The HKMA is mandated to keep FX trading within a range of HK$7.75 to HK$7.85 per US dollar. The current band was discontinued in 2005 and has never been broken. If it gets too close to either end of the band, the HKMA intervenes by either buying or selling the city’s currency. As the chart below shows, the currency traded at the extremely weak end of the range for most of the year, under pressure from the strengthening US dollar. This pressure has eased somewhat recently as interest rate expectations have eased somewhat. But this is only likely to be a short-term fix, as the social and economic costs of defending the bond are enormous. The peg to the Hong Kong dollar is like a gold standard and, like the gold standard, the weaknesses of such mechanisms are always social and economic.
Because of its peg to the US dollar, Hong Kong has no independent monetary policy; it had to follow the Federal Reserve and tighten at a time when it should be doing the opposite. If the Chinese economy as a whole has been struggling on the back of its extraordinary “zero Covid” policy and the mother of all debt bubble hangovers, Hong Kong has fared even worse, contracting 4.5% year on year in the third quarter. The benchmark Hang Seng index is down nearly half since its 2018 high, even after a recent rebound.
With growth headed in the wrong direction and the HKMA forced to hike interest rates, Hong Kong has had to resort to the only option for currency-pegged countries: massive government spending. However, there is very limited room for any country to increase fiscal spending without investors worrying about the accompanying increase in borrowing (debt) and the sustainability of the peg. No wonder, then, that fiscal policy has done little to mitigate the sharp downturn.
This is not just a cyclical problem either. Hong Kong’s best days are behind him. China’s political interference has only increased. The labor force, especially the higher earners in finance, is shrinking. I doubt the weakness is purely cyclical, and if not, Hong Kong’s tax base has been permanently eroded. That’s a problem because Hong Kong is now a massively leveraged economy.
That the government has very little debt isn’t really the point, as private sector debt more than makes up for it. Andrew Hunt, an independent economist who has followed Asia closely for decades, points out that the external debt is nearly $500,000 for every person working in Hong Kong. According to the World Bank, domestic debt has doubled since 2007. Housing debt has been growing particularly fast, and despite a price slide showing all signs of accelerating, Hong Kong property is still among the most expensive in the world.
It is this huge rise in debt, falling asset prices and the increasingly gloomy outlook for Hong Kong’s economy that makes defending the peg so much more problematic than it was during the Asian crisis of the late 1990s. The ramifications of all this can be seen in the HKMA’s Exchange Fund, which, among other things, manages Hong Kong’s foreign exchange reserves. His wealth has fallen to $417 billion from $500 billion at the end of last year, the largest drop ever, according to the HKMA.
Most of the decline in Exchange Fund assets over the past few months, however, is not due to intervention, but rather to two other sources. The first is that the government had to tap into the Exchange Fund to make up for lost revenue, according to HKMA and government data. Barring a slight surplus in 2020-2021, the government has reported a consolidated budget deficit since 2019. To reduce these deficits – and create this very small surplus – the government tapped into the accumulated budget surplus managed by the Exchange Fund. From a peak of HK$1.17 trillion ($150 billion) in 2018-2019, the budget surplus shrank to HK$957 billion by the end of March and HK$704 billion by the end of September. Over a four-year period beginning in 2019-2020, the government also set aside HK$82.4 billion as a housing reserve, according to government and HKMA data. Although kept separately, this was also money from previous budget surpluses.
These transfers are counted as current revenue in government accounts, although they are the product of previous years’ revenue. The government says this is because it uses cash accounting. That’s why the proceeds from the $10 billion green bonds it has issued are counted as income. It has not treated other debts this way, nor would any other accounting system on the planet. Over the past year, the government doubled the amount of green bond debt it could have outstanding at any given time.
In addition, potential government liabilities are increasing. Since 2019, the amount of loan guarantees provided by the government, mostly for smaller businesses, has increased from HK$27.8 billion to HK$133.4 billion, annual reports show. These only enter the government’s balance sheet when companies default, and the current default rate is just 2.6%, according to the government. But you can also keep failing companies afloat if you lend them enough money at rock-bottom interest rates.
To me, the fascinating way the government must generate revenue reeks of desperation. And if spending is cut, the economy will almost certainly fare even worse, creating a vicious circle of even slower growth, more defaults and less revenue. The government says these are one-off problems caused by the pandemic and other isolated cases. The problem is that budget deficits predated Covid. And given the likely profile of the Chinese economy in general and Hong Kong in particular, I don’t see that changing.
The second reason why the Exchange Fund’s assets have gone down is investment losses. Although most look to total assets when considering the firepower at the HKMA’s disposal, that’s not entirely accurate. The peg isn’t backed by the full $417 billion, but by the backing fund, which is about half that amount and just 10% more than the HKMA’s monetary base calculations (the same percentage higher than a year ago). The totals are smaller, however, as the money supply has contracted by about 9%. Although this gives an indication of the deflationary forces gripping Hong Kong, the money supply would have contracted more had the HKMA not tapped into the Exchange Fund.
In various annual reports and statements, the HKMA says it could use the rest of the portfolio to defend the peg if necessary. There is a mechanism whereby this happens automatically when the assets of the companion fund shrink to just 5% above the monetary base. On the other hand, if the value of the companion fund is at least 12.5% higher than the monetary base, money will be transferred to its investment portfolios. What the HKMA won’t tell me is whether there is any discretion in this process.
There are three other portfolios: the Strategic Fund, which includes only its interests in Hong Kong Exchanges and Clearing; the mutual fund, which includes public debt and stocks; and the Long-Term Growth Fund, which invests in real estate and private equity.
How much are all these funds worth now? HKMA does not count the gains and losses of its strategic fund in total returns. As good as. But the support fund contains nothing but dollars and probably short-dated government bonds or similar substitutes (but since it had mark-to-market losses we can’t be sure). The other two portfolios hold most of the HKMA’s risk. Based on some reasonable assumptions, around a quarter of the Funds’ exposures are likely to be in non-US dollar denominated assets.
This is also where, according to the HKMA, sits the overwhelming majority of HKMA’s equity and credit risk, of which there are plenty. Total equity exposure, detailed in the annual report late last year, was HK$745 billion. But there is almost certainly more. Exposure to private equity and real estate joint ventures is lumped in with real estate in another category of unlisted and fairly nebulous HK$443 billion ‘mutual funds’. The HKMA makes it very difficult to figure out what is where.
The fund contains all publicly traded bonds and shares. It’s reasonable to assume, although I don’t know for sure and the HKMA won’t say that all stock is marked to market monthly. Its long-term strategic growth fund is another matter. At the end of last year, this fund had assets worth around HK$515 billion. Valuations of its unlisted investments are published semi-annually, but the latest performance numbers are based on valuations as of late March.
Apparently, the HKMA is very good at real estate and private equity investing, having made a small profit unlike almost everyone else. These results should be taken with caution. As anyone involved in such valuations will know, they tend to be expressions of hope, models, and heroic assumptions rather than anything approaching a price at which such assets could be sold. And it’s gotten a lot worse since then anyway.
Call me old-fashioned, but a government that clearly needs cash and a bunch of assets that are likely to continue to fall in value makes it quite likely that the Exchange Fund’s assets will need to continue shrinking — and that the reasons for doing so will add even more pressure the cone.
This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.
Richard Cookson was Head of Research and fund manager at Rubicon Fund Management. He was previously Chief Investment Officer at Citi Private Bank and Head of Asset Allocation Research at HSBC.
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