Report on Financial Market Review by the Hong Kong SAR Government in April 1998

7/28/2019 Report on Financial Market Review by the Hong Kong SAR Government in April 1998

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REPORT ON THE FINANCIAL MARKET REVIEWTABLE OF CONTENTS

S OAT.i ?.sCVj CLASS NO, 'EXECUTIVE SUMMARYCHAPTER 1 INTRODUCTION AND OVERVIEWTHE FINANCIAL TURMOIL 1.1-1.2COMMISSIONING OF THE REVIEW 1.3-1.6THE FUNDAMENTAL PRINCIPLES 1.7-1.8BACKDROP TO THE REGIONAL FINANCIAL 1.9-1.12TURMOILVIEWS AND ADVICE TAKEN 1.13-1.17

CHAPTER 2 THE REGIONAL FINANCIAL TURMOILSPREAD OF THE CONTAGION 2.1-2.3TURMOIL IN HONG KONG 2.4 - 2.6IMPACT ON HONG KONG AND THE REGION 2.7-2.12

CHAPTER 3 THE MONETARY SYSTEMAN ACCOUNT OF EVENTS IN THE MONETARY SECTOR

Monetary Scene prior to October 1997 31. -3 .4Events during the week of 20 October 1997 3.5-3.9The Aftermath 3.10-3.12Measures Taken 3.13-3.14Characteristics of the October Currency Attack 3.15 - 3.24Post October Events #& * J t A 3.25 - 3.27Ss*

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OPERATION OF THE LINKED EXCHANGE RATE SYSTEMSupport for the Link 3. 28 -3 .2 9Currency Board System 3.30Evolution of the Monetary Base in Hong Kon g 3.31 - 3.33Mechanics of the Linked Exchange Rate System 3. 34 -3 .3 5Clearing Balance of the Banking System 3.3 6- 3.4 1Exchange Rate Level 3.42 - 3.45

PROPOSALS RECEIVED FROM THE ACADEM ICS AND OTHERSProposals for Reform 3.46US$LAF/HK$ Put Option 3.47 - 3,49Put Option - First Variation 3.50 - 3.53Put Option - Second Variation 3.54 - 3.58Put Option - Third Variation 3.59Dollarization 3.60-3.63AEL (Argentina, Estonia and Lithuania) Mod el 3.64 - 3.65Other Proposed Measures 3.66 - 3.69

IMPACT OF THE DEFENCE OF THE EX CH AN GE R ATE ON THE BANKI NG SECTOR

Background 3.70 - 3.73The Impact on Ban ks' Liquidity and Funding 3.74 - 3.79The Impact on the Availability and Cost of Credit 3.80 - 3.88(Loan Growth)The Impact on Bank s' Profitability 3. 89 -3 .9 5The Impact on Ba nks' Asset Quality 3.96 - 3.98Public Perception of the Impact on the Banking 3.99 - 3.102Sector and on Individual Banks


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REVIEW ON BANKING ISSUESSupervision and Transparency 3.1 03- 3.10 6Lessons Learnt 3.107Consultancy Study 3.108The International Dim ension 3.109

MACROECONOMIC ISSUESThe Competitiveness Issue 3.1 10 -3. 11 4"Th e Interest Rate Pain " 3.115 - 3.125

CONCLUSIONBackground 3.126-3.127General Conclusions 3.1 28 -3.1 41

CHAPTER 4 SECURITIES AND FUTURES MARKETSTHE MARKETS BEFORE AND DURING THE 4.1 -4.1 3TURMOILTHE STOCK MARKET

Short Selling and Stock Borrowing and Lending 4.14 - 4.32Margin Financing 4.33 - 4.37Relaxation of Takeove rs Threshold 4.38 - 4.43Com pliance of SEHK Listing Rules 4.44Th e Hang Seng Index 4.45 - 4.53


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FUTURES AND DERIVATIVES MARKETSIntroduction 4.54 - 4.66Trading System of Hong Kong Futures Excha nge 4.67 - 4.79Margin Level for HSI Futures Contracts 4.80 - 4.85Derivative Warrants 4.86 - 4.103

MARKET SURVEILLANCE AND RISK MANAGEMENTAlleged Market Manipulation 4.104 - 4.116Surveillance of Trading and Member Conduct 4. 11 7- 4.1 23Link-up of CCASS and RTGS 4.124 - 4.129Investor Participation in CCASS 4.1 30 -4 .13 3Cross Margining 4.1 34 -4.1 36Financial Resources Rules 4.1 37 -4 .13 9Stock Collateral 4.140 - 4.141

MARKET TRANSPARENCY, INVESTOR PROTECTION AND EDUCATIONIntroduction 4.142Disclosure of Information by Companies Listed on 4.143 - 4.145the SEHKAccess to Corporate Information 4.146 - 4.147Fidelity and Compensation Schemes of Stock 4.1 48 -4 .15 0MarketInvestor Resources Centre 4.151Investor Education Programme 4.152 - 4.153Promotion of Use of Plain Language 4.1 54 -4 .15 5


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THAPTER 5 SUMMAR Y OF R EC OMMENDATIONSTHE TURMOIL IS PROGRESSINGSUMMARY OF RECOMMENDATIONS

5.1-535.4

ANNEXESAnnex 2.1Annex 3.1

Annex 3.2Annex 3.3

Annex 3.5

Annex 3.6

Annex 3.7

Annex 3.8Annex 3.9

Annex 3.10

Annex 3.11

Chronicle of EventsCircular announcing the establishment of the LiquidityAdjustment Facility (LAF) dated 27 May 1992Circular on LAF borrowing dated 23 October 1997Circular clarifying the definition of "repeated borrowers"dated 12 Novem ber 1997

Annex 3.4 Concluding statement of IMF Article IV ConsultationsA technical note on Hong Kong's linked exchange ratesystemProfessor Goodhart's analysis on the recent events in HongKong and proposals received from the academ icsUS$ LAF / HK$ put option proposed by ProfessorChen N ai-fii and his colleaguesTechnical analysis of the US$ LAF/HK$ put option proposalLetter from Mr. David Goldsbrough of IMF dated5 December 1997 commenting on the US$ LA F proposalLetter from Mr. David Goldsbrough of IMF dated 20February 1998 comm enting on the put option proposalAEL (Argentina, Estonia and Lithuania) model proposed byProfessor Tsang Shu-ki

Annex 4.1 Performance of Major Overseas Stock Markets (table)


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Annex 4.2 Short selling turnover - September 1997

Annex 4.3 Hon g Kong Futures Exchange LimitedMigration of Trading of Hang Seng Index Futures andOptions Contracts to the Automated Tra ding System


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E X E C U T I V E S U M M A R YINTRODUCTION

Affected by the contagion effect of the regional financial turbulence, theHong Kong dollar came under speculative pressure on several occasions in the secondhalf of 1997. Overnight interbank interest rate surged briefly to 280% on 23 Octoberunder the automatic adjustment mechanism of the currency board system. During thatweek and the following week, the securities and futures markets in Hong Kong alsoexperienced the most severe volatility in history, recording a 1,438 points (13.7%) fall inthe Hang Seng Index on 28 October and a 1,705 points (18.8%) rebound on the followingday.2. While we have ridden through this particularly stormy period with ourcurrency remaining stable and the securities and futures markets operating orderly andefficiently, the combination of the interest rate hike and the asset price adjustments inboth the securities and property sectors have caused serious concern among the localcom munity. The Financial Affairs P anel of the Provisional Legislative Council called fora special briefing by the Administration on 31 October 1997. On 2 Novem ber 1997 theFinancial Secretary made public his intention to call for a review of our currency defence.The Provisional Legislative Council further passed a motion on 26 November 1997.Among the Members who spoke during the motion debate, there was an overwhelmingsupport that the linked exchange rate with the US dollar should be maintained tosafeguard the well-being of the economy and investors' confidence in Hong Kong dollar.Nonetheless, they strongly urged the Administration to review the operation of thecurrency defence mechanism as well as the operation of the financial markets especiallyshortselling activities and the trading of derivatives. The motion also called for actions toenhance the Government's ability to withstand such volatility and strengthen investoreducation. Supporting the motion, the Secretary for Financial Services reiterated theAdministration's commitment to launch a comprehensive review once the regionalturmoil had settled.

