“We walked to the brink and we looked it in the face.” — John Foster Dulles, United States Secretary of State under President Dwight D. Eisenhower from 1953 to 1959
“People like me who were engaging in brinkmanship with the party economic bosses and the open dissidents who were being arrested were pursuing a common goal in different ways.” — Vaclav Klaus, Czech economist and politician who served as the second President of the Czech Republic from 2003 to 2013
Turkish Lira and Non-Resident Holdings
After a sharp decline between January and August last year and crossing the 7 handle, the Turkish lira rebounded by 15 per cent from September through December, following a massive interest rate hike by the Turkish central bank. The currency, following a period of relative calm for during the first two months of 2019, has once again started dropping like a stone, although not as precipitously as last year.
The recent decline in the lira has been triggered by an economy stuck in stagflation and heightened political instability, which, of course, has been par for the course under President Recep Tayyip Erdoğan. The currency came under pressure this week after fresh elections were announced for the city of Istanbul on the demands of the AK Party, Turkey’s ruling party, which narrowly lost control of the city in municipal elections last March.
Nonresident investors in Turkish capital markets have responded to the economic and political uncertainties by dumping their holdings of domestic bonds and equities. Net outflows of nonresident portfolio investment in local currency assets amounted to US dollars 1.4 billion in March and April as foreign investors pulled capital out of both the domestic bond and equity markets. Nonresidents now hold only 12 per cent of domestic public debt, down from over 20 per cent in 2018.
The chart below compares the Turkish lira-US dollar currency pair (inverted) to the sum of the nonresident holdings of the domestic bond and equity markets. As can be seen from the chart, the currency pair has been tightly correlated with the level of nonresident holdings of domestic assets.
TRY / USD (Inverted) vs. Non-Resident Domestic Bond and Equity Holdings
Source: Bloomberg
With limited room for the nonresident holdings to fall much further — assuming that Turkey is not dropped from global equity and bond indices, events that would force passive investors to also sell down Turkish assets — we would be tempted to go long the lira at current levels, were it not for the unpredictability of Turkey’s leadership.
Hong Kong Dollar Peg
From The Wall Street Journal on 25 April 2019:
Kyle Bass, the often-bearish hedge-fund manager who won big during the global financial crisis, has trained his sights anew on the Hong Kong dollar.
Mr. Bass’s Dallas-based Hayman Capital Management LP published its first investor letter in three years this week, titled “The Quiet Panic in Hong Kong.” Mr. Bass gained publicity a decade ago for his bearish bets against securities tied to the U.S. housing market.
The investor letter, which was viewed by The Wall Street Journal, argues that a combination of rapid growth in floating-rate mortgages, the gap between local and U.S. short-term interest rates, and mounting geopolitical tensions between the U.S. and China put Hong Kong’s currency arrangement at risk of breaking.
“Hong Kong currently sits atop one of the largest financial time bombs in history,” Mr. Bass said in the letter. He said the size and leverage of the city’s banking system made it similar to Iceland, Cyprus and Ireland before their financial crises.
The Asian Financial Crisis originated on 2 July 1997, the day after the sovereignty of Hong Kong was transferred from the United Kingdom to China, with the devaluation of the Thai baht.
The crisis came to be defined by the speculative bets by western hedge fund managers against the many dollar-pegged currencies of South East Asia and precipitating the near collapse of famed US hedge fund Long Term Capital Management.
Hong Kong, too, was embroiled in the crisis; however, unlike Thailand, South Korea and Indonesia, the authorities in Hong Kong chose asset price deflation and economic pain over letting go of their currency peg. The Hong Kong Monetary Authority (HKMA) at one point in 1997 raised overnight interest rates to over 200 per cent, testing speculators’ wherewithal in holding on to their shorts against the currency and in the local stock market. As a corollary of the HKMA’s actions to deter speculators, GDP declined by 5 per cent in 1998 compared to growth of 5.3 per cent in 1997, unemployment reached 6.4 per cent and real estate prices in city-state more than halved.
The spillover effects of a collapsing real estate market were particularly damaging for Hong Kong’s economy. As property values fell, banks curtailed lending and land sales, a significant source of government revenues, fell off a cliff, sending the government’s fiscal revenues plunging. The government, accustomed to running a fiscal surplus, experienced a fiscal deficit of approximately US dollars 3 billion in 1998/99.
The HKMA ended up spending around US dollars 15 billion to fight off short sellers, including buying up stocks and borrowing all the stocks available in the market.
Hong Kong’s experience and the measures taken by its authorities in defending the currency peg is a testament to the pain the city-state is willing to endure to defend the Hong Kong dollar’s peg to the US dollar. Anyone seeking to duke it out with the HKMA should expect a long and arduous battle with little hope of victory in the near term.
