The Post Office Investment Fund
22 April 2010
Hong Kong's Audit Commission yesterday published a report on the provision of postal services by Hongkong Post (HK Post), the government-owned "Trading Fund" - a term it uses for a Government entity which is meant to be run on a stand-alone basis like a company, under the Trading Funds Ordinance.
Unfortunately this report did not cover the bigger issue with HK Post, namely its huge pile of cash and investments, and the location of its facilities on prime land. If you were an analyst looking at its accounts but didn't know whose accounts they were, then you would think that it is an investment fund which operates a postal service on the side, rather than the other way around, as we explain later in this article. We also look at the Government's general tendency to stash money away in different bodies rather than pass recurrent spending through the budget and the Legislative Council.
The declining importance of mail
The report takes aim at a number of issues, including the fact that 97 of the 125 post offices make an operating loss. The 3 biggest losers lost $14.9m between them in the year to 31-Mar-2009. You can bet that those are on outlying islands or remote parts of the New Territories. Now the mail goes both ways, outbound and inbound, and for now, there is a universal service obligation for postal deliveries. HK Post has the mail monopoly, and it is not really practical to charge an increased tariff for mail to remote places, even though it costs more to deliver. Since HK Post still has to deliver mail, it can continue to collect outbound mail from post boxes at the same time.
We say "for now", because as the importance of hard-copy correspondence declines in favour of e-mail (digitally signed where needed) and online payments, then there is little justification for the universal service obligation either. You can already pay almost all your bills online, receive bank statements online, apply for vehicle licenses online, and do your tax returns online. At some point, it will become socially acceptable to sell off the Post Office, scrap its monopoly, remove its universal service obligation, and allow it to compete freely. It would probably still deliver to all but the most difficult locations (because commercial users of direct mail marketing will require that) but it would not have to. The alternative is to require those who live in remote locations to collect their mail from a post office box, or for the remote addressee to pay someone to collect it and deliver to them. Indeed, competing service providers might enter the market, receiving mail from HK Post and delivering to customers at a charge to the addressee. This would not be much different than paying to get your newspapers delivered.
However, there is no reason why HK Post should continue to operate manned post offices at a loss. If people choose to live in remote places, then they should be prepared to come to urban areas for counter service, or use commercial courier services instead. Urban dwellers should not have to cross-subsidize rural dwellers. The sale of postage stamps can be done through other outlets, including convenience stores, or even online, using 2D barcodes. In the UK, 2,500 branches of the Royal Mail were closed over 18 months since Oct-2007 as part of what they called the "Network Change Programme". The postal monopoly of Royal Mail was abolished on 1-Jan-2006, and the market is now regulated by the Postal Services Commission.
The cash-fat balance sheet of HK Post
Here's what the Audit Commission report didn't cover. Take a look at the latest annual report for the year to 31-Mar-2009. The balance sheet is in page 110 of the PDF. What we see is capital and reserves of HK$4.15bn. Of this, there is $1,800m of cash and bank deposits, $964m of "structured" notes and deposits, and $458m of "held-to-maturity securities". That's a total of $3.22bn, so the cash and investments amount to about 78% of net assets.
Note 23(a) on investment policy says:
"To provide an ancillary source of income, surplus cash is invested in a portfolio of financial instruments. The portfolio includes held-to-maturity securities, structured notes, structured deposits and bank deposits. It is the POTF's policy that all investments in financial instruments should be principal-protected."
In other words, their policy is that they should only invest in bonds or capital-guaranteed products where the downside is zero. They allow themselves some risk, by swapping the certainty of a fixed rate of return for the possibility of higher returns, but they should always get their money back in the end. Note 12 shows that the held-to-maturity securities are debt securities (bonds). Note 13 shows that most of the structured notes bear "interest" (surely, they mean investment returns) at rates determined by reference to the value of underlying investment funds (whatever those are) and underlying market indices (probably equity markets). It also says:
"For these structured notes, the embedded derivatives are separated from the notes and accounted for as derivatives... Due to the significant decline in the value of the underlying investment funds resulting from the deterioration of the world's financial markets during 2008, the embedded derivative of one structured note was crystallised on 5 December 2008, while the host contract was still being accounted for separately. Upon crystallisation, the payoff of the structured note would be the same as a zero-coupon bond with the maturity date unchanged."
Now, take a look at note 5. They booked a loss of $121.8m on "net realised and revaluation losses on derivative financial instruments". That loss was greater than all the other interest income and investment returns, dragging them into a negative net investment return of $22.5m for the year. If it is principal-protected, then that loss on the derivative should eventually be recovered by the maturity of the bond, but it just underlines that there is no free lunch in capital-guaranteed products - you are buying a combination of a derivative (usually a call-option on an index) and a discounted bond which matures at par.
