The Government's intervention - why it was wrong
In August, the Hong Kong Government intervened in the stock and futures markets, startling the world. The intervention attracted popular support in Hong Kong and only muted criticism. Nonetheless, the intervention takes Hong Kong into uncharted waters and will have damaging long term consequences.
During the period from 14 to 28 August the Hong Kong Government spent an estimated HK$120 billion intervening in the stock and futures markets. Although in Asia government stock price support programmes are not unusual, Hong Kong had never seen such intervention before. And no government anywhere, it appears, has claimed to be buying stocks in order to defend its currency. The Hong Kong Government had written a new page in global financial history.
The intervention, and the rhetoric of war against hostile foreign forces that accompanied it, struck a chord with the Hong Kong people. A groundswell of popular support greeted the intervention. Long frustrated by the Government's inability to address economic problems, people at last found a target for their grievances - the international speculator - and in the newly proactive Government a champion for their cause. The Government's approval rating rose. The pages of the press filled with images of monetary chiefs fighting crocodiles and other representatives of the evil foreign forces threatening Hong Kong.
Although there were expressions of disquiet with the intervention, which had been done without reference to the legislature and rode roughshod over securities market laws, these were relatively few. International commentary was more negative, particularly the reaction of US Federal Reserve Chief Alan Greenspan. However, the Federal Reserve then lost the moral high ground by itself rescuing hedge fund Long Term Credit Management. And the calls of many world leaders, like Britain's Tony Blair, for review of the international financial system lent credence to Donald Tsang's call for regulation of hedge funds. The Hong Kong financial markets stablised somewhat in September. Overall, by time of writing, the Hong Kong Government appeared to be stronger after the intervention than before it.
Rationale for the intervention
Was the Government then right to intervene? In order to judge an act, one should consider its rationale.
Countering attack?
The most frequent reason given by the Government for the intervention was to counter a supposed "double market play" by international speculators. Details of this alleged double play vary with each telling, but the gist of it involved speculators shorting the Hong Kong dollar in the money markets in the hope of driving up interest rates, thereby causing the stock market to fall; from which, having taken out short positions in the futures market and/or the stock market, they could profit.
The possibility of such transactions had been examined in detail by the SFC as set out in the Report on Financial Review published in April 1998. The SFC's conclusion, with which the Government concurred, was that, at least at that time, there was no evidence of such double play. It is true that after April, open positions in the futures contracts did rise significantly, but this alone has no sinister implication. For every short position in the futures market there is a long position. In any event, the Government has not made public any further investigations it may have made, and has produced no evidence that in fact the double play existed in the life-threatening manner alleged.
On launching the intervention, Donald Tsang gave the following chain of reasoning. He said that the Government had asked itself whether it was corrupt. "The answer was, objectively, no". The Government asked whether companies had been profligate. "The answer is no", he said. The Government asked itself whether the economy was adjusting to the Asian economic crisis. "The answer is yes", said Mr Tsang. He then concluded that speculators must be at work because currency movements were "not consistent with expected market adjustments".(¹)
In other words, because the market did not agree with the Government, there must have been a conspiracy. On such reasoning as this, the Government hazarded Hong Kong's reputation and tens of billions of its taxpayers' money.
Interested parties?
Even more disquieting is the possibility that the Government acted on the advice of self-interested parties. The Government claimed to be fighting against the hedge funds who held short futures positions, but by definition this means they fought for the holders of long positions, who as a result made large profits or avoided large losses. Who was long in the futures market? Attention has been drawn to the fact that many parties would have been privy to the Government's intervention plans. And why were just four brokers chosen to execute the Government's orders, and why those four? It is understood that the SFC is investigating possible front running of the Government's trading, but it will take an extensive investigation to clear the suspicions that insiders at least benefitted from their knowledge of the intervention and perhaps even prompted it.
Punishment?
The Government made up for its lack of evidence by the vehemence of its rhetoric. The campaign against the alleged speculators was announced as a virtual declaration of war: "I'm going to hurt them. I'm going to hit them where it hurts". This "Judge Dredd" approach to financial regulation received a rousing chorus of support from the populace. But however reprehensible these alleged unnamed speculators may have been, seeking to punish and hurt them is a different goal from protecting the currency. In fact, personalising and dramatising the "war" may increase rather than decrease stability.
In any case, it is difficult to differentiate technically between speculation and investment. However defined, speculators have been the lifeblood of the Hong Kong market since it began.
When the Government announced the 37 measures aimed at strengthening the currency board and the regulation on short selling, it won the support of many moderates. But the 37 measures are not consistent with the intervention that preceded them. If the 37 measures were appropriate, there was no need for the intervention. If the intervention was effective, there was no need to introduce this ad hoc string of measures in such haste.
Averting disaster?
A further justification was that if the Government had not intervened, the consequences would have been catastrophic, the Hang Seng Index falling to 5000, interest rates rising to 50% and banks collapsing. These predictions cannot be tested, and are from a Government not known for the accuracy of its forecasting (the Asian crisis was expected to be "over" by Christmas of 1997). But say they were correct. It is
highly likely that investors would have come into the market again if 5000 had ever been reached, and indeed well before that. Some subsequently expressed their frustration that the Government had pushed prices up before they had had a chance to buy. Interest rates, which have shot up on several occasions before, would have come down. And Hong Kong's banks are supposed to be well capitalised and able to withstand temporary shocks of this kind. Armageddon would surely not have come.
But suppose further that the Government was right and there would have been a disaster which the Government averted by intervening. Unless the speculators are now all dead, or the Hong Kong Government has unlimited funds and unlimited political licence to continue intervening - neither of which is the case - this means merely that disaster has been deferred and hangs over us still. Intervention on these grounds is a one-off tactic, not a strategy.
