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Hong Kong In-Depth Research Report Series -Timing When Speculating On De-Pegging And Other Trading Opportunities

Hong Kong In-Depth Research Report Series

-Timing when Speculating on De-pegging and Other Trading Opportunities

Those whom the gods wish to destroy, they first make mad.

-Euripides

Lincoln Li

Email: Lincoln.Li@Selerityinc.com

Mobile: 518-203-8247

Executive Summary:

This is the second in-depth report which discusses the possibility that the Kong Kong Dollar (HKD) will cease to be determined by the currency board system.[1] In the previous report, the author discussed the unsustainability of pegging the HKD to the USD when the Chinese economy is deteriorating and the Fed is increasing interest rates. The first report proposed a de-pegging in the near future in order to mitigate costs while the HKD is still strong in view of capital inflows from the mainland. Such a decision could lead to a win-win situation for both the Hong Kong (NYSE:HK) government and investors. However, governments frequently lack the capacity to choose the best options. Therefore, the HK government is likely to maintain the current system, even at a high social and economic cost, in the expectation that the environment will change and relieve it from pressure. This could happen, for example, if the Chinese economy rebounded.

Considering that the HK government owns huge amounts of foreign reserves, it is not easy for investors to pick the best time to speculate on a de-pegging of the HKD. An HKD crisis might come about following a collapse of the housing bubble in mainland China. This report covers several methods which can be adopted to gauge the risks associated with a de-pegging of the HKD and a collapse of Chinese housing bubble. It is believed that the crisis will eventually come, whether the HKD is de-pegged or not, and there will be huge trading/arbitrage opportunities. In this regard, careful research and review of the HK government's massive intervention during 1997 is insightful. At the same time, identifying the impact of a de-pegging on Hong Kong's local companies and determining the most vulnerable parts of the system can increase investors' chances of success. The recent development of the Hong Kong bond market might provide a good goal.

Speculation Timing

Choosing the best timing is the most critical aspect of short sellers' behavior when speculating on a HKD de-pegging, especially considering the HK government owns huge amounts of foreign reserves and has the capacity to generate support from the Chinese central government. A fundamental practice is to check Hong Kong's trade environment. There are two methods: the first one is to use residency-based Balance of Payments (BOP) data and the second method is to use currency-based BOP data. However, each method has its own shortcomings due to the special status of Hong Kong as an international financial center.[2]

An alternative solution is to assess the credibility of the Hong Kong currency peg through comparing interest rates differences between HK and the U.S. Fung and Yu applied a Bayesian framework to the Svensson test.[3] Rather than simply addressing whether the Convertibility Zone is either fully credible or non-credible, the Bayesian approach provides time-varying estimates about the evolution of the degree of credibility of the Convertibility Zone at each point in time.[4] Their work results shows as follows.

In 2015, the Swiss National Bank (SNB) had claimed "with utmost determination" that it would buy foreign currency "in unlimited quantities"[5] and broke its promises. HKMA's research into the event is worth paying special attention to as the Institute made a similar promise. Hui, Lo and Fong studied the dynamics of the Swiss Franc and used market data to calculate the drift term and stochastic process. Their research is based on the assumption that the speed of the mean-reverting drift is estimated as a function of increasing foreign reserves. Through research on the drift strength, when the Swiss Franc was at its strong point, their result shows the condition for breaching the limit was met in November 2014, about two months before the SNB abandoned the limit.[6] A similar process might also be suitable in studying the HKD.

Monitoring HK fundamentals is important, however, investors have to consider the 'honeymoon effect' and the Krugman-type target-zone models which suggest that the exchange rate function will appear to be less sensitive to changes in fundamentals than the corresponding free-floating exchange rate. The effect of fundamentals on the exchange rate decreases when the exchange rate deviates from its central parity.[7]

However, as the first in-depth report suggested, the HKD is heavily reliant on China's economy. During January 2016, the huge movement in the HKD has little to do with fundamentals in Hong Kong but it correlates with changes in the mainland. The Chinese housing bubble is regarded as the Sword of Damocles to the Chinese economy and a collapse of the Chinese housing bubble might destroy investors' confidence in the HKD. Therefore, gauging and estimating the timing of the collapse of the Chinese housing bubble might be more important.

