HONG KONG MONETARY AUTHORITY

1. HONG KONG MONETARY AUTHORITY Briefing to the Legislative Council Panel on Financial Affairs 6 May 2005

2. DISCUSSION TOPICS • HKMA Annual Report 2004 • Updates on • Currency Stability • Banking • Financial Infrastructure • Hong Kong as an International Financial Centre • Exchange Fund

3. HKMA ANNUAL REPORT 2004: HIGHLIGHTS (1) Monetary stability • monetary stability maintained despite • depreciation of the US dollar • market speculation about revaluation of renminbi • interest rate increases in the US • the exchange rate remained stable, with a modest strengthening in the fourth quarter to 7.7745 at the end of 2004

4. HKMA ANNUAL REPORT 2004: HIGHLIGHTS (2) Banking stability • full implementation of the risk-based supervisory approach • the HKMA and Hong Kong’s banking sector continued to prepare for the implementation of Basel II • the Hong Kong Deposit Protection Board was formed after the enactment of the Deposit Protection Scheme Ordinance to oversee the project for establishing the Deposit Protection Scheme • the Commercial Credit Reference Agency was launched

5. HKMA ANNUAL REPORT 2004: HIGHLIGHTS (3) Market infrastructure • the Clearing and Settlement Systems Ordinance became effective • system improvements were made to ease banks’ liquidity pressure at times of large fund flows related to initial public offerings • the three note-issuing banks issued the remaining three denominations of the new series of Hong Kong banknotes ($20, $50 and $1,000) • the Treasury Markets Forum was established

6. HKMA ANNUAL REPORT 2004: HIGHLIGHTS (4) Hong Kong as an International Financial Centre • the launch of Asian Bond Fund 2 was announced • renminbi services were introduced by banks in Hong Kong. Total outstanding renminbi deposits in Hong Kong exceed RMB12 billion yuan by the end of 2004 • adopted a more pro-active approach towards Hong Kong’s international credit ratings: Standard & Poor’s, Fitch Ratings, and Rating and Investment Information all upgraded their outlook on Hong Kong’s sovereign rating from negative to stable

7. HKMA ANNUAL REPORT 2004: HIGHLIGHTS (5) Reserves management • the Exchange Fund achieved an investment return of $56.7 billion or 5.7% in 2004 despite considerable volatility in the bond, equity and currency markets • the Fiscal Reserves' share amounted to $14.5 billion, which exceeded the amount budgeted ($12.3 billion) in the fiscal year 2004-05

8. HKMA ANNUAL REPORT 2004DISCLOSURE ON OPERATING EXPENDITURE • Breakdown of the HKMA’s operating expenses now included in the Annual Report • Budgeted expenditure for the current year now included, with breakdown, in the Annual Report • Staff establishment and strength, by department, included in the Annual Report

9. HK$ million 2004 Budget* 2004 Actual 2005 Budget* Staff Costs 474 490 - Salaries and other staff costs 421 - Retirement benefit costs 25 Premises and equipment expenses - Operating lease charges 11 10 5 - Other premises expenses (including utility charges and management fees) 37 33 31 General operating costs - Maintenance of office and computer equipment 31 30 27 - Financial information and communication services (including trading, dealing terminals and data link charges) 28 27 30 - External relations (including international meetings) 14 13 15 - Professional and other services (including service fees for operating the interbank payment system) 39 35 26 - Training 5 4 5 - Others 15 10 14 TOTAL 654 608 643 ADMINISTRATIVE EXPENDITURE(2004 AND 2005 BUDGETED) * Includes supplementary budget and relevant provisions in project budgets for the year.

10. UPDATE OF PROGRESS IN KEY FUNCTIONS AND RESPONSIBILITIES • Currency Stability • Banking • Financial Infrastructure • Hong Kong as an International Financial Centre • Exchange Fund

11. CURRENCY STABILITY (I) Spot exchange rate

12. MOVEMENTS IN THE AGGREGATE BALANCE Aggregate Balance

13. HONG KONG DOLLAR AND US DOLLAR INTEREST RATES (I)

14. HONG KONG DOLLAR AND US DOLLAR INTEREST RATES (II)

15. 2005 1998 1999 2000 2001 2002 2003 2004 CURRENCY - MARKET EXPECTATIONS (I) 12-month Hong Kong dollar forward points

16. CURRENCY - MARKET EXPECTATIONS (II) 12-month Hong Kong dollar forward points

17. MONETARY CONDITIONS • Currency Board arrangements working effectively. • Fed funds target rate on an increasing trend, returning to “normal”. • Capital outflow has led to higher Hong Kong dollar interest rates, although they remain below US rates. • Domestic monetary conditions affected by factors pulling in different directions.

