In September 1997, big hedge funds such as Quantum, Tiger, Omega and others, entered into Hongkong money market to borrow Hongkong dollars at around 7 %. This was done after several winning attacks by the funds in Asia countries, such as Thailand, Indonesia, South Korea and Malaysia. At this point in time Hongkong stock market was still relatively unscratched. Most of the people in Hongkong, including the government authority, were firmly believe that the unique relationship with China and the huge reserve that Hongkong had, were well equipped to prevent the contingent effect from her Asian neighbors. It is on this background that the economic war begins.

In October 1997 after acquiring huge amount of HK dollar from the money market, hedge funds began their operation. They applied the techniques we discussed in How Hedge Fund operates in Asia, by firstly established short positions in Hang Seng index futures and then began to borrow shares scripts from banks and securities firms. They then started short selling in the stock market and spreading rumor that with all the countries in Asia devalued their currencies, Hongkong government would have no choice but let her currency depreciate so as to maintain her competitiveness. All these actions created a panic for public and genuine foreign investors. After seeing the financial meltdown in Asian countries, the public investors including investment funds began to feel uneasy and started to unload their holding and created a crash in the stock market. When the Hongkong stock market looked like following her Asian neighbors footsteps, her HK dollar began to feel tremendous pressure from short selling. Immediately, it increased the pressure in Hongkong dollar  money market. On 23^rd October 1997, when the speculative attack was at its fiercest, overnight HK dollars cost as much as 250% to borrow. The benchmark 3-month HK interbank offered rate (Hibor) was fixed at 37%, while 6-month HK dollar funding at 33%. At this moment, hedge funds started to lend out the borrowed HK dollar in the money market and enjoyed a huge profit on the interest rate differential. While Hongkong government were still busy defending the HK dollar peg, the hedge funds started to square off their Hang Seng Index futures short positions, bought back the short selling shares from the stock market and declared a windfall profit in this operation. Leaving Hongkong government a big hole in her economy and financial market.

However, being a free market believer, Hongkong government continued to operate its stock market, financial futures and money market as per normal but improved the efficiency in monitoring banks’ HK dollar movement. With the strong back up by China government, Hongkong remained fully committed in pegging the HK dollar with US dollar. This policy had constantly invited further attacks by the hedge funds. It was especially apparent between June to August’98 when hedge funds shorted Hang Seng Index futures, and profiting from the pegged currency system. Each time when the hedge funds attacked, no matter how efficient the monitoring system was, the hedge funds could still easily make money out of it by using the same old strategy. This had make Hongkong to be welknown in the financial world as an ATM machine for the hedge funds, for whenever the hedge funds need money they can easily apply the same tactic as describe above, and get money out of it.

In late July to early August’98, Japan announced worst than expected economic data, Yen was fiercely attacked by foreign exchange speculators and dropped from 135 per US$ to 147. Hedge funds saw this as a great opportunity to break Hongkong dollar peg. This round they combined all the forces that they can gathered, included small and big hedge funds, mutual funds and some big foreign banks. They started borrowing HK dollar heavily in the money market, taking in about HK$100 billion from the money market at a rate between 8-10%. Subsequently, they started short selling Hang Seng Index futures when index was about 8,500. They then borrowed HSBC, HK Telecom and other big blue chips shares from foreign owners and securities firms.

In early August the economic war of the century began. Hedge funds started to spread rumor about the possible devaluation of China’s Yuan due to the weakness in Japanese Yen, they pushed down Yuan exchange rate in the black market to create the necessity atmosphere. Then they started to attacked HK$, by firstly short selling HK$ in the foreign exchange market. Secondly, continue to sell down Hang Seng futures index towards 7,500 level. Thirdly, spread rumor about Hongkong government will soon have to unpeg the HK dollar. Under normal circumstances, this will create a panic in the stock market and a shot up in domestic interest rate. However, at this point in time, Hongkong government began her counter attack strategy. First, she bought about HK$35 billion from the foreign exchange market using her US$ reserve. By doing so, she managed to stabilize HK$ exchange rate and at the same time indirectly pumped in HK$ into the money market, which prevented the shortage of HK$ in the market and therefore eased off the interest rate.

Seeing what was happening in the money market, hedge funds started to bring out their second weapon, using media and rating agencies to spread rumor about worsening of Hongkong economy and the inevitable unpeg on currency. Stock market continued to be jittered by the tense environment and on 13^th August, Hang Seng index plunged to new low and close at 6,660. Hedge funds thought that while they may not be able to make money in the foreign exchange and money market, they can still make a windfall profit in short selling shares and the futures index. They were confidence that Hang Seng index would drop to their targeted level of 5,500 in the next few days and started counting their profit, without realizing that Hongkong government was preparing for the second wave of counter attacking.

