,791 495,782,638 309.191.694 61,754,755 581J53.76I 120,724,530 149,396.432 35,146.523 34,744.752 909,062.000 143,856.375 475.031.689 10.483,198 243,823.700 87,191.010 737.324.000 91,965.861 22,177.826 58.612.000 120,935.794 323,108.875 3,667,467.127 1,020,547.847 55,439.044 124.484,400 29.392.000 225,851,302 1,171.483,000 73,987,000 1.902,822,000 26.322.500 54.363J84 538,382,000 715,797,880 613.47L560 52,766.109 102,824,812 73.090,000 49,392.395 294,174,049 87.971.587 71.136.880 32.831.897 20,107.^)0 94.348319 871,983,200 71U250 32,7343H 13368300 79,969.638 63,172,404 6,063,050 2,673.476,000 119.745,066

1.75 0.65 3J2 2.04 D.03 0.02 3.41 4.27 3.00 0.30 0.03 1.71 5.04 7.87 2.51 1.06 1.65 1.05 0.12 2.81 0.36 3.90 1.54 2.30 1.44 2.35 1.04 1.14 6.10 2.33 6.05 1.75 0.03 0.04 0.14 3.69 1.52 1.78 0.43 2.81 1.52 2.34 2.29 4.52 0.72 0.45 0.07 0.45 3.71 0.09 0.78 0.27 1.92 0.07 1.65 0.74 0.03 0.03 0J0 0.72 5.30 1.74 2.02 O.03 2.91 0.37 2.10 0.10 0.03 0.05 0.02 1.13 3.48 0.14 0.92

0J9 5,04 0.29

j.JO a l o

2.65

0.33 0.28 0.50 0.22 3.16 3.23 2.47 0.00 0.04

Note: There are totally 241 designated securities for stort selling The name of a designated security will not appear in this report if there is no short selling transaction recorded in that designated security

Short selling turnover - October 1997

ilrj

iflULS 23

3gSfM

293 13K
j 1U3K

ftflUC*

3! 688
1 109

291
3IMi 1123

Amoy Properties APT Satellite Holdings Bank of East Asia Caihay Pacific Airways CCT Telecom Holdings Cheung Kong (Hodings) i'licung Kong Infrastructure China Aerospace lm'l China Liyht China Overseas Land China Resources Beijing Land China Resources Enterprise China Travel C'hina-HK Photo

4,250,000 33,500 1,790,400 7,036,000 2,420,000 6,135,000 2,415,000 1,731,600 4,307,500 8,046,000 1,438,1)00 5,330,000 3,7K(),O00 130,000 3,574,000 4,H92,(KK) 60,000 510,500 195,500 5,068,000 128,000 7,480,000 1,126,000 3,190,000 6,170,000 3O4,(KK) 1,307,000 31,441,000 2,710,000 3,951,(XX) 80,(KX) 498,000 5,920,000 329,000 11,534,182 2,292(HX) 46,446,()(X) 9,314,800 6,206,000 l,568,(K)0 476,000 3,9()6,0t) 2,347,000 120,()()() 200,(X)0 50,tX)0 428,000 290,0(X) 200,000 4,210,000 127,000 1,136,000 54,(M)() 260,(XM) 2,718,000 2,18(),(M)() 194,(KK) 442,000 150,(K)() 16,(HM) 4.574,000 X9,5()0 2K8,(X)() 352,(X)O 5,750,lXK) 2,095,(XX) 3,077,500 5,000 504,000 3,800,000 50,000 483,000 3,68&,00Q 5,801,(X)0 L840,(XX) 30.000

226,352,599 4,295,500 136,232,511 233,055,852 3,993,622,442 341,769,306 54,699,726 828,364,020 156,181,267 731,162,534 61,873,400 424,888,543 723,207,097 13,382,000 269,507,163 254,270,683 19,720,263 38,967,313 5,404,456 153,468,008 89,324,491 455,763,078 87,581,642 123,699,500 668,365,624 35,663,100 43,017,566 106,971.420 (>4,034,246 141,370,705 199,626,000 351,815,086 210,883,367 56,017,229 900,557,313 92,752,254 736,101,427 266,392,434 258,579,351 76,099,092 38,094,000 518,361,485 889,478,214 9,891,500 91.512,318 306,986,840 14,949,593 398,633,500 646,646,<XX) 196,824,962 50,441,475 72,115,000 90.886,004 94,491.100 156,330,404 949.674,000 37,442,983 152,404,000 240.763,000 82.570,275 130,195,593 6,831,500 60,311,096 129,684,000 198,288,865 111,990,727 99,286,249 22,242,000 67,827,000 1,324,355,280 120,968,000 38,160,886 148,766,813 KO/778,168 24,541,2(X) 104,574,335

0.78 1.31 3.02

1.81)

4.42
(1.21 I

2.76 1.K1 !

2.32 j
1.25 ! 0.52 ! 0.97 ;

267
1 I9>
4411

C'rnc Pacific
COSCO Pacific Dah Sing Financial Dao Heng Bunk Dickstm Concepts Int'l First Pacific Great Eagle Holding Guangdong Investment Guangnan (Holdings) Guangshen Railway - H Shares Guangzhou Investment Guoco Group Hang Lung Development Hang Seng Bank i lendeison Investment 1 lenderson Land Hing Kong Holdings HKCB Bank HtHding HK& China Gas Hong Kong Hotels Hong Kong Telecom Hongkong Electric Hopewetl Holdings HSBC Holdings Hutchison Whampoa Hysao Development International Bank of Asia liUn Chemical - H Shares KaWahBank Kerry Properties Lai Sun Development Lippo China Resources Liu CHong Hing Bank Maanshan Iron & Steel - H Shares Muilf-Asia Int'l New WtidU Development New World Infrastructure Ng Fung Hong Ltd Peregrine Investments Qingling Motors - H Shares Shanghai Industrial Holdings Shanghai Petrochemical -H Shares Shangri-La Asia ShtMtgautg Conctml Century Skwgiutg Concctrd lni'l Shun Till Itoldings SinoLaiwi . SnuoTooe Tekconvnuinicatiuns South China Morning Post Stone Electronic Technology Sun Hung Kai Properties Swire Pacific 'A* Swire Pacific 'B' Television Broadcasts Ttngyi (Cayman Islands) Tip Glory Intl Holdings Triplenic Holdings Union Bank Wharf {[foldings) Wheelock&Co Wing Hang Bank /lieuhai Kef 1111112; 11 Shares

l.tt
0.3(1
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223
11.H

sit if a #!!

3.62 3.30 0.14 1.64

13

142
4S
2711

1203

525 123 53 10

mmmm
lift te'fe*ti

mmmm-m

2.58 0.92 0.85 3.04 2.94 4.23 2.79 0.04 0.14 2.81 0.5V 1.2X 2.47 6.31 3.50 2.40 2.06 1.25 0.75 0.26 1.21 0.22 0.02 2.Wi 0.07
0,(13

It
97
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535 65S 3 45 H ft 54 5 13
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1fi&&4ttt IlilftM. .

