INTERPLAY OF U.S. INTEREST RATES AND LOCAL STOCKS

C O N F I D E N T I A L SECTION 01 OF 02 HONG KONG 002472 SIPDIS SIPDIS STATE FOR EAP/CM AND EB TREASURY FOR OASIA GKOEPKE STATE PASS USTR USDOC FOR 4420 NSC FOR WILDER E.O. 12958: DECL: 06/14/2031 TAGS: ECON EFIN HK CH SUBJECT: INTERPLAY OF U.S. INTEREST RATES AND LOCAL STOCKS COULD DELAY CHINA BANK LISTING AND SLOW HONG KONG'S ECONOMY Classified By: Chief Simon Schuchat; Reasons: 1.4 (b/d) SUMMARY/COMMENT -------------- ¶1. (C) Driven by jitters over the direction of U.S. interest rates, Hong Kong stocks have seen double-digit declines over the past month, in line with the sell-off affecting other Asian exchanges and, to a lesser extent, the U.S. markets. This city's economy, however, is heavily oriented towards finance and property, and it is therefore particularly sensitive to higher U.S. interest rates as well as negative market sentiment. Among the views of our contacts: a continued market decline could delay key listings planned for this year, including the Industrial and Commercial Bank of China (ICBC),which is reportedly aiming to conduct an initial public offering (IPO) in September. Continued local uncertainty about U.S. Federal Reserve interest rate policy is driving investors out of the market ad leading those who stay in to more heavily discont stocks seen as relatively risky. If upcomingU.S. inflation data leads to greater-than-anticiated Fed tightening, Hong Kong will be affected mmediately because its currency is pegged to theU.S. dollar, local mortgages tend to be adjustable-ate, and the city's wealth is heaily invested in local property. The jury is still out, however, on whether the combination of anxiety about U.S. interest rate policy and stock declines has already become an economic force in its own right. Further, with recent broad-based and above-trend growth (8.2 percent GDP expansion in the first quarter),Hong Kong probably has some wiggle room even if negative market sentiment is sustained for an extended period. END SUMMARY/COMMENT SHARP DOWNTURN, LIKE OTHER ASIAN EXCHANGES -------------- ¶2. (U) Hong Kong's main stock index, the Hang Seng (HSI) hit a six-year high on May 8 and has since seen a double-digit decline, as has the Hang Seng Chinese Enterprise Index (HSCEI). The local slide is in line with other key regional markets, with the notable exception of Shanghai, whose positive performance reflects ongoing reforms as well as the closed nature of China's capital account: Index Percent Change Since May 8 Hong Kong (HSI) -11.9 Hong Kong China Stocks (HSCEI) -19.2 Shanghai (SSE-CI) 3.2 Japan (Nikkei) -19.8 Korea (Kospi) -17.1 Taiwan (Taiex) -15.2 London (FTSE) - 9.0 US (S&P 500) - 7.6 HOLDING THE FED RESPONSIBLE -------------- ¶3. (C) Conventional wisdom ties the recent global sell-off primarily to concerns about the scope of U.S. inflation and direction of interest rate policy. Beyond the data itself, however, is the question of how market participants perceive the actual clarity of Fed policy in the wake of Chairman Bernanke taking over from Alan Greenspan, according to a new Deputy General Manager at Hang Seng Bank, Andrew Fung. Fung was highly critical of what he termed "unclear signals" from the Fed, suggesting that a lack of obvious direction with regard to interest rates has generated unnecessary confusion and volatility for global markets that is itself creating economic harm. Fung said that as far as Hong Kong's market is concerned, it will be difficult to restore confidence among investors. Fund managers have now become excessively pre-occupied with protecting themselves from further losses that threaten their performance. Consequently, they are differentiating risk among investments in more pronounced ways, and many are staying on the sidelines, particularly by parking money in lower-risk bonds. Even if uncertainty about interest rates cleared up tomorrow, many players would stay out of the market for at least several months, according to Fung. Of course, if adverse U.S. inflation data comes out HONG KONG 00002472 002 OF 002 and the Fed actually does tighten more than expected, prospects for stocks in Hong Kong would be very negative for the rest of the year, he said. DELAY IN INITIAL PUBLIC OFFERINGS? -------------- ¶4. (C) Fung believes that market sentiment has already changed so significantly that Hong Kong is unlikely to look attractive to IPO issuers for months to come. Noting that ICBC reportedly plans a listing in September, Fung predicted the bank would delay it for two reasons. First, it may be hard to raise the money ICBC is looking for in a declining market. Second, there is an issue of "ego" involved: the Bank of China just had a very successful IPO priced at 2.2 times book value. Fund believes ICBC will only be willing to go forward if it believes it can match or exceed that figure. Backing up Fung's sentiment about an IPO downturn are reports that local property developer Shui On Land has had lackluster response to its IPO (underway this week),and that Henderson Land is set to delay its listing of a real estate investment trust, originally anticipated to take place later this month. AN ARGUMENT FOR OPTIMISM -------------- ¶5. (C) Standard Chartered Global Economist Tai Hui displayed an optimism that contrasted with Fung's negative sentiment. Concerning IPOs, Hui believes that it is faith in the issuers themselves that will determine the success of new offerings. Based on the Bank of China's recent success amidst a falling market, both institutional and retail investors are likely to warmly embrace ICBC's debut, which Hui doubts will be delayed. Shui On's IPO was perhaps over-valued to begin with, and Henderson's delay may be attributable to unrelated business issues. As for the direction of Hong Kong's stock market, Hui predicted choppy weeks ahead, but argued that there has been no change in the positive fundamentals underpinning the companies trading here. In his view, markets were too optimistic in early May with regard to global inflation and monetary tightening trends. Now they are overdoing it in the other direction. Hui also pointed to the role of hedge funds, whose trading patterns during this period of uncertainty are likely increasing market volatility. He suggested that that stabilization will come for Hong Kong and other regional markets, perhaps as a result of inflation data from the U.S. Fed turning out weaker than feared or a revised perception that the Fed has indeed reached the end of its tightening cycle. Hui acknowledged that he and his colleagues at Standard Chartered stood out as more optimistic concerning these trends than many other forecasters. EFFECT ON HONG KONG -------------- ¶6. (SBU) Much of Hong Kong's wealth is tied up in property. Consumer demand among the middle and upper classes here is vulnerable to changes in interest rates, which affect payments on adjustable mortgages. Because the local currency is pegged to the U.S. dollar, local interest rates rise and fall with those in the U.S. (barring temporary variances caused by surges of speculative capital). As a result, Hong Kong stands to be affected significantly by U.S. inflation data and interest rate decisions. ¶7. (SBU) Local economic growth, however, has recently been broad based and above trend, so there is likely significant wiggle room, even if market sentiment remains negative for an extended period. The 8.2 percent first quarter GDP growth capped off two years of impressive expansion, much of it fueled by China's continued high rate of growth. Most analysts expect that determined moves in the mainland to slow loan growth and avoid overheating in specific sectors will dampen economic activity here as 2006 progresses. A continued rise in U.S. interest rates would add to that effect. That said, local investment banks continue to plan on 6 to 7 percent growth this year and none have reduced their projections based on concerns about a negative wealth effect caused by recent uncertainty in local financial markets. Cunningham