CONTRIBUTION TO THE REVIEW3. This Review covers the mechanism for defending the linked exchange ratesystem and the operating mechanisms of the securities and futures markets during thisperiod of volatility. The major contributors to the Review w ere the Hong K ong M onetaryAuthority (HKMA) and the Securities and Futures Commission (SFC) in their respectiveambits.4. The HKMA had the benefit of the views from a wide spectrum of peoplewith an interest and the capacity in technical issues of this nature, including those in theacademic field, here in Hong Kong and elsewhere. In particular, the HKM A received the


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expert advice from the International Monetary Fund (IMF) team which happened to be inHong Kong for the annual Article IV Consultations in the second half of October, whenthe speculative attack on the currency occurred. Having w atched closely ho w our linkedexchange rate system worked to ensure exchange rate stability, the IMF experts providedobjective advice and also gave specific opinion on a number of proposals that wereceived during this review. The HKMA also had the benefit of the advice of ProfessorCharles Goodhart of the London School of Economics who is also a member of theMonetary Policy Committee of the Bank of England . Professor Goodh art has long beenassociated with monetary developments in Hong Kong.5. As regards the review on the securities and futures markets, we workedclosely with the SFC and were assisted by the Stock Exchange of Hong Kong (SEHK),the Hong Kong Futures Exchange (HKFE) and the Hong Kong Securities ClearingCompany (HKS CC). Throughout the financial turmoil, the SFC had also maintainedclose contact with its overseas regulatory counterparts, and discussed the appropriatemeasures to respond to the situation as it developed .6. The review also took the benefit of advice from experts in the financialmarkets, including fund managers, securities brokers, and bank treasurers most of whomhave extensive experience working in sophisticated international financial centres . View swere also widely sought from academics and the market participants. As the rev iewprogressed, the financial turmoil continued to affect the currency and the financial sectorsof several regional econom ies. There were also isolated incidents of individua l financialinstitutions in Hong Kong being affected, including the mini-run on the InternationalBank of Asia and the default of the Peregrine Gro up and the C A Pacific Gro up.

FUNDAMENTAL PRINCIPLES7. The Review has been premised on two fundamental princip les. First,consistent with the mandate in the Basic Law, and bearing in mind the long-term interestof Hong Kong as an open and externally-oriented economy, we must maintain andenhance the status of Hong Kong as an international financial centre. Second ly,consistent with the objective of maintaining the stability of the Hong Kong dollar, thelinked exchange rate (LER) system which has served Hong Kong well must be preserved.

THE REVIEW8. While we are not insensitive to the pain that has been inflicted on theeconomy by the interest rate hike and the asset price adjustments, we are pleased to notethat the defence mechanism for the currency has very effectively preserved the stab ility ofthe exchange rate and the monetary system. The prudential regulatory fram ewo rk forboth the banking and the securities sectors which we have carefully built up over the

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years have formed effective buffers against the recent shocks. Yet we have not beencom placent. We have taken a thorough look at each facet of the currency defencemechanism and the securities and futures markets and have identified a number of areaswhere improvements can be made. Some of these measures have been immediately putin place to give prompt effect. Others may take som e time to be examined in greaterdetail, for the targeted market to be developed, and for the necessary legislative and ruleamendm ents to be formulated and put in place. In drawing the conclusions and therecommendations, we have been careful in striking a balance between the need forprudent regulation and the room necessary for free market development; and a balancebetween the need for improvements and the need for stability and certainty.

TH E REVIEW ON TH E CUR REN CY D EFENCE

9. In respect of the currency defence, we have examined the events in themonetary sector in detail, focusing on the currency attack in October 1997. W e set out adiscussion on the operation of the linked exchange rate system and evaluate the variousproposals from academics which aimed at relieving pressures on interest rates. We havealso conducted an assessment of the impact of the recent events on banks' liquidity,profitability and asset quality. The HKM A has drawn lessons on the banking side andhas made recommendations regarding ways in which both the actual position of banks,and the public perception of their position can be improved. This Review also exam inesthe wider implications of the link for the macro economy.10. The conclusions of the review on the defence of the currency are asfollows -

(I) Role of interest rates(a) Under the automatic adjustment m echanism of the LER sy stems, it is themarket which determines the level of interest rates required to maintain afixed exchange rate.(b) As exchange control or credit control is not an option in Hong Kong, thereis little, if any, room for selective infliction of interest rate pain on thespeculators under our LER system.(c) Whilst one or two of the schemes proposed by the academ ics aiming atsuppressing increases in interest rates may have some psychological value,they may carry the risk of unde rmining the c redibility and self-adjustingmechanism of the LER system.

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(II) Conduct of foreign exchange and money market operations bv the HK M A(a) Instead of rigidly buying and selling US dollars against H ong K ongdollars at the fixed exchange rate of 7.80, the HKMA should continue itsexisting practice of leaving the foreign exchange market very much alone.If there is risk of instability in the exchange rate, the HKMA should, as inthe past and at undisclosed levels around 7.80, establish its passivepresence in the foreign exchange market in accordance with the discipline

of the currency board system.(b) Operating under the rule-based currency board system, the clearingbalance of the banking system, an important part of the monetary base,will vary in accordance with the flow of funds into and out of the HongKong dollars. Only in exceptional circumstances, such as Initial PublicOfferings of shares and other large scale Hong Kong dollar transactions,will the HKMA consider directly varying the clearing balance temporarilywithout the corresponding change in its US dollar hold ings. Theseoperations are carried out for the benefit of promoting general marketstability. In all other activities conducted by the HKM A w hich may havethe effect of varying the clearing balance of the banking system such as atransfer of fiscal reserves and the issue of Exchange Fund Bills and Notes,the HKMA ensures that such effect is neutralized as the case may be, byrecycling or sterilizing Hong Kong dollar liquidity. This practice shouldcontinue.(c) For the purpose of facilitating the smooth functioning of the paym entsystem, the HKMA should continue to provide intra-day liquidity as wellas overnight liquidity through the Liquidity Adjustment Facility (LAF) byentering into the repurchase arrangements involving predominatelyExchange Fund Bills and Note s. It should also continue to d iscouragerepeated borrowings from LAF.(d) The clarification of the definition of "repeated borrow ers" enables theinterbank market rates to rise in a less drastic manner, as wasdemonstrated during the week commencing 12 January 199 8. This hascontributed to a more orderly market reaction to the gradual shrinkage inthe interbank liquidity. The present definition of a repeated borrow ershould be maintained.

(Ill) Banking systemA sound and properly regulated banking system is essential to the maintenanceof exchange rate stability. We should continue to reinforce our efforts in

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ensuring that banks in Hong Kong will manage prudently their risks, havingregard to the special circumstances of Hong Kong's currency board system, andpay special attention to the quality of their assets so as not to be overly exposedto those which are vulnerable to interest rate volatility. It is recomm ended thatstrategic issues to further strengthen the resilience of Hong Kong's bankingsystem to external and internal shocks be thoroughly considered in theconsultancy study to be conducted in 1998.

(IV) Pain tolerance level of Hong Kong(a) In the defence of the Hong Kong d ollar, sharp rises in interest rates willinevitably inflict pain not only on the currency spec ulators, but also on thehome owners with floating rate mortgages and corporates with floating

rate liabilities. One way to provide som e insulation for the innocentparties from fluctuations in short term interest rates would be throughborrowing fixed rate funds.(b) It is recomm ended that steps should be taken for the Ho ng Kong M ortgageCorporation (HKMC) to play a greater role in developing the necessarymarket infrastructure to promote fixed rate mortgages as an additionalfinancing option for home buyers. This can be achieved by the HKMCgiving a clear indication of its intention to buy fixed rate mortgages frombanks, thereby encouraging banks to originate such mortgages which theywould otherwise be reluctant to grant because of the short term maturityand floating rate nature of ban ks' funding base. The HKM C may give apre-commitment to banks to acquire those mortgages as they areoriginated. This will effectively protect banks from th e market risk due tochanges in interest rate after the origination of the mortgages as the bankscan offload of those mortgages to the HKM C.(c) It is recomm ended that steps be taken to develop the debt marke t, throughencouraging the institutionalization of savings, especially the MPF, to

prom ote the demand for fixed rate debt securities.

THE REVIEW ON THE SECURITIES AND FUTURES MARKETS11. In respect of the review of the operation of the securities and futuresmarkets, we have also examined the events prior to and during the market volatility inOctober 1997 to January 1998. We have considered in some detail the key issues ofconcern relating to the stock market, viz. risk management, shortselling and stockborrowing and lending; the regulation of margin financing activities which was a majorfactor in the default of the C A Pacific Grou p; the enforcement of compliance w ith SEHK


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Listing Rules by company directors, financial advisors and sponsors; and therepresentativeness of the Hang Seng Index (HSI). We also discussed the role andfunction of the futures and derivative markets and their products, examining the tradingsystem of the Hong Kong Futures Exchange especially in respect of the trading of HSIFutures contracts; the appropriateness of the margin level for HSI Futures contracts; andthe function and market implications of derivative warrants. We have also add ressedallegations of market manipulation; discussed ways to improve surveillance of tradingand member conduct; and considered means to improve management of risk in themarket at the investor, intermediary and market levels. Measu res to impr ove m arkettransparency, investor protection and education are also recommended.12. The major conclusions and recommendations for the securities and futuressector are as follows -

tl ) The market and regulatory systems(a) Throughout the period of volatility in the securities and futures m arkets,the trading, settlement and risk management systems continued to work

w el l The institutional and regulatory framework put in plac e in the lastten years have proved to be effective in providing an ope n, fair and orderlymarket.(b) In the two cases where provisional liquidators had to be appoin ted inrespect of Peregrine and C A Pacific, the failure of these companies didnot cause any substantive systemic problem, nor did they lead to furthervolatility in the market.(c) Taking stock as of 31 March 1998, our market is among the least affectedin the region. In US dollar terms, the stock market in Hong Kong shrankby 24% compared with the position at the end of June 199 71.

(II) Issues of concern in the Stock Market(a) Shortselling, subject to regulation, is a widely accepted legitim ate marketactivity in most major securities markets. The SEHK did not detec t anyimproper activities in short selling reported to it during September toNovember 1997. Nor did SFC detect any link between improper shortselling and market volatility during the period. No ting that mark ettransparency is very important to the regime for shortselling, it isrecommended that the reporting requirements for short open interest

When compared with end June 1997 and expressed in US dollar terms, the Taiwan market lost15%. Tokyo and Singapore shrank by 31% and 27%, respectively. Others in South East Asia lost45% (Philippines) to 79% (Indonesia).

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and other relevant information be enhanced to increase markettransparency. On the other hand, a level playing field is important to theregime for stock lending and borrowing which complements short sellingactivities. We believe noted that the introduction of a central StockBorrowing and Lending facility by HKSCC in early 1999 will provideequal access to stock borrowing and lending to all investors.

(b) The C A Pacific incident made it clear that the largely unregulated marginfinancing activities by broker-related finance companies should be broughtback into the regulatory fold. In this regard, the work of the cross-agencyworking group established in December 1997 was expedited with a viewto publishing a consultation document in early May 1998 and tointroducing the relevant legislative amendments to the first LegislativeCouncil as soon as possible. It is recommended that these broker-related finance companies be subject to prudential regulation by theSecurities and Futures Comm ission. The major areas of regulationinclude capital adequacy, risk management, and conduct of business.(c) It is recommended that the SFC review the concept of TreasuryShares2 in the


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(Ill) Issues concerning the Futures and Derivative M arkets(a) Derivative products including index futures are important riskmanagem ent tools in portfolio managemen t. They add liquidity to themarket and increase the diversity of the market product base. As such theyare essential for the development of the Hong Kong market and to meetthe needs of the local institutional fund industry. Such ne eds will growwith the introduction of Mandatory Provident Fund schem es. Without

them the Hong Kong securities markets cannot remain competitive in theregion. It is recommended that we continue to improve our marketrules to maintain an effective regulatory regime.(b) We welcome the HKFE's decision to migrate the tradin g of HSIFutures contracts to the Automated Trading System. Noting the leadtime necessary to put the relevant systems in place both at the Exchangeand for its broker members, we also welcome the HKFE's initiatives toimprove the information dissemination system of the open outcrysystem in the interim.(c) It is noted that the margin requirement of the HKFE on HSI Futures

contracts is already among the highest in the world and has served theExchange and its Clearing Company well during the turmoil. It isrecommended that the SFC and HKFE continue to explorerefinements to the calculation of margin level in o rder to maintain theflexibility to meet exceptional mark et volatility.(d) There was substantial growth in the derivative warrant market followingthe relaxation of issue requirements in August 199 6. There wereindications that derivative warrants add to short term volatility as a resultof the corresponding hedging activities by issuers. We welcome theSEHK initiatives to review the listing rules for derivative warrantswith a view to reducing the impact of warrant issues and settlement

on the cash market and improving transparency and investor'sprotection. We expect that the SEHK will subm it the relevantchanges to the Listing Rules to SF C before m id 1998.

(IV) Market Surveillance and Risk Managem ent(a) There had been allegations that speculators had profited through marketmanipulation across the securities, futures and currency ma rkets; that somehad taken advantages of the expected interest rate surge following theattack on the currency, the ensuing liquidity squeeze and the sellingpressure on the cash market; that certain brokerage houses had taken

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positions prior to the announcements of certain economic analysis by theirown firms, and so on. The SFC investigations have found no evidenceto substantiate any of these allegations of market manipulation.(b) Recognising the importance of market surveillance to ensure tradingactivities in the market are conducted in a fair and orderly manner, it isrecommended that the capability of the SFC and the exchanges in thesurveillance of trading and members' conduct be further enhanced.Where necessary, legislative amendments will be considered tostrengthen the capability of the SFC and the exchanges in obtainingmarket information from the intermediaries. It is also recomm endedthat measures to better manage and eliminate risks at various levelsbe introduced -

(i) link-up of CCASS and RT GS 3 in May 1998;(ii) introduction of Direct Investor Participation in CC ASS also inMay 1998;(iii) detailed examination of the feasibility of cross marginingbetween HKFE and SEHK; and(iv) promulgation of revised Financial Resources Ru les in thesecond half of 1998.We also welcome the acceptance of stock collateral by HKSCC sinceend December 1997 to alleviate part of the liquidity pressure onmarket intermediaries.

(V) Market Transparency. Investor Protection and Education(a) The heated activity in the market during the first half of 1997 and thevolatility that followed both point to the importance of enhancing markettransparency to enable investors to make their decisions based on equaland adequate knowledge about the fundamentals and prospects of thecompanies and investment products concerned. It is equally important toprotect investors through regulations that protect their rights andopportunities and to educate them about the market.

This is a linkage between the Central Clearing and Settlement System (CC ASS) of HKSCC whichhandles 99.5% of SEHK transactions and the Real Tim e Gross S ettlement System (RTGS ) ofHKM A which is the money settlement system among banks. The linkage will further reduce themarket risks of settlement for HKSCC and the parties to the trade.


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(b) The following measures have either been introdu ced or are understudy in order to achieve greater transparency and provide betterprotection and education to investors -(i) revision to the financial disclosure prov isions in the SEHKListing Rules to improve the transparency of financialexposure of listed companies to their investors and the market;(ii) with effect from February 1998 a requ irem ent on listedcompanies to provide corporate communications to allinvestors who deposit their shares with the CCASS;(iii) review of fidelity insurance and compensation schemes ofSEHK to ensure the provision of cost-effective protection toinvestors and market practitioners;(iv) establishment of an Investor Resources Centre within 1998;(v) provision of various investor education prog ram m es and

enquiry/complaint facilities; and(vi) a requirement of the use of plain langu age in compan yprospectuses and communications.

THE BROADER PERSPECTIVE13. The regional financial turmoil started off in Thailand in the middle of1997 and quickly swept through to the rest of South East Asia. Then tow ards the yearend, financial troubles in Japan and corporate bankruptcies in South Korea rocked NorthAsia. In early 1998, the fall-out in Indonesia gave a fiirther shock to S outh E ast A sia andthe rest of the region. These events have tended to compound eac h other, resulting inserious regional crises with profound im plications for the global financial ma rkets. HongKong as a significant member of the global and regional financial community could nothave been immune.14. In all these events, the most conspicuous features of the turmoil weresubstantial downward pressure on the stock markets, upsurge in interest rates, risinginflation and, with the exception of Hong Kong, sharply depreciated and highly volatileexchange rates. Businesses experienced a widespread liquidity squeeze as the bank ingsectors exercised stringency on account of diminishing deposits, falling v alue in co llateraland worsening quality of loans. These led to greatly increased corporate difficulties, withknock-on effects on local consumer and investment spending. Overall econom ic grow thin the affected places dipped and unem ployment correspondingly rose.


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15. This region which is stricken by the financial turmoil was the region thatwas hailed not too long ago for its strong growth and economic dynam ism. The crux ofthe problem, in many cases, lies in the structural and systemic weaknesses in the financialand corporate sectors which were overlooked at the times of exceptionally remarkablegrowth. In certain cases, these weaknesses were exacerbated by lax regulation, anddeliberate policies favouring the growth of particular sectors and excessive exposure toparticular sources of funding instead of being guided by competition and marketefficiency.16. Hong Kong generally has little of such structural and systemic problems.However, through a period of exceptional buoyancy in the economy and highly bullishoutlook for the future, the stock and property markets in Hong Kong had gone toexcessive heights. For examp le, residential property prices rose on average by as muchas 80% to the peak during the two years prior to October 1997. The HSI gained by 1.4-fold to reach the record high in August 1997 in slightly more than 2 1/2 y ears. At thatrecord high, the P/E ratios for Blue Chips surged to an average of 17 times, while thosefor Red Chips and H shares were even more dramatic, at 52 and 30 times respectively.In retrospect, while the fundamentals of the economy at that time remained generally andbasically sound, the sharp escalation in asset prices to unsustainable levels did expose asubstantial weakness making our financ ial sector open to assault. It was against thisbackground that the heavy speculative attack on the Hong Kong dollar took place in thelatter part of October 1997. The subsequent adjustments, painful though they were , inhindsight was perhaps not only unavoidable but even necessary.17. Going through this period of volatility, we continue to take comfort thatour sound fundamentals, robust financial systems and market-oriented policies along withthe flexibility of the economic structure have afforded us the best protection. To m aintainour resilience against adversities, we must preserve all these underlying attributes. Ontop of this foundation, we would further refine our systems by the whole range ofimprovement m easures outlined in this report. And they are by no means the end of ourefforts. We must keep up our vigilance to ensure that we have the dynamism in themarket as well as the vigour in our regulatory framework to ensure our long-termcompetitiveness.18. Perhaps an important lesson for us to learn from the regional financialturmoil is exactly the saying of "staying vigilant while in peace". As w e are riding outthe storm and renewing our strengths, we must n ot forget the pains too quickly. Insteadwe should be watching out for the risk of any asset price bubbles, and make adequatepreparations against possible m arket downturn in times of particular buoyancy . So is theneed to watch out for any inherent imbalances in the economy and have themexpeditiously and effectively addressed.

