1. HONG KONG MONETARY AUTHORITY Briefing to the Legislative Council Panel on Financial Affairs 21 November 2008

2. 2 Updates on –Financial Market Crisis –Currency Stability –Banking Industry –Financial Infrastructure –Hong Kong as an International Financial Centre –Exchange Fund DISCUSSION TOPICS

3. 3 FINANCIAL MARKET CRISIS

4. 4 GLOBAL CREDIT MARKET CRISIS INTENSIFIES Deleveraging by financial institutions leads to a credit crunch and heightened risk aversion Source: Bloomberg Flight to quality US dollar

5. 5 FROM LIQUIDITY AND SOLVENCY CRISES TO A CONFIDENCE CRISIS Liquidity CrisisSolvency Crisis Confidence Crisis

6. 6 Sovereign CDS spreads (bps) Source: IMF GFSR, Bloomberg Global Financial Stability Map Source: IMF GFSR EFFECTS ON MARKET CONFIDENCE Monetary and Financial Conditions Risk Appetite Credit risks Emerging market risks Market and liquidity risks Macro-economic risks

7. 7 MONEY MARKET LIQUIDITY DRIES UP Source: Bloomberg Cash hoarding by financial institutions paralysed interbank funding markets Source: Bloomberg 3M USD-LIBOR over 3M OIS5Y Swap rate over 5Y US Treasury yield

8. 8 Source: Bloomberg, 10-Q SEC Filings of respective institutions Writedowns are depleting capital rapidly. New capital raised lags behind. The IMF says banks may need US$675 billion in fresh capital. CAPITAL DEPLETION AT FINANCIAL INSTITUTIONS Writedowns, Credit Losses, and Capital Raised in the US

9. 9 EMERGING MARKETS UNDER INCREASING STRAINS Flight to safety led to sharp currency depreciations and stock market declines Global risk aversion puts stress on inter-bank liquidity and funding costs in many emerging markets Exchange rate per US$ (End-2006=100) Three-month interbank interest rates Source: Bloomberg

10. 10 INTERNATIONAL MEASURES TO ADDRESS THE CRISIS Liquidity –Liquidity injection –Expansion of central bank facilities –Coordinated policy rate cuts Capital replenishment –Facilitated sales –Removal of troubled assets –Capital injection –Nationalisation Confidence –Restrictions on short-selling –Increase in deposit protection –Bank debt guarantees

11. 11 MONETARY POLICY SHIFTED TO ADDRESS GROWTH RISKS Six major central banks lowered rates in a co-ordinated move to ease global monetary conditions Some regional central banks have also reduced rates as inflation risks recede Source: Bloomberg Co-ordinated rate cut by six central banks Regional policy rates lowered

12. 12 IMPACT ON FINANCIAL MARKETS IN HONG KONG Tighter credit and liquidity conditions in the interbank money market Higher term interest rates Asset quality of banks affected Nervousness among depositors Tightened credit supply, affecting funding for SMEs and other customers

13. 13 CURRENCY STABILITY

14. 14 CURRENCY STABILITY HONG KONG DOLLAR STRENGTHENED

15. 15 MEASURES IMPLEMENTED BY THE HKMA Liquidity –Within-zone forex operations to inject liquidity into the bank system –Five measures to provide liquidity assistance to individual banks –Lowering borrowing cost at Discount Window –Increase supply of EF paper –Two refinements to the liquidity assistance to individual banks

16. 16 LIQUIDITY INJECTION INTO THE BANKING SYSTEM Five operations conducted between 18 September and 27 October –Expanded the Aggregate Balance by HK$24.8 billion –Consistent with the Currency Board principles As a result of these actions and the triggerings of strong-side Convertibility Undertaking, the Aggregate Balance reached HK$84.3 billion on 24 November Within Convertibility-Zone operations

17. 17 LIQUIDITY INJECTION INTO THE BANKING SYSTEM Aggregate Balance increased

18. 18 LIQUIDITY PROVISION Increase supply of EFBNs –Offered a total of HK$4 bn of additional Exchange Fund Bills on 28 October and 4 November –Matching within-zone forex operation on 20 October –Consistent with Currency Board principles Benefits –Meet increased demand for EF paper –Improve banks’ access to the HKMA’s liquidity facilities Increasing supply of Exchange Fund paper

