Stock market elation will soon evaporate
Investors responded to the weekend's bailout of US mortgage giants Fannie Mae and Freddie Mac with elation yesterday, bidding up the Hang Seng Index by 4.3 per cent. Yet although the rescue must come as a huge relief to the Chinese government, whether it is necessarily such a positive factor for Hong Kong-listed stocks is less clear.
On one level the US$200 billion package was very good news for the equity market. By throwing Fannie and Freddie a lifeline, US Treasury Secretary Henry Paulson removed one of the big sources of uncertainty hanging over financial markets. With the chance that either of the agencies would default on their debt eliminated, investors rediscovered some of their appetite for risk and bought heavily into Hong Kong equities.
In reality, however, there was never any possibility that Washington would allow either agency to default. The political consequences would have been far too damaging. Not only would a default have inflicted a crushing blow to the ailing US property market, it would also have ignited a diplomatic firestorm.
Between them, the two agencies have issued more than US$5 trillion in outstanding bonds and mortgage-backed securities. More than US$1 trillion of that debt is held by overseas investors, with the managers of China's foreign exchange reserves by far the biggest buyer (please see the first chart below).
According to data from the US Treasury, as of June last year, China owned US$387 billion of US agency debt, but that figure certainly understates the true size of Beijing's holdings. Allowing for the rapid growth of the mainland's foreign reserves over the last year and considering that some of its reserve assets are likely to be held indirectly by custodian banks, the real figure is probably closer to US$500 billion. Brad Setser at the Council on Foreign Relations in New York estimates it to be US$465 billion.
Obviously, the Chinese government has a lot at stake in Fannie and Freddie and in the past couple of months Beijing's reserve managers and their opposite numbers at the world's other reserve-rich central banks have been getting nervous.
With US house prices down almost 20 per cent from their July 2007 peak, mortgage foreclosures on the rise and the share prices of both Fannie and Freddie down more than 90 per cent from last year's highs, agency debt was no longer looking like such an attractive proposition.
As a result, foreign central banks have been scaling back their purchases. Last month, they reduced their stock of agency debt held in custody at the Federal Reserve Bank of New York by US$13 billion and instead ramped up their purchases of Treasury bonds (see the second chart).
This cut-back raised the possibility that Freddie and Fannie might not be able to secure sufficient funding in the market and that they could default on their debts.
That possibility alone was enough to force Mr Paulson to step in.
But while Sunday's rescue eliminates the chance of a default, it is hardly an unqualified positive. Rather, the simple fact that a bailout was necessary emphasises the extreme fragility of the US housing market and, by extension, of the US economy.
Regardless of yesterday's rally, that fragility is decidedly negative for Hong Kong stocks. With property prices falling, US homeowners are no longer able to extract cash from their houses by taking out second mortgages, severely curbing their ability to spend.
With ordinary Americans already shouldering the burden of higher petrol prices, wages static and unemployment rising, there are worrying signs that US consumer spending is about to run into a brick wall. Ominously, container shipments from China to the US were down 21 per cent in June compared with a year earlier.
If America's usual pre-Christmas US spending spree fails to materialise this year, Chinese exports will suffer and Hong Kong companies will be badly hurt. Yesterday's elation will soon evaporate.