International: Hong Kong Risks Falling Off the Asian Bull

JAKARTA -- Hong Kong is usually viewed as the most liquid proxy for the Asia ex-Japan equity universe. This, together with falling interest rates, has helped the Hang Seng to perform this year despite continuing severe deflationary pressure at home.

The real three-month Hibor rate is still 9.6% and the real prime rate is 12.5%. Hong Kong may be a more familiar market to many experienced Asian fund managers than the traditionally less open Northeast Asian stock markets, but the territory's liquidity premium should not be exaggerated. A look at recent turnover trends shows that Hong Kong is becoming increasingly less liquid than either Korea or Taiwan. Moreover, this trend looks likely to accelerate rather than reverse.

If Hong Kong risks losing its premier liquidity status, it also risks decoupling from the continuing bull market in the Asia ex-Japan universe on the back of any renewed bearish sentiment toward China. As Greed & Fear has warned repeatedly, China remains the one economy in Asia that could still go wrong for the simple reason that it is the only one, aside from the special case of Taiwan, that has yet to suffer a crash landing.

Greed & Fear had become less concerned about the mainland in recent months because the authorities there were clearly no longer in denial as they sought to deal with their problems. The latest set of interest rate cuts announced yesterday are a signal of further policy activism to combat accelerating deflation, as is apparent from the official statement that the cuts are aimed at stimulating consumption. The interest rate cuts make sense, although it has to be questioned how effective they will prove to be. The real one-year renminbi lending rate remains at 4.6% in China and the real one-year renminbi deposit rate remains at 8.2%, with a new set of inflation figures due to be reported by the end of this week.

The fact that interest rates have been cut again is clear evidence of just how concerned, if not desperate, the authorities have become. For they have taken a big risk by cutting rates this much since one-year renminbi deposit rates are now more than 2 percentage points lower than equivalent U.S. dollar deposit rates in China. And that is before any possible Federal Reserve rate increase. This raises the continuing risk of a massive shift from domestic currency savings accounts into foreign currency deposits, if not out of the Chinese banking system altogether, given the leaky capital account and a plentiful supply of mattresses. The exchange-rate issue in China, therefore, continues to lie just below the surface; set aside for now but not forgotten. Then there is the fiscal option.

China may well announce more fiscal pump priming. But this, as the Japanese example shows, is no panacea for liquidity traps. It also raises the risk that China, via the use of such policies, risks compounding its already considerable vulnerability to over-investment and politically driven lending, which are the root cause of the deflationary trend.

So the financial markets may well again begin to focus on the view that the logical outcome of this deflationary situation is an exchange rate adjustment, especially if Zhou Rongji's agenda of accelerated structural reform and privatization has been delayed by domestic political pressures. This seems quite possible post the Belgrade bombing and the WTO setback. Even if China sticks to its present exchange rate policy, a renewed rise in the risk premium in the Hong Kong dollar is not out of the question should China's economy be seen not to be responding to fiscal and monetary stimulus.

The risks are virtually all on the downside here since three-month Hibor is now only 34 basis points above Libor. And clearly any rise in U.S. dollar rates will only add to the pressures on Hong Kong. For Hong Kong is the one country in Asia that cannot decouple from U.S. interest rates, courtesy of its exchange-rate system.

These factors prompt Greed & Fear to use the opportunity provided post China's interest-rate cut to reduce further the weighting in Hong Kong from 29% to 25%. Having deprived oneself last week of the opportunity to continue borrowing money to invest in running bull markets, the only way to outperform the index meaningfully is to underweight the one stock market that Greed & Fear is not comfortable being fully weighted in, in what is a roaring bull market in Asia ex-Japan.

Hong Kong's problem as a stock market is that it continues to borrow most of its good news from its regional neighbors, China excepted. At home there is little to cheer about in the immediate term as interest rates have already declined to U.S. levels. Hong Kong badly needs a story to justify further advances since all bull markets run on stories, not "fair value" analysis. In the long term Greed & Fear has already identified the theme that will ultimately carry the Hang Seng Index to unimaginable heights. This is privatization and contracting out of services currently performed by the government.

Competitiveness Counts

Greed & Fear has no doubt that the Asian crisis has alerted the Hong Kong government to the competitiveness issue. The government is now engaged in the necessary process of using the excuse of the deterioration in the fiscal position caused by the present recession to accelerate privatization and contracting out. To cite one practical example now being pursued, the Housing Authority is preparing to contract out the management of government housing estates. This, apparently, will be used as a test case for contracting out throughout the public sector.

This initiative is being adopted out of the ideological conviction that the private sector will perform these services in both a better and a more cost-efficient manner. Still this process involves, as it does anywhere, the difficult political task of taking on the considerable vested interests involved. This will take time, especially given C.H. Tung's clear penchant for gradualism, which is why the stock market cannot ride on this theme over the summer.

The equity market is therefore likely at best to drift as it digests disappointing first-half corporate results, the lack of room for further interest rate cuts and the possibility of growing problems in China. It should be noted here that the number of direct quoted plays on privatization and the contracting out of government services are now extremely limited and are certainly not in the index. Such names as are available can be obtained from ABN Amro's Hong Kong research department.

