A wider financial war is being waged by America against China. Stories about China’s banks being short of dollars are incorrect. Alasdair Macleod explains…
Behind the Huawei story, we must not forget there is a wider financial war being waged by America against China and Russia. Stories about China’s banks being short of dollars are incorrect: the shortage is of inward capital flows to support the US Government’s budget deficit. By attracting those global portfolio flows instead, China’s Belt and Road Initiative threatens US Government finances, so the financial war and associated disinformation can be expected to escalate. Hong Kong is likely to be in the firing line, due to its role in providing China with access to international finance.
Hong Kong in Trouble?
Last week, The Wall Street Journal published an article claiming China’s banks are running out of dollars. Clearly, this is untrue. China’s banks can acquire dollars any time they want, either by selling other foreign currencies in the market, or by selling renminbi to the People’s bank. They have their dollar position because they choose to have it, and furthermore all commercial banks use derivatives, which are effectively off-balance sheet exposure. Furthermore, with the US running a substantial trade deficit with China, dollars are flooding in all the time.
Following the WSJ article, various other commentators have come up with similar stories. How convenient, it seems, for the US Government to see these bearish stories about China, just when they need to ramp up inward portfolio flows to finance the budget deficit.
There is, anyway, a general antipathy among American investors to the China story, so we should not be surprised to see the China bears restating their case. One leading China bear, at least by reputation for his investment shrewdness, is Kyle Bass of Hayman Capital Management. According to Zero Hedge, he has written his first investment letter in three years, saying of Hong Kong, “Today, newly emergent economic and political risks threaten Hong Kong’s decades of stability. These risks are so large they merit immediate attention on both fronts.”
If only it were so simple. It is time to put the alternative case. Hong Kong is important, because China uses Hong Kong and London to avoid being dependent on the US banking system for international finances. And that’s why the US’s deep state want to nail Hong Kong.
Bass is correct in pointing out the Hong Kong property market appears highly geared, and that property prices for office, residential and retail sectors have rocketed since the 2003 trough. To a large extent it has been the inevitable consequence of the currency board link to the US dollar, which broadly transfers the Fed’s inflationary monetary policy to Hong Kong’s more dynamic economy. Bass’s description of the relationship between the banks, the way they finance themselves and property collateral is reminiscent of the factors that led to the secondary banking crisis in the UK in late-1973. Empirical evidence appears to be firmly on Bass’s side.
Except, that is, for a significant difference between events such as the UK’s secondary banking crisis, and virtually every other property crisis. Hong Kong is a truly international center, and the banks’ role in property transactions is as currency facilitator rather than lender. In 2017, Hong Kong was the third largest recipient of foreign direct investment (substantially property) after the US and China. FDI inflows rose by £104bn to total nearly $2 trillion. Largest investors were China, followed by corporate money channeled through offshore centers.
So, yes, Hong Kong banks will be hurt by a property crisis, but not as much as Bass implies. It is foreign and Chinese banks that have much of the property as collateral. It is not the Hong Kong banks that have fueled the property boom with domestic credit, but foreign money.
Bass fails to mention that a collapse in property prices and the banking system is unlikely to be confined to Hong Kong. Central banks have made significant progress in ensuring all banking systems are tied into the same credit cycle. Unwittingly, they have simply guaranteed that the next credit crisis will hit everyone at the same time. It won’t be just Hong Kong, but the EU, Japan, Britain and America. Everyone will be in difficulty to a greater or lesser extent.
Interestingly, the Lehman crisis, which occurred after Hong Kong property prices had already doubled from 2003, caused strong inflows to develop, driving the Hong Kong dollar to the top of its peg. The situation appears to be similar today, with US outward investment at low levels, but near-record levels of foreign ownership of dollar assets. Despite Hong Kong’s foreign direct investment standing at $2 trillion, the prospect of capital repatriation to Hong Kong should not be ignored.
Probably the most important claim in Bass’s letter is over the future of the currency peg operated by the Hong Kong Monetary Authority (HKMA). He claims that the “aggregate balance,” which is a line-item in the HKMA’s balance sheet, is the equivalent of the US Fed’s excess reserves, and that “Once depleted, the pressure on the currency board will become untenable and the peg will break.”
