China puts Hong Kong's future on the line

By Rashmi Kumar

Hong Kong’s status as Asia’s biggest and most vibrant financial hub is at risk – yet again.

Over the years, China’s desire for greater control over the territory and the rapid rise of its own financial centres have sown doubts over Hong Kong’s longevity as a leading financial centre. 

Now China’s determination to impose a new security law in Hong Kong – bypassing the special administrative region’s own legislature, and calling into question Deng Xiaoping’s ‘one country, two systems’ policy for the city – has revived fears over Hong Kong’s future.

The timing could not be worse. 

Hong Kong is still reeling from the economic effects of the Covid-19 pandemic and of the social unrest that has become a feature of life in the city since March 2019 when the first protests took place against a proposed extradition law. 

The protests picked up pace and became a broader pro-democracy movement; the extradition law was dropped.

Protests started up again in Hong Kong in late May this year following China’s announcement that it would impose sweeping national security laws – which it later formally approved – on the territory. 

The new security legislation targets secession, subversion, terrorism and foreign interference – terms that are used by the authorities to describe Hong Kong’s pro-democracy protests.

The US, which has been at loggerheads with China over a wide range of issues, from trade to the origin of the coronavirus, was quick to criticize the move and threatened to withdraw Hong Kong’s special trading rights on the grounds that it no longer considers the territory to be autonomous from China.

Where does that leave the financial sector in Hong Kong, which serves as the regional headquarters for about 30 multinational banks and where over 70 of the world’s 100 largest banks have operations?

One important question is what these troubles mean for Hong Kong’s capital markets, which combine the know-how of local and foreign bankers and investors with a steady flow of deals from Chinese companies.

Hong Kong’s position as a centre for IPOs has only strengthened in the last few years since the Hong Kong Stock Exchange relaxed the rules covering secondary listings of companies and listings by pre-revenue biotechnology firms. 

These changes boosted HKEx’s competitive advantage over the New York Stock Exchange and the Nasdaq, two of the most popular listing destinations for Chinese firms.

But the US is starting to lose its appeal as a place for Chinese companies to do their IPOs.

President Donald Trump recently called for recommendations to protect US investors from the risks of investing in Chinese companies, increasing pressure on the firms to comply with US accounting and disclosure rules. 

Nasdaq plans to tighten listing rules, reflecting its concerns about some Chinese companies seeking US IPOs. Earlier this year, Luckin Coffee, which had a US IPO in early 2019, announced that an internal investigation has accused its chief operating officer and other employees of fabricating sales deals. 

This means that as a venue for IPOs, at least, Hong Kong’s near-term future looks bright, thanks to rising US-China tensions, whereas China’s new security law will have little impact on HKEx’s IPO flow, simply because this is dominated by Chinese deals.

In 1997, when the UK handed Hong Kong back to China, just one third of the listings on the Hong Kong exchange were from Chinese companies, according to Dealogic. Last year, more than 60% of the listings in Hong Kong, including both primary and secondary IPOs, were of mainland Chinese firms. 

Of the $40.3 billion raised in Hong Kong in 2019, about $32 billion was raised by Chinese companies.

That lead by Chinese issuers is unlikely to change, and could in fact grow bigger as many US-listed Chinese technology firms, such as Tencent Holdings, Baidu and NetEase, return to Hong Kong for secondary listings. 

But one area where the impact of US-China tensions will be most evident is on the banks running some of the capital markets transactions in Hong Kong.

A head of equity-linked products based in Hong Kong predicts that some Chinese issuers may start ditching international banks, particularly US banks, from their transactions to avoid any possible political repercussions in China.

He cites the example of a request for proposals that he received at the end of May for an equity-linked deal. The request was sent by a Chinese provincial state-owned company operating in the telecommunications, technology and media (TMT) sector.

“I was shocked,” he says. “I was expecting to compete with the big US banks, but not a single one of them received the RFP. The issuer has been buddies with the US banks before, so it was quite shocking. The company is in the more sensitive side of the TMT sector, so we can already see the ramifications of the US-China cold war situation.”

He adds that Trump may struggle to get some of his measures, particularly those restricting US IPOs of Chinese companies, signed off by the US Congress, but that doesn’t mean companies and banks can be complacent.

