The butterfly effect on Hong Kong’s economic future

As the confrontation between the US and China escalates, it is very hard for Hong Kong to hide from the crossfire. The US is set for a more hawkish tone and Hong Kong can become an easy target to contain China. One could argue, more critically, Hong Kong is the fortress of arbitrage between the West and China. Although its role so far served well for different stakeholders, this might change due to the growing risk of a new cold war, this time between the US and China . Without doubt, Hong Kong has close economic ties with mainland China. First, financial services, the most important sector, and tourism are more exposed to China . Second, re-exports of Chinese goods to the US gr ow rapidly since the trade war began. But Hong Kong also imports advanced technologies from the US for China as it is exempted from export controls under the Hong Kong Policy Act. Third, Chinese investment continues to be re-routed through Hong Kong, especially for acquisitions abroad. These suggest China increased its gains in Hong Kong but it is much opaque to argue the same for the US. But the cornerstone of Hong Kong’s economic prosperity is the global recognition of its special status, which is also the reason for more activities of Chinese firms. The US-China trade war and the gains made by China open questions on Hong Kong’s future. While we believe the risk of an immediate revoke of the Hong Kong Policy Act remains low, the US could use Hong Kong as a bargaining tool in ongoing negotiations with China. Beyond the biggest stick (revoking the Act, which could harm US interests too) , the US could exert stricter export controls and more regular checks on the rules of origin . Although advanced technologies onl y account for a small share of Hong Kong ’s imports from the US, a sudden change in the US policy or a “natural” sudden reduction in such imports could have an important negative signalling effect to Hong Kong . The t rade tensions will lead to higher scrutiny on China’ sensitive imports from the US, which will increase China’s dependency on Hong Kong on such imports. But the US can str engthen its scrutiny, as shown by the already low approval rate of expor t licenses granted to Hong Kong. A similar story is happening for foreign direct investment where Hong Kong firms are treated as Chinese capitals (Australia as an example ) . In a world dominated by two contending powers, it seems clear Hong Kong will have a hard time in having the cake (Chinese business) and eat it all (maintain the special status with the US). But Hong Kong has limited choices. We should envisage the latter (the special status with the West) as doomed to become weaker – if not disappear – over time if the current trend continues. Such butterfly effect in Hong Kong’s global status may be behind the negative sentiment that accompanied Hong Kong in 2018 and is likely to continue. This is not good news for asset prices in Hong Kong.