Asset prices in Hong Kong have been surging lately. Last month home prices in the city hit a new record, up 16 per cent from a year ago. At the same time, Hong Kong’s stock market has been among the world’s strongest major markets so far this year, comfortably outperforming the US S&P 500 index. Yet there is a powerful reason for would-be buyers to beware. One of the main forces that has long supported Hong Kong’s markets is likely to go into reverse in the second half of this year.
For years, Hong Kong’s asset markets have been kept afloat by a tide of money. Now, because of the peculiarities of Hong Kong’s monetary system, that tide is set to recede.
In Hong Kong there are two broad ways money can be created. First, as in other systems, money is created when banks lend. That might sound strange at first, especially given that the city’s banks have a modest Hong Kong dollar loan-to-deposit ratio of just 76 per cent. But when a bank makes a loan, it credits the money to the account of the borrower. So as loans rise, so do deposits, and so does the amount of money in the system.
The second way money gets created is via inflows of international capital. Because of its “currency board” exchange rate link to the US dollar, Hong Kong automatically imports US monetary policy. So when the US Federal Reserve initiated its “quantitative easing” (QE) policy in the depths of the financial crisis in 2008, purchasing assets in the market, international liquidity duly started to pour into Hong Kong. As the Fed’s balance sheet expanded, so did the reservoir of liquidity in the city’s financial system.
Hong Kong’s banks absorbed some of the inflows onto their balance sheets by allowing their net foreign exchange assets to rise. But for the most part, they sold the foreign currency inflows to the Hong Kong Monetary Authority (HKMA). To preserve the city’s fixed exchange rate, the HKMA sold Hong Kong dollars to the banks, which pushed up the size of the city’s monetary base. Taken together, these two measures – Hong Kong banks’ net foreign exchange assets and the Hong Kong dollar monetary base – make up what can be regarded as Hong Kong’s accumulated pool of international capital flows.
Changes in the depth of this liquidity pool reflect cross-border capital flows into and out of Hong Kong’s financial system. As the first chart shows, as the Fed’s successive rounds of QE pumped up its balance sheet four and a half times over, so Hong Kong’s liquidity pool – the components of the Hong Kong dollar monetary base plus Hong Kong banks’ net foreign assets – expanded in parallel.
All that liquidity had to go somewhere, and much of it found its way into the city’s equity market, which climbed 170 per cent between the start of QE and the end of the Fed’s balance sheet expansion at the end of 2014.
This leaves Hong Kong asset prices vulnerable to a deep correction when the Fed begins to shrink its balance sheet once again. That point is now approaching. Fed chair Janet Yellen has said it will start to unwind its asset holdings when interest rate hikes are “well under way”.
Other officials have suggested that this means when the Fed’s benchmark interest rate has reached 1 per cent. US investors now believe that will happen by the end of July. The implication is that the Fed could start to wind down its asset holdings in the second half of the year, so beginning to shrink its balance sheet.
At that point, it would not be surprising to see liquidity begin to drain out of the Hong Kong pool. And as it does so, Hong Kong assets are likely to come under pressure. As the second chart shows, fluctuations in the Hong Kong stock market, in particular, tend to be closely influenced by liquidity flows into and out of the city’s financial system.
Admittedly, the correlation is by no means perfect. Lately the picture has been greatly complicated by illicit flows from mainland China which fail to show up in the standard monetary data. However, research by the HKMA suggests that while these flows are sizable compared with legitimate liquidity flows, they are less correlated with moves in either local equity prices or the property market.
In other words, mainland money may not be sufficient to support Hong Kong asset prices once the Fed starts to shrink its balance sheet in earnest. The city’s markets may be pumped up at the moment, but in another six months the tide may have started to turn. ■
Tom Holland is a former SCMP staffer who has been writing about Asian affairs for more than 20 years