Financial typhoon warning for Hong Kong

By Harry Wilson 9:30PM BST 05 Apr 2014

The restaurants are fully booked, the shops are packed, the financial markets are booming. For Hong Kong things have, on the face of it, never been so good.

“One country, two systems” has proved to be a good deal for the former British island colony that today has become a financial centre, not just to rival its old ruler but to eclipse it.

Work in London as a middle-ranking investment banker and you can hope to earn about £286,000 a year in salary and bonuses. Do the same job in Hong Kong and you can earn an extra £30,000.

Take into account the city state’s low personal tax rate and you are looking at a considerably more lucrative career. An attractive prospect as long as you are not too bothered by the dire air pollution.

“It has shops to rival New York and offshore banking services to match Geneva,” says one Hong Kong-based investment banker who long ago left London for Asia.

Last year, a record 54 million tourists, most of them from the Chinese mainland, thronged through the island’s increasingly jammed shopping malls, while millionaires and billionaires from the People’s Republic bought up luxury properties, feeding a real estate boom to match any seen in the West.

The Chinese influx, while profitable, has not been to the taste of all the territory’s citizens, who blame “the locusts” for pushing up home prices and forcing them out of central districts.

At the same time, Hong Kong has the continued to hold the dubious distinction of topping The Economist’s “crony-capitalism” index, with billionaires estimated to have squirrelled away fortunes equivalent to nearly 60pc of GDP, more than treble the level in second-placed Russia.

The boom, therefore, is not one that has been universally applauded or universally shared, adding to the sense of an unbalanced economy.

With every boom there is also the ever-present spectre of bust. Hong Kong knows a thing or two about this and its modern financial history has been marked by a series of spectacular bubbles followed by huge crashes.

Duncan Innes-Ker, an Asia analyst at the Economist Intelligence Unit, has followed Hong Kong’s ups and downs for several years and says the present boom is the natural consequence of the West’s and particularly the American response to the crisis.

“When you get low US interest rates you get a property bubble in Hong Kong. To my mind, this looks like the latest in a cycle of boom and busts,” says Innes-Ker.

However, Asianomics, a Hong Kong-based research firm, thinks the current upcycle is masking the tell-tale signs of a sharp and possibly unprecedented correction.

“Hong Kong is in the path of the typhoon developing on the mainland,” says Sharmila Whelan, an analyst at Asianomics.

“A nasty downturn in China and a sudden sharp correction in the Hong Kong property market would severely buffet the territory’s economy. China’s problems have become insurmountable and the likelihood that 2014 will prove the year of reckoning is growing,” says Whelan.

She and her colleagues last month published a comprehensive analysis of Hong Kong’s current position and concluded that a bust was already apparent and that its cause was the same as that of the boom: China.

To see why, you have to look closely at the changes that have taken place in the financial relationship between Hong Kong and China since the crash of 2008.

Before the crisis, China had never represented more than 10pc of the total external claims of Hong Kong-based financial institutions, but with the implosion of the West, the island’s exposure to the mainland has rocketed and, as of late last year, stood at 49pc of claims.

Much of the rise has come from the rapid growth of the offshore subsidiaries of China’s largest state-controlled banks, which have increasingly used Hong Kong as a base for sourcing foreign currency funding to pump back into the domestic economy.

This has been accelerated by the People’s Bank of China’s clampdown on renminbi lending, which has led Chinese banks and companies to borrow money cheaply offshore, mainly in dollars, to invest at home at higher rates of interest.

Moody’s last month issued a “negative” outlook on the Hong Kong-based operations of three out of five of the larger banks, including those of China Construction Bank and the Industrial and Commercial Bank of China (ICBC), over the rapid growth in their loan books.

One of the most extreme examples is Wing Lung Bank, which is currently being taken over by Singapore-based Oversea-Chinese Banking Corporation, which has almost doubled its lending in the last four years as it ramped up its mainland loan book from 8pc of total loans to 40pc by the middle of 2013.

This has helped feed the growth in China over the last five years of the largest and most rapid expansion in credit in history that has transformed the People’s Republic of China into the world’s second largest economy on the back of a construction and manufacturing boom without precedent.

“This is a PRC town,” says one senior Hong Kong-based banker. “A decade ago if you heard someone speaking Mandarin you assumed they had accidentally walked over the border, today you can’t get a good job unless you speak it.”

Andrew Scott, professor of economics at London Business School, says the danger to Hong Kong from its exposure to a Chinese crash is clear. “Hong Kong banks are definitely exposed to the mainland through significant lending and are very dependent on the People’s Republic of China central bank for liquidity in renminbi.

“So a real estate crisis in the PRC would have a major impact on Hong Kong bank balance sheets and GDP. Of course, if a PRC crisis meant less Western money flowing into China that would also affect Hong Kong,” he says.

The problems of Hong Kong may seem a long way from the UK, but with two major London-listed and regulated banks still big players in its financial system, HSBC and Standard Chartered, what is happening in the territory is of close interest to the British authorities.

Last year’s Bank of England stress tests on HSBC and Standard Chartered focused predominately on the impact of a Chinese and Hong Kong financial crisis to the exclusion of almost all other risks.

In the case of HSBC, the lender was told to model for a halving in Hong Kong property and stock market values, as well as a 50pc reduction in mainland property.

Even HSBC’s house broker, Credit Suisse, appears alarmed at the storm clouds gathering over China and recently cut its recommendation on the bank’s shares from “buy” to “sell”, warning about the potential unwind of the dollar-renminbi “carry” trade.

Although neither HSBC nor Standard Chartered are likely to have lent much directly to mainland Chinese businesses the issue is more a question of whether they have lent to financial institutions that have lent to businesses that could be hit hard in the event of a severe downturn.

Victor Wang at Credit Suisse points out that it is almost impossible to distinguish “real” trade financing from “carry trade”, but estimates that the speculative trading could be worth at least $200bn (£120.5bn).

Hong Kong’s financial supervisor is widely seen as one of the world’s best macro prudential regulators, but Innes-Ker questions whether even the super-savvy Hong Kong Monetary Authority (HKMA) can save the territory from the crisis that could be unleashed if China’s credit bubble were to burst in an uncontrollable fashion.

“The biggest risk is that you’ve got a financial sector that is several times the size of the economy and you have to question whether the authority’s ability to step in is relatively constrained,” he says.

Others are more sanguine about the risks.

“The Chinese economy is so controlled they will be able to manage any issues. The idea that the authorities don’t see these problems is ridiculous. If something is happening it is because they tolerate it,” says one Hong-Kong based banker.

Boom or bust, Hong Kong is in for a rollercoaster ride.