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