19. 19 LIQUIDITY PROVISION TO INDIVIDUAL BANKS Five measures to provide liquidity assistance to individuals banks (effective until March 2009) Five measures: –Expansion of eligible securities for Discount Window borrowing –Tenor of repo through Discount Window extended to 3 months –Waiving the penalty rate for using over 50% EF paper in accessing the Discount Window –Conduct forex swaps with banks if needed –Offer term lending against collateral if needed (refined on 6 November to extend maximum tenor and lower the applicable interest rates) These backstop liquidity facilities reassure banks about the availability of funds

20. 20 LOWERING THE COST OF LIQUIDITY Lowering the borrowing cost of banks at the Discount Window by 100 bps Original formula for determination of the Base Rate: –the higher of (a)US Fed Funds Target Rate plus 150 bps, or (b)the average of the five-day moving averages of the overnight and one-month HIBORs New formula: –US Fed Funds Target Rate plus 50 bps Adjusting Base Rate Formula (effective until March 2009)

21. 21 THE BASE RATE FORMULA ADJUSTED

22. 22 INTEREST RATES EASED CURRENCY STABILITY INTEREST RATES EASED

23. 23 EFFECTIVENESS OF THESE MEASURES Market tension reduced Confidence in the financial system strengthened Systemic failures guarded against A gradual adjustment process worldwide envisaged before normal functioning of the global financial system can be fully resumed

24. 24 RISKS TO CURRENCY STABILITY RISKS TO CURRENCY STABILITY Global economic slowdown amid lingering financial market turmoil, posing risk to domestic economic growth and weighing on domestic asset prices Potential systemic risk to the global financial system, and associated contagion risk to Hong Kong Inflation remains high but is likely to recede Risks associated with the Mainland economy

25. 25 MODERATION IN ECONOMIC GROWTH Real GDP growth slowed notably in Q2 due to weaker private consumption and exports A slowdown in the global economy will reduce growth in Hong Kong through the trade channel

26. 26 DECLINES IN DOMESTIC ASSET PRICES Domestic equity prices declined in tandem with the sharp fall in the global stock markets More uncertain economic outlook restrained activity in the property market, affecting house prices and transaction volume

27. 27 IMPACT OF TIGHTER GLOBAL FINANCIAL CONDITIONS ON THE DOMESTIC ECONOMY The global credit crunch will raise business borrowing costs, restraining capital investment Turbulence in the global financial markets will reduce activity in the domestic financial sector Negative wealth effect stemming from the decline in asset prices will weigh on domestic demand Deterioration in growth prospects and financial conditions will undermine business confidence Well-capitalised banking system and stronger corporate balance sheet will help withstand the shocks

28. 28 Inflation INFLATION REMAINS ELEVATED, BUT LIKELY TO PEAK SOON The underlying CCPI inflation stayed high at 6.1% yoy in September, driven by higher costs of food and rental Inflation is likely to peak soon as increases in food prices and housing rents start to moderate

29. 29 RETREAT IN GLOBAL OIL AND FOOD PRICES CPI inflation in the regional economies

30. 30 RISKS ASSOCIATED WITH THE MAINLAND ECONOMY  The Mainland’s growth slowed markedly from 10.4% in H1 to 9.0% in Q3. Further declines are likely amid the worsening global environment.  Inflationary pressures have continued to ease, with headline inflation declining to 4.0% in October, from 7.9% in H1.  The stock market has remained volatile. The property market weakened significantly, particularly in big cities.  Mainland authorities have shifted their overall policy stance to “proactive fiscal policy and accommodative monetary policy”  Three interest rate cuts and two RRR cuts since September  Fiscal stimulus package of RMB 4 trillion announced on 9 Nov  The slowdown in the Mainland economy and weakening asset markets are likely to affect Hong Kong’s economic outlook.