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%K 183 488 156

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32,3

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234 17
.Mil

2.14 0.25
I..1K
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,UK f9

0.2X 1.74 0.23 0.52 0.29 O.Oh 0.02 3.51 1.31 0.48 0.27 2.90 1.87 3.10 0.02 0.74 0,29 0.04 1.27 2.48 7.1H 0.75 0.03

liB
6*; 7

242 K3 315 583

41)9

m%m%

16 19 87 511

322
268

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4 20 302 UK

mmmm

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: There are tolall}'241 designated securities lor slort selling The rjiiiMC of ;nit*sjpjiaietl Nt-cmiiy will mi appear in thi% ivptui if iheic is no short sctliup ir; l m that dcsigimuul si*

Short s e l l i n g t u r n o v e r - N o v e m b e r 1 9 9 7

101 23 991 293 138 1 1038 31 670 2 688 1109 291 308 267 1199 142 396 41 270 1203 525 123 10 11 97 12 535 655 3 45 8 6 54 5 13 14 368 183 683 488 606 17 301 318 230 18 90 1122 78 363 338 69 218 697 521 242 83 583 409 16 19 87 511 322 268 349 4 20 302 1033

tp IS M"JSitfL'& HWL

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1 ^S^WI'A 3fc-&"&3TB.

^IttEftsKI- -njBi

Amoy Properties Bank of East Asia Beijing Datang Power - H Shares Cathay Pacific Airways CCT Telecom Holdings Cheung Kong (Hodings) Cheung Kong Infrastructure China Aerospace Int'l China Eastern Airlines - H Shares China Light China Overseas Land China Resources Beijing Land China Resources Enterprise China Travel CIT1C Pacific COSCO PacificFirst PacificGold - Face Holdings Great Eagle Holding Guangdong Investment Guangnan (Holdings) Guangshen Railway - H Shares Guangzhou Investment Hang Lung Development Hang Seng Bank Henderson Investment Henderson Land Hing Kong Holdings HKCB Bank Holding HK& China Gas Hong Kong Hotels Hong Kong Telecom Hongkong Electric Hopewell Holdings HSBC Holdings Hutchison Whampoa Hysan Development Jilin Chemical - H Shares Ka Wah Bank Kerry Properties Lai Sun Development Leading Spirit (Holdings) New World Development New World Infrastructure Ng Fung Hong Ltd ONFEM Holdings Oriental Press Peregrine Investments Qingling Motors - H Shares Regal Hotels Int'l Shanghai Industrial Holdings Shanghai Petrochemical ~H Shares Shangri-La Asia Shenyin Wanguo (HK) vShougang Concord Int'l Shougang Concord Technology Shun Tak Holdings Sino Land South China Morning Post Stone Electronic Technology Sun Hung Kai Properties Swire Pacific 'A' Swire Pacific "B1 Television Broadcasts Tingyi (Cayman Islands) Top Glory Int'l Holdings Union Bank Wharf (Holdings) Wheelock & Co Wing Hang Hank Yizhcng ttwmicat - H Shares

5,171,500 1,122,200 15,000 6,092,000 804,000 9,862,000 3,201,000 889,200 3,450,000 6,060.500 5,276,000 1,332,000 9,288,000 3,626,000 3,851,000 3,276,000 5,480,000 144,000 293,000 9,694,000 510,000 1,018,000 2,156,000 1,954,000 5,238,500 322,000 3,606,000 40.000 80,000 8,160,000 400,000 14,882,000 3,458,500 48,558,000 5,702,400 9,801,000 1,178,000 1,250,000 1,943,000 458*000 1,974,000 500,000 4,025,000 433,000 1,004,000 260,000 250,000 2,010,000 2,146,(KK) t,256,(XX> 1,312,000 2,500,000 620,000 450,000 500,000 550,000 362,000 3,922,000 836,000 300,000 6,270,000 1,993,500 42,500 122,000 1.112,000 2,400,000 172,000 6,230,000 3/718,000 83,0<X> 260,000

92,611,762 88/799,316 64.549,000 95,252,800 3,030,599,346 202,362,389 43,675,280 370,101,928 209,H0,5(X> 110,807,067 513,814,193 29,157,000 284,348,058 468,462,507 139,754,907 264,594,197 161,569,703 131,991,184 43,033,785 297,439,156 60,877,283 82,679,500 466,768,125 32,595,190 86,052,057 56,(X)7,465 113,267,357 73,166,752 149,063,006 143,541J44 40,669,511 526,830,470 59,544 J 95 412,550,598 139,130,442 166,303,351 64,095,429 559,784,600 328,239,615 12,023,115 95,061,251 580,046,062 180,598,600 36,554,285 63,187,800 55,913,680 43,783,800 54,656.511 75,983, iOW 49,911,539 79.784.675 683,266,600 25,834,000

175,652*000 45,069, H 6 106,364,650 63,140,500 77,413,000 119,297,918 67,206,999 14.345.159 141,376,350 36,056.000 926,332.160 26,589,153 102,886,431 90,246,(XH) 7.921.4CX> 1.102.127,500

5.58 1.26 0.23 6.40 0.03 4.87 7.33 0.24 1.65 5.47 1.03 4.57 3.27 U.77 2.76 1.24 3.39 0.11 0.68 3.26 0.84 1.23 0.46 5,99 6.09 5.75 3.18 0.05 0.05 5.68 0.98 2.82 5.8! 11.77 4.10 5.89 1.84 0.22 0.59 3.81 2.08 0.09 2.23 1.18 1.57 0.47 0.57 3.68 2.82 2.52 1.64 0.37 2.40 1.34 0.18 0.31 0.80 3.68 1.32 0.39 5.26 2.97 0.30 0.86 3.08 0.26 0.65 6.06 4,12 1.05 0.02

Note: There are totally 241 designated securities for start selling The name of a designated security will not appear in this report if there is no short selling transaction recorded in that designated security

AnnexjLs HONG KONG FITURES EXCHANGE LTD.

Hong Kong Futures Exchange Limited Migration of Trading of Hang Seng Index Futures and Options Contracts to the Automated Trading System

Purpose This paper has been prepared by the Hong Kong Futures Exchange ("Exchange") at the request of the Financial Services Bureau of the Government of the Hong Kong Special Administrative Region for discussion by the Provisional Legislative Council Panel on Financial Affairs at a meeting to be held on 2 March 1998.

Background In April 1997, the Board of Directors, in consideration of future business plans for the Exchange, decided that all new futures and/or options contracts introduced on the Exchange would be traded on the Automated Trading System ("ATS"). Further, the Board articulated its vision that the Exchange should migrate the trading of Hang Seng Index ("HSI") futures and options contracts from the open outcry environment to ATS when conditions were perceived to be correct. In making such decision the Board was cognizant of the fact that no exchange in the world had attempted to move the trading of a high volume established futures and/or options contract from open outcry to electronic order matching or vice versa. Thus, the Board had no historical precedent upon which to evaluate how trading of HSI futures and options products would be affected by a change in their trading environment. Consequently, the Board felt that further study of the acceptability by Members and their clients of the ATS environment was necessary before a final decision to migrate the HSI futures and options products was taken. Thereafter, in September 1997 the Exchange introduced trading of Red-Chip futures and options on ATS. The introduction of the Red-Chip products on ATS provided the Exchange with information and insight as to the acceptability of electronic order matching of equity index based futures and options trading in its market. Based on such information and insight the Board, in December 1997, decided that it was the appropriate time to commence the process to migrate the HSI futures and options products to ATS and initiated a survey of the membership to confirm its decision.

