Hong Kong first in global firing line as Libor shock hits currency

Hong Kong is being forced to intervene to defend its currency peg and stem capital outflows, becoming the first global casualty of surging dollar Libor rates and US monetary tightening.

The enclave’s authorities are preparing to sell "exchange fund bills" to drain liquidity, raising fears of a credit squeeze and a property correction that could quickly turn into a cascade.

“The Hong Kong dollar is at its weakest level in 33 years. It suggests an imminent risk of capital flight,” said Francis Chan, a bank analyst for Bloomberg Intelligence.

The Asian hub is fast emerging as a test case of the global tightening cycle, forced to import the monetary policy of the US Federal Reserve – nolens volens – as a result of its long-standing exchange link to the US dollar.

The worry is that a sudden surge in borrowing costs could bring Hong Kong’s spectacular housing boom to a screeching halt and expose the fragility of its "carry trade" lending to highly-leveraged Chinese companies.

The price-to-earnings ratio of the enclave’s property market has reached an all-time record of 19, compared to previous peak of 14 at the onset of the East Asia crisis in 1998. That episode was followed by a 60pc crash in house prices.

The highpoint of this bubble may have been the $200m mystery purchase in December for two flats at "The Peak" on Mount Nicholson, an offshore haunt of Shanghai’s super-rich.

The Bank for International Settlements says Hong Kong’s financial system is the most dangerously over-stretched in the world. The "credit gap" is 45 percentage points of GDP above its long-term trend, a sign of extreme behaviour and the best known predictor of banking crises. The BIS says that any persistent gap above 10 points is a warning.

The Japanese bank Nomura said its gauge of financial risk for Hong Kong is flashing 54 different early warning signals, more than in 1998. “The economy is highly vulnerable to capital outflows or asset quality deterioration,” it warned in a report over the weekend.

What has crystallised concerns is the recent surge in three-month US dollar Libor rates to a 10-year high of 2.29pc – up 50 basis points since early February. This has made it impossible for the Hong Kong Monetary Authority to continue tolerating local Hibor rates near 1pc. In effect, the HKMA can no longer keep propping up the credit system with super-easy money.

Speculators are taking advantage of the gap between the two rates to exploit yield arbitrage. This has pushed the Hong Kong dollar to the legal limits of its trading band. Mr Chan warned investors to brace for a “Hibor surge” as Hong Kong rates recouple with US rates over coming months, setting off a lending crunch. “Only corporations with high credit quality will continue to enjoy cheap funding,” he said.

Norman Chan Tak-lam, HKMA’s chief executive, vowed last Thursday to defend the peg and issued a solemn warning of bleaker days ahead. "This will put an end to the era of Hong Kong's extremely low interest rates for a long time," he said.

Hong Kong has deep pockets: its foreign exchange reserves are $441bn, and its external net assets are four times GDP. The HKMA is well able to defend the currency peg. It fought off a speculative attack by George Soros and a wolf pack of hedge funds in 1998.

It is nevertheless a victim of the "Impossible Trinity”: you cannot control the currency, and monetary policy, and have open capital flows. In times of stress, one must give.

What seems clear is that the housing market is heading for trouble. Roughly 90pc of mortgages are linked to three-month Hibor. Capital Economics expects house prices to fall by a third over coming years. “The property market is living on borrowed time,” said Mark Williams, the group’s chief Asia strategist.

Hong Kong’s banking system is 8.3 times GDP and the absolute scale is large enough to have global systemic consequences. HSBC and Bank of China alone have Hong Kong deposits of almost $700bn between them.

The enclave has been a hub for lending to mainland China, heavily exploited by companies evading credit curbs at home. In a sense it has become part of China’s vast shadow banking nexus.

Defenders say the banking system is rock solid with a liquidity coverage ratio of 146pc. The HKMA raised the "countercyclical capital buffer" from 1.25pc to 1.875pc in January.

Yet one stark figure reveals the disturbing nature of the problem. Hong Kong’s private debt-service ratio has risen to 28pc, the highest in the world. This is an astonishing level given that borrowing costs have until now been nailed to the floor.

Assuming that the Libor/Hibor gap closes and that the Fed raises rates seven more times by late 2019 as expected, the mathematics are frightening. Three-month borrowing costs in Hong Kong will quadruple from 1pc to 4pc. With or without a Pacific trade war, this will prove an excruciating stress test.