LC Paper No. CB(1)839/98-99

Ref : CB1/PL/FA/1

Members present :

Hon Ambrose LAU Hon-chuen, JP (Chairman)
Hon Eric LI Ka-cheung, JP (Deputy Chairman)
Hon James TIEN Pei-chun, JP
Hon David CHU Yu-lin
Hon Cyd HO Sau-lan
Hon Albert HO Chun-yan
Hon NG Leung-sing
Hon Margaret NG
Hon Ronald ARCULLI, JP
Hon James TO Kun-sun
Hon CHEUNG Man-kwong
Hon Ambrose CHEUNG Wing-sum, JP
Hon HUI Cheung-ching
Hon Bernard CHAN
Hon SIN Chung-kai
Hon Jasper TSANG Yok-sing, JP
Hon Timothy FOK Tsun-ting, JP

Members attending :

Hon Martin LEE Chu-ming, SC, JP
Hon CHAN Kam-lam

Members absent :

Hon Kenneth TING Woo-shou, JP
Dr Hon David LI Kwok-po, JP
Dr Hon Philip WONG Yu-hong
Hon FUNG Chi-kin

Public officers attending :

Mr Bryan CHAN

Principal Assistant Secretary for Financial

Services (Securities)

Miss Clara TANG

Principal Assistant Secretary for Financial

Services (Banking and Monetary)

Miss Priscilla CHIU

Head (Monetary Policy)

Hong Kong Monetary Authority

Attendance by invitation :

Agenda item I

Mr John GREENWOOD

Vice Chairman

Chief Group Economist, Invesco Asia Ltd

Agenda item II

Mr Tom Y HSIAO

Vice Chairman

The Hong Kong Capital Markets Association

Agenda item III

Mr Andrew H C FUNG

President

The Hong Kong Financial Markets Association

Agenda item IV

Hong Kong Investment Funds Association

Mr Desmond CHAN

Chairman

Mr Richard HAW

Chairman, Stock Exchange/Securities and Futures

Commission Sub-committee

Agenda item V

Hong Kong Stockbrokers Association

Mr Dannis LEE Jor-hung

Chairman

Mr Wilfred WONG Wai-sum

Vice Chairman

Mr Paul FAN Chor-ho

Vice Chairman

Mr Kenny LEE Yiu-sun

Vice Chairman

Agenda item VI

Hong Kong Securities Professionals Association

Mr TONG Leung-sang

President

Mr WAN Moon-chi

Vice Chairman

Mr Trini TSANG Chi-suen

Committee member

Agenda item VII

The Institute of Securities Dealers Limited

Mr Keith LAM Hon-keung

Chairman

Ms CHOI CHAN Po-sum

Director

Agenda item VIII

Mr Alan SMITH

Vice Chairman, Pacific Region

Credit Suisse First Boston (Hong Kong) Limited

Clerk in attendance :

Ms Estella CHAN

Chief Assistant Secretary (1)4

Staff in attendance :

Ms Pauline NG

Assistant Secretary General 1

Ms Connie SZETO

Senior Assistant Secretary (1)1

Mechanism for defending the linked exchange rate system

The Chairman said that the meeting was the first of a series of two special meetings scheduled as a result of the Panel's decision to solicit views from market practitioners and academics on the mechanism for defending the linked exchange rate (LER) system. He informed members that the meeting would be conducted in eight sessions, during which each invited party would first make a short presentation on the subject and then answer members' questions afterwards. Written submissions provided by the invited parties had been circulated to members before the meeting.

I Mr John Greenwood
(LC Paper No. CB(1)437/98-99(01) tabled at the meeting)

2. Mr John GREENWOOD was of the view that the LER system was especially suitable for Hong Kong as a small open economy with large external sectors, and the system had been successful in maintaining stability of the Hong Kong dollar.

3. Elaborating on his advocacy of maximum flexibility in the rest of the local economy while maintaining the LER system, Mr GREENWOOD emphasized that it would be highly desirable to allow all other nominal and real economic variables free to vary since the imposition of control and restrictive measures on economic activities, such as setting wages and prices for goods, would disrupt the ability of the private sector in adapting to economic shocks.

4. Responding to an enquiry, Mr GREENWOOD remarked that it was technically feasible to peg the Hong Kong dollar with a basket of currencies of its major trading partners such as the Mainland and Japan. However, he doubted the option would benefit Hong Kong in combating speculative attacks on the Hong Kong dollar. Moreover, the US dollar peg had the advantage that it was easily understood by the general public and changes in US interest rate were readily translatable into equivalent changes in the Hong Kong interest rate.

