Bill Ackman Has Made This Bet Before. He’s Making It Again.

Bill Ackman Has Made This Bet Before. He’s Making It Again.
Luke Suddards

about 1 year ago5 mins

  • The Hong Kong Monetary Authority maintains a trading band, between 7.75 and 7.85 Hong Kong dollars to the US dollar, by buying and selling foreign currency.

  • Billionaire investor Bill Ackman is using put options to bet that the peg will break.

  • Many have bet on the peg breaking in the past and lost: the Hong Kong Monetary Authority has massive foreign exchange reserves ($417 billion) it deploys to keep the value of its currency within the band.

The Hong Kong Monetary Authority maintains a trading band, between 7.75 and 7.85 Hong Kong dollars to the US dollar, by buying and selling foreign currency.

Billionaire investor Bill Ackman is using put options to bet that the peg will break.

Many have bet on the peg breaking in the past and lost: the Hong Kong Monetary Authority has massive foreign exchange reserves ($417 billion) it deploys to keep the value of its currency within the band.

Bill Ackman is making a bold wager in Asia. The founder and CEO of Pershing Square Capital Management, once dubbed “Baby Buffett” by Forbes, is betting that the Hong Kong dollar (HKD) is going to snap out of its longstanding peg with the US dollar. He says it’s “only a matter of time before it breaks,” and if it does, it could pay off nicely for him. Maybe that’s why he’s not alone in his view. Let’s take a look…

What’s the Hong Kong dollar peg and why’s it there?

A currency peg fixes one country’s currency to another, usually the US dollar, or to a basket of currencies. The Hong Kong dollar has been pegged to the value of the US dollar since 1983 – and it’s currently allowed to trade between 7.75 and 7.85 Hong Kong dollars per US dollar. When it gets close to either edge of that range, the Hong Kong Monetary Authority (HKMA), which is effectively the city’s central bank, intervenes – using its vast foreign currency reserves to buy or sell Hong Kong dollars, nudging its price back toward the center of the band. If it’s buying its currency, the move shrinks the available supply of Hong Kong dollars in the banking system, known as interbank liquidity and pushes up domestic borrowing costs. If it’s selling, the opposite occurs.

Now, the peg does make the Hong Kong dollar something of an oddball among the currencies of wealthy economies. Most of its peers “freely float” in the market, meaning their value is mostly determined by supply and demand. But Hong Kong has stuck with the old peg: after all, it’s got an open economy with a lot of export companies that benefit from a stable, easily convertible currency – the kind that helped make the city a global financial center in the first place. The peg also benefits Chinese companies that can raise funding through Hong Kong’s deep financial market. Additionally, the capital controls in China mean Hong Kong is used as a good entry and exit point for the inflow and outflow of funds.

What’s the problem with the peg?

Well, no system is perfect and there are certainly some trade-offs with this one. The peg leaves the HKMA in a straitjacket from a monetary policy perspective – when the US Federal Reserve hikes rates, the HKMA has to follow suit, regardless of what’s happening in the domestic economy. Right now, for example, like during the 1997 Asian financial crisis, the Hong Kong economy actually needs lower interest rates to help give it a boost, but it has to mirror the US’s high interest rates. In the past, the problem has been the reverse: the ultra-low rates from 2008 to 2016 fueled a property bubble in Hong Kong.

What’s the current state of play for the HKD?

Until recently, the Hong Kong dollar was trading weaker against the greenback, which means it was near its upper band (7.85), because it’d become popular for use in a strategy known as a “carry trade”. In essence, the Hong Kong dollar is borrowed at a cheap interest rate and sold in favor of the higher-yielding greenback, to profit from the difference in yield. But a general softening in the US dollar and the intervention by the HKMA pushed the currency pair back down toward its lower band of 7.75.

Hong Kong dollar per US dollar. Source: TradingView.
Hong Kong dollar per US dollar. Source: TradingView.

So what’s Ackman’s view?

He’s said on Twitter that the peg “no longer makes sense for Hong Kong”. He cited a recent opinion piece in Bloomberg, from Richard Cookson, head of research at Rubicon Fund Management, who wrote that the surge in debt (big fiscal boost from the government), falling asset prices, and a weakening economy are all making the peg unsustainable. Added geopolitical risks as China looks to exert more influence in Hong Kong have led to new instability and an exodus of high earners, particularly in the finance sector, which has hurt Hong Kong’s tax income.

Ackman says his hedge fund has a big short position against the Hong Kong currency. He’s using put options, which give him the right (but not the obligation) to sell at a fixed price on a specified date. It’s a smart way to play the “tail risk scenario” of Hong Kong’s peg snapping. By using an option, Ackman’s limiting his risk or loss to the cost of the option, but his potential reward is much higher.

Saba Capital Founder Boaz Weinstein also sees trouble for the peg and says if it breaks, the payoff could be upward of 200-to-1. It’s kind of like a lottery ticket: small cost to enter, but huge reward if you win.

What are the chances he’s right?

It’s still something of a long shot. For starters, this almost-40-year-old peg has never broken, so it’s got history on its side. Plus, the HKMA has plenty of firepower to defend the peg – with $417 billion in its foreign currency reserves. And in the unlikely scenario that those reserves were depleted, China’s central bank could provide additional US dollars. Bear in mind, China has the world’s largest foreign-exchange reserves at more than $3 trillion. No hedge fund or speculative investor could go to battle against that war chest.

Hong Kong’s financial secretary recently sent a stern message to speculators, warning they’d lose if they bet against the Hong Kong dollar. (Sounds like he has a point to prove.) And, the architect of Hong Kong’s dollar peg, recently said that “because the city has a currency board tasked solely with maintaining the peg, rather than a central bank that conducts domestic monetary policy, speculation against the Hong Kong dollar always fails.”

Hong Kong’s foreign currency reserves, priced in US dollars. Sources: HKMA and Bloomberg.
Hong Kong’s foreign currency reserves, priced in US dollars. Sources: HKMA and Bloomberg.

This isn’t the first time Ackman’s taken aim at the Hong Kong dollar peg. He did it in 2011, too, and lost – at the time believing the HKD was undervalued, destined to snap the band’s lower boundary. Even George Soros, famed for “breaking” the Bank of England, has bet against the peg and lost, in the wake of the Asian financial crisis.

Pegs don’t necessarily last forever. Switzerland’s central bank rocked markets in 2015 when it dropped the franc’s peg to the euro. But what’s perhaps more possible is that as tensions rise between the US and China, the Hong Kong dollar is unpegged from the greenback, and pegged instead to the Chinese yuan – as a way to challenge the dominance of the world’s reserve currency. It may be unlikely that Hong Kong’s peg will be abandoned, but that doesn’t make it impossible. Good luck, Bill.

Finimize

BECOME A SMARTER INVESTOR

All the daily investing news and insights you need in one subscription.

Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

/3 Your free quarterly content is about to expire. Uncover the biggest trends and opportunities. Subscribe now for 50%. Cancel anytime.

Finimize
© Finimize Ltd. 2023. 10328011. 280 Bishopsgate, London, EC2M 4AG