HONG KONG MONETARY AUTHORITY

1. HONG KONG MONETARY AUTHORITY Briefing to the Legislative Council Panel on Financial Affairs 17 February 2005

2. PROGRESS INKEY FUNCTIONS & RESPONSIBILITIES • Currency Stability • Banking • Financial Infrastructure • Hong Kong as an International Financial Centre • Exchange Fund

3. CURRENCY STABILITY (I) Spot exchange rate

4. MOVEMENTS IN THE AGGREGATE BALANCE Aggregate Balance

5. HONG KONG DOLLAR AND US DOLLAR INTEREST RATES

6. 2004 1999 2000 2001 2003 2002 1998 CURRENCY - MARKET EXPECTATIONS (1) 12-month Hong Kong dollar forward points

7. CURRENCY - MARKET EXPECTATIONS (2) 12-month Hong Kong dollar forward points

8. IMPROVED COMPETITIVENESS

9. MONETARY CONDITIONS • Currency Board arrangements working effectively. • Fed funds target rate on an increasing trend, returning to “normal”. • Capital inflow has prevented the Hong Kong dollar interest rates to keep in line. • Easy monetary conditions prevailed despite higher US interest rates. • Catch-up can be quite sharp; overshooting possible.

10. CURRENCY STABILITY (II) External factors • The US dollar and external imbalances of the US • US monetary tightening • Volatility in oil prices • Pressure on the renminbi exchange rate • Macroeconomic conditions on the Mainland

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

12. 1998 1999 2000 2001 2002 2003 2004 INVESTMENT GROWTH ON THE MAINLAND

13. 1999 2000 2001 2002 2003 2004 1998 TRADE BALANCE OF THE MAINLAND

14. (year-on-year change, %) (year-on-year change, %) 6 6 CPI inflation 5 5 CPI inflation excluding food 4 4 3 3 2 2 1 1 0 0 -1 -1 -2 -2 -3 -3 Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul 1999 2000 2001 2002 2003 2004 1998 INFLATION ON THE MAINLAND

15. (year-on-year change, %) (year-on-year change, %) 25 25 M2 Loans of financial institutions 20 20 15 15 10 10 Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul 1999 2000 2001 2002 2003 2004 1998 MONEY AND CREDIT GROWTH ON THE MAINLAND

16. Domestic factors Economic recovery External position Inflation? Unemployment Public finance CURRENCY STABILITY (III)

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

18. BALANCE OF PAYMENTS ACCOUNT Current account surplus ($ billion)

19. CONSUMER PRICE MOVEMENTS

20. LABOUR MARKET

21. 2001 2002 2003 2004 2000 FISCAL DRAWDOWNS ($ billion) ($ billion) Net quarterly changes in fiscal placement with the Exchange Fund

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

23. BANKING SECTOR PERFORMANCE

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

25. BANKING SECTOR PERFORMANCE Diversification of income source (retail banks) 30.3% 30.3% 33.8% 39.3%

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

27. BANKING SECTOR PERFORMANCE Delinquency or rescheduled loan ratio (%) Charge-off ratio (%) Consumer banking: declining trend in charge-off and delinquencies Credit card charge-off ratio: 3.76% Credit card delinquency ratio: 0.44% Mortgage delinquency ratio: 0.38% Rescheduled mortgage loan ratio: 0.47%

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

29. BANKING SECTOR - 2005 OUTLOOK • More competitive and challenging environment • Profitability • narrowing interest margins • continuous cost pressure • Moderate increase in loan demand alongside economic growth • Steady improvement in asset quality • Banks’ balance sheets remain strong & capital level remains high • Challenges ahead • Interest rate and market risks • China-related issues • Technology issues • Volatility in financial statements owing to wider use of fair value accounting • Sharp return of interest rates to more “normal” levels may present challenges

30. BANKING SECTOR - WORK PROGRESS (I) • International Accounting Standards and Hong Kong Accounting Standards • Convergence of HKAS with IAS for accounting periods beginning on or after 1 January 2005 • Higher volatility in banks’ financial statements due to wider application of fair value accounting • Review of relevant policy areas in consultation with industry associations and the accounting profession

31. BANKING SECTOR - WORK PROGRESS (II) • Implementation of Basel II in HK • On-going, extensive consultation reflects general support of implementation proposals • Considering comments on proposed amendments to the Banking Ordinance. Banking (Amendment) Bill 2005 to be introduced into LegCo in April 2005 • Continue to develop relevant rules and guidelines and monitor AIs’ preparations for the revised capital regime

