FRBSF Economic Letter
1996-35 | November 29, 1996
Hong Kong is one of the great success stories of economic development. In less than fifty years Hong Kong has transformed itself from a sleepy trading village to one of the wealthiest and most dynamic cities in the world. Per capita income has increased by a factor of ten since 1960. A stable political and legal environment was an essential ingredient to this success. To a large extent, Hong Kong borrowed its political and legal institutions from Great Britain, which has controlled Hong Kong for more than 150 years.
June 30th, 1997 will be the last day of British rule in Hong Kong. On the following day Hong Kong will revert to Chinese control, technically becoming a Special Administrative Region of China. Although Britain and China began planning for the turnover more than a decade ago, considerable uncertainty remains over how China will actually govern Hong Kong. Like most political documents, the jointly negotiated constitution for post-1997 Hong Kong (called “The Basic Law”) is open to alternative interpretations, depending on how one chooses to define such general concepts as “national security,” “free press,” and “economic system.”
Although China has vowed to preserve the vibrant economy of Hong Kong, and no doubt recognizes its own economic interests in doing so, it has also made clear that it intends to apply its political philosophy in Hong Kong. Thus, an unprecedented experiment is set to take place, as China attempts to combine a market economy with a communist political system. Many observers doubt the viability of this so-called “one country/two systems” combination in an economy like Hong Kong’s. While an agrarian and low-tech manufacturing economy like China’s may be able to combine elements of a market economy with little political freedom, Hong Kong’s sophisticated financial services-oriented economy depends vitally on uninhibited access to and use of information.
The uncertainty surrounding China’s future treatment of Hong Kong has revealed itself in many ways. At the same time Hong Kong citizens form long queues to apply for foreign visas and passports, Hong Kong businesses rush to open factories in China and form alliances with Chinese firms. There is clearly a process of hedging and diversification taking place, but anecdotal evidence on visa applications and the formation of joint ventures can be difficult to assess. Thus, this Letter will attempt to provide more formal, quantitative evidence about Hong Kong’s future. In particular, it exploits the idea that stock and bond prices embody forecasts of the future in order to chart the evolution of investors’ beliefs about post-1997 Hong Kong. Not surprisingly, these beliefs have fluctuated widely in response to news from China. More surprising is the fact that, at least up to this point, investors apparently expect business to go on as usual after China resumes control.
The days when Hong Kong was known as a maker of toys and textiles are long gone. During the past two decades Hong Kong has become one of the world’s leading financial centers. In the early 1970s, manufacturing accounted for about 30 percent of GDP, with textiles and clothing accounting for about half of manufacturing. In contrast, manufacturing now accounts for only about 15 percent of GDP, while financial services now account for nearly 30 percent. Moreover, although Hong Kong is only half the size of Luxembourg, with a population about the same as the state of Indiana, it nonetheless boasts the world’s eighth largest stock market and its fifth largest foreign exchange market. The tiny territory is also the home to more than 320 bank branches, nearly double the number in Singapore, its closest financial rival in the region.
An interesting aspect of Hong Kong’s role in the global capital market is that it resembles its role in world trade. In both commodity and financial markets Hong Kong plays the role of middleman. Just as in commodity trade it acts as an entrepot trading center (particularly with respect to Chinese imports and exports), in the capital market Hong Kong serves as a broker and clearinghouse for the transfer of financial resources throughout Asia. Most other financial centers (e.g., New York, London, Tokyo, Zurich) are based on highly developed domestic financial markets (or in the case of Japan, are based in a country whose currency is a “vehicle currency,” which in turn derives from its importance in world trade). In contrast, until quite recently Hong Kong’s domestic capital markets were thin and underdeveloped.
Part of the explanation for the lack of a deep domestic capital market lies in the minimal role of the government in Hong Kong. In the past, the Hong Kong government rarely ran fiscal deficits, and hence had no need to sell bonds to the public. In addition, until the 1990s there was essentially no central bank in Hong Kong, and hence no open market operations.
The lack of tradeable securities denominated in Hong Kong dollars (other than equities) makes it difficult to track the evolution of market expectations about certain aspects of post-1997 Hong Kong. However, beginning in the early 1990s, the Hong Kong authorities made a deliberate effort to introduce a government securities market. Two considerations motivated this effort. First, the nascent Hong Kong Monetary Authority wanted to take a more active part in the control of liquidity in the banking system, and the buying and selling of riskless short-term securities is an efficient way of doing this. Second, introducing a range of government securities across a broad spectrum of maturities would provide the market with a benchmark yield curve that would facilitate the hedging and risk management activities of banks and their customers. Hong Kong businesses had been calling for this for many years. The government’s strategy was to start at the shortend of the marturity spectrum and gradually introduce longer and longer maturities. The introduction of these securities has been very successful, and by November 1995 the government was selling seven-year bonds denominated in Hong Kong dollars. The remainder of this Letter will discuss how data from this new market, along with data from the more established stock market, can be used to draw inferences about investors’ expectations concerning post-1997 Hong Kong.