“If the US wants to give some teeth to its measures, it could ask US banks to get special permission if they want to pursue a deal with a Chinese company or a state-owned firm in Hong Kong,” he adds. “Trump could do it by executive power, but this would be shooting one of the key parts of the US investment banking market in the foot.”

The tensions could mean that Chinese banks and brokers will soon be able to edge out US banks when it comes to winning mandates, particularly from Chinese state-owned clients, in this banker’s opinion. 

That might be good for the Chinese banks and brokers but could also affect the market negatively because of their relative lack of experience in pricing complex transactions.

A Hong Kong-based equity fund manager says international investors and asset managers would continue to come to Hong Kong to invest in securities, especially China-focused ones that are not traded anywhere else.

Hong Kong’s equity market has its own appeal too, as it is a highly liquid market compared with others in Asia, he adds.

Between January and April, the average daily turnover on HKEx was HK$116.1 billion ($15 billion); by comparison, at the Singapore Exchange, average daily securities turnover was much smaller, at just S$1.6 billion ($1.1 billion).

Another big question mark hangs over the stability and fate of the Hong Kong dollar’s 36-year-old peg to its US counterpart. 

The Hong Kong dollar is pegged in a narrow range of 7.75-7.85 to the dollar. The Hong Kong Monetary Authority (HKMA), which acts as the territory’s central bank, buys and sells the currency at either limit to maintain the range and track US interest rates

Money changers in Hong Kong experienced a surge in demand for US dollars in late May, a sign of nervousness about the peg’s future. 

Most experts think this fear is unfounded – although there are those who think the Hong Kong currency could eventually be pegged to the Chinese renminbi instead of the dollar. 

Hong Kong adopted a fixed exchange rate against the dollar in October 1983, following a sharp fall in the currency. When Trump recently threatened to revoke the city’s favoured trade status with the US, there was some immediate pressure on the Hong Kong dollar, but it was fleeting. Three-month Hong Kong dollar currency forwards edged up slightly, indicating fear that the peg could break.

Speaking in late May, Alicia García Herrero, Natixis’ chief economist for Asia Pacific, says that the US-China-Hong Kong situation could put pressure on the Hong Kong dollar in the event of large capital outflows from the city.

“We are already seeing a deceleration of bank deposits and a widening of the spread between Hibor [Hong Kong interbank offered rate] and Libor [London interbank offered rate], which are both signals of draining liquidity,” she tells Asiamoney.

“Still, even if the liquidity pool in the Hong Kong banking system gets smaller, the Hong Kong Monetary Authority has a lot of room to act, which probably explains why the situation has calmed down in the past few days.”

One option for the HKMA includes injecting more Hong Kong dollar liquidity into the financial system, she adds. But if the situation were to last months, the last resort could be the introduction of capital controls to save the peg.

While this might save the peg, “the damage on Hong Kong’s offshore centre status would be huge, at least as regards its international nature,” says García Herrero.

The peg does not require approval from the US in order to be maintained and is unlikely to be touched, largely thanks to the sheer size of foreign exchange reserves of over $440 billion held by the HKMA – more than twice the central bank’s monetary base. 

If the US takes a harsher stance against Hong Kong, it could trigger capital outflows. But this would also be manageable as the US accounted for just 1.9% of Hong Kong’s foreign direct investment at the end of 2018, according to the Hong Kong government’s census and statistics department.

The HKMA’s chief executive, Eddie Yue – still in his first year in the job – tried to reassure markets at the end of May in a note he published on the central bank’s website. 

He emphasized that the free flow of capital and free convertibility of local currency will continue to be safeguarded, as will the peg to the US dollar, calling the exchange rate mechanism the “bedrock” of Hong Kong’s financial system.

“Hong Kong needs to answer a key question: what kind of a financial centre can it be in the future?” says García Herrero.

“It can be a centre for Chinese offshore activities with a regional nature. However, if it wants to continue to be an international financial centre, capital controls should be off limits.”

The greater concern is the more general impact on Hong Kong’s banking system, something that is hard to predict because of the myriad uncertainties facing banks in the SAR.

Finance and insurance accounted for one fifth of Hong Kong’s GDP in 2018, according to the government’s census and statistics department.

Ratings agency Fitch said that it was changing the outlook for Hong Kong banks’ operating environment to negative in late May – in part due to the pandemic and in part because of the prolonged unrest in the city. 

