Principal Monthly Viewpoints (June 2020)
What is the United States-Hong Kong Policy Act?
The United States-Hong Kong Policy Act is also called the US-HK Relationship Act. According to the Act, the United States regards Hong Kong as a "non-sovereign entity" distinct from the PRC and recognises that it can enjoy treatment different from Mainland China. The special treatment includes granting Hong Kong status as a separate customs territory, the establishment of bilateral relations between the United States and Hong Kong, currency convertibility, and separate arrangement on travel visas. However, in response to the recent decision of the PRC planning to impose national security legislation in Hong Kong, United States President Donald Trump has stated that he will revoke Hong Kong's preferential treatment and will sanction officials involved in the erosion of Hong Kong’s autonomy but he has not disclosed the details of the actual measures yet.
Since the United States, under the current Act, has always treated Hong Kong as a separate customs territory, it has not been affected even though the United States imposed significant tariffs on China in the trade war between the two countries. In addition, as an independent economy recognised by the Act, Hong Kong can enter into independent bilateral agreements on economics, trade and finance with the United States. Regarding currency convertibility, the Act allows for Hong Kong dollars to be freely exchanged with US dollars without any upper limit. Finally, the United States recognises passports and travel documents issued by the Hong Kong government, and Hong Kong citizens can apply for US visas independently.
What are the implications of the recent political developments on the Hong Kong economy and investment markets?
At the economic level, the large-scale demonstrations that had quieted down for a while may start up again should the National People’s Congress pass the draft of Hong Kong’s National Security Law, especially before the Legislative Council election in October. Further development depends on the implementation details of the law. However, the progress of Hong Kong's economic recovery will be hindered if the political situation in the city intensifies again.
On top of the National Security Law, the cancellation of the United States' special economic treatment of Hong Kong will induce another factor of great uncertainty. The related measures may have serious effects on Hong Kong’s status as an international financial centre, the attitude of foreign investments and the flow of capital. Should President Trump suspend Hong Kong's separate customs treatments, it may also strike a further blow to the local economy, especially the export and re-export industries, the outlooks of which are still bleak. The implications, meanwhile, depend on the intensity and time frame of Trump's related policies.
In any case, it is almost certain that the Hong Kong economy will continue to decline this year. The impact of the large-scale protests that happened last year has not completely subdued. Consumption, foreign trade and investment activities have basically stagnated, compounded by the impact of COVID-19 at the beginning of the year with the further uncertainties. Although the scale of fiscal measures announced by the Hong Kong government so far is equivalent to about 10% of the GDP, the local economy will tend to further decline throughout the year and is expected to record an expanded negative growth of 4%-5% for 2020.
In respect to the investment markets, the Hang Seng Index slumped around 7% in May and was the worst performer in the major global stock markets (Chart 1). The short-selling ratio of the main board further climbed to nearly 21%, which was at the highest level since records began in 1998. At the same time, the volatility of Hong Kong stocks continued to increase while the volatility of the Hang Seng Index, as measured by 90-day price volatility, rose to its highest level since 2012.
Chart 1: Hang Seng Index once again underperformed global stocks and experienced the worst month since 1998
Source: Bloomberg, PAM (As of 2/6/2019)
Southbound capital inflow continued to increase their holdings of Hong Kong stocks for a while. The cumulative volume reached HK$274 billion in the first five months, surpassing the total volume of the year 2019. Meanwhile, the market share of mainland investors has continued to rise. However, it is expected that Hong Kong stocks will still be under relatively substantial stress in the near future. Internally, the city faces a series of negative factors – local economy and political outlook, as well as earnings downgrade. Externally, it has to face the uncertainty of China-US relations, the development of the global pandemic, and the recovery of the global economy. The volatility of the Hong Kong stock market is expected to remain elevated in the short term. Domestic sectors such as real estate, landlords, retail and finance will probably face challenges.