18. CURRENCY STABILITY (II) External factors • Global developments • Volatility in oil prices • External imbalances • US monetary tightening • Mainland macro adjustment and the RMB • Geo-political conflicts

19. 1998 1999 2000 2001 2002 2003 2004 INVESTMENT GROWTH ON THE MAINLAND

20. 2000 2003 2004 1998 1999 2001 2002 MONEY AND CREDIT GROWTH ON THE MAINLAND

21. RENMINBI - MARKET EXPECTATIONS 12-month RMB non-deliverable forward points

22. Domestic factors Growth and inflation External position Property price Unemployment Public finance CURRENCY STABILITY (III)

23. STRONG ECONOMIC RECOVERY (Seasonally adjusted quarter-on-quarter change)

24. CONSUMER PRICE MOVEMENTS

25. CCPI RENTAL COMPONENT

26. BALANCE OF PAYMENTS ACCOUNT Current account surplus

27. PROPERTY MARKET

28. GRAPHICAL ANALYSIS

29. LABOUR MARKET

30. 2001 2002 2003 2004 2005 2000 FISCAL DRAWDOWNS Net quarterly changes in fiscal placement with the Exchange Fund

31. BANKING SECTOR PERFORMANCE Local AIs remains well capitalised Period-end figures. There is a break in series at end-December 2001 owing to a change in the reporting population.

32. BANKING SECTOR PERFORMANCE Revival in loan growth (retail banks) Quarterly percentage change

33. BANKING SECTOR PERFORMANCE Delinquency or rescheduled loan ratio (%) Charge-off ratio (%) Consumer banking: declining trend in charge-off and delinquencies Credit card delinquency ratio (Dec 04): 0.44% Credit card charge-off ratio (Dec 04): 3.76% Mortgage delinquency ratio (Mar 05): 0.29% Rescheduled mortgage loan ratio (Mar 05): 0.42%

34. BANKING SECTOR PERFORMANCE The extent of residential mortgage lending in negative equity continued to improve Period-end outstanding figures

35. BANKING SECTOR PERFORMANCE Contraction in net interest margin (retail banks)

36. BANKING SECTOR OUTLOOK • Change to a rising interest rate environment • Potential for rapid increase in rates given remaining differential with US • Impact on banks: • Repricing delays • Impact on holdings of fixed-interest instruments • Second-round effects on credit quality and loan demand • Banks need actively to manage interest risk. The HKMA is keeping risk management under close review • Stress tests indicate banks remain resilient to series of standardised shocks

37. BANKING SECTOR - WORK PROGRESS (I) • Residential mortgage lending (RML) • on 28 February 2005 the HKMA issued on a circular on cash rebates • reminding authorized institutions of the need to monitor carefully the risks associated with residential mortgages • limiting the level of cash rebates to no more than 1% of the loan amount • on-site examinations on residential mortgages being conducted

38. BANKING SECTOR - WORK PROGRESS (II) • Implementation of Basel II in HK • continue to develop relevant rules and guidelines in consultation with the industry and monitor AIs’ preparations for the revised capital regime • the Banking (Amendment) Bill 2005 tabled on 6 April being considered by a Bills Committee • early passage of the Bill is essential to ensure implementation according to international timetable

39. BANKING SECTOR - EXEMPTION OF LIABILITY CLAUSES (ELCs) • Safe Deposit Box (SDB) Services • DBSHK Incident: 78 out of 83 cases settled • guidance provided to AIs on the use of ELCs in SDB agreements: • ELCs should be reasonable • ELCs should be drawn to customers’ attention • Customers should be advised to take out insurance as appropriate • by the end of April, all relevant AIs will have amended their ELCs • 2 AIs decided to terminate their SDB services • Other Personal Banking Services • reviewing the reports submitted by AIs • will publish the results of the review once they are available

