Money madness

The Asian crisis will continue until Hong Kong and China devalue their currencies.

Mr. Dizard is the Gekko columnist in the Sunday New York Post (www.nypost.com) and can be reached at dizard@nypost.com.

Back in the middle of August, daytime CNBC addicts -- who include many of the investing public -- were being told that their world was on the brink of chaos, that Life as We Know It was at risk of being hit by a financial asteroid. The standard-issue doomsayers, all of them friends of mine, were being wheeled out and planted in front of studio cameras to comment on the imminent bear market.

All this was prompted by a 10.1 per cent decline in the S&P 500 index. The S&P was still up by more then 12 per cent for the year, but so conditioned had investors become to a permanent bull market that a correction that was the equivalent of a summer-camp hazing was enough to make them cry for their mommies.

There was a real cause for the decline -- the permabears were right about that. The market has cranked into its valuation measures the assumption that corporate earnings will continue to grow at double-digit rates, and instead the operating earnings on the S&P are likely to be nearly flat over the next few quarters. You can blame the Asian financial crisis, and the subsequent crash in growth in that third of the world economy.

Furthermore, the Asian crisis has turned into a continuing decline, thanks to the tight-money policies of the region's central banks, led by the Bank of Japan, the Bank of China, and the Hong Kong Monetary Authority. "How long can they stand the pain?" You hear that question all the time about central bankers who direct punitively restrictive monetary policies. The answer, of course, is: "A very long time indeed, because they aren't the ones who are feeling it." The central bankers are served their lunches on linen that is just as crisp as it was before the crisis; their cars pick them up and drop them off with the same efficiency; aides and legislators are just as deferential. Parties are actually more fun because the billionaires and even models really want to hear what they say.

Lately, speculators have focused on the Hong Kong authorities, who have kept the HK dollar pegged to the U.S. dollar at a ratio of 7.73 to 1 in the face of the regional financial crisis and a developing domestic depression. They have done this by keeping interest rates very high.

Not long ago, currency boards such as Hong Kong's were being touted in some quarters as the answer to emerging markets' needs for a quick credibility fix that would in turn lead to low interest rates and ready access to foreign capital. The concept is a simple one: the monetary authority issues local money -- cash and demand deposits -- only when it has sufficient reserves of some awe-inspiring foreign currency to redeem it at a fixed rate. Given this "peg," all you need to do in the event of redemption is raise short-term rates or allow the money supply to shrink. Over the long run, your willingness to allow this free convertibility will lead to interest rates that converge to the low levels prevailing in the big-brother currency.

That's the idea. If you buy that simple chain of reasoning, then you will note that the Hong Kong authorities have foreign-exchange (mostly dollar) reserves sufficient to cover the monetary base four times over. Combined with high local interest rates, that should be enough to fend off the speculative attacks of New York hedge funds and their piratical followers.

But it isn't. The simple concept is adequate only for a simple economy, which Hong Kong's is not. In a low-tech colonial outpost, trade might be conducted with demand deposits and cash, but Hong Kong's wealth is heavily concentrated in the property market. That is financed by longer-term deposits, and the monetary authorities' reserves cover only 40 per cent of those. If depositors in local banks get spooked and start pulling their money out of banks, or if banks begin to fail because their loans are not seen to be good, then all of a sudden Hong Kong's 77 billion U.S. dollars in reserves look quite inadequate to the task.

And bank failures are probably not far off at the present rate of economic descent. Property loans are made at no more than 70 per cent of appraised value, but that was the appraised value of last year, and market values are now below that level. As they sink further, the banks find themselves in the position of going broke at first slowly, then very quickly. The higher cost of funding from the interest-rate rises doesn't help.

Why would the Hong Kong authorities persist in holding the peg in these circumstances? Why not abandon the peg, cut interest rates, and get the economy restarted? There is a rationale, though not one that will hold up for much longer. Hong Kong's costs are out of control, and the combination of the fixed currency and the depression in real-estate values has the effect of forcing outright cuts in wages and rents. Right now, the rents have come down about to domestic American levels, which in the context of Asia means they have a ways yet to go.