Exchange Fund

The HKSAR Government's Exchange Fund was established by the
Currency Ordinance of 1935 (later renamed the Exchange Fund
Ordinance). Since its inception, the fund has held the backing to the note
issue. In 1976, the fund's role was expanded. The assets of the Coinage
Security Fund (which held the backing for coins issued by the
government), as well as the bulk of foreign currency assets held in the
government's General Revenue Account, were transferred to the fund.
On December 31, 1978, the Coinage Security Fund was merged with the
Exchange Fund.

In 1976, the government began to transfer the fiscal reserves of its
General Revenue Account (apart from the working balances) to the fund.
This arrangement was introduced to avoid fiscal reserves having to bear
exchange risks arising from investments in foreign currency assets and to
centralise the management of the government's financial assets. The fiscal
reserves are not permanently appropriated for the use of the Exchange
Fund, but are repaid to the General Revenue Account when they are
required to meet the obligations of the general revenue. Through this
transfer of the fiscal reserves, the bulk of the government's financial
assets are, therefore, placed with the fund.

The Exchange Fund's statutory role, as defined in the Exchange Fund
Ordinance, is primarily to affect the exchange value of the currency of
Hong Kong. Its functions were extended on the enactment of the
Exchange Fund (Amendment) Ordinance 1992 by introducing a
secondary and subsidiary role of maintaining the stability and integrity of
the monetary and financial systems, with a view to maintaining Hong
Kong as an international financial centre.

The HKMA manages the Exchange Fund. Apart from ensuring that the
fund meets its statutory roles, the HKMA's principal activity on a
day-to-day basis is the active management of the fund's assets. These are
held mainly in the form of bank deposits, equities and marketable
interest-bearing instruments in certain foreign currencies and in Hong
Kong dollars.

The HKMA adopts a programme, initiated on its formation in April 1993,
of reviewing its investment operations and strategy. Having regard to the
statutory purposes for which the Exchange Fund was created and
maintained, the investment style and strategies now in place closely
resemble those of comparable central banks and monetary authorities.
Strategies appropriate to a long-term fund - such as a benchmark
approach and a greater use of the long-term capital markets - have been
adopted, and the range of currencies and instruments used has also been
increased.

The HKMA continues to place great emphasis on establishing links with
other market participants. The management style is one of openness and
co-operation with the market, with a view to encouraging close working
relationships to enable the markets to play their part in assisting in the
HKMA's management of the fund. In terms of day-to-day operation, the
HKMA has established three portfolios: (a) a portfolio of assets to act as a
hedge against the interest-bearing liabilities of the Fund, to ensure that it
can at all times meet all the claims upon it; (b) a portfolio of liquid
reserves to be available whenever required to meet market operational
needs; and (c) an investment portfolio to preserve the fund's value for
future generations in Hong Kong. The returns from the management of
the fund and the investment style adopted are set out and explained in the
HKMA's annual report each year.

Another function related to the Exchange Fund is to supply notes and
coins for public use. Banknotes in denominations of $20, $50, $100, $500
and $1,000 are issued by the Hongkong and Shanghai Banking
Corporation Limited, the Standard Chartered Bank and the Bank of China.
The note-issuing banks may issue currency notes only against
non-interest-bearing Certificates of Indebtedness issued by the Fund. The
Fund bears the paper and printing costs relating to the note issue.

The government issues coins of $10, $5, $2, $1, 50 cents, 20 cents and
10 cents denominations. Administration of the coin circulation is the
responsibility of the HKMA. Exceptional public demand caused the total
number of new coins placed into circulation in 1997 to reach a record
1.2 billion pieces, compared with the normal order volume per year of
about 300 to 400 million coins. The total notes and coins in circulation
at the end of 1997 was $92.2 billion.

During the year, three commemorative coin products were issued to
mark the establishment of the HKSAR. They included a $1,000 gold coin
and two commemorative coin sets (available in both proof and brilliant
uncirculated versions). Both coin sets were of seven coins with their own
special design and in the same denominations as the seven currently
circulating coins. A philatelic-numismatic cover incorporating a $10 coin
with special design and a $5 stamp were also issued during the year to
commemorate the opening of the Lantau Link.

In March, the government sold 15 per cent of the shareholding of the
Hong Kong Note Printing Limited to the China Banknote Printing and
Minting Corporation, a PRC state-owned enterprise. In October, the
HKSARG sold a further 10 per cent of the company's issued shares to
each of the three note-issuing banks. The HKSARG will continue to
maintain a majority stake in the note-printing company. The sale of shares
will widen and strengthen the shareholder base of the company and
contribute to the future success and development of the company.

On December 31, 1997, the Exchange Fund's total assets stood at $535
billion, of which foreign currency assets amounted to US$64 billion.
Accumulated earnings amounted to $172 billion. The fund's financial
position for the six years from 1991 to 1996 inclusive, is shown at
Appendix 19. With a view to showing the government's continued
commitment to greater openness and transparency, and to providing the
public with more evidence of the considerable strength of Hong Kong's
external position, foreign reserves figures were made available on a
monthly basis from January 1997. Based on unaudited figures, the fund's
total assets stood at $569 billion and its accumulated earnings amounted
to $182 billion at June 30, 1997. Foreign currency assets, excluding
forward transactions to be settled, amounted to US$75.3 billion at
December 31.

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