Red Chips are stocks which are mainly held by C hinese entities, including state-ownedorganisations, provincial and m unicipal authorities, whereas H shares are Chinese state-ownedcompanies listed on SEHK.

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CHAP T E R 1INTRODUCTION AND OVERVIEW

THE FINANCIAL TURMOIL1.1 In late May 1997, the Thai baht came under severe speculative attack.Selling pressure was also experienced by the Philippine peso and Malaysian ring git Asthe Thai baht was attacked again in early July, the Bank of Thailand floated the bahtwhich immediately fell from Bht 26 to the US$ to Bht 30. While the IMF pledged arescue programme amounting to US$3.9 billion to assist the Thai government, thecontagion spread to the neighbouring economies, including Malaysia, Indonesia and thePhilippines.1.2 In late October, the turmoil spread further. In the week preceding 20October, the New Taiwan dollar depreciated sharply by 6.5% when the Taiwaneseauthorities decided not to defend its currency. How ever, the Hong Kong dollar remainedunaffected. On 21 and 22 October, speculators launched massive short selling of HongKong dollar in the expectation that we would give up our linked exchange rate and jointhe row of competitive devaluation. They were joined by fund m anagers who decided toswitch out of Hong Kong and sold in the stock market, as well as others who felt itprudent to hedge their Hong Kong dollar exposures and sold Hong Kong dollars forward.The defence mechanism for the Hong Kong dollar under the currency board system wasautomatically kicked in. In accordance with the currency board arrangement, the HongKong Monetary Authority (HKMA) sold a substantial amount of US dollar in the foreignexchange market in defence of the Hong Kong do llar exchange rate. As banks did nothave sufficient Hong Kong dollars in their clearing balance with the HKMA to settle theforeign exchange deals done during these two days, they aggressively bid funds in theinterbank market which did not actually exist. The HKMA also issued a statementdiscouraging licensed banks from repeated borrowings from the Liquidity AdjustmentFacility (LAF). The market became so one-sided and trade so thin that the overnightinterbank interest rate surged from 9% to 280% at around noon time on 23 O ctober. Onthat day, the Hang Seng Index fell by 1,211 points (10.4%) to close at 10426 and stockmarkets world-w ide also suffered severe loss. In the ensuing da ys, while the currencystabilised in the spot market, the liquidity eased and the overnight rate softened quickly toclose to LAF bid rate, the term rate remained significantly higher than the Best LendingRate, and the stock market experienced a period of high volatility and high turnover.


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COMMISSIONING OF THE REVIEW1.3 There wa s, understandab ly, conside rable public conce rn at the high levelsof interbank interest rates, however temporary as they turned out, as they drove assetprices sharply downwards, affecting considerably the wealth of the community, many ofwhom w ere innocent parties. Rather naturally then, as the high interest rates w ere for thepurpose of defending the Hong Kong dollar, the blame was in turn put on the LERsystem, with renewed queries on the suitability of the system for Hong K ong . But as theAsian currencies succumbed to speculative attack, leading to devastation not only in thestock market, but also substantial corporate and banking losses, public opinion quicklyrealized the crucial importance of the stability of the Hong Kong dollar both in HongKong and the region. The attention of critics was then turned to the defence of the HongKong dollar itself, mounted by the HKMA .L4 The critics tended to ignore the fact that Hong Kong was the last and theleast to be affected by the currency turmoil that has been sweeping through the region.There was, indeed, considerable pressure being felt even far b eyond th e re gion, as far asand as apparently unconnected as Latin America. The contagion also spread to most ofthe large, liquid, sophisticated and established m arkets. But the pain w as ob viously therelocally and nobody liked it, regardless of ho w m uch w orse the alternative m ight b e.1.5 At the same time, as the securities and futures ma rkets experiencedexceptional volatility when the regional currencies, especially Hong Kong dollar, wereattacked, and there was a significant net fall in the market, there were concerns thatcertain aspects of the securities and futures m arkets were adversely affecting the m arket.The major issues of concern were volatility allegedly being exacerbated by shortselling ofcertain major shares in the market and trading related to derivative wa rrants. There w erealso allegations of market manipulation. These included suggestions of internationalparticipants taking advantage of the expected interest rate hike in the defence of the HongKong dollar, by first taking a short position in the index futures market and thenlaunching an attack against the currency and of speculators reaping substantial profitsfrom the futures market through manipulation across the futures and securities markets;and investment houses taking short positions in the m arket with a view to benefiting fromanticipated announ cements of their financial and econom ic analysts.1.6 The Financial Affairs Panel of the Provisio nal Leg islative Cou ncil calledfor a special briefing by the Administration on 31 O ctober 1997. On 2 Novem ber 1997the Financial Secretary made public his intention to call for a review of our currencydefence. The Provisional Legislative Council further passed a motion 1 on 26 November1997. There was an overwhelming support among M embers who spok e during themotion debate that the linked exchange rate with the US dollar should be maintained inorder to safeguard the well-being of the economy and investors' confidence in HongKong dollar. Nonetheless, they also strongly urged the Adm inistration to review theoperation of the currency defence mechanism as well as the operation of the financial

The Motion reads "Review of the Operating Mechanism of Hong Kong's F inancial M arket".


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markets especially shortselling activities and the trading of derivatives. The motion alsocalled for actions to enhance the Government's ability to withstand such volatility andstrengthen investor education. Supporting the motion, the Secretary for FinancialServices reiterated the Administration's commitment to launch a comprehensive reviewonce the regional turmoil had settled.

THE FUNDAMENTAL PRINCIPLES1.7 The Review has been premised on two fundamental princ iples. First, wemust maintain our position as an open, mature and liquid international financial centre.This is not only because of the mandate in the Basic Law that the Government of theHong Kong Special Administrative Region shall provide an appropriate economic andlegal environment for the maintenance of the status of Hong Kong as an internationalfinancial centre. It is also the only way that serves the long term interest of Hong Konggiven our external orientation and enables Hong Kong to play our strategic role in thenat ion 's economic development. Secondly, consistent with the object of maintaining thestability of the Hong Kong dollar which is essential for our trade-oriented economy, thelinked exchange rate system must be preserved.1.8 The Rev iew therefore focuses on the technical and practical levels to see ifthe operation of the existing systems can be further refined or improved. With theexception of margin financing activities2 for which there is a demonstrable need forprudential regulation, we do not propose to introduce drastic changes just for the sake ofchange. The existing currency defence mechanism has proved effective in maintaining astable currency. The regulated industries in the banking and securities sectors havewithstood the exceptional volatility during this period, and have proven that the currentregulatory regimes are functioning well. But we are not complacent. And we have notleft a stone unturned in the conduct of this Review.

BACKDROP TO TH E REGIONAL FINANCIAL TURMOIL

1.9 In addition to bearing in mind the major principles underlying ourfinancial and monetary policies and fundamental to this Review, we should also see thevolatility we experienced in the context of the developments in Hong Kong and in theregion prior to the onslaught of the attack.1.10 Starting from the end of the 1980s, the economic success of Asia becamethe headlines of international journ als and publications. There was a bullish atmosphereall over the region. Strong export growth and ambitious infrastructure projects suggestedan "As ian Miracle" . Foreign capital poured into emerging economies in the region toreap a return impossible elsewhere. Benea th this track record of high grow th, significant

"Share fina ncing", or comm only referred to as "m argin financing", refers to the provision of loansagainst stock collateral for the purpose of financin g stock transactions.


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structural and systemic weaknesses accumulated in the financial and corporate sectorsover time but receiving little or no attention. Worse still, there existed d elibera te policiesand entrenched political settings stretching those strains. The gove rnm ent policiesencouraging open borrowing by domestic enterprises in foreign currencies, the thrust ofindustrial policy prompting the banks to lend relentlessly to the conglomerates onprojects of feeble viability and sometimes obscure and problematic business, andsupervisory relationships amongst the corporations, the financial institutions and theregulators were sources of the problem. Then there were the lax supervision on banks, inrespect of their excessive exposure to real estates, and the closely webbed linkagebetween political and business interests, thereby impeding competition and efficiency.Such examples can go on. In short, international speculators may not be singly blamedfor destabilising the financia l markets and the econom y. The finan cial crises must beanalysed for the root causes which are very often entrench ed dom estic m alais e. (This isprecisely the approach taken by the international financial institutions in constructingprogrammes to assist the stricken economies to come out of their crisis.)1.11 Hong Kong generally has little of such structural and syste mic problem s.In particular, our monetary system is robust with a well constituted exchange rate regimeunderpinned by substantial foreign exchange reserves and effective monetary devices, ourbanking system is well-supervised to ensure prudent lending and decent balance sheet andcollateral strength, and our securities markets are properly and smoothly run. Thegovernment budget is prudent and debt-free. We have non -interve ntionis t policieswhereby private enterprises are left to make their own business decisions, for which theyare entirely accountable, and where the Government facilitates, not directs, thedevelopment of the economic sector. We have fair and transpa rent rules and a levelplaying field, as well as the protection accorded by a sound judicial system coupled witheffective enforcement. We have a high degree of flexibility in the econ om ic syste m, anda highly adaptable workforce. As experience over the years vindic ates, all these positiveattributes have enabled our economy to weather shocks and vicissitudes efficaciously asthey occur. The same attributes should enable us to live throug h the imp act of theregional financial turm oil.1.12 However, through a period of exceptional buoyancy in the economy andhighly bullish outlook for the future, the stock and property markets in Hong Kong hadgone to excessive heights. For example, residential property prices rose on average by asmuch as 80% to the peak in October 1997 in jus t a m atter of two years. The Hang SengIndex gained by 1.4 fold to reach the record high in August 1997 in slightly more thantwo and a half years, At that record high, the P/E ratios for B lue C hips surged to anaverage of 17 times, while those for Red Chips and H shares3 were even more dramatic,at 52 times and 30 times respectively. In retrospect, while the fundam entals of theeconomy at that time remained generally sound, the asset prices had escalated to analmost unsustainable level and well above the underlying fundamen tals. This expo sed a

Red Chips are stocks which are mainly held by Chinese entities, including state-ownedorganisations, provincial and municipal authorities, whereas H shares are Chinese state-ownedcompanies listed on SEHK.


