As Beijing moves closer to implementing a controversial security law in Hong Kong, questions are growing about the semi-autonomous city’s future as a global financial hub. Once a pawn between China and the Britain, Hong Kong’s fate is again out of its own hands.
The heavy-handed measure essentially violates the “One Country, Two Systems” arrangement that was put in place after the former British colony, which had been ceded to Britain by China in 1841, was returned to Chinese hands in 1997. The arrangement, which was supposed to remain in place until 2047, provides Hong Kong citizens the freedoms that their mainland peers don’t have, and also created a special conduit for international finance, making the city a unique place for US dollars to mix with Chinese enterprises under Western financial standards.
Now, that conduit is at risk of short circuiting. In retaliation to China’s proposal to implement the new law, the US government has threatened to eliminate some of its special policy exemptions that grants Hong Kong essentially tariff-free trade between the two places, and many other privileges. Perhaps more worryingly for the financial hub, the door has also been opened for the US Treasury to impose sanctions against Chinese officials or businesses there. Hedge funds and other big investors, meanwhile, may decide Hong Kong isn’t so special anymore, and that sooner or later they’ll face the same restrictions on information, capital, and freedoms as in other Chinese cities. China said that it will “fight back” if the US sanctions come through.
There are major concerns for the big-time money managers and bankers who have made the financial center their home. The security law brings with it a formal presence for Chinese secret police, and could make it easier for officials in Beijing to target outspoken traders or analysts they disagree with. (Chinese regulators targeted US trading firm Citadel Securities in 2015, when they blamed “malicious” foreign short-sellers for a stock market meltdown. The trading company agreed to a $97 million settlement over alleged trading violations in January 2020.) Some hedge funds and traders are considering moving (paywall) to another Asian financial hub like Singapore to avoid being swept up by the law, and to head off tighter restrictions that could be on the way from China, according to the Financial Times.
The stakes are also high for mainland China. Hong Kong, while it only accounts for less than 3% of China’s GDP, is the country’s most important offshore fundraising destination. Chinese firms, ranging from tech champions to some of China’s largest state-owned entities, have raised funds in Hong Kong through IPOs, bonds, or loans. Chinese entities can freely exchange US dollars and Hong Kong dollars, and they can transfer the money to other countries with almost no official limitation, something they’re not able to do back home.
Probably partly driven by such concerns, stocks listed in Hong Kong tumbled when China’s government said it would impose the security law. The Hang Seng equity index has yet to make up those losses compared with other international benchmarks, like France’s CAC 40 and Japan’s Nikkei.
But for now, most other market measures are showing little concern. The share price of Hong Kong Exchanges and Clearing, the company that operates stock and derivatives exchanges in Hong Kong, has rallied about 13% this year, putting it ahead of other big exchange companies like Nasdaq in New York and London Stock Exchange Group. International depositors don’t appear to be yanking their money. Derivatives linked to volatility in the Hong Kong dollar spiked when the security law was reported, but have steadily declined since.
Charles Li, chief executive of the Hong Kong exchange, acknowledges that the former colony has become a “political football” between Beijing and Washington. But he also argued in a blog post that the new security law will have no impact on financial transactions and capital flows, and that any change in trade status would be manageable, as Hong Kong exports hardly any goods to the US.
“Nuclear option”
Among the tools the Trump administration could deploy, the most damaging one, dubbed the “nuclear option” by some, is to limit China’s access to US dollars. Doing so would cause a major disruption, as China needs dollars to fund its infrastructure projects and to conduct most investment and trade activities overseas. Right now China is running low on US currency, as it posted a deficit (link in Chinese) in its current account balance—its trade balance and net income from overseas investments—during the first quarter. This means China spent more US dollars than it received during this period, something that has not happened since 2018 .
The worry for Hong Kong is that American politicians could block Chinese entities there, especially banks, from the US dollar clearing system, or even fracture the Hong Kong dollar’s peg to the US currency. Despite Hong Kong authorities’ repeated claim that the city has plenty of currency to weather US sanctions and to defend the peg, hedge fund manager Kyle Bass reportedly launched a fund to bet against the Hong Kong dollar’s stability.
“People should be much more worried than they are,” said Michael Every, head of financial markets research for Asia-Pacific at Rabobank. He argues that US sanctions of an individual could escalate, resulting in tit-for-tat sanctions from both sides that ends up dragging in Chinese financial institutions.
This could cause a bifurcation, giving rise to separate dollar and yuan financial systems. In such a scenario, Hong Kong would become a purely Chinese financial centre, with only a small leftover of talent that might do some grey market deals in the international arena. “It sounds ridiculous, but it can all happen if we have strong sanctions on an individual,” Every said. “Are both sides going to make it zero sum, or are they going to find some way to compromise?”
For now, the nuclear option seems unlikely. A miscalculation on Washington’s part could also boost the usage of China’s yuan for international payments.
“There are lots of American banks in Hong Kong, so I don’t expect to see the country hurt its own companies for the sake of sanctioning China,” said Terence Chong Tai-leung, associate professor of economics at the Chinese University of Hong Kong. “The situation this time is different from when it imposed financial sanctions on Iran, as the US did not have as much operations in Iran as it has in Hong Kong and the mainland.”
In the meantime, US-listed Chinese tech companies, facing much more scrutiny in Washington and a more welcoming regime in Hong Kong, have gravitated to Hong Kong’s exchange. Chinese gaming giant Netease listed there this week and was embraced by retail investors. But despite the short-term boost from those listings, whether Hong Kong can remain a haven for the dollar deals and Western financiers will come down to decisions made far away, in Beijing and in Washington.
This story has been corrected in the fourth paragraph to show that Citadel Securities, not Citadel the hedge fund, was targeted by Chinese regulators.