Hong Kong: In The Eye Of A Hurricane

Deep flaws are undermining the city-state's economy--and its recovery

Perhaps nothing better epitomizes the wild swings of Hong Kong's fortunes than the travails of Wong Kwan. A former chef who fled China during the Cultural Revolution, Wong made a bundle in local real estate and in 1996 paid a shocking $118 million for a pair of mansions on exclusive Victoria Peak. At that point, stock in his Pearl Oriental Holding Ltd. was flying high. But these days, Wong is saddled with collapsed property deals involving more than $290 million. He is scrambling to sell his Peak palaces and is suing a company that backed out of a property sale. Wong says Pearl will hang on, but its stock is down 90% in 12 months.

As Hong Kong enters the Chinese Year of the Tiger, it may seem to the outside world that the scrappy city-state is already snapping out of a funk that has dogged the economy since the Asia crisis flared up in July. On Feb. 2, the Hang Seng index soared 14%, to around 10,500. But behind the burst of euphoria, there remain hundreds of stories like Wong's--tales of glorious wealth, fabulous consumption, vaunting ambition, and a rude fall to earth. Business confidence, shaken by plunging property values and high interest rates, is at a 15-year low. The underlying fear is that worrisome cracks have been exposed in the pillars of an economy that had seemed the glittering jewel of the Pacific Century. A full recovery may take years.

How did one of Asia's safest havens end up humbled along with the region's other Tigers? Unlike its hard-hit neighbors, Hong Kong doesn't have a collapsing currency, underwater banks, or empty skyscrapers. Indeed, with its superb infrastructure, location, and pool of entrepreneurial talent, Hong Kong remains Asia's premier business hub. Because it focuses on services, not manufacturing, most assumed the city would not get hurt by the currency devaluations that have swept the region.

HEAVY DEBT. But the Asia crisis is forcing Hong Kong to confront two big flaws in its economy. One is that its wealth is heavily based on real estate, and prices have been kept artificially high by the government and a cartel of developers. As a result, Hong Kong has become one of Asia's costliest places to do business. The other handicap is that Hong Kong pegs its currency to the U.S. dollar. That helped the enclave weather shocks such as the 1989 Tiananmen Square massacre. But it left Hong Kong no room to maneuver after the rest of Asia's currencies plunged, making the city even more expensive (table, page 52).

So Hong Kong is in a bind. If it drops the peg now, capital will flee. But to support its currency, the government will have to keep interest rates high, even though that is causing property prices to fall. As the Asian crisis drags into its eighth month, the high rates are exacting a toll. The slump has spread from property to Hong Kong's banking and retail industries. And more individuals and businesses are having a hard time paying debts.

Deep down, investors know something has to give. So despite government assurances on the Hong Kong dollar, many are quietly converting them into greenbacks and have been staying out of the market. The Feb. 2 bounceback may mean the slide has bottomed out. But the damage done since last July is still frightening. The Hang Seng stock index has fallen 37%, wiping away $230 billion in equity wealth, more than the city's gross domestic product of $175 billion. Residential prices are down 30% and may tumble another 20%. SocGen-Crosby Securities estimates that by June, the value of Hong Kong property will have dropped by $143 billion from a September, 1997, peak of $476 billion. Interest rates, as low as 5.2% last year, have soared above 12%.

Hong Kong's savvy businessmen had envisioned a far rosier scenario for 1998 and beyond. After the handover to the Chinese last July, Hong Kong was supposed to enter a new era of prosperity. As the financial capital of an economic superpower, Hong Kong would amass even vaster wealth by backing new factories, highways, and condos on the mainland. Hong Kong markets would float shares of thousands of mainland companies, allowing China to finance the restructuring of state-owned enterprises. And rents would keep rising as multinationals kept flocking in.

The optimists say there is nothing intrinsically amiss with this vision. The current woes, boosters say, are merely a needed cyclical correction. They welcome the steep drop in inflated property prices and the expected corporate streamlining. They also laud the government for staving off a currency collapse. "By the third quarter, Hong Kong will be ready to roar again," says William H. Overholt, a managing director of Bankers Trust's Hong Kong office.

