The HKMA has a mandate to keep currency trading within a range of HK$7.75 to HK$7.85 per US dollar. The current group was created in 2005 and has never been broken up. When it gets too close to both ends of the strip, the HKMA steps in, either buying or selling the city’s currency. As the chart below shows, the currency has been trading at the low end of the range for most of the year, under pressure from the rising US Dollar. This pressure has eased somewhat recently, as interest rate expectations have eased somewhat. But this is probably only short-term relief, as the social and economic costs of anchor defense are enormous. The peg of the Hong Kong dollar is like being on the gold standard, and like the gold standard, the weaknesses of these mechanisms are always social and economic.
Due to the peg to the US dollar, Hong Kong does not have an independent monetary policy; it had to follow the Federal Reserve and tighten at a time when it should be doing the opposite. While China’s economy as a whole has struggled mightily due to its extraordinary ‘zero-Covid’ policies and mother of all debt bubble hangovers, Hong Kong’s has done even worse, falling back by 4.5% in the third quarter compared to the previous year. The benchmark Hang Seng index has shrunk by nearly half since its 2018 peak, even after a recent rebound.
With growth going in the wrong direction and the HKMA set to hike rates, Hong Kong had to resort to the only option for fixed-currency countries: massive government spending. There is, however, very little room for a country to increase its fiscal spending without investors worrying about the concomitant increase in borrowing (debt) and the sustainability of the peg. It is therefore not surprising that fiscal policy did little to mitigate the sharp slowdown.
Nor is it simply a cyclical problem. Hong Kong’s best days are behind him. China’s political interference has only increased. The active population, in particular high earners in finance, is shrinking. I doubt the weakness is simply cyclical and if not, Hong Kong’s tax base has been permanently eroded. Which is a problem, because Hong Kong is now a massively indebted economy.
That the government has very little debt is not really the issue because 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 foreign debt amounts to nearly $500,000 for every person working in Hong Kong. Domestic debt levels have doubled since 2007, according to the World Bank. Real estate debt has been rising particularly rapidly, and despite a decline in prices that shows all signs of accelerating, real estate in Hong Kong remains one of the most expensive in the world.
It is this huge increase in debt, plummeting asset prices and increasingly bleak outlook for the Hong Kong economy that makes peg defense far more problematic than during the Asian crisis of the late 1990s. You can see the effects of all of this in the HKMA Exchange Fund, which, among other things, manages Hong Kong’s foreign exchange reserves. Its assets fell to $417 billion from $500 billion at the end of last year, according to the HKMA, its biggest drop ever.
However, most of the decline in Exchange Fund assets in recent months has not come from interventions but from two other sources. The first is that the government had to dip into the Exchange Fund to make up for the shortfall, according to data from the HKMA and the government. In addition to a slight surplus in 2020-21, the government has had a consolidated budget deficit since 2019. To reduce these deficits – and create this very small surplus – the government has dipped into the accumulated budget surplus managed by the Exchange Fund. After peaking at HK$1.17 trillion ($150 billion) in 2018-19, the budget surplus fell to HK$957 billion at the end of March and to HK$704 billion at the end of September. . Over four years, starting in 2019-20, the government also transferred HK$82.4 billion set aside as housing reserve, according to government and HKMA data. Although separate, it was also money from past budget surpluses.
These transfers are accounted for as current revenue in the government’s accounts, although they are the product of revenue from previous years. The government says it is because it uses cash accounting. It’s also the reason he cites for counting proceeds from $10 billion of “green bonds” he issued as income. He didn’t treat other debts this way and it wouldn’t happen in any other accounting system on the planet. Last year, the government doubled the green bond debt it could have at any time.
In addition, potential public commitments are increasing. Since 2019, the amount of loan guarantees the government has provided, mostly to small businesses, has increased from HK$27.8 billion to HK$133.4 billion, according to annual reports. These will only appear on the government’s balance sheet when companies default, and the current default rate, according to the government, is just 2.6%. But you can keep even insolvent businesses on life support if you lend them enough money at rock-bottom rates.
To me, the intriguing ways in which government must find revenue smacks of desperation. And if spending is cut, the economy will almost certainly do even worse, creating a vicious circle of even slower growth, more defaults, and less revenue. The government says these are one-off issues caused by the pandemic and other isolated incidents. The problem is that budget deficits predate 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 Exchange Fund assets have fallen is due to investment losses. While most look at global assets when thinking about the firepower available to the HKMA, that’s not entirely accurate. The peg is not backed by all of that $417 billion, but by the guarantee fund, which is about half that amount and just 10% above the HKMA’s monetary base calculations. (the same percentage higher than a year ago). However, the overall amounts are lower because the money supply has shrunk by about 9%. While this gives an indication of the deflationary forces gripping Hong Kong, the money supply would have shrunk further had the HKMA not called on the Exchange Fund.
In various annual reports and statements, the HKMA indicates that, if necessary, it could use the rest of the wallet to defend the peg. There is a mechanism by which it will do this automatically if the assets of the guarantee fund shrink to only 5% more than the monetary base. On the other hand, if the value of the guarantee fund is at least 12.5% higher than the monetary base, money is transferred to its investment portfolios. What the HKMA won’t tell me is if there is any discretion in this process.
There are three other portfolios: the Strategic Fund, which contains only the shares of its holdings in Hong Kong exchanges and clearings; the Investment Fund, which contains public debt and equities; and the Long-Term Growth Fund, which invests in real estate and private equity.
How much are all those funds worth now? The HKMA does not count the profits and losses of its strategic fund in the overall returns. Just as well. But the guarantee fund contains nothing but dollars and, presumably, short-term treasury bills or close substitutes (but since it suffered losses at market price, we can’t be sure) . The other two portfolios are where most of HKMA’s risk is. Based on reasonable assumptions, probably around a quarter of the funds’ exposures are to assets other than the US dollar.
According to the HKMA, the overwhelming majority of HKMA’s equity and credit risks, of which there are many, also reside there. Total equity exposures disclosed in its annual report at the end of last year stood at HK$745 billion. But there is almost certainly more. Exposures to private equity and real estate joint ventures are lumped together with real estate in another category of unlisted and rather nebulous “investment funds” amounting to HKMA$443 billion, it is very difficult to know where to find.
All publicly traded bonds and stocks are contained in the Investment Fund. It is reasonable to assume, although I’m not sure and the HKMA won’t say, that all holdings are 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 figures used end-March valuations.
Apparently, the HKMA is very good in real estate and private equity investments since, contrary to almost everyone’s performance, it showed a small profit. These results should be taken with a grain of salt. As anyone involved in such valuations knows, they tend to reflect hope, modeling and heroic assumptions rather than anything approaching a price at which these assets could be sold. And things have since gotten much worse.
Call me old fashioned but a government clearly needs cash and some of the assets that have probably fallen in value further, so it’s more likely that Exchange Fund assets have fallen further – and the reasons for that put even more pressure on the ankle.
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Richard Cookson was Head of Research and Fund Manager at Rubicon Fund Management. Previously, he was Chief Investment Officer at Citi Private Bank and Head of Asset Allocation Research at HSBC.
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