Country risk: China crisis puts Hong Kong on a higher risk trajectory


Jeremy Weltman
Published on:

The special administrative region’s problems only serve to heighten Singapore’s attractions as analysts scramble to adjust their risk scores.

Hong Kong protests 780
Hong Kong protests under the watchful eye of Beijing

Long regarded for its macro-fiscal strengths, political stability and financial and trading links, Hong Kong is the 14th safest investor domain worldwide, according to Euromoney’s risk survey.

The special administrative region (SAR) has a total risk score of 79.4 out of a maximum 100 points, and is nestled between Austria and Chile in the global rankings.

But its pre-eminence has been slowly eroding as pro-democracy activism has been building in recent years, worsening lately with a small but perceptible dip in its risk score in Q2 exacerbating its longer-term decline.

The protests highlight the interwoven nature of political and economic risk for investors, including the delicate aspect of Hong Kong’s relationship to mainland China enshrined in the Basic Law since the handover from British rule.

How China responds is crucial to Hong Kong’s reputation as a low-risk investor domain, not least with local elections to be held in October and pro-democracy activists showing no inclination to accept any form of compromise, signalling tensions with Beijing will drag on for some time.

Analysts’ response

Euromoney’s survey asks analysts to regularly assess risk indicators, including the economic outlook, institutional risk, regulatory and policymaking environment, and government stability that are clearly all salient factors of the current crisis.

With analysts invariably becoming much more concerned, notably as the US-China trade dispute also festers, their risk scores are expected to worsen in the third quarter survey to be completed in September.

The social unrest is not only a current concern, but it is also gnawing away at Hong Kong’s longer-term appeal by highlighting the dichotomy of the 'one country, two systems' approach that Beijing seems intent on slowly dismantling with its constant meddling in the SAR’s domestic affairs.

China is not playing fair with the flavour of the handover rule book, according to one survey contributor who asked not to be named – and by introducing a bill enabling mainland China to extradite anyone for trial, it has pushed campaigners to breaking point.

The tensions were aggravated by the perception of police brutality, but grievances have been bubbling away for years, tied to China extending its influence into more and more aspects of public life aided by a compliant administration led by a handpicked chief executive.

And Hong Kong’s plight can only increase the attractiveness of Singapore, which has seen its risk score improve over the last five years, and is currently the world’s safest investor domain, beating Hong Kong on 14 of the 15 economic, political and structural risk indicators:


Negative economic effects

Hong Kong’s GDP growth should rebound during the fourth quarter from its low base, with Q4 2018 growth only 1.2%. However, the economy weakened more than first thought in the second quarter, slowing to 0.5% year on year, with retail sales and tourism undermined.

Plus, the third quarter may be even worse.

The latest private sector purchasing managers’ index (PMI) reveals a large drop from 47.9 in June to 43.8 in July – the lowest level in a decade – with new orders vanishing.

Business confidence has remained negative this year, notably deteriorating in the finance, manufacturing and retail sectors.

Samuel Tse, an economist at DBS Bank, has downgraded his forecast for Hong Kong’s GDP growth this year from 2.5% to zero.

With the government also saying growth will now be 1% at best, other economists are following suit as the embattled chief executive Carrie Lam offers to stage talks with protestors after weeks of peaceful demonstrations (though some have been violent, sending out a negative investor image of the offshore trading post and financial-sector hub).

The protests are merely adding to the negativity already caused by increased trade friction between the US and China, causing Hong Kong’s merchandise exports to contract in the eight months since November, with shipments to the US and Japan down sharply in June.

Negative wealth effects arising from stock market volatility have also dampened private consumption, and with protests causing consumers and tourists to stay away and shops to close, retail sales are expected to contract quite severely this year. Airlines and the hospitality sector are suffering, while the real estate market is in decline.

Meanwhile, households are facing higher food bills, notably pork prices, which skyrocketed because of African swine fever, pushing headline inflation up to 3.3% in both June and July.

“The clearly negative situation in which Hong Kong finds itself calls for a policy response from the Hong Kong government”, says Alicia Garcia Herrero, chief economist for Asia Pacific at Natixis Bank.

Hong Kong authorities are not able to utilize exchange rate or monetary policies determined by the US Federal Reserve by virtue of the fact that the Hong Kong dollar has a linked exchange rate operating through a currency board arrangement.

This requires the monetary base to be backed by foreign currency reserves and entails automatic interest rate adjustments to the flow of funds.

Consequently, any unilateral economic stimulus leans heavily on fiscal measures.

The government has announced a HK$19.1 billion ($2.4 billion) fiscal package, but this is only 4% of total fiscal spending, or less than 1% of GDP. It is spread thinly and there is recognition among risk experts that the government will need to concoct a bigger response, though with revenue falling that will hit the fiscal balance.

But that’s not all.

“Given that the second quarter only incorporates two weeks of the 11-week long protests so far, investment is bound to perform even worse in Q3”, says Garcia Herrero, who also notes that several countries have issued travel alert warnings to tourists and transit visitors.

Investors in retreat

On the financial implications, she adds: “While there have lately been some short instances of rapid appreciation of the Hong Kong dollar in early July thanks to the retreat of carry trade activities towards the US dollar, the Hong Kong dollar moved back towards the weak end of the band thereafter as capital outflows become the dominant trend. In fact, a climbing loan-to-deposit ratio testifies to the reduction in the deposit base.”

Although this is a testing time for investors, it has the potential to become much worse should China intervene. Hong Kong’s share of China’s GDP has waned over the years, but it remains important to Beijing.

“The city’s economic foundations are based on free capital movement, while mainland China still maintains a relatively close capital account. This means Hong Kong can facilitate China’s access to foreign capital,” says Garcia Herrero.

“Hong Kong’s role has helped mainland China in keeping its financial sector insulated without suffering the negative consequences of such isolation, i.e. limited access to finance or difficult access to global assets. In essence, Hong Kong is China’s financial firewall.”

That suggests China will tread carefully, especially given the concentration of mainland banks.

Local elections in October will meanwhile provide another test of social cohesion, but there may be even bigger ones to come if the demands for democratic elections, personal freedoms and accountability are routinely ignored.