5. On whether the fixed exchange rate of HK$7.78 to US$1 should be reviewed in the long run and whether interest rate hike was an inevitable price to be paid in defending the LER, Mr GREENWOOD explained that in fixing the exchange rate, economists would measure the respective prices of a basket of internationally traded goods and their variations in Hong Kong and the United States (US). Whilst the prices of these goods had been fairly consistent in the respective places over the past 15 years, the prices for domestic goods in Hong Kong, such as those for housing and transportation, had risen significantly relative to those in US reflecting greater improvements in standards of living in Hong Kong. As regards the impact of high interest rate on the general public, Mr GREENWOOD said that interest rate was only a short term price indicator reflecting the supply and demand of money in the money market. It did not reflect the purchasing power of money which should be the major concern of the public at large. Notwithstanding fluctuations in interest rate at times, the purchasing power of money was not affected in the long run.

6. Mr GREENWOOD opined that the seven technical measures introduced by the Hong Kong Monetary Authority (HKMA) were entirely consistent with the principles of the Currency Board (CB) system of "full backing" and "full offset" and had been successful in strengthening the CB arrangements in Hong Kong. The principles, if followed diligently, would ensure robustness of Hong Kong's CB making it less vulnerable to speculative attacks.

7. As regards the concern that the provision of a discount window (DW) was a departure from the conventional CB arrangements, Mr GREENWOOD pointed out that an entirely automatic operation of a CB system was no longer suitable for the modern economy. The successful implementation of an effective CB system depended very much on the provision of last resort liquidity support to banks. Nonetheless, the provision of discounting facilities must be based on the principles of full backing and full offset, and be resorted to on a minimal basis so as not to undermine the self-adjusting abilities of the CB system. Rather than reacting passively in the money market as in the case of a pure CB system, it was justified for HKMA to conduct market operations in response to certain set criteria.

8. Commenting on the mechanism for determining the base rate for the DW, Mr GREENWOOD opined that the rate should be fixed on the basis of explicit criteria and the process should be as open and transparent as possible. However, it was desirable for HKMA to maintain some reserved power in this regard for coping with unusual crises. He suggested that the base rate be linked with the inter-bank interest rate.

9. On the desirability of establishing a central bank in Hong Kong to undertake the functions of HKMA, Mr GREENWOOD was of the view that whilst HKMA had performed certain functions of a central bank, it would not be beneficial for Hong Kong to establish its central bank per se. Indeed, the issues to be concerned with should be the rules under which HKMA operated and the degree of disclosure to the market. He stressed that HKMA had abided by the disciplines of a CB system.

10. As regards actions to be taken in tackling increasing competition from Singapore in the financial services sector, Mr GREENWOOD was of the view that the Government and private sector needed to be alert to any competitive threat to their positions. Technological improvements and innovations that would lower the cost of dealing and improve the information for investors should be adopted to enhance Hong Kong's competitiveness.

II The Hong Kong Capital Markets Association
(LegCo Paper CB(1)437/98-99(02))

11. Mr Tom Y HSIAO said that the Hong Kong Capital Markets Association (HKCMA) generally supported the seven technical measures introduced by HKMA to strength the CB arrangements in Hong Kong but was concerned that two of the measures, namely, the ineligibility of private debt issues for acceptance at the DW and discouragement of nine supranationals from issuing Hong Kong dollar bonds with less than three-year maturity, would have negative implications for the development of the capital market. Mr HSIAO supplemented that in 1996 and 1997, certificates of deposits totalling HK$45.3 billion and HK$20 billion were issued by local banks and Hong Kong branches of foreign banks respectively. If such new issues were no longer eligible for acceptance at the DW, the attraction to banks of holding these instruments would diminish resulting in greater difficulty and/or higher cost for banks to obtain funding. Moreover, of the total issue volume of HK$30.6 billion bonds by supranationals for 1998, 86% had maturity of two years or less. The discouragement of supranationals from issuing Hong Kong dollar bonds with less than three-year maturity would affect market liquidity, reduce the availability of currency swap for genuine corporate end-users and deprive investors of high quality short term investment.

12. Upon enquiry, Mr HSIAO remarked that while the restriction of private debt issues from access to the DW was a relatively permanent measure, HKCMA believed that limiting supranationals to issue Hong Kong dollar debt to maturity of at least three years should be a temporary measure which could be lifted when the market stabilized. HKMA should pursue other measures, such as making reference to Singapore's practice of imposing the restriction that debts could only be issued for local use, so as to avoid manipulation by currency speculators.