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weakness making our financial sector so vulnerab le to assault. This was particularly sowhen, amidst the regional financial turmoil, the asset prices and exchange rates of theaffected econom ies around us had already come down so much. It was against thisbackground that the heavy speculative attack on the Hong Kong dollar took place in thelatter part of October 1997. It was also against this background that short positions hadbeen accumulated by investors, especially institutional ones, in the futures market.VIEWS AND ADVICE TAKEN1.13 In conducting the review, the HK MA had the benefit of advice from awide spectrum of people with an interest and the capacity in technical issues of thisnature, including those in the academic field, here in Hong Kong and elsewhere. TheHKMA have also had the benefit of advice from experts in the financial markets, inparticular the fund managers and the bank treasurers w ho deal with currencies day in andday out and have extensive experience working in sophisticated international financialcentres.1.14 There are then the technical experts of the International Monetary Fund(IMF), who happened to be in Hong Kong for the annual Article IV Consultations in thesecond half of October, when the currency attack occurred. The IMF experts w ith wideinternational experience watched closely how our linked exchange rate system worked toensure exchange rate stability and were thus in a very good position to give us objectiveadvice . They also subsequently on their return to Washington gave useful advice on anumber of proposals we had received during this Review .1.15 Last but not the least, the HK MA had the valuable advice in person fromProfessor Charles Goodhart of the London School of Economics who is also a mem ber ofthe Monetary Policy Com mittee of the Bank of England. Professor Goodhart has longbeen associated with monetary developments in Hong Kong. Way back in 1983 when thelinked exchange rate system was first established, Professor Goodhart, who was thenspecial economic advisor to the Governor of the Bank of England, travelled to HongKong , together w ith David Peretz of the UK Treasury, at the request of the then FinancialSecretary, the late Sir John Bremridge, to give a critical examination of the viability ofthe linked exchange rate system for implem entation in Hong Kong. He has kept in closetouch with the Hong Kong monetary scene ever since. Indeed, Professor Goodhart servedfor a number of years as a member of the Exchange Fund Advisory Committee untilMarch 1997 and he is now Special Advisor to the HKM A.1.16 The review on the securities and futures markets is largely contributed bythe Securities and Futures Commission (SFC) who in turn were assisted by the StockExchange of Hong Kong (SEHK), the Hong Kong Futures Exchange (HKFE) and theHong Kong Securities Clearing Company (HKS CC ). In the course of the Review, theSFC and the exchanges had widely sought the views and advice from people in themarkets, including securities brokers and fund m anagers. Views expressed and conveyedby the media have also been taken into account. The SFC also had close contact with its


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overseas regulatory counterparts throughout the financial turmoil and at several meetingsof senior officials of the regulators of the major overseas markets, the SFC discussed, atlength, the appropriate mea sures to respond to the situation as it deve loped.1.17 As the Review was progressing, the financial turmo il continued in theregion and to some extent in Hong Kong . We have taken into acco unt the issuesunravelled in the subsequent events, in particular the defaults of the Peregrine Group andthe C A Pacific Secu rities and its related financ e com pany.


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CHAPTER 2THE REGIONAL FINANCIAL TITRMOTI

SPREAD OF THE CONTAGION2.1 The regional financial turmoil started off in Thailand in the middle of1997 and quickly swept through to the rest of South East Asia. In late May, Thai bahtcame under severe speculative attack. Selling pressure was also felt in the Philippinepeso and M alaysian ringgit. On 2 July, the Bank of Thailand announced the adoption ofa "managed float" regime for the Thai baht. The value of the baht imm ediately fell bymore than 10%. In the two weeks that followed, the authorities in the Philippinesallowed the peso to float and those in Indonesia and Malaysia allowed the rupiah andringgit to depreciate.2.2 In August 1997, a second wave of speculative attacks took place. A llASEA N currencies subsequently fell, with the baht, rupiah, and ringgit depreciating m oresharply than in July. Major corrections set in across regional stock markets.2.3 During this time, the Hong Kong dollar remained unaffected4. The stockmarket, however, experienced a significant fall as a consequence of the tumbling of otherregional markets, partly due to the general atmosphere, and partly because Hong Kongremained the most liquid market which allowed fund managers to liquidate their positionsin order to meet demands for redem ption on regional funds. By 15 October 1997, HangSeng Index (HSI) had fallen by 20% from its historical high in early August, closing at13384.

TURMOIL IN HONG KONG2.4 On 20 October, the New Taiwan dollar depreciated by 5.8%, as a result ofthe authoritie s' announcem ent of allowing the currency to float. This sparked offspeculation on the resolve of Hong Kong authorities in maintaining the linked exchangerate with the US dollar. On the same day, Morgan Stanley published therecommendation of one of its analysts to unload Asian stock holdings, including HongKong shares.

2.5 On 21 and 22 October 1997, Hong Kong dollar was under heavyspeculative attack. There was massive short selling as well as hedging in the forward

There were incidents of selling pressure on Ho ng K ong dollars in mid July and mid August, but thissubsided somewhat in September and early October. See chapter 3 for further detail.


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markets. With the ensuing liquidity squeeze and interest rate hike 5, coupled with themarket's reaction to the Morgan Stanley recommendation, the HSI plummeted 1211points (10.4%) on 23 October in addition to the loss of 1963 cumulated during theprevious three days, closing at 10426. At one point, the HSI was a s low as 9766 (1871points or 16% down ). Daily turnover totalled $34 billion6.2.6 HSI rebounded strongly by 718 points (6.9%) on the following day (24October), mainly encouraged by the easing pressure on the dollar peg and the climb downof the interest rates. Turnover remained high at HK$30 billion. The market continued toremain highly volatile in the following couple of days. Led by the fall of the HSI, theDow Jones Industrial Average (DJIA) plunged by a record of 554 points (7.2%) on 27October, which in turn triggered the largest single day fall of the HSI on 28 October by1438 points (13.7%). Following the rebound of the DJIA on 28 O ctober, H SI also openedhigh on 29 October and closed with its largest single day gain by 1705 points (18.8%).The period of high volatility and high turnover continued u p to 4 N ovem ber.

IMPACT ON HO NG K ON G AND THE REGION

2.7 In the months that followed, the turmoil continued in the region. Asillustrated in the chronicle of events in Annex 2.1, problems in Indonesia and Koreacalled for the approval of two more rescue programm es (after Thailand) am ounting to US$23 billion and US $57 billion, respectively. None theless, the announcem ent ofIndonesia's 1998 budget deepened concerns as to the country's commitment to economicand financial reforms. This triggered further fall in rupiah and other S outh E ast Asiancurrencies, and another round of sell-off across Asian stock markets.2.8 In all the affected econom ies, the most conspicuous features of the turmoilwere a downslide in the stock markets, an upsurge in interest rates, and, with theexception of Hong Kong dollar, highly volatile exchange rates. The ge neral b usinessclimate deteriorated as a result of increased stringency in the banking sector o n acco unt offalling collateral values and worsened loan qualities which led to a widespread liquiditysqueeze on business. Corporations experienced various degree of difficulties. The knockon effects were exhibited in reduced consumer and investment spending, reducedeconomic growth and an increase in unem ployme nt. While Hong Kong cou ld not stayimmune to this regional contagion, the effects on interest rates and stock market pricesare among the lightest felt in the region while the exchange rate of our currency remainedeffectively unchanged (see Table 2.1 below).

As highlighted in para 1.2 and described in more detail in chapter 3, the overnigh t interbank ratesurged to a record high of 280% for a short period of time on 23 O ctober.Compared with an average daily turnover of $5.67 billion in 1996 and $12.63 billion in the firsthalf of 1997.