H O N G K O N G F U T U R E S E X C H A N G E LTD.

HKFE Migration of HSI Products to ATS Page 2

The Exchange's survey of its 118 Members who were actively trading HSI futures and options contracts in December 1997, asked Members if they agreed with the Board's view that the Exchange should take immediate steps to prepare for the migration of the HSI futures and options products from the open outcry system used on the trading floor to electronic order matching on ATS. One hundred thirteen (113) Members responded to the survey with 86 Members agreeing and 27 Members disagreeing with the Board's view. In January 1998, following the completion of the survey, the Board re-confirmed its decision to migrate trading of the HSI futures and options products to ATS and the membership and public were advised the migration process was scheduled to be completed in 18 to 24 months.

Requirements for Migrating HSI Futures and Options to ATS The conversion into a fully electronic market place will require an estimated capital investment by the Exchange in excess HK$100 million. Further, it is estimated that a similar investment will be required by the Exchange's membership to upgrade their respective dealing rooms, systems and electronics equipment. In summary, the Exchange's migration plan calls for: construction of a new primary data-center; expansion of the back-up data center; upgrading of the primary and back-up ATS computer systems to alpha; expansion of the ATS communications network from 73 Members to all 120 Members; upgrading the primary communication network; installation of a back-up communication network; construction of anew ATS dealing center; installation and testing of two (2) major upgrades of the ATS operating software; development of additional system to enhance market surveillance; development of a fully automated settlement system; installation of approximately 200 additional ATS dealing terminals in Members' offices, and; training of an additional 300 to 500 employees of Members in the operation of ATS.

Report on Financial Market Review

Executive Summary

Financial Services Bureau Government of the Hong Kong Special Administrative Region April 1998

E X E C I I T I V F STTMMAPV INTRODUCTION

B I B . R E C .N C (f?D A T E R E C D ' 1 9 9 8 C L A S SN O . r s# A U T H O RN O .

Affected by the contagion effect of the regional financial turbulence, the Hong Kong dollar came under speculative pressure on several occasions in the second half of 1997. Overnight interbank interest rate surged briefly to 280% on 23 October under the automatic adjustment mechanism of the currency board system. During that week and the following week, the securities and futures markets in Hong Kong also experienced the most severe volatility in history, recording a 1,438 points (13.7%) fall in the Hang Seng Index on 28 October and a 1,705 points (18.8%) rebound on the following day. 2. While we have ridden through this particularly stormy period with our currency remaining stable and the securities and futures markets operating orderly and efficiently, the combination of the interest rate hike and the asset price adjustments in both the securities and property sectors have caused serious concern among the local community. The Financial Affairs Panel of the Provisional Legislative Council called for a special briefing by the Administration on 31 October 1997. On 2 November 1997 the Financial Secretary made public his intention to call for a review of our currency defence. The Provisional Legislative Council further passed a motion on 26 November 1997. Among the Members who spoke during the motion debate, there was an overwhelming support that the linked exchange rate with the US dollar should be maintained to safeguard the well-being of the economy and investors' confidence in Hong Kong dollar. Nonetheless, they strongly urged the Administration to review the operation of the currency defence mechanism as well as the operation of the financial markets especially shortselling activities and the trading of derivatives. The motion also called for actions to enhance the Government's ability to withstand such volatility and strengthen investor education. Supporting the motion, the Secretary for Financial Services reiterated the Administration's commitment to launch a comprehensive review once the regional turmoil had settled.

CONTRIBUTION TO THE REVIEW 3. This Review covers the mechanism for defending the linked exchange rate system and the operating mechanisms of the securities and futures markets during this period of volatility. The major contributors to the Review were the Hong Kong Monetary Authority (HKMA) and the Securities and Futures Commission (SFC) in their respective ambits. 4. The HKMA had the benefit of the views from a wide spectrum of people with an interest and the capacity in technical issues of this nature, including those in the academic field, here in Hong Kong and elsewhere. In particular, the HKMA received the

expert advieefrom the International Monetary Fund (IMF) team which happened to be in gg OTgHforthe armi&l Article IV Consultations in the second half of October, when the speculative attack on the currency occurred. Having watched closely how our linked exchange rate system worked to ensure exchange rate stability, the IMF experts provided objective advice and also gave specific opinion on a number of proposals that we received during this review. The HKMA also had the benefit of the advice of Professor Charles Goodhart of the London School of Economics who is also a member of the Monetary Policy Committee of the Bank of England. Professor Goodhart has long been associated with monetary developments in Hong Kong. 5, As regards the review on the securities and futures markets, we worked closely with the SFC and were assisted by the Stock Exchange of Hong Kong (SEHK), the Hong Kong Futures Exchange (HKFE) and the Hong Kong Securities Clearing Company (HKSCC). Throughout the financial turmoil, the SFC had also maintained close contact with its overseas regulatory counterparts, and discussed the appropriate measures to respond to the situation as it developed,, 6. The review also took the benefit of advice from experts in the financial markets, including fund managers, securities brokers, and bank treasurers most of whom have extensive experience working in sophisticated international financial centres. Views were also widely sought from academics and the market participants. As the review progressed, thefinancialturmoil continued to affect the currency and the financial sectors of several regional economies. There were also isolated incidents of individual financial institutions in Hong Kong being affected, including the mini-run on the International Bank of Asia and the default of the Peregrine Group and the C A Pacific Group.

FUNDAMENTAL PRINCIPLES 7. The Review has been premised on two fundamental principles. First, consistent with the mandate in the Basic Law, and bearing in mind the long-term interest of Hong Kong as an open and externally-oriented economy, we must maintain and enhance the status of Hong Kong as an international financial centre. Secondly, consistent with the objective of maintaining the stability of the Hong Kong dollar, the linked exchange rate (LER) system which has served Hong Kong well must be preserved.

THEREVIEW While we are not insensitive to the pain that has been inflicted on the economy by the interest rate hike and the asset price adjustments, we are pleased to note that the defence mechanism for the currency has very effectively preserved the stability of the exchange rate and the monetary system. The prudential regulatory framework for both the banking and the securities sectors which we have carefully built up over the
8

years have formed effective buffers against the recent shocks. Yet we have not been complacent. We have taken a thorough look at each facet of the currency defence mechanism and the securities and futures markets and have identified a number of areas where improvements can be made. Some of these measures have been immediately put in place to give prompt effect. Others may take some time to be examined in greater detail, for the targeted market to be developed, and for the necessary legislative and rule amendments to be formulated and put in place. In drawing the conclusions and the recommendations, we have been careful in striking a balance between the need for prudent regulation and the room necessary for free market development; and a balance between the need for improvements and the need for stability and certainty.

