#1 Investment Weekly – Better than alternative

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.

#1 Investment Weekly – All the world’s a stage

I spent a good two hours watching the celebrations marking the 60th anniversary of the founding of the People’s Republic of China in Tiananmen Square last week. The marching was impressive as the world watched China’s actors on the big stage. As I come from a military family I think I’m quite qualified to comment on the precision of China’s goose-stepping armed forces. But there was something odd about the precision. It was the fact that China’s military leaders, or maybe the Party organizers, deemed it necessary that all the troops on parade had to be the same height (apparently 1.75m) and weight. There was no deviation from this requirement. Everyone was the same.

Now, for the largest standing armed forces in the world, I’m sure it wasn’t difficult to pick only troops that were the required height and weight, but it struck me as being a bit too precise and lacking diversity. Anyone that has watched the Trooping of the Colour in London will appreciate the precision of the marching but will also understand how odd the absolute uniformity of the Tiananmen parade was. Members of the armed forces of all countries come in all shapes and sizes, why did the organizers insist on this sameness? The simple explanation is: symbolic unity (although cynics might argue that it symbolizes the Party’s Marxist dogma of “the individual is not as important as the whole”). In fact, the uniformity symbolised the fact that China’s armed forces have kept the country unified since 1949 – unlike most militaries around the Asia-Pacific region. It has been the PLA, not the Communist party that has kept China unified, terrified and, therefore, harmonious.

This brings me to the next point: the overwhelming desire of the overseas press to describe the National Day events in a disharmonious fashion. Although it could be almost correct to say that the celebrations were linked in some way to the Communist Party, the national day celebrations were marking the 60th anniversary of the founding of the People’s Republic not the communist party (which was founded in July 1921). However, headlines by the world’s press were completely misleading and forums were ablaze with China’s propagandists trying to overwhelm any negative comments. The Times incorrectly wrote “Millions watch huge military parade to mark 60 years of communism”. The response from China’s netizens was immediate: don’t bash China, leave us alone, you don’t know what you are talking about because you have not visited China etc. The vitriolic Chinese forum contributors generally shoot themselves in the foot by trying to defend their positions. They don’t understand that China’s closed doors produced one economic disaster after another in the first 30 years of the PRC, while China’s poor reputation abroad (of a backward and bitter nation) means that very few people would dare to visit the Mainland (even including your Hong Kong based author). Without the rule of law and an independent police and judiciary, China’s reputation overseas will remain poor.

However, the parade was not aimed at a foreign audience. It is true that millions of Chinese watched the parade on TV – although the Times didn’t mention that CCTV’s live coverage to the Mainland was actually delayed by 30 seconds. However, to say that the parade, which was not completely dedicated to the military, was marking 60 years of communism is clearly wrong – although some party hardliners would have secretly celebrated 88 years of communism in China in July (because of the auspiciousness of the number). At least half of the parade was dedicated to the achievements of the provinces of China as well as the 56 different ethnic populations living within China’s borders. The floats were pretty standard fare, with the exception of the flat screen TV displays. I spotted Hong Kong’s float near the end of the procession, followed by Macau’s and finally Taiwan’s. This was a curious addition because, of course, Taiwan does not recognize being part of the mainland. The mainland obviously believes it is a province of China and hence the inclusion of the float. I haven’t seen or heard any reaction to this unilateral decision to include Taiwan in the party in this way.

The scale of the parade means that it was equivalent to a mini-stimulus package for the Chinese economy (as well as giving something of a fillip to the confidence of China’s ever-growing consumers). There were no official figures about how much the parade cost, but we know there were 100,000 civilians, 3,700 musicians and singers and 8,000 troops involved, all of which needed dressing (with the female troops wearing rather flattering mini-skirts and kinky boots) and equipping. The vehicles all needed painting and servicing beforehand. The world is certainly watching the economic performance of China as a litmus test for the health of the current recovery.

So what has the 60th anniversary got to do with the Hong Kong stockmarket? Quite a lot, because as this newsletter pointed out last week, China holidays will reduce liquidity, and this in turn will result in weaker stock prices (down another 3% last week). Average daily turnover last week was only HK$45 billion, even with a new IPO practically everyday. The index closed the week below its 20-day moving average, and is likely to stay below this week. The only consolation is that there is support for the index at the bottom of the Bollinger Band, which is where it closed last Friday. Fortunately, the bottom of the band is still rising, so any declines in the Hang Seng Index will be gradual and stage managed. After all, the world is watching.