Because stocks and long-term bonds yield returns over an extended period of time, their prices implicitly embody forecasts of the future. Bondholders face the risk of outright default, as well as inflation (or currency) risk. Stockholders face the more considerable and volatile risks associated with unknown future dividends and capital gains. Doubt and pessimism about the future will be reflected today in higher interest rates and lower stock prices, as investors demand extra compensation in the face of increased risk.
Checking for a post-1997 risk premium in government bond yields is complicated by the fact that since 1983 Hong Kong has linked its currency to the U.S. dollar. In fact, the original motivation for the link was to deter currency speculation in the run-up to 1997. (The uncertainty accompanying the initial negotiations between Britain and China during 1983 had caused a run on the currency.) This means that interest rates in Hong Kong also are tied to the U.S. With a (credibly) fixed exchange rate, any difference between Hong Kong and U.S. interest rates would open up arbitrage possibilities, as investors could borrow money at the lower interest rate and then lend it out at the higher rate. Therefore, the appropriate measure of risk in the government bond market is given by the spread between Hong Kong and U.S. interest rates. In effect, this spread measures investors’ confidence in the sustainability of the currency link. For a given matched maturity, a widening of the spread indicates that investors suspect the Hong Kong dollar might be devalued by that date, and therefore they demand a higher interest rate in order to invest in Hong Kong dollars rather than in U.S. dollars.
Figure 1 plots the (monthly, end-of-period) difference between 3-year government bond yields in Hong Kong and 3-year government bond yields in the U.S. The units on the vertical axis are annualized percentages, so that a value of 0.5 represents a one-half percentage point yield differential (i.e., 50 basis points). The data begin in May 1994 and end in June 1996. Note, beginning with the July 1994 observation, these bonds will mature after the Chinese takeover. (Although for comparison purposes it might be interesting to examine this differential for maturities before the takeover, 3-year government bonds were not issued in Hong Kong until 1994.)
This figure shows that there is indeed a discount on Hong Kong bonds, but it is surprisingly small — on average only about half a percent. Of course, a 50 basis point differential in highly liquid and efficient capital markets like those of Hong Kong and the United States is not an insignificant amount. Still, one might have thought it would be greater. Maintaining the link means that China will be allowing the United States to dictate monetary policy in an influential part of its economy, and it is not at all clear (especially given the recent tensions between the U.S. and China) whether China will go along with this. Moreover, the ultimate credibility of the link rests on a vast stock of U.S. dollar reserves that the Hong Kong Monetary Authority holds as backing for the issuance of Hong Kong currency. Some skeptics have pointed out that China might be tempted to use these reserves for other purposes.
On the other hand, some observers have claimed that Chinese firms have a vested interest in keeping the link alive because they have been using it to circumvent the limited supply of foreign exchange in China. In particular, by underinvoicing, Chinese exporters can acquire hard currency offshore that they do not repatriate. With the currency link, any renminbi (the Chinese currency unit) shifted overseas through Hong Kong are effectively converted into U.S. dollars. Of course, as the renminbi becomes increasingly convertible, the incentive to do this diminishes.
The evidence from the stock market seems to tell a similar story, although the signal-to-noise ratio is much smaller, since there are so many other factors affecting stock market returns. As seen in Figure 2, although the Hang Seng index has been quite volatile, there is no indication that there has been a break in trend. (The Hang Seng Index is a value-weighted average of 33 actively traded bluechip stocks.) Most of the major movements can be attributed to developments in the global capital market (such as the crash in October 1987) or to developments in China (such as the drop in June 1989 following the Tiananmen Square massacre). For example, regression analysis by Chan and Wei (1996) shows that while favorable news from China increases Hong Kong stock prices and unfavorable news reduces Hong Kong stock prices, on net the favorable and unfavorable news have roughly balanced out, and as a result there has been no clear break in the trend (or the level) of the Hang Seng index.
Investors must look to the future when deciding how much to pay for a stock or bond. As a result, in competitive capital markets prices reflect average opinions about the future. This simple fact has been used to draw inferences about what people think post-1997 Hong Kong will be like. Contrary to both doomsayers and pro-Chinese enthusiasts, evidence from the financial markets suggests that business will go on pretty much as usual on July 1st, 1997.
Chan, Yue-cheong, and K.C. John Wei. 1996. “Political Risk and Stock Price Volatility: The Case of Hong Kong.” Pacific-Basin Finance Journal 4, pp. 259-75.
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