Trouble in Hong Kong- Part Deux (May 20 2019)

KyleBass

May 20, 2019

Trouble in Hong KongPart Deux

All,

As a follow‐up to our letter dated April 22, 2019, we want to address a few critical issues related to Hong

Kong’s reserves. We have heard from the architect of the Hong Kong Dollar (HKD) peg himself, ivorytower

academics in Maryland, journalists, and sell‐side economists since the introduction of our thoughts

regarding the reserve plight of the Hong Kong Monetary Authority (HKMA). The most frequent and basic

response to our thesis has been the following: “The HKMA reports approximately $436 billion USD of

foreign currency reserves. This incredible pile of dollars would make it foolish to think that the HKMA

could ever possibly be in danger of running out of reserves.”

The operative questions that must be answered are:

1. Are Hong Kong’s FX Reserves adequate as determined by the IMF’s Reserve Adequacy

Formalism?

2. How much of the reported $436 billion USD of FX Reserves 1 are actually useable by the HKMA?

The answers to these questions require plunging deep into the rabbit hole of central bank accounting and

reserve management. Apologies in advance for the technical nature of this note. Unfortunately, this kind

of analysis is required to unmask the broad, misguided (and misleading) statements being made regarding

the supposed reserve adequacy of Hong Kong.

Hong Kong Doesn’t Meet Basic IMF Reserve Adequacy – The Asset Side of the

Equation

For a currency like the Hong Kong Dollar (HKD), which is (and has been for 36yrs) effectively pegged to the

United States Dollar (USD), within the 7.7500/7.8500 band, the HKMA uses Foreign Exchange (FX) Reserve

interventions to both maintain the currency peg and import the United States Federal Reserve’s monetary

policy into Hong Kong. These interventions change both sides of the HKMA’s balance sheet – i.e.,

extinguish an HKD liability along with the sale of an USD asset at the weak‐side of the band (7.8500) or

create an HKD liability along with the purchase of an USD asset at the strong‐side of the band (7.7500).

For a pegged currency like the HKD, the amount of FX Reserves that are freely available is equivalent to

1

HKMA Foreign Currency Reserve Asset press release on May 7, 2019

CEDAR MAPLE PLAZA II, 2305 CEDAR SPRINGS ROAD, SUITE 400, DALLAS, TX 75201 TEL. 214-347-8050 FAX 214-347-8051


how much the central bank’s balance sheet can be shrunk. The problem with the possibility of

extinguishment is the consequence of doing so. Once the excess reserve (or aggregate balance) is

depleted, additional extinguishments drain precious liquidity from the money supply and increase

interbank and retail interest rates.

Over the past several years the International Monetary Fund (IMF) has conducted extensive research 2

into the adequacy of central bank FX Reserves to prevent or hold off balance of payment and currency

crises. The IMF’s conclusions have been published in a series of reports. They identify primary factors

related to trade, banking system, and cross‐border financial claims, which can lead to capital outflows in

a stressed environment and therefore necessitate a minimum level of FX Reserves 3 .

We have calculated the minimum reserve requirement for Hong Kong as per the below IMF’s formula:

IMF Minimum FX Reserves = 10%*Exports + 10%*Broad Money Supply + 20%*Other Portfolio

Liabilities + 30%*Short Term Debt

A straight‐forward evaluation of this equation indicates a minimum reserve requirement for Hong Kong

of (10%*$684b) 4 + (10%*$1,828b) 5 + (30%*$1,047b) 6 + (20%*$384b) 7 = $642 billion USD, which is far in

excess of either the HKMA’s reported FX reserves or our adjusted value.

However, in fairness, a few of these items warrant conservative Hong Kong‐specific adjustments. First,

while Hong Kong exports its own goods, it primarily serves as a trans‐shipment hub for Chinese companies.

Therefore, we adjust Hong Kong’s direct exports from our initial calculation to only include domestic

exports ($119 billion USD, not the total $683 billion USD of exports). Second, we make an adjustment for

the proportion of Hong Kong M2 that is comprised of HKD, and not the total M2 ($925.2b, not $1,828b).

The net result of even the conservative minimum reserve requirement is therefore: (10%*$119b) +

(10%*$925.2b) + (30%*$1,047b) + (20%*$384b) = $495 billion USD.

We have been reminded by several news outlets, opinion writers, and even the peg’s architect that the

HKMA has an insurmountable pile of FX reserves that currently stand at $436 billion USD. Leaving the

primary discussion behind regarding how many reserves are actually useable, and based upon a generous

calculation of needed reserves, Hong Kong FALLS SHORT of basic IMF reserve adequacy by all

calculations.

2

See www.imf.org/external/np/spr/ara for an extensive list of IMF research on central bank reserve adequacy.

