Hong Kong should follow Australia’s example and start raising local interest rates, but it can’t. Instead, the HKMA can only stand idly by and watch massive inflows of hot cash from China pour over the border. Although we are not in bubble territory just yet, if things continue as they have, then Hong Kong will experience another asset bubble and the subsequent, inevitable, bust that follows. This sounds like a bad scenario, but the alternative (a free-floating Hong Kong dollar) is worse.
Asset prices in Hong Kong are starting to rise at an alarming rate as demand is far outstripping supply. The first asset class to begin moving was the (very-transparent) price of local equities, the new phase has been high-end property prices. Both these asset classes have been buoyed by low inflation, low interest rates and high liquidity.
Hong Kong property price, HS Index and Hibor (rebased to 100) 1993-2009

Investors should take the hint that China is not happy with the concentration of inflows of liquidity into Hong Kong assets when the visa restrictions on travel to Macau were lifted in mid September, along with the approval of the Wynn IPO. The move can be taken to mean that China is concerned that excess liquidity is driving asset prices too high too fast. However, as the chart shows, prices are not excessively high relative to historic levels in either local or in foreign currency terms.
Overseas investors have experienced some pretty poor returns in recent years, with the HS Index showing a 21% return in Euro terms (2.1% CAGR) and 37% return in yen terms (3.4% CAGR) since the turn of the century. Yet these investors have had to contend with the same risks as US$/HK$ investors (which have tacked a 7.1% CAGR in the same period).
HS Index in HK$, yen and Euro terms (rebased to 100)

Although there is no way to confirm and quantify what would have happened if Hong Kong had a free-floating currency during the 1998 Asian Financial Crisis or in the 2008 financial crisis. However, if Iceland and Latvia are any indication, then the returns for overseas investors would have been even worse. Although weak fundamentals have impacted the value of the Krona and the Lat, currency speculators have played some part in depressing the values of these small, independent currencies. The impact of a severely devalued currency in Hong Kong would have been compounded by the fact that a weaker currency should help export competitiveness. Unfortunately, Hong Kong’s manufacturing base has been completely relocated to Guangdong, thus mitigating this benefit. Instead, import price hikes would have ramped up consumer prices, devaluing the currency further. In times of crises, the peg has served Hong Kong well, while this benefit is counterbalanced by the lack of control during times of recovery and expansion.
Last week’s sudden strength in equity prices coincided with the end of Golden Week, the hike in Australian interest rates and further US$ weakness. IPOs turned positive, adding to the impression that turnover rose. The illusion will diminish this week as investors take stock of China’s intentions regarding inflows into Hong Kong as the HKMA continues to sell HK$ to keep the peg in its designated range. Falling turnover in equities may not dampen prices significantly, as the 20-day moving average should provide technical support. However, the market will also have to contend with discussions among bankers about the frothiness of the local property market, with a potential increase in mortgage rates on the cards if things don’t cool down.