THE REVIEW ON THE CURRENCY DEFENCE 9. In respect of the currency defence, we have examined the events in the monetary sector in detail, focusing on the currency attack in October 1997. We set out a discussion on the operation of the linked exchange rate system and evaluate the various proposals from academics which aimed at relieving pressures on interest rates. We have also conducted an assessment of the impact of the recent events on banks' liquidity, profitability and asset quality. The HKMA has drawn lessons on the banking side and has made recommendations regarding ways in which both the actual position of banks, and the public perception of their position can be improved. This Review also examines the wider implications of the link for the macro economy. 10. follows (I) The conclusions of the review on the defence of the currency are as

Role of interest rates (a) Under the automatic adjustment mechanism of the LER systems, it is the market which determines the level of interest rates required to maintain a fixed exchange rate. As exchange control or credit control is not an option in Hong Kong, there is little, if any, room for selective infliction of interest rate pain on the speculators under our LER system. Whilst one or two of the schemes proposed by the academics aiming at suppressing increases in interest rates may have some psychological value, they may carry the risk of undermining the credibility and sel^adjusting mechanism of the LER system.

(b)

(c)

(II) Conduct of foreign exchange and money market operations bv the HKMA (a) Instead of rigidly buying and selling US dollars against Hong Kong dollars at the fixed exchange rate of 7.80, the HKMA should continue its existing practice of leaving the foreign exchange market very much alone. If there is risk of instability in the exchange rate, the HKMA should, as in the past and at undisclosed levels around 7.80, establish its passive presence in the foreign exchange market in accordance with the discipline of the currency board system. Operating under the rule-based currency board system, the clearing balance of the banking system, an important part of the monetary base, will vary in accordance with the flow of funds into and out of the Hong Kong dollars. Only in exceptional circumstances, such as Initial Public Offerings of shares and other large scale Hong Kong dollar transactions, will the HKMA consider directly varying the clearing balance temporarily without the corresponding change in its US dollar holdings. These operations are carried out for the benefit of promoting general market stability. In all other activities conducted by the HKMA which may have the effect of varying the clearing balance of the banking system such as a transfer of fiscal reserves and the issue of Exchange Fund Bills and Notes, the HKMA ensures that such effect is neutralized as the case may be, by recycling or sterilizing Hong Kong dollar liquidity. This practice should continue, For the purpose of facilitating the smooth functioning of the payment system, the HKMA should continue to provide intra-day liquidity as well as overnight liquidity through the Liquidity Adjustment Facility (LAF) by entering into the repurchase arrangements involving predominately Exchange Fund Bills and Notes. It should also continue to discourage repeated borrowings from LAF. The clarification of the definition of "repeated borrowers" enables the interbank market rates to rise in a less drastic manner, as was demonstrated during the week commencing 12 January 1998. This has contributed to a more orderly market reaction to the gradual shrinkage in the interbank liquidity. The present definition of a repeated borrower should be maintained.

(b)

(c)

(d)

(Ill) Banking system A sound and properly regulated banking system is essential to the maintenance of exchange rate stability. We should continue to reinforce our efforts in

IV

ensuring that banks in Hong Kong will manage prudently their risks, having regard to the special circumstances of Hong Kong's currency board system, and pay special attention to the quality of their assets so as not to be overly exposed to those which are vulnerable to interest rate volatility. It is recommended that strategic issues to further strengthen the resilience of Hong Kong's banking system to external and internal shocks be thoroughly considered in the consultancy study to be conducted in 1998.

(IV) Pain tolerance level of Hong Kong (a) In the defence of the Hong Kong dollar, sharp rises in interest rates will inevitably inflict pain not only on the currency speculators, but also on the home owners with floating rate mortgages and corporates with floating rate liabilities. One way to provide some insulation for the innocent parties from fluctuations in short term interest rates would be through borrowing fixed rate funds. It is recommended that steps should be taken for the Hong Kong Mortgage Corporation (HKMC) to play a greater role in developing the necessary market infrastructure to promote fixed rate mortgages as an additional financing option for home buyers. This can be achieved by the HKMC giving a clear indication of its intention to buy fixed rate mortgages from banks, thereby encouraging banks to originate such mortgages which they would otherwise be reluctant to grant because of the short term maturity and floating rate nature of banks' funding base. The HKMC may give a pre-commitment to banks to acquire those mortgages as they are originated. This will effectively protect banks from the market risk due to changes in interest rate after the origination of the mortgages as the banks can offload of those mortgages to the HKMC. It is recommended that steps be taken to develop the debt market, through encouraging the institutionalization of savings, especially the MPF, to promote the demand for fixed rate debt securities.

(b)

(c)

THE REVIEW ON THE SECURITIES AND FUTURES MARKETS 11. In respect of the review of the operation of the securities and futures markets, we have also examined the events prior to and during the market volatility in October 1997 to January 1998. We have considered in some detail the key issues of concern relating to the stock market, viz. risk management, shortselling and stock borrowing and lending; the regulation of margin financing activities which was a major factor in the default of the C A Pacific Group; the enforcement of compliance with SEHK

Listing Rules by company directors, financial advisors and sponsors; and the representativeness of the Hang Seng Index (HSI). We also discussed the role and function of the futures and derivative markets and their products, examining the trading system of the Hong Kong Futures Exchange especially in respect of the trading of HSI Futures contracts; the appropriateness of the margin level for HSI Futures contracts; and the function and market implications of derivative warrants. We have also addressed allegations of market manipulation; discussed ways to improve surveillance of trading and member conduct; and considered means to improve management of risk in the market at the investor, intermediary and market levels. Measures to improve market transparency, investor protection and education are also recommended. 12. The major conclusions and recommendations for the securities and futures sector are as follows (I) The market and regulatory systems (a) Throughout the period of volatility in the securities and futures markets, the trading, settlement and risk management systems continued to work well The institutional and regulatory framework put in place in the last ten years have proved to be effective in providing an open, fair and orderly market. In the two cases where provisional liquidators had to be appointed in respect of Peregrine and C A Pacific, the failure of these companies did not cause any substantive systemic problem, nor did they lead to further volatility in the market Taking stock as of 31 March 1998, our market is among the least affected in the region. In US dollar terms, the stock market in Hong Kong shrank by 24% compared with the position at the end of June 1997 .

(b)

(c)

(II) Issues of concern in the Stock Market (a) Shortselling, subject to regulation, is a widely accepted legitimate market activity in most major securities markets. The SEHK did not detect any improper activities in short selling reported to it during September to November 1997. Nor did SFC detect any link between improper short selling and market volatility during the period. Noting that market transparency is very important to the regime for shortselling, it is recommended that the reporting requirements for short open interest

When compared with end June 1997 and expressed in US dollar terms, the Taiwan market lost 15%. Tokyo and Singapore shrank by 31% and 27%, respectively. Others in South East Asia lost 45% (Philippines) to 79% (Indonesia).

