Hong Kong Isn’t Just Another Chinese City

The U.S. is also an important patron. Consider the territory’s inflow of dollars, which soared after the global financial crisis

By BLOOMBERG

When two parents go through an ugly divorce, it’s best that the child stays neutral. The same could be said for Hong Kong’s economy as the U.S. and China appear to be going their separate ways.

Of course, Hong Kong is part of China. Still, over the past decade it has benefited enormously from an influx of U.S. cash. The U.S.-Hong Kong Policy Act treats the former British colony as a jurisdiction separate from the mainland. This has opened the city to billions of investment dollars, trade benefits and laxer travel restrictions to the U.S. That special status can be revoked if the Trump administration deems the territory no longer “sufficiently autonomous.” By suspending an extradition bill, which would have allowed criminal suspects to be sent to mainland China, Hong Kong has narrowly escaped catastrophe.

Hong Kong Chief Executive Carrie Lam may believe that staying close to China is in the city’s best interest. After all, money from the mainland has propped up Hong Kong’s real-estate market, and its investment bankers have earned millions of dollars in fees from arranging public offerings for China Inc.

This perception is flawed: The U.S. is also an important patron. Since the collapse of Lehman Brothers in September 2008, the city has drawn more than $115 billion, or roughly one-third of its GDP, as shown by back-of-the-envelope calculations based on the Hong Kong Monetary Authority’s metrics. That’s largely thanks to the Federal Reserve’s quantitative-easing program.

For evidence of this influx, look no further than the HKMA’s monetary base. Because Hong Kong’s currency is pegged to the greenback, its de facto central bank has to manage a pool of U.S. dollars, which is reflected in the so-called aggregate balance. When faced with strong, persistent inflows, the HKMA has to pay the city’s banks for their U.S. dollar deposits to defend the peg. Since late 2008, the aggregate balance has swollen by as much as HK$400 billion ($51 billion).

Consider, too, the billions of dollars worth of foreign currencies Hong Kong banks are now holding. To invest in the city’s real estate or stock markets, foreigners need to convert their money into Hong Kong dollars, which shows up as net assets on banks’ balance sheets. As of March, the latest data available, these assets had doubled to HK$700 billion since late 2008.

Tide in, tide out. Hot money can leave just as quickly as it came, given Hong Kong’s open economy. Political uncertainty can easily trigger a crisis of confidence and an abrupt exodus of capital.

So consider the extreme: If the two million street protesters hadn’t stopped Lam from pressing forward with the extradition bill, and if U.S. President Donald Trump scraps Hong Kong’s special status, could billions of U.S. dollars flee the city?

Even without this political kabuki, the city’s capital flows can be volatile. AIA Group Ltd.’s HK$159 billion IPO in October 2010, for instance, led to a sharp increase in banks’ net foreign-currency asset positions, which quickly unwound the following month. The same can be said for the spring of 2015, when the Hang Seng Index rallied on the heels of a neck-breaking bull market in the mainland, only to be followed by a spectacular crash that summer.

Outflow pressures had already been building because China’s economy is slowing, with local banks’ net foreign-currency positions declining since last July. That’s only been exacerbated by the trade-war squabbles, as the U.S. and China attempt to disentangle everything from the electronics supply chain to intellectual property.

Hong Kong has been lucky so far, having remained relatively unharmed by the trade war. But the unfortunate timing of this extradition bill raises the question of whether Lam, an impeccable technocrat and self-proclaimed perfectionist, fully appreciates the fragility of the city’s neutral status. Its prosperity isn’t derived from one superpower or another, but both. Alienating either could trigger capital flight.