Hong Kong is the Berlin of the 21st Century

Originally published on  https://jheconomics.com/ July 29, 2020 by George Magnus

Among the many points of tension and distrust that have become features of the deteriorating state of relations between China and the United States, and indeed many other nations, few are as symbolic as Hong Kong. It was already a cauldron of protest and controversy but China’s decision to implement a National Security Law (NSL) in Hong Kong, criminalizing acts of secession, subversion, terrorism and collusion with foreign powers, has compromised the city’s future as Asia’s premier financial center, and driven a dagger through what remained of the policy of engagement with China.

There was never any question that Hong Kong was going to be absorbed gradually into the Mainland as ‘another Chinese city’, exemplified, for example, by the 2018 completion of the Hong Kong-Zhuhai-Macau bridge as part of the Greater Bay Area project. Yet, as the protests evolved last year, especially the siege of the Hong Kong Polytechnic University last November just as the pandemic was kicking off in Wuhan, Beijing felt compelled to act.

Hong Kong is of little economic significance to China, accounting for barely 3 per cent of China’s $13 trillion GDP, but it punches far above its economic weight as a financial center, a window for Chinese companies looking to the outside world and vice versa, a regional or global base for over 8000 companies doing business with China, and a conduit for capital and investment, especially US dollars, flowing into China. China’s decision to accelerate its absorption into the Mainland was nevertheless clearly driven by its emphasis on control and ‘stability maintenance’—euphemisms for the unchallenged rule of the Communist party.  Inevitably, the US, UK and many others also now see Hong Kong as Beijing does.

Two weeks ago, President Trump signed into law the Hong Kong Autonomy Act, which provides for the implementation of mandatory sanctions against individuals, entities and financial institutions in response to the NSL. This followed earlier certification by Secretary of State Pompeo under the Hong Kong Human Rights and Democracy Act that Hong Kong no longer enjoyed sufficient autonomy to justify special treatment by the US regarding security, visas, and exports of goods and technology.  

Days earlier the US also passed the Uyghur Human Rights Policy Act of 2020 requiring various Washington bodies to report on human rights abuses by the Communist party and government against the Uyghur people in ‘Xinjiang Autonomous Province’. Sanctions (mostly symbolic) were imposed under the Global Magnitsky Human Rights Accountability Act 2016 against party officials including the party secretary of Xinjiang, who’s also a member of the Politburo.

These moves are significant because they add an important tool to the financial leverage which the US is uniquely equipped to deploy, by virtue of the role and status of the US dollar as the world’s principal reserve currency, and the reach and influence of US financial institutions.  By weaponizing capital in this way, finance has joined trade, commerce, technology, cybersecurity and traditional military and maritime hot spots. There is little question that, if it chose, the US government could sanction individuals and or financial institutions in Hong Kong, potentially also restricting access to US dollars and or undermining the Hong Kong dollar peg, which has been the anchor of financial stability in Hong Kong since it was established in 1983.

Were the peg to be undermined, it is doubtful that the consequences would not envelop US banks and global financial markets too, and so messing with the peg would be high risk. Yet, in current geopolitical circumstances, who knows? Is there any turning back?

The recent series of formal policy statements by Secretary of State Pompeo and by Attorney General William Barr, National Security Adviser Robert O’Brien, and FBI Director Christopher Wray, respectively, marked an important point, however one is inclined to view the content. It can be labelled ‘the end of engagement’ with China, at least as far as we have known it. Arguably, President Xi Jinping got his oar in first, but the Trump administration has made it official. Quite what its intentions are between now and November is a matter of conjecture, and if it is using US-China relations as a re-election strategy, danger surely lurks.

Yet, it is possible to imagine that a change of US leadership and, more importantly, a change in US leadership from 2021 could bring a new, more distant but possibly more stable pattern of engagement with China. Much depends also on developments in Beijing and on any internal party pressure brought to bear on Xi Jinping, who has lost for now China’s most important external relationship.

As far as Hong Kong, itself, goes, there is no turning back. With September’s elections to the Legislative Council looming, Article 6 of the NSL requires all candidates to swear an oath of allegiance. Other articles stipulate NSL education and the removal of academic freedom, interference with the judiciary, an array of prohibitions on protest, and extra-territoriality so that anything deemed an offence against the NSL outside Hong Kong is punishable on Chinese territory.

The harsh and abrupt change in Hong Kong’s political status and legal environment may yet take time to influence the decisions of those who are there for the express purpose of doing business in China. Two major British banks, HSBC and Standard Chartered both took the unusual step of announcing support for the NSL in deference to the Chinese government and their business interests in China. Some firms could simply move to the Mainland proper, for example, Shenzhen or Shanghai, if life in Hong Kong became too difficult.

The critical issue may now be the aftermath of the elections when attention will doubtless switch to the way in which the NSL is implemented. If this should reflect the conduct and implementation of law in the Mainland, which is essentially to instill fear and self-censorship—to which Hollywood, many Western companies, and several airlines can testify—the outcome for foreign firms and foreign nationals resident in Hong Kong is likely to be dire. More so, even than if the NSL was ‘clarified’ so that it became much more transparent as to what sort of actions or statements are or are not permitted what the punishments are.

The likelihood is that the Mainland regime will prevail, and so the impact on firms that don’t have to be in Hong Kong, and on those whose business depends on transparency and the rule of law, will be negative. Trading foreign exchange, fixed income derivatives, trade financing and so on can be done pretty much anywhere and some of these types of business could easily migrate to Singapore or Tokyo, aided and abetted by both ancillary and geographic networking effects.

Other forms of financial intermediation, such as IPOs, or investment banking and capital markets activities for Mainland firms—business lines in which Chinese banks typically lag behind the competition—may well stay put, even under new rules. China surely knows that even though Hong Kong’s financial status is secondary to party interests, it still has vested interests in preserving some of Hong Kong’s attractions.

With financial sanctions either in situ or looming, and with Hong Kong’s financial hub status under pressure, Beijing’s interest in Yuan internationalization has received new interest after a hiatus in which much of the earlier hype tended to die down. China’s desire to ‘de-dollarize’ the global financial system and have the yuan play a bigger role is a long-standing goal, and yet, the Yuan’s share of global reserves, and its role in global payments and as a denominator for trade and global bond issuance have persistently remained very low.

There is a strong temptation to consider stressed US-China relations and the use of financial leverage as reasons why China will accelerate the internationalization of the Yuan. Yet, in the real world, this process is systemic, not the result of what happens in Hong Kong, or the marketing campaigns of banks, or a president’s or finance minister’s wishes. It depends fundamentally on the ability of foreigners to accumulate claims over time, in this case in Yuan, and for that to happen, China either has to run balance of payments deficits in perpetuity, or abandon capital controls allowing Yuan to flow overseas and circulate freely. The former requires the government to change economic policies so that savings fall relative to investment, which is to say wealth and income (and power) redistribution to households and private firms. The latter requires the government to trust its citizens, cede control to markets, and abolish controls on outward capital movements. The likelihood of either of these happening in the coming decade or more can be considered to be virtually non-existent.

All in all, China’s actions in Hong Kong seem destined to diminish it, and in the end, to frustrate Beijing’s own ambition. Hong Kong’s status is more likely to erode than implode, unless martial law or some other emergency is declared. Yet, what happens in Hong Kong will be watched as closely as a symbol of the new division in the world as Berlin was a generation ago.