How the 1998 attack on the Hong Kong dollar peg was viewed

This was originally published with the headline ‘More than the peg’ in Benchmark’s fourth quarter edition in 1998. There were strong views at the time that the Hong Kong dollar peg would fail. This was only a year after hand-over. This article turns out to be a comprehensive look at what pressures the Hong Kong economy and its currency were facing.

The bad news for Hong Kong is that George Soros gets his currency bets right most of the time, just ask John Major, President Suharto, Mahathir Mohamad or Boris Yeltsin. Now Hong Kong’s financial secretary, Donald Tsang is contemplating his odds as apparently, George Soros is betting against the Hong Kong dollar. Gerry O’Kane assesses his chances of getting it right once more and what the implications are if the peg stays or goes.

Donald Tsang, Hong Kong’s financial secretary

As cool as he may seem, Hong Kong’s Financial Secretary Donald Tsang Yam-kuen must be losing sleep over the state of the peg. The reality is that political considerations look set to determine the peg’s future while the economic issues become ever-more complex. (And something that never went away.)

By August 31, Salomon Brothers, a US investment bank estimated that Tsang had ploughed HK$117 billion (US$15 billion) into the futures and equities markets: nearly 15% of Hong Kong’s reserves. The move has had other implications for the peg’s viability and scenarios not envisaged six months ago.

Instead of the continued forex skermishing, Tsang’s enemies have gone through the Reserve’s back door and shorted stock and futures. This was seen as leading to heavy sales in forward Hong Kong dollar markets, pushing up interest rates and further spooking stock investors. Tsang called up the Exchange Fund. His move into equities raised eyebrows, not only because it had become the biggest defense of an equity market by a government ever seen, anywhere, but because it threatened Hong Kong’s laissez faire reputation.

Anil Daswani, Salomon’s head of Hong Kong research, believes that at least one US fund took a zero weighting on the index because regulations forbade it from investing in markets which were being manipulated. Phrases like “foreign barbarian speculators”, also did nothing to boost confidence in Hong Kong’s free-market tradition. And “confidence”, remember, is a word heavily associated with the Hong Kong dollar.

To add complexity, one side-effect of buying stock through the Exchange Fund is reserves decline as foreign assets are converted into Hong Kong dollar denominated stock. Moreover, the move denies a crucial part of the peg mechanism, allowing assets to deflate.

What this means to the Peg

There are nearly as many opinions as dollars as to whether the peg will stay or go. The big houses, such as Goldman Sachs are sticking to their line that the peg can hold. Peter Wong, a director at South China Securities, says it will stay but the yuan will devalue next year. Vociferous critics, such as Peter Everington, chairman of Regent Pacific, say it is inevitable that something will have to change. “I think that probably by the end of summer next year, both will have gone.”

His colleague, chief executive Jim Mellon, gives the peg a more cautious 50/50 survival chance. W.I. Carr’s chief economist, Michael Taylor, recently entered the fray by announcing that the peg would go before Chinese New Year in February 1999.

Speculative attacks won’t work

One thing is certain: Hong Kong’s reserve cover is too high for any simple speculative attack to work. Joseph Yam’s September announcement that the HKMA would strengthen the peg mechanism has poured water on the speculators’ fire. In May, according to Fred Hu, a senior economist with Goldman Sachs, Hong Kong had US$96.2 billion in liquid foreign exchange reserves, excluding over US$18 billion in the Land Fund. This was equivalent of 815% of the currency in circulation. If China’s liquid foreign exchange reserve was added it totaled US$236.8 billion. In other words, try forcing the peg to break and get set to live in a cardboard box.

This issue now is twofold:

  • at what price will the peg become too expensive to keep?
  • what political pressures, and from where, will force a change in view?

Issue number two is dictated by Beijing and the China card has become the real joker in this game. Ignoring economics, Everington believes that people like Tsang and chief executive Tung are ultimately not responsible for any decision on the peg.

“People are finding it too easy to blur the images; Hong Kong is now owned by China. It is purely down to China,” he argues.

Peter Wong takes a different view. “No, I think Hong Kong makes its own decisions. Hong Kong people make Hong Kong’s business, Beijing says it stands behind the peg and it won’t devalue the yuan.” As for any yuan devaluation, W.I.Carr having previously stated that a yuan devaluation would not necessarily force the Hong Kong peg to go, have now changed their view.

W.I.Carr’s Taylor told BENCHMARK that he expects Hong Kong will wait for the yuan devaluation before making a move to devalue the Hong Kong dollar and all this will happen by February.

However history tells us that a yuan devaluation doesn’t automatically mean the Hong Kong dollar peg will go too. The yuan has devalued by 70% since the 1980s without any affect on the Hong Kong dollar.

Everington also predicts that the yuan will devalue. Pressures from restructuring state owned enterprises, saving the banking system from collapse and regional devaluations hitting exports, would all push for yuan devaluation. Against the argument is a current account surplus (albeit weakening), huge foreign currency reserves, signs of increasing liquidity in the system and the highly public government statements saying the yuan will be defended to the end.

The peg also faces the US dollar surge alone. Japan’s unstable yen, its property companies retching at the sight of their bottom-lines, banks juggling loan portfolios and unemployment reaching record levels have kept the yen quiet. These issues make it far more complex than simply blaming rapacious speculators. So far the HKMA has been successful in its defense. “The peg is working exactly as it should do,” concedes Everington. But he points out, the sheer size of the problem in conjunction with other factors is not something defenders of the peg ever envisaged.

When will economic reality sink in?

What many of the critics are ultimately arguing is that while the HKMA could defend the value of the Hong Kong dollar until the proverbial cows come home, it simply becomes an exercise of denying reality.