Fitch warned that a change in US policy towards the SAR could increase uncertainty and dampen investor sentiment, placing additional pressure on banks’ earnings. 

But it is not all bad news.

“Hong Kong’s banks have been resilient despite the social unrest last year,” Grace Wu, a senior director in Fitch Ratings’ financial institutions group in Hong Kong, tells Asiamoney.

“Even by taking into account the increase in loan provisions they have made, their 2019 annual numbers are still very respectable”.

She adds that banks in Hong Kong have built up capital buffers in the last decade, and their liquidity positions are unlikely to change substantially soon.

HSBC and Standard Chartered – both UK-based banks but with big operations in Asia, particularly Hong Kong where, along with Beijing-owned Bank of China, they are official banknote issuers – publicly showed their support for the security law in early June.

In a statement seen by Asiamoney, Standard Chartered says the national security law “can help maintain the long-term economic and social stability of Hong Kong”. 

It added that the bank was “positive that Hong Kong will continue playing a key role as an international financial hub”. 

HSBC laid out its stance initially in a WeChat post. 

HSBC tells Asiamoney: “We respect and support laws and regulations that will enable Hong Kong to recover and rebuild the economy and, at the same time, maintain the principle of ‘one country, two systems’.”

There was an immediate backlash. David Cumming, the chief investment officer of Aviva Investors, said his firm was “uneasy” with the banks’ announcements, adding that “if companies make political statements, they must accept the corporate responsibilities that follow”. Aviva is a shareholder of both banks.

But the harshest words came from Mike Pompeo, US secretary of state, who said HSBC was being used a pawn in discussions between China and the UK. “That show of fealty seems to have earned HSBC little respect in Beijing, which continues to use the bank’s business in China as political leverage against London,” said Pompeo in a statement on June 9.

HSBC and Standard Chartered both declined to comment beyond their original statements. 

But banks in the city will be impacted if the security law leads to an exodus of foreign companies – and employers – from the region.

A survey conducted in early June by the American Chamber of Commerce in Hong Kong – which received responses from 180 members, or 15% of its members – found that 60% were worried the new law would harm their business operations in Hong Kong. 

About 34% had developed contingency business plans, such as excluding Hong Kong from future strategic plans for Asia Pacific, while some businesses were considering plans to leave the city or open a sister company in Singapore.

For bankers and investors, there is still plenty of uncertainty. The extent of the actions by the US against Hong Kong and China over the security law is still to be seen, as is the process by which the law will be implemented and how seriously it will infringe the one country, two systems model.

“It can hurt Hong Kong’s role and reputation as a regional financial hub,” says Louis Kuijs, head of Asia economics at Oxford Economics.

Hong Kong-based Kuijs, who worked at the IMF in Washington DC, at the World Bank’s China office and at Royal Bank of Scotland before joining Oxford Economics, points out that a lot of companies use Hong Kong as a hub to move money in and out of China.

“Depending on the severity of US measures, there is a risk that they may not be comfortable using Hong Kong and may go elsewhere,” he says. “It won’t happen overnight, but it would be worrying for the city.”

Chan Kung, founder and chief researcher at Beijing-based think tank Anbound Consulting, says that a robust financial industry needs a free environment.

“The requirements of capital are very clear; the freer the better, and it should be without any restrictions,” he tells Asiamoney.

He agrees with others that Hong Kong’s standing as a financial centre is under threat because of the new security law. But he also thinks that the subject of Hong Kong’s role as a financial centre is unlikely to be at the top of the list of the Chinese government’s priorities.

“Between economics and politics, China’s historical experience shows that it has always chosen politics,” says Chan. “I think this will not change in the future, and the world needs to understand this.”

Hong Kong remains important for the Chinese government, in large part because of its plans to develop the Greater Bay Area (GBA), Chan says. 

The GBA project encompasses Hong Kong and Macau, as well as nine municipalities in southern China – Guangzhou, Shenzhen, Zhuhai, Foshan, Huizhou, Dongguan, Zhongshan, Jiangmen and Zhaoqing in neighbouring Guangdong province. It covers an area of about 56,000 square kilometres – or roughly the size of Latvia – has a population of about 71 million and a GDP of $1.6 trillion.

The aim is to deepen cooperation and integration within the GBA to create a region that is economically advanced and open for international investors, while marking a step forward in the one country, two systems model. 

