Outlook on China
The bearish outlook on China has been many-fold, with its structural shift away from a manufacturing base to that of an innovation orientated and consumer-driven economy naturally having contagion effects, most notably on export-driven economies such as Europe and Japan. However, Hong Kong has been moving into the spotlight recently, with its currency peg with the US Dollar prompting fears that its (currency) function as an effective pressure valve will start to show the strains that ultimately develop alongside economic change.
So what are these changes that have prompted China perma-bear Kyle Bass (Hayman Capital Management) to warn of a potential breakage in the Dollar peg and prompt capital outflows as investors scramble to safety. Essentially, the risks are fundamentally political in nature. Prior to China’s economic rise to prominence, Hong Kong was China’s primary southern port and at its peak, contributed 25% to China’s total GDP in 1993 as Bass points out. Since then, China has continued to invest heavily in infrastructure spending, and from the turn of the century, has built numerous ports, thereby removing its reliance on Hong Kong. Consequently, the special administrative region has had to evolve its economy in order to compensate for the loss of trading business. In response, HK has reinvented its self into a service export region, attracting an influx of foreign influences to cater for this process. It has also developed into a major importing region as a consequence, no doubt to facilitate and accommodate the foreign investment in human capital in part.
So far, the economic cycle relative to China’s development has a familiar ring to it – similar perhaps to the UK’s migration away from manufacturing to services some 45-50 years ago. The UK’s economic parallel may be partly linked to its colonial establishment in Hong Kong, but some 36 years ago, under Margaret Thatcher, the UK began negotiations to hand Hong Kong back to China. This prompted a run on the HK Dollar as investors feared the British rule and order would be discarded for the ‘heavy hand of Communist China’ – as Bass puts it – and the currency devalued by around 50% against both the US Dollar and British Pound. As a result, the HK government decided to peg the currency to the greenback in a hasty quest to calm investor sentiment. Later when China took control of Hong Kong, the Asian Crisis took hold with some believing this process as part of the breakdown in trust in the region. The Thai Bhat sparked off the Asian rout, with the Malaysian Ringgit a notable casualty as contagion spread. The former removed its peg from the Dollar and losing 50% in the process. The Malaysian government also had to resort to lifting the Overnight rate sharply to counter heavy speculative bets against its currency.
Hong Kong Currency Peg
Back to Hong Kong and more recent times and the effect of tying the HK Dollar to the US reserve currency naturally involves undergoing monetary policy synergy, or importing US policy to use the terminology of Bass. As economic cycles diverge as a natural consequence of the myriad of variables affecting the global economy and imbalances thereon, Hong Kong has seen a boom in its economy at a time when the US economy was forced to reduce rates to zero and implement a series of quantitative easing measures alongside this. Real Estate prices skyrocketed as a consequence. Now, however, the tables have turned and in a currency peg, the HKMA (Hong Kong Monetary Authority) has been forced to use its amassed reserves in order to protect currency parity. Fears that once reserves have been depleted and that rates will spike as a consequence, the peg is seriously in question. As noted above, the currency devaluation can be devastating.
With the ongoing wrangling over jurisdiction and potentially greater influence by China, investor fears over the fate of the HK Dollar are heating up again, and as the economic consequences of maintaining the peg are stretched to their limit, the political fears which contributed to the Asian crisis in 1997 are slowly re-emerging in nature. This is complicated by the fact that Hong Kong remains China’s center for raising US Dollars, so political detente in keeping the peace with the US is a balancing act in itself. Even so, Investors, therefore, will start to – if not already – transition out of their HK Dollar denominated assets which in turn exacerbates the run on the domestic currency. Safe havens are instinctively the first point of call, and while the thirst for US Dollars continues, long term value investors will no doubt look to switch into the traditional havens where Gold has perennially held its place. With financial leverage in the region also at a notable peak, the level of devaluation could be significantly more destructive as we have seen in Argentina.