DESPERATE MEASURES
Goaded by attacks on its currency, free-market Hong Kong intervenes in the bourse. Will the gamble work?
By Alejandro Reyes
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He was once known as Yam Yat-chiu - One-Trick Yam. Joseph Yam, chief executive of the Hong Kong Monetary Authority (HKMA), was the butt of jokes for having only one response to attacks on the Hong Kong dollar: high interest rates. No longer. These days, the head of the SAR's quasi-central bank is dubbed Yam Fa-chiu or Bag-of-Tricks Yam. On Aug. 14, he used about $517 million from the fund meant to defend the Hong Kong dollar's peg to the U.S. dollar to buy blue chips and futures contracts. He accused speculators of dumping the Hong Kong dollar to drive down stock prices - after buying contracts betting this is precisely what would happen. Says the new-look Yam: "I'm going to hurt them. I'm going to hit them where it hurts. I'm trying to tell them 'don't manipulate our currency.'"
By Aug. 19, the benchmark Hang Seng Index had soared 14.4% from the pre-intervention close. Some people indeed got mauled. Those who sold index stocks they did not have - the short sellers - had to buy the blue chips at much higher prices to cover their obligations. Had stock prices fallen, they could have pocketed the difference between what they sold and what they later bought. Others who bet that the index would drop by the end of the month can wait till then to learn their fate - or cut their losses now, knowing that the government is speculating the other way. There were signs of continuing intervention last week, though Yam would not confirm or deny it. But in a letter to London's Financial Times, he promised to "step back from the stock and futures markets" - as soon as speculators stop attacking the Hong Kong dollar.
Still, Hong Kong could end up winning the skirmish but losing the war. "Intervening in a market is always very dangerous," warns John Wadsworth, chairman of Morgan Stanley Dean Witter Asia. "The extent to which it is really damaging to Hong Kong depends upon the next steps and how things actually evolve over the next several months." Reactions from the finance sector have been overwhelmingly negative. "Once started, you have to do it constantly," says Lui Ting-ming, director of the Hong Kong University of Science and Technology's Economics Research Center. "In Japan, the government and major companies have been intervening to prevent the Nikkei from plummeting through the 15,000 level. This has delayed market regulation, and worse still, dampened international investor interest."
The government's tactics called into question Hong Kong's traditional dedication to the free market. Coming on top of a stimulus package announced in June that was designed to cushion the fall of property prices, the intervention suggests that the SAR is not just fighting speculators. Two prominent developers - Lo Ka-shui of Great Eagle and Raymond Kwok of Sun Hung Kai - strongly defended the government's move. Says an American banker: "It smacks of the government looking after the big property guys." Property prices and other costs in Hong Kong have been falling, but analysts say they need go still lower if the SAR hopes to remain competitive as an international financial center.
Yam and other officials insist they had no choice but to intervene. The HKMA had been largely unprepared when speculators mounted their first attack on the dollar in October. Powerful international hedge funds dumped $5-billion worth of borrowed Hong Kong dollars. The inter-bank rates were raised to an astronomical 280% to punish the speculators, who had to pay huge amounts in interest on the funds they borrowed. (So did ordinary Hong Kongers, who had to pay more in mortgage payments and other loans as the lending rate went up too.) But the wily speculators had another target. They expected the stock market to be spooked by the rate rise, so they had built up short positions. The Hang Seng fell 13.7% Oct. 28 - and the speculators made far larger gains than the interest they had to pay on money they borrowed.
They struck again on Aug. 5. Sources say some HK$30 billion ($4 billion) were sold that day, chiefly through U.S. investment banks Merrill Lynch, Goldman Sachs, Morgan Stanley and Bankers Trust. Their clients are believed to be Hungarian-born financier George Soros and his associates. (None of the parties would deny or confirm their involvement.) This time, the HKMA was ready. Instead of absorbing the Hong Kong dollars, it got the Treasury to buy them. Financial secretary Donald Tsang describes the operation as routine. The government needed extra Hong Kong dollars because it planned to run a fiscal deficit of HK$21.4 billion ($2.8 billion) this year to fund its stimulus measures.
Unlike in October, there was no change in the Hong Kong dollar balance in the banking system, so interbank rates increased from 4.5% to just 7.5%. The HKMA's strategy so shocked bankers that Goldman Sachs and Bankers Trust reportedly called Yam's office to ask why inter-bank rates had not risen as sharply as they automatically have done under the peg system. But the stock market got nervous anyway. Perhaps not coincidentally, rumors that Chinese central bank chief Dai Xianglong was considering a limited devaluation of the renminbi began circulating. In Singapore and London, the talk was that Hong Kong was poised to break the peg. Beijing and Hong Kong issued denials, but the Hang Seng fell to a five-year low on Aug. 13 (see chart).
