Hong Kong

The Asian crisis is forcing it to examine the deep flaws in its economy. But does Hong Kong have the will to change?

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 insists Pearl will pull through, 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 by 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. Recent polls show that business confidence, shaken by falling property prices and a spike in 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 to be 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, rather than manufacturing, most assumed Hong Kong would not get hurt by the currency devaluations that have swept the region.

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. It does so by keeping one U.S. dollar in reserve for every 7.74 Hong Kong dollars in circulation. That peg 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 dropped sharply, making the city even more expensive (table, page 19).

DEBT LOAD. 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 claim 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.

DESIGNER CLOTHES. 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 that it remains vulnerable to booms and busts caused by 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 sharply lower costs for everything from expatriate housing and accounting services to restaurant meals. The more expedient method of lowering costs--a cheaper currency--simply 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. Most local businessmen believe the Hong Kong dollar eventually will be pegged to China's renminbi as the two economies become more integrated. That will take years.

So the travel, financial, and retail sectors continue to contract as Southeast Asia and Korea slide into recession. 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 in China for Hong Kong-financed property projects and the wares of popular retail chains such as Esprit and Giordano.

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 their ambitious plans to keep issuing shares on the Hang Seng. Red chips raised a record $10 billion last year in Hong Kong, double the previous year's total. That figure is expected to shrivel to $3 billion in 1998.

Yet another danger is that China will devalue its currency later this year to regain its competitive edge with Southeast Asia. Beijing insists it won't, but the markets are dubious. A weaker renminbi would put more pressure on Hong Kong to end the U.S. dollar peg--or push its rates up even further to defend it. "High interest rates for an extended period of time will kill the economy," frets one top business leader.

So far, the Hong Kong government has not explained how it will navigate these dangerous shoals. At a time when he is facing his greatest test, the new chief executive, Tung Chee-hwa, has kept a low profile. He knows that property prices must drop sharply for Hong Kong to stay competitive. But he is shying away from confronting the property barons, who are among his strongest backers. Tung's government is even taking commercial land off the market to help stabilize prices. As legislative elections approach in May, opposition candidates will step up their criticism of the government. Even some Tung allies are lashing out. "We are living in extraordinary times, and we need extraordinary measures," says Allen Lee, a member of the pro-business Liberal Party.

Government critics are calling for everything from corporate and property tax cuts to increased infrastructure spending. They hope such measures will be mentioned in a Feb. 23 budget address by Financial Secretary Donald Tsang. The Hong Kong Monetary Authority, meanwhile, is mulling ways to boost confidence in the dollar peg. Nevertheless, some investors aren't taking chances. Late last year, for example, Hong Kong utility China Light & Power Co. moved half of its massive $2 billion-plus hoard of Hong Kong dollars into other currencies. Other Hong Kong companies have begun hedging much of their $60 billion in foreign-currency debts.

A LITTLE LARGESSE. To buoy sentiment for the Hong Kong dollar, some experts are proposing a kind of insurance system backed by the government's $92.8 billion in hard currency reserves. The idea is to give buyers of short-term paper the option to cash the notes in for a fixed amount of U.S. dollars. If the plan works, authorities hope they will be able to bring down interest rates and resume growth in credit.

Hong Kong can afford a little largesse. Despite having a low corporate tax rate of 16.5%, it has run a budget surplus for years. By cutting taxes further, Hong Kong may ease complaints about soaring costs. Hutchison Telecommunications (Hong Kong) Ltd. and Star Telecom Ltd. are shifting part of their operations to Macau, where salaries can be 80% cheaper. And airlines have long protested the high fees that will be charged at Hong Kong's new airport, which opens in July.

But it will take more than a few simple gestures to stem the mounting feeling of despair. Sadly, it's a despair created by years of real estate speculation. From 1991 to 1996, developers borrowed liberally at interest rates that were lower than the rate of inflation. Rates were kept low to discourage foreign funds from flowing in and fueling inflation. Cheap credit and ever-climbing rents meant developers and homebuyers alike had plenty of money to play with. Also, by severely limiting the amount of land it put up for sale despite intense demand, the British helped inflate prices. An estimated one-third of the Hong Kong government's revenue still comes from land sales. What's more, the government usually sells its land in huge tracts costing hundreds of millions of dollars. Only a few elite developers have such resources.