The aggregate balance on the HKMA’s balance sheet has declined significantly over the last year, from HK$180bn to HK$54.4bn currently. The decision about changes in aggregate balances comes from the banks themselves, and for this reason they are commonly taken to reflect capital flows into and out of the Hong Kong dollar. This is different from aggregate balances reflecting actual pressures on the peg, as suggested by Bass.
The HKMA maintains a US dollar coverage of 105%-112.5% of base money (currently about 110%) and has further unallocated dollar reserves if necessary. The peg is maintained by the HKMA varying its base money, not just by managing a base lending rate giving a spread over the Fed’s fund rate, not just by influencing the commercial banks’ aggregate balances, but by addressing the three other components that make up the monetary base. These are Certificates of Indebtedness, Government notes and coins in circulation and Exchange Fund Bills and Notes (EFBNs). In practice, it is the EFBNs in conjunction with the aggregate balances that are used to adjust the monetary base and keep the currency secured in the Convertibility Zone of 7.75 and 7.85 to the US dollar.
In maintaining the peg, the HKMA prioritizes maintaining it over managing the money supply. There is little doubt this goes against the grain of mainstream Western economists who believe inflation good, deflation bad. Over the last year base money in Hong Kong contracted from HK$1,695bn to HK1,635bn. Does this worry the HKMA? Not at all.
How the Chinese will act in the circumstances of a new global credit crisis is yet to be seen, but we should bear in mind that they are probably less Keynesian in their approach to economics and finance than Westerners. Admittedly, they have freely used credit expansion to finance economic development, but theirs is a mercantilist approach, which differs significantly from ours. We simply impoverish our factors of production through wealth transfer by monetary inflation. We think this can be offset by fueling financial speculation and asset inflation. China enhances her production and innovation by generating personal savings. Wealth is created by and linked more directly to production.
The objectives and effects of monetary and credit inflation between China’s application of it and the way we do things in the West are dissimilar, and it is a common mistake to ignore these differences. The threat to China’s ability to manage its affairs in a credit crisis is significantly less than the threat to Western welfare-dependent nations whose governments are highly indebted, while China’s is not.
China is sure to see the financial and monetary stability of Hong Kong as being vital to the Mainland’s interests. Apart from the Bank of China’s Hong Kong subsidiary being the second largest issuer of bank notes, the Peoples’ Bank itself maintains reserve balances in Hong Kong dollars, which in the circumstances Kyle Bass believes likely, they can increase to support the HKMA’s management of the currency peg.
It is a mistake to think the Hong Kong property market is as much of a systemic danger as it first appears. Expectations of a devaluation of the peg appear to be wishful thinking by the bears.
Far more important are the consequences of the cyber and financial war being pursued against China and Russia, its close ally, by the American deep state. Under President Trump it was accelerated by his trade tariff policies, which are fundamentally an attack on China’s economy. China will be a hard nut to crack, and the effect of America’s trade protectionism has been to trigger a diminution in international trade, which is now becoming apparent. The negative effects on the American economy appear to be being underestimated.
The attempt to destroy Huawei’s 5G global ambitions is both the current and most visible part of an undeclared cyber and financial war. Trade protectionism was only a step along the way. The financial war is now escalating with the global economy facing at least a significant recession, almost certain to trigger an overdue credit crisis. The Chinese have long been on a financial war footing, as shown by Qiao Liang’s analysis of how America needs global portfolio flows and what they are prepared to do to attract them. Western thinking that the Chinese and their Russian allies are vulnerable to American hegemony has been disproved time and again. Financial analysts consistently fail to understand the Chinese are not muppets.
China will not be provoked, and by standing firm, they are sure to protect Hong Kong and get on with diverting investment flows from a failing US economy into its Belt and Road Initiative. This will force a financial crisis on the Americans of their own making. At least, that’s how China has always seen it and they see no need for their passive financial war strategy to change.