3

The IMF publishes 55 countries’ minimum reserve levels in its studies; however, the IMF chooses not to publish

Hong Kong’s figure.

4

2018 Hong Kong Domestic Goods and Services Exports, source HKMA & CEIC

5

2018 Hong Kong M2, source HKMA & CEIC

6

IMF reported 2017 Short Term Debt, source IMF 2018 Article IV report for Hong Kong

7

2018 Hong Kong IIP Portfolio Debt and Other Liabilities, source CEIC

2

© Hayman Capital Management, L.P. 2019


How much of Hong Kong’s FX Reserves are actually useable? – Constraints on the

Liability Side

This issue is analogous to the current debate surrounding the size of the United States Federal Reserve’s

balance sheet. The extraordinary measures taken since the financial crisis led to the Fed’s balance sheet

expanding to a peak size of $4.7 trillion USD. Beginning in the fall of 2017, the Fed began to reduce the

total size of the balance sheet which now stands at $3.9 trillion USD and is forecast to shrink to

approximately $3.5 trillion USD. Since 2018, a debate has ensued as to how much the Fed’s balance sheet

could actually be run off. Between the USD currency‐in‐circulation and the Basel 3 Liquidity Coverage

Ratios (LCRs) that US banks are required to satisfy, the Fed cannot possibly reduce its balance sheet

anywhere close to zero. Our own estimate is that the Fed couldn’t go much below $3.5 trillion USD

without causing severe interest rate volatility as banks would start to bid for fed funds in ways the Fed

would have trouble smoothing out with open market operations. The ensuing economic consequences

would be disastrous to a highly levered economy.

Therefore, if you can’t reduce your liabilities, you can’t reduce your assets by definition. The Fed originally

said their balance sheet was going to shrink to around $2.5 trillion but they are giving up at $3.5 trillion.

It turns out that banks needed more reserves than they realized, and they only learned this through bank

surveys. But they also have started to have issues with controlling short term rates (which is why they

keep cutting interest on excess reserves (IOER) because the fed funds rate isn't acting as they thought it

should).

Several adjustments to the HKMA’s stated official FX Reserve position must be made to determine the

usable amount. For example, the Exchange Fund Bills outstanding, a 1.1 trillion HKD liability of the HKMA,

cannot be taken to zero, which would be necessary if the corresponding 144 billion USD of FX Reserves

could actually be used. With the advent of Basel 3 and implementation of the LCR, banks must carry

adequate amounts of high‐quality liquid assets (government bonds and central bank reserves). This is the

primary reason that “FX Reserves” is a misnomer, unless the FX stabilization segment of the central

bank balance sheet is set aside expressly for the defense of the currency peg.

For Hong Kong, the below table shows the Basel 3 LCR requirements by bank and then in total. The banks

do not disclose a breakdown of their LCR requirements by underlying currency. Whereas 51% of Hong

Kong’s broad money is HKD denominated, we conservatively estimate that only 40% of Hong Kong’s LCR

requirements need to be held in HKD denominated assets. Thus, the HKMA can only run off approximately

289 billion HKD exchange fund bills before they reach the minimum required currency board size of

exchange fund bills of 841 billion HKD. This 841 billion HKD is the required bare minimum of exchange

fund bills in the Hong Kong system.

3

© Hayman Capital Management, L.P. 2019


Bank Assets (HKD) % of Total LCR Requirement (HKD) LCR Assets (HKD) LCR Ratio LCR Req/Bank Assets

HSBC 7,587B 32.2% 973B 1,567B 161% 12.8%

Tai Yau Bank 2,922B 12.4% 158B 498B 79% 5.4%

Bank of China (Hong Kong) 2,820B 12.0% 310B 496B 160% 11.0%

Tai Sang Bank 1,720B 7.3% 101B 282B 70% 5.8%

Hang Seng Bank 1,424B 6.0% 140B 293B 209% 9.8%

Standard Chartered 1,167B 4.9% 137B 212B 155% 11.7%

ICBC Asia 894B 3.8% 39B 72.8B 186% 4.4%

Bank of East Asia 816B 3.5% 34B 60.4B 180% 4.1%

CCB Asia 481B 2.0% 20B 56.1B 277% 4.2%

DBS Hong Kong 408B 1.7% 23B 36.3B 155% 5.7%

Citic International 363B 1.5% 18B 45.5B 259% 4.8%

Others 2,991B 12.7% 150B 5.0%

Total 23,593B 2,102B

Estimated HKD Portion

Minimum HKMA Currency Board Size

40%

841

Source: Various bank Pillar 3 regulatory disclosures, Hayman estimates. Note Category 2 banks like Tai Yau and Tai Sang do not satisfy the LCR,

but a Hong Kong‐specific Liquidity Maintenance Ratio. We make the relevant adjustments in the above table.

