During most of July the Hong Kong dollar has been bumping up against its upper band of 7.75 Hong Kong dollars per US dollar. This means that the Hong Kong Central Bank has been forced to sell HKD to maintain the peg. In doing so, the Central Bank has printed more HKD, expanding the monetary base.

The question is why the sudden demand for Hong Kong dollars? What’s going on here?

At first I was perplexed as to why this was occurring now. Although there was no reason why there shouldn’t be an influx of capital into Hong Kong, at the same time I couldn’t figure out what caused the sudden immediate need.

As usual prices move first, and the reason becomes apparent after.

It turns out that the US and European sanctions on Russia are having interesting effects on the global financial system. The Russian oligarchs, fearful of having their US dollars confiscated, are buying Hong Kong dollars by the fistful.

http://themacrotourist.com/images/Azure/PutinAug0514.png

According to Bloomberg:

OAO MegaFon (MFON), billionaire Alisher Usmanov’s wireless operator, said it has been shifting cash holdings into Hong Kong dollars, a move people say metals producer OAO GMK Norilsk Nickel (GMKN) is also undertaking, as the U.S. and Europe ratchet up sanctions against Russia.

MegaFon decided to keep about 40 percent of its cash in Hong Kong dollars given the global markets disturbances, Chief Financial Officer Gevork Vermishyan said in a phone interview. The Moscow-based carrier has traditionally kept its foreign cash in U.S. dollars and euros, according to the company.

Norilsk Nickel, the world’s largest producer of nickel and palladium, is also keeping some of its cash in Hong Kong dollars now, two people with knowledge of situation said, asking not to be identified as information isn’t public.

This makes perfect sense. The Hong Kong dollar is pegged to the US dollar so the Russians are able to maintain exposure to the world’s largest currency without the direct threat of confiscation.

“Keeping money in Hong Kong dollars is essentially equivalent to keeping it in U.S. dollars because of the currency peg,” said Vladimir Osakovskiy, chief economist of Bank of America Corp.’s Russian unit. “Still, for Russian companies it’s much safer from the standpoint of sanctions.”

From a Russian point of view the Hong Kong dollar is a perfect escape mechanism for their capital.

But what does this mean for Hong Kong?

As the capital has flowed in, the Hong Kong Central Bank has been forced to print HKD to maintain the peg. This has caused the monetary base to jump sharply during the last month.

http://themacrotourist.com/images/Azure/HKDMBAug0514.pngHong Kong Monetary Base</a> </div>

That in itself is not new. Ever since the 2008 credit crisis Hong Kong has been forced to defend the peg and the monetary base has been continually climbing.

http://themacrotourist.com/images/Azure/HKDMBLTAug0514.pngLong term chart of HKD monetary base</a> </div>

Although this trend has been in place for quite some time, the Russian capital inflow has pushed this base up into new highs.

Ultimately this peg cannot hold. It makes no sense for Hong Kong to be pegged to the US dollar anymore. It might have made sense in 1983 when they instituted it, but its time has long passed. A peg against a trade weighted currency basket, or even a peg to the Chinese currency is a much better solution for Hong Kong. And if the peg to the US dollar is to stay, at the very least it should be revalued upwards.

You would think that hedge funds would be attracted to the fact that the Hong Kong Central Bank is defending a peg whose fundamentals appear mis-priced. This sort of limited risk bet with large potential gain in the case of a revaluation, usually draws them in like a group of teenage boys dropped off in front of a sun screen lotion convention.

And in fact, for a while in 2011 the trade was all the rage. Our favourite hedge fund hype-ster Bill Ackman even produced a 149 page slide presentation of the great opportunity in buying Hong Kong dollars. It is a really good presentation and the logic is actually quite sound. Go read it – you won’t regret it like the Herbalife presentations. But as they say, timing is everything. I hope that Bill’s wife is a patient woman because he seems to have a little bit of a problem with being “early.”

Bill’s presentation a few years ago caused a little flurry of hedge funds who scampered into the trade, but when the hoped-for revaluation didn’t happen overnight, they quickly lost interest. Even though the fundamental case for a Hong Kong dollar revaluation has not dramatically changed, there has been precious little market chatter about the possibility.

Which is why I am even more attracted to the trade today. The Hong Kong dollar is rising – not because of Bill and the rest of his hedge fund cronies thinking they have outsmarted the worlds’ Central Bankers. No, it is rising because there is real demand for Hong Kong dollars in the global financial system.

When Bill presented his slide show he almost guaranteed that any revaluation would be delayed by a year or two. A Central Bank cannot be seen as being pushed around by some hedge fund. Yes, it happened with the Bank of England and George Soros, but that has haunted them ever since. In the case of Hong Kong the peg is defendable in the short run because the pressure is to revalue upwards. The Hong Kong Central Bank can maintain the peg indefinitely if they are willing to accept inflation. When it is the other way round, and the currency is being attacked for being too high, the defence is much more difficult as the Central Bank eventually runs out of money.

Not having any hedge funds advocating the revaluation is a huge plus in terms of increasing the chances of it actually happening.

I am not going to pull an Ackman by overhyping the chances of this occurring. The odds do not favour it. The most likely outcome is that the Russian capital will eventually all be moved into Hong Kong and the inflows will stop. The Hong Kong Central Bank will print more money to defend the peg and suffer the consequences.

But this peg does not make sense, and there is a chance that this weird unintended consequence of the Russian sanctions ends up being the trigger that forces Hong Kong’s hand.

The HKD is allowed to trade in a band of 7.75 to 7.85 against the US dollar. That means that even if we buy 7.75 upper band and sell the 7.85 lower band, the most we can lose is 1.3%. Think about that for a second. The Euro or the Yen moves 1% in a week all the time. We are effectively getting a free option.

Buying the Hong Kong dollar is a great risk reward trade. It might not work, and I might be joining a motley crew of hedge fund mopes predicting the end of the peg’s demise, but it seems to me that this is one of those out of the blue surprises that might catch everyone napping. As one of my buddies likes to say, “I am never wrong – I am just early sometimes.” I hear Ackman might be adopting this as the new slogan for Pershing Square…


Positions

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