VI

and other relevant information be enhanced to increase market transparency. On the other hand, a level playing field is important to the regime for stock lending and borrowing which complements short selling activities. We believe noted that the introduction of a central Stock Borrowing and Lending facility by HKSCC in early 1999 will provide equal access to stock borrowing and lending to all investors. (b) The C A Pacific incident made it clear that the largely unregulated margin financing activities by broker-related finance companies should be brought back into the regulatory fold. In this regard, the work of the cross-agency working group established in December 1997 was expedited with a view to publishing a consultation document in early May 1998 and to introducing the relevant legislative amendments to the first Legislative Council as soon as possible. It is recommended that these brokerrelated finance companies be subject to prudential regulation by the Securities and Futures Commission. The major areas of regulation include capital adequacy, risk management, and conduct of business. It is recommended that the SFC review the concept of Treasury Shares in the context of the review of Share Repurchase Code which has just begun. It is recommended that the SFC and SEHK consider the introduction of measures such as application for court orders and mandatory remedies to strengthen the enforcement of compliance of SEHK Listing Rules. It is noted that the Hang Seng Index is a carefully constituted and largely representative index for the stock market in Hong Kong. We welcome the initiatives taken by Hang Seng Index Services Ltd (HSIS) to constantly review the various Hang Seng indices, and the introduction of the new Hang Seng 100 Index. It is further recommended that the SFC continue to discuss with HSIS on possible improvements to the representativeness of the related indices. We would also encourage the HKFE to launch the trading of futures contracts on the new HSI 100 as soon as possible.

(c)

(d)

(e)

"Treasury shares" refer to issued shares held by a company but not cancelled as a result of share repurchase. Such stock is available for reissue, but receives no dividends and carries no votes.

vn

(Ill) Issues concerning the Futures and Derivative Markets (a) Derivative products including index futures are important risk management tools in portfolio management. They add liquidity to the market and increase the diversity of the market product base. As such they are essential for the development of the Hong Kong market and to meet the needs of the local institutional fund industry. Such needs will grow with the introduction of Mandatory Provident Fund schemes. Without them the Hong Kong securities markets cannot remain competitive in the region. It is recommended that we continue to improve our market rules to maintain an effective regulatory regime. We welcome the HKFE's decision to migrate the trading of HSI Futures contracts to the Automated Trading System, Noting the lead time necessary to put the relevant systems in place both at the Exchange and for its broker members, we also welcome the HKFE's initiatives to improve the information dissemination system of the open outcry system in the interim. It is noted that the margin requirement of the HKFE on HSI Futures contracts is already among the highest in the world and has served the Exchange and its Clearing Company well during the turmoil. It is recommended that the SFC and HKFE continue to explore refinements to the calculation of margin level in order to maintain the flexibility to meet exceptional market volatility, There was substantial growth in the derivative warrant market following the relaxation of issue requirements in August 1996. There were indications that derivative warrants add to short term volatility as a result of the corresponding hedging activities by issuers. We welcome the SEHK initiatives to review the listing rules for derivative warrants with a view to reducing the impact of warrant issues and settlement on the cash market and improving transparency and investor's protection. We expect that the SEHK will submit the relevant changes to the Listing Rules to SFC before mid 1998.

(b)

(c)

(d)

(IV) Market Surveillance and Risk Management (a) There had been allegations that speculators had profited through market manipulation across the securities, futures and currency markets; that some had taken advantages of the expected interest rate surge following the attack on the currency, the ensuing liquidity squeeze and the selling pressure on the cash market; that certain brokerage houses had taken

vm

positions prior to the announcements of certain economic analysis by their own firms, and so on. The SFC investigations have found no evidence to substantiate any of these allegations of market manipulation, (b) Recognising the importance of market surveillance to ensure trading activities in the market are conducted in a fair and orderly manner, it is recommended that the capability of the SFC and the exchanges in the surveillance of trading and members' conduct be further enhanced. Where necessary, legislative amendments will be considered to strengthen the capability of the SFC and the exchanges in obtaining market information from the intermediaries. It is also recommended that measures to better manage and eliminate risks at various levels be introduced (i) (ii) link-up of CCASS and RTGS3 in May 1998; introduction of Direct Investor Participation in CCASS also in May 1998; detailed examination of the feasibility of cross margining between HKFE and SEHK; and promulgation of revised Financial Resources Rules in the second half of 1998.

(iii)

(iv)

We also welcome the acceptance of stock collateral by HKSCC since end December 1997 to alleviate part of the liquidity pressure on market intermediaries,,

(V) Market Transparency. Investor Protection and Education (a) The heated activity in the market during the first half of 1997 and the volatility that followed both point to the importance of enhancing market transparency to enable investors to make their decisions based on equal and adequate knowledge about the fundamentals and prospects of the companies and investment products concerned. It is equally important to protect investors through regulations that protect their rights and opportunities and to educate them about the market.

This is a linkage between the Central Clearing and Settlement System (CCASS) of HKSCC which handles 99.5% of SEHK transactions and the Real Time Gross Settlement System (RTGS) of HKMA which is the money settlement system among banks. The linkage will farther reduce the market risks of settlement for HKSCC and the parties to the trade.

IX

(b)

The following measures have either been introduced or are under study in order to achieve greater transparency and provide better protection and education to investors (i) revision to the fmancial disclosure provisions in the SEHK Listing Rules to improve the transparency of financial exposure of listed companies to their investors and the market; with effect from February 1998 a requirement on listed companies to provide corporate communications to all investors who deposit their shares with the CCASS; review of fidelity insurance and compensation schemes of SEHK to ensure the provision of cost-effective protection to investors and market practitioners; establishment of an Investor Resources Centre within 1998; provision of various investor education programmes and enquiry/complaint facilities; and a requirement of the use of plain language in company prospectuses and communications.

(ii)

(111)

(iv) (v)

(vi)

THE BROADER PERSPECTIVE 13. The regional financial turmoil started off in Thailand in the middle of 1997 and quickly swept through to the rest of South East Asia. Then towards the year end, financial troubles in Japan and corporate bankruptcies in South Korea rocked North Asia. In early 1998, the fall-out in Indonesia gave a further shock to South East Asia and the rest of the region. These events have tended to compound each other, resulting in serious regional crises with profound implications for the global financial markets. Hong Kong as a significant member of the global and regional financial community could not have been immune. 14. In all these events, the most conspicuous features of the turmoil were substantial downward pressure on the stock markets, upsurge in interest rates, rising inflation and, with the exception of Hong Kong, sharply depreciated and highly volatile exchange rates. Businesses experienced a widespread liquidity squeeze as the banking sectors exercised stringency on account of diminishing deposits, falling value in collateral and worsening quality of loans. These led to greatly increased corporate difficulties, with knock-on effects on local consumer and investment spending. Overall economic growth in the affected places dipped and unemployment correspondingly rose.