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2.1: Changes in exchange rates, interest ra tes and stock market performance

Market

HongKongTaiwanJapanSingaporePhilippinesMalaysiaKoreaThailandIndonesia

Exchange rates

end6/977.747

27.81114.61.43026.382.525887.924.72432

end3/98(change)7.749(-0.03%)

32.867(-15%)133.32(-14%)1.6145(-11%)38.08(-31%)3.665(-31%)1385(-36%)

38.9(-37%)8575(-72%)

Short-terminterest rates

end6/976.06%

10.5%0.63%3.56%10.97%7.35%

12%15.81%14.6%

end3/98(change)5.55%(-8%)7.6%

(-28%)0.69%(+10%)4.46 %(+25%)18.88%(+72%)10.91%(+48%)

21%(+75%)24.5%(+55%)47%(+222%)

Stock Market Performance

Market Indicesend6/9715197

903020605198828091077745527725

en d3/9811519

90911652716292238720481459541

% Changesinlocalterm-24%

+ 1%-20%-18%-20%-33%-35%-13%-25%

inussterm-24%-15%-31%-27%-45%-54%-59%-45%-79%

2.9 In Hong Ko ng, there were three incidents of individual financialinstitutions running into problems. In early November 1997, rumours on several localminor banks had been circulating in the stockbroking circle. This precipitated in a bankrun on 10 November on the International Bank of Asia (IBA). The IBA had over theseveral days of rumours m ade preparation with its liquidity and was able to deal with thecustomers' deman ds. Th e stock market also reacted sensibly. In fact, on the day thebank run commenced, the Hang Seng Index went up by about 200 points. This hadcertainly assisted to contain the damage of the run. The ran did not spread to other banks,reflecting the general confidence in the strength of the banking system overall in HongKong.The short term interest rates for K orea and the Ph ilippines quoted are Korea Certificates of deposits91 days middle rate and Philippine Treasury bill 91 days middle rate respectively. Others are1-month interbank rates.


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2.10 The second incident was the default of the Peregrine Gro up, one of thelargest local investment firms. The Group took on a substantial exposure to certain fixedincome investments in the region and the associating exchange risk of currency whichbecame non-performing. This led to the insolvency of the Group and th e eventualapplications for provisional liquidation on 13 January 1998.2.11 The third incident occurred with the CA Pacific Gro up. The defaultoccurred when its finance company subsidiary exceeded its credit limit to the banks as aresult of the default of its major debtors and its assets being tied up in a significant non-securities related loan. As a result of this financial problem of the finan ce com panysubsidiary, CA Pacific Securities, which was a regulated securities dealer and whichrelied on the former for finance to settle its trade could not perform its obligations withCCA SS. This prompted the SFC to apply for the appointment of provisio nal liquidatorsin respect of the securities company on 19 January 1998 in order to safeguard theinterests of its clients.2.12 None of these incidents created systemic implications for Ho ng Kong .Even during and immediately following these incidents, the market reacted sensibly 8.They also demonstrated that the regulated entities under both the banking and securitiesregimes had within themselves the necessary prudential management which provided theprotection for their investors. The CA Pacific case , howe ver, highlighted the need tobring hitherto unregulated margin financing activities from outside regulated entities intothe regulatory regim e.

The HSI dropped 8.7% on 12 January as a result of the announcement of interest rate on theprevious Friday and breakdown of negotiation between Peregrine and a potential investor. Themarket rebounded strongly by 7.4% the next day because of performance in the US marketovernight, despite the appointment of provisional liquidators in respect of Peregrin e. On 19January 1998 when the C A Pacific incident occurred, the HSI rose by 5.6%, and it remained atthat level on the following day.

10


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C H A P T E R 3THE MONETARY SYSTEM

AN ACCOUNT OF EVENTS IN THE MONETARY SECTORMonetary Scene prior to October 19973.1 The monetary scene in Hong Kong was relatively quiet in the first half of1997, with the foreign exchange and money markets reacting calmly to the death of Mr.Deng Xiao-ping in February and the resumption of the exercise of sovereignty by Chinaover Hong Kong on 1 July. During this period, the Hong Kong dollar exchange ratemoved within a narrow range of 7.73 to 7.75. Except on occasions due to IPO activitiesor month-end settlements, the interbank interest rate for overnight money stayed withinthe corridor set by the LAF Offer and Bid Rates. In respect of the longer term interestrates, there was a noticeable compression in the spread between the yields of ExchangeFund paper and the US Treasuries of corresponding maturity, partly reflecting the popular"carry-trade" undertaken by international funds in borrowing yen to invest in higher-yieldpaper. The yield spread in the ten-year area narrowed from around 90 basis points at thebeginning of the year to 54 basis points at the end of June 1997.3.2 Elsewhere in the region, problems were brewing. Balance of paymentpressure was building up and the structural problem in financing long term investmentswith short term capital flows was attracting greater attention. With the US financialmarkets continuing to outperform many of the Asian financial markets, the balance ofrisk and return produced a sharp reversal of the capital inflow into the region.Weaknesses in the financial systems of some of the Asian economies, partly the result ofinadequate supervision and development of the financial infrastructure, further inhibitedthe ability of those economies in dealing with the volatility in capital flows.3.3 Thus financial turmoil in East Asia unfolded with the floating of the ThaiBaht on 2 July. Amidst strong selling pressure, the Philippines Peso, Indonesian Rupiah,Malaysian Ringgit and to a lesser extent, the Singapore dollar experienced sharpdepreciations in July and August (see the sequence of events in Annex 2.1). Affected bythe contagion effect of the regional currency turmoil, the Hong Kong dollar came underspeculative pressure on a couple of occasions in these two months. In addition tospeculative shorting of the Hong Kong dollar, there were small and medium-sized sellingorders, probably associated with equity-related hedging.

11


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3.4 The selling pressure subsided somew hat in September and early October.The HKM A started to pick up US dollars as some speculators began to un wind their shortpositions built up earlier. Moreover, there was some inflow of funds as overseassubscribers and sponsoring banks positioned themselves for a major IPO exercise.However, as financial turbulence swept from Southeast Asia to Northeast Asia in mid-October, speculators mounted another raid against the Hong Kong dollar.Events during the week of 20 October3.5 In the week preceding 20 October, the Taiwanese authorities decided notto defend the New Taiwan dollar, as a result of which it imm ediately dep reciated sharplyby 6.5%. There were rumours in the market that Hong Kong migh t, for com petitivereasons or otherwise, also lose its willingness to defend the linked exchan ge rate system,encouraged by calls from individual politicians and industrialists to devalue the HongKong dollar, to float it or to determine a weak er level for the link . Th is triggeredsignificant selling in the stock market as many foreign fund managers decided to switchout of Hong Kong. There were also others who felt it prudent to hedge the ir Hon g Kongdollar exposures by selling Hong Kong dollars forward. There we re obviouslyspeculative shorting of the Hong Kong dollar as well. The selling pressure on the H ongKong dollar became significant on Tuesday 21 October in Hong Kong, and throughoutLondon and New York trading. It intensified on the following day (22 October) asfurther speculative and hedging positions were taken, and there were signs th at the banksreportedly were also jumping onto the bandwagon, without bothering as to how theycould fund these short positions, on their own accounts and on behalf of their custome rs.In these two days, the HKMA sold a substantial amount of US dollars in the foreignexchange market.3.6 The foreign exchange transactions conducted on 21 and 22 October weredue to be settled on 23 and 24 October respectively. Insofar as the sale of US dollars bythe HKMA was concerned, the settlement would involve the HKM A debiting th e clearingaccounts of the banks which had sold the Hong Kong dollars to the HKMA.Surprisingly, the banking sector at large did not seem to be aware of the impendingshortage of interbank liquidity, notwithstanding repeated reminders by the HKMA to thecounterparties on the need to consider how they would make sure that they had adequatefunds in their clearing accounts to effect settlement of the deals done with the HKMA.They were also reminded that, in accordance with the discipline of the currency boardsystem, Hong Kong dollars sold to the HKMA could only be recycled on a permanentbasis into the market through sales of US dollars to the HKM A. The alternative would befor banks to borrow through LAF on a repeated basis, which was not encouraged, as wasclearly laid down in the circular announcing the establishment of LAF on 27 May 1992(Annex 3.1). Yet overnight HIBOR remained fairly stable and closed at around 5.75% on22 O ctober.

