By Lincoln Li :
The Hong Kong In-Depth Research Report Series
Those whom the gods wish to destroy, they first make mad.- Euripides
This in-depth report is the second that discusses the possibility of a de-pegging of the Hong Kong Dollar (HKD) to the USD.  In the previous report, the author discussed the unsustainability of HKD to peg with USD under a deteriorating Chinese economy and an interest rate hike of the Fed. The first report proposed a de-peg in the near future to mitigate the cost when the HKD is still strong under capital inflow from mainland. Such decision could lead to a win-win result for both Hong Kong government and investors. However, governments always lack capacity in choosing best options. Therefore, the Hong Kong government has a large chance to maintain the current system even at high social and economic cost so that they could expect outside environment change such as a rebound of Chinese economy to relieve itself from pressure.
Considering Hong Kong government owns a huge amount of foreign reserve, it's not easy for investors to pick the best timing to make a bet on the de-peg. The HKD crisis might outbreak following a housing bubble collapse in mainland China. This report will introduce several methods in gauging the risks of HKD's de-peg and Chinese housing bubble collapse. When crisis finally comes, whether HKD de-pegs or not, there are huge trading/arbitrage opportunities, and a careful research into the replay of HK government's massive intervention during 1997 is insightful. At the same time, accessing the impact of a de-peg to Hong Kong local companies and finding the most vulnerable part of the system can increase investors' chance to succeed. The recent development of Hong Kong bond market might provide good targets.
Choosing the best timing is the most critical part for short sellers in betting a HKD de-peg, especially considering the HK government owns huge amount of foreign reserve and capacity to receive support from Chinese central government. A fundamental practice is to check Hong Kong's trade environment. There're two methods, the first one is using residency-based Balance of Payments data and the second is using currency-based BOP data. However, each method has its own shortcomings due to the special status of Hong Kong as an international financial center. 
An alternative solution is assessing credibility of the Hong Kong currency peg through comparing interest rates differences between HK and the U.S. Fung and Yu applied Bayesian frame work to the Svensson test.  Rather than simply addressing whether the Convertibility Zone is either fully credible or non-credible, the Bayesian approach provides time-varying estimates about the evolution of the degree of credibility of the Convertibility Zone at each point in time.  Their work results are as follows.
In 2015, the Swiss national bank, which claimed "with utmost determination" to buy foreign currency "in unlimited quantities" , broke its promises. HKMA's research in the event is worth paying special attention as the institute made similar promise. Hui, Lo and Fong studied the dynamics of Swiss Franc and using market data to calculate the drift term and stochastic process. Their research is based on the assumption that speed of the mean-reverting drift is estimated as an increasing function of foreign reserves. Through research on the drift strength when the Swiss Franc is at its strong side, its result shows the condition for breaching the limit was met in November 2014, about two months before the SNB abandoned the limit.  A similar process might also suitable in studying HKD.
Monitoring the HK fundamental is important. However, investors have to consider the 'honeymoon effect' which the Krugman-type target-zone models suggest that the exchange rate function will appear to be less sensitive to changes in the fundamentals than the corresponding free-floating exchange rate. The effect of fundamentals on the exchange rate decreases when the exchange rate deviates from its central parity. 
However, as the first in-depth report suggests, the HKD is heavily rely on China's economy. During 2016 January, the huge movement of HKD has little to do with fundamentals in Hong Kong but changes in mainland. The Chinese housing bubble is regarded as the Sword of Damocles to the Chinese economy and a collapse of Chinese housing bubble might destroy investors' confidence in HKD. Therefore, gauging and estimating the timing of Chinese housing bubble collapse might be more important.
In measuring the Chinese housing situation, housing price is an important parameter. However, the Chinese official data is well known for its poor quality, not to mention the high-profile housing price data. In order to solve the issue, Deng, Girardin, and Joyeux in their research papers offered a creative way to measure the housing price using high frequent transaction data. 
