Destructive Ambiguity
15 October 2003
Twenty years ago today, and before our time here, Hong Kong was a very different place. A 99-year lease on the "New Territories" which comprise the majority of Hong Kong's land area was in fact not new at all, but set to expire on 30-Jun-97, and Britain and China were deep in negotiations about the future, which as we now know, resulted in a smooth handover of the whole colony. But back then, the financial markets were in turmoil, China was a much more backward place and nobody much fancied the idea of being ruled by men in Mao suits.
In a Saturday press conference, the Government announced that the Hong Kong dollar would be pegged at the rate of 7.8 to the US dollar, and this took effect the following Monday morning, 17-Oct-83. Since then, despite numerous shocks to the global financial system, the rate has stayed close to the peg, reaching a low (for the HK$) of 7.90 on 7-Jul-84.
A dark day in a free market
However, the darkest day came on 14-Aug-98, when the Hong Kong Monetary Authority (HKMA), the Government's quasi-central bank, waded into the stock market and began buying up the 33 stocks in the Hang Seng Index, purportedly to defend the peg. The Hang Seng Index had closed at a multi-year low of 6,660.42 the previous day - and the Government perhaps saw the sign of the devil in the details when others were just sensing a buying opportunity coming along. In Hong Kong, the Government believes in free markets, except when the market goes against them. It's a bit like believing in elections provided you know who will win.
Over the following two weeks, ending in a blitz on 28-Aug-98 (the day of that month's futures contract expiry), the Government spent some HK$118bn (US$15bn) buying about 15% of the free float of the index members, and driving the index up 17.6% (it fell 7.1% the day after they stopped). The purported targets of this were hedge funds who had been shorting the Hong Kong dollar, to push up local interest rates, hoping that the stress on the market would help drive down the index, where they had also sold index futures. HKMA Chief Joseph Yam said he was going to "hit them where it hurts", earning himself a short-term action-man nickname of "Yambo".
All this happened just a couple of months before we established Webb-site.com, but you can read our coverage of this and editor David Webb's letters to the newspapers in our archive under Market Intervention. We were then, and remain, opposed to government intervention in markets, and believe there was no justification for it. In the aftermath, the Government claimed sovereign immunity from its own laws on disclosures of shareholdings and market manipulation as well as from disclosure obligations under the non-statutory Takeover Code. It has recently reiterated that immunity in relation to the MTRC.
Following the summer, the HKMA realised that there was a flaw in the peg mechanism which allowed short-term interest rates to be spiked excessively, at which point, rather than attracting capital to the higher interest rate, the effect is to drive it away by the fear of a break in the peg. A 100% interest rate only earns you 1.9% in a week, but if you think there is a 20% chance of a 20% devaluation in the next week, then you will expect to lose 4% if you stay in the local currency, which is more than double the interest, so you will still head for safety and convert your currency, thereby exacerbating the shortage of local currency. You might think this was obvious, but in the first 15 years of the peg, it wasn't obvious to the authorities.
So the HKMA took their night-caps off and put their thinking caps on, and realised that they should never have allowed rates to be squeezed in this way. On 5-Sep-98 they introduced the so-called "seven technical measures" to modify the currency board, and effectively converted the HKMA into a central bank. A full discount window was introduced to which Government bills and notes from certain other issuers could be presented as security for short-term HK$ funds, greatly expanding the monetary base. If this had been done earlier, the intervention might never have happened. It now takes enormous amounts of short positions to have any major upward effect on rates.
Peg still flawed
But a flaw remains, and the HKMA is currently dancing around the problem. The convertibility undertaking they have given to convert HK$ into US$ at 7.8 to 1 is one-sided (protecting the HK$ on the down-side by guaranteeing a conversion into US$ at 7.80), when it should be symmetric. After recent pressure on Asian countries (particularly mainland China) to revalue their currencies upwards against the US dollar, and with a booming stock market, there has actually been excess demand for HK$, and rather than meet that at 7.80, the HKMA has allowed the rate to slip to as low as $7.70.
