Have you heard of the infamous double play that hedge funds used to bring Hong Kong’s economy to its knees in 1998? India, as it tries to understand the games hedge funds play, could learn from that episode.
The Asian economic crisis started in July 1997. Hong Kong had initially done far better than Thailand, South Korea, Indonesia and Malaysia. Till it was attacked using what has come to be called the double play.
Here’s how it went. Hong Kong was committed to a fixed exchange rate against the US dollar through a currency board. By the end of 1997, a group of hedge funds thought that they could make a killing by forcing Hong Kong to devalue its currency. That’s what they had done successfully in many Asian countries in the preceding months.
What they did in Hong Kong was more complicated. In early 1998, the hedge funds built up their armoury by swapping US dollars for Hong Kong dollars. They then shorted the stock market in a sudden coordinated attack, both in the cash and futures segments. They followed it up by shorting the Hong Kong dollar as well.
The Hong Kong Monetary Authority (HKMA) was forced to increase interest rates all the way up to 280% to defend the fixed exchange rate. That brought down the stock market. The short sellers made a killing. Meanwhile, the Hong Kong dollars that the hedge funds had collected in the swap market started earning them usurious rates of interest.
The plunge in share prices led to a capital outflow and further pressure on HKMA to abandon the fixed exchange rate and sharply devalue the currency. That would have given the hedge funds that had shorted the Hong Kong currency another windfall. It was then that HKMA chose an unusual step. Rather than protecting the currency by selling dollars from its reserves, HKMA went in and supported the stock market. It bought $120 billion of shares in two weeks, because that was where the epicentre of the double play lay. (HKMA sold these shares at a huge profit five years later.)
So, why should India bother about an episode of a daring—and brilliant attack—on an Asian central bank 10 years ago?
I am not suggesting here that India will be in any similar danger any time soon. But there are two lessons worth remembering. One, hedge funds often take complicated positions that straddle the share, bond and currency markets. I am not sure that all the loose talk about hedge funds pouring money into India takes this simple fact into account—they may also be speculating in the offshore market for Indian derivatives and currency. The rupee and the stock indices may be part of coordinated trades that we know little about, or even care to know.
Two, the response in Hong Kong, too, was unconventional. HKMA is, like the other institutions in that great mercantile city, a committed bastion of free-market thought. Yet, it had no qualms about abandoning its standard practice and actually buying in the stock market to prop up its currency. The lesson: a central bank may need to use blunt instruments in special times.
In 1999, when the fires that raged across Asia had been doused, Barry Eichengreen and Donald Mathieson wrote a paper for the International Monetary Fund. It was called Hedge Funds: What Do We Really Know? (It is a question that still evades a clear answer.)
Eichengreen and Mathieson identified three main classes of hedge funds. First: the macro funds, which study a country’s economic fundamentals and take large, unhedged positions (going fully long or short) in that country’s markets. Two: the global funds, which pick stocks across the world based on the prospects of individual companies. Three: the relative value funds, which study correlations between the prices of various securities (emerging market bonds and US bonds, for example) and try to profit when prices deviate from their expected relative paths.
Long Term Capital Management (LTCM), the hedge fund that was set up by some of the most highly regarded traders and financial economists in the world, was a relative value fund that tried to bet on prices that were off the path estimated by the fund’s statistical models. The story of how LTCM blew up in 1998 has been wonderfully retold in Roger Lowenstein’s book, When Genius Failed.
So, the point is a simple one. Hedge funds make complicated bets, often across countries and markets. They often do it with huge leverage. These funds are part and parcel of the modern financial landscape. They cannot be wished away.
India, too, is attracting billions of dollars of hedge fund money. That’s not a bad thing in itself. But there should be more clarity about what this money is all about. Given this fact, the central bank and the stock market regulator are justified in keeping a close eye on their activities.
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