Commentary on Political Economy

Thursday 25 April 2019

China and Hong Kong A Time-Bomb

Kyle Bass, the often-bearish hedge-fund manager who won big during the global financial crisis, has trained his sights anew on the Hong Kong dollar.
Mr. Bass’s Dallas-based Hayman Capital Management LP published its first investor letter in three years this week, titled “The Quiet Panic in Hong Kong.” Mr. Bass gained publicity a decade ago for his bearish bets against securities tied to the U.S. housing market.
The investor letter, which was viewed by The Wall Street Journal, argues that a combination of rapid growth in floating-rate mortgages, the gap between local and U.S. short-term interest rates, and mounting geopolitical tensions between the U.S. and China put Hong Kong’s currency arrangement at risk of breaking.
“Hong Kong currently sits atop one of the largest financial time bombs in history,” Mr. Bass said in the letter. He said the size and leverage of the city’s banking system made it similar to Iceland, Cyprus and Ireland before their financial crises.
The Hong Kong dollar operates under one of the longest-standing currency pegs in the world, and has traded in a tight range between 7.7 and 7.9 to the U.S. dollar for 35 years.
The Hong Kong Monetary Authority, the city’s de facto central bank, has recently intervened to support the currency. The aggregate balance, a measure of funds deposited by commercial banks with the authority, has declined by 80% since mid-2017.
Persistent PegThe Hong Kong dollar's close link to the U.S. dollar has survived for more than threedecades.
In a phone interview, Mr. Bass wouldn’t disclose the specific nature or size of his bets against the Hong Kong dollar, but his investor letter described “a portfolio structure that will efficiently hedge investors invested in Hong Kong, China and the rest of Asia,” which would also “maintain a massive asymmetry to a negative outcome in Hong Kong and/or China.”
Because of the broad belief that the peg will hold, most types of currency-market options that pay off if the Hong Kong dollar weakens are cheap, and could produce large returns, relative to the initial outlay, if the peg should break.
This isn’t the first time Hayman has taken positions against the Hong Kong dollar. In 2016, the firm sold off most of its investments in other asset classes so it could short Asian currencies including the Hong Kong dollar and Chinese yuan.
The fund was burned on those positions, losing 19% on investments in 2017 after a rally in the yuan.
Mr. Bass said he felt compelled to act now due to a combination of macroeconomic and geopolitical headwinds. In the letter, he raised concerns that China’s central government was “impinging on the autonomy of Hong Kong.”
In a March filing to the Securities and Exchange Commission, Hayman reported $423.6 million in discretionary assets under management. That is down from $770 million in mid-2016 and $2.3 billion at the end of 2014.
Mr. Bass in the interview pointed to a previous episode of stress in which Hong Kong defended the peg, suggesting that it would no longer be able to do so if it happens again. 
During the Asian financial crisis, the HKMA raised overnight interest rates to as high as 20% to stem the flood of money leaving the city, sending house prices crashing.
Then, about 90% of Hong Kong’s mortgage lending was done at fixed interest rates, according to Mr. Bass. Most is now indexed to one-month interbank rates, and leverage has climbed considerably in the intervening period, meaning borrowers would be far less able to weather a sudden rise in rates, he said.

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