13. On measures to facilitate the development of the local debt market, Mr HSIAO said that HKCMA had been co-operating closely with HKMA to strengthen the local debt market and measures proposed by the Association in this regard were contained in the submission provided to the Panel. As to the prospect of Hong Kong becoming the debt market capital of Asia, he opined that Hong Kong's debt market development was already ahead of the rest of the Region.

III Hong Kong Financial Markets Association
(LegCo Paper No. CB(1)437/98-99(03))

14. Mr Andrew H C FUNG of the Hong Kong Financial Markets Association (HKFMA) opined that although HKMA's measures had stabilized the market, their effectiveness had not been subjected to the test of large scale fund flows as these measures were only introduced just before the emergence of financial problems of certain hedge funds. On the proposed 30 measures to strengthen the order and transparency of securities and futures markets, Mr FUNG said that whilst these measures together with HKMA's seven technical measures were expected to make manipulation in financial markets more difficult, the substantial increase in regulation inevitably imposed a negative impact on the transaction volume of the money and stock markets.

15. Mr FUNG said that HKFAM was supportive of maintaining the LER system. He observed that in the absence of LER systems in Southeast Asian countries, even with substantial depreciation of their currencies in the wake of the Asian financial turmoil, these countries were still suffering from high interest rates and other economic problems.

16. As regards the appropriate level of foreign reserves to be maintained for defending the currency and counteracting heavy cash outflows without resorting to high interest rate, Mr FUNG said that HKMA's measures had increased the banks' liquidity and enlarged the clearing balance of the banking system so that it was less susceptible to currency attacks. Notwithstanding that the level of foreign reserves had fallen somewhat as a result of offsetting the pressure on interest rates, the current reserves level still stood at seven times the monetary base. He opined that the stability of a currency depended ultimately on market sentiment and public confidence on the currency.

17. On views about the Government's operations in the stock and futures markets in August this year, Mr FUNG remarked that HKFMA considered the operations justified in that they prevented a collapse in the markets as there were signs of manipulative plays by speculators creating sharp falls in share prices and confidence crisis in the Hong Kong dollar. Members of HKFMA, however, had different views on the impact on the stock market of government holding a substantial amount of shares of private corporations.

IV Hong Kong Investment Funds Association
(LegCo Paper No. CB(1)437/98-99(04) tabled at the meeting)

18. Mr Desmond CHAN of Hong Kong Investment Funds Association (HKIFA) remarked that HKIFA was of the view that over-valuation in the financial market over the past year, to a certain extent, had reflected weaknesses in the economy, which had arguably led to speculative attacks on the Hong Kong dollar. Mr Richard HAW supplemented that evidence of over-valuation included surges in stock prices, in particular those of Red Chips, and property prices during the period prior to the Handover in 1997.

19. As regards the Association's view on Government's August operations in the equity market, Mr CHAN said that the operations seemed justified in combating speculators' manipulative attacks in order to prevent catastrophic effects on the local economy. However, due to limited information available to the Association, an overall assessment could not be made. He further commented that although other governments would also make investments in their respective stock markets, it was unusual for a government to hold substantial quantity of equity shares of private companies. It was advisable for the Exchange Fund Investment Limited (EFIL), which was newly set up to manage the stocks acquired by Government, to arrange sales of the stocks in an orderly manner after the market had stabilized so as to avoid creating volatility in the market. It was also important for EFIL to ensure sufficient transparency in its operation, to clearly specify its investment objectives, (i.e. to stabilize the market rather than to make profit), and to adopt measures in compliance with securities related legislation as well as relevant rules and regulations of the exchanges.

20. Responding to an enquiry, Mr CHAN remarked that although members of HKIFA observed that there was net outflow of capital from Hong Kong in August this year, they also believed that a stable currency and interest rate environment, which were expected results of HKMA's measures and Government's 30-point programme to strengthen the order and transparency of securities and futures markets, would attract foreign investment to return to Hong Kong.

21. On disclosure of information of listed companies, Mr HAW concurred with members that increased disclosure would enhance protection for investors and prevent over-valuation of stock prices. However, the measure might become less effective when the market had become very heated and investment decisions were made irrationally. Commenting on the closure of the Guangdong International Trust and Investment Corp (GITIC), Mr HAW said that GITIC was not a listed company on the Hong Kong Stock Exchange and disclosure of information on its financial position was only relevant to the banking community in considering their exposures to the corporation, rather than to the general investing public.

