Post-Coronavirus Hong Kong: Abiding Strategic Relevance

The mass protests against the government in Hong Kong stopped with the eruption of COVID-19. It was only a pause as all the underlying conditions that fueled the protests are still there. As the COVID-19 pandemic is slowly coming under control, attention is also returning to the confrontation between protesters and the government in Hong Kong. On April 18, the government arrested 14 veteran pro-democracy leaders, charging them with organizing and participating in “unlawful assemblies last summer and fall.” It is as if the government has fired a warning shot across the bow to warn protesters to stay off the streets after Hong Kong has recovered from COVID-19.

What may happen in post-COVID-19 Hong Kong is anyone’s guess. But this is the right time to review the strategic position of Hong Kong in relation to mainland China in terms of finance and trade, which is the larger context needed for a better understanding of how China’s longer term developments may affect Hong Kong’s strategic relevance. Simon Ogus, a member of the Forbes Asia Panel of Economic Commentators, has provided just such an in-depth analysis. Simon is a leading economist who has lived in Hong Kong for three decades, specializing in analyses of the economies and politics of Asia. He is widely acknowledged as one of the few who presciently predicted and publicly warned of the coming of both the 1997 Asian financial crisis and the 2008 global financial crisis. His insights are strategic in the best sense of the word.

Hong Kong’s Strategic Position

Despite Hong Kong’s well-documented troubles, at this juncture, the SAR remains indispensable to Beijing as a controlled funnel for financial flows both in and out of the mainland. The SAR also remains overwhelmingly the principal gateway for both renminbi trade settlement and offshore renminbi deposit taking (90% and 80% of the 2019 totals, respectively). And it also dominates bond and equity trading in and issuance for mainland companies. Only Hong Kong combines an internationally top-notch financial and legal architecture with an un-replicable pool of talent with deep Chinese knowledge, connections and expertise.

Hong Kong will continue to play a pre-eminent role in Beijing’s renminbi internationalization project. One can fairly expect the yuan’s role as a transactional, trade finance and internationally investible currency to be carefully and steadily expanded, though not without the potential for periodic episodes of retrenchment. However, full currency convertibility seems far from imminent, if indeed it can ever be tolerated. The renminbi may rise over time to become a secondary reserve currency on a par with say the yen or the old Deutschmark, but as things stand currently, it is unlikely to grow into a principal reserve currency that replaces or even operates at a similar level to the U.S. dollar. According to the 2019 BIS triennial survey on foreign exchange and derivatives turnover, the renminbi remained a pygmy in the rankings of international trade (and investment) currencies involved in only 4% of transactions compared to the 88% share for the dollar.

Beijing should have some success over time in raising this share as increasing numbers of overseas merchants begin to accept and use Chinese digital payment platforms. Nevertheless, overseas adoption of Chinese payment systems only applies, at this stage, to current transactions which remain merely a tiny subset of total investment flows. The broader challenge for Beijing remains to create a large enough pool of investible RMB assets and hence sufficient trade and investment flows in its own currency to be able to insulate itself from the U.S.-dominated financial system.

International investor purchases of onshore Chinese assets are, from a very low base, on the rise. Increased purchases in the sovereign bond markets have been seen thanks to the renminbi’s inclusion in the SDR basket. Foreigners are also allocating greater amounts to the local Chinese bourses, almost all of which remains funneled through Hong Kong. Nevertheless, many remain leery about mainland accountancy, legal and convertibility issues and continue to prefer to invest in offshore securities where they perceive their investment protections are somewhat more robust. At this stage, foreign investors hold less than 3% of Chinese onshore bonds and only 4% of onshore equities by market capitalization.

The PRC could, in theory, help kill two birds with one stone by encouraging its firms to issue far greater quantities of bonds and shares overseas denominated in renminbi. Hong Kong would seem to be the logical place to start and the process could be turbo-charged by switching the currency of new or even existing Chinese domestically focussed business listings into renminbi while simultaneously encouraging the deepening of local currency hedging markets.

Chinese offshore stock market listings already total around $3 trillion, equivalent to about 40% of the domestic markets’ capitalization. Prior to 2014, the HKEX was overwhelmingly dominant but because of its unwillingness to embrace dual-class share structures, which allow companies to issue shares with different voting rights, Chinese tech companies tended to gravitate towards the NYSE and Nasdaq. In April 2018, the HKEX relented and changed its rules to permit “innovative” companies to list with dual-class structures.

The timing seems to have been apposite if last year’s Alibaba listing is anything to go by. Although the company might have been prompted by the rule change to pursue its secondary listing, not to mention the chance for China-Hong Kong Stock Connect inclusion, the proposed U.S. Equitable Act seems to be focussing minds. Were this Act to come into force, then the importance of Hong Kong’s stock exchange as a source for China listings will only increase further.

There are a number of ways that the SAR could lose its privileged perch, of course. Great financial centers and city states have come and gone over the centuries and historians a century hence could be writing about Hong Kong’s descent into irrelevance. However, for this process to accelerate alarmingly some or all of at least three things would need to happen.

First, and most optimistically, the mainland could move rapidly towards developing a fully functional rule of law, transparent and free financial markets and fully open capital accounts. This does not appear to be imminent.

More destructively, mainland practices could be increasingly allowed to seep into the local commercial legal system. Were the courts to start to be perceived to be ruling in a systematically biased manner in favor of mainland entities, Hong Kong’s unique attractions could be rapidly eroded. To date, there is little evidence of politicization in areas of contract adjudication but it is an issue that bears close monitoring.

The final threat comes from an ungovernable Hong Kong that provokes a harsher, direct intervention from Beijing. It ultimately remains incumbent on the SAR’s leadership to promote policies that can assuage local unhappiness in order to head off such a tragic scenario. Recent developments are far from encouraging.