In measuring the Chinese housing situation, the price of housing is an important parameter. However, the Chinese official data is well-known for its poor quality, and especially the high-profile housing price data. In order to solve this issue, Deng, Girardin, and Joyeux in their research papers offered a creative way to measure housing prices using highly frequent transaction data.[8]

After solving the price data issue, investors need to model the dynamics of Chinese housing development. However, the increase in Chinese housing prices has come about in conjunction with fast economic development and there are disputes about whether China's rapidly increasing housing prices indicate a bubble. Yang and Gete conducted research which suggested that productivity, savings gluts, and tax policies, are the key drivers. They pointed out that productivity and land shocks affect housing quantities more than prices, while tax policies and savings glut shocks affect house prices more than quantities of houses available for sale. However, when the sample focus is closer to 2014, housing preferences and credit shocks become increasingly important in explaining house prices and volume, while population shocks explain a larger share of the dynamics of residential investment. During 2016, the credit shock might have played an even greater role, especially considering that residential mortgages became a major driver of Chinese new credit and accounted for 70% of new monthly loans by August 2016. [9] As credit evolved into the dominant role, the high profile Asian hedge fund managers Beilesi, which has just funded its own fund, Lingfeng Capital, leveraged the Log-Periodic Power Law (LPPL) model[10] to predict the timing of the collapse of the housing bubble based on the assumption that in order to maintain such a Ponzi scheme credit has to match the power law.[11]

(China M2 Growth Rate diverged from the Power Law)

Target Choosing

When the de-pegging risk is measured by a market consensus, investors face choices when determining what to do next. Assessing the de-pegging impact on local firms and identifying the most vulnerable parts of the system are thus critical.

Previous financial crises in Hong Kong have usually related to housing bubbles and banks' unrestricted lending.[12] When de-pegging risks emerge, banks are highly likely to become the first choice for short sellers. However, the recent control of Loan-to Value measures has reduced the exposure of banks in the real estate sector[13] and there is a possibility that the Hong Kong government will depart from its Laisser faire policy and directly support banks, considering that non-interventionism in Hong Kong has never been a matter of economic conviction but primarily a question of political convenience.[14]

The recent development of Hong Kong's bond market might provide better goals. Banks used to be the dominant financial intermediaries in Hong Kong, however, the growth of the corporate bond market has accelerated considerably. After the 2008 financial crisis, outstanding corporate bonds posted a significantly faster growth rate of 17% per annum on average, far outpacing economic growth. It is appropriate to recall the quote on the front of this report: "Those whom the gods wish to destroy, they first make mad". BIS has already shown its concerns over such fast development of Hong Kong's bond market.[15] The bank pointed out that bond issuers are less confined to corporates with top credit ratings and corporations with lower credit ratings are now able to gain access to the bond market. Also as the pricing of corporate bonds are usually based on major government bond yields (notably the US Treasury yields), the increased use of bond financing could make corporate borrowing costs more sensitive to global monetary and financial conditions. There are also huge mismatches of currency due to the low cost of issuing USD denominated bonds instead of HKD denominated bonds. As of the end of 2014, the outstanding amount of corporate bonds in Hong Kong stood at US$101.8 billion, of which 14%, 65% and 22% were denominated in HKD, USD and other currencies respectively.[16] When the crisis emerges, these low credit companies with large outstanding USD denominated bonds are expected to be hit hard as de-pegging will not only hit their balance sheets but also worsen their financing situations due to their inverted capital structures.[17] Also compared with the U.S. bond market, the Hong Kong bond market is narrow and the spreads quoted are quite wide which also facilitates an attack by short sellers.[18]

The development of the bond market is also limited by the government's capacity to support the HKD as corporate bond issuers might be unable to tolerate swings in short-term rates. A similar case occurred back in the early-1990's with the British Pound when the credibility of the commitment of the Bank of England to support sterling was limited due to the fact that 90% of home mortgage loans were issued at floating interest rates rather than fixed interest rates.[19] On the other hand, the Swedish central bank raised the interest rate to 75 percent (annualized) and limited the incentive to borrow weak currencies for speculative purposes and successfully rebuffed George Soros.[20]

