Henry Liu demonstrates why FinReg, however well designed, cannot be counted upon to prevent future market failures.
A rule of finance: All trading models buy safety by externalizing risk to the trading system.
There is an invisible, but solidly anchored assumption in all structured finance and derivative trading models -- namely, that a systemic collapse would trigger a government bailout. Since each and every derivative trading model derives protection by externalizing risk to the trading system, systemic risk expands automatically (making systemic meltdown inevitable). Institutions, then, have an incentive to be considered of "systemic significance" in order to secure a fail-safe advantage in interconnected transactions, even though by themselves they are not "too-big-to-fail". These trading models are operative when they are marked-to-model, but inoperative when they are marked-to-market in a downturn. This is the point when these models' fail-safe strategy by government bailout is activated.
Even a government like Hong Kong, which assumes a radical laissez faire posture, has had to intervene directly in the equity market because of the connections between a fixed exchange rate and unregulated financial markets that allow manipulators to attack its equity markets by rigging the automatic effect of exchange rates on interest rates to create deflationary pressure on stock prices.
As you will see, focusing on "too-big-to-fail" alone leave windows of vulnerability for "too-connected-to-fail" hazards.
Hong Kong Monetary Authority Fought Off Hedge Fund Attacks in 1997
In October 1997, three months after China recovered Hong Kong following a century and a half as a British colony, the HK$, which had been pegged to the US$, came under powerful, repeated, speculative and manipulative attacks due to the contagion effects of the Asian financial crisis. The automatic monetary adjustment forced interbank interest rates in Hong Kong to shoot up to unprecedented levels (up to an astronomical 300% at one point), reflecting substantial risk premiums on the HK dollar. This generated severe deflationary consequences for the financial and property markets, as well as the entire economy.
The interventionist role the Hong Kong Monetary Authority (HKMA) played in handling violent market turbulence was controversial by the standard of its own free market ideology. HKMA later admitted that as Hong Kong's link mechanism was on "autopilot" during the attacks, the interest rate adjustments were part and parcel of the working of a currency board regime, and therefore generating an inevitable and painful financial crisis. The fact that such financial and economic pain was avoidable by de-pegging was not officially acknowledged as an option.
Hong Kong was the target of speculative and manipulative attacks four separate and sequential times during the Asian financial crisis of 1997. The first three attacks took the form of garden variety currency dumping, whereas the fourth attack targeted the structural vulnerability of the Hong Kong's currency board regime after speculators were convinced that HKMA would defend the peg at all cost. And speculators were waiting to be the happy recipients of guaranteed profit from HKMA's fixation on the peg.
The first attack took place in October 1997, as a result of contagion from the regional financial turbulence that began in Thailand in July 1997. Currency speculators took large naked short positions against the HK dollar, with the expectation of profiting from the breakdown of the Hong Kong linked exchange rate regime. However, interbank interest rates soared in response, forcing speculators to unwind their naked short position as the high cost of borrowing made leveraged naked short trades unprofitable.
Although the automatic defense mechanism inherent in the currency board regime prevented the breakdown of the currency peg, the penalty took the form of unsustainably high interest rates. For example, the overnight interbank interest rate on October 23, 1997 reached as high as 500%. This local interest rate volatility echoed the external market volatility, created psychological shocks to market participants that forced the market to put a risk premium on Hong Kong dollars. Consequently, local banks increased their precautionary demand for liquidity, resulting in continuing high level of interest rates for the HK market. A liquidity crisis developed, further exacerbating already abnormally high interest rates.
This high interest rate anomaly incurred huge adjustment costs in the Hong Kong economy, particularly in the finance, business and property sectors. Labor costs, even though they accounted for only about one-third of the operating expenses of an average corporation in Hong Kong, as compared to the US average of two-thirds, had to be reduced by management through lay-offs and cuts in real wages and benefits in the early 1998. Asset prices such as land, real property and company shares, together with rental and dividend income, also plummeted sharply and swiftly.
The high cost of defending the currency peg system manifested itself in severe price deflation. It triggered further speculative and manipulative attacks in January and June, 1998, each time draining substantial wealth from Hong Kong companies and residents into offshore hedge fund accounts. The monetary defense mechanism successfully maintained the currency peg in the market at the cost of generating sharp, across-the-board price deflation in the economy.
The Hong Kong dollar continued to trade at the pegged exchange rate to the US dollar, but the same US dollar was buying more assets in Hong Kong than before the crisis. The currency board regime merely deflected currency devaluation toward asset deflation. The exchange value of the HK dollar remained fixed to the US dollar, but Hong Kong asset prices and wages fell. It would be less painful to the local economy if asset prices and wages remained unchanged while the HK dollar was devalued against the US dollar.
The HKMA was able to defend the fixed exchange rate of its currency because it had large foreign reserves, but it did so by allowing wealth to be drained from the Hong Kong economy through asset deflation, weakening its market fundamentals. The net economic outcome was negative on balance. The monetary operation was successful, but the economic patient was left near dead.
In August 1998, the fourth and near-fatal attack took place, targeting at the automatic adjustment mechanism of the Hong Kong currency board regime. This took the form of simultaneous attacks on money and equity markets, known in hedge fund tactics as a "double play".
In a double play, before launching attacks, manipulative traders would pre-fund their attacks with highly leveraged positions with HK dollars in the debt market, engaging in big swaps to access large sums in HK dollars that multilateral entities had raised through their bond issuance. Speculative and manipulative traders then spread rumors about imminent Chinese yuan devaluation and a pending collapse of the Hong Kong equity and property markets. At the same time, they made large naked short positions in the stock futures index market. Then, they induced an interest rate hike by dumping their pre-funded HK dollars in the spot and forward market to force the HKMA to buy HK dollar with US dollars from its reserves. All these actions induced the Hang Seng index to plummet sharply and abruptly, from 16802 in June 1997 to 6708 in August 1998. Within three days beginning October 20, 1997, the Hang Seng index dropped 23%.
