Hong Kong: The next financial domino?

Bloomberg reported that Carmen Reinhart had a chilling warning about Hong Kong:

Hong Kong’s rolling political turmoil could prove a tipping point for the world economy, Harvard University economist Carmen Reinhart said.

Noting an incidence of shocks that have rattled global growth, including the intensifying U.S.-China trade war, Reinhart cited Hong Kong as among her main concerns. Having previously warned that Hong Kong faces a housing bubble, she said the world economy could be hit by “shocks with a bang or with a whisper.”

“One shock that is concerning me a great deal at the moment is the turmoil in Hong Kong,” which could impact growth in China and Asia generally, Reinhart said in an interview with Bloomberg Television’s Kathleen Hays.

“These are not segmented regional effects, these have really global consequences. So what could be a tipping point that could trigger a very significant global slowdown, or even recession -- that would be a candidate, that could be a candidate,” said Reinhart, who specializes in international finance.

Indeed, the unrest has taken a toll on the local economy.

...and GDP growth expectations are tanking.

Let me calm everyone down, and you can timestamp this forecast. China will not send the troops into Hong Kong in 2019, which reduces tail-risk. At the same time, however, investors should not ignore Carmen Reinhart's warnings either.

The full post can be found here.

Everybody was umbrella fighting...

In my last two posts, I highlighted the rising tail-risk from the protests in Hong Kong (see The Big Kahuna Korrection, or buy Yom Kippur? and HK tail-risk is rising). While the markets focuses on the actions of the ECB and the US Employment report this week, the risk of the derailment of one of the three key engines of global growth, namely China, is heightened.

Xi shows the world that he can handle an umbrella too

Lots of analysis and opinions
Since I penned those two posts, much analysis has been written about the so-called umbrella protests in Hong Kong, where pro-democracy residents are in the streets over a decision by Beijing to limit the candidates for the election of Hong Kong`s next chief executive. Here is the summary from Bloomberg:

The most violent protests in Hong Kong in almost 50 years pose a dilemma for President Xi Jinping: clear the streets and risk embedding anti-China sentiment in a city that has prized its relative freedom, or make concessions and appear weak at home.

Thousands of protesters have remained on the streets, refusing to back down after Hong Kong police on Sept. 28 fired tear gas and pepper spray in the worst clashes since unrest swept the city in 1967, led by pro-Communist groups inspired by Mao Zedong’s Cultural Revolution. The protests prompted banks to close branches in the central area and pushed the main Hong Kong stock market index down a further 1.4 percent today.

As China prepares to celebrate the 65th anniversary of the establishment of the People’s Republic of China, Xi may want to demonstrate his grip on power on the mainland as he presses an anti-corruption drive that has snared senior officials and seeks to curb separatist sentiment in the Xinjiang region. Even so, acting forcefully to quell the protests may threaten Hong Kong’s standing as a city where businesses prize the rule of law and citizens cherish their freedom of expression.

Here is the key dilemma facing Chinese President Xi Jinping:

“When push comes to shove, Xi Jinping has to calculate what this means for his own authority,” said David Zweig, professor of political science at the Hong Kong University of Science and Technology. “It is a delicate balance between not having a terrible outcome in the streets and looking weak. I am not sure if the students quite understand that.”

As well, Xi has to consider the risks that protests could spread to nearby Macau, or even China itself. If he does intervene forcefully, then he can kiss the dream of Taiwan reunification under the Hong Kong formula of ”One Country, Two Systems” for a generation.

Sara Hsu, writing in The Diplomat, outlined three possible outcomes. First, the protesters could back down, either willingly or grudgingly. The government could come to some form of compromise with the demonstrators (as they did before in Wuhan in 2011). The first two outcomes would calm markets and likely see relief tallies in risky assets. The third is the most unpleasant and involves a clampdown with dire consequences:

Third, Beijing may use violence, perhaps real bullets, to crack down, in a Tiananmen-like confrontation. This is the least desirable outcome for both Hong Kong and Beijing, as it would stifle relations between the two regions for some time to come. It would dampen trade and investment with Hong Kong, harm the stock market, which contains a large percentage of Mainland-based companies, and put the Shanghai-Hong Kong Stock Connect program on ice. Currently, trade from the Mainland into Hong Kong measured at $384.8 billion in 2013, direct investment from Hong Kong into the Mainland weighed in at $73.4 billion in 2013, and the market capitalization of Mainland firms listed in Hong Kong amounts to $1.8 trillion. Disruption of these financial flows would cause a serious economic shock to both regions.

