The precarious situation of the Hong Kong/U.S. dollar peg has come to light after Kyle Bass, managing partner at Hayman Capital Management, went public with what he believes to be an asymmetric trade based on the high likelihood that the HKD breaks its peg with the USD. This article examines the facts presented by Bass, counterpoints to his thesis, and how to trade around the idea.
I do not hold Bass’ conviction that the peg is destined to break as the United States’ exported tightening credit on over-leveraged Hong Kong markets, a theme that will be explained later, has paused. However, a HIBOR (Hong Kong Interbank Offered Rate) and LIBOR (London Interbank Offered Rate) spread of 80 bps has led to massive conversions from the lower yielding HKD to the higher yielding USD. In light of this, the Hong Kong Monetary Authority (HKMA) is running out of reserves to defend the peg, increasing the likelihood of a break. With a massive risk-reward ratio, I believe that this trade is worth putting on.
The Second Order Effects of the HKD-USD Peg
In order to sustain its peg, Hong Kong must keep the same monetary policy as its anchor. If interest rates meaningfully diverge between the two countries, investors will convert to the currency with the higher yield. If investors all convert from HKD to USD (as many are doing now), the HKMA will have to sell its dollar reserves and purchase more of its own currency in order to sustain its peg of 7.75-7.85:1 (HKD:USD).
Importing nearly a decade of near-zero interest rates have stabilized the peg, but led to massive inefficiencies in the Hong Kong economy. For one, it has the most expensive real estate in the world. Benefiting from ultra-low rates and rapid Chinese credit growth, wealthy Chinese have pushed real estate costs to $10,000 per square foot. For reference, property in San Francisco sells for $4,400 per square foot. Mortgage loans are also floating and indexed to 1-month HIBOR. Therefore, the interbank lending rate cannot rise and close the 80 bps gap without crashing the property market. In fact, a 12.5 bps move higher in HIBOR in 2016 led to a 7% drop in real estate prices as seen below.
(Source: "The Quiet Panic." Kyle Bass' investor letter)
Hong Kong was essentially an emerging market with recession-level interest rates. In order to take advantage of this, the private sector levered indiscriminately. Private sector credit to GDP is at 300%. The Hong Kong banking system is levered to 850% of GDP, with 280% lent to Chinese property investors.
Then, and perhaps most importantly, we have the HIBOR-LIBOR spread dilemma. HIBOR should remain higher than LIBOR in the midst of capital flight from HKD. This would lead to more conversions from USD to HKD and bring the exchange rate to equilibrium of roughly 7.80 as the chart below suggests. However, the exchange rate is pushing the upper bound and HIBOR yields remain low because Hong Kong is awash with liquidity due to Chinese credit expansion. In what’s known as the liquidity effect, a higher monetary base means there is plenty of money in existence to lend, pushing lending rates lower.
(Source: JPMorgan Global Fixed Income Blog)
Between a Rock and a Hard Place
Conversion from HKD to USD continues due to this arbitrage opportunity and due to Hong Kong’s proposed extradition laws that have wealthy families and Chinese dissidents fleeing the country. With these conversions, the HKMA has purchased a total of $11.586 bn (HKD) to defend the peg, the fourth intervention in the past year. In total, the HKMA has spent 80% of its reserves defending the peg and the HIBOR/LIBOR gap continues to exist, currently at 72 bps.
If the bleeding does not stop, Hong Kong will run out of reserves to defend its peg in less than a year. If this occurs, Hong Kong has two options: 1) Hike rates to prevent capital flight, thereby crashing its overleveraged banking and real estate sectors. 2) Unpeg from the USD, thereby crashing the value of the HKD.
I derive most of these points from Louis Vincent-Gave, founder and CEO of Gavekal Research. Louis argues that, for one, the expensive Hong Kong property market is rational given that the tax rate is half that of mainland China (drawing many wealthy Chinese) and no alternatives exist near Hong Kong that provide access to the financial center. For these reasons, property will always be expensive in Hong Kong and concerns about valuations are overdone.
Additionally, using the 1997 Asian currency crisis as a guide, many see a recession as a necessary precondition for the currency to unravel. With anchor U.S. rates no longer rising, the catalyst for said recession seems less likely. Additionally, while Hong Kong banks are enormously levered, they rely mostly on direct deposits to pay liabilities, giving them a reliable and steady source of income. Lastly, Hong Kong has had a budget surplus of 1-2% GDP since 2003 which it can use to defend the currency if need be.
While Kyle Bass foresaw the 2008 Global Financial Crisis, he also predicted ruin for Japan due to its unconventional monetary policy and China due to its unprecedented credit expansion. If the peg break did not happen, this would not be the first Bass has cried wolf.
What to do
Taking both perspectives into account, shorting the HKD is an asymmetric trade from a risk/reward perspective. The HIBOR/LIBOR spread is still wide and Hong Kong is on the verge of running out of reserves. With a lower bound of 7.75 and an upper bound of 7.85 as seen below, speculating on the break of the currency peg offers a downside risk of 1.27% and an upside reward of roughly 50% if using the Thai Baht crisis as a guide.
(Source: "The Quiet Panic")
A possible pairs trade if one believes the global economy will recover and the HIBOR/LIBOR gap will close involves being long Hong Kong banks while shorting the currency to hedge against losses. In scenario a) the global economy recovers and the banks are proven strong, providing months or years of capital gains and a 1.2% maximum loss on the currency. In scenario b) Hong Kong goes to hell in a hand basket but a tight stop loss on Hong Kong banks will limit downside risk and an unpegged currency leads to 50% profit.
While understanding that Hong Kong is the financial hub of Asia, I would personally not invest in banks levered to 850% of GDP. As long as the HKMA continues to run out of reserves due to the HKD/USD carry trade, I believe speculating on the break is worth investigating due to the asymmetric risk/reward ratio.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.