Governor Chris Patten and the Prince of Wales watched forlornly as the Union Jack slid down its flagpole for the last time as Hong Kong morphed from Her Majesty’s Crown Colony to a Special Administrative Region (SAR) of the People’s Republic of China amid fireworks and cannon salutes in Victoria Harbour that distant July evening in 1997. Beijing promised to rule Hong Kong, its gateway to international financial markets, under the principle of “one country, two systems”. Now 2 million Hong Kong citizens have protested on the streets, forced Chief Executive Carrie Lamb (selected, not elected) to withdraw her extradition bill and demanded her resignation. This is the most serious challenge to the monopoly of power and political legitimacy of the Chinese Communist Party since the June 1989 Tiananmen Square massacre. So what will be the economic and financial fallout of the Hong Kong crisis?
The Hong Kong peg to the US dollar, in place since 1983 as Margaret Thatcher announced Britannia’s intention to return the Crown Colony to Deng Xiao Ping’s China in 1997, was born amid massive capital flight, a property meltdown and and a loss of investor confidence in the colonial government. The Hong Kong dollar peg is now under the spotlight again, even though the Hong Kong Monetary Authority (HKMA) boasts reserves of $400 billion plus.
The three month Hong Kong Interbank Rate (HIBOR) is now the highest since 2008, so onshore liquidity has unquestionably tightened due to the sheer scale of capital flight, an exodus of fear amplified by a People’s Liberation Army major-general’s vitriolic speech branding Hong Kong’s capitalists and financiers as “bloodsucker landlords and enemies of the people”, Maoist era abuse that evokes the madness of the Great Helmsman’s Cultural Revolution.
Hong Kong borrowing rates have spiked higher on rising volatility even though US money market rates have plummeted after the Powell Fed’s dovish bias at the June FOMC. The mathematics of the peg means Hong Kong interbank rates should have fallen with US rates, as they rose in 2018 after the Federal Reserve increased the Fed Funds rate four times. The fact that HIBOR rose and did not fall is a testament to an ugly reality in international financial markets. Hong Kong has lost its credere (belief) in Planet Forex. Are global investors now questioning the future of the Hong Kong dollar peg? Yes. Is Hong Kong’s future as a global financial center under threat? Yes. Has President Xi Jinping, the most powerful Chinese autocrat since the death of Chairman Mao, lost face in the Middle Kingdom? Yes.
These factors will have a seismic impact on the Hong Kong property market, the most leveraged and expensive per square foot in the world, thanks to untold billions in hot money from the Mainland. Private sector credit is an unsustainable 350% of the Hong Kong GDP. Home prices have soared sevenfold since 2004 and Hong Kong now boasts the most expensive residential/office property in the world – with car parking slots in Central flipping for 1 million Yankee dollars! Hong Kong’s M3 money supply has quadrupled since the property bull market got going in 2004, more than double the rate of nominal GDP. Affordability ratios are unreal. Any speculative attack against the Hong Kong dollar peg will force the HKMA to sell US dollars, squeeze the onshore money markets and raise policy interest rates. This means Hong Kong faces the mother of all property market crashes, the worst since the late 1990’s, when almost a third of Hong Kong homeowners (including two of my second cousins!) suffered negative equity.