As the Hong Kong stock market started to plunge, other speculators saw opportunities for profit through massive naked shorting. The Hong Kong financial markets fell into chaos, as further naked short selling created panic selling of shares in free fall.
The Damage by Naked-Short Attacks
The current ban against naked short selling by Germany during the 2010 EU sovereign debt crisis is driven by more than mere phantom fears. The German defensive measure has the 1992 experience of the British pound and the 1998 experience of Hong Kong dollar with naked short selling as cautionary guides.
During the Asian financial crisis of 1997, speculators and manipulators exploited the automatic interest rate adjustment mechanism of the currency board regime, turning speculation into manipulation for certain profit. Hedge funds took naked short positions simultaneously in the Hong Kong stock and futures markets. Simultaneously, they sold yet-to-be-borrowed Hong Kong dollars against the US dollar. Under the currency board regime, the HKMA must stand ready to buy back HK dollars released into the market to maintain the peg.
This was the structural dilemma inherent with the currency board regime. On the one hand, continuing buybacks of HK dollars by the HKMA automatically shrank the Hong Kong monetary base and drove HK dollar short-term interest rate up sharply. On the other hand, the overnight interest rate having risen sharply to 500% at one point in October 1997, triggered precipitous drops in stock and stock futures prices and produced hefty profits for short-sellers. After every attack, market confidence plummeted further by the hour, creating an imbalance of sellers over buyers to push share prices further down.
The HKMA feared Hong Kong's economy could very well bleed to death if the downward vicious cycle was permitted to continue. If the economy should die from hemorrhage of wealth, no further purpose would be served by preserving the currency board. And if the downward asset price spiral was allowed to continue, the currency board would eventually also collapse after the large foreign reserves was exhausted, because wealth was draining from Hong Kong with no stop loss limits.
It soon became clear that the option was not even to choose between letting the economy collapse and letting the currency board regime collapse. The two are linked so that as one sinks, the other would be dragged down with it. The economy must be saved along with the fixed exchange rate. Yet few acceptable options were available to reverse the trend of depleting foreign currency reserves while bleeding the equity market dry. Among all the unpalatable options available, only two stood out with some uncertain promise: 1) outright capital control and 2) direct market intervention. Both were not cost-free silver bullets.
Malaysia's Capital Control Not Operative for Hong Kong
While earlier in the 1997 Asian financial crisis, Malaysia had adopted capital control with positive results, Hong Kong would not benefit from similar measures because, unlike Malaysia, the Hong Kong economy was primarily an outward-oriented trading economy with no sizable domestic market of its own. Hong Kong therefore chose direct market intervention with its huge foreign reserves. When manipulative and speculative attacks intensified again in August 1998, the HKMA intervened with its reserves of US dollars simultaneously in the money, stock and futures markets, in addition to buying back Hong Kong dollars in the foreign exchange market.
During the last two weeks of August, 1998, the HKMA imposed temporary penalty charges on targeted lenders that served as settlement banks for the manipulators and speculators to make speculative funds more expensive while HKMA itself bought US$15 billion worth of Hang Seng Index constituent stocks (8% of the index's capitalization). In addition, it took naked long positions that pushed the stock futures 20% higher to squeeze the naked short sellers. After the massive market intervention by the HKMA, the exchange rate of the HK dollar quickly stabilized, and currency futures and short-term interest rates returned to sustainable levels. Manipulator and speculators were left licking their wounds but not until substantial damage had been done to the Hong Kong economy. To soften anticipated neo-liberal criticism, the HKMA labeled its market intervention as "market incursion".
Still, for this unprecedented "market incursion", the HKMA received harsh criticism for deviating from its long-standing "positive nonintervention" policy. In defense, the HKMA argued that the "incursion" was justified by Hong Kong's strong economic fundamentals as well as the severity of the regional financial turmoil. The HKMA contended that without forceful incursion to foil market manipulation, not only would the currency board have collapsed but there would also have been serious regional and global ripple effects. It was a "too-big-to-fail" argument that was summarily dismissed by US neo-liberals who quietly did the same on a much larger scale in 2008.
The 1998 market incursion was a deviation from Hong Kong's economic policy of "Positive Non-Interventionism" adopted under British imperialism after WWII to appease US free market ideology. The policy was first officially implemented in 1971 by John James Cowperthwaite, a Scottish civil servant in the British Colonial Office who worked to remove all colonial government interventionist preference toward trade with Britain in order to facilitate more trade with the US, the world's biggest market with seemingly inexhaustible purchasing power.
Friedman Condemned Hong Kong for Market Intervention
Milton Friedman's opinion in the October 6, 2006 Wall Street Journal, less than a year before the global credit crisis that imploded in New York in July 2007, criticizing Hong Kong for abandoning Positive Non-Interventionism, praising instead Cowpertheaits as having been "so famously "laissez-faire" [in ideology] that he refused to collect economic statistics for fear this would only give government officials an excuse for more meddling." This is an amazing praise from Friedman who was known for his 1953 propositions for a "positivist" methodology in economics which stresses the important of economic data.
Hong Kong's Sin Repeated by the US
Notwithstanding their stern criticism of the HKMA in 1998, the Federal Reserve and the US Treasury also engaged in direct market intervention in US markets a decade later in 2008. This was done under the rationalization of saving "systemically significant" private institutions that were deemed "too big to fail". At least the HKMA bought all the listed shares in the Hang Seng index, rather than toxic assets from only selected distressed firms as the Fed and Treasury did, which was decidedly less evenhanded or market neutral.
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