The Battle Over Hong Kong and Currency Supremacy

Just as the world reached a ‘lull’ in the COVID-19 pandemic, China’s legislature introduced a new national security law to suppress “separatism,” “subversion,” and “terrorist activities” – bypassing Hong Kong’s Legislative Council (1). The details of this national security legislation are yet to be finalized, though it is reasonably foreseeable that the legislation will lead to Chinese security agencies operating in Hong Kong, the suppression of free speech, and a stricter legal system, as suggested by previous attempts at similar legislation (2). Such broadly defined legislation allows China to silence political resistance - signaling a great loss in Hong Kong’s autonomy and sovereignty. While this security measure is not expected to take effect until September 2020, the proposed legislation has already sparked international tension. This article examines Hong Kong’s importance to the global economy as well as the potential implications of US-China tensions on both nations’ currencies.

The Issue

When Britain ceded Hong Kong to China in 1997, both parties agreed that Hong Kong would operate under the “one country, two systems” arrangement until 2047 (3). Despite this, Secretary of State Mike Pompeo recently announced that the State Department would no longer recognize Hong Kong as significantly autonomous (4, 5). Doing so endangers many US-China agreements that give Hong Kong its special international status, as acknowledged by the United States-Hong Kong Policy Act of 1992 (6). Part of Hong Kong’s special status allows USD to be freely exchanged with Hong Kong dollars (HKD are pegged to USD), allowing massive amounts of international business to flow through Hong Kong and serving the interests of many developed economies (6, 7).

Through a joint statement, the United States, United Kingdom, Australia, and Canada expressed concern regarding Beijing’s proposed law – saying it curtails the Hong Kong people’s liberties and erodes Hong Kong’s autonomy (8, 4). Germany, reflecting the sentiments of the European Union, expressed similar concerns, as did Taiwan and Japan (8). Given US-China tensions, the world is now looking at how the US will respond. The US may impose tariffs on Hong Kong exports as well as restrictions on travel and American exports of goods and technologies – all of which are currently imposed on mainland China (5, 6).

Why Hong Kong Matters

Hong Kong is a massive financial hub with respect to foreign direct investments (FDI), currency conversions, and corporate financing. Hong Kong attracts such business due to its special status, as well as its high trustworthiness. According to the 2019 World Justice Project Rule of Law Index, Hong Kong scored 16th out of 128 on the Rule of Law Index – better than China in every metric (9). Therefore, Hong Kong is the conduit through which many international businesses prefer to conduct transactions with Chinese firms. Compared to mainland China, Hong Kong’s advantages include a non-politicized law system, low taxes, competent regulators, and free movement of capital (10). International businesses prefer to raise equity in Hong Kong compared to Shanghai and Shenzhen due to these legal protections, whereas it can be difficult to move money out of mainland China (10).

However, Hong Kong is also important for Chinese businesses, themselves. While Hong Kong comprises a much smaller portion of the Chinese economy than it used to in the late ’90s (11, 12), its role as a financial gateway is crucial. Most offshore Chinese IPOs take place in Hong Kong (12). Further, Chinese firms mainly sell bonds through Hong Kong, for the HKD is stable compared to the Yuan (10). Roughly 70% of Chinese FDI inflows are conducted through Hong Kong (11), and Hong Kong also serves as a conduit of Chinese outbound FDI due to preferential tax terms on trade and investment between the two entities (10). China can also more easily influence its offshore exchange rate through Hong Kong than through alternative financial hubs (10).

Currency Implications

Hong Kong’s Linked Exchange Rate System (its currency peg) maintains currency stability (7), which is crucial given that Hong Kong serves as a large international currency exchange hub. While pegged currencies pose the risk of rapidly unraveling if a central bank runs out of funds with which to buy and sell the pegged currency, the Hong Kong Monetary Authority has a hefty $535 billion with which to regulate the HKD (7). Strategically, damage to Hong Kong’s reputation as a currency exchange hub hurts Chinese interests. That is, unless China is aiming to disrupt the Asian currency exchange market.