As the Hong Kong government is highly likely to choose to support the current system, investors need to be alert to the government's intervention and the ensuing trading opportunities. In this regard, a case study can be insightful. During the 1997 Asian financial crisis, the Hong Kong government spent hundreds of billions of HKD in supporting the market. Although no details have been revealed, Goodhat reviewed the government's strategy based on an intensive study of market data and reports.[21] His research showed that short sellers were highly leveraged and if speculators could push down the stock index by 1000 points within 100 days, the cost would be HKD 400 million and the net profit would be HKD 3.6 billion. In order to foil the speculators' double-down strategy, the Hong Kong government conducted a counter double-play strategy, not only in the Hong Kong market but also in the London market as many Hong Kong stocks are listed on both stock exchanges under different currencies. The fierce confrontation between the two sides created huge arbitrage opportunities. For example, during the two days before the August index futures expired, the prices of the London GBP trading with HSBC dropped considerably while the London HKD trading with HSBC and the HKD trading with HSBC remained much higher.[22] When similar scenarios emerged, investors who carefully studied reviews of previous interventions and used their discretion in judging the circumstances were the most likely to grasp trading opportunities, especially considering that when under extreme stances, many algorithim arbitrage trading strategies had to turn down due to huge de-pegging risks.

Conclusion:

Timing is critical for speculating on a de-pegging of the HKD. This report has provided several methods for gauging the risks of a de-pegging of the HKD and a collapse of the Chinese housing bubble. As far as choosing a target is concerned, this report indicates that other than short banks and real estate companies, low credibility companies which have issued large amounts of USD denominated bonds might be better targets. Careful study of the Hong Kong government's intervention in the stock market in 1997 is also insightful due to the huge number of arbitrage opportunities at that time.


[1]. The first in-depth report on HKD can be accessed at sgi.seleritycorp.com/special-report-hong.../

[2]. The Nexus Of Official And Illicit Capital Flows -The Case Of Hong Kong, Yin-Wong Cheung, Kenneth K. Chow and Matthew S. Yiu, HKIMR Working Paper No.25/2015

[3].Assessing the Credibility of The Convertibility Zone of The Hong Kong Dollar, Laurence Fung and Ip-wing Yu, HKMA Working Paper 19 /2007

[4]. Ibid.

[5].See the press release "Swiss National Bank sets minimum exchange rate at CHF 1.20 per euro" by the SNB on 6 September 2011 http://www.snb.ch/en/mmr/reference/pre_20110906/source/pre_20110906.en.pdf.

[6]. A Quasi-Bounded Model for Swiss Franc's One-Sided Target Zone During 2011-2015, C. H. Hui, C. F. Lo and T. Fong, HKIMR Working Paper No.15/2015

[7]. Ibid.

[8]. Fundamentals and the Volatility of Real Estate Prices in China: A Sequential Modelling Strategy, Yongheng Deng, Eric Girardin, Roselyne Joyeux, November 2015

[9]. China's Credit Fire Hose Floods Housing Market, WSJ, www.wsj.com/articles/chinas-credit-fire-...

[10]. The bubble is Ripe, Beilesi, barrons.blog.caixin.com/archives/24765

[11]. Mr. Bei is using M2 data in his public article, however in China, the social financing data might be more insightful data and it's very likely Mr.Bei adopted such data in his trading model. Selerity has conducted an in-depth report on China's social financing data and full report can be access at sgi.seleritycorp.com/special-report-shad.../

[12]. Profits, Politics, and Panics: Hong Kong's Banks and the Making of a Miracle Economy, 1935-1985, Leo F. Goodstadt, Hong Kong University Press, pp 163-181

[13]. How Does Loan-To-Value Policy Strengthen Banks' Resilience to Property Price Shocks - Evidence from Hong Kong, Eric Wong, Andrew Tsang and Steven Kong, HKIMR Working Paper No.03/2014

[14]. The Global Crisis: Why Laisser-faire Hong Kong Prefers Regulation, Leo F. Goodstadt, HKIMR Working Paper No.01/2010

[15]. The rise of Hong Kong's corporate bond market: drivers and implications, David Leung, Ceara Hui, Tom Fong, BIS Papers No 83

[16]. Ibid.

[17]. The Volatility Machine: Emerging Economics and the Threat of Financial Collapse, Michael Pettis, Oxford University Press, pp 132

[18]. What Futures for The Hong Kong Dollar Corporate Bond Market? Tony Latter, HKIMR Working Paper No.19/2008

[19]. Financial Markets and European Monetary Cooperation: The Lessons of the 1992-93 Exchange Rate Mechanism Crisis, Corsetti, Giancarlo; Pesenti, Paolo A.; Buiter, Willem H., Cambridge University Press, pp 57-58

[20]. Ibid.

[21]. Intervention to Save Hong Kong: Counter-Speculation in Financial Markets, Charles Goodhart and Dai Lu, Oxford University Press, 2003, pp 39-96

[22]. Ibid.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.