As a financial system which serves to bridge the East to the West, Hong Kong has established itself as a crucial intermediary for advanced Western economies to interact with mainland China, the second largest economy in the world. In turn, Chinese companies utilise the former British colony to raise capital offshore, in their efforts to expand abroad.

However, Hong Kong’s status as Asia’s main financial hub is under scrutiny following the imposition of a national security law by Xi Jinping’s Chinese Communist Party. The newly imposed law exclusively forbids any act of subversion of state power, secession, foreign interference, and splittism in the territory – all of which can be trialled in Chinese court. [1]

The Chinese government bypassed Hong Kong’s legislative body, in which some have expressed as controversial to the autonomous, laissez-faire status the city was promised until 2047, under the Sino-British Joint Declaration. [2]

Whilst there are wide-ranging perspectives as to how such legislation may shape local markets, here are a few early takeaways investors are paying particular attention to.

A Pessimistic Market Reaction Saved by China

The Hang Seng Index (HSI), Hong Kong’s stock exchange, tumbled by 5.6% once the security law was announced by Beijing on May 22nd. This drop marked the bourse’s worst one-day performance in nearly five years. Investors with exposure to the benchmark rapidly shifted their assets abroad amid the abrupt sell-off – worried that China’s sweeping new law will trigger more pro-democracy protests and lead business to a standstill once again. [3]

US president Donald Trump’s announcement that Hong Kong will be withdrawn from its ‘special trading status’ also contributed to this effect. The city would no longer be recognised by the US as a separate customs territory and would be forced to face stronger US protectionist measures, similarly to China. [4]

As of early July, Hong Kong equities entered a bull market alongside China’s CSI 300 index of Shanghai and Shenzhen listed shares. This was mainly prompted by large support from Chinese traders, pumping billions into Hong Kong’s stock market after the sharp drop in mid-May. According to a Bloomberg article, Chinese onshore investors have injected $35.4 billion this year across the border. [5] Such inflows were mainly targeted at state-owned Chinese companies, yet they inherently reflect China’s willingness to go at full lengths to support Hong Kong’s local equity market.

A Boost to Hong Kong’s Equity Market

The imposition of the national security law has undoubtedly contributed to the geo-political and economic battle between the US and China.

As a result, the ongoing tension may well act as a boost to Hong Kong’s equity market. In light of a bill passed by the US Senate two months ago, mainland Chinese companies are turning their attention to Hong Kong’s stock exchange. This bill demands for listed companies to now comply with US accounting standards. This presents a legislative burden for Chinese companies which could eradicate $1tn worth of listings on American stock exchanges. [6] To capitalise on this, the Hong Kong exchange is creating more incentives for mainland companies to list on their benchmark, such as enhancing shareholder protection policies and loosening regulation for companies with unequal voting rights. [7]

Correspondingly, the HSI is set to benefit from a set of lucrative stock offerings, as more mainland companies are considering secondary listings and equity sales in the city.

Influential Chinese technology companies have already launched offerings – with many more having unveiled their plans to do so. Last November, e-commerce giant Alibaba raised nearly $13bn in a secondary share offering which truly boosted the Hong Kong exchange. [6]

NetEase and, two tech companies listed on the NASDAQ, have recently raised a combined $7bn in secondary listings on the HSI – fearing that a deteriorating US-China relationship will limit their abilities to raise funds in the US. Talks that internet company Baidu, YumChina and ByteDance (owner of TikTok) are to follow the footsteps of their Chinese counterparts are underway. [8]

Mounting US-China tensions stemmed by the national security law have likely heightened Hong Kong’s role as an offshore financial centre, and investment bank Jefferies believes $600bn could circulate into the Asian financial capital in the coming months. [9]

The future of ‘H-shares’ – a term given to publicly-traded mainland Chinese companies listed on Hong Kong’s stock exchange – seems bright, as new listings are likely to help dozens of mainland companies facing legislative and capital-raising difficulties in the West. Yet, more H-shares inevitably comes with added pressure, and perhaps control, from Xi Jinping’s government. For the Hong Kong stock exchange, finding the adequate balance between its own needs and those of Beijing will be a tough task.

