Hong Kong: small economy, big risks
7 August 2019
The mass protests in Hong Kong over the past several weeks are leading to an increasingly confrontational situation. The likelihood of the protests weakening with time now seems small, the Hong Kong Government and the protest movement are moving further apart, and the action and rhetoric is escalating: Chinese officials stated this week that ‘those who play with fire will perish by it’.
One increasingly possible outcome is the deployment of PLA troops on the streets in support of Hong Kong police, and large numbers of detentions of protesters to disrupt and deter the protests. Just under halfway into the 50 year handover period, this would mark a de facto ending of the ‘one country, two systems’ approach: a model that has been weakening markedly over the past several years anyway. This would be deeply sad for Hong Kong, and will also have economic consequences.
Among other things, a Chinese crackdown on Hong Kong would likely lead to some international capital, firms, and people exiting Hong Kong, which would compromise the functioning of the Chinese economy. But there are several reasons that suggest that Chinese security forces on the ground remains a plausible scenario despite these economic costs.
First, Mr Xi’s track record is one of prioritising politics over economics. His Presidency has seen the abolition of Presidential term limits, the ending of reform and opening up, an increasing role of the state, as well as a more assertive political role in the region and beyond. He seems to have a clear view on China’s place in the world. And President Xi cannot afford to look weak on Hong Kong.
Second, there are limits to the additional economic costs that could be imposed on China. The US has now covered all of its Chinese imports with tariffs, and has imposed various sanctions on Chinese technology firms. This constrains the ability of the US to do more. A Chinese intervention in Hong Kong may make resolution of the trade war more challenging – but there is no resolution in sight, and the trade wars will likely continue at least until after the US Presidential Election in November 2020. In any case, President Trump has indicated that he will give China a free hand in Hong Kong: he is more concerned about the US/China relationship than the future of Hong Kong.
Elsewhere, Europe would likely be wary of imposing substantial sanctions given the current challenges to its economy. And the UK is not in a position to do much: Brexit is consuming all of its political oxygen, and China is an important market for a post-Brexit ‘global Britain’. Similarly, a regional response from ASEAN or others is unlikely.
Third, the Hong Kong economy has already been largely absorbed into the mainland economy and is less distinctive than it was. Hong Kong is deeply integrated into the Greater Bay Area, Hong Kong’s manufacturing activity has shrunk to about zero, and Hong Kong’s GDP now accounts for less than 3% of China’s GDP. Of course, Hong Kong is an important entry-point for trade and capital into China. Hong Kong’s exports and outward FDI stock are 185% and 515% of GDP respectively, much of which are international flows routed through Hong Kong to China. Hong Kong has valuable capabilities, but many aspects could be replicated elsewhere over time (Shanghai, Shenzhen) or partly retained in Hong Kong with a new political structure.
Although the preference will be to give further time and support to the Hong Kong authorities to resolve this situation, there is not much to stay Mr Xi’s hand if this approach does not work. So what are the economic and market implications of Chinese action in Hong Kong?
First, these political tensions are already imposing economic costs on Hong Kong – in addition to the impact of a slowing Chinese economy and the trade wars. Hong Kong’s economy and markets are sensitive to variation in world GDP and trade growth. Hong Kong’s GDP growth was negative in Q2 (-0.3% qoq), exports are weak (-9% in the year to June), and tourism and retail sales are down. Hong Kong equities are off 9% since 25 July. Chinese intervention in Hong Kong would amplify these dynamics, generating larger economic and financial costs than those from the trade wars.
Second, there would be an economic cost in China, with a more pronounced economic slowdown as well as stresses in the financial system if foreign capital flows into China were disrupted. One consequence would be for the CNY to depreciate further to provide support. This would create a ripple effect across Asia given the CNY’s increasingly central role in the Asian exchange rate system.
Third, Chinese intervention in Hong Kong would increase the likelihood of a change in Hong Kong’s exchange rate regime – which is a political choice as much as an economic choice. I have thought the HKD peg against the USD to be politically vulnerable for some time, even though it provides a useful economic function. A Chinese intervention that signalled an end to the one country, two systems approach may be the necessary catalyst for a change in the exchange rate arrangement – perhaps to a peg against the RMB, or against a basket of currencies.
Hong Kong is on the front-lines of the changing global economic and political environment. It benefited from the US-led system and strong Chinese growth for several decades, and is now bearing the brunt of the changed strategic landscape from trade wars to a more assertive China. There are several reasons to remain cautious on the Hong Kong economic, market, and strategic outlook.
Despite Hong Kong’s small size, these political risks have the potential to have a meaningful impact on global economic activity, given the current economic fragilities, as well as to create contagion across global markets. As is often the case, global change is most quickly and cleanly seen in small economies.
Dr David Skilling
Director, Landfall Strategy Group