12


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3.7 In the morning of 23 October, the HKMA issued a circular to all licensedbanks reminding them, in very much the same spirit as the earlier circular in 1992, of theneed to organize their Hong Kong dollar funding prudently and not be overly dependentupon the LAF for last resort liquidity support. The circular also warned them that theHKMA might impose penal interest rates for repeated borrowers to discourage the use ofLAF to fund a short Hong Kong dollar position (Annex 3.2).3.8 As the banks collectively had sold more Hong Kong dollars to the HKMAthan they could settle by using their credit balances in their clearing accounts with theHKMA, the banking system was seriously short of Hong Kong dollar liquidity for thepurpose of interbank clearing. Given that the HKMA does not normally allow overdraftand the banks did not wish to resort to LAF on a repeated basis, interbank interest ratesshot up very quickly as banks were bidding very aggressively for funds in the interbankmarket. The market was rather one-sided as the major interbank lenders held on to theirsurplus liquidity in such tense market con ditions. There was also a rumour spreading inthe market that the HKMA would charge an exorbitant penal rate of 1000% on LAFborrow ing. In the absence of offers, the overnight interbank rate kept on rising andreached 280% around noon time in a nervous and thinly traded market. At that time, theHong Kong dollar exchange rate began to rebound sharply as the exceptionally highinterest rates forced many speculators, who required Hong Kong dollar funding, tounwind their short positions. There were also some local corporates selling US dollars toacquire Hong Kong dollar funding either to avoid borrowing at, or to take advantage ofthe high return available from, the high Hong Kong dollar interest rates. Some corporatesalso switched US dollars into Hong Kong dollars to buy back their shares in the stockmarket.3.9 Under the influence of high interest rates and reversal of outflows, thespot Hong Kong dollar exchange rate rebounded sharply from 7.7500 in the late morningof 23 October to 7.60. Although the exchange rate in the forward m arket was still on theweaker side of 7.80, with the substantial interest rate premium, it was quite clear that thespeculative tide was beginning to turn. The HKMA started picking up US dollars in thespot market. Some of these were for same day value which gave some immediate reliefto the tightness in the interbank market. Thus, when the market reopened after lunch,interbank rates soon eased and overnight HIBOR came down to close at 100% - 150%.The HK MA continued to pick up US dollars during the night in London and New York, aclear indication that more speculators were closing out their short positions. On 24October, the HKM A continued to buy US dollars spot and for same day value. As HongKong dollars were reinjected into the system, overnight HIBOR softened to around 7.0%by 10:00 a.m. and closed at 5.0% at the end of the day. The Best Lending Rate (BLR )and interest rates for deposits covered by the Interest Rate Rules of the Hong KongAssociation of Banks (HKAB) were nevertheless adjusted upwards by 0.75% on this day.The Aftermath3.10 After 23 October 1997 there was a steady inflow of funds in the rest ofOctober and Novem ber. This can be attributed to three m ain factors :

13


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(a) speculators reversing their short Hong Kong dollar pos itions ;(b) banks in Hong Kong selling US dollars for Hong Ko ng dollars to avoidpaying the high interest during a period of tightness in the Hong Kongdollar interbank m arket; and(c) depositors and corporates converting US dollars into Hon g Ko ng dollars tobenefit from the high Hong Kong dollar deposit rates.

3.11 Largely in accordance with the discipline of the currency board system,the purchase of US dollars by the HKMA entailed an increase in the supply of interbankliquidity, as the HKMA credited the clearing accounts of the banks concerned when theforeign exchange deals were settled. The aggregate Hong K ong dollar ba lance in theclearing accounts of licensed banks, before they made use of LAF to get rid of theirexcess liquidity, rose significantly from around HK$3-4 bn in mid-October to HK$12 bnby the end of the month, and further to H K$26 b n by end-Nov ember.3.12 Overnight HIBOR quickly eased to jus t over the Bid Rate of LA F at 4% .Term rates also came down. How ever, the downw ard adjustment in the term rates wasimpeded by market fears of another sudden liquidity squeeze as a result of anothercurrency attack as the financial turmoil in the region continued. On e-mo nth H IBO R, forinstance, eased from a high of 45% on 23 October to 12% by the end of the month, butremained stubbornly at around that level in early November, notwithstanding asignificant inflow into the Hong Kong dollar. The Hong K ong dollar yield cu rve thusassumed an unusual inverted "U-shape", with a very steep portion running from theovernight to the one-month area (Chart 3.1). Desp ite the wide gap betwe en the overnightrate and the term rates (of around 5-6 percentage p oints), banks w ere cons ervin g liquidity(by lending surplus liquidity short term and giving up yield) and refraining from gappingactivities (borrowing short and lending long), which had apparently become highlyprofitable, because of the unsettling external environment and the alleged uncertaintiesconcerning access to LAF .

14


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16 % per annumChar t 3 .1H K $ A N D U S $ Y I E LD C U R V E S(as at 7 November 1997)

14 ~12 ~10 -8 -6 4 -2 -01 Week

EF Bills/Notes

US T reasuries

1Y 2Y 3Y 4Y 5Y 7Y 8Y 9Y 10 Y

161412108

C h a r t 3 . 21 M o n t h A N D 3 M o n t h H I B O R

1MH1BOR

031 OCT 10NOV 20NOV 28NOV

15


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Vo per annumC h a r t 3 . 3H K $ Y I E L D C U R V E S

October 31, 1997

September 30, 1997

51 Week 2Y 3Y 4Y 5Y 7Y 8Y 9Y 10Y

Measures Taken3.13 With the term rates, crucially in the one-m onth area, staying at well aboveBLR, banks without a retail deposit base were finding it rather difficult to conduct theirbanking business normally. There was understandably great d iscontent, particularly forthose who are relying heavily on interbank funding, and some pressure for pushing BLRhigher. Given the continued inflow into the Hong Ko ng dollar, how ever, it was feltnecessary first to address the anomaly in the interbank market. After con sultation w ithmarket participants, the HKM A issued a circular to banks on 12 No vem ber clarifying thedefinition of "repeated borrowers" on the access to LAF. Repeated borrow ers are definedas those which have borrowed through LAF on eight occasions in any period of 25 daysor on four consecutive days in which LAF is open. If a repeated borrower fails to providea satisfactory explanation of their repeated use of LAF and continues to borrow, a penalrate may be charged on future borrowing (Annex 3.3). This has remo ved un certainty aswell as anxiety within the banking sector regarding the av ailability of L AF .3.14 Helped by the above measure, the term rates in the interbank marketstarted to come down since the third week of Novem ber. One-m onth H IBO R eased toaround 7.5% to 8% towards the end of Novem ber. Similarly three-m onth HIBO Rdeclined from 12% at end-October to 9.5% at end-Novem ber (C hart 3.2). There rem ains,however, a considerable differential between the Hong Kong dollar and the US dollarinterest rates, which reflects the Asia risk premium . At the longer end of the Hong Kongdollar yield curve, the yield on the ten-year Exchange Fund paper also firmed up duringthe October episode, but much more moderately when compared with the shorter terminterest rates. This is a reflection of market confidence in the long-term stability of theexchange value of the Hong Kong dollar (Chart 3.3).

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Character is t ics of the October Curren cy Attack3.15 There are a few characteristics of the October currency attack that areworth special mention. First is the severity of the attack. The magnitude of the sellingpressure on the H ong Kong dollar was the largest ever encountered since the inception ofthe link in October 1983 and it came quickly.3.16 Second, wh ilst the attack was largely speculative in nature , given that theHong Kong dollar was (and still is) the only remaining major freely convertible currencyin the region on a fixed exchange rate regime after all others had tumbled, there was aconsiderable amount of hedging, largely by overseas investors but also by some localcorporates, out of Hong Kong dollar assets into foreign currencies to cover exchange risk,as they perceived it. But confidence on the Hong Kong dollar, particularly on the part ofthe Hong Kong general public, on the determination of the Government to maintain thelinked exch ange rate system, and on the ability of the HKMA in delivering exchange ratestability remained remarkably high.3.17 Third, Hong Kong dollar deposits and the money supply did show somemo dest decline after the October currency attack. Our consultation with bankers revealedthat this was not the result of any detectable loss of confidence by dep ositors. Rather thiswas the result of a fall in Hong Kong dollar loans (including overdrafts and loans securedupon H ong Kon g dollar deposits) under the influence of higher Hong Kong d ollar interestrates. Dem and for new Hong Kong dollar loans also fell off as uncertainties in econom icprospects for Hong Kong, seen in the wider context of the region, arouse greatercautiousness amongst businesses, consumers and home bu yers.3.18 Fourth, the form of the currency attack was a rather typical one through aforward sale of the Hong K ong dollar, which speculators did not have. And this wasdone by a spot sale of Hong Kong dollars matched by a TT swap for whatever period,typically three or six mon ths, involving the exchange in the use of Hong Kong dollars forUS do llars over that period. Thus, a speculator shorting the Hong K ong dollar did notreally have to comm it any resources other than the credibility of its name. The USdollars that he bought out of Hong Kong dollars were used to swap into the Hong Kongdollars that he was shorting and for settlement. With the spot exchange rate remainingstable, being supported rather passively by the HK M A, the focus of such activity is on thevery active, liquid and deep TT swap market.3.19 The TT swap market is also where the funding risks are priced andtransferred. The HKM A had repeatedly been alerting banks operating in the market to becautious in not inadvertently funding speculators cheap ly, thereby exposing themselves tothe risk of a liquidity squeeze. A defensive m ove for banks was to widen the bid andoffer spread of the TT sw aps. Their alertness or otherwise to this would be reflected inthe speed with which the prices of the TT swaps, and correspondingly the interbankinterest rates for term m oney, move . In the October currency attack the banks stillappeared slow in attaining a full realization of what was coming, although the prices ofthe TT swaps did mo ve up significantly at the beginning of the week of 20 October 1997.


