How Hong Kong Beat the Speculators
A Newsletter Exclusive
Believe it or not but George Soros used to be a hedge fund manager too. His Quantum Fund will go down in legend as the second best performing hedge fund after RenTech's Medallion Fund. Begun in 1969, the fund reportedly returned 35% a year net of fees into the mid 1990s.
With the outbreak of the Asian Financial Crisis in the late 90s, Soros and a number of other funds speculated on currency depreciations across all across Asia. He invested a sum of money betting that Hong Kong would abandon its efforts to link its own currency to the US dollar.
But the Hong Kong government spent $15 billion in August 1998 to subvert those expectations and force the currency speculators to close their trades. The peg has not been seriously challenged since then.
In this video, we are going to talk about the currency peg, why it matters, and how Hong Kong beat the speculators.
How the Peg Works
Hong Kong’s money exists in several forms. In addition to the bank notes that you find in people's wallets, there are certificates of indebtedness and other financial instruments issued by the Hong Kong Monetary Authority. Together, we have the monetary base.
The peg requires that every Hong Kong dollar within that monetary base has to be backed by US dollars at a rate of 7.80. Every transaction of Hong Kong dollars going in or out of the system is exchanged at a similar range.
The Hong Kong monetary authority has the capacity to intervene into the currency markets to maintain the pegged exchange rate. Natural forces such as currency arbitrage traders also help in keeping the market currency exchange rates close to the pegged rates.
I hope that did not confuse you too much. The key point to think about is that, unlike Tether, each Hong Kong dollar in your hand is backed by an equivalent amount of US Dollars. It is like back in the old days of metals-backed currencies but in this case, the US Dollar is the gold or silver.
A History of the Hong Kong Currency Peg
So why have a peg? Until 1935, the Hong Kong currency was linked to silver. That year, the Government confiscated all the silver from the banks and linked the Hong Kong dollar to the British pound sterling. The rate was 1 pound to 16 HKD.
In 1972, the British government decided to freely float the pound, meaning to allow the currency markets to determine the exchange rate. So the Hong Kong government relinked the Hong Kong dollar to the US dollar. When the US dollar also went free floating two years later in 1974, the Hong Kong government decided to follow suit and float its currency.
This did not go well. These were turbulent times. Economic conditions were volatile from year to year. Inflation went from 2.7% in 1975 to 15.5% in 1980. The HKD exchange rate wildly moved from $5.13 to $9.60.
And then throughout 1982 and 1983, negotiations between China and the United Kingdom loomed over Hong Kong's future and economic viability post-1997. There was wild speculation over what might happen and the currency reflected that uncertainty.
The currency fluctuations threatened the stability of the banks. The Hang Seng stock market index dropped 30% from July to September 1983. The Hong Kong dollar lost 15% of its value against the US dollar in just two days. People, as they always tend to do, panic-bought toilet paper in the supermarkets.
The government needed to bring stability to the currency markets. So on October 17, 1983, the Hong Kong government imposed a currency peg of $7.80 HKD to $1 USD. They picked $7.80 because it was a nice middle between the $6.60 before the crisis and $8.80 at the time of announcement.
It has been like this ever since. Things have been up and down at times afterwards but the key point is that the government considers the peg a critical contributor to stability within the Hong Kong economy. Many of its businesses depends on trading and monetary flows between itself, China and the West, so having the peg be questioned is a problem.
Okay let us bring in our guy. The Quantum fund follows a global macro strategy. This means that it invests based on theses about the world’s economies. For example, the manager might think that the world is heading for much more inflation and thus make bets that pay off if inflation happens. For a time this was a very effective investment strategy.
Soros is infamous for "breaking" the Bank of England with a single currency trade. What does that mean?
The summer of 1992 was a period of economic instability in Europe and the United Kingdom. The countries of Europe were attempting to manage their currencies ahead of a formal currency union - a situation where all of these European countries would use one currency.
But political squabbling broke out between those governments, causing mass uncertainty. The monetary policy did not suit the current, weak state of the British economy. Traders began to sell the British pound for other currencies. This caused the pound's exchange rate to decline.
For many currencies today, that is alright. But here in this particular situation, the governments had agreed to maintain their currencies' exchange rate within a tight range. The Bank of England pledged to spend its foreign reserves to keep the currency within that range despite those pressures.
Soros and the Quantum Fund had already made a lot of money betting against the Italian lira. So when his lieutenant Stanley Druckenmiller, himself another well-known hedge fund manager, recommended a $2 billion US bet against the pound, Soros wanted to go bigger.
He took his entire $5 billion USD fund and borrowed $10 billion USD to bet against the British Pound. The Bank of England spent about $27 billion in foreign currency to defend the currency, but eventually caved and let the pound's value fall.
