The day Hong Kong panicked
Stephen Vines reveals the secret story of how a government crushed the speculators and wounded the markets
Sunday 07 February 1999
Sir Donald Tsang, Hong Kong's diminutive bowtie-wearing financial secretary, even spoke the language of Clint Eastwood films. "I'm going to hurt them," he warned. "I'm going to hit them where it hurts and tell them don't come here and make a lot of money."
On 28 August last year Sir Donald peered through his thick glasses and saw the big-league speculators make his day. After a frenzy of market intervention in which it spent some pounds 9.6bn, what was supposedly the world's most laissez faire government became the world's biggest state shareholder. The speculators were seen off but at a cost yet to be paid.
How and why it happened has, until now, been a closely guarded secret. However, after a two-month investigation by The Independent on Sunday, the real story can be told.
The blunt fact is that the people who run Hong Kong's financial affairs panicked, and once they had finished panicking they managed to persuade some of the most important global market players that they had pulled off a brilliant coup.
There were good reasons to panic. Share prices were going through the floor; property prices, which underpin share prices, were in freefall; speculative activity was pushing up interest rates to near unbearable levels. The authorities were receiving reports, allegedly, that a number of smaller banks and broking houses were teetering on the brink of collapse. "The fear factor was horrendous," recalled Peter Churchouse, the managing director of Morgan Stanley Dean Witter in Hong Kong. "There was almost hysteria around the trading rooms of Hong Kong."
By the middle of August that hysteria was coming to boiling point. Many influential market players were confidently forecasting that Hong Kong would have to abandon its currency's fixed link to the US dollar, which had helped see it through a number of crises in the past two decades. The hedge funds and big investment houses were circling for the kill. If they succeeded in breaking the link, they stood to make billions of dollars. According to Joseph Yam, the chief executive of the Hong Kong Monetary Authority (HKMA), the speculators would have netted some pounds 300m for every 1,000 point fall they could engineer in the Hang Seng index. If they actually succeeded in forcing a devaluation of the currency, their bets on its fall would produce profits running into the billions.
From his office in a gleaming tower facing the Bank of China building, Mr Yam studied a small avalanche of reports about the build-up of short futures markets contracts in the Hang Seng index - positions taken by speculators who believed the market would fall. Speculators were also going short in individual stocks, and going short on the Hong Kong dollar.
Across the road Sir Donald was looking at the same flow of information. "They were getting more and more worried," said a senior-level insider. Mr Yam asked the watchdog Securities and Futures Commission (SFC) to provide him with evidence of market manipulation, and was not pleased to be told that such evidence did not exist. "A bunker mentality started to grow," said the source. "They could not accept a confluence of events was under way. And they were taking it personally."
On 7 August, a week before the government started intervening in the market, Mr Yam alleged that Hong Kong was facing a "severe conspiracy" by speculators trying to break the Hong Kong-dollar peg. Later he said "speculators launched co-ordinated and well-planned attacks across our markets".
The problem was that he failed to produce a scrap of evidence to back these allegations of a conspiracy. Mr Yam declined to be interviewed but two of his officials spoke to The Independent on Sunday. When they were asked to produce evidence of a conspiracy, they provided considerable detail of how the speculators were operating in the market, but they could not offer any evidence of collusion - only a suspicion that the players talked to each other. Market participants talking is hardly unusual.
"The facts are all there," insisted Amy Yip, the HKMA director who runs the reserves management department. "A number of players in the market consistently and repeatedly [were] making the same play to reap a profit." In Hong Kong this may be viewed as a conspiracy but elsewhere in the world it is known as playing the markets.
Hong Kong's problem is that, until recently, it had a market designed for plays by well-funded investors looking for spectacularly high returns from leveraged investments - in other words, investments requiring only a proportion of the funds to be paid upfront.
"It's like an automated teller machine," said Mr Churchouse. The process is simple. Speculators take big short positions in the futures market, the stock market and the currency market. They then start putting pressure on the Hong Kong dollar, forcing the HKMA to raise interest rates because Hong Kong operates under a currency board where the government defends its currency not by buying the Hong Kong dollar in the foreign exchange market but by squeezing the local currency out of the market. This forces up interest rates and thus makes it more and more expensive for speculators to get their hands on the money to cover short positions.
As interest rates rise, stock prices fall, so those holding short positions stand to make a profit. When the Hong Kong dollar came under pressure in October 1997, overnight interest rates rose above 300 per cent. The squeeze hurt but the speculators were beaten off.
"Both sides learned from that experience", said Peter Pang, the HKMA director responsible for monetary policy and markets. According to him, and everyone else in the government, this led to the "double play" where the speculators moved heavily into both the foreign exchange and equity markets so they could get one market to produce the desired effect on the other.
