Pegged to Faustian pact

ONE CAN STILL find analysts who believe in Hong Kong. But in light of the gyrations on Wall Street, it is getting harder and harder to find investors who do. A Merrill Lynch poll of global fund managers offers the most recent gauge of deteriorating confidence: Last month a net 9 per cent of money managers polled liked Hong Kong but this month the ratio dived to minus-16 per cent. The problem is not that the SAR is suspected of harbouring the type of accounting scandals which have dragged United States markets to five year lows. It is that Hong Kong's economic position is so fragile, it has few defences against the global market storm. Barring the half-dead Shanghai B-share market, the Hang Seng Index has come closer to matching the losses on Wall Street than any other Asian bourse this year. Yesterday provides a prime example - as regional markets absorbed another fearful night on Wall Street, only Taiwan performed worse. That is because the SAR was dealing with more than another bad night on Wall Street. Late on Tuesday, it was announced that the unemployment rate rose to a new record of 7.7 per cent. The figures were not a surprise. Every month the SAR is treated to a confirmation of its economic malaise: steepening deflation, rising unemployment, falling property prices and until recently, declining exports. Many analysts are saying it all comes down to the peg, the Faustian deal which has given the SAR its relative stability at the price of crippling deflation. In a recent note to clients, CLSA strategist Christopher Wood said: 'The single most positive buy signal for the Hang Seng Index would be an announcement that the Hong Kong dollar will be floated.' He lowered his rating on the SAR because he did not think the Government would drop the peg. 'The result is that the present, mostly malign, drift looks set to continue,' he said. As with the United States, Hong Kong's economy is still working out the excesses of a bubble. The only difference is that its bubble was on property rather than the Internet. Hong Kong residential property is down 60 per cent from its peak and rents are down 40 per cent. Yet many investment houses, such as Goldman Sachs, see more declines ahead. Some analysts, including UBS Warburg's Franklin Lam and Stephen Brown of King Eng Securities, have long been calling the bottom in residential prices. But with no recovery in sight, they are beginning to resemble those gospel prophets carrying 'the end is nigh' placards. More and more, Hong Kong is being compared with Japan, which slipped into a deflationary cycle a decade ago and has never crawled out. The cycle becomes vicious as lower tax revenues create budget deficits, forcing policies which can promote more contraction. Salomon Smith Barney strategist Ajay Kapur said: 'Once you get into a deflationary period the fiscal balances obviously get worse. The next response is to try to correct fiscal balances - like taxes have to go up. That's a box Hong Kong is in.' Salomon is therefore keeping an underweight on the market. There is one silver lining in the cloud - the mainland. 'I'm really bullish on China. Some of its growth will spill over to Hong Kong . . . we've already seen it on the ports. That could be helpful by the end of year,' Mr Kapur said. Yet China has been humming along at growth of more than 7 per cent in the past five years, and it has not helped Hong Kong. Why will it in the future? Goldman Sachs economist Dick Li says the China boom has been helping Hong Kong. The problem is that, at the same time, competitive mainland pressure has been hurting Hong Kong. And the two cancel each other out for a desultory net effect. China is helping what Mr Li calls the 'tradeable' sector - tourism, transport and financials, in the sense that mainland companies such as the Bank of China are raising cash on the SAR. But competitive pricing pressure from the much cheaper mainland is hurting non-tradeable's such as property and retail prices. In the absence of a major policy change, such as busting the peg, Hong Kong is stuck in a waiting game. It is waiting, essentially, for Wall Street to recover. Indeed, the few SAR optimists out there are really Wall Street optimists. Morgan Stanley's Hong Kong and China strategist Henry Ho is taking solace from the bank's US strategists such as Barton Biggs, who are calling for an upswing on Wall Street. The same carrot is driving the optimism of Brook McConnell, president of boutique investment house South Ocean Management, expecting a 'violent eruption' on the upside in the US. Graphic: anal18gbz