The scale of global economic fallout since Thailand’s markets crashed under the strain of a corrupt and over-stretched banking system, has grown beyond anyone’s imagination.

“Look, we know that Hong Kong’s reserves are something like six times gross domestic product and the peg’s defense mechanism operates like a well-tuned Ferrari, well this US dollar bull market has hit it with a sledgehammer and Ferraris can’t take that,” trumpets Everington.

Japan, as the world’s second largest economy, went some way to curtailing any charge of the US dollar bull in the past. Now, with its economy in tatters, its banking system on the verge of extinction and its politicians unwilling to take hard decisions, the china shop is in a mess. The US dollar has been unchallenged. Others pose the question more succinctly. At what point does defending the peg become unviable because of other issues such as social chaos, banking carnage and corporate suicide?

HSBC says nothing but economist walks

Of course, not all support the premise. The Hongkong and Shanghai Bank (HSBC) in both London and Hong Kong refused to even discuss the matter. However, it seems within the bank there is an issue. Its chief economist in London, Roger Bootle, left at the end of August. Word around the City of London was that he was off to set up his own consultancy, partly because he was fed up parroting the bank’s line.

The usually media-happy John Greenwood at INVESCO, architect of the peg back in 1983, avoided BENCHMARK’s calls at all costs. The very fact that Greenwood was in Hong Kong from his San Francisco base during the HKMA intervention period suggests he was here trying to help Donald Tsang and Joseph Yam out of their corner. Many financial commentators see the decision to keep the dollar peg as political not economic.

eMake no mistake, while Yam and Tsang can strip off the wads of cash to defend the peg, there is a price: interest rates rise and assets deflate. So far the peg system is working but at what cost to the people Tsang is supposedly representing; Hong Kong citizens? Unemployment has hit five per cent, the highest in over 15 years and it will go higher. This is a serious shock for the majority of workers who do not remember hard times. Of course, while that may be a political stick to beat politicians elsewhere in the world, it matters little to Beijing where people don’t have a vote or, according to cynics, Hong Kong’s Legco, where it’s citizens only have a quasi-vote.

Painful examples of keeping the Peg

The fall in the Hang Seng index is another example of the peg mechanism working: assets are deflating. The index was a shade above 7,000 when Mr. Tsang went on his futures and equities spending spree, some 60% below its peak of a year ago. Similar to the fall in property prices. Peter Wong, believes the peg is here to stay but agrees that asset prices will have to continue to fall.

“There’s no doubt that everything is overvalued and there either has to be a revaluation in the dollar or asset prices have to shrink, this will continue.”

He does have a proviso however. “Hong Kong, I believe, can take the pain of a decline in asset prices but should they fall suddenly by 60% from here because of some loss of confidence [there is that word again], then the whole system could collapse”.

So should the deflation approach with high interest rates continue, what will Hong Kong face? The property companies, for example, will see their share price plummeting and home purchases declining as their customers struggle to meet high mortgage debt.

Hong Kong property prices unsustainable

Figures show that two out of three Hong Kong companies either invest in real estate or develop property. In turn, banks have 47% of their loans on property; figures unmatched anywhere else on the planet. While the banking system is regarded as one of the best regulated, with capital adequacy ratios (CAR) averaging 14%, the assets supporting this CAR (i.e. property) are deteriorating rapidly. And as Goldman Sachs points out; currency pegs are brought down by an unwillingness of the authorities to allow the banking system to crumble under the weight of high interest rates. By the middle of August property prices had declined by 50% from their peak at the time of the handover.

Too long over-valued

Everington watches all of this with an “I-told-you-so” attitude. For years he argued the Hong Kong dollar was way over-valued. “Now Hong Kong has to take it on the chin, there has to be deflated asset prices. It is ugly but it has to be done.” But he still questions whether deflation is the total answer and he certainly does not believe deflation has gone far enough, pointing to property prices.

“Look at property around Tsing Yi. It is floating around HK$4,000 per square foot and while that’s down 40%, it remains at a 10% premium to prices in New York. Are you telling me Tsing Yi is worth more than Manhatten? I don’t think so.”

Wong says he thinks asset deflation is already over half-way there, although wages have not fallen.

While banking giants like HSBC will not crumble from property company collapses, smaller banks could. This increases the likelihood of a run on deposits, something Hong Kong people have done with alarming regularity in conditions much less severe than the current ones. This may explain Tsang’s intervention in the index. By slowing the pace of stock price declines, it gives banks time to make provisions for anticipated asset losses.

There is, of course, the converse of all this. Should Hong Kong reset the peg to HK$10 (the most common scenario) there will be other types of pain. While share prices would initially stabilise, concerns would grow over US dollar corporate debt, well in excess of US$50 billion. This situation would also hit the banking system but Everington thinks the situation is far more manageable than the alternative.

Additionally, since exports make up such a small part of the economy compared to services, GDP would be unlikely to suddenly recover. Then there is that sticky concept of “confidence”. Once the peg had been unhitched, credibility would be hit, and other peg levels might suffer continuing attacks.

Lots of downside, little upside

So where does that leave us? Regent’s Jim Mellon has to be near the mark when he says there’s a 50/50 chance of the peg going. From an investment standpoint the risk to the Hong Kong dollar is on the downside. You should absolutely have half of your money in US dollars if you ever plan to leave Hong Kong for good. If you own a property in Hong Kong and have borrowed in Hong Kong dollars you should take your US dollar holding higher still. The only downside is less interest on your US dollar cash (two per cent at the time of going to press), a small price to pay given the enormity of Hong Kong’s economic woes. Put another way, who do you trust most, a banker or unelected politicians? Difficult.

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