Hong Kong is a city with a purpose. Always a hub of trade and a link between the markets of west and east, it now forms a key plank in China’s heroic efforts to get around economics. One of the many economic “laws” that china flouts is the impossible trinity –the notion that you can have two of the following three policies but not all at once: Free capital flows, control of monetary policy, and a fixed exchange rate. We have real world examples of the trinity’s inexorable logic to work from. The united kingdom when joining the ERM attempted free capital flows and a fixed exchange rate with the deutschemark, but an unwillingness to follow Germany’s tight monetary policy forced it to abandon the fixed exchange rate. Closer to home for me, the Asian financial crisis in the 90’s arose from large capital flows, fixed exchange rates and tighter monetary policies than the west. Fixed exchange rates gave the impression of low risk – and investors piled in – only to pile back out when Thailand were unable to defend their FX peg in response to capital outflows. The world changed in response. Those willing to give up control of exchange rates enjoyed monetary independence and free flowing capital – such as the UK. Europe formed a currency union effectively fixing exchange rates, but gave up control of monetary policy as the price of exchange rate stability. Asian economies either stagnated or pursued a mercantilist set of policies to build unassailable foreign exchange reserves, whilst keeping capital flows under wraps.
Now however the brutal logic of the marketplace is being supplanted, in part, by the even more brutal logic of total political control. China, having pursued Asian mercantilism par excellence, are now seeking to push a command economy style solution to the impossible trinity. The exchange rate “floats” but under the watchful eye of the PBOC. Capital controls are in place but are porous. Monetary policy actively manages liquidity and credit in every part of the system. The impossible trinity is only impossible because of free markets. Remove free markets and the rules no longer apply. Hong Kong is a crucial piece of that puzzle. China wants and needs access to capital markets on its own terms. Hong Kong is where it happens. With a fixed exchange rate, NO monetary policy (well, no official one) and a highly credible fixed exchange rate to the USD, it’s the perfect intermediary between China’s command economy and the international capital markets. This allows china the benefits of free capital flows without the cost of having to give up control of either monetary policy or its exchange rate mechanism.
However there is a cost. A normal economy has a stock of capital which maps onto a stock of financial capital (ie the money supply) because generally, in a capitalist economy, you need to borrow some money to get a project going. Borrowing creates money, investing creates real wealth. So the size of your economy relates to the amount of money. You can gin up the money supply a bit by lending more to consumers or to purchase financial assets, but there are risks to that, financial assets and consumption don’t create new cashflows to pay back the loans – so you end up with defaults. Hong Kong however has another issue. It’s money supply has to be sufficient to handle the capital flows between China and the western financial markets. However you measure China’s GDP, it is orders of magnitude bigger. This week, HKD interest rates have been spiking due to an IPO by “Ping An Healthcare” – a technology company intermediating between doctors and patients in China. Ping An is raising a total of $1.1bio USD. For the HK economy, that’s an enormous amount. The retail portion of this is 300x oversubscribed, and brokerages must find enough liquidity to cover all of these orders. These IPO’s happen with some regularity. So the HK economy has to have a money supply far bigger than it needs most of the time. That money is free to go around causing problems. Most obviously, HK property is absurdly expensive. Ditto any of the basic necessities of life that have any kind of rent component. Luxury, buying in imported brands is cheap enough, but space and land cost serious money.
And there are costs at the macro economy level also. Recently, the HKD traded right to the weak side of the 7.75/7.85 trading band vs the USD that the HK authorities maintain. This obliged the HKMA to spend USD to buy back HKD at the 7.85 level, and the market only stopped forcing them to do this when the IPO lockup period for Ping an was in sight. The reason HKD was trading so weak? Interest rates in the territory are over 1% lower than the US! Remember our impossible trinity? You’re not supposed to be able to have your own monetary policy with fixed exchange rates and free capital flows… and yet the territory needs vastly looser liquidity conditions than the US to do its financing job for China. So to buy this option back from the capital markets, the HKMA are forced to spend USD to maintain the value of their currency – whilst banks, hedge funds and retail all happily swap their HKD for USD or other higher yielding currencies and earn a low risk return. The HKMA is paying the private sector for the money supply it needs to keep the whole territory in business.
So how long can they keep doing this? Prior to the Fed beginning its hiking cycle, the pressure on the HKD was limited – and inflows to the territory would replenish the HKMA’s stocks of USD. Now that’s harder to imagine. Right now, the HKMA’s reserves are vast and cover the total size of the territory’s banks’ balance sheets several times over . So it’s a stable situation for now – but the direction of travel is clearly towards abandoning the peg or restricting capital flows. Years of mercantilism have given China, and HK, the firepower to pay their way around the impossible trinity for the time being – but as we saw before in the 90’s, what seems very solid can unravel exceptionally fast once confidence disappears – so I look forward to keeping you all informed about the state of play!