Currently, the USD accounts for 43% of international payment transactions, whereas the Yuan accounts for only 1.66% (13). By maintaining the international currency of choice, the US is in an extremely privileged international position, so undermining the power of the USD in favor of the Yuan may serve Chinese interests. China clearly wants greater control of its financial transactions, as demonstrated by its cross-border Yuan payment system and encouragement of the Yuan in trade settlements and crude oil futures contracts (13). In a bid to maintain greater control over transactions and lower Asian reliance on the USD for transactions, China may become the first nation to launch a digital currency (14). This roll-out would allow China to monitor transactions for terrorism and fraud (15), and it has the potential to be adopted by surrounding countries for faster foreign-exchange transactions (16).

Chinese smartphone apps like WeChat and Alipay have established efficient mobile payment processes and have paved the way for a digital currency rollout in China (15), as well as in surrounding Asian countries in which such services grew by 40%+ in 2019 (17). Adopting a digital currency could also reduce China’s exposure to US financial institutions (thus reducing the risk of sanctions) and create a different settlement mechanism for cross-border transactions – reducing Asian businesses’ reliance on the USD (14). For these reasons, a Deutsche Bank analysis shows this could shift the epicenter of global economic power to China (18). With the implementation of a national digital currency, China can potentially damage or even dethrone the USD as a popular currency of exchange among Asian markets.

If China manages to internationalize the Yuan, the free flow of capital through the HKD may no longer be relevant to Chinese interests – negating many benefits of Hong Kong maintaining its special status. At the same time, the USD’s power has declined; the allocation of global reserves in USD has decreased from 66% to 60.8% since 2015 (13), and recent coronavirus stimulus packages expanded US national debt to $25 trillion. While the USD may be losing credibility, Asian countries may not view a Chinese digital currency as reliable either. What is clear, however, is that China is encroaching on Hong Kong well before 2047, and its plan to do so may be related to its proposed digital currency. 

Any drastic response by the US may only push China to quicken its digital currency development, but a weak response may suggest to China that it has the freedom to push harder on Hong Kong. In reality, China’s massive economy does carry weight in such decisions, as demonstrated by HSBC and Standard Chartered publicly supporting China’s new national security law (19). It’s not a matter of which countries or businesses will benefit from this situation but, rather, how much each will lose. It is certainly in developed economies’ interest for Hong Kong to maintain its autonomy, but the US has the most to lose if China moves forward with creating its own Asian currency exchange system. Therefore, the Trump Administration’s response will largely influence how China proceeds.

Works Cited:

1. The National People's Congress. (2020, May 28). Decision of the National People's Congress on Establishing and Completing the Hong Kong's Special Administrative Region's Legal System and Implementation Mechanisms for the Preservation of National Security. China Law Translate. Retrieved 3 June 2020, from https://www.chinalawtranslate.com/en/hknationalsecuritydecisionfinal/

2. Bradsher, K. (2020, May 28). China Approves Plan to Rein In Hong Kong, Defying Worldwide Outcry. Nytimes.com. Retrieved 2 June 2020, from https://www.nytimes.com/2020/05/28/world/asia/china-hong-kong-crackdown.html

3. Campbell, M. (2019, Aug 27). What Happens to Hong Kong When 'One Country, Two Systems' Expires in 2047? (2020). Bloomberg.com. Retrieved 2 June 2020, from https://www.bloomberg.com/news/articles/2019-08-27/countdown-to-2047-what-will-happen-to-hong-kong-quicktake

4. Cohen, J. (2020, May 29). Is Hong Kong Still Autonomous? What to Know About China’s New Laws. Council on Foreign Relations. Retrieved 2 June 2020, from https://www.cfr.org/in-brief/hong-kong-still-autonomous-what-know-about-chinas-new-laws

5. Wong, E. (2020, May 7). Hong Kong Has Lost Autonomy, Pompeo Says, Opening Door to U.S. Action. Nytimes.com. Retrieved 2 June 2020, from https://www.nytimes.com/2020/05/27/us/politics/china-hong-kong-pompeo-trade.html

6. Stevenson, A. (2020, May 28). Will the U.S. Soon Treat Hong Kong Like China? Much Is at Stake. Nytimes.com. Retrieved 2 June 2020, from https://www.nytimes.com/2020/05/28/business/hong-kong-special-status-explained.html

