Friday, February 6, 2015

Breaking the Hong Kong dollar

Hong Kong is an amazing place. It is a sophisticated country with well developed laws and markets that promote freedom and prosperity. It is consistently ranked as one of the easiest places in the world to do business. It is one of the most important financial centers in the world and its connection to China and proximity to other Asian nations position it well for the growing reemergence of Asia as the dominant global super power. With these positives in mind it is no surprise that billionaire investor Bill Ackman named the Hong Kong dollar as one of the most undervalued currencies in the world in 2011. While we have great respect for Mr. Ackman, he is not a global macro guy. When he made this call we had several investors calls asking us if we were putting on the same position. Our answer then was that no we weren't and if anything we would be taking the other side of his trade. There's a whole host of reasons why our research led us to feel this way. Here's just a few:

  • non-performing loans were growing in China
  • infrastructure investment as % of GDP was completely blown out of proportion
  • China's monetary base was being expanded at double the rate of the U.S.
  • shadow banking via commodity loans was (and still is) a giant fraud waiting to be exposed
  • ghost cities show that the construction boom has gone way too far
  • real food inflation exists which is entirely different from inflation from increased economic productivity
Let's now talk about the history of Hong Kong's currency peg and where we find ourselves today.

Hong Kong has had a peg to the dollar of 7.8 since 1983. The peg first started in 1972 at a rate of of 5.65. Between 1974 and 1983 the Hong Kong dollar floated meaning that markets would set the exchange rate. Singapore, who shares many similarities to Hong Kong, on the other hand has what they call a managed float. Singapore, rather than peg their currency to the dollar, or any other currency, monitors its trading within a floating band. When markets get volatile history has proven Singapore's monetary authority doesn't try to interfere much in protecting the band which is smart because it would be very expensive for them to do so.

Why is this all relevant? Over the last 15 years Hong Kong and Singapore have competed fiercely as Asian financial centers. Both do an excellent job and both have attracted enormous capital inflows from the region. If one country is doing good then the other one is doing good and vice versa. This means that comparing their currencies can give us early warning signs of cracks in the system. Comparing their currencies also lets visualize the potential pressure building on the Hong Kong dollar peg and gives an indication of which direction it may break.

In this chart you can see quite clearly that the U.S dollar is rising rapidly against the Singapore dollar. As I write USDSGD is trading around 1.35. It's kind of like visualizing the movement of tectonic plates below the surface before an earthquake is felt up above. We believe the USDSGD will cross 1.40 by the end of the year. Should things really accelerate towards 1.50 then we believe the Hong Kong dollar will break and the U.S. dollar will rapidly appreciate against it.

We believe that there are also other early warning signals we can watch to anticipate the break. With Hong Kong's intimate relationship to China it's valuable to understand the role of the yuan in China and in Hong Kong.

The Relationship Between CNY and CNH

It's not uncommon for investors (and politicians) in the western hemisphere to be confused by China's currency. Is it the renminmbi or the yuan? It doesn't help that there are 3 different currency abbreviations RMB, CNY, and CNH. Renminbi is simply the name of the currency whereas the yuan is the unit of account. An easy analogy that others have used is to think about Britain's currency which is called the sterling however Britain uses the pound as one of its units and the pound is what is most often referred to FX trading. So for trading purposes its best to start thinking in terms of yuans. 

Next becomes the question about CNY vs CNH. CNY is the onshore yuan market rate and CNH is the offshore yuan market rate. As you might guess with China's tight controls the onshore rate is more controlled than the offshore rate. While the offshore rate is a market rate it naturally tracks the onshore rate. Comparing the two can be quite useful. If CNH is at a premium to CNY it shows the markets expectations that the yuan will be fixed higher by the PBOC. If it is lower it shows that the market is anticipating yuan weakness. Now remember that since CNH and CNY are typically quoted as USDCNH and USDCNY a premium would be reflected as USDCNH trading below USDCNY i.e. it takes less offshore yuan to buy 1 dollar than onshore yuan.

In the chart below I have subtracted the offshore rate from the onshore rate. Anything below the line is showing weakness in the offshore market which could be an early sign that the onshore market may soon follow. Yuan weakness will mean Hong Kong dollar weakness.

While many people were caught off guard by the EURCHF peg being removed most believe it won't happen to USDHKD because its been there since 1983 whereas the EURCHF only lasted a few years.

We of course having predicted the EURCHF peg break from the day it was put on believe differently and this week apparently we are not the only ones as we noticed that one of our FX brokers, Saxo Bank raised currency margins to a whopping 20% on three currencies. Care to guess what those currencies are? They are HKD, CNY, and CNH. I would bet that Saxo Bank is looking at their client FX positions and realize that most clients holding those currencies are long rather than short and thus exposing Saxo to significant losses if there's a peg break. Smart move by Saxo and others will surely follow. Let's watch carefully this giant game of chicken that central bankers are playing and see who blinks next. Our bet? Clearly the Hong Kong Monetary Authority.

No comments:

Post a Comment