Further, the wider economic implications of a crackdown should also be considered. A shock to the China/Hong Kong trade nexus, combined with an arrest in direct investment into the Mainland, would sharply impact the rest of the world, cutting off access to imported goods from China, and rerouting export channels to Shanghai, creating congestion and reducing exported goods to China. A crackdown would also call for an international response, possibly in the form of a trade embargo, as has been implemented against Russia. This would certainly disrupt trade, and would weaken economic ties between China and the West.

Why a crackdown is likely
Here is my two cents worth on the decision making process. I believe that there are many reasons for the authorities to lean towards using force to resolve the situation.

First, the fact that the world is watching is unlikely to much to affect the actions of the authorities. Beijing was full of western reporters in 1989, but their presence did not deter the Politburo`s decision to send in the troops into Tiananmen Square in the face of an existential threat to their authority, which the Hong Kong protests are today.

As well, China has evolved since 1989 and they appear to be better prepared for incidents like these. Zero Hedge posted a provocative piece about PLA (People`s Liberation Army) Police Riot units. Note that they refer to a Shezhen based riot police unit, who are typically trained to handle protesters with non-lethal force, rather than the regular PLA employed in 1989, who were not. The presence of these PLA riot police units that could use non-lethal force to put down the demonstrators would serve to mitigate the kinds of outcomes seen in 1989 where PLA units were ordered in and start shooting.

In addition, a recent poll by the University of Hong Kong (via the WSJ) shows that the protesters do not enjoy majority support. Only 27% of Hong Kongers agreed with the Occupy Central movement while 54% disagreed. This will serve to give Bejing the moral authority to put down what might be perceived as an unpopular insurrection.

Xi loses face
Lastly, there is the matter of the Chinese culture and character that I have not seen talked about in much of the analysis that I have read. These protests are occurring at the start of the Chinese national holiday commemorating the Mao Zedong Communist Liberation of China. Moreover, the protesters have given an October 1st deadline, the day of the national holiday, for the current HK executive CY Leung to resign. As well, this week marks the start of Golden Week holiday, when many Mainlanders go to Hong Kong to shop. Moreover, the protesters have boxed themselves in a corner so that HK chief executive Leung has nothing to offer them.

In effect, these protests are a direct affront to Xi Jinping and will cause him to lose face.  You don`t provoke a major Chinese leader and make him lose face without suffering consequences. Such actions are likely to cause emotional reactions that go beyond the normal political and economic calculus that accompany such decisions.

I hope that I am wrong, but I fear that events are likely to turn out in a less than benign fashion. Neither side seems to backing down and we will either see a settlement or a violent confrontation in the next few days. The outcome will be critical for the fate of Hong Kong, Macau, China, Taiwan and the growth outlook for the Asia-Pacific region.

Stay tuned.

HK tail-risk is rising

In yesterday's post (see The Big Kahuna Korrection, or buy Yom Kippur?), I wrote that, based on my interpretation of sentiment indicators, the US stock market appeared to be getting close to a bottom. However, there is a chance that the market could fall further if a bearish catalyst were to appear.

One of the possible catalysts I cited was political unrest in Hong Kong (also see stories by CNN.and Bloomberg):

Over in Asia, how will Beijing react to the latest developments in Hong Kong's Occupy Central pro-democracy campaign? Could China institute a crackdown in a way that would spook the markets. (See my previous post Big trouble in little Hong Kong for the key quote: "The fact that you are allowed to stay alive, already shows the country's inclusiveness").

Since I wrote those words, the Occupy Central pro-democracy movement has clashed repeatedly with police.

While images like this appear to be iconic:

...and seemingly cute to a western audience who is naturally supportive of democracy:

On the other hand, sentiments like the one expressed by this T-shirt represent a direct challenge to Beijing's authority and steers the pro-democracy movement down a very risky road.