As for the bond market, individual rating agencies may further downgrade Hong Kong's sovereign rating if the United States cancels its special treatment of Hong Kong. Rating agencies have cited that they would consider Hong Kong's level of autonomy under "0ne country, Two systems" when adjusting Hong Kong's ratings. In the short to medium term, Hong Kong is still unlikely to be replaced by other Mainland cities such as Shanghai or Shenzhen. However, the increasingly closer economic, financial and socio-political ties between China and Hong Kong may cause individual rating agencies to review Hong Kong’s current sovereign ratings. It will be difficult for Hong Kong to stand alone, especially when China’s own rating gets lowered. The cost of corporate bond issuance in Hong Kong may further increase.
Will the Hong Kong dollar peg regime be affected? Will the recent events cause heavy capital outflow and be a drag factor for Hong Kong forex market performance?
The Linked Exchange Rate System is an important pillar of the local financial system. The system was implemented in 1983, much earlier than the enactment of the United States-Hong Kong Policy Act. The system was established by Hong Kong and does not need the permission of the United States. For the system to function smoothly, Hong Kong should have sufficient US dollars so that the HKMA can fulfil its commitment to sell and buy Hong Kong dollars in the range of HK$7.75-7.85 per US dollar.
If the supply of Hong Kong dollars is greater than demand when capital outflow and the market exchange rate weakens to the weak-side Convertibility Undertakings of HK$7.85 to one US dollar, the HKMA stands ready to buy Hong Kong dollars from banks. The Aggregate Balance (a component of the Monetary Base) will then contract to drive Hong Kong dollar interest rates up, pushing the Hong Kong dollar away from the weak-side limit to stay within the Convertibility Zone.
In the period of the international financial turmoil of 1997-98, Hong Kong's monetary base was only about HK$95 billion. There was a rush of capital inflow after the global financial crisis in 2008 and resulted in a sudden increase of the monetary base, which has now exceeded HK$1.70 trillion. The capital inflow and outflow are unlikely to have a substantial impact on the exchange rate of Hong Kong dollars (Chart 2).
Chart 2: Hong Kong’s monetary base has significantly expanded, as compared to the base during 1997-1998 financial crisis
Source: Bloomberg, PAM (As of 1/6/2019)
Hong Kong’s foreign exchange reserves reached US$440 billion as of the end of April, and that amount is more than double of the base currency. In addition, if we calculate with the exchange rate of HK$7.8 to one US dollar, the current scale of foreign exchange reserves is equivalent to around 46% of Hong Kong Money Supply M3. This ratio is higher than the level of 38% during the Asian financial turmoil in 1998, the 2003 SARS outbreak (about 43%) and the 2008 financial tsunami (around 38%). It is expected that this ratio should be able to maintain the stability of the Linked Exchange Rate System.
Although the Hong Kong dollar one-year forward once fell below the HK$7.85 weak-side Convertibility Undertaking, the strong spot market remained close to the HK$7.75 strong-side Convertibility Undertaking. It is believed that the sudden volatility of the forward exchange rate was mainly due to the reports of the proposed National Security Law, which drove the demand for short-term hedging needs. Since then, the Hong Kong dollar one-year forward exchange rate has gradually moved away from the weak-side Convertibility Undertaking (Chart 3).
Chart 3: The strong USD/HKD spot market remained while the forward exchange rate fluctuated
Source: Bloomberg, PAM (As of 2/6/2019)
In fact, Hong Kong enjoys interbank rate advantage after the substantial rate cuts in the foreign markets. The spread between the one-month Hong Kong Interbank Offered Rate (HIBOR) and the US dollar LIBOR is currently at a historically high level, attracting continuous capital inflow to Hong Kong and causing arbitrage transactions (Chart 4). The aggregate balance of the banking system has as a result risen from its low point of HK$54 billion to nearly HK$95 billion. The liquidity condition eased. We do not see any obvious signs that there is a large amount of capital outflow from either the Hong Kong dollar market or the banking system. In addition, the Hong Kong secondary listing of Chinese companies may increase capital demands. These factors should support the Hong Kong dollar currency and offset some of the negative influences of the United States' decisions.
Chart 4: The historical high HIBOR-LIBOR spread attracts arbitrage transactions
Source: Bloomberg, PAM (As of 2/6/2019)
(Written on 2nd June 2020)
Senior Investment Specialist
Principal Asset Management (Asia)
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