Chris Burford wrote:
> I will comment on Michael and Henry's more substantial questions tomorrow.
> But briefly the following seems relevant.
> To remind us that not all the world is today celebrating the 1992nd
> birthday of baby Jesus, the Christmas Day edition of Asiaweek is helping us
> to keep in touch with those healthy capitalist emotions, envy and
> schadenfreude, in a web page devoted to
> "If Only I Bought"
> >Had you bought Hong Kong's Hang Seng index Aug. 13, when it closed at
> 6,660 points, you would be one happy camper today. The Hang Seng is up some
> 55% since Aug. 13, the first day the SAR used its reserves to buy blue
> chips. (The government says currency speculators were
> attacking the Hong Kong dollar, which was pegged to the greenback, to bring
> down the stock market, in which the speculators had bought short positions.)
The following is an excerpt from a speech by the Chief Executive of the Hong Kong Monetary Authority (HKMA), Mr Joseph Yam, on November 23, 1998 at "Inside Asia Lecture 1998" organised by The Australian in Sydney. It provided the official account and justification of the government "incursion" into the HK stock market.
"But free market principles cannot mean markets that are left defenceless against manipulation. One troubling aspect of the Asian crisis, and a sign of larger problems in the world financial system, has been the extreme volatility in markets created by the rapid flows of highly leveraged funds around the world. As markets in the region became more vulnerable, these flows increasingly took on a predatory character and became more and more subtle in their planning and sophistication. This August, as you know, the Hong Kong financial markets became the target of a well planned attack by international hedge funds. We took unconventional actions to fend off that attack and to fortify our financial system against future attacks. Not unexpectedly, these actions have been the cause of extensive controversy, and of a great deal of misunderstanding. Let me attempt to present the issue from Hong Kong's perspective by outlining what happened in August and explaining why we took action.
Oddly enough, Hong Kong became a target because of the transparency of its financial system: we were singled out for our efficiency and predictability rather than for any fundamental flaws. Under our rule-based currency board system, any change in the Hong Kong dollar monetary base must be strictly matched, at the linked exchange rate, by a corresponding change in the amount of foreign reserves held by the currency board. This is an autopilot mechanism, in which we in the HKMA have minimal discretion: the currency board simply acts passively in response to capital flows. Under the autopilot mechanism, an expansion of the monetary base causes interest rates to fall; a contraction causes them to rise. The crucial element in the monetary base influencing the rise and fall of interest rates is the aggregate balance that banks maintain in their clearing accounts held with the currency board. Notwithstanding the enormous volume of transactions that goes through our banks, the aggregate balance is minimal, because our financial infrastructure is so efficient. We have a real-time interbank payment system and no reserve requirements, so that banks in Hong Kong do not need to maintain large balances in their clearing accounts with the currency board: in August the aggregate balance was as low as HK$2 billion. This meant that the aggregate balance, and hence interbank interest rates, was highly sensitive to speculative attack.
We saw a series of such attacks over the past year, when various currency speculators took large short positions against the Hong Kong dollar with the aim of destabilising the linked exchange rate. On all these occasions the attacks drove up the interbank interest rates to very high levels. To the extent that the speculators had to borrow in the interbank market to fund their short Hong Kong dollar positions, the interbank interest rates were high enough to force the currency speculators to abandon the attacks, unwind their short positions, and incur substantial losses. The finely tuned currency board system worked well, but the interest rate volatility was extreme: during one attack, on October 23, 1997, the overnight interest rate shot up to nearly 300%. The stock market took a nosedive, and the HKMA was sharply criticised for relying on this single tool, the interest rate, to defend the Hong Kong dollar.
In August the speculators adopted a more sophisticated ploy. They introduced a form of double play aimed at playing off the currency board system against the stock and futures markets. First, to avoid being squeezed by high interest rates, they prefunded themselves in Hong Kong dollars in the debt market, swapping US dollars for Hong Kong dollars with multilateral institutions that have raised Hong Kong dollars through the issue of debt. At the same time, they accumulated large short positions in the stock index futures market. They then sought to engineer extreme conditions in the money market by dumping huge amounts of Hong Kong dollars. This sell-off was intended to cause a sharp interest rate hike, which in turn would have sent the stock market plummeting. The collapse of the stock market would have enabled them to reap a handsome profit from the futures contracts they had taken out.
A few figures will help give some idea of the scale of this attack and the vulnerability of Hong Kong's markets at the time. We estimate that the hedge funds involved had amassed in excess of HK$30 billion in currency borrowings, at an interest cost of around HK$4 million a day. They also held an estimated 80,000 short contracts, which translated into the following calculation: for every fall of 1,000 points in the Hang Seng index they stood to make a profit of HK$4 billion. If they could have engineered that fall within 1,000 days they would have broken even. If they could have achieved it within 100 days they would have netted HK$3.6 billion. All they had to do was to wait for the best moment to dump their Hong Kong dollars, to drive up interest rates and send a shock wave through the stock market. August was an opportune time: turnover in the stock market had shrunk to about a third of its normal level; there was bad news as the Government announced that first-quarter GDP growth had been negative; and rumours were flying around predicting the devaluation of the Renminbi and the severing of the link between the Hong Kong dollar and the US dollar.
