HONG KONG: The huge capital inflows that have fueled the Hong Kong stock market rally over the past few months could also trigger a sharp turn-around, analysts have warned.

Share prices have rebounded nearly 70 percent from their recent trough in early March as "hot money" continued to flow in during the past couple of months, flooding the asset markets with cash.

However, analysts warn that the flow of money could reverse at any time as the external conditions that support capital inflows are changing.

"The US dollar is regaining its strength while yields of US Treasury bonds are rising. This could signal a potential reversal of capital flow," said Thomas Ng, investment strategist at Quam Securities Co Ltd.

A market consensus notes that a large chunk of the "hot money" came from institutional investors who had borrowed cheap US dollars and tried to make quick profits by investing in cheap loans in asset markets that had been battered by the financial crisis. This operation is known as carry trade in the financial market.

"A strengthening US dollar and rising Treasury yields could trigger a wave of unwinding in dollar carry trades as both mean rising cost for dollar debts," Ng said, referring to a process wherein carry traders sell down their non-dollar assets to repay their dollar debts.

The Japanese yen used to be a favored carry-trade currency until Washington's quantitative-easing pushed its interest rates down to near-zero levels, analysts said.

Market watchers recall that surges in yen's value in the past had triggered shocks to asset markets.

Andrew Wong, managing director at Tanrich Securities Ltd, expects the rally in the US dollar to continue for two months.

"In that case, a medium-term correction is expected for the local bourse, which could see the benchmark index retracing to as low as 16,400 points by July," he said.

Analysts said higher Treasury yields could also siphon off some liquidity from equity markets as a big portion of the "hot money" is believed to come from European institutions that traditionally park their funds in Treasury bills rather than in equities.

That portion of "hot money" could flow back into the bond market once bond yields rally back to attractive levels, they said.

Another development that could cause a reversal in capital inflows is Beijing's moves to mop up surplus liquidity in the market after its stimulus measures succeeded in bailing out the economy.

Market players widely believe that some of the active capital that flowed into the local asset markets came from the mainland.

The China Securities Regulatory Commission has issued new regulations on initial public offerings (IPOs) recently, signaling an imminent reopening of the IPO market, which was suspended last September amid plunging share prices.

The central government has gained full confidence in the country's economic recovery and is now shifting its attention to microeconomic problems, said Tao Dong, chief regional economist for non-Japan Asia at Credit Suisse.

"Beijing is taking steps to deal with (the problem of) excessive short-term liquidity in the market. The initial move is to reopen the IPO market," he said.

While there are no clear signs indicating a significant unwinding in dollar carry trades, analysts note that capital inflows have eased and may even have ceased.

"The inflow of hot money, which has been supporting the current market rally, has significantly eased since late last month. This is a negative factor for the prospects of the share market," said Dickie Wong, research director at Kingston Securities Ltd.

He noted that the Hong Kong Monetary Authority, the city's de facto central bank, has stopped buying US dollars since mid-May, a move it has resorted to in recent months to defend the Hong Kong currency's peg to the dollar.

Market watchers said any concrete sign of liquidity withdrawal could trigger a stampede as investors are turning cautious because valuations of shares have climbed to levels that cannot be justified by fundamentals.

(HK Edition 06/16/2009 page4)