Some Thoughts on Hong Kong

Political tensions in Hong Kong are nearing a boiling point. If mainland China police forces go into Hong Kong, then all bets are off. That is not our base case and so our investment outlook hinges on some sort of negotiated political settlement occurring.


Popular protest that began in response to a planned extradition law have widened and intensified. We are now in the tenth week of protests. Flights were canceled for the second straight day today as protestors took over parts of the main terminal. As of this writing, riot police have now engaged the protestors in the terminal.

The response of Hong Kong authorities has hardened in recent days. This shouldn’t be too surprising given that the police brought former Deputy Commissioner Alan Lau out of retirement to lead the crackdown. He was known for his support of hardline responses to protestors. Use of tear gas and rubber bullets has picked up, as have physical altercations using billy clubs. The primary goal of dispersing the protestors has been replaced with arresting them.

It seems that the Hong Kong authorities are for now resisting any sort of political solution. This cannot last. The extradition law has been suspended, but protestors want its full withdrawal. They are also demanding the resignation of Chief Executive Carrie Lam, investigations into alleged police brutality, greater democracy, and amnesty for those arrested in the clashes. UN human rights chief Michele Bachelet and her office has said there is credible evidence that Hong Kong police used force in ways that are “prohibited by international norms and standards.”

Reports suggest Chinese police forces are massing in the neighboring city of Shenzhen. Rhetoric out of China has hardened, with some officials likening the protestors to terrorists. For now, we suspect this is just an implied threat and an intimidating show of force. The optics of an actual incursion of mainland forces into Hong Kong would be awful, to state the obvious. While the odds of this happening are getting higher, we remain hopeful that cooler heads will prevail and the two sides in Hong Kong can move towards some sort of limited political sentiment.

The resignation of Carrie Lam would be an easy bone to throw to the protestors. The post of Chief Executive is filled by Beijing. As such, she will simply be replaced by another pro-mainland politician. In terms of the other demands, we think most are possible, the exception being greater democracy in Hong Kong. We could see some investigations into police brutality and perhaps even some amnesty can be granted, but greater democracy in Hong Kong is just not in the cards.

Investors have bought into the notion that “one country, two systems” will be maintained until 2047 (see A Brief History Lesson below). Any heavy-handed efforts by the mainland to crack down on the Hong Kong protests will directly feed into investor concerns that those two systems can’t or won’t be maintained by China. That in turn will call into question the entire rule of law in Hong Kong and markets will tank. Once lost, trust and credibility may never be regained.



The UK gained control of parts of Hong Kong via three treaties with China. Because these agreements were signed under duress, China came to call them the “unequal treaties.” In 1842, the Treaty of Nanking ended the First Opium War and ceded control of Hong Kong to Queen Victoria. In 1860, the Convention of Peking ended the Second Opium War and ceded control of Kowloon to the UK was well. Lastly, China’s defeat in the First Sino-Japanese War gave the UK to squeeze further concessions with the Second Convention of Peking in 1898. This leased the New Territories to the British for 99 years.

After China gained a seat at the United Nations in 1971, it embarked on the long and winding road of regaining sovereignty over Hong Kong and Macao. No progress was really seen until 1979, when then-Governor of Hong Kong Murray MacLehose traveled to Beijing to discuss Hong Kong’s status with then-leader Deng Xiaoping. In 1982, former Prime Minister Heath was asked by Prime Minister Thatcher to meet with Deng. It was then that Deng first outlined his plan to make Hong Kong a special economic zone that would retain its capitalist system. Thus, the notion of “one country, two systems” was born.

Thatcher visited China in October 1982 to meet with Deng. The UK was pushing to maintain its presence in Hong Kong. On the other hand, China was taking a hard line, refusing not only to extend the 99-year lease but also refusing to recognize the so-called “unequal treaties” that had ceded Hong Kong and Kowloon sovereignty to the UK.

By all accounts, these talks were testy. It is said that Deng even hinted at the possibility of taking Hong Kong by force. Thatcher then traveled to Hong Kong, becoming the first Prime Minister to visit the colony whilst in office. She stressed that all three treaties were valid and must be respected. At around the same time, the National People’s Congress was in session and passed the Article 31 amendment that allowed for the establishment of Special Administrative Regions (SARs) when necessary.

Markets began to take notice of the difficult situation. The Hang Seng Index fell over 60% from its July 1981 peak to its October 1983 trough. With HKD freely floating then, it weakened from around 5 per USD in early 1981 to almost 9 per USD in September 1983 before the peg was introduced in October 1983.

By late 1983, the UK had backed away from its intent to administer Hong Kong after 1997. This led to the signing of the Sino-British Joint Declaration in May 1985. China would regain sovereignty over Hong Kong, Kowloon, and the New Territories effective July 1, 1997. In return, China pledged to maintain “one country, two systems” for a period of 50 years until 2047.



Under the original peg arrangement, HKD could not trade on the weak side (above) of the 7.8 peg rate but could appreciate without limit to the strong side (below 7.8). It has only been seriously challenged once, during the Asian Crisis that started in 1997. When the crisis deepened in 1998, interbank rates soared as foreign reserves fell, and the domestic money supply shrank. The HKMA also took some unorthodox steps then, such as buying Hong Kong stocks as the Hang Seng plunged. Ultimately, the HKMA prevailed and we would expect similar success if the HKD were to come under sustained pressure again.