We acted swiftly to defeat the manipulators at their own game with a series of measures that threw them off their guard, drove them out of the market, and raised the defences against future attacks. First, drawing on the official reserves, we went into the stock and futures markets. In the second half of August we accumulated US$15 billion worth of shares: I am happy to say they are now worth US$19 billion, but our aim was not to make money; it was simply to deter manipulation by making sure that it did not pay off. That objective was achieved. The manipulators were forced to close out their short positions, in many cases with heavy losses. And we followed through with a package of technical measures to strengthen our currency board arrangement to make our money market less susceptible to manipulation. These measures are working well. Further reforms are being introduced in the securities and futures markets to reduce the possibility of market dislocation.
Our actions served their purpose of deterring market manipulation. We could not passively sit through the speculative attack and see our markets overshoot to produce profits for the manipulators, and our entire financial system brought to the brink of collapse. We do not pretend that our intervention in the markets was not a controversial act. This was not a decision that we enjoyed taking. It involved many risks, not least among them the risk of being misunderstood. Our critics, both at home and abroad, have accused us of intervening with the aim simply of propping up the stock market; of being too afraid to face the pain from the necessary interest rate volatility under a strict currency board system operating in difficult conditions; even of trying to introduce a novel form of state ownership by acquiring a substantial interest in Hong Kong's major corporations. The essence of these charges is that what we did in August marked the end of our long-standing and hugely successful philosophy of non-intervention in the markets."
The HKMA chief goes on to say:
"Currency devaluation is not the only means to achieve economic adjustment, and the argument that Hong Kong is losing out by maintaining the link makes little sense for such an externally oriented economy. Hong Kong is achieving its adjustment through other variables. Asset prices and the cost of production, particularly in the form of land and rentals, have come down very sharply. Wages are easing. Manufacturers and service providers are increasingly able to lower their costs while at the same time seeking improvements in productivity."
In other word, price correction is a deliberate government policy for the sake of defending the peg. Anyone who invest HK assets under these conditions of expressed official warning is playing with fire, except speculators or manipulators.
For the future, the HKMA has this to say:
"For Hong Kong, the challenge is to see through the economic adjustment that is now in train, to continue to promote our competitiveness, and to plan for economic recovery. There is no denial that this is a painful process. Nor can there be any pretence that the current downturn will be over quickly, whatever the positive signs in the markets over the past few weeks."
If this is not a signal to sell, I don't konw what is. Only day traders should stay in.
While the technical success was impressive, though not as impressive as if the HKMA had prepared the HK Futures Exchange to diligently and strictly enforce the new settlement rule of T+2 (within 2 days after the trade to deliver the short shares), instead of the lenient T+2 or 4, thus allowing the overseas short sellers time to borrow share rather than having to buy from a risen market at a loss. There are a nest of problems associated with this "incursion". The need for the "incursion" which required US$20 billion in 2 trading days at the end of August, 1998, was self created by the government's insistence of maintaining the currency peg, thus opening HK's financial structure to attacks on its inherent inconsistency. It is like handcuffing oneself to the kitchen stove because it will reduce one's risk of being run over by a truck. The penalties exceed the benefits. At any rate, the factor that really made the "incursion" successful was the Russia default. It created a panic among hedge funds which quickly left HK to deal with more serious problems. How many times can HK expect to be that lucky?
As for the 55% profit if an investor had bought on August 13. the risk was substantial, because no one expected the HK government to cut off its nonintervention in the market after its repeated claim of being committed to non-intervention in the free market. And no one expected Washington would let Russia default. Besides, the market was no longer "free" after October, 1997. By August 1998, credit was generally unavailable to small investors for speculation in the HK stock market. The only significant players were hedge funds like Robertson's Tiger Fund or Sorors' Quantum Funds or Merriweather's LCTM who already pre-arranged crony financing. The 55% paper profit is useless for the normal investor, because in order to cash out in substantial amounts, the very sell off will bring the market back down, and long term holding is still highly risky. With the DJIA moving 200 points almost daily, day traders in Manhattan who play in their lunch hours while holding a low paying job can generate better returns with less risk. That is finance capitalism: the big fish plays a riskless game at great profit, the smart little fishes eat the left over at great risk, the rest of the population pay the bill. As the saying goes: to make $4 billion out of $20 billion is inevitable; to make $4 out of $20, that is hard work.
> >Property was clearly not the place to be in. The choicest homes in most
> cities saw a drastic drop in values - if they could find buyers at all.
> According to Jones Lang Wootton Research, your $100,000 invested in a prime
> Hong Kong residential property in January is now just a piddling $43,400.
This has led the HK government to suspend further land leases until March 1999 to help pop up the property market. This is a serious situation because the banking system is threatened with heavy non performing mortgages. It soes not take a rocket scientist to figure out if all of the mortgage carry a 70/30 loan to equity ratio, a drop of market value of 57% will put the property under water, leaving a bank with a loss at foreclosure. Of course, the currency peg requires high interest rates which reduces property value and increase payment defaults, which in turn reduce market value, etc - a classic downward spiral.
Henry C.K. Liu
> Chris Burford