Hong Kong Hubris and the LME

State capitalism is advancing, this time courtesy of the government of what purports to be the freest, most private-sector economy in the world: Hong Kong.

It may be no particular surprise that an Asian exchange was one of the bidders when the member owners of the London Metal Exchange offered it for sale to the highest bidder – or at least the bidder with the best combination of cash and supposed willingness to keep the business in London rather than move it lock stock and barrel to Hong Kong, Chicago, Singapore, Dubai, Geneva or wherever.

Quite what motivated HK Exchanges and Clearing, the listed company which owns and operates Hong Kong’s stock and futures exchange monopoly, is less than clear but appears a classic of trophy-hunting expedition carried out by the HKEC chief executive, mainlander Charles Li Xiaojia, with the complicity of a board packed with government yes-men.

The government appoints six of 13 members plus the chairman, currently Chow Chung-kong. Chow has a knighthood acquired when working in Britain, but no longer uses it – he is a member of Beijing’s Chinese People’s Political Consultative Council (CPPCC). He recently took over from Ronald Arculli, a lawyer, member of the rubber stamp Executive Council and former representative of property developers on the Legislative Council. Arculli remains on the board. Independents elected by the public are a small minority sometimes viewed as trouble makers for questioning the wisdom of the incestuous insiders – shareholder activist David Webb was once a member but resigned in protest at the board’s actions.

The price tag of £1.4 billion (US$2.15 billion) for the LME is more than 100 times its earnings in 2011 so extracting value from this purchase for its own shareholders is going to be a tough, perhaps insuperable task. But the Hong Kong government as a major shareholder and de facto controller does not seem to care. It wants the prestige of ownership and to be able to boast of its own ability to pay the highest prices regardless of value. The other shareholders – the public – did not have any say in the matter as HKEC is sitting on a huge pile of cash derived from its monopoly position in Hong Kong and the huge sums which accrued during and after the local listing of the major mainland enterprises – the banks, insurance companies, etc. It can easily fund the purchase from cash and bank loans though will need a bond or equity issue at some point.

It is ironic that Hong Kong maintains this government-controlled monopoly while London allows free rein to all comers, local and foreign, to make a competitive market. On the other hand HKEC’s apparent success is built largely on the surge of mainland stock and the continued restrictions on foreigners investing in mainland listed Chinese companies.

HKEC has actually been an abysmal failure in its feeble and belated attempts to attract listings from elsewhere or new products in financial or commodity futures. It has lagged far behind even Singapore, let alone London. It came very late to the Russian party so far only attracting Rusal, the aluminum giant which is proving a disaster for investors, and a few European listings. HKEC remains a relatively high cost exchange thanks in part to the lack of competition enabling it to maintain high fees.

So instead of growing organically HKCE is buying a trophy. Presumably it has some vague idea that because China is the world’s largest importer of most of the metals which the LME trades, somehow the trading, or at least some of it, can be brought back to Asia, whether to Hong Kong or, in future, to Shanghai and to yuan denomination of trades and with Shanghai becoming the major warehouse for metals.

For sure, the hand of Beijing is in this as demonstrated by the role of China Development Bank in financing the purchase. But the HKCE has had to promise not to interfere with the LME’s own development plans and for it to remain supervised by Britain’s Financial Services Authority.

LME earnings may be boosted in the short term at least by a big increase in fees. But HKCE is buying just as metal prices appear to have peaked after a bull run of nearly 10 years. With supply now looking likely to increase faster than demand for many metals, interest in metals trading by hedge funds and other non-trade investors may well wane and with it the hopes that profits will increase by anywhere near enough to justify the price.

China may be the largest single metals buyer but it is still only about 35 percent of the total for traded metals and Middle East and Indian traders as well as western hemisphere ones are likely to continue to prefer London. And if London falters it seems just as likely that business will migrate to the nation which hosts most of the biggest commodity markets – the US.

The losing bidder this time was Intercontinental Exchanges Inc (ICE) the Atlanta based network seeking to add metals to its trades in agricultural, energy and financial futures products. Its shares rose in New York on news that it had been outbid. Likewise, in Hong Kong investor common sense overrode hubris and the shares slumped by 5 percent.

If HKCE makes a mess of the LME, the business will more likely end with ICE than in Hong Kong/Shanghai.

At HK$112 a share HKCE is less than half its 2007 price peak and nearer the bottom than top of its 12-month performance. But at 24 times earnings even before the LME deal, the shares look less attractive than ever.