Investment?
Yet a further reason given by the Government for the intervention was that the stocks were a good investment. Attention was drawn to the fact that hitherto the reserves had been invested overseas; why not take the opportunity to invest them at home? And fortuitously, following a jump in the market in early October, the Government was able to announce that it had made a profit. The investments would be held "for the long term"; indeed, a dedicated company, Exchange Fund Investment Limited, was set up to manage them. Assurance was given that it would manage the investments actively in the taxpayers' interests, appointing directors if necessary and exercising its rights as a shareholder.
But did the intervention constitute a good investment? Whether or not the Government succeeded in stinging the speculators, it itself was stung. The intervention cost far more than originally expected. Believing its own rhetoric of a market dominated by hedge funds, the Government found itself buying up the entire holdings of Edinburgh fund managers who were amazed at the prices on offer. Having purchased 8.9% of Hongkong Bank at as much as HK$173 per share, the Government found the stock subsequently falling to HK$131.
Secondly, and more importantly, the intervention was supposed to be a "temporary" measure in an emergency, a "10 day surgical strike" in the Financial Secretary's rather strained metaphor. But a "long term investment" is not a temporary measure: it changes the character of Hong Kong for the long term. It is astonishing that in the week the Beijing Government signalled its abandonment of trust and investment companies by the closure of GITIC, the Hong Kong Government set up its own "ITIC" to control its new clutch of part-state-owned companies.
Adventurism
From the information so far revealed, it appears that the Government formed a view without solid evidence, conducted tactics as if it were strategy, and made up the rationale for its actions as it went along. Bowling public opinion along with the rhetoric of crisis, it was largely able to deflect criticism. Demands for an account could be deflected on grounds of national security. Critics were denounced as unpatriotic. Doubling up its bets, it eventually put so much into the market that the prophecy of crisis became self-fulfilling: the Government created an event so large that the world had to take notice. Most gamblers would then retire defeated, but the Hong Kong Government was not only a player but also a regulator and policy-maker of the markets in which it played. It was thus able to change rules, and in pressuring the clearing house attempted to do so retrospectively to retrieve its "winnings" even after the game had ended.
The sequence of events recalls the Hunt brothers' attempt to corner the world silver market in 1980. The brothers found the world too big for them, and in addition they faced a regulator who prosecuted them for breaches of the securities laws. But the Hong Kong's monetary officials had funds large enough, and there was no regulator to prosecute them because they were the regulators.
Damage done
The damage done by the intervention is thus deep, undermining the basic structure and philosophy of Hong Kong.
- Hong Kong's major competitive advantage, compared with the rest of Asia, was that its government had been, "a referee rather than a player". This crucial advantage has been dissipated. The Government intervenes in all asset markets and part-owns the leading companies.
- Another major competitive advantage had been the rule of law. This has been called into question. Actions like those taken by the Monetary Authority would probably amount to market manipulation or price fixing and hence a breach of the Securities Ordinance, and would certainly trigger a disclosure obligation under the Securities (Disclosure of Interests) Ordinance. But the Authority claimed exemption under the Adaptation of Laws Ordinance. Technically this may be so, but it means that one player in the marketplace is above the law while the others must obey it.
- The Hong Kong stock market, formerly Asia's freest, can no longer claim to be free or fair. The biggest player in the market can do more or less what it pleases.
- The Government also intervened in the role of its regulators. Having appointed the SFC and, indirectly, the two exchanges, as regulators of the market, the Government pushed them aside and imposed the 30 measures itself. In doing so, the Government set aside 10 years of institutional development and asserted itself in a role for which it does not have expertise or resources.
- The possibility that parties close to the Government benefitted from or even inspired the intervention remains uncomfortably strong. If unaddressed, the intervention could mark a twist in Hong Kong's spiral downwards into crony capitalism.
- Finally, did the intervention help the currency? Far from reassuring investors, the Government's action convinced many that the community could not bear the pain of asset price falls and would abandon the US dollar link. One fund manager's reaction was to tell his analysts to assume that the Hong Kong dollar would be devalued 50 per cent. Rating agencies also downgraded Hong Kong after the intervention.
What the Government could have done instead
Manipulation of the stock market is illegal. If the Government had concerns about manipulation it should have investigated these through the existing laws and prosecuted or at least deterred the manipulators. If the laws were considered insufficient, they could have been amended - as indeed the Government tried to do with its 30 measures - and the manipulators would have been caught or deterred. If, somehow, this could not have been done, and further, it was actually the case that speculators were manipulating the markets below a level which fundamentals would have justified, there would have been turbulence but the market would have defeated the manipulators in the end. Witness the flood of investment money into the Hong Kong market in early October. And the collapse of hedge fund strategies in September and October. And witness the Government's own failure, despite its vast resources, to "manipulate" the price of HSBC.
What the Government should now do
- The Government should acknowledge its mistakes and commit to reform. The officials responsible should resign.
- The Government should sell its shareholdings, ideally immediately, having first declared its intention, but at least as soon as possible.
- The Government should institute an orthodox currency board mechanism without delay. Such board should be backed by a law and operated independently of the Government but with accountability to the Legislature.
- Such currency board should be separated from the HKMA in a distinct institution. The other functions currently performed by the HKMA should be passed to appropriate institutions: management of the Government's reserves to the Treasury; banking supervision to a dedicated banking regulator, or broad financial services regulator along the lines of the UK's Financial Services Authority; and securities market development to appropriate market operators and practitioners.
(1)"When Donald went to war", SCMP, 29 August 1998