Now that he's closed out his yuan short to focus on his geopolitical activism, Hayman Capital's Kyle Bass has moved on to his next big trade: Betting against the Hong Kong dollar's 36-year-old peg.
While Bass waits for that long-shot bet to pay off, he's also shorting other Southeast Asian currencies, a play that has likely already generated some short-term profits. But in the weeks since he first informed investors in his Hayman Capital about his latest trade in his first investor letter in three years (which we published here), critics - including two columnists with Bloomberg Opinion and the Hong Kong Monetary Authority itself - have pilloried his investment thesis, arguing that it's based on a misunderstanding of how the HKMA's currency-reserve management mechanism actually works.
Here's a snippet from the double-byline Bloomberg column critiquing Bass's argument:
What Bass calls excess reserves is better known in Hong Kong as the aggregate balance. This can go to zero and stay there for years without the peg breaking. It is, in fact, how the currency board mechanism works.
Hong Kong fixed the value of its currency at 7.8 to the dollar in 1983 and has kept the system, with some minor adjustments, ever since. As the HKMA gently explains to Bass, when the aggregate balance shrinks, then local interest rates rise. Higher rates reduce the incentive for investors to sell the Hong Kong dollar. Bass’s breathless analysis points to the “staggering” 80-basis-point gap between Hong Kong’s interbank rate and U.S. Libor and concludes that investors will switch into the higher-yielding currency. This is exactly what is supposed to happen.
If anything, the aggregate balance is still too big. Hibor has been subdued because banks kept on depositing cash with the HKMA, even at zero interest. As Bass correctly observes, Hong Kong benefited hugely over the past decade from inflows triggered by the Federal Reserve’s quantitative easing and the city’s proximity to China’s credit boom. The aggregate balance is still higher than before the Lehman bust and needs to fall further so that Hibor can rise.
They also exhorted Bass to 'pay attention to history' - a reference to Bill Ackman's failed bet against the HKD peg from eight years ago.
Now, Bass has published a riposte of his own where he addresses some of these criticisms. Here's the big-picture takeaway: While Hong Kong does have a massive pile of FX reserves, it needs most of what it has to guarantee that its financial system is well-lubricated with dollars. This leaves little room for shrinkage in the HKMA's balance sheet to defend the peg.
Anybody who's interesting in learning more can read his latest missive below: