the Ackman investment idea

Bill Ackman, the hedge fund manager behind Pershing Square Capital, delivered a keynote address at a CNBC investment conference on Wednesday, September 14th.  In his remarks, he suggested that investors buy the Hong Kong dollar.  He expects that currency, which has been pegged to the USD for the past 28 years, will soon be revalued upward.  One possible revaluation target is the Chinese renminbi (Hong Kong is, after all, basically a province of China; another would be a basket of currencies representing Hong Kong’s trade flows (which is what many smaller countries move to when they unpeg from the greenback).

Pershing Square has already acted on this idea.

his reasoning

I didn’t hear his talk, but I did see his subsequent appearance on CNBC to explain his thinking.  He has two points:

lots of potential upside, no downside

–by buying one-year options on the HKD you can get 25x leverage.  If you used .5% of your capital to buy options and the HKD were repegged against the USD at a level 30% higher, you’d make a profit of more than 10% of your capital.  Against this huge gain, the downside is tiny:  you lose  the .5%.

the peg isn’t economically justified

–when a small country pegs its currency to another nation’s, it has to keep its short-term interest rates in line with the other country’s.  US interest rates are at zero,  as we heal from the massive damage done by the financial crisis.  For Hong Kong, which is growing strongly, a zero interest rate policy is massively over-stimulative and the source of destructively high levels of inflation.  Therefore, a move to a more appropriate exchange rate is likely.

is that it?

Pretty much.  Mr. Ackman also says he’s studied the history of Hong Kong carefully and that in”similar circumstances” Hong Kong has changed its peg.  It’s hard to believe he’s serious about that, though.  I don’t see how any decision a colonial governor might have made several decades ago in support of the interests of the UK would cast any light on the decision Beijing might make today in support of its own national interest.

Mr. Ackman’s reasons aside,

what could go wrong?

Pegs are usually motivated by economics.  Not in this case.  The Honk Kong peg is all about politics.

1.  The current peg was introduced to stem massive outflows of money from Hong Kong when Beijing and London announced in 1983 that Hong Kong would be returned to the mainland in 1997.  Given that many Hong Kong citizens had fled from China after WWII, losing all their possessions doing so, something had to be done to lessen the fear of a repeat.

Hong Kong citizens have long since come to understand that hitching their star to Beijing was the luckiest thing that ever happened to them.  So avoiding panic selling of the HKD is no longer a reason for having the peg.

2.  The inflationary buildup caused by the peg, almost from its onset, forced traditional Hong Kong industries like textiles, garments and electronic assembly out of the colony and into the mainland–initially into the nearby Special Economic Zone of Shenzhen.  In other words, it expedited the technology transfer that Beijing desired to hasten the mainland’s industrial development.

In this regard as well, I think the peg has long since outlived its usefulness.  Cost differences are still a motivation for having as much as possible of the management and administrative structure of a firm on the mainland, though.  And  that has forced faster infrastructure development in the major eastern urban areas.

However, I think there’s still a reason that Beijing would like to keep the HKD/USD peg.

3.  Beijing has made it clear that it wants the renminbi to become an important international currency, perhaps one day an alternative to the USD as a reserve currency for the world.  China has put a tremendous amount of effort into furthering this goal over the past couple of years in, for example, the way it has structured bilateral trade agreements and in the way it is fostering Hong Kong as a center of offshore renminbi finance.

Making the HKD a more attractive substitute for the renminbi doesn’t advance this effort.  It sets it back.  That’s why my guess is that a revaluation of the HKD dollar won’t happen.  If Beijing had its way (and it probably eventually will) the HKD will be supplanted by the renminbi, even in Hong Kong, and just fade away.

A much safer way of playing possible revaluation would be to buy Hong Kong stocks that have revenues linked to the renminbi and costs linked to the HKD.  But you’d stand to make a 20%-30% gain on revaluation, not the 2500% jackpot Mr. Ackman is hoping for.