Hong Kong’s Exchange Fund, the HK$4.5 trillion (US$574 billion) war chest that defends the local currency, has played a vital role in maintaining the stability of local financial markets during many crises over the past 25 years. The fund faced a test of its mettle immediately after the handover. On July 2, 1997, Thailand floated its currency in a move widely regarded as the beginning of the Asian financial crisis. Hong Kong had to rely on the Exchange Fund to defend the local currency and financial markets against an attack of short-sellers led by George Soros, who deployed a “double play” strategy to manipulate the city’s currency and stock markets through late 1997 and 1998. In August 1998, the Hong Kong Government spent HK$118 billion, or 18 per cent of the Exchange Fund at the time, to buy 33 constituent stocks of the Hang Seng Index, supporting the stock market in a fight against currency speculators who had built up positions in Hang Seng Index futures to profit from a falling market as they tried to break the peg. “The crucial role of the Exchange Fund in defending the stability of our financial market is best exemplified in the Asian Financial Crisis,” said Eddie Yue Wai-man, CEO of Hong Kong Monetary Authority (HKMA) , the de facto central bank that manages the fund. “We claimed victory in the end, and the contribution of the Exchange Fund was written into history,” Yue said in a written interview with the Post . Even Soros later praised the fund’s success in fending off his attack. Joseph Yam Chi-kwong, who established the HKMA in 1993 and acted as its CEO until 2009, led the intervention in 1998. The Exchange Fund supported the Hong Kong dollar, making it the only Asian currency to weather the Asian financial crisis, while other Asian currencies all suffered devaluations, he said. The Thai baht weakened 56 per cent, the Indonesian rupiah 85 per cent and the South Korean won almost 95 per cent during the six-month period between July and December 1997. Malaysia’s currency also fell 50 per cent and the Japanese yen dropped 34 per cent during the one-year period until July 1998. “The key to success in defending the fixed Hong Kong dollar exchange rate during the Asian financial crisis in 1997-98 was the very substantial resources that we had in the Exchange Fund,” Yam told the Post . “There was sufficient ammunition for intervention both in the foreign exchange market and the stock market to fight off market manipulators.” The Exchange Fund’s history stretches back to 1935, when Hong Kong first established it to provide backing to the issuance of banknotes in the city. This was at the time when China abandoned the silver standard, and Hong Kong opted for the pound sterling as backing for the Hong Kong dollar. The currency changed to free float in 1974, but the government replaced this with the fixed-rate system pegging it to the US dollar at HK$7.8 in 1983. Hong Kong should stick to US dollar currency peg: Joseph Yam Although the introduction of the peg preceded the handover by nearly a decade and a half, the move was very much related to 1997. When China and Britain first started to negotiate about the future of Hong Kong, it created a crisis of confidence, forcing Yam and other officials to set up the peg. “The peg, which fixed the local currency with the US dollar, has encouraged international investors and businessmen to invest in Hong Kong, as they do not need to worry about currency risks,” said Raymond Yeung, chief economist for the Greater China region at ANZ. “The peg and the Exchange Fund have played a vital role to maintain Hong Kong as an international financial centre and act as a fundraising centre,” Yeung said. The city has been the largest IPO market worldwide seven times in the past 13 years. Yam recalled that the original primary purpose of the Exchange Fund was to affect “the exchange value of the currency of Hong Kong”. In 1992, a law change expanded this remit to include the maintenance of “the stability and integrity of the monetary and financial systems of Hong Kong”. The same change also paved the way for setting up the HKMA in 1993 to manage the fund. Another important law change came in 1995, giving the HKMA full control over the monetary base by requiring all banks to set up clearing accounts with the Exchange Fund. This took effect in 1996, when the HKMA also introduced real-time gross settlement for interbank transactions. “These two major law changes before the handover have provided clear usage and legal status of the Exchange Fund,” Yam said. “These proved to be important during the 1998 market intervention.” The Exchange Fund has come a long way since the handover. With total assets at HK$4.5 trillion as of March, it has expanded to eight times its HK$568.74 billion size at the end of June 1997. The Exchange Fund is now the world’s seventh-largest sovereign wealth fund, and the third-largest in Asia, behind only China Investment Corporation and Singapore GIC, according to data from the Sovereign Wealth Fund Institute. Hong Kong has not experienced a short-seller attack of the same scale since the Asian Financial crisis, but the HKMA still relies the Exchange Fund to keep the confidence of the public, HKMA’s Yue said. For example, during the global financial crisis in 2008, the Exchange Fund provided a full guarantee for all deposits in Hong Kong and lent capital and liquidity support to banks, Yue said. More recently, social unrest in 2019 led some fund managers, such as Kyle Bass, Thomas Roderick and Kevin Smith, to turn bearish, talk down the Hong Kong dollar and local markets. Their efforts were in vain, but still brought pressure on Yue, who took over as the third CEO of the HKMA in