Figure 1: HSI Price Fluctuations

Hedge Funds Threaten To Leave

“It’s impossible to think [the law] won’t have a huge impact”.

“We’re a little bit nervous”.

These are two of the many worried reactions Hong Kong-based hedge fund managers shared regarding the implementation of the national security law.

Reluctant to finding themselves in the crosshairs of this political crisis, some hedge fund managers are considering an exit to rival financial centres in Asia, such as Singapore or Tokyo. They express growing concerns about the future of Hong Kong’s financial landscape – fearing a scenario in which China decides to tighten its grip on the local financial system. Any amendment to financial regulation, or introduction of capital controls, is likely to trigger an exodus of international hedge funds and subsequently large capital outflows.

Unfortunately, this would mean a huge blow to Hong Kong’s status as the main destination for hedge funds in Asia. The 449 hedge funds located in Hong Kong manage $92bn altogether, a sum representing more than the total funds managed in Singapore, Japan and Australia combined. [10] [11]

Is the Hong Kong Dollar Peg to the Greenback Under Threat?

As seen below, the Hong Kong dollar is pegged within a narrow band of 7.75-7.85 to the US dollar. Operating by a fixed exchange rate enables a stable currency and allows the central bank to intervene if needed.

Figure 2: Recent HKD Movements

The announcement of the national security law caused a slight currency weakening in May, from HKD7.7500 to HKD7.7578 per US dollar. Since then, the Hong Kong dollar has strengthened and is currently trading towards the band ceiling (see Figure 2).

The Hong Kong Monetary Authority (HKMA), the city’s independent central bank, uses its large pool of US dollar reserves to maintain its currency within the narrow band. Needing these reserves to protect its currency peg, Hong Kong established itself as the dollar-denominated capital raising centre in Asia. The HKMA currently holds $440bn of foreign currency reserves – that is twice the value of the local money supply. [12]

Yet, there is increasing speculation as to whether the linked exchange rate system will be maintained once China bears more control over Hong Kong. If not, this would have a detrimental effect on Hong Kong’s role as an offshore US dollar funding centre in Asia – and surely impact the city’s financial significance.

The alternative would be to peg the HKD to the renminbi, a move the Chinese government is likely to execute in the future.

However, are we likely to see a Hong Kong Dollar peg to China’s renminbi anytime soon?

Whilst Hong Kong’s future is uncertain, the answer tilts towards a no.

Hong Kong’s financial secretary recently insisted that the government had no intentions to remove the currency peg to the US dollar. He added that a removal of ‘special trading status’ would have no effect on the exchange rate system, and “Hong Kong’s position as an international financial centre”.

Used for now 36 years, the peg system has extensively helped both international investors and mainland Chinese companies. China is unlikely to force a removal of the peg as of now, since it would entail less access to dollar-denominated funding for mainland companies. Along with the current legislative complications in the US, it is in China’s best interests to retain one of the territory’s main privileges. [13]

The US Retaliates Against the National Security Law – What Does the Future Hold for Hong Kong?

On the 15th of July, Donald Trump revoked Hong Kong’s economic and trade privileges, as a countermeasure against the national security law. The order given by the US president will equally have implications on local security and travel.

The HSI ended flat following the news, after China once again provided support for the benchmark. [14]

As Hong Kong finds itself in the eye of a geo-political storm, local markets are likely to take a toll if the US-China relationship deteriorates to a further extent. As of now, US-China ties have hit their lowest point since both countries started to engage in diplomatic relations forty years ago.

The national security law highlights the beginning of authoritarian pressure that is menacing the independence of Hong Kong’s financial system. Although China is likely to dictate the city’s future, Hong Kong will have to be diligent if it wishes to remain Asia’s financial capital.

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