Initially, Mr Yam reverted to his 1998 Yambo persona, aided and abetted by hereditary textiles tycoon and new Financial Secretary Henry Tang, and took some glee in claiming that those who had been shorting the HK$ were now in pain. "The speculators have suffered big losses...I don't sympathise with them" said Tang on 24-Sep-03. On 2-Oct-03 this was followed by Yam's comment in his web column:
"there is no harm to have a bit of constructive ambiguity, if only for the purpose of making those shorting the Hong Kong dollar realise that this is not so much of a one-side bet. We are in the business of ensuring exchange rate stability, not bailing out currency speculators."
One cannot help thinking that beneath the surface of this administrator lies a man who, despite all claims to the contrary, yearns for a floating exchange rate which would make his role as the manager of our foreign currency reserves so much more exciting. And so much more dangerous for Hong Kong.
His latest utterance was:
"we will not actually tolerate any deviation which is big enough that it would undermine credibility and confidence in the system".
Think about that. It implies that he believes some deviation does not undermine credibility. We disagree - the moment you start to have a "managed float" with a range of allowed deviation, then you encourage people to test the boundaries. You are in fact inviting speculation by introducing uncertainty, and you are playing with fire, Mr Yam. If there really are speculators out there who have been short HK$, then the rational thing for them to do now is to short some more, in the knowledge that sooner or later you will have to return to the peg rate, and maybe even overshoot the other way. Those with capital to spare will simply double their bets.
But the whole point of the peg in 1983 was to reduce uncertainty, not to increase it. The stated goal of deterring speculation is directly contradicted by the policy of introducing uncertainty into the rate. Ambiguity is not constructive, Mr Yam, it is destructive to stability.
If there was a rigid 2-way convertibility, then speculators would not be attracted in the first place, and interest-rate arbitrage would ensure that the money supply remains in balance with the demand; whenever there were too many HK$ in circulation, the lower interest rate would attract conversion to US$, and when there was more demand for HK$, higher interest rates would attract inflows. That is how a true peg should work, but it is muddied when you start allowing a band of flotation, and the interest rate arbitrage system for attracting and repelling capital flows collapses. Take a leaf out of the Bank of England playbook, where many of your deputies have come from - it was the flexible range of the Exchange Rate Mechanism that was its downfall when the pound bust its 6% boundaries in 1992. There was nothing constructive about that.
If this Government truly believes in a peg system, then it should hold the rate rigidly fixed at HK$7.80, and guarantee to convert both ways. That would prevent any movement beyond transaction costs, because anyone who could buy US$ at HK$7.79 could turn around and get HK$7.80 from the HKMA. That would be a true peg, not the "managed float" we are now witnessing.
Meanwhile, as the Government is running a fiscal deficit, it has to dig into its reserves, most of which are held in foreign currency assets, so that means that as long as the rate remains out at HK$7.74, the Government is losing about 0.77% on each conversion as it sells US$ to buy HK$ to pay its bloated civil service, not to mention Mr Yam's HK$9m salary - whoops, we did. Perhaps he'll take US$ pay instead, and save us the conversion.
According to Mr Yam's column, the HKMA has sold about US$8bn in the open market in the last 12 months to fund the deficit. That's an average of US$667m per month, and at a difference of HK$0.06 from the peg rate, it is now costing the taxpayers an extra HK$40m per month to fund it.
How to profit
The Government cannot afford for the peg to break upwards, because this would result in further deflation of prices, first in imported goods that fill our stores, and then in property rents and values, just at a time when the authorities have been trying to shore up the property market to head off looming problems with mortgages which have so far been contained. Longer term, it can't afford the volatility that a floating exchange rate would cause either.
So finally, here's how you can make a little money. If you hold HK$ and have no plans for it in the next few months, then consider doing what we did, and switch into US$ at around the current HK$7.74 level or better. You'll get a better interest rate on short-term time deposits in US$ than HK$ (shop around, the difference is about 0.5% per annum) and you'll make 0.78% (less transaction costs) when the rate goes back to HK$7.80.
© Webb-site.com, 2003
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