40. BANKING SECTOR - INTERNET BANKING FRAUD • Update since February 2005: • 5 more reports of fake bank websites received • no further financial loss by customers was involved • Progress of two-factor authentication implementation: • implementation by the end of June is on schedule • common methods adopted: digital certificate, SMS-based one-time password (OTP) and security token-based OTP • launch of consumer education programme in May 2005 to promote public awareness of two-factor authentication

41. MARKET INFRASTRUCTURE • Review by the Financial Infrastructure Sub-Committee of EFAC of financial infrastructure development • development strategy: safe and efficient financial infrastructure based on a multi-currency, multi-dimensional platform • main review areas include mainland-related financial infrastructure, payment systems and debt settlement systems. • scheduled for completion in mid-2005. • Ongoing oversight of the designated clearing and settlement systems • off-site review of regulatory returns • planning of on-site examinations

42. HONG KONG AS AN INTERNATIONAL FINANCIAL CENTRE (I) • Renminbi business in Hong Kong • outstanding renminbi deposits totalled RMB13.9 billion yuan at the end of February 2005 • use of renminbi bank cards facilitates Mainland tourists’ spending in Hong Kong • further development of renminbi business in Hong Kong to follow three strategic directions: (i) diversification of renminbi assets and liabilities of banks in Hong Kong; (ii) denomination and settlement of trade in renminbi; and (iii) development of a renminbi debt issuance mechansim in Hong Kong • to study the establishment of a clearing and settlement platform for renminbi transactions

43. HONG KONG AS AN INTERNATIONAL FINANCIAL CENTRE (II) Asian Bond Fund 2 (ABF2) • The HKMA, together with the other 10 EMEAP central banks and monetary authorities, announced the launch of ABF2 in December 2004. • All 11 EMEAP Members will invest in ABF2, with an initial size of US$2 billion in total. • Implementation: • Phase 1: Confined to EMEAP central banks. • Phase 2: To be offered to other public and private sector investors, through listing where appropriate. • Two important components of ABF2  the Pan-Asian Bond Index Fund and Hong Kong Bond Fund  will be listed on the Hong Kong Stock Exchange.

44. 20052 20041 20031 20021 (HK$ billion) Q1 Full Year Full Year Full Year Gain / (Loss) on HK equities* (3.5) 12.0 21.2 (11.8) Gain / (Loss) on other equities* (0.9) 11.2 26.8 (22.7) Exchange gain / (loss) (3.0) 8.5 22.9 27.2 Total return from bonds, etc 5.3 25.0 18.8 54.3 Investment income (2.1) 56.7 89.7 47.0 * including dividends 1 Audited figures; 2 Unaudited figures EXCHANGE FUND PERFORMANCE

45. 2005 I 2004 I (HK$ billion) Q1 Full Year* Q1 Q2 Q3 Q4 Investment income / (loss) (2.1) 56.7 16.8 (7.2) 14.1 33.0 Other Income 0.0 0.2 0.0 0.1 0.0 0.1 Interest and expenses (1.3) (4.8) (1.1) (1.1) (1.3) (1.3) Net investment income / (loss) (3.4) 52.1 15.7 (8.2) 12.8 31.8 Treasury’s share 0.7 (14.5) (4.5) 2.1 (3.6) (8.5) Revaluation gain on premises affecting accumulated surplus 0.0 0.9 0.0 0.0 0.0 0.9 Increase / (Decrease) in EF accumulated surplus (2.7) 38.5 11.2 (6.1) 9.2 24.2 * Audited figures EXCHANGE FUNDCHANGE IN ACCUMULATED SURPLUS

46. VERY VOLATILE FOREIGN EXCHANGE MARKETS USD depreciation

47. UNCERTAIN OUTLOOK FOR EQUITY MARKETS Dec 03 = 100

48. INTEREST RATE IN THE US

49. HONG KONG MONETARY AUTHORITY Briefing to the Legislative Council Panel on Financial Affairs 6 May 2005