In HK Post's case, some of its structured notes are of up to 5-year maturity, as shown in note 23(c). so they'll be waiting a while to get their money back. Since they didn't need the money for at least 5 years, they should have returned it to Government instead. Furthermore, the issuing bank usually makes more profit on these products than it does on bank deposits - otherwise why would it peddle them to depositors in the first place? Incidentally, HK Post's annual accounts are audited by the Audit Commission, so they should have had something to say about this in yesterday's report.
Readers might be wondering where all the cash came from, given that the Audit Commission has just criticised HK Post for running 97 of its 125 post offices at a loss. Well, HK Post does make an overall operating profit, and it only returns part of that to the Government in the form of profit tax and dividends. The cash and bank deposits, net of a government loan, were $1.38bn at 31-Mar-2002, so they have swollen by $1.84bn in 7 years. Incidentally, you won't find any annual report online before 31-Mar-04, because they've been deleting the older ones. Luckily, we downloaded them earlier.
HK Post's best ever year was the year ended 31-Mar-1998, which included philatelic sales surrounding the 1-Jul-97 handover of sovereignty, something which can safely be called a non-recurring item. That year, it booked sales of $4.93bn and an operating profit of $1.23bn. Sales dropped to $3.52bn the next year, indicating that the surge in philately added around $1.4bn to turnover.
If HK Post were a listed company, investors would be demanding to know why it is hoarding so much cash, and why it is speculating in structured notes and structured deposits. This isn't a listed company, and the annual audit report is addressed to the Legislative Council. So, Dear Legislators, you should be asking the same questions. HK Post should return to market principles which Trading Funds are supposed to follow, and return its "surplus cash" to its only shareholder, the Government, rather than stashing it in questionable investments. Let the Government do that through the Hong Kong Monetary Authority's Exchange Fund - they're rather good at making questionable investments.
The other hidden asset of HK Post which received no mention in the Audit Commission's report is its property bank. That includes the prime piece of land on which sits its grotty old 1970s-era headquarters in Central. The accounts do not reflect the site's value, but its about 50,000 sq ft of land, so at a plot ratio of 15 you could put about 750,000 sq ft of offices on it - and look across the street at Jardine House, Exchange Square and IFC. Take an accommodation value of say HK$10k per gross sq ft and the land is worth maybe $7.5bn. The General Post Office used to benefit from a waterfront site (it moved to this one after the 1960s reclamation), because before the Cross-Harbour Tunnel, all the mail arrived by sea (including surface mail from Kowloon and airmail from Kai Tak). Not any more, which is just as well, because there's a new reclamation in front of it. It could easily be moved to somewhere less central, releasing the land for sale.
There's just one snag though - in an article in the HK Star on 14-Aug-1976, it was reported that Hongkong Land, which owns Jardine House (then Connaught Centre), was promised by Government in 1971 that nothing in front of it would be built higher than 120 feet, or five stories. If true, then it was incredibly short-sighted of the Government. We don't know how long that agreement lasts - it might be as long as the land lease, which runs from 1970 to 2110 (in two lots of 75 years), but it would be pretty amazing if it covers all the new land in front of the GPO too. We note that the article mentions the new 1976 post office has a central vacuum cleaning system "with a much higher sucker capability than ordinary systems". The same might be said of HK's then Government when it came to land deals - so little has changed!
HK Post is not the only pot of gold
HK Post is just one of several Government-owned bodies which are hoarding public wealth. Others include (figures at 31-Mar-2009):
- The Securities and Futures Commission, sitting on cash and bonds of HK$4.90bn
- The Mandatory Provident Fund Schemes Authority had $5.11bn and racked up an investment loss of $283m for the year
- The Urban Renewal Authority had $7.67bn
- The West Kowloon Cultural District Authority had $21.6bn in the bank
- The Housing Authority had a whopping $57.5bn, including $6.11bn in equities on which it lost $4.11bn that year.
Rather than try to bring liquid assets back under centralised management (and Legislative Council authority for spending), the Government is busily creating more separate pots of gold. In the last 2 years it has annexed $26.3bn to the West Kowloon Cultural District Authority (which has yet to break ground in the West Kowloon Cultural Desert) and $18bn to set up a Research Endowment Fund under the University Grants Council (which could have continued to receive annual funding instead). This reduces Legislative Council oversight of annual spending, leads to an uncoordinated approach to investment management, and also makes it harder to retract the money from bodies which have outlived their utility.
© Webb-site.com, 2010
Organisations in this story
- HKSAR Government
- HKSAR Research Grants Council
- HKSAR University Grants Committee
- HONG KONG HOUSING AUTHORITY (THE)
- Mandatory Provident Fund Schemes Authority
- SECURITIES AND FUTURES COMMISSION
- URBAN RENEWAL AUTHORITY
- WEST KOWLOON CULTURAL DISTRICT AUTHORITY