15. This region which is stricken by the financial turmoil was the region that was hailed not too long ago for its strong growth and economic dynamism. The crux of the problem, in many cases, lies in the structural and systemic weaknesses in the financial and corporate sectors which were overlooked at the times of exceptionally remarkable growth. In certain cases, these weaknesses were exacerbated by lax regulation, and deliberate policies favouring the growth of particular sectors and excessive exposure to particular sources of funding instead of being guided by competition and market efficiency. 16. Hong Kong generally has little of such structural and systemic problems. However, through a period of exceptional buoyancy in the economy and highly bullish outlook for the future, the stock and property markets in Hong Kong had gone to excessive heights. For example, residential property prices rose on average by as much as 80% to the peak during the two years prior to October 1997. The HSI gained by 1.4fold to reach the record high in August 1997 in slightly more than 2 1/2 years. At that record high, the P/E ratios for Blue Chips surged to an average of 17 times, while those for Red Chips and H shares4 were even more dramatic, at 52 and 30 times respectively. In retrospect, while the fundamentals of the economy at that time remained generally and basically sound, the sharp escalation in asset prices to unsustainable levels did expose a substantial weakness making our financial sector open to assault. It was against this background that the heavy speculative attack on the Hong Kong dollar took place in the latter part of October 1997. The subsequent adjustments, painful though they were, in hindsight was perhaps not only unavoidable but even necessary. 17. Going through this period of volatility, we continue to take comfort that our sound fundamentals, robust financial systems and market-oriented policies along with the flexibility of the economic structure have afforded us the best protection. To maintain our resilience against adversities, we must preserve all these underlying attributes. On top of this foundation, we would further refine our systems by the whole range of improvement measures outlined in this report. And they are by no means the end of our efforts. We must keep up our vigilance to ensure that we have the dynamism in the market as well as the vigour in our regulatory framework to ensure our long-term competitiveness. 18. Perhaps an important lesson for us to learn from the regional financial turmoil is exactly the saying of "staying vigilant while in peace". As we are riding out the storm and renewing our strengths, we must not forget the pains too quickly. Instead we should be watching out for the risk of any asset price bubbles, and make adequate preparations against possible market downturn in times of particular buoyancy. So is the need to watch out for any inherent imbalances in the economy and have them expeditiously and effectively addressed.
Red Chips are stocks which are mainly held by Chinese entities, including state-owned organisations, provincial and municipal authorities, whereas H shares are Chinese state-owned companies listed on SEHK.

XI

REPORT ON FINANCIAL MARKET REVIEW FREQUENTLY ASKED QUESTIONS

1.

What happened on 23 October 1997 - The Black Thursday?

The financial turmoil in Asia, which unfolded with the floating of the Thai Baht on 2 July, worsened further in mid October. In the week preceding 20

October, the Taiwanese authorities decided not to defend the New Taiwan dollar. There were rumours in the market that Hong Kong might also lose its

willingness to defend the linked exchange rate system. Selling pressure on Hong Kong dollar intensified on 21 and 22 October.

Consistent with the currency board arrangements (see answer to Question 2), the Hong Kong Monetary Authority (HKMA) rather passively bought a substantial amount of Hong Kong dollars to defend the exchange rate. These foreign exchange transactions were due to be settled on 23 and 24 October respectively. The settlement would involve the HKMA debiting the clearing

accounts of the banks which had sold Hong Kong dollars to the HKMA.

On Thursday 23 October, the HKMA issued a circular to all licensed banks reminding them, in very much the same spirit as the circular in 1992, of the need to organize their Hong Kong dollar funding prudently and not be overly dependent upon the LAP for last resort liquidity support. The circular also warned the banks that the HKMA may impose penal LAF rates for repeated borrowers to discourage the use of LAF to fund a short Hong Kong dollar position.

As the banks collectively had sold more Hong Kong dollars than they could settle by using their credit balances in their settlement accounts with the HKMA, the banking system was seriously short of Hong Kong dollar liquidity. Given that the banks did not wish to resort to LAF on a repeated basis, they bid aggressively for funds in the interbank market. Interbank interest rates

-15-

shot up very quickly and briefly touched 280% around noon time on 23 October. The rise in interest rate effectively reversed the capital outflow and fended off the speculators. The Hong Kong dollar exchange rate at one time rebounded to 7.60 level.

When speculators began to unwind their short positions in Hong Kong dollar by selling US dollars, the HKMA rather passively picked up the US dollars and recycled the Hong Kong dollars into the banking system in the afternoon of 23 October. Short term interest rates began to ease.

By close of the day, overnight interbank interest rate came down to 100% and on 24 October, the rate further eased to around 5%.

2,

How does the linked exchange rate system operate? What is a currency board system? rate stability? How does the currency board system ensure exchange

The linked exchange rate system introduced in Hong Kong since October 1983 is a form of currency board arrangement, which requires the monetary base to be Mly backed by a foreign currency at a fixed exchange rate. The monetary base is normally defined as the sum of banknotes in circulation and the balance of the banking system (the reserve balance or the clearing balance) held with the currency board for the purpose of effecting the clearing and settlement of transactions between the banks themselves, and also between the currency board and the banks.

Insofar as banknotes are concerned, the issue and redemption of bank notes by the note issuing banks are required to be made against US dollars at the fixed exchange rate of HK$7.80 to US$1. Specifically, Certificates of

Indebtedness, which give the authority to the note issuing banks to issue bank notes, are issued and redeemed against US dollar at the fixed rate of HKS7.80.

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At present, all licensed banks are required to maintain a clearing account with the HKMA for the account of the Exchange Fund. The aggregate balance in these accounts represents the clearing balance of the banking system. In operating the clearing accounts, the HKMA ensures that this crucial part of the monetary base is also subject to the discipline of the currency board arrangement. Except in some exceptional circumstances such as initial

public offering of shares which may result in sharp volatility in the demand for liquidity, the clearing balance of the banking system will vary in accordance with the amount of US dollars sold to or bought from the HKMA at the initiative of the banks.

The requirement for the monetary base to be backed builds in a selfadjustment mechanism under the currency board system to restore exchange rate stability when it comes under pressure. Specifically, when there is an inflow of funds and foreign currency to which the domestic currency is linked (US dollar in Hong Kong's case) is sold to the currency board, the monetary base will expand. In the other direction, when there is an outflow of funds and the domestic currency is sold to the currency board, the monetary base will contract. The expansion and contraction of the monetary base will cause domestic interest rates to fall or rise respectively, creating the monetary conditions necessary to counteract the initial capital flows to restore exchange rate stability.

3.

Did the HKMA "squeeze" the money market to drive interest rates up to exceptionally high levels on 23 October and subsequently inject liquidity to keep interest rates low to reduce the pain?

The HKMA did not "squeeze" the money market on 23 October to drive interest rates up to defend the currency. The interest rate hike was a

consequence of the banks selling more Hong Kong dollars to the HKMA than

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they could settle, thus creating an acute shortage in the interbank liquidity. To be precise, the surge in interest rate was caused by those shorting the Hong Kong dollar.

In the face of the liquidity shortage and the high interest rates as well as the need to settle the clearing balance, banks could choose to borrow Hong Kong dollars from the HKMA at the end of the settlement day, through the Liquidity Adjustment Facility (LAF). Alternatively, banks could obtain Hong Kong dollars more permanently from the HKMA by selling US dollars to it. The

latter, being the less costly option, was exactly what happened in the afternoon of 23 October. As banks started to sell US dollars to the HKMA, some of which were valued for the same day, liquidity was recycled back into the banking system and interbank interest rates began to ease.

Following the successful currency defence, there was a steady inflow of funds in the rest of October and November 1997 as speculators unwound their short position, and depositors switched into Hong Kong dollar to benefit from the high Hong Kong dollar deposit rates. In accordance with the discipline of the currency board system, the purchase of US dollars by the HKMA entailed an increase in the clearing balance of the banking system, which rose significantly from around HK$3-4 bn in mid-October to HK$ HK$42 bn in early December. In short, the increase in interbank liquidity was caused by an inflow of funds. The HKMA has not artificially injected liquidity into the

interbank market to depress the interest rate.