The optimists may want to reconsider. Of course, Hong Kong is hardly in danger of collapsing like Indonesia. But rather than a speedy return to boom times, Hong Kong will likely have to live with diminished expectations--and the realization it remains vulnerable to market shocks around the region.

Hong Kong knows it must bring its costs in line with the rest of Asia. The hope is that lower property values will translate into lower costs for everything from expatriate housing and accounting services to restaurant meals. The more expedient method of lowering costs--a cheaper currency--isn't an option right now. Hong Kong officials fear a devaluation would trigger massive capital flight, and interest rates would still have to stay high to protect the currency.

So the travel, financial, and retail sectors continue to contract. More worrisome, there are signs that China's economy is slowing as well. Growth on the mainland may slip from 9% last year to as low as 6% in 1998. That means a smaller appetite for Hong Kong-financed property projects and the wares of its retail chains.

Hong Kong's dreams of serving as China's Wall Street also are suffering. The collapse in equity markets has forced many Chinese companies to shelve ambitious plans to keep issuing shares on the Hang Seng. Red chips raised a record $10 billion last year in Hong Kong, double the 1996 total. That figure is expected to shrivel to $3 billion in '98.

So far, the government has not explained how it will navigate these dangerous shoals. The new chief executive, Tung Chee-hwa, has kept a low profile. He knows Hong Kong must lower prices to stay competitive. But he is shying away from confronting the powerful property barons. In fact, the government is taking commercial land off the market to stabilize prices.

Government critics are calling for everything from corporate and property tax cuts to increased infrastructure spending. The Hong Kong Monetary Authority, meanwhile, is mulling ways to boost confidence in the dollar peg. But some investors aren't taking chances. Companies have started to convert Hong Kong dollars into other currencies and hedge their foreign-currency debts.

JITTERS. At any rate, it will take more than gestures to stem the mounting despair. It's a despair created by years of real estate speculation. From 1991 to 1996, developers and investors borrowed liberally at interest rates that were lower than the rate of inflation. Also, by severely limiting the amount of land it put up for sale despite intense demand, the British helped inflate prices. The government usually sells land in tracts costing hundreds of millions of dollars, and only a few developers can afford to bid.

The end of cheap money, and government promises of more land for middle-class housing, may mean the end of the "era of supernormal profits," says Otto Wong, property analyst at Jardine Fleming Securities Ltd. The tycoons of real estate--billionaire members of the property cartel such as Cheung Kong's Li Ka-shing, Henderson Land's Lee Shau-kee, and the Kwok brothers of Sun Hung Kai Properties Ltd.--show no signs of cracking.

But weaker players will be forced to sell off assets. Take Sino Land Co. In early 1997, Chairman Robert Ng bid a staggering $1.5 billion for a 275,000-square-foot site in the city's gritty Chai Wan district. Now, Sino is in a squeeze. It holds such posh properties as the Mayfair in the Mid-Levels, where each of its 60 luxury apartments boasts harbor views and wine refrigerators in each kitchen. The expected monthly rental for a four-bedroom flat: $19,000. But instead of collecting fat rents, Sino is being forced to put the units up for sale.

The real carnage, however, will be among the many neophyte players who risked millions in the final wave of speculation. Chinese businesses were especially reckless. Companies owned by various municipalities, the People's Liberation Army, and state enterprises got burned buying office towers and condos. Mainland companies also were active in last year's frothy stock market, typically buying up to l0% of all red-chip offerings at dizzyingly high prices.

The slowdown also is bad for banks. Most Hong Kong banks remain well-capitalized by world standards. But analysts expect margins to contract, and provisions for bad loans to grow. HG Asia estimates bank earnings will decline as much as 30% this year. "There is going to be a rationalization of the banking system," predicts Paul A. Coughlin, managing director of Standard & Poor's in Hong Kong.

For now, Hong Kong has no choice but to ride out the storm. With their monetary-policy options limited, officials can only hope that falling rents make the city more competitive. They also are praying that China won't be the next shoe to drop in the Asian crisis.

It's a dispiriting picture, and one that a rebound in the stock market can't entirely erase. In the Year of the Tiger, Hong Kong will need its legendary resiliency more than ever.

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