Dragon Down

What’s happened to Hong Kong? Having finished first and second in the last two editions of the Baseline Profitability Index, China’s door to the world now languishes in 11th place. It’s still a great place to invest, but doubts about Hong Kong have been building for a while. The territory’s closeness to the mainland’s economy, once its main asset, may end up being a liability.

With low unemployment — approximately 3 percent — low taxation, and good services, Hong Kong for years has been an expats’ paradise and a magnet for highly skilled professionals, especially those in financial services. It has thrived on its unique feature as part of China, but with a separate legal, judicial, and regulatory system that comes as a legacy of being a British colony until 1997. To paraphrase Deng Xiaoping, this tiny territory is the reason for “one country, two systems.”

Over the years, the authorities in Beijing have worked toward implementing Deng’s vision to use the capitalist skills of Hong Kong to help China’s economic transformation. Such was the role of Hong Kong for the development of mainland China that Deng explicitly advocated the preservation of Hong Kong’s capitalist, free system, wishing that it should continue for “100 rather than 50 years.”

Today the city is the entrepôt of China’s trade in Asia and a leading international financial center. It handles more than 60 percent of foreign direct investments into mainland China. Its banks have been doing business with the mainland for years, and the mainland’s most important banks are well represented in Hong Kong as well. And since 2010, when Beijing embarked on the renminbi (RMB) strategy — a policy experiment to develop the RMB as an international currency — Hong Kong has been providing the main offshore market for the RMB and the testing ground for its use outside China.

Furthermore, through Hong Kong, Beijing has been experimenting with the gradual and controlled opening up of China’s financial market. Even if Hong Kong is an integral part of China’s currency strategy and financial reforms, at the same time it offers the necessary degrees of separation between the two markets. Keeping these markets separated — but within the same country — in principle enables China’s monetary authorities to monitor the flow of external funds between offshore and onshore accounts and to avoid the huge influx of funds that could create instability in domestic financial markets.

But this is where things have become a bit complicated. The majority of the RMB business goes through Hong Kong; it handles approximately 70 percent of global RMB payments. RMB funds flow in through trade payments or other channels, they become RMB deposits, and these RMB funds can then be used, deployed, or exchanged freely into other currencies in the market. Hong Kong’s RMB offshore foreign exchange market has become a major currency hub in Asia. A few years ago it was nonexistent.

The RMB business has gradually changed the activities and business of Hong Kong’s financial center. For example, the Hong Kong dollar now trails behind the RMB as the second-most-used currency for cross-border payments between the mainland and Hong Kong — the first one is the greenback — with a share of approximately 12 percent of cross-border payments. Using the RMB as a proxy, it is evident that Beijing’s influence over Hong Kong has become broader and deeper.

Of course, China’s proximity means business — and implicitly a peaceful coexistence — and this has been for years the assumption around which Hong Kong’s authorities have built the city’s prosperity. But proximity also means massive externalities — environmental, to be sure, as anyone who has tried counting lanes of shipping traffic on a hazy day can attest, but also economic and financial.

The slowdown and the readjustment of the Chinese economy toward domestic demand have had an impact on Hong Kong’s economy. In addition, the Hong Kong dollar’s peg to the U.S. dollar, as well as the need to maintain a fixed exchange rate, poses a policy dilemma for the monetary authorities. On the one hand, Hong Kong needs to deal with the deceleration of the Chinese economy, which might require a more accommodative monetary policy. On the other hand, the expected tightening of U.S. monetary policy might also require Hong Kong’s monetary authority to follow the Federal Reserve. In the meantime, foreign demand for assets in Hong Kong has grown so quickly that upward pressure on the Hong Kong dollar has kept the monetary authority intervening to the tune of hundreds of billions a year.

As China transitions toward a more balanced model of economic growth and the country’s domestic financial sector gradually liberalizes, Hong Kong will inevitably be part of the process. Although it is difficult to predict the long-term outcome of this transition, it’s also plausible to expect Hong Kong’s further integration into mainland China and a role more in tune with Beijing’s policy goals — within, of course, the “one country, two systems” framework. But the risk is that Hong Kong becomes increasingly less relevant as China becomes more open. In fact, with new channels to invest directly in the mainland — such as Shanghai-Hong Kong Stock Connect — will Hong Kong still be necessary as the main “door” to China’s market?

Image credit: PHILIPPE LOPEZ/AFP/Getty Images