4.

Is the cost of maintaining the link too high in view of the interest rate pain inflicted on the economy?

Sudden and sharp interest rate hike inevitably inflicts some pain on the economy and on the asset markets, especially when these markets exhibited signs of overheating. However, it is wrong to assume that

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interest rate volatility is unique to a fixed exchange rate regime.

The adoption of floating rate regime does not shield other Asian economies from high interest rate volatility during the financial storm. Take Singapore as an example, affected by the contagion effect of the financial crisis, one month SIBOR (Singapore interbank interest rate) rose from 3.12% in early July 1997 to 12% in late October. Hit by

another wave of currency speculation, one-month SIBOR further surged to 20% in early January 1998.

The above example clearly shows that it is incorrect to assume that Hong Kong interest rates would remain stable in the face of external shocks if we had adopted a floating rate regime. In fact, the uncertainty and disturbance caused by a change in the exchange rate regime would significantly undermine investors1 confidence. Interest rate was likely

to stay at a high level as a result of the high risk premium associated with exchange rate uncertainty. The extent of interest rate increase in Hong Kong should also be put in proper perspective. While overnight interbank rate once touched a high of 280%, it quickly eased to a range of 5%-6% as there was ample liquidity on the back of an inflow of fund after the October episode. Term rates came down more slowly, but helped by the stabilization of the external environment, their spread over US interest rates has narrowed to the pre-October levels since early February 1998. In respect of the retail interest rate, the best lending rate (BLR) quoted by major banks, which is a key lending rate, has been adjusted upwards only by 150 basis points from 8.75% to 10.25%. Along with the easing of the interbank interest rates, BLR was adjusted downward by 25 basis points in

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March 1998. Expressed in real terms (i.e. adjusted for inflation), the BLR in Hong Kong, roughly at around 5.5%, is not high by international standards (USA: 6.2%)

Furthermore, while we are not insensitive to the interest rate pain on Hong Kong's economy, we recognize that when compared with some of the neighbouring economies under a floating exchange rate regime, Hong Kong has in fact fared much better in terms of exchange rate, asset prices and stock market performance. 5, Are there means to alleviate the interest rate pain while maintaining exchange rate stability, as proposed by some academics? Under a fixed exchange rate system, interest rates have to go up and down to be consistent with the exchange rate. As exchange control or credit control is not an option in Hong Kong, there is little, if any, room for selective infliction of interest rate pain on the speculators under our linked exchange rate system.

While some of the schemes proposed by the academics aiming at relieving the interest rate pain may have some psychological value, they may carry the risk of undermining the credibility and self-adjusting mechanism of the linked exchange rate system. As expounded by the experts at the International Monetary Fund (IMF),

"It is wishful thinking to believe that the exchange rate link can be defended without an active use of interest rates. Of course, interest rates can be kept low - temporarily - during a speculative attack if the HKMA is prepared, one way or another, to offset the domestic

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liquidity impact of any foreign exchange outflow.

This can be done

through direct injections of liquidity or more complicated schemes of the type being proposed in the US$LAF. But the end result will be the same: the foreign exchange outflow will continue and at some point the HKMA would have to call a halt to the game by allowing interest rates to rise or by abandoning the link.'*

"Postponing the necessary use of the interest rate tool is likely to increase speculative pressures. We have ample recent evidence on this from around the Asia region, and it must be especially true in Hong Kong where the no-discretionary nature of the currency board arrangement is at the heart of policy credibility. Moreover, if speculators, and Hong Kong dollar asset holders generally, are given the impression that the 'pain1 of higher interest rates is not tolerable politically, then they are more likely to launch new speculative attacks/' 6. Are there ways to improve the resilience of the economy to the interest rate pain? Underpinned by a strong banking system and prudent business practices generally, the Hong Kong economy has exhibited a high degree of resilience against the interest rate pain.

Reflecting the strength of the banking system in Hong Kong, the capital adequacy ratios of locally incorporated banks average around 17% and the problem debt ratio stay below 2%. Furthermore, prudent lending to the property sector, including notably the 70% loan to value ratio in residential mortgage lending have enabled our banks to weather the correction in property prices. The prudent behaviour of the banks has in turn encouraged prudent business practices.

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We are mindful that interest rate pain does affect those who have not taken part in the currency speculation, because there is little room for selective infliction of pain on the speculators. In this context, the

development of fixed rate debt market will offer corporate borrowers an additional option which can protect them from interest rate fluctuations. The interest risk is shifted to holders of fixed rate assets, most of whom are long-term institutional investors who are in a better position to weather short term interest rate fluctuations.

The government has played an important role to develop the local debt market by improving the market infrastructure and the provision of a benchmark yield curve (i.e. a long term interest rate reference). We will continue our effort in this area.

In the household sector, the main liability item is mortgage lending. Through the Hong Kong Mortgage Corporation, we are developing the necessary infrastructure to promote fixed rate mortgages as an additional choice for home buyers which will insulate them from adverse movements in interest rates.

7.

Is the Hong Kong economy losing its competitiveness in the face of the sharp depreciation of the regional currencies? Is the Hong Kong dollar overvalued?

A7.

As Hong Kong has moved into high value-added services sectors (with the services sector contributing 85% of GDP), it is relatively less affected by the depreciation of other currencies in the Asian region. Nevertheless, some slowdown in economic growth appears unavoidable

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because of the slackening in economic activities in the region as a whole. Nevertheless, Hong Kong will continue to benefit from steady noninflationary growth in Mainland China and the US, the two major markets for our goods and services.

It is not meaningful to debate what the right nominal exchange rate level is or whether the Hong Kong dollar is overvalued or undervalued. With the nominal exchange rate firmly anchored at HK$7.80 to US$1, economic variables, such as interest rate, money supply, prices (including asset prices) and the level of economic activities would adjust to external shocks to restore macroeconomic equilibrium.

We should take more active measures, such as tighter cost controls, productivity improvement and expansion into new markets, to enhance our competitiveness and to strengthen the buffer against external shocks. The recent corrections in asset prices and rental and an easing of wage pressure should also help in this respect.

8.

Was the stock market manipulated during the financial turmoil and what measures are there to prevent market manipulation?

During the financial turmoil, there were suggestions that the extreme market volatility was caused by market manipulation. However, findings of the Securities and Futures Commission (SFC) did not lend any support to such a suggestion. In fact, the market instability was caused by many external factors, including the devaluation of regional currencies. On the other hand, the surge of asset prices over the past few years had significantly increased the likelihood of an adjustment in the economy. Trying to exploit this opportunity, currency speculators

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attacked the HK dollar, leading to a surge of the interbank rates. Under these adverse circumstances, market volatility was inevitable.

In a volatile market situation, it is natural that investors make different trading decisions to protect their own interests. More importantly, as an open and free market, we must allow our investors to trade stocks freely and fairly in our market at any time they want. The SFC as the market regulator is provided under the law with adequate and effective surveillance and investigatory power to ensure the properness of operation of market activities and conduct of market participants. In addition, in order to further improve its ability to detect improper market activities, the SFC is working closely with the two Exchanges to explore ways to enhance their surveillance capacity, including real time access to trading information so that the SFC can have a better overview of market situation manipulation. and detect more efficiently possible market

9.

