It looked like the first sign of impending doom: after years of too-good-to-be-true GDP growth numbers and a furious bull run in equities, a thunderous collapse in China’s markets that turned regional and global jitters into full-blown panics amid a shock devaluation of the renminbi.
So where to find opportunity in Asia, among all the goomy news? We believe the Hong Kong dollar might offer an interesting risk-reward. The Hong Kong dollar, that strange stepchild of a currency that exists within a small capitalist enclave adjoined to a titanic Communist state and whose health crops up as a subject of debate whenever China starts to get wobbly, may be a powerful way to track the aftereffects of its master’s economic hangover. It’s survived so far, with a peg between 7.75 and 7.85 USD that has lasted for 32 years. As Chinese markets have calmed down somewhat and worry around the currency has retreated, in our opinion now is the time to short the HKD against the greenback.
While there was a flurry of concern over the fate of peg in the days after the renminbi devaluation, the conventional wisdom that it is here to stay seems to have reasserted itself. We’ll note upfront that it is next to impossible to predict the precise likelihood of any movement. Central banks are both capricious and opaque; the Hong Kong Monetary Authority (HKMA), the currency board that oversees the HKD, is no exception. And breaking the peg would no doubt lead to the loss for Hong Kong of major credibility in the markets. Given the huge role the financial services sector plays in its economy, such a loss would be a double blow. There’s also the fact that the peg has worked well — or worked well as far as dubious instruments of monetary policy go — for the three-plus decades it has been in place, judging by Hong Kong’s economic miracle.
So inertia and central banking stubbornness are on its side, both strong anchors. But like all pegs it is not, on its fundamentals, sustainable. Consider the worrying fact that even before the meltdown in China, there was considerable and sustained pressure driven by capital inflows against the strong side of the peg this spring. The HKMA fought back with a series of interventions under the direction of Norman T.L. Chan. And good times for China can mean bad times for the peg: when demand for Chinese equities rises, inflows come through the Shanghai-Hong Kong Stock Connect, a trading platform set up in 2014 to allow mainlanders to buy H-shares for the first time (and canny foreign speculators to game the pricing differences between listings on the two markets). While demand on the Connect was more muted than initially speculated, it functioned like a firehose during the parabolic rocket-fueled climb of the mainland market in the weeks before it fell apart this summer. HKMA intervention, of course, became an even bigger theme after the meltdown, with another series of interventions to defend the peg in August and September from pressure “possibly because of asset reallocations following the renminbi depreciation,” in the dry terms used by the HKMA’s half-yearly report.
Hong Kong as a consequence of the peg must also follow U.S. monetary policy. This means that it has seen an insane loosening over the past six years. The benchmark rate of the HKMA at .5% hovers just higher than the Fed’s near-zero benchmark rate of .25%. This has been a big factor in the skyrocketing value of real estate in the city — one major gauge of Hong Kong property prices, the Centa City Monthly Index, is up 60 percent since 2010. The real-estate bubble is seen as fragile given the exposure to greater China’s economic problems. Consequently, a looming rate hike from the U.S. Federal Reserve will be causing sleepless nights at the HKMA. Rising rates will inflict more pain on the Hong Kong retail and tourism sectors that are already suffering. Having grown at double digits for several years, retail is now contracting, largely because of the strengthening of the HKD and the China meltdown which caused mainland Chinese shoppers to stay home. It’s a classic double bind for the HKMA: low rates and continued real-estate inflation or higher rates and economic slowdown, both fuel for public outrage.
This dilemma came into sharp focus last fall during the Umbrella Movement/Occupy Central protests, which were motivated as much by inflated real estate prices and slow wage growth as they were by Beijing’s clampdown on Hong Kong’s electoral freedom. This simmering anger also complicates — and to our thinking, almost wholly undermines — one of the arguments that the HKD peg is stable: namely, that the small, relatively agile, and open economy of the city will allow the pressure against the peg to escape in other ways, specifically by businesses cutting back on labor costs. Occupy Central adds major political risk to any such effort, and if the HKMA is faced with a choice between endless unrest about the economic conditions of everyday Hong Kongers and making a radical decision about the dollar peg, there’s no intrinsic reason preventing them from doing so.