After solving the price data issue, investors need to model the dynamics of Chinese housing development. However, the Chinese increasing housing price is albeit with fast economy development and there are disputes that whether Chinese fast increasing housing price indicates a bubble. Yang and Gete conducted a research and suggested that productivity, savings glut, and tax policies are the key drivers. They pointed out that productivity and land shocks affect housing quantities more than prices, while tax policies and savings glut shocks affect house prices more than quantities. However, when the sample is closer to 2014, housing preferences and credit shocks become increasingly important to explain house prices and volume, while population shocks explain a larger share of the dynamics of residential investment. During the 2016, the credit shock might played an even more important role especially considering that residential mortgage became a major driver of Chinese new credit and accounted for 70% of monthly new loans in August 2016.  As the credit become the dominate role, the high-profile Asian hedge fund managers Belesi, who just funded his own fund, Lingfeng Capital, leveraged the Log-Periodic Power Law (LPPL) model  to predict the timing of collapse of the housing bubble based on the assumption that in order to maintain such Ponzi scheme the credit has to match the power law. 
(China M2 Growth Rate diverged from the Power Law)
When the de-pegging risk has become a market consensus, investors are facing choices in determining what to do next. Accessing the de-peg impact to local firms and choosing the most vulnerable part of the system are thus critical.
The previous financial crisis in Hong Kong usually related to the housing bubble and banks' unrestricted lending.  When the de-peg risks emerged, banks are very likely to become the first choice for short sellers. However, the recent control of Loan-to-Value measure has lowered the exposure of banks in the real estate sector  and there's possibility that Hong Kong government departs Laissez-faire policy and directly supports banks, considering that non-interventionism in Hong Kong has never been a matter of economic conviction but primarily a question of political convenience. 
The recent development of Hong Kong's bond market might offer better targets. Banks used to dominate the financial intermediate in Hong Kong. However, the growth of the corporate bond market has accelerated considerably. After the 2008 financial crisis, outstanding corporate bonds posted a significantly faster growth of 17% per annum on average, far outpacing economic growth. Just like what the quote said "Those whom the gods wish to destroy, they first make mad". The BIS already showed its concerns over such fast development of Hong Kong's bond market.  The bank pointed out that bond issuers are less confined to corporates with top credit ratings and corporations with lower credit ratings are now able to gain access to the bond market. Also, as the pricing of corporate bonds are usually based on major government bond yields (notably the US Treasury yields), the increased use of bond financing could make corporate borrowing costs more sensitive to global monetary and financial conditions. There is also huge mismatch of currency due to low cost in issuing USD denominated bonds instead of HKD denominated bonds. As of the end of 2014, the outstanding amount of corporate bonds in Hong Kong stood at US$101.8 billion, of which 14%, 65% and 22% are denominated in HKD, USD and other currencies, respectively.  When the crisis emerged, those low credit companies with large outstanding USD denominated bond are expected to hit hard as a de-peg will not only hit their balance sheet but also worsen their financing situation due to their inverted capital structures.  Also compared with U.S. bond market, the Hong Kong bond market is narrow and the spreads quote is quite wide which also facilitates short sellers' attack. 
The development of the bond market also limited the government's capacity in defending the HKD as those companies might be unable to suffer from swings in short-term rates. Similar case can be found back in the 1992's British Pound attack when the credibility of the commitment of the Bank of England to defend the sterling is limited due to the fact that 90% of home mortgage loans were at floating rather than fixed interest rate. On the contrary, the Swedish central banks raised the interest rate to 75 percent (at annual rate) and limit the incentive to borrow weak currency for speculative purpose and successfully defeat Soros. 