On 14^th August, Hongkong government began her first time of intervention in the stock and futures markets. First, they started buying heavy blue chips like HSBC and HK Telecom in the stock market. In order not to let the hedge funds known in advance, she bought the shares through U.K. , China and Hongkong brokerage firms, so as to give an impression that the buying of shares were done by general investment funds. On this day, HK government had used about HK$4 billion to buy shares and Hang Seng Index shot up 574 points at close. This had caught hedge funds off guard and HK government only announced her intervention after market closed. Most of the hedge funds were still holding their short positions and had to top up margin in Hang Seng Index futures.

In view of this adverse position that was running against them, on 16^th August Mr Soros decided to create some negative news to pull down the market. He took the opportunity and announced that Russia should devalue its rubble so as to rescue its economy. The next day, 17^th August, markets in U.S. and Europe took Mr Soros advice seriously and plunged. 17^th August was Hongkong public holiday, hedge funds were expecting that after a plunged in Europe and U.S., on 18^th August when Hang Seng started trading, it would probably drop 1,000 points. However, Hongkong government continued to intervene in the market and to their surprise Hang Seng only dropped a mere 13 points.

The next six days, the battle between hedge funds and Hongkong government continued, where hedge funds continued shorting the market and Hongkong government remained the main buyer. At the same time, hedge funds used their media connection to spread news against HK$ peg. On the other hand, Hongkong government also used the same tactics of hedge funds, through local media and brooking firms spreading rumor that she had ready HK$1 trillion (back by Chine reserve) to combat the speculators. She then asked trust funds not to lend scripts to hedge fund for short selling and invited big local tycoons to joint hand in buying shares. The battle was very fierce and market continued to jig saw up and down. But both hedge funds and Hongkong government knew very well that the final battle that would decide the ultimate winner would only come at the expiry date of Hang Seng August future index, whereby most of the futures contracts would have to close out, roll over or cash settlement. To prepare for the finale, Hongkong government started to do spread trades in Hang Seng futures index. She bought aggressively the August contracts and sold the same quantity for September month. This action had widened the spread between the two months contracts, whereby September contract was now much lower than August month. The purpose was to make a rollover of hedge funds’ short position more costly therefore forcing them to close out in August. During this period, most of the small hedge funds had no choice but to square off their positons and left the market. The only players that hanging in the battle field were big hedge funds such as Quantum, Tiger and Omega. On 27^th August, hedge funds launched their attack. They sold a total of HK20 billion in the stock market and at the same time sent the chief investment strategist of Quantum Fund to announce in the press that Hongkong government would surely loss, for hedge funds do not fight in a no win battle. At this point in time, the hedge funds were desperate and hoped that by saying out in the press, there would have people joining them to sell the next day.

The next day, 28^th August, was the final day of the battle. Both sides had gather huge amount of bullets hoping to kill the other party. On this day, Hongkong stock market created a historic record with a total volume of HK$75 billion transacted (about 15 times of average daily turnover). Hang Seng index had managed to hang on for a small gain and closed at 7829, above psychological level of 7,800.

Now, the mother of economic war of 1998 is over, perhaps we can examine the gains and losses by both parties.

From Hongkong government point of view, she had achieved the following:

1. A gain of an estimated HK$1.6 billion in this operation that included the transactions done in August and the open positions marked to current market price.
2. Continue to hold substantial short contracts in September Hang Seng futures index, which could be used for protecting the down move in futures index in case hedge funds attack again.
3. Holding substantial amount of HSBC and HK Telecom shares, and became 2^nd major shareholder of a few big listed blue chip counters. This will make the borrowing scripts by hedge funds more difficult in future and therefore preventing short selling.
4. Successfully defended the crash in stock market, hence prevented a sharp down turn in her 3^rd quarter economy.

As for hedge funds, they had lost in this battle but was not too unbearable, for most of their short positions were established when Hang Seng was around 8,000 to 8,500 level. In actual fact, after netting with the previous attacks they are still profitable.

The question is, will hedge funds come back again for the revenge? Although Hongkong government has put up a few rules to tighten the control in the stock market and financial futures, my hunch tells me that the battle is not over and that a next attack is very likely, unless U.S. government realizes the danger of hedge funds to the world economy and set some regulations to control them.