31. 31 BANKING SYSTEM STABILITY Exchange Fund to provide 100% guarantee for all customer deposits with authorized institutions (effective until the end of 2010) A precaution. The banking system is robust, but developments in the global financial market could erode the community’s confidence Supervisory scrutiny to minimise moral hazard

32. 32 DEPOSIT PROTECTION SCHEME  The HKMA is assisting the Deposit Protection Board in its review of the coverage of the DPS. The Board is expected to formulate recommendations in Q1 2009

33. 33 CONTINGENT CAPITAL FOR BANKS Contingent Bank Capital Facility to provide additional capital to banks if needed (effective until the end of 2010) A precaution. Capital positions of banks in Hong Kong are among the strongest in the world (14% vs. the minimum of 8%)

34. 34 BANKING INDUSTRY

35. 35 BANKS ’ LIQUIDITY POSITION AND RISK EXPOSURES IN THE CURRENT ENVIRONMENT  Retail banks ’ average liquidity ratio in Q3 2008 remained high, at 43%  Local banks in general have seen increases in deposits. The trend continued with the announcement of full deposit protection on 14 Oct 08  HKMA is closely monitoring deposit movements and growth of risk assets after full deposit protection  HKMA issued a guideline in Oct 08 on moral hazard issues

36. 36 Quarterly average liquidity ratio of retail banks BANKING SECTOR PERFORMANCE Liquidity Level Remains High

37. 37 Rising HK$ loan-to-deposit ratio BANKING SECTOR PERFORMANCE

38. 38 BANKING SECTOR PERFORMANCE Net interest margin of retail banks narrowed Net interest margin of retail banks (quarterly annualised)

39. 39 BANKING SECTOR PERFORMANCE Loan Quality Was Good But There Were Signs Of Deterioration Overview of loan quality

40. 40 BANKING SECTOR PERFORMANCE Local AIs Remain Well Capitalised Capital adequacy ratio of locally incorporated AIs

41. 41  HKMA issued a circular in October urging AIs to adopt a supportive attitude towards SME customers.  HKMA has discussed with AIs their SME lending policies, encouraging them to be accommodative and flexible within the bounds of prudent credit assessment.  HKMA has reflected AIs’ views to Government to fine-tune the SME Loan Guarantee Scheme. LENDING TO SMEs

42. 42 LEHMAN-RELATED ISSUES - COMPLAINT-HANDLING AND INVESTIGATIONS  Upto 20 November, 18,672 complaints have been received, of which 7,779 cases have been assessed to determine whether investigation should be opened based on prima facie evidence  166 cases involving 9 banks have gone through further investigation and adequate justifications found for referral to the SFC  The HKMA will work closely with the SFC in any further investigations necessary to expedite the process  Provision of mediation services through HKIAC announced on 31 October

43. 43  HKMA working closely with Hong Kong Association of Banks and HKSAR Government on the Minibond buy-back proposal  appointment of independent financial advisers to ensure fairness of the process  ascertaining current value to determine buy-back price for individual series  Reminded relevant banks  to deal with customer complaints promptly and fairly  to take initiative to negotiate settlement with vulnerable customers where there is mis-selling on the part of the banks  to ensure compliance with all applicable requirements in selling investment products to customers, particularly to the more vulnerable sectors  Report to FS being prepared LEHMAN-RELATED INVESTMENT PRODUCTS

44. 44  The Consultant’s report was published in July for consultation until the end of October.  The report acknowledges the robust condition of Hong Kong’s banking sector. The report recommends a number of enhancements to provide an even sounder foundation to cope with the challenges ahead.  The HKMA is studying the comments received, and intends to finalise a policy response to the Consultant’s recommendations in the first half of 2009. REVIEW OF THE HKMA’S WORK ON BANKING STABILITY

45. 45 ANTI-MONEY LAUNDERING AND COUNTER TERRORIST FINANCING  The FATF has completed a mutual evaluation of Hong Kong:- –Hong Kong obtained “Compliant” or “Largely Compliant” ratings in respect of 30 Recommendations. –The core financial sectors (banking, securities and insurance) fared reasonably well in the evaluation.  The HKMA issued guidance on transaction monitoring in July

46. 46 OVERSIGHT OF THE PAYMENT SYSTEMS  Despite the tension in the financial markets, all designated systems remain in compliance with the safety and efficiency requirements under the Clearing and Settlement Systems Ordinance (CSSO).  The clearing and settlement system for Renminbi transactions in Hong Kong was designated and given statutory finality protection under the CSSO on 11 July 2008. This brings all currencies (HKD, USD, EUR, RMB) CHATS under the oversight regime of the CSSO.  The first credit card with Octopus function was introduced in July.

