Chapter 5: Exchange Fund

The Exchange Fund was established by the Currency Ordinance of 1935 (later renamed the Exchange Fund Ordinance). Since its creation, the Fund has held the backing to the banknote issues of Hong Kong. In 1976, the Fund's role was expanded. The backing for coins issued and the bulk of the foreign currency assets held in the Government's General Revenue Account, were also transferred to the Exchange Fund. Meanwhile, to centralise the investment management of its financial assets, the Government began to transfer the fiscal reserves of its General Revenue Account (apart from the working balances) to the fund. Therefore the bulk of the Government's financial assets are placed with the Fund. On December 31, 1978, the Coinage Security Fund was merged with the Exchange Fund.

Prior to April 1, 1998, fiscal reserves were placed with the Exchange Fund as deposits on which market interest rates were paid by the Fund to the General Revenue. As the official reserves had grown significantly over the years, it was decided that the fiscal reserves placed with the Exchange Fund should seek to achieve a higher long-term real rate of return. With effect from April 1, 1998, the return on the fiscal reserves placed with the Exchange Fund is linked to its overall return.

Upon the establishment of the Hong Kong Special Administrative Region on July 1, 1997, the assets of the Land Fund Trust were vested in the Hong Kong SAR Government. The Chief Executive appointed the Financial Secretary as the public officer to receive, hold and manage the Land Fund, as part of the Hong Kong SAR Government reserves. Subsequently, the Land Fund was established by resolution made and passed by the Provisional Legislative Council under section 29 of the Public Finance Ordinance. Between July 1, 1997 and October 31, 1998, under the direction of the Financial Secretary, the Land Fund was managed by the HKMA as a portfolio separate from the Exchange Fund. Effective from November 1, 1998, the assets of the Land Fund, which itself has still remained as a separate government fund, were merged into the Exchange Fund and managed as part of the Investment Portfolio of the Exchange Fund.

The Land Fund will continue to be administered in accordance with the Resolution of the Provisional Legislative Council of July 1997. The placement of the whole of the Land Fund, along with the fiscal reserves, with the Exchange Fund, for a return that is the same as that on the Exchange Fund, was an investment decision taken by the Financial Secretary under the terms of the Resolution. The Exchange Fund's statutory role, as defined in the Exchange Fund Ordinance, is primarily to affect the exchange value of the Hong Kong dollar. Its functions were extended on the enactment of the Exchange Fund (Amendment) Ordinance 1992 by introducing a secondary 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 day-to-day activity is the management of the Fund's assets. These are invested mainly in the OECD bonds and equities. To meet the Government's operational needs, part of the Exchange Fund is also held in Hong Kong dollar denominated securities.

To meet the objectives of preserving capital, providing liquidity to maintain financial and currency stability and generating an adequate long-term return, the Exchange Fund is managed as two distinct portfolios. The first is a Backing Portfolio to ensure that the monetary base related to the currency board operations is fully backed by highly liquid, primarily short-term, US dollar denominated debt securities. The second is an Investment Portfolio to preserve the Fund's value for future generations in Hong Kong. The long-term asset allocation strategy of the Exchange Fund is guided by the investment benchmark, which defines bonds and equities mix as well as the overall currency composition of the Fund. The management of the Fund and the investment style adopted are set out and explained in the HKMA's annual report.

On December 31, 2001, the Exchange Fund's total assets stood at $979.4 billion, of which foreign currency assets amounted to $877.6 billion (or US$112.5 billion). The accumulated surplus of the Exchange Fund amounted to $302.7 billion. The Fund's financial position from 1997 to 2001 inclusive is shown at Appendix 19. With a view to showing the Government's continued commitment to greater openness and transparency, foreign currency asset figures have been published monthly since January 1997. In addition, an abridged balance sheet of the Exchange Fund and a set of Currency Board accounts are published for each month.

Another function related to the Exchange Fund is currency issuance. Banknotes in denominations of $20, $50, $100, $500 and $1,000 are issued by the three note-issuing banks: The Standard Chartered Bank, The Hongkong and Shanghai Banking Corporation Limited and the Bank of China (Hong Kong) Limited. The Bank of China (Hong Kong) Limited assumed the role of a note-issuing bank in place of the Bank of China following the restructuring of the Bank of China Group on October 1, 2001. The note-issuing banks may issue currency notes only by surrendering non-interest-bearing US dollar backing at a fixed exchange rate of 7.80. Thus the Fund enjoys the seigniorage of the currency notes.

Through the HKMA, the Government issues coins of $10, $5, $2, $1, 50 cents, 20 cents and 10 cents denominations. Sufficient quantities of all denominations of coins have been maintained for injection into the market when required. The total of notes and coins in circulation at the end of 2001 was $113 billion.

On June 20, 2001, the Bank of China (Hong Kong) Limited and Standard Chartered Bank put into circulation their enhanced $1,000 banknotes, bearing the additional security features which had already been applied to the $1,000 banknote of The Hongkong and Shanghai Banking Corporation Limited in 2000. The new features include a holographic windowed thread, coloured fluorescent fibres and a highlight watermark showing the number '1000'. After the launch of the enhanced $1,000 banknotes, there was a significant decrease in 2001 in the number of counterfeit $1,000 banknotes detected.