Until recently I had been very positive regarding the long term outlook for Hong Kong. Despite the Chinese takeover, it had appeared as though the Hong Kong market would remain the freest in the world. It was my opinion that a free market coupled with low tax rates would ensure that Hong Kong would inevitably re-assert itself as one of the world's great economic success stories. However, everything changed on 14th August when the Hong Kong Financial Secretary announced to the world that the government was intervening in the share market as a means of maintaining order in the currency market. This intervention effectively means that the Hong Kong share market is now rigged and therefore unsuitable for long term investment.

Due to its continued peg to the US Dollar, the HK Dollar has become very expensive relative to all other Asian currencies (with the exception of the Chinese Yuan). This over-valuation has naturally attracted speculators who hope to profit from an eventual de-pegging, or re-pegging, of the HK Dollar. However, the perception of the Hong Kong and Chinese governments is that a de-valuation of the currency would be seen as a failure of their economic management. They have stated unequivocally on many occasions that the peg WILL be maintained. A reversal, at this time, would cause an unbearable loss of face and must therefore be avoided at all costs.

In order to defend the currency and its peg to the US Dollar, interest rates have been held at high levels for the past 10 months. High real interest rates have resulted in 60% and 40% falls in the stock and property markets respectively, a credit crunch and an economy which is now officially in recession after experiencing a contraction in each of the first two quarters of 1998. The government has now revised its forecast GDP growth rate for 1998 to negative 4%. Hong Kong is also the only country in Asia which is experiencing deflation in the true sense of the word, with the supply of money decreasing.

Courtesy of its large foreign currency reserves, it is technically possible for the HK government to successfully defend the currency peg for a long time to come. With this in mind, speculators have been making a two pronged attack by simultaneously shorting the Hong Kong Dollar and the Hang Seng Index. Short selling of the currency causes interest rates to be driven up which, in turn, leads to declining share prices. To ward off the speculators who are attempting to profit from this dual play, the government began buying selected blue chip stocks on August 14th. Since that date the HK government has purchased over HK$100 billion worth of shares, using around 15% of its foreign currency reserves in the process. Intervention by the government reached a crescendo on Friday 28th August as an all time record of HK$79 billion of stock changed hands. Of this HK$79 billion turnover of stock, HK$70 billion was purchased by the government. Despite the government being on the buy side of almost 90% of all transactions (in terms of dollars), the Hang Seng Index fell by 1% on that day.

Disregarding the massive evidence to the contrary, governments continue to believe that they can fly in the face of economic reality and bend markets to their will in order to achieve greater stability. Japan has now been in a recession for 9 years, yet the Japanese government refuses to make the structural changes (lower taxation and less regulation) which are essential to create a sustainable recovery. Instead they prefer, with the help of the US, to manipulate the foreign exchange markets in a futile attempt to construct the illusion that their policies are working. The end result of such manipulation is usually to prolong the problem and cause increased volatility.

Governments have always tried to manipulate markets and they have always failed. The reason they fail is that all manipulation distorts the means by which information is transmitted in any market - price. "Price" is the mechanism by which supply and demand are brought into balance. Whenever a government intervenes in a market, prices are supported at levels which do not match the supply/demand fundamentals. This leads to a greater imbalance than could otherwise have occurred and increases the severity of the resultant correction. The additional problem faced by governments today in their misguided attempts at manipulating markets is the sheer size and speed of global capital flows. The August 31st edition of Barrons contains an interview with Marc Faber, the international investor who predicted several years ago that the enormous credit expansion occurring throughout Asia would inevitably lead to financial turmoil. During this interview Faber was asked to explain the unprecedented dimensions of the current contraction, to which he replied : "The reason may be that capital is so much bigger than the real economy. The world's GDP is about $22 trillion. But the financial markets churn around maybe $1 or $2 trillion a day. So the power of financial markets over the real economy is too great."

In Hong Kong, the government's extraordinary attempts at market intervention have no chance of success. Last Friday we saw the absurd situation where the government was virtually the only buyer in the market. Continued buying at the current rate will mean that, in two week's time, the Hong Kong government will have zero foreign currency reserves and a large portfolio of stocks. Since the stocks could never be sold without causing the dramatic fall in prices which the intervention was designed to prevent, Hong Kong's currency would then be at the complete mercy of the speculators. Realising that this form of manipulation has almost run its course, the government has already started moving down the path of increased regulation . Margins have just been increased by 50% on large futures positions and it is likely that short selling in a declining market will be banned.

Whilst the Hong Kong government is waging its war against large speculators, the citizens of Hong Kong are making their own statement regarding the currency. In order to attract HK Dollar deposits, banks are being forced to offer substantial interest rate premiums for HK Dollars versus US dollars. For example, a 6 month HK Dollar time deposit at Hongkong Bank provides a 4 percent higher interest rate than a 6 month US Dollar time deposit. Whilst the uncertainty remains regarding the peg, Hong Kong people will generally be unwilling to hold a substantial portion of their cash in HK Dollars. Speculative attacks aside, major selling pressure on the HK Dollar will likely continue to come from HK citizens and businesses converting their currency to US Dollars, maintaining upward pressure on HK Dollar interest rates and consequently downward pressure on the stock and property markets.

History shows us that the same mistakes are made time and again. Governments will always be able to rationalise their attempts at market manipulation and the long term effects of such manipulation will always be detrimental. The Hong Kong Dollar's peg to the US Dollar must eventually go, with the only question being how much of the country's reserves will be expended in its defense and how much damage will be done to the stock market. Once the government steps aside and allows the currency and the stock market to fall to a level at which they are not perceived to be over-valued and at which new buying emerges, then real interest rates will decline and an economic recovery can begin.

Milhouse

3 September 1998

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