Mainland China's Economic Pacification Of Hong Kong

|
Includes: CHN, CN, CXSE, EWH, FCA, FHK, FLCH, FLHK, FXP, GXC, KGRN, PGJ, TDF, WCHN, XPP, YANG, YINN, YXI
by: Albert Goldson
Summary

Although the US-China trade war has greatly intensified, a potential Black Swan is emerging as the wealthy megacity Hong Kong sinks into chaos.

Continued mass demonstrations threaten mainland businesses already struggling with lower demand and high debt because of the high level of PRC and Hong Kong economic co-dependency.

Gold prices could spike should the PRC intervene with mainland law enforcement or the PLA to halt the violent demonstrations, followed by economic pacification that would reduce Hong Kong to to nothing more than a large back-office financial administrative city.

The PRC finds itself in two-front “war”, each of increasingly intensity, with all sides digging deeper without any clear resolution in sight. The first is economic - the trade war with the US. The second is primarily political (with economic consequences) as Hong Kong residents demand that the PRC cease encroaching upon the 1997 agreed-upon autonomous rights. From the perspective of the PRC, the Hong Kong demonstrations are no longer an annoying distraction, but rather, a separatist insurrection against the PRC’s sovereignty.

From an economic perspective, the Hong Kong economy will suffer long-term massive convulsions to key sectors, should the PRC decide to enter Hong Kong with mainland law enforcement or the PLA.

At the present moment, I project three scenarios that can play out:

  1. The resignation of Carrie Lam, Hong Kong Chief Executive: This is the best-case, short-term scenario. The PRC pressures Carrie Lam, a key demand from Hong Kong’s residents, which temporarily eases and perhaps diffuses tensions, and provides political and economic stability. It’s a low political price for the PRC using Carrie Lam as a political sacrifice to “buy” stability, particularly since none of Hong Kong’s chief executives since the 1997 agreement have served out their full terms.
  2. The PRC intervenes with mainland police: This assumes that the mass demonstrations continue unabated and begin to overwhelm Hong Kong law enforcement. Curfews could also be imposed.
  3. The PRC intervenes with the PLA: This is the worst-case equivalent of a military invasion and would certainly result in unimaginable chaos with a declaration of a state of emergency and keeping the PLA in Hong Kong to discourage further violence.

The PRC’s best option is the resignation of Carrie Lam for the following reasons:

  1. Hong Kong becomes a smoldering political fire instead of an out-of-control one, providing at least a short-term modicum of stability.
  2. China can focus all its efforts on negotiating with the US on their trade conflicts.
  3. For its long-term objectives, diffusing the Hong Kong movement strongly sends a message to Taiwan that the PRC is capable of a political, not violent, solution to resolve issues.

On the other hand, under the worst-case scenario, for its open defiance the PRC may reduce Hong Kong to nothing more than a large back-office financial administrative city as Shanghai picks up the slack. Foreign businesses will decamp (Singapore is the next best destination in Asia), the wealthy will liquidate what they can and tourism will plummet.

Below are several charts provided by Statista, a German online portal for statistics that makes data collected by market and research institutes, with respect to Hong Kong’s preeminence as the city of choice by ultra-high net worth individuals, expatriates and tourists:

The Top 10 Cities with the Highest Ultra High Net Worth Population, September 27, 2018. In Hong Kong, Ultra-High Net Worth Individuals defined as having $30 million or more grew 31% in 2018 to 10,000 vs. the second-highest NYC with 8,900.

Where the Rich Park their Money, June 19, 2018, with data provided by the Boston Consulting Group. Foreign private wealth in Hong Kong ranked # 2 with US$1.1 trillion, behind Switzerland with US$2.3 trillion.

Where Expats Earn the Highest Salary, March 1, 2018. Hong Kong ranked # 9 with average salary of US$148,140.

The World’s Most Visited Cities, January 31, 2018. A huge 26.6 million people spent at least one night visiting Hong Kong in 2017, well ahead of second-placed Bangkok with 21.2 million.

Notwithstanding, Hong Kong is a critical a global financial center for the PRC, which is why the PRC has been reluctant to intervene. A comprehensive summary of the Hong Kong and mainland China economic dependency is articulated on the web page "Hong Kong and The Mainland of China - Some Important Facts" provided by the Trade and Industry Department of the Hong Kong government. Below are some facts supporting this co-dependency:

  • The PRC is Hong Kong’s largest trading partner since 1985 with a share of about 50%.
  • The PRC is Hong Kong’s largest supplier of goods since 1982.
  • Hong Kong is the PRC’s fourth-largest trading partner (after the US, Japan, and S. Korea) and the second-largest export market (after the US).
  • Hong Kong is the largest investor of foreign direct investment in the PRC.

Here is a summary of various investment vehicles specific to Asia that could be vulnerable to severe downward pressure should the Hong Kong situation take a turn for the worse:

Hang Seng Index (OTC:HGSXF) Hong Kong stock market.

MSCI AC Asia Pacific Index (MXAP:IND) includes large and mid-cap firms including those from Hong Kong and China.

ABF Hong Kong Bond Index Fund (2819) (HDKOWD) - an ETF which holds Hong Kong government and quasi-government bonds.

ABF Pan Asia Bond Index Fund (2821) (HKG:2821) - an ETF comprising Asian local currency debt.

Schroder Asian Equity Yield (SCHEQYF-SP) - a fund that holds an array of Asian blue chips that pay generous dividends.

Aberdeen Global - Asia Pacific Equity Fund that is a play on a rising Asia-Pacific economies and is exposed to all the volatilities of such growth.

The Gold Play

Mainland Chinese businesses were struggling with lower demand well before the China-US trade war reached new levels. With lower demand, loans are more difficult to pay off a situation that’s exacerbated by currency swings if their debt is denominated in US dollars. Furthermore, additional capital controls don’t allow mainland Chinese firms to diversify.

For this reason, gold becomes an ever more enticing investment alternative for mainland China and Hong Kong businesses as a hedge whose increasing demand puts upward price pressure on the yellow metal globally.

Recommendation

The intensity of the demonstrations have not abated since my recent SA article, "The Demise Of Hong Kong's Economic Dominance", published August 1, 2019. Nonetheless, I believe that the PRC is fervently seeking a face-saving political solution with the resignation of Carrie Lam to avoid the aforementioned worst-case scenarios.

Even with an immediate solution, I expect it to be short-lived. In the meantime, I expect a progressive economic hollowing in Hong Kong as foreign companies and ultra-high net worth individuals decamp to avoid a near-future flare-up that may not end as peacefully.

Even before the situation spirals out of control despite the best efforts of all parties, I recommend initiating an exit strategy to liquidate or short Hong Kong or Hong Kong-related businesses and investments in the property market, banking & finance, retail and tourism sectors.

With respect to any of the above scenarios, I believe that gold will be an excellent “flight to safety” hedge to offset the continued economic chaos and uncertainty.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.