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3.20 Speculators also used to a muc h smaller extent put option s in the HongKong dollar. These ha ve the same effect on the m arkets as the institutions w riting theoptions would "delta hedge" their exposure through a sale of the Hong Kong dollar in theforward or spot market.3.21 In an attempt to undermine public confidence in the link, those withspeculative positions also spread rumours in the market. Some financial institutionsinvolved in these activities even went to the extent of advising their customers to hedgeall their Hong Kong dollar assets and foreign currency liabilities, supporting their advicewith "analyses " or rumours of one sort or another. A popular story line they deployedduring the October episode was that the Government had lost its will to maintain the linkas the economy had become uncompetitive in the face of the sharp depreciations of theregional currencies. This regrettably is an inevitable feature of financial ma rkets, even inthe most sophisticated financial centres, and it is always a task for the authorities todemonstrate determination and ability to pursue a policy that it believes to b e in the bestinterest of the com munity.3.22 Fifth, although widely reported in the press that some specu lators operatedsimultaneously in the foreign exchange market and the Hang Seng Index futures market,there was no clear evidence of such coordinated and concerted effort on the occasion ofthe October currency attack. Clearly, as interest rates increased in the defence of theHong Kong dollar, stock prices would tumble and the speculators would also gain from ashort position in Hang Seng Index futures if they have on e. While there is d oubt as towhether individual speculators are big enough to m ove the m arkets in this m anner, this isa possibility that the authorities must be fully alert to. Thus, the HKM A has since beenkeeping even closer contacts w ith the securities regulators in the exchange of informationon irregular market activities.3.23 Sixth, with globalized financial markets encouraged by rapid financialliberalization, financial turmoil has become highly contagious internationally, muc h m oreso than generally anticipated. Market corrections are also a lot sharper than expected.These are demonstrated by the fact that the interest rate hike on 23 O ctober sent the HangSeng Index down by 1,211 points (or 10.4%) on the same day and further by 646 points(or 5.8%) on 27 October. This triggered significant falls in New Yo rk and other stockmarkets around the world. Further in response, the Hang Seng Index sh ed 1,438 points(or 13.7%) on 28 October.3-24 Seventh, nevertheless, a downw ard adjustment in asset mark ets has beenanticipated for some time. They exhibited signs of "irrational exuberan ce" before thecorrections in October. The Hang Seng Index rose by 24% from end-1996 to its peak inearly August 1997, with the price earnings ratio increasing from 17.2 to aroun d 19.5during this period. Property prices on average increased by 43 % during th e first threequarters of the year, encouraged by rapid credit expansion. Thus when interest rates sho tup on 23 October, the corrections in the asset markets, which were somewhat overdue,came sharply and abruptly.

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Post October Events3.25 Higher interest rates in Hong Kong and some flight to quality against thebackground of continued financial turmoil in the rest of Asia led to substantial inflows offunds into Hong Kong in November. Foreign reserves at US$96.5 bn were at a recordhigh at the end of the m onth. But as interbank interest rates eased under the influence ofample liquidity in the interbank market, coupled with the seasonal increase in the demandfor US dollars for backing additional issue of banknotes ahead of the festive season, inDecember there was a steady outflow of funds. The HKM A sold a considerable amountof US dollars in that month, and the level of interbank liquidity correspondingly fell, inaccordance with the discipline of the currency board system, to HK$8.1 bn at the end ofDecember.3.26 These trends continued into the new year. As the level of interbankliquidity fell further to below zero on Friday, 9 January 1998, a number of banks had toborrow last resort liquidity from LAF and interbank interest rates firmed up, leading to anupward adjustment of HK AB deposit rate and BLR by 0.75%. Sentiment was alsoaffected by sharp falls in stock markets and exchange rates throughout Asia. Theweakening of the Yen to 135 against the US dollar triggered another round of sell-offs ofAsian cu rrencies. The exchange rate for the Indonesian R upiah, for exam ple, fell to a lowof over 10,000 on 8 January 1998 compared with around 2,500 in the middle of 1997.Korean won depreciated from 890 to 1,800 during the same period. The Singapore dollaralso fell, triggering substantial tightening in money market conditions there, with onemonth SIBOR touching 20% .3.27 The outflow from the Hong Kong dollar was once again stemmed by thehigher interest rate and the shortage of Hong Kong dollar liquidity. By the middle ofJanuary, US dollars were gradually sold back to the HKMA for Hong Kong dollars andinterbank interest rates resumed its downtrend. Once again the linked exchange ratesystem has held up well and operated in exactly the manner that it was supposed to.

OPERATION OF THE LINKED EXCHANGE RATE SYSTEMSupport for the Link3.28 The successful defence of the Hong Kong dollar during the Octoberepisode has received very positive evaluations from the central banking community andinternational financial organizations. The IMF strongly endorses Hong K ong 's continuedcomm itment to the linked exchange rate system. The IMF team conducting the annualArticle IV Consultations happened to be in Hong Kong in the second half of October1997 and observed closely the events during the week of 20 October. In comm enting onthe HKMA's defence of the Hong Kong dollar in the concluding statement of theCon sultation, the IMF team stated that "appropriately, the authorities have taken forcefulaction during the past two weeks to tighten significantly monetary conditions, and havesuccessfully dem onstrated their ability and com mitm ent to defend the link It is

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important to recognize that allowing interest rates to rise in response to exchange marketpressures is an essential element of the currency board mechanism that lies at the heart ofHong Kong's m onetary arrangements. Recent events demonstrate that the system isworking exactly as intended ...." (see IMF Report at Annex 3.4).3.29 Within the local community, there is also a widely held consen sus that thelinked exchange rate system should be maintained, as it has buttressed confidence inHong Ko ng's monetary and financial system. Nevertheless, concerns have been raised asto whether the interest rate pain could have been less severe had the H KM A mou nted thecurrency defence differently. These concerns are understandab le given tha t higherinterest rates affect all those who borrow Hong Kong dollars, including the innocenthome mortgage payers and others not taking part in the currency specu lation. To addressthese concerns and the proposals for alternative defence strategies that have so kindlybeen put forward, and encouraged also by the Financial Secretary's call for a review ofcurrency defence, it would be useful to re-examine the framework for the operation of thelinked exchange rate system and its developm ent over the years. A detailed technicalnote on Hong Kong's monetary system is at Annex 3.5. The salient aspects aresummarized in the paragraphs below.Currency Board System3.30 The linked exchange rate system is what is known academ ically as acurrency board system, which theoretically requires the monetary base to be backed by aforeign currency at a fixed exchange rate. The mo netary base is normally defined as thesum of the amount of bank notes issued and the balance of the banking system (thereserve balance or the clearing balance) held with the currency board for the purpose ofeffecting the clearing and settlement of transactions between the banks themselves andalso between the currency board and the banks. The m onetary base would increase whenthe foreign currency (in Hong Kong's case, US dollars), to which the domestic currencyis linked, is sold to the currency board for the dom estic currency (capital inflow ). Itwould contract when the foreign currency is bought from the currency board (capitaloutflow). The expansion or contraction in the monetary b ase would lead to interest ratesfor the domestic currency to fall or rise respectively, creating the monetary conditionsthat automatically counteract the original capital inflow or outflow respectively, ensuringstability of the exchange rate throughout the process.Evolution of the Monetary Base in Hong K ong3.31 Insofar as banknotes are concerned, since the inception of the linkedexchange rate system in October 1983, the issue and redemption of bank notes, throughthe note issuing banks, are required to be made against US dollars at the fixed exchangerate of HK$7.80 to US $1. Specifically, C ertificates of Indebtedness, which give theauthority to the note issuing banks to issue bank no tes, are issued and red eemed againstUS dollar at that fixed rate and for the account of the Exchange Fund.

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3.32 How ever, at the time when the linked exchange rate system wasintroduced, there was no institutional arrangement whereby banks in Hong Kongmaintained clearing accounts with the currency board. Thus that part of the monetarybase represented by the clearing balance of the banking system w as initially not subject tothe discipline imposed by a currency board system. Rather, it was subject to the actionsof the Management Bank of the Clearing House of HKAB, The Hongkong and ShanghaiBanking Corporation Limited (HSBC), in the interbank market, which are mostly dictatedby comm ercial considerations. This anomaly was corrected in 1988 through the so-calledAccounting Arrangements which required HSBC, as the Management Bank of theClearing House of HKAB, to maintain a clearing account w ith the then Monetary AffairsBranch of Governm ent for the account of the Exchange Fund. Thus the monetary basewas only transparently defined then. The Accounting Arrangements were subsequentlyreplaced by another arrangement, on the occasion of the introduction of Real Time GrossSettlement for interbank transactions in Hong Kong towards the end of 1996, requiringall licensed banks to maintain a clearing account with the HKMA for the account of theExchange Fund. In operating the Accounting Arrangem ents (1988 - November 1996)and the settlement accounts (since December 1996), the Monetary Affairs Branch andsubsequently the HKMA have ensured that the whole of the monetary base is subject tothe discipline of the currency board arrangement. These reform measures have thusstrengthened the linked exchange rate system of Hong Kong in ensuring exchange ratestability.3.33 Whilst the HKMA is acutely aware of the need to observe strictly thediscipline of the currency board system in respect of activities impacting upon themonetary base, the reform measures do put the HKMA in a position to vary the monetarybase directly without the corresponding change in its US dollar holdings. But asdemonstrated later on, when these operations are conducted, they are done for goodreasons and in a way w hich does not undermine that important discipline. But this hasbeen the subject of some controversy, notwithstanding the high degree of transparency inthe relevant activities undertaken by the HKMA.M echanics of the Linked Exchange Rate Sys

Documents

Report on Financial Market Review by the Hong Kong SAR Government in April 1998