That was when Yam dipped into his new bag of tricks. He may have routed the short-sellers. But hedge funds are believed to be holding on to 20,000 Hang Seng Index futures contracts, which will expire toward the end of August. The strike price is believed to be between 8,000 and 9,000 points. HKMA sources say the speculators may be paying HK$4 million every day on the HK$30 billion they borrowed - but they can make as much as HK$4 billion in profits from index futures if the Hang Seng were to fall to 5,000 points by the end of the month.
Some may already be squaring their positions, given the government's evident determination to support the stock market. But they may come back. Ironically, many analysts say the intervention may put more pressure on the peg. "Essentially, Hong Kong is no longer running a currency board," says Simon Flint, a regional economist at I.D.E.A. in Singapore. When Hong Kong fixed its currency's exchange rate at 7.8 to the greenback 15 years ago, it promised to back every note issued with an equivalent amount of U.S. dollars. Before the intervention, Hong Kong's total reserves topped $96 billion - eight times what is needed to redeem all Hong Kong dollars in circulation. Under the currency arrangement, interest rates go up or down depending on market forces. The government is not supposed to intervene.
That is why finance czar Tsang took pains to reassure everyone about Hong Kong's currency policy. "Our commitment to the currency board system is paramount and unchanged," he stressed in his post-intervention press conference with Yam. "What we are dealing with are very exceptional circumstances. We have deployed our exchange reserves to deal with very specific attacks on the Hong Kong dollar through a very unconventional means. [But] we are not going to abandon the system." Yam made the same case in his letter to the Financial Times. "We are not against the taking of short positions by anybody," he wrote. "But we do object to people manipulating our currency . . . to make profits in short positions in stock index futures."
The Hang Seng may stay aloft until the end of the month. And after that? "This is a bearish market, and it will remain so for a long time," says Damien Hatfield of Deutsche Securities in Hong Kong. "Government intervention can't change this. Investors will continue to short-sell, and the index will spiral down further. If intervention continues, I'm afraid that Hong Kong's reserves will dry up one day." The short-term outlook looks dim. The economy shrank 2.8% in the first half of this year and unemployment is running at 4.8%. Still, some insist the SAR's fundamentals remain intact. "There is no foreign debt, and foreign-exchange reserves are the fourth-largest in the world," says Stewart Aldcroft of fund-management group Templeton Franklin Asia. "Speculators are just wasting their time."
Hong Kong's challenge is to prove him right. It must also convince the markets that the SAR is not intervening to put a floor on asset prices. Property values have already fallen by more than 45% since their peak last year. Christopher Wood, an economist with Santander Investment Securities Asia, expects real estate values across the board to eventually plummet by 80%. Another issue: the connection between the renminbi and the Hong Kong dollar. The conventional wisdom is that the Hong Kong peg would go if the yuan were to depreciate. Others argue the link is merely psychological. "But psychology in today's markets is extremely important," says Morgan Stanley's Wadsworth, who believes Beijing will honor its promise not to devalue the renminbi.
How about re-pegging the Hong Kong dollar at a higher rate? That would only give speculators a new target. Steven Xu, a regional treasury economist with Standard Chartered Bank, proposes dollarization instead (see Viewpoint) - the use of the American dollar as legal tender. "With dollarization, there is no speculation against the exchange rate because there is no exchange rate peg," says Steve Hanke, the Johns Hopkins University professor who advised Indonesia on its controversial plan to introduce a currency board for the rupiah last year.
But he thinks the solution for Hong Kong is a return to a pure currency board. "The HKMA is to blame for a great deal of the unwanted speculation in the Hong Kong currency and equity markets," says Hanke. "Since 1983, it has been opportunistic, taking on many new roles and responsibilities." That includes engineering interest-rate rises instead of letting market forces determine rate levels. For his part, Wood doubts whether the government would seriously consider dollarization because the policy is unlikely to appeal to China on nationalistic grounds. Hong Kong is not likely to make drastic changes anytime soon. Says Wadsworth: "The public assurances the Hong Kong government has given that this [intervention] is a one-off event are as encouraging as I could imagine anything it would say, given the riskiness of intervening at all. We just have to wait and see." For No-Need-for-Tricks Yam, perhaps?
- With reporting by Law Siu-lan/Hong Kong
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