Hong Kong as Schrodinger’s Cat

Some of our pressing current challenges seem self-inflicted.  The UK decision to leave the EU was not compelled by external circumstances.  A non-binding referendum that won by 52% to 48% was taken to be a binding decision to break a 45-year old treaty.  

From before the end of WWII through 2016, the US sought to create and enforce a multilateral trading system.  It was not perfect, of course, but it had succeeded in growing trade and reconciling disputes, which trade even among the closest of allies is fraught. Now a President who did not win a majority of the popular vote is not only critical of the US course but is trying to roll it back.  

The US and China are now engaged in high-level negotiations over trade.  China entered the WTO in 2001 as a non-market economy.  To join, all the other members had to agree to China’s tariff schedule.  Because it was not a market economy, the average tariff is considerably higher than leading market economies. Chinese officials seemed to think that it would automatically be regarded as a market economy after being in the WTO  for 10 or 15 years.  

However, the US and Europe do not see it that way.  It is easier to take anti-dumping action against a non-market economy than a market economy.  China wants the status and privilege of being a market economy.  The US and Europe offer it in exchange for specific actions, including a reduction in the average tariffs, which China appears to be moving toward.  

The US and China do not agree on the bilateral trade balance. A good part of the disagreement turns on how Hong Kong is treated.  For many things, China says Hong Kong is part of China, a Special Administrative Region.  On trade issues, it wants to say Hong Kong is separate.  Shipments of goods from New York to New Jersey are not counted as exports, but mainland sales to HK are considered exports and purchases are considered imports.  They are not.  

China reported that its reserves stood at $3.14 trillion as of the end of March.   Hong Kong has $440 bln in reserves then, but aren’t those China’s too?    Hong Kong owns $194 bln of US Treasuries as of the end of January.  Shouldn’t they be added to China’s nearly $1.17 trillion for a fairer assessment of China’s holdings?  

The US and most of the world recognize that Taiwan is part of China as well.  However, as China does not have physical control of Taiwan as it does Hong Kong, it makes sense for these purposes to consider Taiwan as distinct from China. 

Yes, Hong Kong and China are often said to be one country with two currencies.  But it is one country, and this fiction of its trade is not helpful and injects an unnecessary obfuscation in the data and how investors ought to think of China.  

China’s currency has been the subject of much discussion.  In effect, because the US is seen able to dominate every rung on the trade tension escalation ladder, that China could devalue the yuan.  We do not think this a very likely.  The depreciation of the yuan might not boost China’s exports and could spur renewed capital outflows.  It could prompt other countries in the region to devalue.  A falling yuan may also undermine other Chinese policy objectives. 

We have argued that the real meaning of the strong dollar policy is the US commitment not to use the dollar as a weapon, as it did for years leading up to 1995.  There is now an arms control-like agreement not to weaponize foreign exchange.  The G7 and G20 have agreed that markets ought to determine exchange rates, though excessive volatility needs to be avoided.  

When Abe and other Japanese officials came too close to the line, the G7 signed a new agreement reaffirming the commitment to de-weaponize foreign exchange.  When US Treasury Secretary Mnuchin seemed to talk the dollar down, others objected and it was quickly walked back.  It is possible that low-level criticisms of comments from other officials are issued, but they have not percolated to levels as Abe or Mnuchin’s comments.   

It has gone nearly unnoticed by the commentariat is that the new governor of the People’s Bank of China indicated it will not weaponize the yuan.  Governor Yi specifically said that China would not use the yuan in the trade conflict with the US.  Of course, words are one thing, and deeds are another, but it is promising.    This does not mean that yuan will not fall, any more than a strong dollar policy says anything about its exchange rate.  Yi’s comments suggest a simple test of his veracity:  We should not see intervention to weaken the yuan.  

The more pressing currency challenge is with the Hong Kong dollar.  Funds have flowed into Hong Kong for real estate and equities.  Note that the Hang Seng is up 3% year-to-date, and an index of mainland shares that trade in Hong Kong is up nearly 5%, while the mainland indices are off more than 3%.  This liquidity coupled with the widening interest rate differential with the increasing dollar LIBOR has weighed on the Hong Kong dollar.  

China announced that as of May 1, the limits on the Shanghai-Hong Kong stock link would quadruple to CNY42 bln (~$6.7 bln a day) to HK and CNY52 bln to the mainland.  The limit was only reached a couple of times in the 3.5-year old facility.   In March, flows from Shanghai and Shenzhen to slowed markedly.  There has even been some net selling of HK shares by mainland accounts, and this has also weighed on the Hong Kong dollar.  

The Hong Kong dollar fell to its weakest end of the band that it is allowed to trade earlier today and for the first time in three years, the Hong Kong Monetary Authority intervened to defend the peg.  Reports indicate that the HKMA sold $104 mln at HKD7.85.  Officials stand ready to intervene further if necessary.   With dollar LIBOR still rising, and the Federal Reserve on course to hike rates further in the coming months, the HKMA may have to step up its efforts.  

 The peg between the Hong Kong dollar and the US dollar has been adjusted a few times over the past 35 years.  The most recent iteration is 13 years old.  Yesterday IMF Managing Director Lagarde endorsed the peg.  There is some speculation that with ties to the mainland economy becoming increasingly significant, that the peg should switch to the yuan.  While this will likely eventually happen, there is no urgency, and it may be many years away.  At the very least, the yuan would need to be convertible.   

When the HKMA intervened in 2015, it was acting to prevent the Hong Kong dollar from appreciated through the top of the band.  According to its figures, the HKMA bought $29.3 bln to defend the peg.  With $440 bln in reserves, it has the means to enforce the band.  We see nothing that would make us question the will to do what is necessary to continue to do so.  


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