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Marcuard's Market update by GaveKal Dragonomics
In the gory aftermath of the global financial crisis, the IMF investigated five countries with outsized financial systems. Iceland was in this group and got the harshest review, while Hong Kong, in contrast, was praised for its prudent financial regulation. Is it possible that in the few years since that report was penned, Hong Kong has morphed into the world’s next “Iceland”? This, at any rate, is the kind of talk we have been increasingly hearing.
Hong Kong’s ratio of banking assets to GDP now tops 7x—same as Iceland at its peak. Of course, Iceland was basically a fishing village that transformed into a national hedge fund overnight. Hong Kong, much like Switzerland, has long been a global financial center. Still, its already large deposit base has been puffed up in the past few years. And with the Hong Kong government keeping a lid on domestic loan growth to prevent a property bubble, a significant portion of Hong Kong’s excess liquidity has found its way to China—claims on Chinese banks and companies have soared from about 25% of Hong Kong’s GDP in 2010 to 145% today.
This China exposure has been a key driver of Hong Kong bank profit growth in the past two years, but it is also to blame for the very high risk premium now placed on Hong Kong’s listed financial stocks. There are two concerns, and they are contradictory. The first is that China-related business will prove transitory; the second is that Hong Kong shouldn’t be wading into China’s shadowy, risky and overextended credit market in the first place.
Most of Hong Kong’s cross-border exposure is on the interbank market. China’s capital account is still pretty closed, but is opening ever wider, with Hong Kong financial institutions taking the lead in cross-border renminbi trade settlement and the development of the offshore RMB asset market. This gives Hong Kong and Chinese banks front-row seats for any arbitrage opportunities between onshore and offshore renminbi funding rates. Over time, these anomalies should smooth out; and anyway, regulators have already cracked down on some of the gaming of the capital account system (such as using fake trade invoices to make leveraged bets on RMB appreciation). Reading brokerage reports on Hong Kong banks, most analysts seem less concerned about the inherent risks of the Chinese interbank exposure, and more concerned that this profitable gig may be up soon.
Meanwhile, credits to Chinese corporates continue to grow, and the quality of such loans has not been tested. Loans to non-bank mainland entities made up 18.6% of total Hong Kong retail banking assets as of last summer, a sharp rise from 11% in 2010. The Hong Kong Monetary Authority point outs that China business loans are “largely backed by guarantees or collateralized,” and we can hazard a guess that Hong Kong banks would at least be lending on commercial terms, in contrast to the political terms sometimes forced on mainland banks. Still, the HKMA has voiced concerns that Hong Kong banks are being too aggressive in seeking new business in an already overleveraged market.
With Hong Kong banks trading at crisis-level valuations, is the market failing to recognize a great deal? The privilege of financing China’s growth has thus far been reserved for Chinese banks only. As the mainland gradually opens it capital account, competition for deposits is growing. If Hong Kong can fill a niche by attracting global deposits, then on-lending funds to the world’s second largest economy, this seems a pretty good little franchise over the long term. Right now, the market is betting that the short-term risks of venturing into China’ murky financial universe at a time of monetary tightening outweigh that long-run benefit.