As the Hong Kong government is very likely choosing to defense the system, investors need also be alerted with government's intervention and the following trading opportunities. Therefore, a case study would be very insightful. During 1997 Asian financial crisis, the Hong Kong government spent hundreds of billions to support the market. Although no details are revealed, Goodhat replayed the government's strategy based on intensive study of market data and report.  His research shows the short sellers are highly leveraged and if the speculators could push down the stock index by 1,000 points within 100 days, the cost would be HKD 400 million and the net profit would be HKD 3.6 billion. In order to cope speculators' double-down strategy, the Hong Kong government conducted counter double-play not only in Hong Kong market but also in London market as many Hong Kong stocks are dual listed and under different currency. The fierce confrontation between two sides created huge arbitrage opportunity. For e.g. during two days before the August index futures expired, the prices of London GBP trading HSBC dropped considerably, while the London HKD trading HSBC and HK trading HSBC remained much higher.  When similar scenario emerged, investors who carefully study the replay of previous intervention and use their discretions in judging the circumstance are most likely to grasp trading opportunities, especially considering under extreme stance, many algo arbitrage trading strategies have to turned down due to huge de-peg risks.
Timing is critical for betting a de-peg of HKD. The report offers several methods in gauging the risks of HKD and Chinese housing bubble collapse. The target choosing also indicates that other than short bank and real estate companies, the low credibility companies which issued large amount of USD denominated bond might be better targets. A careful study of reply on 1997 government's intervention in the stock market is also insightful due to huge amount of arbitrage opportunities.
. The first in-depth report on HKD can be accessed at here .
. The Nexus Of Official And Illicit Capital Flows -The Case Of Hong Kong , Yin-Wong Cheung, Kenneth K. Chow and Matthew S. Yiu, HKIMR Working Paper No.25/2015
. Assessing the Credibility of The Convertibility Zone of The Hong Kong Dollar , Laurence Fung and Ip-wing Yu, HKMA Working Paper 19/2007
. See the press release " Swiss National Bank sets minimum exchange rate at CHF 1.20 per euro " by the SNB on 6 September 2011
. A Quasi-Bounded Model for Swiss Franc's One-Sided Target Zone During 2011-2015 , C. H. Hui, C. F. Lo and T. Fong, HKIMR Working Paper No.15/2015
. Fundamentals and the Volatility of Real Estate Prices in China: A Sequential Modelling Strategy , Yongheng Deng, Eric Girardin, Roselyne Joyeux, November 2015
. The bubble is Ripe , Beilesi, Caixin
. Mr. Bei is using M2 data in his public article. However in China, the social financing data might be more insightful data and it's very likely Mr. Bei adopted such data in his trading model. Selerity has conducted an in-depth report on China's social financing data and full report can be access at Here .
. Profits, Politics, and Panics: Hong Kong's Banks and the Making of a Miracle Economy, 1935-1985, Leo F. Goodstadt, Hong Kong University Press, pp 163-181
. How Does Loan-To-Value Policy Strengthen Banks' Resilience to Property Price Shocks - Evidence from Hong Kong , Eric Wong, Andrew Tsang and Steven Kong, HKIMR Working Paper No.03/2014
. The Global Crisis: Why Laisser-faire Hong Kong Prefers Regulation , Leo F. Goodstadt, HKIMR Working Paper No.01/2010
. The rise of Hong Kong's corporate bond market: drivers and implications , David Leung, Ceara Hui, Tom Fong, BIS Papers No 83
. The Volatility Machine: Emerging Economics and the Threat of Financial Collapse, Michael Pettis, Oxford University Press, pp 132
. What Futures for The Hong Kong Dollar Corporate Bond Market? Tony Latter, HKIMR Working Paper No.19/2008
. Financial Markets and European Monetary Cooperation: The Lessons of the 1992-93 Exchange Rate Mechanism Crisis, Corsetti, Giancarlo; Pesenti, Paolo A.; Buiter, Willem H., Cambridge University Press, pp 57-58
. Intervention to Save Hong Kong: Counter-Speculation in Financial Markets, Charles Goodhart and Dai Lu, Oxford University Press, 2003, pp 39-96
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