Hong Kong Weakens Its Hand

Plus thoughts on US and Japanese bonds, the Korean economy and Indonesia.
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At first glance it looks like a cute compromise to reconcile two irreconcilable positions -- to sell or not to sell. At second glance the

Hong Kong Monetary Authority's

announcement looks less smart.

The authorities may have actually weakened their hand by announcing that they have become a long-term seller of 70% of their Hong Kong share portfolio. The 5% allocation of the Exchange Fund to Hong Kong equities means that only HK$46 billion of the current HK$150 billion Hong Kong equity portfolio will be kept for long-term investment.

Greed & Fear remains of the view that the Hong Kong government may have missed out on the best opportunity to unload all of its shares during the rally in the final quarter of 1998. Meanwhile, the buzz created by talk of


theme parks and "cyberports" looks like a classic case of clutching at chopsticks. Spontaneous combustion is what has made capitalism work in Hong Kong, not high-tech coated infrastructure projects.

Moderation Not an Option

Market action of late suggests the following trade for the community of absolute return investors: Go long U.S. Treasury bonds against Japanese government bonds. The backup in the U.S. long bond has reached a level where it has begun to ignore the deflationary realities of the global economy.

It is true that U.S. consumer confidence remains rock solid, now linked umbilically to the health of the U.S. stock market. But the reality is that talk of a soft landing is now probably no more than a fond hope. The economy will remain strong so long as the stock market is going up. If the equity market stalls, however, there will be a nasty erosion in consumer sentiment with positive consequences for bond prices. The U.S. will therefore either continue to be good for world financial markets or bad. Moderation has long since ceased to be an option.

The best argument going for the U.S. equity market remains buoyant liquidity, which is fine as long as U.S. Federal Reserve Chairman

Alan Greenspan

elects not to change policy and target asset bubbles. Meanwhile, three cautionary points are worth noting. First, U.S. loan growth is rolling over. This could be a sign of economic weakness ahead. Second, the Dow transportation index has still not confirmed the

Dow Jones'

new high. The transport index peaked on April 16, 1998.

Third, the Brazilian situation continues to play out with the real now having suffered a 43% devaluation. There is as yet no realistic solution to Brazil's fiscal mess. The longer this continues, the greater the danger of contagion throughout Latin America. Meanwhile, the lower the real goes the more likely it is to have practical consequences for industries in Asia in terms of competitive devaluation pressures. A good example is steel.

If it makes sense to go long U.S. Treasuries it equally makes sense to go short the Japanese government bond because of the inevitable deterioration of Japanese government finances. The trade can also be financed by borrowing yen. The

Bank of Japan's

actions to push short-term interest rates to zero are confirmation that the central bank has opted to target a certain level of reserves in the banking system -- in the hope that this will ultimately increase the money supply via a credit expansion. This is undoubtedly negative for the yen.

Still, another (presumably intended) consequence of the policy is the steepening of the yield curve, which should be positive for the banking sector. (In the short term, the banks are being hit with losses on their bond trading portfolios.) This suggests another trade: Go long those Japanese banks which are likely to avoid nationalization and short the JGB.

The Bond-Bank Flip-Flop

The pattern for the last nine years has been for Japanese bonds to rally as Japanese bank share prices decline, the reverse of normal practice. The opposite will now occur since the revival of the few key surviving banks will go hand in hand with an inevitable deterioration in government finances as the taxpayer picks up the tab. In this sense, the credibility issue that has surrounded Japan's private banking system during the 1990s will turn into a credibility issue for Japan's government.

The banks most likely to survive are

Bank of Tokyo-Mitsubishi


Sanwa Bank


Sumitomo Bank

. Share price performance should also be helped by the likelihood that the banks will finally start cutting employees in the year ahead. As discussed here last week, Japan has emerged out of denial. This has both a micro and a macro component. The macro is discussed above. The micro will mean dismantling the employment system, a process which should begin in the forthcoming fiscal year. The Japanese banking system, for example, employs 427,000 people.

Korea's Determination

A trip to Seoul is now a reassuring experience. In the old days, Greed & Fear used to feel exasperated when visiting the Korean capital about the lack of any reform momentum. The reverse is now the case. Korea has made by far the most reforms of any country in the region. Yet the overwhelming concern among thinking Koreans, as well as among ever-skeptical foreigners, is whether corporate restructuring has stalled. The most common complaint is that nothing has really changed in the corporate sector because excess capacity has not been shut down; just because the capacity now has one owner instead of two is irrelevant.

This is to protest too much. Clearly, it would be positive to see factories actually closed in Korea. But more has happened than the critics acknowledge. Take


exit from the car industry. Even if no capacity is taken out for now, the new owner will have significant scope to cut costs in areas such as marketing and component procurement. It is wrong to say that nothing has happened. More has also happened in terms of employee retrenchment than critics acknowledge.

Samsung Electronics

has cut its headcount by a quarter, or 17,000 people, since the crisis began. Likewise,

Hyundai Motors

has let 10,000 go out of a total workforce of 45,000. Only 277 were actually fired; the rest opted to take voluntary retirement.

Also, the official 8.5% unemployment level in Korea is greater in reality than meets the eye since 38% of the workforce is self-employed. These folks are hardly going to sack themselves. Indeed only 32% of the workforce are described as permanent, with 20% of employees defined as temporary and 10% as part-time, according to

Ministry of Labor

statistics. These numbers reflect a far more flexible labor market than the one implied by traditional notions of Korea's rigidly unionized labor system.