There are other HKMA liabilities of the currency board, such as Currency‐in‐Circulation and Placements

by Central Banks, which also cannot be readily extinguished by the HKMA and thus render the

corresponding 70 billion USD of FX Reserves unusable.

The remaining large category of HKMA liabilities is Hong Kong Government Statutory Deposits and Fiscal

Reserves – amounting to 1.5 trillion HKD in total. These accounts are both the working capital of the Hong

Kong government as well as the long‐term saving funds for government entities such as the Civil Service

Pension Fund, the Housing Authority, the Employees Retraining Board, Hospital Authority and Elite

Athletes Development Fund, amongst others 8 . Also, the Capital Works Reserve Fund and the Land Fund,

other Hong Kong government entities which hold funds with the HKMA, are used to finance infrastructure

projects such as the subway and railroad expansions and eventually the ambitious Lantau Reclamation

project (which itself is projected to wipe out more than half of the city’s fiscal reserves) 9 .

Once we adjust for the portion of the currency board that cannot be used (i.e., currency‐in‐circulation, a

large portion of the EFB, etc.), we then deduct a portion of the Hong Kong Government’s Deposits and

Fiscal Reserves 10 and some other smaller liabilities.

The below table shows our calculations which both tie the HKMA/Exchange Fund reported Total Assets to

the HKMA’s reported FX Reserve figure, as well as, our adjustments to arrive at usable FX Reserves.

8

See Notes 26 & 27 of the 2018 Exchange Fund Annual Report for a comprehensive list

(https://www.hkma.gov.hk/media/eng/publication‐and‐research/annual‐report/2018/17_ExchangeFund.pdf)

9

https://www.scmp.com/news/hong‐kong/hong‐kong‐economy/article/3002340/massive‐hk624‐billionreclamation‐project‐will‐be

10

We estimate that only 80% of the 1.5 trillion HKD are held in foreign currency.

4

© Hayman Capital Management, L.P. 2019


Source: 2018 Exchange Fund Annual Report, HKMA, Hayman estimates

These deductions lead us to our conclusion that the HKMA’s useable FX reserves are approximately $57

billion USD (or only 13% of reported reserves). To be clear, the HKMA will have to do some serious

maneuvering to use anything substantially more than the Aggregate Balance 11 , which as of May 17, 2019

stands at 54 billion HKD or $7 billion USD.

The greater question for investors is to what end? Why would the HKMA spend all of their remaining

liquidity supporting a 36‐year relationship that has changed so dramatically over the last decade? Given

China’s desire to increase the international use of the RMB and reduce the key role of the USD in global

finance, why does a Chinese city still effectively use the USD as its currency?

In conclusion, it is abundantly clear that Hong Kong fails the IMF’s definition of reserve adequacy. As if

this fact were not worrisome enough, Hong Kong’s actual useable reserves, at a meager 13% of reported

11

The Aggregate Balance is the total size of the Hong Kong banks’ clearing accounts held at the HKMA. This is

equivalent to the Reserve Balance that US banks hold with the Federal Reserve System.

5

© Hayman Capital Management, L.P. 2019


eserves, are woefully inadequate. The architects of the peg should be commended for the fact that it

lasted for as long as 36 years.

The great divide between perception and reality can only be explained with a deep analysis. Investors

should heed this warning and convert their HKD to USD before the relationship changes. Historically,

listening to beleaguered bankers and enshrined establishment academics has cost investors dearly in

times of crisis. The plight of the HKMA is a novel one for today’s modern financial system. The way

investors conventionally think about breaking pegs is for the monetary authorities to run out of assets. In

this case, the liability constraints are also severe and represent a financial strait‐jacket for the HKMA in

their ability to navigate this fast‐boiling crisis. Remember, under current agreements, the HKD peg to the

USD will naturally expire in 2047. The switch is inevitable and the real debate is when the world should

begin discounting the timing of the expiration.

Sincerely,

J. Kyle Bass

Managing Partner

Hayman Capital Management, L.P.

Inquiries: Steele Schottenheimer 214‐347‐8045 or ss@haymancapital.com

The information set forth does not constitute an offer, solicitation or recommendation to sell or an offer to buy any

securities, investment products or investment advisory services. Such an offer may only be made to eligible investors

by means of delivery of a confidential private placement memorandum or other similar materials that contain a

description of material terms relating to such investment. The information and opinions expressed herein are

provided for informational purposes only. This may not be reproduced, distributed or used for any other purpose.

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© Hayman Capital Management, L.P. 2019

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