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What's going on in Hong Kong?ol

Steve Luk of Jardine Fleming Hong Kong, outlines some of the concerns, risks and likely outcomes in the Hong Kong/China region.

Saturday, October 25th 1997, 12:00AM

by Philip Macalister

There are several factors which have sparked concern in Hong Kong and which seem responsible for the recent rapid dive of the Hang Seng.
The unexpected 7 per cent devaluation of the New Taiwan dollar caused worries once again on the health of the Hong Kong dollar/US dollar peg. Inter-bank interest rates in Hong Kong have shot up to over 10 per cent and the exchange rate has weakened to 7.75.
There is also likelihood that the prime rate will be raised by at least 50 basis points tomorrow, (Friday 24 October).

The likelihood that the HKD/USD peg will go is very low due to political considerations, but any defence of the peg will translate into higher interest rates and, if these were to stay high, would impact negatively on the property market and banks’ profit margins.
Another factor in the decline of the Hang Seng is the downgrading of developed Asia by Morgan Stanley’s Barton Biggs from 2 per cent to 0 per cent in the global portfolio.
US funds have reacted to this call by heavy selling in the Hong Kong stock exchange.
There is also a risk that more selling pressure will be exerted on the Hong Kong market if the share price of China Telecom falls significantly below the Initial Offer price.
China Telecom listed on Wednesday night in New York and Thursday in Hong Kong.
China’s lower than expected third quarter growth, being just 8 per cent, has also affected the market. The low growth has prompted many economists to revise down their 1998 GDP growth for both Hong Kong and China.
If economic growth in China slows to 7 per cent in 1998, the impact will be threefold.
Firstly, Hong Kong’s GDP growth will have to be revised downward; secondly, the unemployment situation in China will worsen, and; thirdly, the Hong Kong property market will suffer.
For this reason there is considerable pressure on the Central Bank to cut interest rates in the near term.
With inflation in China falling to 0 per cent in September, there is also concern (particularly from foreign investors) that China will undergo a deflationary period due to excess inventories, excess capacity, inefficiencies in the state sector, and the potential massive layoff of workers from state enterprise reforms.
Such a deflationary period would contribute to a slowdown in the growth of the economy.
What’s to Come?
It is expected that in the near term there will be an announcement in China reducing interest rates. It is too early, however, to tell if GDP growth will slow to 7 per cent in 1998, as much depends on the timing, extent, and success of the credit relaxation program.
The Central Bank has taken a sensible approach in credit relaxation. Past economic cycles in China are evidence that it is relatively easy to reflate the economy by pumping money into the system.
Such an approach, however, will result in higher inflation as well as stock market and property market speculation without solving the underlying issue of the inefficiency of the state sector.
Undoubtedly the risks associated with investing in Hong Kong have increased, and hinge on the future path of interest rates and economic growth in China next year.
While there is still confidence in the longer term outlook for China, the currency situation seems to be relatively uncertain and may remain with us for some time to come. The HKD/USD peg is more than likely to remain intact.
The Hong Kong market is now trading at around 10x 1998 earnings, presenting interesting buying opportunities.
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