HONG KONG 2005

The Government is committed to strengthening Hong Kong's competitiveness as an international financial centre and the premier capital formation centre for the Mainland through enhancing its regulatory regime, promoting corporate governance, upgrading financial infrastructure and fostering the development of the bond market.

Enhancement of Hong Kong's regulatory framework will continue in the light of international experience and standards. The objective is an effective regulatory framework that will ensure sound business standards and confidence of the market but without unnecessary impediments. There are also other major initiatives to enhance Hong Kong's competitiveness as an international financial centre.

Quality financial reporting is of paramount importance for upholding Hong Kong's corporate governance regime. The Hong Kong Financial Reporting Standards (HKFRS), which are issued by the HKICPA, have been fully convergent with the International Financial Reporting Standards (IFRS) in all material aspects since January 1, 2005. This uniform accounting platform, well understood by global investors and financial analysts, enables the comparison of corporations and their results in different jurisdictions and leads to greater confidence in the transparency and quality of Hong Kong's financial markets.

In addition, the Government is acutely aware of the need to maintain an effective, transparent and accountable regulatory regime for the accountancy profession that is on a par with international standards. The proposal to establish the Financial Reporting Council recognises the importance of reassuring the markets and the investing public that Hong Kong's financial reporting and corporate governance frameworks are, and will continue to be, robust.

The Financial Reporting Council, which is to be an independent statutory body, will oversee both an Audit Investigation Board and the Financial Reporting Review Committee. The former will be tasked to investigate suspected irregularities concerning auditors of corporations/collective investment schemes listed in Hong Kong, while the latter will be responsible for enquiring into suspected non-compliance of financial reports of such corporations/schemes with the relevant legal, accounting and regulatory requirements.

Building on the very strong public support received in the two public consultation exercises in September 2003 and February 2005, the Government introduced the Financial Reporting Council Bill into the Legislative Council in June 2005. At year-end, the bill was under the scrutiny of the Legislative Council.

The saving rates in Asia are high compared to other regions and this is expected to be a long-term trend. Located at the heart of Asia, Hong Kong is well positioned to further develop as an international asset management centre. According to the Fund Management Activities Survey 2004 released by the SFC in July 2005, which covered licensed corporations and registered institutions, the combined fund management business had grown by 23 per cent from $2,947 billion in 2003 to $3,618 billion in 2004. Since the establishment of the SFC in 1989, the number of retail funds in Hong Kong had more than doubled from 781 to 1 933 in 2004, with a 15-fold increase in value from $283 billion to $4,300 billion. These findings again confirmed Hong Kong's position as Asia's major asset management hub for investors worldwide.

To provide a conducive environment for the further development of Hong Kong as Asia's asset management centre, the Government abolished estate duty, with retrospective effect from July 15, 2005. In addition, the Government also proposed to exempt offshore funds from profits tax, so that Hong Kong's tax treatment of offshore funds will be on a par with other international financial centres such as the United States and the United Kingdom. The SFC also continued to review relevant codes and guidelines and facilitate the launch of new investment products and international funds' access to local market.

The SFO came into force on April 1, 2003 and has been implemented successfully since then. During the year, the SFC continued to maintain and update the SFO in light of market developments.

The Government consulted the public on proposed amendments to the ordinance to give statutory backing to major listing requirements in January 2005. The proposed legislative amendments provide for sanctions for breaching the statutory listing requirements. In tandem with the Government's consultation, the SFC consulted the public on proposed amendments to the Securities and Futures (Stock Market Listing) Rules which would stipulate the statutory listing requirements. The proposed amendments to the SFO as well as the draft subsidiary legislation to be made by the SFC will be refined in light of the comments received.

Following consultation on a review of the disclosure of interests regime under Part XV of the SFO, the SFC recommended adoption of most of the proposals contained in the consultation paper to make filing easier, ease the operation of the de minimis exception and define change in the nature of interest. Legislative amendments will be proposed to implement the recommendations.

In early 2005, the SFC consulted the market on proposed amendments to Schedule 5 of the SFO, which aimed to fine-tune the legal definitions of certain regulated activities to accommodate the latest market development, including extending the definition of 'asset management' to include real estate investment scheme management. The amendments were gazetted in November and were to come into effect in January 2006.

The SFC concluded the consultation on a review of the level and funding of the Investor Compensation Fund in March 2005 and the amendments to the Securities and Futures (Investor Compensation — Levy) Rules came into effect in October, providing for an automatic levy suspension and re-instatement mechanism under which the investor compensation levies will be suspended if the net asset value of the Investor Compensation Fund exceeds $1.4 billion and re-imposed if it falls below $1 billion. In November, the SFC gazetted an exemption notice to suspend the investor compensation levies on securities and futures transactions with effect from December 19, 2005.

The Standing Committee on Company Law Reform (SCCLR), established in 1984, meets regularly to consider amendments to the Companies Ordinance to ensure that it meets the changing needs of the business community. The Companies Registry provides secretariat support for the SCCLR.

