It's a sign of desperation and, normally, an act of last resort: A government sees local stocks tumbling and intervenes to prop up prices. Except that Hong Kong, where that has been happening steadily through the last half of August, is supposed to be a hands-off kind of place. But by throwing an estimated $3 billion in foreign reserves at speculators to fend them off, Hong Kong has shown that it's afraid of what those betting against the Hong Kong dollar could do to the economy. And that has perversely encouraged the speculators to keep attacking all the more--with increasing effectiveness. "Hedge funds smell blood," says Cliff Tan, a Singapore-based foreign-exchange analyst at Warburg Dillon Read.
It's possible they'll get it. At the heart of this uproar is the government's pledge to keep its currency pegged to the U.S. dollar. If the peg breaks, say authorities, chaos will follow. The Hong Kong dollar might tumble as much as 40%, like other Asian currencies. Then, all bets are off that China will be able to withstand devaluing its currency, too. Further devastating currency devaluations in Asia would follow. Traders don't care: In August, the Hong Kong Monetary Authority said hedge funds were deliberately trying to crash the stock market by launching an all-out attack on the peg. So it slammed them to wipe out the short positions they had taken in equities. Tough stuff. Yet as a result, the government may have greatly boosted the chances that the peg will go--and with it, the foundation of the Hong Kong economy.
FOUR OPTIONS. Why? In the end, no government can withstand month after month of attacks on its currency and bourses if it is resolved to strike back through interventions. Eventually, that depletes the treasury, plentiful as Hong Kong's is. "Before this intervention, and before the turmoil in Russia, I wouldn't have even questioned the government's commitment to the peg," says a Hong Kong-based analyst for a prominent U.S. investment bank who has moved his money out of the Hong Kong dollar. "Now, the probability of something happening with the currency, such as a 40% devaluation, has increased dramatically."
The peg may not go quite yet. As it stands, Hong Kong has four options with its currency, all of them far from perfect. It could release the peg and let the Hong Kong dollar float freely. It could continue to stick with the peg and hope speculators are sufficiently unnerved by its tactics that they figure it's too risky to keep attacking the currency. It could go the drastic route of dollarizing its economy--making the U.S. dollar legal tender. Or, finally, it could repeg the dollar at a rate lower than the current 7.8 to one greenback.
Each of these options is fraught with problems. If Hong Kong stays the course, interest rates will stay high, property and stock prices will keep getting hammered, and unemployment will keep rising. Although both stocks and real estate have fallen about 50% in the past year, analysts say there's still a lot more room to fall. Morgan Stanley Asia Ltd. says residential property prices still need to drop 40% to 50% more from present levels. As property prices fall, so does the Hang Seng, which is dominated by property-linked companies.
Dollarizing the currency would leave traders nothing to attack, and it might stabilize things. Yet the move would be politically unpalatable to Beijing, which took control of Hong Kong last year. Accepting the greenback as legal tender on Chinese soil would be a bitter pill to swallow. Other issues: Hong Kong would have to raise $115 billion from China or elsewhere to cover every Hong Kong dollar in circulation. Dollarization also isn't guaranteed to bring down interest rates. With the economy stalling, credit risk remains high--and so could rates. Although the government denies it, market sources say Hong Kong's elite Central Policy Unit is at least exploring dollarization with Washington.
Letting the currency float freely or repegging it to the U.S. dollar at a lower rate might help ease the pain by making local stocks and properties cheaper to international investors. Or it might not. Interest rates might rise in response to the increased volatility, as they have done throughout emerging markets in the past year. And keeping a peg at all might keep attracting attacks.
Still, some investors think a repegging is the most sensible way to let the economy adjust. That would make wages more competitive internationally. "The best thing that can happen is to realign the peg," says Jim Mellon, chairman of Hong Kong-based fund manager Regent Pacific Group Ltd. "Asset prices are adjusting, but wages are not. You either need to cut the currency or be willing to accept mass unemployment."
Whatever happens, it is going to take Hong Kong years to overcome the effects of its recent interventions. In a sentiment typical of many, a Hong Kong-based international fund manager derides the "Mahathirization" of the Hong Kong economy, a caustic reference to Malaysian Prime Minister Mahathir Mohamad's distrust of markets and his heavy-handed attempts to prop up local companies. Indeed, Mahathir is the only international leader who has spoken out in favor of Hong Kong's intervention, saying it has proved his point about the power of hedge funds.
Hong Kong's leaders insist that nothing has changed. "The only objective is to eliminate the manipulation," says Esmond K.Y. Lee, the New York representative for the Monetary Authority, and to "restore the intrinsic value of shares, to make them more in line with economic reality and the fundamentals."
WIDESPREAD PAIN. Meanwhile, the damage is spreading. Rising rates are hitting smaller banks and property players hard. Loans tower over the Hong Kong economy at a rate of 150% of gross domestic product--one of the highest ratios in Asia. That means a lot of people get hurt by a rise in interest rates.
Consumers are cutting back drastically. Retail sales are down 15% so far this year, and stores all over Hong Kong are going bankrupt. The feeling in Hong Kong is that the local business community, led by property developers, is pleading with Hong Kong Chief Executive Tung Chee-hwa to protect their interests. "The pain is leading people who have the ear of Mr. Tung to pressure him into doing something," says Merrill Lynch & Co. Vice-President Richard Margolis. "He is responding to that pressure."
Government officials strenuously deny that they are in the pocket of the property barons. They point out that the HKMA is buying all kinds of stocks, not just property. "The government has to take some decision to guard the public interest," says David K.P. Tsui, director of the Hong Kong Economic & Trade Office in New York. The question is whether clumsy market manipulation truly serves the public interest in a place that holds itself up as a model economy. The betting is that it doesn't.