AS a premier Asian financial center parked at the doorstep of one of the fastest-growing economies on the planet, Hong Kong has long lived a charmed life.
The former British colony’s Western-style legal and regulatory system made it a magnet for global investors interested in buying listed Chinese stocks on the Hong Kong Stock Exchange.
Its banks, insurance companies, ports and cargo carriers have made a nice living off their powerful neighbor. An added bonus: Since 2008, low global interest rates in the post-financial crisis era have powered a property market that has kept the $300-billion economy humming.
Yet, now China’s economy is decelerating and just turned in its weakest full-year economic growth since 1990. Global investors are no longer gravitating to Hong Kong—they’re scrambling for the exits.
The Hang Seng Index has slumped 13 percent so far this year. Housing prices have fallen 8 percent from their September peak and are poised to drop as much as 30 percent this year, according to Bocom International Holdings Co. analyst Alfred Lau.
The Hong Kong dollar peg is under pressure and short-term interest rates have spiked. Exports are falling and big-spending Chinese tourists are staying away.
“Hong Kong is facing a wave of pressure,” said Kevin Lai, chief economist for Asia excluding Japan at Daiwa Capital Markets in Hong Kong, who likens the growing storm to the market gyrations of the Asian financial crisis. “The situation right now is potentially worse” than the regional turmoil in 1997 and 1998.
Lai is particularly concerned about the rapid credit expansion over the past five years, as Chinese companies rushed to borrow in Hong Kong, leaving the city’s banks “massively leveraged and exposed.” Daiwa estimates that $237 billion in broad inflows has poured into Hong Kong since 2005.
Capital flows accelerating
For Hong Kong, the worst-case scenario could play out like this: A sustained dive in the Hang Seng Index and heavy downward pressure on the local dollar triggers a massive departure of capital, squeezing liquidity in the banking system and driving up interest rates. That, in turn, sparks a speculative attack on the local dollar peg, forcing the Hong Kong Monetary Authority to defend it by spending its foreign-currency reserves. Or abandon the peg altogether.
Capital flows out of Hong Kong appear to be accelerating. The Hong Kong dollar has traded at the lower side of its trading range against the US dollar, and recently touched a seven-and-a-half year low versus the greenback. Local interest rates have also surged: The three-month Hong Kong Interbank Offered Rate (Hibor) has jumped 30 basis points to 0.697 since the end of last year, exceeding the London Interbank Offered Rate on January 20.
A sustained spike in Hibor could push mortgage rates higher, further hurting housing affordability, Morgan Stanley analysts led by Derrick Y. Kam wrote in a note. The bank said it cut its price targets for Hong Kong property stocks by an average of 17 percent.
While global investors can quickly withdraw money from this Westernized financial center, local banks and investors face a tougher time pulling their cash out of the mainland economy.
“It could take a matter of seconds for the rest of the world to draw money out from Hong Kong—but it would be a lot more difficult for Hong Kong to do the same from China,” Lai said.
If the US Federal Reserve (the Fed), which raised rates last December for the first time in almost a decade, pushes up rates again as expected later in the year, it could pull the rug out from housing prices that have surged more than 350 percent from their low in 2003. To maintain its peg with the US dollar, Hong Kong must match interest-rate hikes by the Fed, increasing borrowing costs to homeowners.
“The property market in Hong Kong is going to go down the tubes when eventually the Americans will continue to increase interest rates,” said Andrew Freris, CEO of Ecognosis Advisory, a Hong Kong-based economic and financial consultancy.
Meantime, Hong Kong developers with significant yuan-denominated cash holdings face greater currency risks from the yuan’s increasing volatility, according to Bloomberg Intelligence.
Retailers paying heavily
Hong Kong retailers are also paying heavily because of Hong Kong’s peg.
The city is losing its luster as a shopper’s paradise for mainlanders, who are instead flocking to Japan and South Korea in search of better bargains for Louis Vuitton handbags and Patek Philippe watches, thanks to those countries’ weaker currencies.
Retail sales fell 3.1 percent in the first 11 months of 2015, with jewelry, watches and clocks, especially hard hit with a 15.4-percent decline. There have been other disappointments, too. The Shanghai-Hong Kong Stock Connect, a program allowing individual investors on either side of the border to invest in each other’s stock markets hasn’t delivered the boost to Hong Kong shares its architects had envisioned.
Since its launch in November 2014, Chinese buyers have only reached the 10.5 billion yuan daily buying quota on two days, and total ownership has never reached the 250-billion yuan limit.
That said, Hong Kong does have a track record of weathering market storms, and its bourse isn’t the only one suffering losses. The MSCI Asia Pacific Index is down 10 percent this year as oil’s slide and concerns over China’s economic outlook dents shares around the world.
The city also has deep resources to respond to any attack. During the 1997-1998 Asian financial crisis, the Hong Kong Monetary Authority spent HK$120 billion buying up Hong Kong stocks, and successfully defending the dollar against speculators.
In 2003 after the severe acute respiratory syndrome virus epidemic leveled the economy, Beijing created a free-trade deal with Hong Kong through the Closer Economic Partnership Agreement that gave its businesses a leg up over rivals in China. Easing of travel restrictions unleashed a flood of Chinese visitors and buoyed retail sales.
Hong Kong’s $358.8 billion in foreign exchange reserves as of the end of December and a budget surplus give local authorities room to maneuver. “The speculators right now want to make Hong Kong just like 1998,” said Banny Lam, cohead of research at the Agricultural Bank of China International Securities Ltd. in Hong Kong.
Lam reckons that a key difference between now and the Asian financial crisis is that the system is flush with interbank liquidity, which means the speculators will be proven wrong.
Yet, even if Hong Kong can pull through the current market turmoil, it faces bigger challenges ahead. David Dodwell, executive director of the Hong Kong Asia-Pacific Economic Cooperation Trade Policy Group, says that going forward the city has to move beyond its position as the gateway to China by having its banks and professional services help Chinese companies establish their global operations using the city as their base.
“For me, the litmus test is the flow of headquarters to Hong Kong,” Dodwell said.
