Portfolio Manager Jennifer James explains why she believes China’s introduction of the National Security Law for Hong Kong is more about politics than economics and why, against the backdrop of ongoing US-Sino trade disputes, Hong Kong is both a symbol and a wedge that may ultimately accelerate the divide between China and the US.

  Key takeaways:

• China’s introduction of its draft National Security Law for Hong Kong prompted sharp rebukes from the US, with Secretary of State Mike Pompeo and President Trump both proclaiming that the proposed law puts Hong Kong’s independence from China at risk.
• As a symbol of broader US-Sino tensions, Hong Kong is stuck between the world’s two largest economies in a struggle for dominance.
• We believe the confrontation between the US and China will continue to escalate, with US sanctions on Chinese parties and increasingly charged rhetoric around the phase 1 trade deal expected in the months ahead.

 

Last week, China’s National People’s Congress (NPC) proposed a draft National Security Law for Hong Kong, establishing an unprecedented and untested path forward for the city. The proposed law prohibits secession, treason, subversion, terrorism and “any behaviour that gravely threatens national security and foreign interference”. In short, it raises uncertainty about the overall rule of law in Hong Kong.

In proposing the new law, China has clearly defined its political aims: to more closely align Hong Kong with Beijing’s domestic agenda. To China, Hong Kong was, and is, a part of China. But the United States responded with sharp rebukes from Secretary of State Mike Pompeo, who said Hong Kong can no longer be considered independent of China, intimating a shift to come in US-Hong Kong relations. President Trump subsequently raised the stakes by officially proclaiming that Hong Kong’s special status is indeed at risk.

Both the introduction of, and reaction to, the National Security Law is, in our view, more about politics than economics. Hong Kong independence serves as a lightning rod for broader US-Sino tensions and, in the simplest terms, Hong Kong is stuck between the world’s two largest economies in a struggle for dominance.

The complex triangle of China, Hong Kong and the US

When Hong Kong was handed over to China by the UK in 1997, it was done under a framework (akin to a constitution) of autonomy called the Basic Law, written by China. The Basic Law allowed Hong Kong to operate as a “special administrative region,” seemingly independent from China and free to operate under a capitalist economic system. In more colloquial terms, this unique governance model has come to be known by the phrase “one party, two systems.” Until 29 May 2020, this system was understood to persist until 2047, when Hong Kong will be officially and wholly returned to Chinese rule.

Until last week, the US had nurtured a bilateral relationship with Hong Kong on the assumption that the city was operating under this “one party, two systems” model and therefore was separate from China until 2047. This was codified years prior to the handover under the US-Hong Kong Policy Act, which established a set of favorable economic and political parameters for Hong Kong, including 0% tariffs on exports to the US, the ability to trade US dollars and visa-free travel for both Hong Kong and US citizens.

However, when protests grew in Hong Kong in 2019 in reaction to China’s interventions, some of which were violent, lawmakers in the US grew alarmed, prompting the US to pass the Hong Kong Human Rights and Democracy Act in November. The Act requires the US to certify annually that Hong Kong is sufficiently autonomous from China in order to retain its favorable relationship with the US, with failure allowing the US to suspend some of the features of the 1992 Act, sanction those responsible for human rights abuses in Hong Kong or prevent the sale of munitions to the Hong Kong police.

Politics, not economics, are driving headlines

Hong Kong is an important financial hub for China, serving as its non-mainland financial gateway to the rest of the world: Hong Kong represents about 60% of China’s outbound foreign direct investment (FDI) and 65% of its inbound FDI as of the end of 2018¹. Hong Kong is also where most Chinese companies have a secondary equity listing, and most offshore Chinese renminbi transactions flow through the city.

However, as a contributor to China’s wealth, Hong Kong only represents about 2.7% of China’s total gross domestic product (GDP)². Compared to the economy of China, it is a small piece of the economic pie. Similarly, Hong Kong is not a significant economic partner to the US. For example, the share of Hong Kong’s exports to the US is only 8% of the city’s total exports, while imports from the US are just 6% of its total imports in 2019¹.

¹Source: Morgan Stanley, Factsheets on Hong Kong, 28 May 2020

²Source: Refinitiv Datastream, December 2019

So, why the strong words from the US? Part of the reason stems from the fact that Hong Kong has been, and remains, a focal point for differing perspectives. For the US, that includes being responsive to Hong Kong protestors and supportive of a free-market economy, even if its days are numbered. At the same time, China is growing impatient with Hong Kong protests and the city’s inability to devise its own National Security Law and has a strong determination to treat Hong Kong as what it will inevitably become – another Chinese city.

Many stakeholders would argue that China has been asking Hong Kong to enact its own national security law ever since the Basic Law was written, and it is only because the Hong Kong legislature was not able to do so that China’s NPC was forced to enact its own version. In 2003, a national security law was introduced to the Hong Kong legislature but was promptly withdrawn after it triggered protests; there have been no subsequent attempts to introduce it. Meanwhile, a series of small but significant interventions by China have left some Hong Kong residents bristling, provoking mass unrest. China may feel it has “no choice” but to take matters into its own hands.

Both the introduction of the law itself (by China) and the reaction to it (by the US) reflects the political struggle between the two countries. Indeed, the US’s reaction to the National Security Law is unique, as both France and Germany, for example, have gone out of their way to express the need for a constructive relationship with China in the past week. While the UK has been more active – for example, offering British National Overseas passports to anyone in Hong Kong eligible for one, even if lapsed – it stopped short of the kind of strong rhetoric coming from the US.

Looking ahead

We await the full text of the National Security Law but believe the final approved law will reflect the broad strokes outlined in last’s week proposal and will ultimately be enacted by September. The response from Hong Kong citizens is likely to be more protests and more arrests, causing Hong Kong’s financial health to continue to deteriorate. Consensus forecasts for Hong Kong’s 2020 GDP is currently -5.0%, but this could worsen, as retail sales are likely to fall further and unemployment – which has risen to a cycle high of 5.2%³ from pre-unrest levels in the high -2.0% area – is likely to rise.

³Source: Census and Statistics Department, Hong Kong, February to April 2020.

As for the US and China, we believe the confrontation is likely to escalate given that both sides are deeply entrenched, led by two leaders who fear – almost compulsively – appearing weak. We expect U.S. sanctions on Chinese parties, more US commentary and/or actions on China’s treatment of the Uighurs and – most important for financial markets – increasingly charged rhetoric around the phase 1 trade deal. China’s NPC last week had reiterated its commitment to the trade deal, but by Monday, 1 June, there were already reports that China had suspended US soybean purchases.

It was never going to be easy. Hong Kong is transitioning back to China at a faster pace than some would like. Against the backdrop of the ongoing US-China trade disputes, Hong Kong is unfortunately both a symbol of and, increasingly, a wedge that may ultimately accelerate the divide between China and the US.