Hong Kong, which for years rode a wave of cheap capital and China’s economic boom, is as vulnerable now as it was before the 1990s Asian financial crisis as those drivers reverse, according to analysis by Daiwa Capital Markets.
In a bearish take on the financial hub, Daiwa forecasts “enormous stress” ahead as money heads out amid a global US dollar debt deleveraging, China’s economy slows and currency weakens, US interest rates increase, and domestic property prices slump.
“If the Asian financial crisis was preceded by a classic credit and housing bubble, we see another one now of a bigger scale,” the Daiwa analysts led by Kevin Lai, chief economist for Asia excluding Japan, wrote in a note. “Money inflows have been unprecedented; we expect this money to leave eventually on the back of global dollar debt deleveraging.”
Daiwa flagged six metrics to gauge Hong Kong’s strength:
Net money inflows: Inflated in recent years by easy US monetary settings and bullish bets on China’s economy and currency.
Total credit expansion: Estimated at about 320% of gross domestic product.
China or regional credit exposure: With an estimated $750bn in loan and bond exposure to China.
Real estate lending: With more lending exposure and a longer and quicker period of house price inflation this time around than in the late 1990s.
The direction of US monetary policy as policymakers consider further tightening Hong Kong dollar’s valuation after an estimated 30% appreciation on a broad, real-effective rate over the past four years Of those, the first four are flashing danger, Daiwa says.
“Measures of macro and financial vulnerability indicate things are no better now than they were just before the Asian financial crisis,” the brokerage said. It isn’t the first time that Lai has warned on Hong Kong. In recent months, the Daiwa economist has highlighted vulnerabilities as the Fed keeps open the option of further rate increases after hiking in December for the first time since 2006.
Because Hong Kong’s currency is pegged to the dollar, the former British colony effectively imports US monetary policy. Rising US interest rates increase the cost of servicing loans taken out in Hong Kong.
Hong Kong was hit hard by the Asian financial crisis that started in Thailand in 1997 and spread across the region, forcing the Hong Kong Monetary Authority to spend HK$120bn buying up Hong Kong stocks and to use its foreign-currency reserves to defend the dollar peg. House prices tumbled 70%.
This time around, Daiwa assumes the HKMA would “defend the peg at all costs,” eroding the monetary base and setting the stage for debt-deflation. In contrast to orthodox thinking, Lai says Hong Kong’s “sizeable reserves” are actually an indication of weakness, and the fact that the currency is pegged prevents a natural currency mechanism.
Hong Kong’s outlook has dimmed as exports fall and big-spending Chinese tourists stay away, prompting an increasing number of analysts to turn cautious on the $300bn economy because of its exposure to China’s slowdown. Moody’s Investors Service last month lowered Hong Kong’s long-term debt outlook. Retail sales in February plunged the most since 1999 as fewer Chinese tourists visited the city during the Lunar New Year holiday. Chinese visitors are projected to fall 3.2% for the year, according to the Hong Kong Tourism Board, with average spending dropping 4%.
Lai’s forecast for gross domestic product to slip towards recession territory this year is an outlier. A median forecast of economists surveyed by Bloomberg tips growth of 1.7% this year and 2.1% in 2017.
And after an initial slump at the start of the year, the Hang Sang Index has rallied, the city’s dollar has rebounded from the weak end of its trading range, and interbank borrowing costs have tumbled after spiking in January.
But that calm may not last long. According to Daiwa’s analysis, the global deleveraging process “has probably started, or at least could be about to begin,” and the first “real test” for Hong Kong could come in the second half, with pressure set to build next year, according to Lai.
