ECONOMICS: Hong Kong's peg
Far Eastern Economic Review
Aug 27, 1998
Politics and the Peg:
Hong Kong fends off speculators at the price of credibility
* By Alkman Granitsas and Henny Sender in Hong Kong with Salil Tripathi
The message was meant to be heard loud and clear. Faced with a falling
public-approval rating and an even more rapidly falling stockmarket, the
Hong Kong government tried to stem the damage.
On August 14, a Friday, it launched a massive and unprecedented
intervention in the stock, currency and futures markets that continued
through the next two trading days. The government bought assets, and it
bought big: By most estimates, it spent HK$3 billion ($385 million) on
August 14 alone, snapping up Hang Seng-index stocks in a bid to drive
currency speculators out of the market. It worked like a charm. The
blue-chip index rocketed 8.5% higher on the first day to close at
7,224.69 points, while interbank rates fell by 50-75 basis points.
But the intervention cost the government more than just money -- it
cost credibility. By intervening, the government casually tossed aside
the carefully cultivated free-market ethics that have distinguished Hong
Kong from other Asian markets. Gone was the explicit compact that
underpins Hong Kong's much-vaunted currency board: If the U.S.-dollar
peg is to remain solid, then the economy must crumple to absorb shocks.
This raises the stakes significantly in the government's confrontation
with speculators. It also sets the government on a risky path -- one
that may prove effective in the short run but will likely lead only to a
dead end. The ultimate ignominy now seems to lurk on the horizon -- a
forced end of the 14-year-old link to the U.S. dollar.
"It is extremely dangerous," says the treasurer of a major
international bank in Hong Kong. "It could be interpreted as the Hong
Kong Monetary Authority losing confidence in the automatic mechanism of
the currency board and losing the stomach for higher interest rates."
Moreover, by seeking an alternative to raising interest rates,
HKMA has relinquished its primary weapon in defending the peg. (Under a
currency board the quid pro quo is that interest rates must rise when a
currency is sold.) While this action may boost confidence among local
investors -- at least temporarily -- it has increased scepticism in the
markets about the peg's survival.
"I know the peg is going," says the head of proprietary trading
U.S. investment bank. With the government keeping a lid on rates,
speculators can borrow more cheaply to bet against the Hong Kong dollar.
The government's actions also may delay the correction in asset
prices needed to restore Hong Kong's competitiveness. But that is only
one worry. If the authorities are reluctant to raise interest rates,
that suggests to many analysts that local banks, particularly smaller
ones, may be in far worse shape than anyone is publicly admitting. Many
expanded their loan books during the first half of 1997, when the
stockmarket and property markets were near their overheated peaks. At
the same time deposits were growing far more slowly. This hints at
funding problems -- even if borrowers aren't yet defaulting on those
There are other concerns, too. "They must be doing this in
anticipation of something which isn't yet in the public domain," says
David Brennan, of Baring Asset Management in London. That "something"
may turn out to be data that show a serious economic decline in the
second half; analysts forecast a contraction of at least 5%.
The stockmarket intervention is also likely to scare away retail
investors. That leaves the market subject to a bitter tug of war between
the HKMA and hedge funds that consider Hong Kong stocks to be
Technically, the government's move was designed to squeeze currency
speculators rather than shore up stock prices. Speculators in the Hong
Kong dollar typically buy short contracts on the Hang Seng index, which
means they make money if the index falls. They then work towards that
result by selling Hong Kong dollars, which automatically drives interest
rates up, and, normally, pushes the Hang Seng lower. By buying stocks,
the government was trying to counter this strategy and rob the
speculators of their guaranteed profits.
While economists may not agree with the government's strategy,
see the logic. "The speculators' strategy is widely known," Andy Xie, a
Hong Kong economist at Morgan Stanley Dean Witter, wrote in a report on
the government's action. "In this respect, while there is some
justification for intervention, it is not strong."
For Hong Kong, however, the issue has now become more and more
local politics. In the past two months, the government has taken a
number of steps to bring down local interest rates and nudge up property
and share prices.
Meanwhile, the Monetary Authority -- the territory's currency
-- is transforming itself into a central bank. That's a process that has
been under way for years, but the interventions of the past three months
have greatly speeded the transformation.
"Trying to hold in place an exchange-rate regime through a currency
board and nonintervention is not very credible," says Don Hanna, an
economist at Goldman Sachs in Hong Kong. "That implies that domestic
policymakers are immune to political pressures and the state of the
Hanna believes the government's exercise wasn't really intended
make a point to international speculators, but was instead targeted at a
domestic audience. He suggests that the government's thinking was that
Hong Kong citizens will believe in the peg as long as they think the
government cares enough to save it. So will the peg break? Not yet. The
Hong Kong public still has faith in its dollar -- and that's crucial to
maintaining its integrity.
There are also some corrective mechanisms that should keep that
faith, at least for now. Chief among them is the property market.
Residential property remains in chronically short supply; only 50% of
Hong Kong people own their own homes. Since this will continue to be the
case for years to come, property holds an inherent value that transcends
short-term problems in the greater economy.
That means that for those who can afford to buy apartments now,
who are still managing to pay their mortgages, property remains a good
investment and store of wealth. That's provided they can hang on long
enough. For them, the compact remains. They earn in Hong Kong dollars,
their mortgages are in Hong Kong dollars and their eventual profits will
be in Hong Kong dollars. Those who can afford to wait, will.
So far, so good. But as goes Hong Kong, so too goes Asia. The
intervention has severely eroded confidence among investors in the
region. Coupled with a sharp devaluation in the Russian rouble and the
humiliation of U.S. President Bill Clinton, Hong Kong's actions led
share prices throughout the region and beyond to tumble. On August 17,
the Monday after the intervention and a holiday in Hong Kong, stocks
slid regionwide, with losses ranging from 3.0% to 3.6% in Singapore,
Kuala Lumpur and Bangkok. In London, too, investors piled out of Asian
stocks and in Tokyo the Nikkei average closed below the psychologically
important 15,000-point level.
"Direct intervention using government funds has proven to be
failure," says P.K. Basu, vice-president of Asian economics at Credit
Suisse First Boston in Singapore. Currency speculators have gleefully
gone to battle with governments three times in the past year -- in
Thailand, Malaysia and South Korea. Each time, the governments have
But the real issue has never been about ideology; it has been
power and politics. Governments in the region resent the erosion of
authority that markets bring. In Kuala Lumpur, many feel that Hong
Kong's move vindicates Prime Minister Mahathir Mohamad's criticism of
market forces. It shows that even noninterventionist Hong Kong has
limited patience with speculators, says the research head of a Malaysian
Mahathir took on speculators in August last year when he temporarily
banned short-selling and asked statutory boards to buy local shares. His
attempts failed and today prices on the Kuala Lumpur Stock Exchange are
at a 10-year low. But Mahathir seems emboldened by Hong Kong's efforts.
Four days after the territory's market foray, he said his own government
was studying new ways to prop up Malaysia's sagging stocks.
"This will build on the emerging backlash against globalization,"
predicts Edmond Cheah, chief executive and executive director of KL
Mutual, an asset management company in Kuala Lumpur. "Governments have
the view that they are stronger than market forces, so they take on the
short-sellers. Meanwhile, the investing funds take the view that as long
as the governments are fighting the inevitable, they can make money."