Bill Ackman: buy the Hong Kong dollar for revaluation potential. Does this make sense?

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.

will Hong Kong break its currency peg with the US$?–probably

the HK$-US$ peg

There has been increasing speculation recently that Hong Kong will abandon the policy, in place for almost thirty years, of tying the HK$ to the US$ at a fixed exchange rate.  Given the tenacity with which the former British colony defended the peg during the Asian financial crisis of the late 1990s (against speculators who seem to have had no clue about Hong Kong), this may seem strange.  But I think the peg has served its purpose and may now be more trouble than it’s worth.  My guess is the peg will go–and in the near future.  In stock market terms, this would be good for domestic firms that use US$ inputs and bad for exporters.

why the peg exists (much more detail in this post)

In the initial post-WWII period, the Hong Kong dollar was pegged for economic reasons, first to sterling and later to the US dollar. In 1974, however, the Hong Kong government decided to let the currency float.

Pegging your currency to that of your largest trade customer makes a lot of sense  for an emerging economy ( the granddaddy of post-WWII pegging successes is Japan), since it ensures that you retain the labor cost advantage that’s your greatest development asset. Doing so has a number of costs, however. One of the most significant is that you give up control of your domestic money policy. You can’t tighten when the other party is loosening, even though that might be the right move for your economy. Why not?  Your interest rates go up; the other country’s go down.  The higher interest rate differential means arbitrageurs short the other currency and use the proceeds to buy yours.  This produces immediate upward pressure on your currency and downward pressure on the other party’s.  So you’d be shooting yourself in the foot.

Therefore, you’re stuck mimicking the money policy moves of your key trading partner. Unless the developing economy is extremely vigilant and conducts a restrictive fiscal policy, the consequences can be disastrous. The most recent example of calamity can be seen in the current situation of Ireland and Spain, which imported a vastly over-stimulative monetary policy through the euro—where interest rates were set with an eye to the needs of much less dynamic members like France and Germany.  Ouch!

unpegging in 1974

In the mid-Seventies, the US was beginning a policy of too much monetary stimulus that would spawn a late-decade inflationary spiral—and the subsequent Volcker medicine (sky-high interest rates and deep recession) of the early Eighties.

Rather than be dragged along down the same path, Hong Kong unpegged.

repegging–why?

In October 1983, however, Hong Kong repegged to the dollar. This had nothing to do with the now more orthodox money path of the US. The key reason was political.  The mainland refused to renew the lease the UK held over Hong Kong, meaning that the British colony would revert to Chinese rule when the then-current lease ended, in 1997.

At first, Hong Kong citizens weren’t thrilled. They had witnessed the ill effects of the Great Leap Forward and the Cultural Revolution, and surmised that they might well be the recipients of extensive “reeducation” to purge them of their capitalist views. Given that the state and the Communist Party owned all the capital, they might forfeit all their personal wealth, as well.  And the UK wasn’t appearing overly worried about the future safety of colony residents (Parliament would eventually deny UK citizenship to the mostly ethnic Chinese Hong Kong citizens, saying they would find the climate of the British Isles inhospitable).

Given this situation, Hong Kong citizens had two priorities:

–find another country willing to make them citizens and give them passports, and

–get as much accumulated wealth as possible out of Hong Kong and out of Hong Kong dollars (which might not exist after 1997).

when to move?

When should you remove you money from Hong Kong? Assume your HK$ would have no value after the handover. Your first thought might be to take your money out of Hong Kong a few months before the fact, to avoid the terminal collapse of the currency.  But everybody is going to be thinking the same thing.  So the date when the currency begins its swoon may not be in 1997 but maybe in 1996. But everyone is probably working that out, as well. So the currency will exhibit terminal weakness even earlier.  Who knows how many iterations of this backing-off process there will be.  The only sure thing is that the penalty for waiting too long will be severe.  Maybe the safest course, then, is to start to move money out of Hong Kong immediately.

To forestall a currency crisis that was already starting to ignite, the Hong Kong government decided to repeg. It though–correctly–that if citizens were guaranteed that their currency would not lose value vs. some internatinoal standard during the runup to the handover, capital flight would be minimized.  The penalty in imported inflation might be high.  But the political necessity overrode this.

the present

The pegging policy worked.

We’re now almost thirty years later. Hong Kong has survived the continual inflationary problems that the peg to the US$ have caused. Citizens have long since realized that the luckiest day of their economic lives was the one when China decided not to renew the UK lease.

So there’s no real reason in today’s post-colonial world to keep the peg.  All it brings is inflation–especially now, when the US is maintaining super-low interest rates as it tries to recover from the near-meltdown of the financial system. And Hong Kong citizens would by and large prefer to hold currency tied to the renminbi than to the US$ anyway.

My guess is that the rumors we’re hearing are a testing of the waters as prelude to replacing the peg.

investment implications

In all likelihood, the HK$ will rise vs the US$ if the peg is removed.  If so, the implications are straightforward.  Any firm with revenues in HK$ and/or costs in US$ will benefit.  Any firm in the opposite situation will lose.