Hong Kong in a hole it dug itself

After piling into the market, the government is struggling for a way out, says Stephen Vines

IF THERE were such a thing as an international central banker's award for chutzpah it would surely go to Joseph Yam, the head of the Hong Kong Monetary Authority (HKMA).

Last week he said the Hong Kong government's unprecedented intervention in the local financial markets was "not the end of non-interventionism, not an abandonment of free market principles, but a measure to ensure that those principles prevailed".

He was speaking about a market raid last August which left the government as the biggest single shareholder in the Hong Kong market and the largest state holder of local shares in the world. The exercise cost $15bn (pounds 8.8bn) and involved purchases of shares in all the 33 companies whose stocks make up the blue-chip Hang Seng index. At the same time the government plunged into the futures market.

The HKMA was also busy in the forex markets at the time. Normally Hong Kong protects its currency from attacks by the operation of a currency board system which drains liquidity from the market to make it expensive for speculators. The government claimed its buying of the local currency had nothing to do with propping up its value but was necessitated by budgetary deficits leading to a shortage of Hong Kong dollars. The exact nature of the intervention remains unknown.

Then there was the decision in April to halt government land sales. Because the government is the only owner of land in Hong Kong, a freeze on sales was designed to lower supply and boost property prices, which had fallen by 50 per cent.

Property stocks account for 70 per cent of the stock exchange's valuation. This means that the government's Canute-like attempt to stop property values falling has a profound impact on the markets. In practice the effect of the land sale freeze has been to increase the stranglehold of the six property development companies which dominate the market. The market now hovers between the push of market forces and the pull of state control.

It in these remarkable circumstances that Sir Donald Tsang, who claims to be the "finance minister of one of the world's most free and open economies", has to consider how to recreate the free market, which has been shattered in less than six months.

The problem is that the government's position in the market is so vast that a sale of its assets would send share prices into freefall. Even Sir Donald acknowledges this and has promised there will be no sudden share sale. He has even hinted that equities might be added to the former colony's reserves, thus making the government's holding a more or less permanent fixture.

Meanwhile, the government is claiming total success for its intervention. Speculators, it says, were trying to make a killing on the local market by a "double play" which would have sent stock prices and the value of the currency plunging. And it claims to have international backing for its actions. But figures recently released by Standard & Poor's Micropal, the fund-tracking organisation, show that US fund managers took advantage of the government's buying spree to offload around a fifth of their Hong Kong portfolios in August. Little of this money will have flowed back.

Indeed, the government's action has distorted the ability of investors to come back into the market. Figures produced by Macquarie Equities estimate that the free float of blue-chip stocks has fallen by 14 per cent. This makes it hard for foreign fund managers to find the shares they want to buy, while it provides some attractive options for short-term market raids by hedge funds.

Mr Yam, who says the stock market intervention had nothing to do with propping up share prices, cannot help boasting about the increased paper value of the government's holdings. Last week he said that it had risen from $15bn to $19bn. But Merton Miller, a Nobel prize-winning economist, has brushed aside any talk of making gains. "There's no way you can make permanent gains this way. You ride it all the way up and if you try to unload the thing you're going to prompt the reverse reaction on the way down." The government, he said, should hold a share auction.

Another proposal involves the creation of an exchangeable bond. This could be issued for shares, with the kind of maturity period which is usual for government bonds. Another is to sell the shares back to the companies. But there are now many weak firms which are in no position to participate in share buy-backs.

Some advisers to the government have suggested putting the shares into a government unit trust, which would surely create the mother of all unit trusts. Even more implausible is the suggestion that it should start filtering the shares out into the market.

It seems more likely that it will opt for a solution which amounts to semi-permanent state holdings. This would mean placing a large part of its portfolio in the Mandatory Provident Fund.

"You no longer have a clear picture of what Hong Kong is about," Mr Miller said. "It used to be a free and unfettered market through competition. But this intervention raises the question: if Hong Kong doesn't stand for free markets then what does it stand for?"