Most of the money taken from Hong Kong will be put in Taiwan, where Greed & Fear is raising the weighting from 18% to 21%. Liquidity is improving there and the dominant electronics sector looks extremely strong judging by export numbers. Demand for foundry services should remain robust while the semiconductor cycle is supported by reductions in capacity over the past three years.

This is not to argue for an absolute investment case against Hong Kong, which would justify aggressive short-selling. That will only come about if China goes badly wrong, at which point Hong Kong could really decouple from the rest of Asia ex-Japan. It is, therefore, for now, more of a relative argument.

Hong Kong's bounce back will ultimately derive from the privatization and contracting out theme since this will provide the really exciting catalytic growth potential. Still, progress here will not be immediate. Meanwhile, the currency board system means that internal costs in the economy need to be adjusted down given the pegged exchange rate. This point seems to have been lost both on Cathay Pacific pilots and civil servants, which is bearish.

Greed & Fear read this week that Hong Kong's Executive Council is likely to come out against salary cuts for the 190,000 strong civil servant workforce. This is unfortunate and follows the government's unhelpful intervention last year over wage levels at Hongkong Telecom. Salary cuts for the civil service would deliver a healthy message that the gravy train has ended and put the public sector on the same playing field as the private sector. Wages have been cut for stockbrokers in Hong Kong, including Greed & Fear. Why not for civil servants?

Indonesian Election

Sometimes it is wrong to be cynical. The Indonesian election held Monday is a case in point, which is why Greed & Fear is increasing the weighting from 5% to 6%. This is a classic good-news story. As the moronic foreign press looks for problems in the delays in the election counting process, the assembled hacks have completely missed the major point.

This is a triumph of democracy in the sense that an amazing 96% of registered voters cast their votes in what has been thus far an extraordinarily peaceful process. Delays in the counting of votes have led to the usual conspiracy theories of electoral fraud and the like. Such theories are natural in a country where political debate has been stifled for more than 30 years.

Indonesians are not, as a consequence, long on political sophistication. But their enthusiasm for the electoral process is refreshing. The delays in counting the votes are in reality the consequence both of the formidable logistics of collating votes in this far-flung archipelago and also because the vote counters themselves at the Election Committee, or KPU, are being painstakingly careful to make sure the process proceeds in the proper manner. This is quite right.

It is also the case that enough of the votes have been counted so far (about 12.6 million out of the total 110 million cast) to make clear that there has been a convincing swing in favor of the pro-reform opposition parties. The result looks likely to be a Megawati Sukarnoputri-led coalition combining the PDI and the PKB. If these two get more than 50% of the vote, which at present looks very likely, it will be the ideal ticket for foreign investors. The military will also support this combination.

It is true that the foreign press can be relied upon again to hype the possible downside. There will be much speculation that Golkar, likely to poll about 20%, will try to buy influence in the People's Consultative Assembly, or MPR, whose delegates are due to actually select the next president in November. Such a view is wrong because it assumes business as usual in Indonesia. This is not the case. Everything has changed during the past year. There is now a free and lively press. Delegates to the MPR will be obliged to respect and indeed reflect pubic opinion. Not to do so would be to stand against the tide of history.

Little is known about Megawati outside Indonesia because she has not bothered to ingratiate herself with the foreign press. Her aim was to get elected by Indonesians. One positive point is that she represents a comforting mother-like, or Ibu, figure to ordinary people and has a familiar name. Another positive point is that her key policy focus is to retain the geographical integrity of Indonesia as a nation state, which was her father's achievement and which is why she is against giving up Timor.

On economic policy, she will defer to her advisers, who are orthodox. The military will support Megawati both because she will preserve national unity and because she does not represent a narrow Moslem ticket. She has Christian and Chinese advisers as well as a half-Balinese father. One potential finance minister, Kwik Kian Gie, for example, is both Chinese and Christian. However, the Moslem side will be accommodated by a coalition arrangement with the moderate PKB.

Indonesia Sovereign Bond Yield

The above is all bullish. Countless unanswered questions remain in Indonesian politics. But the electoral trend is fundamentally positive because it means the country should soon have a government with popular legitimacy. Meanwhile, the stock market will continue to celebrate falling interest rates for most of the rest of this year.

This process has further to go despite the big decline already seen in recent months. The one-month SBI is now 23.48%, down 117 basis points from last week's auction, while the three-month SBI plunged 649 basis points from 29.82% to 23.33% in this week's auction. People who put on rupiah carry trades two months ago will probably now start taking profits. This is natural. Still, interests rates will be much lower by the end of the year.

There is no reason why the one-month SBI should not be as low as 15% by year-end. The Indonesian sovereign bond yield has also declined this week to 11.9%, down from 14.2% on June 2. This means a significant decline in the discount rate applied to value Indonesian assets. The currency could also go much higher, say 6,000 rupiah, as confidence returns. Indonesia is the one country in Asia with a Latin American flight capital culture. That means there are tens of billions of U.S. dollars offshore that could return. This is equivalent to an outstanding short position in the rupiah.

Those foreign investors who were waiting for the elections before deciding to go back into Indonesia should now invest. If Greed & Fear was to recommend two blue-chip stocks, they would be Indofood and Telkom, both among ABN Amro's five top picks. Indonesia will be the best-performing market in Asia, if not the world, in U.S. dollar terms this year. Indofood is still 52% and Telkom is 66% below their 1997 U.S. dollar highs.

>To order reprints of this article, click here: Reprints