Below the surface, Hong Kong’s position as a global financial hub is shifting

Hong Kong’s business community has largely fallen into line with Beijing’s decision to implement its new National Security Law (NSL). Voices expressing concern about the erosion of the institutional foundations of ‘one country, two systems’ have been muted at best. The end of protests has only added to the perception of local and international businesses that the NSL is an effective tool to restore order.  

The truth is that while Hong Kong’s economy is suffering from the impact of the pandemic, its role as a gateway linking China’s financial sector with global markets has been unaffected. It appears for now that the CCP’s gamble has worked out – the more repressive political environment has not impacted the financial center. 

Indeed, it has remained immune to both the protests and the introduction of the NSL. Even at the height of the protest movements in 2019, Hong Kong pulled off some of the largest IPOs, including the secondary listing of Chinese tech companies Alibaba, JD.com, NetEase as well as the IPO of Budweiser’s Asia Pacific unit. This trend continued in 2020. By the end of the third quarter, listings on Hong Kong’s stock market raised over 20 billion USD putting it behind only the Shanghai Stock Exchange and NASDAQ.  

One major boost for IPOs in Hong Kong has been a result of US-China tensions spilling into the financial sector. This has resulted in the “home coming” via secondary listings of attractive Chinese companies listed in New York. Biotech company Zai Labs and logistics company ZTO Express raised over 2 billion USD in September. But the largest is yet to come, as Alibaba plans for a listing of its fintech company Ant Group. This is likely to be one of the biggest ever in the world.  

The ability of Chinese businesses to raise capital will be further improved by the expansion of the ‘connect’ mechanisms, which enable access to China’s financial markets via Hong Kong. The moves by the financial regulators in Hong Kong and China will facilitate the opening of China’s financial markets. The established Hong Kong Stock and Bond Connect mechanism has added new financial products that investors can access, and other new mechanisms are in the pipeline, including for exchange traded funds (ETF) and insurances. 

Returns soar, trust dips 

For rent seeking institutional investors, China is an attractive destination with its financial markets outperforming the rest of the world. The flurry of new listings and the expansion of mechanisms accessible for foreign investors are likely to facilitate a higher exposure to the Chinese market.  

The damage inflicted to Hong Kong’s underlying institutions - most notably its judiciary and freedom of speech - has increased political risk, but in the eyes of investors, this weighs little compared to the opportunity for returns. 

In terms of trust, that is a slightly different story. Hong Kong’s institutional framework has long enjoyed a high level of trust and while this has been damaged, it has not been wiped out. Investors still prefer to use Hong Kong to access China’s financial markets. China’s financial markets are more attractive than ever, but distrust in its institutional framework remains high. 

Longer term risks 

While investors are enjoying good returns, they should not ignore the longer-term impact of the erosion of Hong Kong’s institutional foundations. Not only are the principles of ‘one country, two systems’ being watered down; the ‘mainlandization’ of Hong Kong is also accelerating. This will impact the independence of the judiciary and the freedom of reporting; it will also erode the separation of powers. These changes will be incremental, but in the end they will affect theinstitutional building blocks that make Hong Kong a true international financial center.   

Pragmatic investors will start to balance risk and opportunities. Hong Kong’s role as ‘Asia’s World City’ will suffer as it becomes less attractive for international talent. It is likely that the share of Chinese professionals in Hong Kong’s financial system will increase rapidly, and this ‘demographic’ change in the composition of companies will further aid the financial and political integration into the PRC.   

It was never realistic to expect the introduction of the NSL to result in the instant deterioration of Hong Kong’s role as a financial center and an immediate exodus of foreign banks. China’s financial markets remain too highly attractive for foreign investors, and Hong Kong continues to be the best option to access these markets while minimizing risk. 

This constellation has enabled China to pull off a feat that would be unimaginable in other countries with important financial markets. However, Hong Kong’s situation has become more delicate. The indirect and direct implications of the NSL will materialize over time and slowly foreign investors will realize that the political risks cannot be ignored. It is therefore far from given that Hong Kong will continue to flourish as a financial center. For it to do so, much will depend on China’s willingness to reform and improve its domestic financial system. Hong Kong’s role as a gateway to Chinese financial markets rests on trust in its institutions. Hong Kong’s financial sector might seem unscathed for now, but the institutional damage has only started to leave its mark. Overambitious policies by the central government still risk undermining trust and may scare off international capital.