Analysis Hong Kong: The Party Is Over

Disclaimer: The information in this report has previously been shared with clients of 375 Park Associates. However, the potential gravity of the situation coupled with our belief that the markets have not properly priced in the risks has led us to release this report to the public.

This report has been prepared solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. The reader should not construe the contents of this report as legal, tax, accounting or investment advice or a recommendation.

The reader should consult their counsel, tax and financial advisors as to legal and related matters concerning the analysis herein. This report does not purport to be all-inclusive or to contain all of the information which the report may require. No investment, divestment or other financial decisions or actions should be based solely on the information in this report.

Introduction

What is currently happening in Hong Kong is more than just the blow back from a badly conceived extradition bill or economic tensions brought on by the trade war. While these issues are part of the city’s risk profile, to fully understand what is happening today one must look to the north – far north, to Beijing.

Since the handover in 1997, Hong Kong has billed itself as the world's gateway to China. However, the environment has shifted over time and it is undeniable that those in the inner circle of Xi Jinping have gradually gained political and economic control over the Special Administrative Region.

This brings us to several unfortunate truths about Hong Kong:

1. Hong Kong is China;

2. Chinese citizens are not free;

3. Hong Kong cannot defend itself.

To elaborate on the final truth, the city has become so dependent on food and energy imports from the mainland that leaders in Beijing can paralyze the city whenever they want.

These truths are difficult to reckon, but this is the situation we - I use ‘we’ as Hong Kong is my second, second home – are facing today.

What does this mean for the people of Hong Kong?

Either they stay and fight a losing battle or leave their home and start a new life elsewhere.

Given the ancestors of many in Hong Kong fled the abuses of the Qing Empire, dueling warlords, the Japanese, the Kuomintang, or the Communist Party of China (CCP) itself, leaving Hong Kong may be the only choice left for those who value their freedom.

What Does This Mean for Investors?

Now is not the time to be exposed to the Hong Kong market as even having U.S. Dollar-denominated investments in Hong Kong represents an irresponsible level of risk. Furthermore, we believe capital markets have significantly mispriced this risk.

Even with the increasingly contentious nature of the protests, rampant abuses by the Hong Kong Police Force (HKPF), and news of the People’s Liberation Army (PLA) moving additional troops into the city, the Hang Seng Index (HSI) closed 2 September at nearly 4.25% higher than its 52-week low.

While the close is nearly 10 percent below the 50-day and 200-day moving averages, it is almost as if Hong Kong investors have convinced themselves they can catch a falling knife. However, we are not convinced that anyone is either that lucky or smart.

The mispricing of the Hong Kong market comes into stark terms when comparing the HSI to the benchmark S&P 500 as the beta risk is a rather low 0.32. While this could change in the coming days, we believe the results indicate a frightening level of complacency, or ignorance, on the part of investors.

However, it is not just the protests or the complacency of the capital markets which should concern investors.

There is mounting evidence that confidence in the Hong Kong Dollar – long considered a haven – is crumbling. While the composition of foreign currency reserves kept by the city’s central bank, the Hong Kong Monetary Authority (HKMA), is reported every March; several analysts believe the HKMA has been using its USD reserves to keep the Hong Kong Dollar (HKD) from going into freefall.

The prospect of eroding USD reserves is significant as the HKD is pegged to the greenback.

Pressure on the HKD can be seen in the pricing of forward contracts on the currency, which in recent weeks has consistently traded outside of the range of the peg.

In an August interview with Reuters, Alicia Garcia Herrero, Chief Asia Pacific Economist for Natixis, noted ‘forward is telling you that some people expect the Hong Kong dollar to move out of the band.’

While the HKD is poised to drop significantly, the fact that it hasn’t is an indication of intervention by the HKMA. Another indication of intervention is the recent surge in the HIBOR (Hong Kong Interbank Overnight Rate), which has made it harder for investors to completely abandon the HKD.

However, the jump in the HIBOR rate could be an indication that the HKMA is running out of the resources needed to fight the shorts as indicated by the 16 percent and 12 percent drops in Other Reserve Assets and Other Foreign Currency Assets respectively in August.

Furthermore, it is worth noting broad money supply in Hong Kong as a percent of the total economy has surged in recent years – so much so, that one might question the structure of the economy.

Based on a snapshot of 10 economies, the average M3-to-GDP was 1.7x. However, Hong Kong has a current M3-to-GDP of roughly 5.3x. If we exclude both China (2.0x) and Hong Kong from the average, the rate falls by 42 percent to 1.2x.

Given the average includes the impacts of Quantitative Easing undertaken by central bankers in the U.S. and the Euro Zone; it would appear authorities in Hong Kong and China are manipulating the money supply, reported GDP, or both.

In fact, a 2014 report in the South China Morning Post noted money laundering was ‘huge’ in Hong Kong and we believe the issue has only grown since then – especially as the Central People’s Government (CPG) in Beijing has cracked down on flows into and out of the gambling dens of Macau.

Why has this been allowed to happen? While Hong Kong's importance to the economy of China has diminished over time, it remains the only viable locale where party officials can cheaply move money offshore.