Soros made a billion dollars in profit and became a legend.
The Asian Financial Crisis
The Asian Financial Crisis refers to a series of financial crises in East and Southeast Asia. It began with Thailand suddenly devaluing its currency, the baht, in July 1997. The Thai stock market dropped 75% and the currency lost almost half of its value.
Thailand had fallen into this crisis due to a financial bubble that developed where cheap money fueled unsustainably high growth. The country's banks made loans backed by speculative property and stock markets, which took a huge hit when those bubbles popped.
It could be said that Hong Kong was in a similar situation to Thailand's. Lots of cheap money flowing into real estate and the stock markets. The Hang Seng stock index and real estate prices fell. Currency speculators started to turned their attention to Hong Kong.
Then in October 1997, the Central Bank of Taiwan announced that it would no longer defend its currency - the New Taiwan Dollar. The Bank spent $12 billion US in foreign reserves throughout the year trying to maintain its 28.6 NTD to USD peg without avail. After the free-floating announcement, the currency immediately fell to 30.5 NTD and then to 34.5 by January 1998.
With Taiwan's currency now free-floating, speculative selling shifted to the Hong Kong dollar. The market was betting that the Hong Kong government would follow suit.
The Hong Kong Monetary Authority at first took standard steps to stem the capital outflows. They asked banks to limit loans for property and stocks. They sold US dollars to buy more Hong Kong dollars to try and defend the currency. But downward market pressures continued to weigh on the Hong Kong dollar.
The government thought that these declines in the currency were not in line with Hong Kong's economic performance. The city's economy had grown 6% every year over the past decade. The city had a healthy budget surplus and nearly a $100 billion USD in foreign reserves. Each Hong Kong dollar had US dollars behind it. How can the currency have these pressures?
In the absence of a fundamental economic reason, the government believed that the moves were the result of speculative actions by hedge funds. They believed the hedge funds were seeking to make profits through the use of a two-tier strategy.
In this theory, a fund was selling short both the Hong Kong dollar and the Hang Seng stock index. Successfully shorting the Hong Kong dollar and breaking the peg would cause the HKD to crash and interest rates to rise. Higher interest rates would then cause stocks to fall.
A fund with a short position on both stocks and the Hong Kong dollar would make money twice-over. The government estimated that the hedge funds had accumulated billions of HKD to execute this "double play" trade.
Thus on August 14, 1998, Financial Secretary Donald Tsang and the Hong Kong government announced that they would intervene into the market by purchasing shares of the Hang Seng stock futures, the underlying stocks themselves, and the Hong Kong dollar. They would spend $15 billion USD in this intervention, eventually taking large positions in Hong Kong's companies. They at one point owned 10% of HSBC.
Such interventions are pretty common today. The Japanese central bank today owns $272 billion of the country's stock market.
But back in the 1990s, Hong Kong's actions shook the business world, as it deviated from the city-state's reputation as a free market. From the perspective of the authorities though, the market was being manipulated. What they were doing was to free it.
Two weeks later on August 28th, the Mainland Chinese government itself remarked on Hong Kong's intervention, lending it their implied support. Traders realized that the investment thesis was not going to play out and bailed on the trade.
The intervention had worked. The Hong Kong dollar peg survived. Hong Kong interest rates returned to normal. That year, the Hong Kong economy grew 3.5%. Good growth despite a financial crisis.
Despite the accusations from the Hong Kong government, it is not exactly clear just how big of a role Soros and his hedge fund peers had throughout the crisis. Were they manipulating things behind the scenes? Or just making money and following the larger crowd? Shortly after the event, Soros said publicly that he did sell short the Thai baht currency, but no other East Asian currencies.
Ten years later though in 2009 he acknowledged in Beijing that his "attack, if you call it that, was without any success." He gave the Hong Kong government credit for intervening like they did.
A study a few years later looked at the $21 billion- USD sized Quantum fund's currency and stock positions throughout the crisis period. Their interpretation of the data says that Quantum did participate in the "double play" position and made $68 billion HKD ($8 billion USD) in profit throughout the whole ordeal.
But most of that was at the start of the crisis. After October 1997, Soros lost $122 billion HKD or $15 billion USD - presumably due to the intervention.
The Asian Financial Crisis made it clear just how much the city-state benefits from its currency peg's stability. So in 2003 the Financial Secretary made it an explicit, written-down policy that they will maintain the peg. The peg has not been seriously questioned since.
A few hedge fund managers like Kyle Bass have speculated against it during the most recent crisis period, to no avail.
It’s not a perfect tool of course. There are some very real reasons why not to have it. For instance, there’s evidence that it imports easy money from the United States, inflating its real estate and stock assets.
But for now, the government continues to consider the peg a cornerstone of Hong Kong's economy. It stays.