When dictatorship is a fact, Revolution is a duty

The good and bad news
The good news, for now, is that the HK Police is dealing with the protesters and the PLA has not taken control. The scenes from the protests are reminiscent of the recent US riots in Ferguson, but the Ferguson riots did not directly challenge Washington's authority while the HK protests represent an existential threat to the Party. Such dissent will not be tolerated.

George Magnus tweeted the following comment and it illustrates the vast gulf of perception between the pro-democracy protesters and Beijing:

As an example, the news that the HK High Court acceded to a petition of habeas corpus and ordered the release of student protest leader Joshua Wong provided a temporary victory to the pro-democarcy movement. On the other hand, it undoubtedly added to Beijing's discomfort and probably increased its resolve to tighten political control of Hong Kong.

I am seeing the eerie echoes of the Tiananmen Square protests here. The wildcard is how Beijing reacts. Already, concerns are rising of a mini-Tiananmen moment:

The potential for a "mini-Tiananmen" movement to evolve from pro-democracy class boycotts at local secondary schools and universities worries the government, a former chief of the Security Bureau says.

Suspicions have also been aroused in the corridors of power that the students are becoming a tool for Occupy Central to boost its fight for genuine universal suffrage, because it has failed to mobilise support from the middle class, according to executive councillor Regina Ip Lau Suk-yee.

But she doubts the pressure will succeed in making Beijing cave in and retract a reform framework laid down on August 31 - ruling out a genuine choice of candidates for voters in the 2017 chief executive poll - despite the political tensions weighing on the Hong Kong government.

As the government`s paranoia mounts, the question of foreign interference will rise (emphasis added):

Ip told the South China Morning Post of prevailing sentiments in the government last week while the class boycotts were in full swing, ahead of the formal launch of Occupy's first operation yesterday.

"On the face of it, the students are voicing their demands for democracy and self-determination," Ip said.

"I think the worry on the part of the Hong Kong government is, what if it becomes a mini-Tiananmen? Who is behind it?"

If there is a crackdown that involves mass bloodshed, the markets will freak out. Risk aversion will go through the roof and China`s growth outlook will tank. At that point, we will then truly see how serious the financial linkages the Chinese financial system have with the West.


What to watch
I am trying not to sound alarmist as events may resolve themselves peacefully. However, to monitor events, I am watching for live updates from the South China Morning Post, whose Occupy Central coverage is outside their pay wall.

As well, I am monitoring the AUDCAD exchange rate cross, as Australia is a more China-sensitive commodity producing country than Canada. The AUDCAD has already violated a key support zone and it is showing downward momentum. Watch if the support that I marked holds.

I am also watching the behavior of the EM bond market to see if global risk aversion spikes:

Stay tuned and brace for volatility. The events in Hong Kong have the potential to overshadow the ECB meeting and the US Employment report this week.



Breaking: The HK government has blinked and has taken riot police off the streets. A statement asks the demonstrators to disperse and go home.

While this may be viewed as a positive development, I see this as potentially more serious because the issue of the protesters' challenge to Xi's authority has not been resolved. If the HK police cannot or will not deal with the protesters, how long before the PLA steps in?

Buy Singapore, sell Hong Kong?

Further to my last post about buying Australia and selling Canada, an alert reader emailed me and asked me to comment about buying Singapore and selling Hong Kong as another pair trade with the Asia Ex-Japan region.

Here again, is Bill Hester's analysis of relative country valutions based on cyclically adjusted P/Es and dividend yields. Indeed, it shows that Singapore as very undervalued and Hong Kong as roughly fairly valued.

The chart below shows the relative total performance of the iShare Singapore ETF compared to the iShare Hong Kong ETF, both in USD. This chart casts more doubt on the profit potential of a Singapore/Hong Kong pair trade.

I wrote in my previous post: "Hester’s analysis, combined with the above chart, screams out for a trade of going long Australia and shorting Canada."

The Australia vs. Canada pair trade that I proposed had the benefit of a valuation spread and price mean reversion. In the Singapore vs. Hong Kong case, the pair is already moving in Singapore's favor and it does not appear to be a mean reversion trade. There appears to be less of a historical price relationship between those two markets than Australia and Canada.

Under these circumstances, I would steer clear of the trade.