The political will to hold on to the dollar-peg is strong. What about the economic reality? One could fairly argue that the political will to defend the peg was also there in Thailand, South Korea and Indonesia but they failed where Hong Kong succeeded. We are of the opinion that the economic reality in favour of the peg remaining are just as strong as the political will.
We quote from the speech given by Mr Norman T. L. Chan, the then Chief Executive Officer of the HKMA, at the Oxford University in 1999 on the lessons from the Asian Financial Crisis (emphasis added):
The banking systems were inadequately supervised and were prone to incurring excessive risks by borrowing short-term funds to finance long-term lending to projects the viability of which was doubtful. Moreover, the corporate sectors of many Asian economies were over-stretching themselves by engaging in risky or unproductive investments. To a varying degree, both the banks and corporates were taking excessive currency risks by borrowing in foreign currencies, which had a much lower interest costs than domestic currencies, to fund projects which could only generate income, if any at all, in domestic currencies. The implicit guarantee of exchange rate stability provided by the governments weakened the alertness to the risks arising from currency and maturity mismatches. As the amounts of international capital flows increased phenomenally in the last few years, disaster struck when the bubble burst.
Excessive currency risk, to paraphrase the words of Mr Chan, were being taken by banks and corporations by borrowing in foreign currencies due to interest rates being lower offshore than onshore. Today, the interest rates in Hong Kong are lower than interest rates in the US. There is no structural reason for banks and corporations to borrow in hard currency and take on excessive currency risks. Implying that one of the conditions that made shorting South East Asian currencies such an asymmetric bet during the Asian Financial Crisis absent for the Hong Kong dollar today.
Short sellers may argue that what makes shorting the Hong Kong dollar particularly attractive is the positive carry i.e. they earn the interest differential between overnight rates in Hong Kong and LIBOR when they short the Hong Kong dollar. Meaning that there is little downside to putting on the trade. This is true till it ceases to be true. If speculators begin to the pile into the trade, overnight rates in Hong Kong will ultimately converge with LIBOR and said free lunch will cease to exist. Should the size of the trade get sufficiently large, the positive carry could even turn into negative carry.
Next, we compare Hong Kong’s monetary base — as defined by the HKMA as consisting as the sum of the certificates of indebtedness outstanding, government notes and coins in circulation, closing aggregate balance, and outstanding exchange fund bills and notes — to the office level of foreign currency reserves held by the HKMA.
Hong Kong Official Foreign Currency Reserves vs. Monetary Base
Source: Hong Kong Monetary Authority
As can be seen in the above chart, the level of foreign reserves held by the HKMA is more than double the city-state’s entire monetary base i.e. the HKMA has sufficient reserves for the entire monetary base to head for the exits twice over. During the Asian Financial Crisis, the HKMA used US dollars 15 billion to fight short-sellers. Today it has more than US dollars 200 billion to fight them with.
We do not have the wherewithal or the appetite for a fight with the HKMA and neither should you!
Definitions
Certificate of Indebtedness
When note-issuing banks in Hong Kong issue banknotes, they are required by law to purchase Certificates of Indebtedness, which serve as backing for the banknotes issued, by submitting an equivalent amount of US dollars at the rate of HK$7.80 to one US dollar to the HKMA for the account of the Exchange Fund.
The Hong Kong dollar banknotes are therefore fully backed by US dollars held by the Exchange Fund. Conversely, when Hong Kong dollar banknotes are withdrawn from circulation, Certificates of Indebtedness are redeemed and the note-issuing banks receive an equivalent amount of US dollars from the Exchange Fund.
Closing Aggregate Balance
Aggregate balance is the sum of balances in the clearing accounts and reserve accounts maintained by commercial banks with the central bank. In Hong Kong, this refers to the sum of the balances in the clearing accounts maintained by the banks with the HKMA for settling interbank payments and payments between banks and the HKMA. The aggregate balance represents the level of interbank liquidity.
Exchange Fund Bills and Notes
Exchange Fund Bills and Notes are Hong Kong dollar debt securities issued by the HKMA. They constitute direct, unsecured, unconditional and general obligations of the Hong Kong Special Administrative Region Government for the account of the Exchange Fund and have the same status as all other unsecured debt of the Government. The Bills and Notes are for the account of and payable from the Exchange Fund.
The Exchange Fund Bills and Notes Issuance Programme ensures the supply of a significant amount of high-quality Hong Kong dollar debt paper, which can be employed as trading, investment and hedging instruments. Authorized Institutions that maintain Hong Kong dollar clearing accounts with the HKMA may use their holdings of Exchange Fund papers to borrow Hong Kong dollars overnight from the Discount Window. Active primary and secondary markets for Exchange Fund Bills and Notes has facilitated the development of a sophisticated Hong Kong dollar debt market.
Source: Hong Kong Monetary Authority
Notes: To read more about the Hong Kong currency board click here
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.