V Hong Kong Stockbrokers Association
(LegCo Paper No. CB(1)437/98-99(05))

22. In supplementing the submission provided by Hong Kong Stockbrokers Association (HKSA), Mr Dannis LEE Jor-hung made the following points :

1. HKSA was supportive of maintaining the LER system in Hong Kong, the basis on which financial institutions had been developed and built upon. Nevertheless, the mechanism of the system should be constantly reviewed in the light of rapid changes in the local and global financial market;
   
   
2. the recent attack on the Hong Kong dollar was to a certain extent induced by over-valuation in the securities market since mid-1997 when stock prices surged up and bore no relation to the assets or prospects of the companies;
   
   
3. HKSA supported Government's operations in the stock and futures markets in August this year which were successful in restoring order in the market and public confidence; and
   
   
4. there should be more co-ordination and co-operation between the two exchanges in devising strategies to tackle increasing competition from Singapore in the financial services sector and the two exchanges should have the same trading hours.

23. Mr LEE also advised that HKSA had put forward improvement measures for the two exchanges, Securities and Futures Commission (SFC) and Financial Services Bureau, which were detailed in the submission for the Administration's consideration.

24. On the Government's 30-point programme to strengthen the order and transparency of securities and futures markets, Mr LEE said that whilst HKSA supported in principle most of the proposed measures, it opined that implementation should be progressive and sufficient flexibility should be allowed to avoid creating difficulties in the operation of brokers. However, HKSA had reservations over the proposals of criminalizing unreported short selling and false reporting activities to SFC and the exchanges. Mr Wilfred WONG Wai-sum stressed the need to strike a balance between maintaining order and transparency in the markets and avoiding over-regulation which would adversely affect market development.

25. As far as the new rule of client identity disclosure was concerned, Mr LEE said that it was necessary to specify clearly the information required from the clients to be disclosed to SFC upon the latter's request. Implementation of the rule should be flexible to avoid causing unnecessary burden on brokers and fund managers.

26. On the impact of strict enforcement of the T+2 settlement rule on overseas brokers, Mr LEE said that settlement efficiency had increased with improvements in the settlement system in recent years. The settlement efficiency of continuous net settlement stock positions had been more than 95% on T+2, and had further improved after the strict enforcement of the settlement rule. Whilst it would take longer to settle transactions involving more market intermediaries such as custodians, it should not be a problem for broker participants to comply with the T+2 settlement requirement. Since the measure required adjustment of all parties concerned, it would be beneficial to review the settlement statistics at a later stage.

27. On the issue of monitoring international fund flows to detect possible currency attacks, Mr LEE opined that increased co-operation and communications among governments and market regulatory bodies on large scale capital flows would be useful in giving early warning signals on currency attacks. Moreover, banks and other financial institutions should be particularly vigilant to their exposures to hedge funds as part of their prudential management of lending activities, which in turn would be effective in curbing the size of speculative funds, hence reducing their damages on the economies under attack.

IV Hong Kong Securities Professionals Association
(LC Paper No. CB(1)437/98-99(06))

28. Mr TONG Leung-sang said Hong Kong Securities Professionals Association (HKSPA) was of the view that despite some drawbacks in HKMA's seven measures, the measures had strengthened the CB arrangements in Hong Kong. HKSPA supported Government's 30-point programme for strengthening the order and transparency of securities and futures markets and had made suggestions to supplement the programme as detailed in the written submission provided to the Panel.

29. On HKMA's seven measure, Mr TONG opined that the one-way convertibility undertaking (CU) of Hong Kong dollar into US dollar at the rate of HK$7.75 provided to banks, though appropriate at this time of a relatively weak Hong Kong dollar, should be both ways in the long term, i.e. it should also allow banks to convert US dollars into Hong Kong dollars at the fixed exchange rate. Moreover, the eligibility of fund papers for the DW should be relaxed to include private debt papers so as to increase the latter's attraction to banks, thus facilitating the development of the local debt market.

30. Members noted HKSPA's concern that since the CU would allow banks to convert any Hong Kong dollars in their clearing accounts into US dollars at the fixed exchange rate of $7.75, the undertaking might be indirectly extended to cover all bank deposits which currently stood at around HK$1,600 billion. If this were the case, the Association doubted whether the existing level of foreign reserves would be able to provide fully for the undertaking. In this connection, Mr NG Leung-sing opined that the possibility of all depositors trying to convert their Hong Kong dollar deposits into US dollars was extremely low. On the contrary, the CU should instil confidence in the Hong Kong dollar making it unlikely for the general public to convert their Hong Kong dollar savings into US dollars.