However, this is about to change. Sources in Hong Kong and on the Chinese mainland indicate those closely aligned to the ruling clique have either converted most of their liquid assets into USD or have moved them out of Hong Kong altogether.

This should not be a groundbreaking revelation as multiple outlets have commented on the capital flight in recent months. The situation is so dire that even Hong Kong’s embattled Chief Executive, Carrie Lamb, warned of a coming economic ‘tsunami’ in early-August.

As such, investors need to take a step back and question whether their exposure to Hong Kong is warranted.

While it is probably too late to do anything about illiquid assets – e.g. real estate and companies - there is a very narrow window of opportunity to either convert HKD assets into USD or to shift funds offshore.

As for illiquid assets, it may already be too late.

Bloomberg reported that Singapore’s Temasek Holdings has placed on hold plans to exit its $3Bn stake in the Hong Kong-based A.S. Watson Group. The planned sale fell through as Temasek could not find a buyer willing to accept its valuation.

While local sources indicated Temasek fielded interest from multiple CCP affiliated companies including Alibaba Group Holding and Tencent. The fact neither company pursued the acquisition is a clear indication that CCP-linked groups believe now is not the time to invest in Hong Kong.

Given the ongoing protests and the coming 70th anniversary of the People’s Republic on 1 October, it is inevitable that something will happen sooner rather than later.

Velvet Glove or Iron Fist?

The party is over in Hong Kong and at this point is only a question of what form the end will take as the status quo ante is no longer viable. From our perspective, there are two potential outcomes - the ‘Velvet Glove' or the ‘Iron Fist'.

Velvet Glove

A ‘Velvet Glove' approach would include an announcement coinciding with the October holidays to dissolve the One Country, Two Systems framework. Under this scenario, the Central Government would declare the arrangement a failed experiment brought about by an unequal treaty with a western power.

Not only would this approach strengthen Xi’s grip on power within China, but it would leave the West with little or no options to counter the move as it would simply be an assertion of Chinese sovereignty over a territory which is broadly accepted as part of China.

While such a move, which would include the dissolution of the Legislative Council and the courts as well as the merger of enforcement agencies such as the HKPF and the Customs and Excise Department with their mainland counterparts, would be met with mass protests; it would underscore the inevitability of Hong Kong’s circumstance.

Furthermore, it would ‘legitimize’ (in the context of the PRC) moves to put an end to the protests once and for all.

Iron Fist

While this approach to the protests would be met with significant backlash from the international community; it would open the door for Mr. Trump to score a ‘win’ in the ongoing trade dispute.

As the name implies, an ‘Iron Fist’ approach would include the declaration of martial law and the deployment of either People’s Armed Police or the People’s Liberation Army on the streets on Hong Kong. Not only would this shutdown the city but it would open the door for violent reprisals against the protesters as well as prosecution in military courts.

However, this scenario is not without downside risk for Xi and his cronies as the American leader would either use the threat of sanctions to force an agreement or would leverage the rare show of bipartisan and multilateral support to implement a wide-ranging list of sanctions against the party and its allies.

This could include the forced delisting of Chinese companies from western stock exchanges, economic sanctions against party members, and even the cancellation of travel visas – including student visas.

Granted, some leaders in Beijing theorize they can withstand sanctions as the Party did following the Tiananmen Square Massacre. But this ignores the fact that China’s economy is so highly levered that coordinated sanctions, tariffs, travel bans, and economic blacklisting may push the country into an economic crisis of epic proportions.

Conclusion

I love Hong Kong and I support the people of Hong Kong in their peaceful endeavor to uphold the integrity of the principles outlined in the Basic Law.

However, we must admit that while Hong Kong today has been granted special consideration by the Central Government, these privileges can be revoked at any time. This is the sad irony of life in the People’s Republic as the PEOPLE are not free.

While my heart is with the people of Hong Kong, I must resign myself to the fact that Hong Kong cannot defend itself and as such the illusion of the freedom and the rule of law once touted by the city's authorities is fleeting and will most likely be extinguished in the coming weeks.

I hope I am wrong, but I fear that this is inevitable.

For investors, there is only one option at this point – get your money out of Hong Kong before it is too late.

Disclaimer: The information in this report has previously been shared with clients of 375 Park Associates. However, the potential gravity of the situation coupled with our belief that the markets have not properly priced in the risks has led us to release this report to the public.

This report has been prepared solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. The reader should not construe the contents of this report as legal, tax, accounting or investment advice or a recommendation.

The reader should consult its counsel, tax and financial advisors as to legal and related matters concerning any transaction described herein. This report does not purport to be all-inclusive or to contain all of the information which the report may require. No investment, divestment or other financial decisions or actions should be based solely on the information in this report.

UPDATE: In December 2019, 375 Park Associates closed its Hong Kong operations. The decision was directly related to the continued decay of the Rule of Law within the SAR. While it is our hope that Hong Kong will be able to find a peaceful way forward that lives up to the ideals of the Basic Law, we are doubtful this will happen.