JITTERS. Now, the cheap money is gone. Tung's government, despite its caution so far, still promises to provide more land for middle-class housing, thus adding to supply. These trends may end the "era of supernormal profits," says Otto Wong, property analyst at Jardine Fleming Securities Ltd.

Dramatic restructuring is in store for the real estate sector. In these shaky days, it's impossible to predict who will get hurt the most. The great 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. Sun Hung Kai, for example, is sitting on $1 billion in cash, has a comfortable debt-to-equity ratio of 20%, and an enormous bank of undeveloped land. With revenue still pouring in from its massive housing estates and office towers, profits are expected to rise slightly this year to $1.9 billion.

Still, the sector is facing its most serious crunch in 15 years. Unlike previous downturns since the mid-1980s, the property market isn't likely to bounce back within months. The Asian currency jitters could keep interest rates up for the rest of the year in order to convince investors to keep their money in Hong Kong dollars. That means prospects for heady profit growth are slim even for rich cartel members. Sun Hung Kai has frozen work on 10 different residential sites and is slashing prices of luxury apartments in a new residential complex by 33%, a move that will accelerate a price war.

Weaker players will be forced to sell off assets to stay afloat. Take Sino Land Co., a developer famous for its extravagant bids at government land auctions. 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. Largely due to such spending, Sino has debt equal to 44% of its equity, one of the highest levels among Hong Kong developers. By 1999, analysts estimate, the ratio will jump to 64%.

Now Sino is in a squeeze. It holds such posh properties as the Mayfair in the Mid-Levels, a residential district favored by expatriates. Each of its 60 luxury apartment units boast harbor views and wine refrigerators in each kitchen. The expected monthly rental for a four-bedroom flat: $19,000 a month. But instead of collecting fat rents, Sino is being forced to put the newly finished units up for sale.

The real carnage, however, will be among the many neophyte players who risked hundreds of millions in the final wave of speculation. Chinese businesses were especially reckless. Firms owned by various municipalities, the People's Liberation Army, and state enterprises got burned buying office towers and condos.

GREAT WALL. Hong Kong companies owned by Southeast Asians are also getting hammered. Stelux Holdings International Ltd., a Hong Kong watch and retail group controlled by a Thai-Chinese family, has taken huge losses in the Bangkok property market. It recently sold a prime Hong Kong property at a $123 million loss to raise cash, while its $125 million convertible bond, traded in Hong Kong, is being pummeled.

All of this bad news is keeping the stock market on edge. Here again, China's high-flying new capitalists have taken an especially big hit. At the peak of last year's frothy market, analysts say, mainland companies and their executives commonly bought up to l0% of all red-chip offerings. "I hear they are all sitting on a lot of losses," says an insider involved with a number of shares. Analysts are waiting for the annual results of such mainland companies as Beijing Enterprises, a Hong Kong-listed company that has interests in everything from McDonald's outlets in Beijing to tourist concessions at the Great Wall. If red chips took huge losses in the market, parent companies in China may be forced to bail them out at a time when they desperately need funds at home.

With most high rollers chastened, the suffering of the financial sector has just begun. The collapse of Peregrine Securities and C.A. Pacific Securities Ltd. may be the first of many casualties. The markets also should be worried about the pressure on ordinary Hong Kong residents. Merrill Lynch estimates that another 10% drop in residential prices would mean that 43% of homeowners will have negative equity in their properties. Rising rates are exacerbating the squeeze. Housewife Bertha Mang found that the interest rate on her variable rate mortgage went up from 10.5% to 11.25% in December. That has pushed the monthly payments on her 1,300-square-foot flat, for which she paid $1.2 million at the peak of the market last August, up by $450, to $7,752. Until rates come down, Mang vows "no spending on luxury items."

Such vows are trickling down to retailers, who already are hit by a falloff in Asian tourists. "It's hard to see when a turnaround will come," says Edwin Ing, executive director at upmarket retailer Dickson Concepts International Ltd.

The slowdown also has been bad for banks. Since most Hong Kong banks are still well capitalized by world standards, few are in mortal danger. But analysts expect margins to contract, and provisions for bad loans to grow. HG Asia estimates that bank earnings will decline as much as 30% this year. Smaller institutions will be hardest hit. Dah Sing, part of a midsize financial group, has begun to lay off employees in what promises to be a major restructuring. "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. To keep creating wealth over the longer term, Hong Kong will have to depend less on property and instead work harder to expand its role as a regional service hub. That means business is praying hard 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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