The Hong Kong Economy Is Stuck In A Rut

Many longtime readers know that I believe the Hong Kong dollar peg is nearing a tipping point. I’ve written about this situation before (you can read about it here and here). But I believe things are growing far more fragile than many realize in the Hong Kong economy.

To give you some context, back in 2019 I wrote:

…again, while I don’t believe the peg will break anytime soon. I do think it’s becoming much more likely than the market expects. Especially as the HKMA (Hong Kong Monetary Authority) bleeds through precious cash reserves defending it. And the Hong Kong economy continues decelerating.

So – three years later – how has the Hong Kong economy fared? Not well at all.

Why? Because Hong Kong is getting squeezed from two sides. On the one end, there’s the Federal Reserve’s aggressive tightening cycle (interest rate hikes), which has forced the Hong Kong Monetary Authority (HKMA) to also tighten.

Remember, Hong Kong has a semi-peg system with the U.S. dollar. Therefore must always follow Fed policy (meaning: if the Fed eases, the HKMA eases, and vice versa). This tightening cycle has put significant pressure on Hong Kong’s already anemic economy and asset prices as liquidity is drained amid higher borrowing costs. For perspective – Hong Kong’s private home prices have plunged 11% in the first 10 months of 2022. And in some areas, prices are down 25%.

But the trouble doesn’t end there. According to the South China Morning Post, an index of lived-in home prices citywide is at a five-year low, and home transactions are down while new-home inventory, cases of negative equity, and foreclosed properties are all at multiyear highs.

Thus the Fed’s tightening is effectively hammering Hong Kong’s asset prices – and none more so than real estate.

Now, on the other end, China’s economy has slowed considerably over the last few years, especially as the authorities pushed for the overleveraged property development sector to effectively deleverage (i.e., reduce debts, raise cash, divest assets). To give you some context – China’s real economic growth has been fading for the last decade as returns diminished (especially with construction) and consumption remains anemic.

China’s real growth was roughly 16% per annum in 2007. Then it was 7% in 2018. And now it’s just 3.9%.

I’ve detailed China’s slowing growth issues before (see here), but why does this matter for Hong Kong? The reason is simple: Because China is Hong Kong’s largest trading partner, by far. For example – here are Hong Kong’s top 10 trading partners in terms of export sales:

As of 2021, China makes up roughly 60% (i.e., $402 billion) of all Hong Kong exports. Meanwhile, the U.S. only accounts for 6% (i.e., $40 billion). Or, putting it another way, the U.S. accounts for just one-tenth of Hong Kong’s exports compared to China.

Thus, as China’s economy slows, Hong Kong will feel it. And it already has: Since China began its deleveraging cycle in 2018 – Hong Kong’s economic growth has stagnated. Just take a look at the chart below – Hong Kong’s GDP remained flat over the last four years (i.e., 10 of the last 14 quarters saw negative GDP growth).

So, now that we understand how Hong Kong’s economy is squeezed – let’s focus on the dilemma for the HKMA and the Hong Kong dollar. Most often – almost always – when there’s an economic slowdown, a central bank will ease monetary policy (such as cutting interest rates, quantitative easing, etc). They do this to try and boost asset prices, lower debt-servicing costs, and – most importantly – keep people employed and spending.

And when an economy is “overheating” – usually when inflation is running high or there’re asset bubbles – a central bank will tighten monetary policy (such as raising rates, quantitative tightening, etc.). They do this to try and slow demand down and make marginal spending and borrowing less appealing.

Thus, with these policy remedies, the HKMA should slash interest rates lower (and should have since 2018) as growth and asset prices plunge amid China’s slowdown. But they can’t, not as long as the HKD is pegged to the U.S. dollar.

Instead, the HKMA was forced to aggressively tighten monetary policy into a vicious slowdown (following the Fed’s rate hikes in 2017-19 and 2022). This has caused chronic anemia within Hong Kong’s economy. And it is bleeding dollar reserves from the HKMA’s exchange fund to maintain the peg.

For instance, Hong Kong’s international reserves have plunged -16% year-to-date – its largest annual drop ever.

That’s because as the dollar gets stronger amid Fed rate hikes (and the dollar is currently around a 20-plus-year high), the HKMA must intervene and sell dollars and buy HKD instead. Said another way, higher interest rates in the U.S. make it more attractive for Hong Kong individuals to hold dollars. Thus the HKMA must sell its own dollar reserves to push down the value and instead buy HKD’s to raise its value – keeping the peg alive.

Thus they’re bleeding reserves and keeping interest rates far too high (strangling growth), all the while asset prices are plunging and both China’s growth cycle and Fed policies are out of sync. That’s a dangerous combination. This is why I believe the Hong Kong economy is in a highly fragile position. And something will have to break (most likely the HKD-dollar peg) – eventually.

In summary, the current Hong Kong economy is stuck between a rock and hard place. They’re feeling a deep and multiyear recession because of China’s slowing growth and deleveraging cycle. And, worse, they’re stuck tightening monetary policy into such a chronic slowdown because of the Fed.

Putting it simply – they’re pegged to U.S. monetary policy yet also pegged to Chinese growth. If both aren’t in rhythm (which they haven’t been since 2008), then there’s growing fragility in Hong Kong. So unless one of those facts changes, I don’t see how Hong Kong can escape this without continuing serious boom-bust cycles.

But, most importantly, I believe that falling asset prices in Hong Kong – especially real estate – is a serious problem. Why? Because domestic credit to the private sector (as a percentage of GDP) has exploded in Hong Kong over the last 15 years. It soared from 135% in 2007 to 260% as of 2021. Thus, any steep and consistent declines in asset prices might trigger a debt-deflation spiral (i.e., when assets are sold to raise cash to repay debts, pushing prices lower, thus forcing more sales; repeat the cycle).

For now, the HKMA seems committed to defending its peg. So it’ll survive a bit longer. Still, I don’t believe this will last, because the current peg doesn’t justify the sinking fundamentals in the economy. As such, breaking from the peg must happen in order to rebalance.

But, as always, time will tell.