47. 47 FINANCIAL INFRASTRUCTURE

48. 48 FINANCIAL MARKET INFRASTRUCTURE (1)  To develop Hong Kong into a regional payment and settlement hub, enhancing its role and status as an international financial centre  Strategy for developing market infrastructure –Maintain smooth and efficient operation of payment systems Operation remains smooth amid recent stress in the financial markets –Enhance the operation of payment and securities settlement systems Extension of RTGS and CMU operating hours Enhancements for Islamic-related transactions and products Migration to SWIFTNet

49. 49 FINANCIAL MARKET INFRASTRUCTURE (2) –Promote links with overseas systems and use of Hong Kong’s financial infrastructure MoU signed with Bank Indonesia in October establishing a payment-versus-payment link between the Indonesian Rupiah RTGS system and Hong Kong’s US dollar RTGS system RTGS links with Mainland China’s foreign currency settlement systems Marketing campaign in Asia and Europe to promote Hong Kong as a payment and settlement hub Turnover of RTGS systems increased

50. 50 TREASURY MARKETS ASSOCIATION (TMA) Inauguration of ACI Asia – The Financial Markets Association in Hong Kong (July 2008) Asia Treasury Markets Summit (July 2008)

51. 51 DEVELOPMENT OF ISLAMIC FINANCE (1) The HKMA adopts a four-part strategy to assist the Government in developing Islamic finance in Hong Kong: Promote market infrastructure TMA recommendations on Islamic bond market development Support the Government’s tax review Develop regulatory framework for Islamic banking window Enhance RTGS infrastructure Encourage product development Maintain dialogue with private sector and Government agencies to resolve tax and regulatory issues to facilitate product development Build international links Associate membership of the Islamic Financial Services Board Organised Islamic finance roadshow in the Middle East in May 2008 Memorandum of Understanding signed with the Dubai International Financial Centre Authority in May 2008 to foster co-operation Promote market knowledge Organised seven professional training workshops this year for Government officials and TMA members

52. 52 DEVELOPMENT OF ISLAMIC FINANCE (2) Positive market response as evidenced by the introduction of Islamic finance products and services:  Islamic mutual funds were introduced by a local bank in late 2007 and an asset management company in the second half of 2008  An exchangeable sukuk offering China exposure through the Hong Kong platform was launched in March 2008 and well received  An Islamic equity index covering China-related stocks in Hong Kong was launched in May 2008  An Islamic banking window was introduced in Hong Kong by a Malaysian bank in August 2008

53. 53 HONG KONG AS AN INTERNATONAL FINANCIAL CENTRE

54. 54 REGIONAL CO-OPERATION STRENGTHENED The HKMA is leading efforts of Asia-Pacific central banks in regional surveillance focusing on the impact of the global financial crisis on regional economies, culminating in the joint statement issued by EMEAP Monetary and Financial Stability Committee on 31 Oct Chairing EMEAP Working Group on Banking Supervision: monitoring progress of EMEAP economies in implementing Financial Stability Forum’s recommendations on enhancing market and institutional resilience Contributing to regional financial co-operation initiatives and crisis management

55. 55 RENMINBI BUSINESS Renminbi business continues to operate smoothly, with outstanding renminbi deposits amounting to 70.0 billion yuan at end-September 2008. After three successful issues in 2007, there have been four more renminbi bond issues so far this year, bringing the total amount issued to 22 billion yuan. Market response was positive.

56. 56 THE INVESTMENT ENVIRONMENT AND PERFORMANCE OF THE EXCHANGE FUND

57. 57 GLOBAL STOCK MARKETS (2008 Q1-Q3) US (S&P-500): 21% China (Shanghai Composite Index): 56% South Korea (KOSPI): 24% Japan (TOPIX): 26% HK (HSI): 35% Singapore (STI): 32% Germany (DAX): 28% UK (FTSE-100): 24% France (CAC-40): 28 %

58. 58 GLOBAL STOCK MARKETS (YTD UP TO END-OCT 2008) US (S&P-500): 34% China (Shanghai Composite Index): 67% South Korea (KOSPI): 41% Japan (TOPIX): 41% HK (HSI): 50% Singapore (STI): 48% Germany (DAX): 38% UK (FTSE-100): 32% France (CAC-40): 38%

59. 59 CREDIT MARKETS TED Spread # Corporate Credit Spread * * Represented by CDX North America 5-year Investment Grade Index # Spread between 3-mo USD LIBOR and 3-mo US Treasury yield