During the financial turmoil, did short selling exaggerate the market downfall or was it a mean of market manipulation?

Short selling, like stock margin trading, is a legitimate market activity. It increases market liquidity through increased circulation of particular stocks. It is also a means of hedging on the part of investors.

During the financial turmoil, short selling transactions contributed to less than 3% of the total market turnover. In particular, on the two trading days with the largest single day fall of the Hang Seng Index ( more than 10%), namely 23 October and 28 October, short selling only accounted for 0.4% and 1.6% of total market turnover respectively. On the basis of

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these figures, short selling should not be the main cause for the significant fall of the market during the turmoil.

At present, all short selling activities at the Stock Exchange of Hong Kong (SEHK) are subject to the Rules of the Exchange under which these activities must be reported. These regulations are intended to ensure the fairness of the market and to enable SEHK to detect and take appropriate action in the event of improper short selling activities to ensure that the market operates on a fair basis. Furthermore, short sellers are required to secure the source of stocks before they can commit in a short sell transaction, hence ensuring the successful completion of settlement and rendering protection for the counterparty's interests. The SFC and SEHK will further strengthen the enforcement on the reporting system and explore other measures to enhance market transparency.

10.

Why should stock borrowing and lending activities be allowed?

Stocks being a kind of private asset, their owners have full discretion and right on their disposal including lending them to others. Such right should not be challenged or restricted. In fact, stock borrowing and lending activities are beneficial to the market. It will increase the liquidity of stocks and market turnover. Stock borrowing and lending activities also help ensure the successful completion of stock settlement by reducing the possibility of settlement problems arising from stock liquid problems of individual broker, thus enhancing the reliability of the market clearing and settlement operation. Besides, stock loans are also an important supplementary activities for some other market operation such as short selling and issuing of derivative warrants. In order to allow better access for investors (and local brokers) to stock borrowing

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and lending, the Hong Kong Securities Clearing Company has recently proposed to establish a centralized stock borrowing and lending system. This proposal receives wide support and is expected to come into operation in early 1999. 11. Was the Hang Seng Index manipulated and not representative?

Like any other indices, the Hang Seng Index (HSI) is subject to the structural characteristics of the market itself. In Hong Kong's stock market, a few listed companies account for a major portion of the total market capitalization and inevitably have a greater impact on market performance. As the objective of the HSI is to reflect market performance, it must inevitably reflect some of the market characteristics; Manipulating the index by trading through these stocks is not as easy as some may suppose, especially in attempts to go against the trend and direction of the market as a whole. As the largest constituent stocks of HSI are also the most extensively traded stock, such attempts would not only involve a huge sum of money but also substantial risks as they have to contend with a large group of investors who might hold different views on the stocks. The SFC also does not accept that the composition of the HSI was a contributing factor in the recent market volatility. As mentioned earlier, the way to prevent market manipulation is by improving market transparency and the surveillance ability of the regulatory bodies but not by reconstituting the composition of the HSI.

The representativeness of the HSI can be measured by its coverage of the market capitalization and turnover of the whole stock market. The aggregate market value of the HSI constituent stocks has been maintained at approximately 70% of the total market value, and its turnover generally covers over 60% of the total market turnover. With

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reference to the All Ordinaries Index (AOI) compiled by the SEHK, which includes all listed stocks on the SEHK, it is also clear that the movement of HSI and that of AOI have been fairly consistent. Even during the financial turmoil in October, the daily change of the HSI still closely resembled that of the AOI. We therefore believe that the HSI has been effectively reflecting the performance of the market.

12.

What are the functions of derivative products? What regulatory measures will the regulators introduce to protect the retail investors?

Because of their leveraged and futures nature, and versatility, derivative products have been an effective hedging tool for investors to reduce the risk exposures of their investments. Hong Kong, being a major international financial centre and an open, mature and liquid market, must provide our investors, both domestic and international, with adequate and appropriate instruments to effectively manage their investment risks. We will therefore continue to develop the derivatives market, and at the same time enhance market transparency and improve our market surveillance. It is also incorrect to associate speculative activities solely with derivatives. Speculation, per se, is considered to be a part of market activities which is also present in the cash market,

13.

Have derivative products, particularly the derivative warrants, led to more market volatilities?

As mentioned earlier, the main use of derivative products is as a tool for investors to hedge against their investment risks and this will in fact

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reduce the volatility of stock prices. It was suggested that the derivatives market, particularly the derivative warrants market, had added to the market volatility during the financial turmoil However, as a matter of fact, issuers of derivative warrants will usually hold the underlying stocks to cover their position. When the market falls, they will minimize their loss by selling the underlying stocks which are no longer needed for hedging purposes. Even though this may add to the short term volatility of the market, this is in fact a reasonable response of stock holders at such times.

To enable investors to better keep track of the market situation, issuers are now required to make public through the Exchange's TELETEXT system the information relating to their buying and selling activities in relation to the derivative warrants they issued and the amount of derivative warrants that remain outstanding in the market.

That apart, SEHK has planned to amend its Listing Rules to minimize the impact of derivative warrants on the cash market especially at the time of issuance and maturity and to improve the transparency and regulation of the derivative warrants market. The proposed changes involve capital and capability requirements on the issuers, management of the timing and quantity of warrants on the same underlying stock, transparency regarding the setting and movement of the prices, and certainty in settlement arrangements.

14.

It was suggested that the futures market lacks transparency. How could it be improved?

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In order to further improve the transparency of the futures market, the Hong Kong Futures Exchange has allocated more than HK$10 million to improve the price dissemination system that supports the current open outcry trading system. The project is designed to enhance the capacity and speed of the market price dissemination system so that time lag in reporting of trades will be minimized. In addition, the Futures Exchange has also decided to earmark HK$100 million to finance the migration of the trading of Hang Seng Index futures and options contracts from the current open outcry environment to the Automated Trading System (ATS). The migration process is expected to be completed in 18 to 24 months' time and all tradings on the Futures Exchange will then be executed on the ATS.

15.

When will the margin financing operated by finance companies be brought into the regulatory regime?

Margin financing has been a popular activity in our market and rather common for some time. There are grey areas in our regulatory framework in respect of margin financing activities operated by finance companies. An inter-agency working group has been set up to consider bringing such activities under more regulation. The review by the working group is almost completed and its recommendations will soon be put to public consultation. The relevant legislative proposals will also be introduced to the first Legislative Council as soon as possible.

16.

What further measures will the market regulators introduce to protect the general investing public?

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The most effective and prudent way to protect the interests of the investing public is to strengthen investor education so that investors can fully understand their investment, the risks involved as well as their rights before making their investment decisions. The SFC and the Exchanges have always recognized the importance of investor education and have produced a series of information booklets to succinctly introduce the Hong Kong investment markets. Besides, both SFC and SEHK have administered an investor hotline to answer questions from investors. The Stock Exchange and the Futures Exchange organize from time to time investor education seminars of different levels and subjects to meet the needs of different investors. In the forthcoming year, the focus of the education programme includes derivatives and futures products, as well as the right of investors.

ENDS

*
A