VII The Institute of Securities Dealers Limited
(LegCo Paper No. CB(1)437/98-99(07))

31. Mr Keith LAM Hon-keung said that the Institute of Securities Dealers Limited (ISDL) supported the preservation of the LER system as vital in maintaining local and international confidence in the Hong Kong dollar, as well as the implementation of the Government's 30-point programme in the stock and futures markets. However, ISDL strongly urged imposition of checks and balances on the power of SFC. It proposed the formation of an independent body to monitor the work of SFC, enhancing communication between SFC and the two exchanges through regular monthly meetings to avoid the problem of duplicated regulation on market practitioners. Other suggestions made by the Institute on improving the existing regulatory system of the stock and futures markets were as provided in the submission. Mrs CHOI Chan Po-sum suggested that to avoid duplicated regulation, members of the Stock Exchange of Hong Kong (SEHK) should be regulated by SEHK and non-SEHK members should be regulated by SFC. She also urged that in enforcing the T+2 settlement rule on share transactions, flexibility should be allowed to brokers for non-compliance due to practical or technical difficulties.

32. As regards the stocks acquired by the Government in its August operation, Mr LAM said that if EFIL decided to sell the stocks, ISDL suggested that they should be sold in small batches at discounted prices through open subscription by small investors so as to prevent corporate investors from buying up large proportion of shares, thus minimising the possibility of market manipulation. The timing and proportions of the stocks to be disposed of should be a matter for the experts to consider in order not to disrupt the market.

33. On the question of whether the Government should merge the equity procured in August into the portfolio of the Exchange Fund, Mr LAM said that it was advisable for the Government to solicit views of the public, market practitioners and experts before making such a decision.

VIII Mr Alan Smith
(LegCo Paper No. CB(1)437/98-99(08))

34. Mr Alan SMITH expressed support for the Government's market operations in August this year and opined that they were necessary as a response to the unprecedented and highly unusual market situation at that time. He added that the market had been stabilized and Hong Kong had benefited from developments elsewhere in the world and the generally calming down of the Asian financial turmoil. The Government had also been successful in explaining its stance and purposes of the market operations to the international financial community. Despite short-term concerns, the operations should not damage Hong Kong's well deserved reputation as a free-market economy. Foreign investors would observe how the Government was going to manage and dispose of the stocks acquired during the operations before deciding whether to continue to invest in Hong Kong.

35. On HKMA's seven measures, Mr SMITH remarked that although currency board purists would argue that by implementing the measures HKMA had deviated from the disciplines of a currency board, measures like the DW and retention of a certain degree of discretion power by HKMA were necessary to plug deficiencies of the currency board in a modern financial system.

36. On the development of a regional debt market, Mr SMITH opined that the root of the Asian financial crisis might be traced to a mis-match between the requirement of long term finance for the infrastructural needs of Asia and the relative immaturity of the domestic capital market in the region. In fact, there should be great potential for the establishment of an Asian debt market. On the one hand, there was a large demand for raising funds by governments, supranational bodies, private financial institutions and business corporations in the region. On the other, Asian people had a very high propensity to save and the central banks of Asian countries generally maintained a high level of reserves. The issues to be addressed were the lack of appropriate market infrastructure and the relative low liquidity of the debt issues. Greater co-operation among governments through inter-governmental bodies such as the Asia-Pacific Economic Co-operation, was necessary to address these issues and to increase knowledge of and transparency about large capital flows, which were essential to the development of a robust Asian capital market. He saw Hong Kong as enjoying a much better position in developing into the centre of Asia's debt market because of its practice of open-door and free-market policies. In his opinion, the ineligibility of private debt issues for DW should not have significant impact on the development of a regional debt market in Hong Kong.

37. As regards the need for an Asian-based ratings agency in facilitating the development of an Asian debt market, Mr SMITH said that a number of Asian governments had started to develop Asian-based ratings agencies comprising experts with rating agency skills and specific Asian knowledge. Credibility was an essential element in assessing the effectiveness of an Asian-based ratings agency. Investors would be concerned about possible government influence on such an agency and would be skeptical about the purpose of forming a purely Asian-based ratings agency.

38. As to whether dollarization was a viable alternative to the LER system in Hong Kong, Mr SMITH remarked that whilst dollarization might be a possible solution to the 1983 crisis when the Hong Kong dollar slid rapidly as a result of massive capital outflows, a LER system was the most suitable monetary system for Hong Kong as it had served Hong Kong well and survived under extreme external depreciation pressure. Nevertheless, it was necessary to study alternative strategies for achieving monetary stability in coping with unusual conditions and other emergencies. As such, the Credit Suisse First Boston (HK) Ltd. had produced an in-depth research paper on dollarization as a thought piece.

IX Any other business

39. The Chairman reminded members that the Panel would meet with local academics and Professor Merton Miller on Saturday, 14 November 1998, at 9:00 a.m. on the same subject as today.

40. The meeting ended at 12:30 pm.


Legislative Council Secretariat
1 February 1999