The Overall Review of the Companies Ordinance and the Corporate Governance Review by the SCCLR resulted in a great number of recommendations for reform. The recommendations have been steadily implemented in the context of a series of major amendments to company law. For instance, the Companies (Amendment) Ordinance 2004 introduces the streamlining of prospectus requirements (which came into effect on December 3, 2004); provisions relating to shareholders' remedies such as a new statutory right to bring a derivative action (July 15, 2005) and the modernisation of the registration regime for non-Hong Kong companies (expected to become operative in 2006 to tie in with the modification of the Companies Registry's computer system).

In addition, a joint Government-Hong Kong Institute of Certified Public Accountants working group was set up in March 2002 to undertake a comprehensive review of the accounting and auditing provisions of the Companies Ordinance. The group's recommendations will be processed in the context of the rewrite of the Companies Ordinance.

HKEx took steps to enhance its CCASS nominee services in 2005, which include, among other things, the enhancement of corporate actions processing (entitlement elections, derivative warrant conversions and subscriptions of preferential offers) and automation of payments. The aim was to streamline the procedures, provide participants with more updated information, extend service hours, and enhance the operational efficiency of the system and its participants.

HKEx also enhanced its investor account services for Investor Participants (IP) in 2005 making them more streamlined and user-friendly. An IP account is a custody account with the provision of associated nominee services. Purchases and sales of shares made by an IP and the resulting settlements continue to be handled by brokers. There were 14 235 IP accounts in CCASS at the end of 2005.

Separately, the SFC worked closely with the Government, various regulatory authorities, and industry and professional associations during the year to promote XBRL (eXtensible Business Reporting Language) for financial reporting in Hong Kong. XBRL is an evolving global standard for faster and more accurate electronic communication of business and financial data.

The HKMA conducted a comprehensive review of Hong Kong's financial infrastructure in the first half of 2005. The objective was to establish a coherent development strategy and implementation plan to build a safe and efficient financial infrastructure based on a multi-currency, multi-dimensional platform, and to develop Hong Kong into a payment and settlement centre in the region. Steps have been taken since the second half of 2005 to implement the recommendations.

Major projects and business initiatives arising from the review include:

The Government has boosted the development of the bond market in recent years by providing the necessary financial infrastructure, simplifying the issuance process, removing regulatory impediments, offering tax incentives and encouraging public corporations to issue bonds. Investor education on bond investment has also been strengthened.

The Hong Kong dollar debt market grew further in 2005, with the total outstanding amount rising to $664 billion at year-end, a 9 per cent increase from a year earlier. Issuers included the Exchange Fund, statutory bodies or government-owned corporations, AIs, multilateral development banks (MDBs), non-MDB overseas borrowers and local corporations.

New issues of EFBNs increased by 4 per cent to $214 billion and accounted for more than a half of the total new debt issuance in 2005. The two-year paper was particularly welcomed by the market, with subscription averaging almost three times the issue size. Against the background of an increasingly restrictive monetary policy in the US and the introduction of the refinements to the Linked Exchange Rate system, liquidity tightened in the banking system in 2005. The Aggregate Balance, a measure of interbank liquidity, declined sharply from a daily average of $30 billion in 2004 to $4 billion in 2005, putting upward pressure on yields, particularly at the shorter end. The yield on the one-year EFBN rose markedly by 332 basis points to 3.9 per cent at the end of 2005.

Excluding the Exchange Fund paper, new issuance of Hong Kong dollar debt totalled $188 billion in 2005, representing a 10 per cent increase from the previous year. Of this total, non-MDB overseas borrowers remained the most active, accounting for 56 per cent of the new issues. That was followed by AIs and local corporates, with shares of 33 per cent and 5 per cent, respectively.

As interest rates were expected to remain on an upward trend in the US over the course of 2005, fixed-rate debt dominated the market. Excluding EFBNs⁵, fixed rate debt constituted about 74 per cent of total new issues in 2005, down from 78 per cent in 2004. The average maturity was broadly stable at around four years.

During the year, there was a growing interest in bond offerings at the retail level. The HKMA offered two issues of retail Exchange Fund Notes, totalling $500 million.⁶ The Hong Kong Mortgage Corporation (HKMC) also issued four series of retail bonds to the public, comprising two series of Hong Kong dollar bonds amounting to $100 million and two series of US dollar bonds totalling US$10 million. All these HKMA and HKMC issues were well received and oversubscribed.

To improve access to the bond market by retail investors, the HKMA planned to launch a Bond Price Bulletin website (www.cmu.org.hk) in January 2006 to provide retail investors with convenient online access to indicative bond prices quoted by individual banks.

The Government is implementing measures to review the existing regulatory framework for offers of shares and debentures in phases. The first phase involved the publication of various guidelines by the SFC in February 2003, of the second phase was the introduction of the prospectus-related provisions in the Companies (Amendment) Ordinance 2004 in December 2004, the SFC in the third phase issued a consultation paper on possible reforms to the prospectus regime in the CO in August 2005. The consultation ended in December 2005 and the SFC is analysing the submissions received (see 'Recent Developments' under Securities and Futures Sector).