Hong Kong will play a key role in this because of its international status, use of basic law and sophisticated transport, trade and aviation platforms.

“China is building the Greater Bay Area, and this requires the long-term stability of Hong Kong, otherwise it will have a serious impact on Shenzhen and Guangdong in China,” says Chan.

Kuijs of Oxford Economics adds that the “function of a gateway to China is still a strength for Hong Kong”.

This has been reflected in the success of schemes such as the Stock Connect system between Hong Kong, Shanghai and Shenzhen, as well as Bond Connect, which allows foreign investors to access China’s onshore bond market through Hong Kong.

Whether or not other cities will be able to supplant Hong Kong is another matter. Beijing has invested heavily in Shanghai to turn it into a finance centre and has promoted Shenzhen as a technology centre, in both cases with the intention of eventually surpassing Hong Kong in terms of global status, says John Sitilides, Washington DC-based geopolitical strategist at Trilogy Advisors. 

He predicts China will look to Shanghai as a possible replacement financial centre. While some global investors may prefer Singapore or Tokyo, both face numerous structural, geographical and cultural hurdles in replacing Hong Kong, he adds.

The Hong Kong equity fund manager cited earlier says Singapore could be a natural winner from the Hong Kong turmoil, thanks to the fact that its infrastructure is already solid and it has a business-friendly regime. 

Yet Singapore’s equity markets lack liquidity and do not have obvious sources of future deal flow, diminishing their appeal. The liquidity of Chinese stocks in Singapore is relatively low, which could potentially deter investors looking for an alternative to Hong Kong.

In other words, Hong Kong won’t be replaced that quickly as Asia’s premier financial centre.

While Beijing has said it would impose the security law to prohibit “splittism, subversion of state power, terrorism or interference by foreign countries or outside influences” in Hong Kong, there is still some opacity about the scope and content of the law. How it will be implemented is not known.

Similarly, Trump has yet to react in detail. He said at the end of May – in direct response to China’s move – that Hong Kong was no longer sufficiently autonomous from China to warrant any special treatment. He asked his government to start the process of eliminating policy exemptions for Hong Kong across extradition, export controls on dual-use technology, as well as customs and travel – but he stopped short of unveiling any specific measures against the SAR.

Hong Kong’s financial community is waiting to see what the impact on the city will be. The head of equity-linked products says that Hong Kong is most likely to see a “slow erosion” of its standing as a financial hub.

“It’ll be a slow decline,” he adds. “Its importance can only change if people’s perception changes, say if companies don’t increase staff in Hong Kong or relocate to Singapore as the next viable option. You’ll see that Hong Kong ceases to grow.”

Or as Hong Kong pro-democracy lawmaker Claudia Mo put it, China’s decision on the new security law marks “the beginning of a sad and traumatizing era” for Hong Kong. “From now on, Hong Kong is nothing but just another mainland Chinese city.” 

2019 February Hong Kong’s Security Bureau proposes amendments to the extradition laws to allow extradition to mainland China and other countries not covered by existing treaties. 

March Thousands of people protest against the proposal in the streets of Hong Kong. 

April 3 The Hong Kong government introduces amendments to the extradition laws that would allow criminal suspects to be sent to mainland China to be tried. 

June 9 More than half a million people protest on the streets of Hong Kong, a key moment for its democracy movement. 

June 12 In one of the most violent days of the protest, riot police use tear gas and rubber bullets on demonstrators. Hong Kong’s business district grinds to a halt. 

July 9 Hong Kong leader Carrie Lam says the bill is dead. 

Mid August Hong Kong’s international airport, one of the busiest in the world, effectively shut down after demonstrators take over main terminals. Flights cancelled for a couple of days. 

September 4 Lam formally withdraws the extradition bill, but this does little to calm protesters, who demand more independence and autonomy from China. 

Middle to end of November Activists barricade themselves in at the Hong Kong Polytechnic University, leading to a protracted siege and battle between protesters and police. 

2020 February Covid-19 hits Hong Kong, preventing large public gatherings. 

May 21 Beijing says it will impose a national security law in Hong Kong, in response to the turbulence of last year. 

May 24 Protesters swing back into action as Hong Kong’s economy comes under further pressure and the city’s status as an international financial centre is questioned.