Opinion: Where is Hong Kong’s perfect storm?

Published: Aug 18, 2014 12:03 a.m. ET

Pressure builds on the Hong Kong dollar’s peg to its U.S. counterpart as the territory’s financial chief warns of trouble ahead for the economy.

HONG KONG (MarketWatch) — Hong Kong has again become the darling of investors as its property market re-accelerates and the Hang Seng Index HSI, +0.67% briefly breached the 25,000 points level for the first time since May 2008. Markets appear happy to ignore clouds gathering, which the financial secretary recently described as a “Perfect Storm.”
Last Friday’s announcement that the economy surprisingly shrunk 0.1% in the second quarter might explain some of the caution. Hong Kong’s economy now appears to have decoupled from its asset markets: Even with a hugely accommodative monetary policy, the territory is hardly able to eke out any growth.
The combination of rising prices and stagnating growth raises the specter of unwelcome stagflation. The growth reversal came as property prices continued to climb, up 3% during the second quarter, which puts overall apartment prices in June 44% above the 1997 peak, according to government data.
These figures will be unwelcome, with unaffordable home prices a longstanding complaint locally. But still, we need to dig deeper to see why Financial Secretary John Tsang felt it necessary to so dramatically sound the alarm.
The worry for Hong Kong’s small, open economy is that is has been riding high on a heady mix of foreign-tourist spending and foreign-money inflows — neither of which it can control.
A decline in the former has been blamed on the economy’s setback in the last quarter. Now the fear is that capital may also reverse when the Federal Reserve raises interest rates.
The economy’s surprise contraction came as spending on luxury items such as jewelry and watches saw big drops. This has been attributed to Chinese shoppers cutting back on conspicuous spending in the wake of the deepening anti-graft campaign on the Chinese mainland. External demand has accounted for most of Hong Kong’s recent growth, and now makes up about one-third of retail sales.
If, as some expect, China’s anti-graft campaign is permanent, Hong Kong’s over-sized luxury-shopping sector may need to shrink. Government plans to build multiple new transport links with the mainland could also prove misplaced.
But these concerns will likely fade in the shadow of the government’s favorite bogeyman — capital flows leaving the territory. This was rolled out again last week by Hong Kong Monetary Authority (HKMA) chief Norman Chan, who warned that investors could get burned in the property and stock markets if “hot money” flows reverse.
But what stands out is that the present problem is the exact opposite: Too much money has been piling into Hong Kong, which has been putting the Hong Kong dollar’s USDHKD, +0.00% peg to the U.S. currency under strain as it tries to break upwards.
Since the beginning of last month, the HKMA has had to sell almost 70 billion Hong Kong dollars ($9 billion) to stop the local unit from breaching the upper end of its trading band. Under the peg to the U.S. dollar, the HKMA is obliged to intervene to keep the Hong Kong currency trading between 7.75 and 7.85 to the U.S. currency DXY, +0.11%
There are a number of explanations for these inflows.
One is the unintended consequences of President Xi Jinping’s anti-corruption campaign. It may have curbed conspicuous shopping, but it has reportedly also seen a rise in covert Chinese money looking to exit the mainland through Hong Kong. Added to this, there have been various reports that Russian funds have been stockpiled in Hong Kong, seeking to evade U.S. and European sanctions.
Another explanation is that funds are taking positions ahead of the Shanghai-Hong Kong cross-border equities trading scheme, which is expected to start this October.

A more fundamental reason could be that capital is attracted to an undervalued Hong Kong dollar under its three decades-old currency regime. This column reviewed the argument for a peg revaluation last month by hedge-fund manager Bill Ackerman. The central tenet is that as the underlying social tension and distortions from inflation get too great for the local population to bear, the government will have no choice but to let it break to the upside.
This recent data suggest we are getting closer to that point. Further, political tensions will ramp up this month as a civil disobedience Occupy Central protest is expected to start, threatening to blockade the territory’s Central Business District unless there is progress on implementing electoral reform.
Of course a revaluation of the peg risks creating an initial financial storm. It would shake-up Hong Kong’s property market and remove the currency arbitrage gains for mainland Chinese shoppers. It would also likely throw a spanner in the huge carry trade of lending by Hong Kong banks to mainland entities (estimated at over a $1 trillion), who had been betting on continued yuan USDCNY, +0.01% appreciation.
In the meantime, it looks likely fund inflows will continue to boost Hong Kong property and stock prices further. There may be a perfect storm coming for the Hong Kong dollar peg.