The Government continues its efforts to develop the domestic and regional bond markets through active participation in ongoing international and regional initiatives. The HKMA, through its chairmanship of the EMEAP Working Group on Financial Markets, played a pivotal role in the launch of the domestic currency-denominated ABF2 in 2005.

During the year, the HKMA, worked with the other 10 member central banks and monetary authorities of the EMEAP Group in implementing the ABF2 Initiative. All 11 members of the EMEAP Group have invested a total of US$2 billion in ABF2, which invests in domestic currency bonds issued by all EMEAP economies except Australia, Japan and New Zealand. ABF2 consists of an ABF Pan-Asian Bond Index Fund (PAIF) and eight single-market funds. The PAIF is a single bond fund investing in domestic currency bonds issued by sovereign and quasi-sovereign issuers in the eight EMEAP economies, whereas the eight single-market funds will each invest in the same type of bonds issued in the respective markets. In May 2005, EMEAP announced the completion of funding of ABF2 and the appointment of the fund managers and master custodian of the nine ABF2 funds. Since then, the EMEAP Group has been working with the fund managers and relevant regulators in preparing for the public offering of the nine funds. By the end of 2005, the PAIF and three single-market funds in Hong Kong, Malaysia and Singapore had been listed. The ABF Hong Kong Bond Index Fund and the PAIF were listed on the SEHK in June and July 2005 respectively. The remaining five single-market funds will be launched in the first half of 2006.

The long-term development of the bond market is promising. Hong Kong's free and open financial markets, with free flow of capital, help create a large international investor base and will continue to fuel the growth of Hong Kong's bond market. Other positive factors contributing to higher demand for bond investments include the vast amount of Hong Kong dollar time deposits, the growing retirement funds in Hong Kong for the aging population, and capital from the Mainland as a result of gradual liberalisation of the capital account.

A well-developed secondary mortgage market plays a useful role in channelling long-term funds, such as insurance and pension funds, to meet demand for long-term home financing. To develop this market, the Government established the HKMC in October 1997 with these core missions:

The HKMC started business with its Mortgage Purchase Programme to acquire mortgage loans for its own portfolio. The HKMC's readiness to purchase mortgage loans from banks facilitates their risk and balance sheet management. Over the years, the HKMC has become a key player in the secondary mortgage market. The HKMC's current mortgage portfolio consists of 72 999 loans with a total outstanding principal balance of $28.3 billion at year-end.

The Mortgage Insurance Programme (MIP) was launched in 1999 to provide mortgage insurance cover to banks in respect of loans advanced by them for the purchase of residential property. The maximum insurance cover is up to 25 per cent of the value of the mortgaged property, which enables the banks to lend home mortgage loans above the 70 per cent loan-to-value ceiling set by the HKMA.

The MIP has steadily gained acceptance by homebuyers and has promoted home ownership through product diversification and improvements to servicing standards. Between 1999 and the end of 2005, over 68 000 applications had been received, out of which a total of $130 billion in mortgage loans were approved. This represented a market penetration rate of 20 per cent. About 94 per cent of MIP loans are for secondary market properties, demonstrating that the MIP is particularly instrumental in promoting the liquidity of the secondary market.

Apart from contributing to banking stability and promoting home ownership, the HKMC also aims to promote the development of mortgage-backed securities (MBS) and the bond market in Hong Kong. The HKMC established a back-to-back MBS programme in October 1999 which provides a platform for banks to effectively repackage their mortgage portfolios into more liquid MBS. The HKMC guarantees the timely payment of interest and repayment of principal for the securitised mortgage loans. Since the inception of the back-to-back MBS programme, $2.8 billion of MBS have been issued.

In December 2001, to further develop the range of products available in Hong Kong's MBS market, the HKMC established the Bauhinia MBS Programme with MBS issuance collateralised with mortgage loans from the HKMC's retained mortgage portfolio. This is a multi-currency programme with conventional bond-style features to make it more attractive to investors. A total of $8.4 billion of MBS had been issued under the Bauhinia MBS Programme by the end of the year, including the first-ever retail MBS in Asia in 2004.

Unsecured corporate debts are the mainstay of the HKMC's funding requirements. Through its debt-issuing activities, the HKMC is able to promote the development of the Hong Kong dollar debt market. In 2005, the HKMC successfully launched 28 debt issues for a total of $4.5 billion under its Debt Issuance Programme, making it the most active corporate issuer of debt securities in Hong Kong for the fifth consecutive year. By the end of 2005, the HKMC had $28.2 billion of debt securities outstanding.

In October 2001, the HKMC pioneered the issue of retail bonds using banks as placing agents. By the end of 2005 the HKMC has issued retail bonds totalling over $11 billion. In view of the solid development of the retail bond market, the HKMC replaced its standalone issues by setting up the Retail Bond Issuance Programme in May 2004. Under the programme, the HKMC has issued an aggregate of $2.3 billion in retail bonds, including US-dollar-denominated retail bonds.


⁵	All EFBNs were fixed rate debt instruments.
⁶	These issues followed the introduction of the refined Retail Exchange Fund Programme under which investors could purchase Exchange Fund Notes through a larger distribution network and at lower prices.