The HKMA runs a strict currency board. In essence, this means that every HKD in circulation is backed by an equivalent amount (at the official exchange rate) of USD. When run correctly, such a peg cannot be broken. Argentina’s peg was broken because it violated several of the basic tenets of a currency board, including central bank financing of the budget deficit.

A minor adjustment was made in May 2005, when a trading band of 7.75-7.85 was introduced around the peg rate. The Hong Kong Monetary Authority (HKMA) is obliged to buy and sell USD to prevent the HKD from breaching either side of the band. It did not have to do so until April 2018, when USD/HKD first started to bump up against the top of the trading band. Yet the mechanics of the peg remain intact. That is, intervention will shrink the money supply, which will then boost local interest rates and support HKD.

The HKMA has several lines of defense even before intervening at the band limits. The HKMA has a mandate to conduct FX and money market as needed to promote the “smooth functioning” of local markets. As a first line of defense, the HKMA typically sells extra debt to mop up liquidity when HKD faces selling pressure. This can be done before HKD trades at the weak limit of the band. As a second line of defense, the HKMA can intervene in the FX market ahead of the trading band limits.

Yet we continue to believe that it is realistic scenario to expect a re-pegging of the HKD to the Chinese yuan at some time in the future. The “one country, two systems” framework is in place until 2047, but one can imagine convergence of the exchange rates before that. It seems that if and when conditions merit (full yuan convertibility, continued integration of Hong Kong into mainland China, etc.), then the Chinese authorities could eventually link or perhaps even unify the Hong Kong dollar with the yuan. This is a long-term proposition, and there will likely be ample warnings and leaks during the process so that investors are not caught unaware. For now, we see no change to the HKD peg.



The Hong Kong economy is likely to fall into recession. GDP growth is forecast by the IMF to decelerate to 2.7% in 2019 from 3.0% in 2018 before accelerating to 3.0% in 2020. GDP rose only 0.6% y/y in Q1, the slowest since Q3 2009 and the fourth straight quarterly deceleration. Q2 data will be reported this Friday, with growth expected to remain steady at 0.6% y/y. With trade tensions persisting and now local activity dampened by the protests, we see clear downside risks to the growth forecasts.

Price pressures may be rising. CPI rose 3.3% y/y in June, the highest reading since March 2015. The Hong Kong Monetary Authority (HKMA) does not have an explicit inflation target nor does it run an independent monetary policy due to the HKD peg to USD. The HKMA raised the base rate nine times since December 2015 to 2.75% before cutting it this month to 2.5%, all in lockstep with the Fed.

Hong Kong commercial banks do not always adjust their Prime Lending rates in response to changes in the Bank Rate. Indeed, the Prime rate has been kept pretty much at the 5% trough by the two largest commercial banks despite the 225 bp of Fed tightening seen since December 2015. This was because Hong Kong liquidity remained ample, keeping most local markets rates low.

The external accounts remain in good shape. Hong Kong has run a current account surplus since 1998. The IMF expects that surplus to be around 3.2% of GDP in 2019 and 3.4% in 2020. Hong Kong runs a large positive Net International Investment Position (NIIP) that’s nearly four times GDP. HKMA foreign reserves stood at a record high $448.5 bln in July. Clearly, Hong Kong has very low external vulnerability across virtually all metrics. This supports our view that any selling pressures on HKD are likely to remain under control.



If mainland China police forces go into Hong Kong, then all bets are off. That is not our base case and so our investment outlook hinges on some sort of negotiated political settlement occurring.

USD/HKD continues to trade near the weak end of the band. Back in July, USD/HKD briefly traded below the 7.80 mid-point. Recent HKD weakness should be seen within the context of overall EM FX weakness. With much of EM likely to come under greater pressure, we suspect USD/HKD will continue to trade largely within the upper half of the trading band above 7.80.

Earlier this year, local liquidity conditions tightened as the HKMA intervened to support HKD at the weak end of the trading band. Interbank lending rates moved higher, as one would expect under the currency board. As the HKD firmed, local liquidity rose, and interbank rates have since eased.

Hong Kong equities are underperforming after outperforming slightly in 2018. In 2018, MSCI Hong Kong was -10.8% and compared to -11.6% for MSCI DM. So far this year, MSCI Hong Kong is up 0.9% and compares to 14.8% YTD for MSCI DM. This underperformance should ebb, as our DM Equity model has Hong Kong at a NEUTRAL position. However, it will be hard for equities to gain much traction until the protests end.

Hong Kong bonds have underperformed. The yield on 10-year local currency government bonds is -81 bp YTD. This is ahead of only the worst performers Japan (-24 bp), Singapore (-39 bp), Norway (-61 bp), Canada (-70 bp), Switzerland, (-71 bp), Sweden (-73 bp), and the UK And Denmark (bot -77 bp). Inflation is likely to remain under control, but with the HKMA likely to resume tightening local liquidity in response to the softer HKD, we think Hong Kong bonds will continue to underperform.

Our latest DM sovereign ratings model update had Hong Kong’s implied rating steady at AAA/Aaa/AAA. This compares to actual ratings of AA+/Aa2/AA+ and so upgrades are warranted.