At the moment the Hang Seng is down as global markets struggle with how to discount lower profit growth and fears of inflation. But over the next year, Hong Kong will experience something that will feel like a boom, a return to the good old days, especially in its most traditional areas of money and real estate.
Hong Kong’s culture is intimately linked to wealth and Hong Kong has created huge wealth despite and because of deflation. Jobs and real earnings gains are now supporting it and the real estate market is a lagging indicator of this. It will catch up, driven by demand, need, greed and affordability - so I would invest in Hong Kong equities with a target of 20,000 for end-2001.
Hong Kong will boom because modern day deflation is of the constructive kind, especially in a place like Hong Kong. It is forced by its currency peg to make itself competitive against its devaluing neighbours by reducing costs and prices. Modern deflation is driven by the new economy to create wealth by reducing prices. The secret of this lies in greater productivity of capital and labour, so that increased profits are capitalised at multiples that reflect low inflation.
Hong Kong may be a user rather than a creator of the new economy. That may leave it short of Nobel prizes, but it won’t lack prosperity. Real labour earnings are through the roof, not because of spiralling wage inflation, but because of falling prices and job creation. Retail sales in volume terms are in positive territory – it is only falling prices that keep sales static in value terms. Giordano is packing them in, stacking them high, selling them cheap and making money.
It’s even more so when it comes to real estate. Property prices are down by about 50% in the residential sector, and with real labour earnings up, housing has not been so affordable since the late-1980s. Savings deposits at financial institutions (a good proxy for household savings) are growing fast with each household now having about HK$1.3m in savings. In 1997, 700sq ft flats in Kowloon cost HK$5m - now they cost less than HK$3m. So the affordability of housing as measured by savings has also improved dramatically.
There is a crying need for more housing in Hong Kong. In the average Hong Kong flat, most people would feel like sardines in a can. But you’d be surprised how many of the most beautiful Hong Kong people live with a mother, two brothers, a sister, four dogs and an amah in the same space. And they’re lucky if they all get a bathroom big enough to swing a mascara brush!
So there’s no doubt that people want not only more, but also bigger and better housing. The supply overhang in flats is now down to about one year. Sure, we know the arguments against an increase in real estate prices given historically high real interest rates. And the number of families in negative equity is still about a quarter of a million out of one million house owners. But I reckon things are going to feel a lot better.
Hong Kong’s banks are flush with money, with the Hong Kong dollar loan-deposit ratio at its lowest for over 15 years. There is so much money about that the spread between Hong Kong interest rates (HIBOR) and global rates (LIBOR) is negative. The real return on savings deposits remains high because of deflation, but is set to fall. The combination of inflation and falling real returns on cash should push all this deposit money towards real estate and equities.
The second reason to buy Hong Kong is the recovery in mainland China’s economy. Of course, much of this story is old hat and hyped by investment bankers and their analyst lackeys plugging the China stock issues. Indeed, a new flood of paper into the Hong Kong capital market from both China and Hong Kong companies is one of the risks to the Hang Seng. But the feeling that you get from visiting China is that the economy is on the move. Retail sales and exports are the drivers and accession to the WTO has put the reformers behind the wheel. The WTO is forcing open domestic markets and is attracting new foreign capital and that’s the most productive part of the economy.
The old structural problems remain. The fatal nexus of state-owned banks and enterprises, sucking up 75% of the nation’s savings and squandering them, is still there. The formation of asset management companies (AMCs) to "buy" the banks’ bad debts is merely shuffling lousy loans around the state’s accounts. The banks’ bad managers stay in place and the state remains the shareholder of the bank, borrower and the AMCs. There are still no banks that can assess risk and price it, so cleaning out their non-performing loans is a bit like Catholic confession - it simply frees them to commit the same old sins with a better conscience.
Also, the fastest-growing bit of the mainland economy remains state enterprise investment, up nearly 13% for the year to date compared with real GDP growth of 8.2% year on year in Q3 2000. That’s a sure sign that problems are building. But for the next two years, China will look good and some of the glitz will be real. The dynamic export sector — which is moving upmarket in technology at the speed of light and putting a huge competitive distance between itself and its lagging Asian neighbours — is driving it. That has to help Hong Kong.
The final leg of my bullish Hong Kong thesis rests on falling US and euro interest rates. Amid all the contradictory data, the US economy seems to me to be slowing fast and Europe is failing to recover. The result will be that central banks will be cutting interest rates by the end of the first quarter of 2001. That’s when risk appetite for all the lagging emerging markets will jump.
There are few Asian investible emerging markets left that really have anything to offer. Hong Kong is as good a proxy as any for investing in Asia. And when the time comes, it will be the first port of call for all those gung-ho investors who really couldn’t tell an emerging market from a submerging one.
David Roche is head of research firm Independent Strategy.
