CONFIDENTIAL
• Reference
531
Achön taken
HKA 233/1
Pa
Mr Stone
HKD
PENSION SAFEGUARDS
m
27/9
I have a number of observations on your letter to David Fish and the draft letter attached to Hong Kong copied to me for comments.
1.
2. First on Mr Wiggham's scheme; I understand the objective of the scheme is to provide a sterling safeguard for the commutable element of pensions over the last five years of pensionable employment. The scheme covers officers retiring before 2002 therefore, at a maximum, provides cover during the first five years of the SARG from 1997. It provides no cover to HMOCS in the event of default on pensions payment.
3.
How would the scheme work as envisaged in Mr Gray's reply?
Five years before retirement Mr HMOCS takes out a HK$ loan from Mr HK Bank. The loan is such that the commutable pension receivable in five years equals the face value of the loan plus its accrued interest over five years. The loan size would be worked out in practice between the actuaries and Mr HK bank.
Mr HMOCS then converts his HK$ loan into a sterling five year deposit and places it at Mr HK bank. He is required to do this because Mr HK Bank wants it as collateral in case of default on the receivable pension. If Mr HMOCs placed his sterling elsewhere - Mr HK Bank would demand a guarantee. This guarantee could only plausibly come from HMG (see below).
4.
But as Mr Gray points out in his paragraph 1. Mr Hong Kong Bank would now be exposed to exchange risk with increased HK$ assets (the loan) and increased sterling liabilities (the deposit). If sterling were to weaken against the HK$ the value of sterling as collateral in HK$ terms would fall. So Mr HK Bank would look for a margin to be deposited to cover this risk - the margin would increase the more sterling depreciated. As Mr Gray pointed out in his earlier letter there is no market for long term forward exchange rate cover, so the margin effectively substitutes for this.
5.
In the event that sterling depreciates Mr HMOCS would have been better off (in sterling terms) if he had not gone into the scheme in the first place. However in the event that the HK$ depreciates against sterling the scheme would provide an effective safeguard.
6.
Mr HMOCS also faces a risk should sterling interest rates turn out to be lower than HK$ dollar rates the bank would lump this in with the exchange rate risk that it faces in the event of default. In the event of pension payment it is just Mr HMOCS who loses out.
CODE 18-77