October 2019 , replacing the retiring Norman Chan Tak-lam. “I still remember vividly how we had to deal with the rumours of outflow of capital soon after I assumed the office of the CEO of HKMA in 2019,” he recalled. “Thanks to team efforts and our strong fundamentals, the rumours did not really gain a foothold.” The Exchange Fund also helped maintain financial stability amid the Covid-19 pandemic. The sheer size of the Exchange Fund, and the high transparency and discipline of the HKMA allow Hong Kong to keep the peg stable, ANZ’s Yeung said. “Many other markets change their monetary policies from time to time, but HKMA and the government have always been determined to defend the peg,” Yeung said. “This is why Hong Kong can keep the currency-board system, while the other markets failed.” HKMA uses the Exchange Fund to intervene in the currency market to make sure the Hong Kong dollar trades between HK$7.7500 and HK$7.8500 per US dollar, a trading band it introduced in May 2005, which Yam said was an important step that added transparency to the peg. The HKMA used the Exchange Fund to buy a total of HK$104.28 billion and sell a combined US$13.38 billion in 14 interventions during the past two months – the first such action in 18 months. The authority intervened 85 times during 2020, selling HK$383.5 billion of Hong Kong dollars to weaken the strengthening currency amid a flood of global capital amid low interest rates. The tide turned in March, when the US monetary authority flagged 10 increases in interest rates through the end of 2023, leading analysts to predict continuing capital outflows and more interventions by the authority. With the support of the Exchange Fund, the local financial market and banking sector has expanded dramatically since the handover. Total deposits at the end of March 2022 stood at HK$15.35 trillion, almost six times higher than the HK$2.707 trillion on deposit at the end of June 1997. The Exchange Fund’s investments today are more diversified than at the time of the handover. In 1997, the Exchange Fund held more than 95 per cent of its funds in bonds and cash, and less than 5 per cent in stocks. It made a profit of HK$235.8 billion from its wide range of investments in 2020, according to its latest full-year audited result. Bond investments contributed the most at 39.3 per cent, overseas stocks at 29.6 per cent, other investments such as private equity and overseas properties at 25.3 per cent, foreign currency valuation gain from its overseas assets at 4.1 per cent and Hong Kong stock investments at 1.7 per cent. The stock-market intervention in 1998 led to the fund holding a portfolio of Hong Kong stocks, which the government sold as the Tracker Fund of Hong Kong, making a handsome windfall. It kept part of the portfolio as a long-term investment, alongside overseas stocks and bonds. In 2007, the government also bought 5.88 per cent of the bourse operator Hong Kong Exchanges and Clearing as a strategic investment. A breakthrough in the Exchange Fund’s investment came in 2009 when Yue, who was then deputy CEO of the HKMA, set up a Long-Term Growth Portfolio (LTGP) under the Exchange Fund to invest in global private equities and real estate outside Hong Kong. “Fast-forward a little more than a decade to today, and we have grown into one of the largest and most important private market investors in the world, with a good reputation in the industry,” Yue said. “Our long investment horizon allows us to selectively deploy capital into private equity, infrastructure and real assets, to enhance long-term returns in a generally low-yield environment.” The LTGP has achieved a 15.3 per cent annualised internal rate of return since its inception. As of the end of September 2021, the market value of investments in the portfolio stood at HK$496 billion, with private equity amounting to HK$377 billion and real estate at HK$119 billion. The compounded annual investment return of the Exchange Fund since 1994 is 4.8 per cent, higher than the inflation rate of 2 per cent in the same period. While the Exchange Fund has defended the currency well, some lawmakers have questioned whether part of the fund could be used for other purposes. In early 2021 lawmakers called on the government to dip into the Exchange Fund to finance the government’s rescue packages for companies and individuals hard hit by the Covid-19 pandemic. It came after the Exchange Fund posted its third-highest earning ever of HK$197.8 billion in 2020. ‘Spicy policies’ helped fortify Hong Kong, save homeowners from defaults “With such a high investment income, can we use part of the earnings or the surplus funds to finance sectors which have been hard hit by the pandemic?” asked Ronick Chan Chun-ying, a lawmaker representing the banking sector in a Legco meeting in February. Yam does not favour any changes to the approach that has served the fund well. “While the Exchange Fund has a sheer size of assets, it also has a lot of liabilities such as the monetary base and government fiscal reserve,” he said. “Should the government need the money, for example, to fund budget deficits, fiscal reserves deposited with the Fund may have to be withdrawn. If we exclude the liabilities of the Exchange Fund from its assets, the accumulative surplus is only about HK$800 billion, which is not excessive.” An abundance of liquid financial resources should be kept in the Exchange Fund to cope with unforeseeable risks, he said. “This is particularly so when we are going through rather turbulent times, with increasing geopolitical tension between the US and China, and the possible destabilising withdrawal of monetary stimulus that is picking up momentum in the developed markets.”