The speculators also learned to get their hands on Hong Kong dollars in advance to avoid being caught short and having to borrow at very high rates to cover their short positions. According to Mr Yam, they had built up a battle chest of HK$30bn (pounds 2.44bn) through an unprecedented number of short-term bond issues denominated in Hong Kong dollars.
The government felt that Hong Kong was a sitting duck. "Obviously we needed to do something to frustrate those plays," said Mr Pang.
On 14 August they did the unprecedented and moved into the stock and futures markets and started taking positions that hurt those betting on a market fall. However, the pressure failed to ease. Mr Yam and Sir Donald, together with the chief executive Tung Chee-Hwa, decided that something far more dramatic needed to be done.
Mr Tung knew all about handling crises. In the 1980s, the shipping empire founded by his father was close to collapse. He organised one of the biggest rescues in corporate history to bring it back from the brink. This proved to be a formative experience and gave him a lasting confidence in his ability to handle the big financial players.
Mr Yam, a man of legendary arrogance, is a career civil servant who learned about markets when he arrived at the helm of the HKMA. "Joseph's the only man in Hong Kong who needs two offices," joked a former colleague - "one for himself and another, bigger one, to house his ego."
He had no doubts he could face down the speculators. Neither did the intensely ambitious Donald Tsang, who is straining at the leash for promotion to the number two slot in the Hong Kong government.
Together, these three men decided to crush the speculators by fighting them on a battlefield they had hitherto dominated. They set 28 August as the day they would enter the stock market and push it up to a level where anyone holding short positions would get badly burned.
The decision was kept a tightly held secret. Even Mr Tung's executive council were not told of the plan. When they were, after the buying operation had begun, most members were too bewildered to say anything.
However, Mr Tung felt it necessary to give prior notice to his bosses in Peking. A day before the intervention started, he got on the phone but failed to find any of the top leaders. So he communicated the message to Liao Hui, the head of the Hong Kong and Macau Affairs office. Mr Tung took Mr Liao's non-committal response as encouragement to go ahead. When the premier and economic tsar, Zhu Rongji, was given the news after returning to Peking, he was not at all happy and told his colleagues that if he had tried intervening in the market like that, he would have lost his job.
Although the government had decided to go into the market, it had not fully realised just how much it would end up spending. "We were not in an investment manager's mode," explained Ms Yip, "we were in a defending mode. Look at it like warfare: we had to hold on to the ground we had gained."
The buying operation was spread among four stockbrokers. A trader from one of the companies said: "We had no idea that we would end up buying the market. When I came in for work I was told to buy all the Hang Seng index stocks I could get. After the first hour I thought this is going to stop soon. But it didn't; we just went on and on."
Sitting on the other side of the market was a chief trader from a large European broker. "I couldn't believe it," he said. "When it started I thought there was some real sucker out there buying everything for some reason I couldn't figure out. Within an hour we all knew it was the government. `Right,' I said to myself, `let's unload all this stock we've been waiting to get shot of for some time'."
The trader was in effect pulling some very large international funds out of the Hong Kong market. Much of that kind of money has yet to come back. Trading volumes in Hong Kong shares have shrunk by about a third this year. Futures trading has been even more severely affected. The government's ownership of a large block of shares has created the kind of market illiquidity which scares off fund managers.
By the end of the day the government had purchased futures contracts at a cost of pounds 313m and had a share portfolio costing pounds 9.3bn, including stocks purchased previously. It was the proud owner of some 10 per cent of all the blue-chip stocks in the territory. The market had never seen a day like it.
"We have frustrated the speculators' plan," said a triumphant Sir Donald. Others saw it differently. The Nobel Prize-winning economist Milton Friedman, once a cheerleader for Hong Kong, described the market intervention as "insane".
The extraordinary irony of the situation is that had the Hong Kong authorities waited until the following week, they would have seen most of the big speculators being forced out of the market because they desperately needed funds to cover the positions they had built up in Russia. After the great Russian default, they were all dangerously over-exposed.
However, it was only with hindsight that this became apparent. Less hindsight was required to see that the government could have frustrated the "double play" by introducing the series of regulatory and trading reforms which were put in place a week after the market intervention ended. These basically made short selling considerably more difficult and introduced tight rules on the settlement of trades which further squeeze the speculators' ability to play the market without putting funds upfront.
Brian Lippey, the managing director of Hong Kong-based fund manager Tokai Asia, said that the government had "legitimate concerns" but sent a "real chill through the market" by intervening rather than taking the regulatory action which was introduced after the share-buying spree. He believes that market participants would have understood and supported reasonable control measures.
However, Ms Yip argued that there was no time to wait for imposing controls. "Once the players had mobilised, introducing the measures would not stop the play itself," she said.
Now the government is left with the task of unloading its massive share portfolio and doing so without disrupting the market. It also needs to restore Hong Kong's reputation for operating free markets. These Herculean tasks have yet to be seriously undertaken, let alone accomplished. However, Mr Yam has already claimed victory in the battle. The claim may yet come to haunt him.
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