60. 60 CURRENCY MARKET FLUCTUATIONS - SURPRISE SURGE OF US DOLLAR

61. 61 CURRENCY MARKET FLUCTUATIONS - SURPRISE SURGE OF US DOLLAR

62. 62 BOND MARKETS DID NOT RALLY AS STOCKS DECLINED

63. 63 INVESTMENT INCOME 2008200720062005 (HK$ billion)Jan – Sep*Full Year Gain/(Loss) on Hong Kong equities ^ (56.9)55.8 35.9 7.0 Gain/(Loss) on other equities ^(43.2)6.718.720.5 Exchange gain/(loss)(13.8)18.717.3 (19.5) Return from bonds # 30.661.031.929.8 Investment income / (loss) @ (83.3)142.2103.837.8 Investment income / (loss) (excluding HK equities) @ (26.4)86.467.930.8 Investment return (including HK equities) ## (5.8%)10.1%8.8%3.5% Investment return (excluding HK equities) ## (1.9%)6.1%5.8%2.9% * figures Unaudited ^ Including dividends # Including interest @ Excluding valuation changes in Strategic Portfolio ## Investment return = Investment income / Total asset at period end

64. 64 CHANGES IN INVESTMENT INCOME, TREASURY’S SHARE AND ACCUMULATED SURPLUS II2007 (HK$ billion) Q3Q2Q1Full year Investment income / (loss)(83.3)(48.3)(20.4)(14.6) 142.2 Other income 0.2 0.1 0.0 0.1 0.2 Interest and other expenses (5.2) (1.8) (1.6)(10.2) Net investment income / (loss)(88.3)(50.0)(22.2)(16.1) 132.2 Payment to Treasury # (34.9) (11.3) (11.8) (27.6) Valuation change of Strategic Portfolio ^ (7.7) (1.2) (1.0) (5.5) 4.7 Increase / (Decrease) in EF accumulated surplus(130.9)(62.5)(35.0)(33.4) 109.3 * Unaudited figures # The fixed rate of fee payment to Treasury for 2007 (w.e.f. 1 April 2007) and 2008 are 7% and 9.4% respectively. ^ The Strategic Portfolio holds the shares of the HK Exchanges and Clearing Ltd purchased for strategic purpose. Valuation change includes dividends. Jan - Sep * 2008

65. 65 HISTORICAL INVESTMENT INCOME YearFull YearQ4Q3Q2Q1 20017.413.610.4(2.0)(14.6) 200247.026.3(2.1)26.5(3.7) 200389.733.58.441.16.7 200456.733.014.1(7.2)16.8 200537.87.319.013.6(2.1) 2006103.836.037.112.518.2 2007*142.233.461.826.320.7 2008*N/A (48.3)(20.4)(14.6) (HK$ billion) * Excluding valuation changes in the Strategic Portfolio.

66. 66 ABRIDGED BALANCE SHEET OF THE EXCHANGE FUND (HK$ billion) At 30 Sep 2008 (Unaudited) At 31 Dec 2007 (Audited) At 31 Dec 2006 (Audited) ASSETS Deposits117.0132.962.4 Debt securities1,052.6922.9828.4 Hong Kong equities115.3184.6122.4 Other equities109.0146.0137.4 Other assets 32.4 28.0 25.8 Total assets1,426.3 ====== 1,414.4 ====== 1,176.4 ====== LIABILITIES AND FUND EQUITY Certificates of Indebtedness179.9163.4156.9 Government-issued currency notes & coins in circulation 7.97.56.9 Balance of the banking system10.110.62.0 Exchange Fund Bills and Notes150.6141.8129.2 Fiscal Reserves Account458.5464.6324.5 Other liabilities 133.2 9.5 49.2 Total liabilities 940.2 797.4 668.7 Accumulated surplus 486.1 617.0 507.7 Total liabilities and fund equity1,426.3 ====== 1,414.4 ====== 1,176.4 ======

67. 67 ROBUST RISK MANAGEMENT Conservative asset allocation to meet the Exchange Fund’s primary investment objectives –Majority in bonds and cash, minority in equities including the passive holding of HK equities Prudent credit risk control measures that minimise the Exchange Fund’s exposure to ‘toxic’ assets and ailing financial institutions

68. 68 RETURN TO THE TREASURY ON FISCAL RESERVES PLACED WITH THE EXCHANGE FUND Based on the investment return of the Exchange Fund in the preceding 6 years Determined at the beginning of the year and is not affected by current year’s return 9.4% for fiscal year 2008/09 6-year moving average irons out fluctuations in annual returns to ensure stable return on fiscal reserves