32. BANKING SECTOR - WORK PROGRESS (III) Safe Deposit Boxes • Update on compensation by DBS for the incident • up to 4 February 2005, 76 out of 83 affected cases have been settled • Actions taken since the incident • The HKMA issued a circular requiring AIs to adopt sound control to safeguard customer assets • The HKAB issued best-practice recommendations on relocation of safe deposit boxes • AIs completed the review of the terms and conditions for safe deposit box service. For those exemption of liability clauses found to be inconsistent with the Code of Banking Practice, the AIs concerned are required to rectify the situation by 31 March 2005 • The industry strengthened the Code of Banking Practice to make it clear that AIs should keep terms and conditions under review to ensure compliance with relevant consumer protection legislation

33. BANKING SECTOR - WORK PROGRESS (IV) • Deposit Protection Scheme (DPS) • Hong Kong Deposit Protection Board has commenced work on the key preparatory tasks • Continue to assist the Board with a view to commencing the scheme in 2006 H2 • Commercial Credit Reference Agency (CCRA) • Operation is smooth so far • Study how sole proprietorships and partnerships can be included in the CCRA database • Consumer issues • Complete the review of the terms and conditions for other banking services • Continue to enhance consumer protection through development of the Code of Banking Practice and monitoring compliance with it • Monitor AIs’ implementation of the arrangement to provide customers a choice whether to have the function of purchasing cash vouchers using their ATM cards

34. MARKET INFRASTRUCTURE • Commencement of the Clearing and Settlement Systems Ordinance in November 2004 • Two detailed documents issued to explain the designation and oversight functions • Designation of five clearing and settlement systems • Smooth entry of the Hong Kong dollar into the CLS system in December 2004 • Smooth payment flows during major IPO activities, including the IPO of the Link REIT

35. HONG KONG AS AN INTERNATIONAL FINANCIAL CENTRE 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, namely the Pan-Asian Bond Index Fund and Hong Kong Bond Fund, will be listed on the Hong Kong Stock Exchange.

36. HONG KONG AS AN INTERNATIONAL FINANCIAL CENTRE • Renminbi business in Hong Kong • renminbi deposits was RMB12.128 billion at the end of December • use of renminbi bank cards is a boost to Mainland tourists’ consumption • 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) a renminbi debt issuance mechansim in Hong Kong

37. INVESTMENT OBJECTIVES OF THE EXCHANGE FUND Investment objectives of the Exchange Fund are: (1) to preserve capital; (2) to ensure that the entire Monetary Base at all times will be fully backed by highly liquid short-term US dollar denominated securities; (3) to ensure sufficient liquidity for the purpose of maintaining monetary and financial stability; and (4) subject to (1) – (3) above, to achieve an investment return that will preserve the long-term purchasing power of the assets.

38. FINANCIAL MARKETS IN 2004 • Overall performance volatile: Q1 strong Q2 sharp decline Q3 moderate Q4 strong rally

39. EXCHANGE FUND PERFORMANCE I

40. EXCHANGE FUNDCHANGE IN ACCUMULATED SURPLUS

41. EXCHANGE FUND PERFORMANCE AGAINST INVESTMENT BENCHMARK • Investment return from 2000 computed in accordance with CFA Global Investment Performance Standards

42. 14% 12.1% 12% 10.8% 10.8% 10.2% 10% 8% 6.6% 6.1% 5.7% 6% 5.1% 5.1% 4.8% 4% 2.4% 2% 1.3% 0.7% 0% 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Compounded Compounded Annual Annual Hong Investment Kong CPI-A Return (1994-2004#) (1994-2004) INVESTMENT RETURN* OF THE EXCHANGE FUND # Hong Kong CPI-A at the end of November 2004 * Investment return from 2000 computed in accordance with CFA Global Investment Performance Standards

43. OUTLOOK FOR 2005 • US interest rate increases expected • Outlook for equities uncertain • Currencies may be erratic

44. US INTEREST RATE INCREASES EXPECTED Fed funds target rate

45. OUTLOOK FOR EQUITIES UNCERTAIN

46. CURRENCIES MAY BE ERRATIC

47. HONG KONG MONETARY AUTHORITY Briefing to the Legislative Council Panel on Financial Affairs 17 February 2005