Beyond Bear, Bird Flu Threatens Chinese Markets

A virulent strain of influenza, both human and monetary, is likely to weigh on share prices in Asia over the balance of this week, as Hong Kong and China struggle with spreading sickness from a new superbug and weakness in the U.S. dollar.

While markets in Asia shrug off any nuggets of good news from the U.S., and energy and food costs spur stifling inflation, the pressure is building to get away from the sliding greenback, especially as Bear StearnsBSC falls victim to a spiraling economic crisis. In Hong Kong, a building focus is revolving around the politically painful, but increasingly economically viable, question of whether to scrap the Hong Kong dollar "peg".

"The Hong Kong dollar link is considered almost sacrosanct within the economy," writes Sean Darby, head of Asian strategy for Nomura Bank in Hong Kong, in a research note this week. Darby adds however that it is increasingly difficult for Hong Kong and China to control inflation with the currency in place.

The Hong Kong dollar is currently pegged at HK$7.8 to one U.S. dollar, while China's currency, the yuan, is pegged more broadly against a dollar-weighted basket. Traditionally, the peg has helped create the huge export and financial market growth that both places are famous for today. As the value of the U.S. dollar has declined, however, controlling inflation and managing profit margins has become a tougher task for many of Hong Kong and China's largest companies.

With $200 billion of U.S. Treasuries being loaned out to cash-strapped mortgage-debt holders, China is finding little use for its dollar-weighted managed currency peg too, as the value of its giant $1.5 trillion holdings looks to be threatened over the longer term.

"In China, [letting the renminbi float freely] would be one way to potentially combat inflation after several tightening measures which so far haven't been effective," says Jeff Papp, a senior buy-side analyst at Oberweis Asset Management in Lisle, Illinois. "Inflation escalating is now becoming the biggest risk to the country's economy and markets. I think it makes sense that [an unpegging of the currency] would happen."

Nomura's Darby adds that there is a "rising probability of Hong Kong being used as an offshore renminbi trading center."

As to the impact on equities, the peg debate is reaching far and wide. While bumper second half 2007 earnings for oil refiners PetroChinaPTR and CNOOCCEO mid-week may give markets a brief reprieve from the heavy selling seen in recent weeks, traders are more likely to focus on the shallowing impact of mainland Chinese energy price controls for these companies this year.

As the price of oil has surged to $111 a barrel in the last week, oil refiners and producers, which should benefit from such price rises, are suffering because of Beijing's need to impose price caps on the resale value of the commodity in order to keep inflation under control. The rising cost of oil and the pressure on the national currency are hurting costs, too.