It is true that the Korean government faces a formidable task in bringing the


to heel. But there are few doubts in Seoul that

President Kim Dae Jung

and his lieutenants remain serious in this intent. Some


, such as Samsung, seem to want to restructure themselves. Others, such as


and Hyundai, still probably cling to expansionist instincts whatever the present rhetoric.

The important point, however, is that the government should ultimately prevail because it controls the banking system. This is of course why restructuring the banking system has gone much further than restructuring the corporate sector. It is also why the only threat that really forced the


to the negotiating table was the threat to curtail bond issuance. It is important to note that controls remain in place over the number of bonds of a particular issuer which an institutional investor can hold.

The HSBC Catalyst

The banking sector remains as critical as ever for Korea. The country is set for what, if concluded, will be the biggest single deal in Asia since the crisis began. That is,


recently announced decision to buy a majority stake in nationalized

Seoul Bank

, based on a formula where non-performing loans can be put back to the Korean government for a certain period following the change of ownership. This deal is far more important than the previous announcement that a 51% stake in the nationalized

Korea First Bank

would be acquired by a U.S. investment consortium.

To allow HSBC to acquire a major domestic retail banking franchise is clear evidence that the government is willing to see the whole banking system change. HSBC will act as a much-needed catalyst by bringing modern retail banking techniques to Korea, as well as the proper pricing of credit. The announcement of the deal will also probably prompt other Korean commercial banks to look for foreign partners if they wish to remain competitive.

The risk is that some of these high-profile deals will come unstuck. Rumours, predictably, abound. There is apparently a problem regarding Korean First Bank in terms of whether to value loans at book or at market. Still, in Greed & Fear's view, these technical issues are likely to be overcome since the government cannot afford to let the reform process stall.

The perception that reform is proceeding remains critical in Korea given the level of equity issuance ahead. An estimated 25 trillion won of rights issues are expected this year, or 18% of the present stock market capitalization, following the 12.1 trillion won which hit the market in 1998. Unless investors believe the reform story they will not take up the stock. But if companies can raise equity, and if -- as is now occurring -- that equity is used to pay down debt and not to expand capacity, the potential for a re-rating of Korea remains enormous because the leverage is so huge.

A Weak Yen Will Harm Sentiment

The secular story for Korea remains therefore profoundly exciting, especially when combined with evidence of an economic rebound even if it only represents restocking of inventories. (Korean industrial production growth was equal to 15% year on year in January 1999 and US exports to Korea increased 42.4% year on year in December 1998.) But Greed & Fear will be happy to remain only slightly overweight Korea for now. The reason is that Korea faces major external threats which are a problem for market sentiment.

Korean stock market investors remain obsessed with the value of the yen. In Greed & Fear's view this obsession is not justified by the comparative trade patterns between the two countries. The Japanese are, for example, exiting the commodity production of semiconductors, while Hyundai and


hardly occupy the same niches of the world auto market. The yen should, therefore, ultimately prove to be yesterday's story if Korea really continues with restructuring.

But for now, sentiment (as well as liquidity) remains critical in determining short-term market moves and the change we have just witnessed in Japanese monetary policy should lead to a sustained weakening of the yen. The Korean government will, for now, seek to counter this by managing a corresponding depreciation of the won.

The other external threat posed to Korea is China's slowing economy. In particular, the demand for Korean products such as petrochemicals has already been suffering from last year's crackdown on smuggling in the mainland, a crackdown designed to counter price deflation. Still, the reality is that none of these factors is a reason to defer restructuring. Indeed, they would suggest accelerating it.

This is why it is positive to read that the

LG Electronics'

takeover of Hyundai Electronics will finally be concluded later, contrary to market rumors. All these high-profile deals will get done precisely because they are not market-driven commercial transactions. Rather, they are government-driven, and should be seen as important symbols of President Kim's commitment to reform. Price, therefore, is not ultimately the determining issue. The direction of change is. It would be nice from a free market point of view to see reform driven from a bottom-up corporate perspective. But it would also be culturally unrealistic.

Korea is a command-driven society. Change will only occur if driven forcefully by the government. The ultimately bullish point is that Korea is run by an individual with a mandate to pursue change who is not being blamed, thus far, for policies of austerity. Thatcherite parallels therefore do apply. This is not yet the case with any other country in Asia.

Indonesia Delays Again

The failure of the Indonesian government to meet a Feb. 28 deadline for bank closures beggars belief. But there is a silver lining. The domestic reaction has been far more outraged, via a free and articulate press, than the reaction from overseas, where many foreign observers have long since given up hope of decisive action. There is now awareness in the domestic media that the cost of carrying the banking system, in terms of negative spread, is now running at about 8 trillion rupiah a month. This is just the cost of carry, not to mention the ultimate cost of recapitalization to be borne by the Indonesian government. This media focus, as well as the focus on the political reasons for the delay, means that action on bank closures may now finally be forthcoming.

If action is not forthcoming, the


and the

World Bank

should clearly stop funding. If these organizations continue to turn a blind eye to non-compliance, they run the severe risk of being made to look like monkeys which would add salt to the wound of what is already a lamentable track record in this particular country. Meanwhile, the most positive point is that both the rupiah and Indonesian stocks are showing extraordinary resilience to the bad news amidst desultory trading volumes. This is what is called bumping along the bottom.

Hong Kong-based Christopher Wood is the global emerging market strategist for ABN-Amro. Wood, a former bureau chief for The Economist, has written three books on Japan and global markets, including The End of Japan Inc. (Simon & Schuster, 1994). At time of publication, he held no positions in the securities or instruments mentioned in this column, although holdings can change at any time. Under no circumstances is this to be used or considered as an offer to sell, or a solicitation or recommendation of any offer to buy. While Wood cannot provide investment advice or recommendations, he welcomes your feedback at