The HKMA, after all, might simply run out of firepower to defend it. It might also come to see the stability a pegged HKD provides as eventually becoming an economic burden vis-à-vis China outweighing the value of keeping it in place. The mainland accounts for 53.9 percent of Hong Kong exports, so any strengthening in the currency is a disaster, and any further devaluations from the PBOC will exacerbate the pressure on the peg. And there could be compelling political reasons for the HKMA to break the dollar peg as well. China’s pressure on Hong Kong has increased in the years since the handover, coming most visibly to fore in the decision of the Standing Committee in August 2014 to restrict possible officeholders in Hong Kong to those chosen from a Beijing-approved slate. It’s not hard to imagine a re-pegging of the HKD to the renminbi as the outcome of a political directive from the mainland to assert its authority and symbolically reinforce Chinese hegemony. And despite some investors’ fetish for the peg, it has not itself been sacrosanct. It was previously set at 5.65 USD. The currency was subsequently floated against the dollar for a decade before being re-pegged in its current band.
And then there’s the fact that, quite simply, pegs don’t work in the long run. Consider what happened with the Argentine peso It was pegged to the USD until the country’s horrific crash in 2001 and the overnight decision to convert all savings accounts in dollars back into pesos at a new, much worse rate, a disaster for its citizens. The euro, a currency in distress because of troubling political and fiscal inputs from its members, is effectively a peg. Its traumas play out on the front pages, though the political reasons behind them are more powerful than in Hong Kong. It’s true that if you’re a commodity producer looking for credibility for your central bank, a peg to the dollar may make sense — at least until the market for that commodity collapses. Witness the pain being felt throughout dollar-pegged oil producers: Nigeria has been forced to depreciate its naira almost 20 percent against the dollar since last June; Saudi Arabia, whose riyal has had a bumpy autumn, though the pressure against it is cushioned by the Kingdom’s vast currency reserves; Venezuela, where the usual schizophrenic divide between the official peg and black-market rates has been exacerbated. More importantly, this summer shows that Asian pegged currencies are indeed vulnerable to Chinese economic tremors: Vietnam moved the dong’s USD peg and Kazakhstan de-pegged the tenge entirely from the USD, all in the aftermath of the renminbi devaluation (both look like competitive devalutations).
Whether the forces of inertia triumph over the increasingly troubled economic realities in the region and worldwide is, as noted, a tough call; hedging a move or a break may be hedging an event that never occurs. But the truly attractive part of this play is that it is not necessary to be able to intuit whatever Mr. Chan and his colleagues at the central bank and their ultimate masters in Beijing may have planned — it’s enough to know that the HKMA will most certainly not revalue the HKD higher against the dollar.
There are two real possibilities here. The first is a peg with the renminbi. Should the PBOC devise a new scheme for greater prosperity that involves such a re-pegging, we predict the result will be a weakening: it’s hard to see China letting the HKD trade at its current rates with the yuan, which would represent a significant appreciation. The Xi government will let the HKD weaken. If the current macro trends continue in China, so too will that weakening — and if there are any further jolts or shocks, it will be accelerated. Should the city’s monetary masterminds float the currency, the central prop in the HKD’s attractiveness as a safe haven vanishes. The bottom then becomes much harder to predict. Consider the tenge, which has gone down almost 63 percent against the USD since its peg broke.
The unease around the HKD has quieted for the moment and will likely stay quiet until China makes another dramatic economic move. But even under the more conservative first scenario, investors can profit massively. Volume may be low here, but through leverage in the options market you can multiply your winnings — leverage that in this case carries almost no downside risk: remember, none of the political powers with control of the printing presses is going to let the HKD slide higher against the dollar than it already has.
The options market in the HKD trembles in sync with Chinese instability. In the days and weeks after the renminbi devaluation, the implied one-year volatility of the HKD — an effective proxy for options pricing — jumped to 3.2 percent, its highest level since 2004 and a more than tripling of its level prior to the devaluation. This shows that there is strong if sublimated sentiment in the markets against the peg as well, a recognition of the factors that make the peg long-term unsustainable.
So it may not move at all, but if it does move there is nowhere for the HKD to go against the dollar but down.