7. Yeung, K. (2019, Dec 9). What is Hong Kong’s dollar peg and why is it important?. South China Morning Post. Retrieved 2 June 2020, from https://www.scmp.com/economy/china-economy/article/3041240/hong-kong-dollar-peg-why-citys-linked-exchange-system

8. Tan, W. (2020, May 29). World leaders react to China's controversial national security bill in Hong Kong. CNBC. Retrieved 2 June 2020, from https://www.cnbc.com/2020/05/29/world-leaders-react-to-chinas-controversial-national-security-bill-in-hong-kong.html

9. World Justice Project. (2020). WJP Rule of Law Index. Worldjusticeproject.org. Retrieved 2 June 2020, from https://worldjusticeproject.org/rule-of-law-index/global/2020/Hong%20Kong%20SAR%2C%20China/table

10. Khan, N. & Saito, Y. (2019, Oct 22). All About the Money: Why Hong Kong Matters So Much to China. WSJ. Retrieved 2 June 2020, from https://www.wsj.com/articles/all-about-the-money-why-hong-kong-matters-so-much-to-china-11571736607

11. Lee, A., Yeung, K., Yiu, E. (2020, May 27). Hong Kong’s business hub appeal in the spotlight as China law looms large. South China Morning Post. Retrieved 2 June 2020, from https://www.scmp.com/economy/china-economy/article/3086363/national-security-law-hong-kongs-appeal-business-hub

12. Sin, N. (2019, Sep 4). Explainer: How important is Hong Kong to the rest of China?. Reuters. Retrieved 2 June 2020, from https://www.reuters.com/article/us-hongkong-protests-markets-explainer/explainer-how-important-is-hong-kong-to-the-rest-of-china-idUSKCN1VP35H#:~:text=China%20uses%20Hong%20Kong's%20currency,be%20channeled%20through%20the%20city.&text=That%20figure%20equates%20to%20roughly%209%25%20of%20China's%20GDP.

13. Yeung, K. & Xin, Z. (2020, Jun 1). Will US opt for ‘nuclear option’ and cut China from dollar payment system?. South China Morning Post. Retrieved 2 June 2020, from https://www.scmp.com/economy/china-economy/article/3087037/hong-kong-security-law-china-weighs-risk-us-will-go-nuclear

14. Yang, Y. & Lockett, H. (2019, Nov 25). What is China’s digital currency plan?. Ft.com. Retrieved 3 June 2020, from https://www.ft.com/content/e3f9c3c2-0aaf-11ea-bb52-34c8d9dc6d84

15. Horsley, S. (2020, Jan 13). China To Test Digital Currency. Could It End Up Challenging The Dollar Globally? Npr.org. Retrieved 3 June 2020, from https://www.npr.org/2020/01/13/795988512/china-to-test-digital-currency-could-it-end-up-challenging-the-dollar-globally

16. Bloomberg News. (2020, Jun 1). China’s Digital Currency Could Challenge Bitcoin and Even the Dollar. Bloomberg.com. Retrieved 2 June 2020, from https://www.bloomberg.com/news/articles/2020-06-01/china-is-making-cryptocurrency-to-challenge-bitcoin-and-dollar

17. Global Consumer Insights Survey. (2019). It’s time for a consumer-centred metric: introducing ‘return on experience’. Pwc.com. Retrieved 2 June 2020, from https://www.pwc.com/gx/en/consumer-markets/consumer-insights-survey/2019/report.pdf

18. Anzalone, R. (2020). Details Of China’s Digital Currency Are Scarce. What Are The Implications?. Forbes. Retrieved 3 June 2020, from https://www.forbes.com/sites/robertanzalone/2020/02/07/details-of-chinas-digital-currency-are-scarce-what-are-the-implications/#66869c1c323e

19. Pham, S., Boykoff, P., Liakos, C. (2020, Jun 4). HSBC, Standard Chartered publicly support China's national security law for Hong Kong. CNN Business. Retrieved 6 June 2020, from https://www.cnn.com/2020/06/04/business/hsbc-standard-chartered-hong-kong-law-intl-hnk/index.html