In Hong Kong, Too Much Of A Good Thing?

Hong Kong has to unload shares without killing the market

Hong Kong Financial Secretary Sir Donald Tsang is facing the kind of problem that most finance ministers would die for. Over the past year, he has watched the government's $15 billion portfolio of local stocks soar in value to about $27 billion. So what's the problem? He has to sell the shares. And do so without depressing the market. Realizing most of that profit would be a pretty neat trick, too. The stocks are, of course, those the government famously acquired in August, 1998, to fend off speculators who were dumping them in the midst of a regional meltdown. In a little more than two weeks, the government became one of the largest shareholders in some of the territory's most prominent companies (table).

That has worried many investors. A government that was, after all, supposedly Asia's staunchest free-market booster, had effectively nationalized about 7% of the benchmark Hang Seng index. Ever since last fall, Tsang has been promising to sell, and everybody with anything in the market has been waiting to see how. Their fear: once he began unloading the shares, the sales might undermine a market still struggling to return to precrash levels.

The exit strategy is going to be a lot messier and slower than the quick-fire buying was. The government is trying to whet the appetites of local retail investors by launching a promotional blitz. But to move so much stock, even over time, the government has to attract big foreign institutional buyers, such as pension and mutual funds. Their initial reactions to the first stage of Tsang's great sell-off, unveiled on Oct. 11, were distinctly skeptical, however. The government has packaged part of its portfolio into an index fund that replicates the 33-stock Hang Seng exactly. It will offer about $2.5 billion worth of shares at a discount to be set on Nov. 8. Most analysts guess the discount will be about 5% of net asset value. If they're right, Tsang may not find many eager buyers. "There is no incentive to buy the fund without a sizable discount," says Jui Lai, who manages a $2 billion Asian portfolio at Boston's Grantham, Mayo & Van Otterloo. "We would consider buying it at a 7% to 8% discount."

NOT ENOUGH BUZZ. Even much bigger discounts wouldn't be high enough for some. "I'm not buying this," says Paul Matthews, president and chief investment officer of San Francisco's Matthews International Funds, which manages $330 million of assets. "Our opportunity to add value is in picking stocks." The trouble for investors such as Matthews is that the government's Tracker Fund of Hong Kong (TraHK), designed by Goldman Sachs, ING Barings, and Jardine Fleming, is stuffed with old-line real estate development companies and banks. They simply don't generate the buzz of New Economy stocks such as Pacific Century CyberWorks, an Internet pioneer that has just invested $500 million in SoftNet Systems of the U.S. What's more, some potential buyers don't want to be stuck with mainland red-chip stocks such as Guangdong Investment or China Resources Enterprises. "There is too much junk in the Hong Kong portfolio," complains Michael Lee, senior Pacific equity analyst at Santander Global Advisers in Boston.

All the same, the Exchange Fund Investment Ltd., the government body that manages the holdings, has tried to cater to large investors' needs. They will, for example, be able to turn in a minimum of 1 million fund units and receive the underlying 33 stocks in exchange. That will allow them to get big lines of the stocks they really want, and sell off what they don't need. Conversely, investors can present packets of stocks in the right proportions and receive fund units in return. Such switching should keep the values of the fund and the underlying shares in lockstep. In fact, TraHKs should behave like the popular "Spiders"--Standard & Poor's 500 Index Depositary Receipts, on which they're modeled--that trade on the American Stock Exchange.

Unfortunately for Tsang, Hong Kong's markets are far less liquid than the U.S.'s. Hong Kong's biggest ever initial public offering, for example, was $2.4 billion, raised by China Telecom (Hong Kong) Ltd. in 1997. That's the size of the initial tranche of TraHK, yet only one-tenth of the government's holdings. So it will sell more shares every three months. Foreign fund managers guess that the market can stump up between $1 billion and $2 billion of new money per quarter, so the tap issues may be that size. This raises a worry that the government might exercise undue influence on the market by turning the spigot on and off. Also, there's a risk that either TraHK or companies wanting to raise capital could be frozen out of the market. For example, an initial public offering--planned to raise about $2.5 billion in Hong Kong and New York for Beijing's oil exploration company, CNOOC Ltd.--could prove severe competition for TraHK.

LOTS OF ADS. Still, a few fund managers believe that pure relief over the fact that the government is finally starting to divest, combined with renewed confidence in Hong Kong, should override these concerns. "I wouldn't be surprised if the fund were oversubscribed and led to a market rally," says Sheldon Ray, Prudential Securities Inc. portfolio manager in Washington, D.C., whose group manages $120 million of funds.

The government is working hard to attract small retail investors with a big ad campaign. Next year, people employed locally will be required to set up private pension funds, presenting a potential market for TraHK. So locals are being courted with come-ons such as bonus shares if they hold the fund for a year. Even so, Tsang has a hard sell ahead of him. Many Hong Kong people prefer the thrill of gambling on individual stocks. "The government won't have lots of people banging at its door," warns Robert Conlon, chief investment officer at Hong Kong-based Investec Guinness Flight Ltd.

Tsang knows that he will have to get rid of shares by other means. The government has mulled selling its own shares back to companies, placing shares through block trades or issuing bonds that buyers could convert into shares when stock prices reach designated levels. Financial sources say that some blue chips, such as Cathay Pacific, Swire Pacific, and HK Electric, are interested in the first possibility, as buybacks generally boost share values. But government-organized share placements could cause problems, since officials might be accused of favoring one company over another. And convertible bonds could lead to the government's assuming debt if the holders decide not to change their bonds into shares. The government also intends to keep about $6 billion worth of shares as a long-term investment.

Investors hope that's all. The temptation to hold on to more may grow. The Hang Seng has been drifting in recent weeks and a spike in U.S. interest rates could push it down further. That could slow the great sell-off. And with the government possibly intervening in the stock exchange every few months when it decides how many new TraHK shares to release, it will be a long while before Hong Kong's bureaucrats leave the market to itself.