Reports Of Hong Kong's Death Seem Greatly Exaggerated

Summary

• Latest big news in Hong Kong is the new national security law being drafted in Beijing, which would outlaw acts considered "treason, secession, sedition, or subversion" in Hong Kong.
• Critics of this measure have called this the end of the "one country, two systems" model that has made Hong Kong Asia's leading financial hub.
• Although the US has already started responding, and increased the level of uncertainty, Hong Kong's status as a financial center is far from binary.
• Hong Kong handled the COVID-19 pandemic better than most other cities of its size, with only 4 deaths so far, and retains many other difficult-to-replace features.
• Chinese investors seem to be viewing this as a buying opportunity.  This article provides a list of specific events and risks to watch out for.
• Looking for a helping hand in the market? Members of Long Run Income get exclusive ideas and guidance to navigate any climate. Get started today »

The big news in Hong Kong in late May 2020 was an extension of national security laws by the National People's Congress in Beijing to outlaw certain activities in the former British colony. An earlier draft of what this would cover refers to Article 23 of the Hong Kong Basic Law (effectively the city's mini-constitution), which requires the city to "enact laws on its own to prohibit any act of treason, secession, sedition, subversion against the Central People's Government...". This move seems clearly aimed at last year's increasingly violent anti-government protests, which seem to be re-starting after months of social distancing during the COVID-19 outbreak, during which an impressively low number of only 4 people have died in Hong Kong so far.

Plenty has been written about this topic by many sources, and while I am not a Basic Law constitutional scholar nor a political analyst, I do aim to highlight some of the main points investors may want to watch out for in the coming weeks, months, years, and decades. In particular, the view that Hong Kong was London last month and became a suburb of Shanghai the next month is unrealistically binary, and there are many details worth watching in this story.

ETFs Affected By Hong Kong

The main ETF tracking Hong Kong-based companies is the iShares MSCI Hong Kong ETF (NYSEARCA:EWH). Additionally, the iShares China Large-Cap ETF (NYSEARCA:FXI) should also be considered a "Hong Kong ETF" as 100% of FXI's holdings are HK-listed mainland Chinese companies or HK-listed futures tracking an index of them. US investors might draw the analogy of having one ETF holding only NYSE-listed companies headquartered in New York City, and a separate ETF of NYSE-listed companies headquartered outside New York City, with some additional differences described under the "One Country, Two Systems" section below. The often quoted Hang Seng Index is a combination of some of the top holdings of EWH and FXI, plus HSBC Holdings Plc (HSBC), which is still called "Hong Kong Bank" here, despite moving its headquarters to London.

On to larger funds that include Hong Kong, the Hong Kong Exchange (OTCPK:HKXCY) is the trading venue for almost 60% of the iShares MSCI China ETF (MCHI) and over 20% of the iShares MSCI Emerging Markets ETF (IEMG). MSCI China is the largest subset of the MSCI Emerging Markets index, but 20% of IEMG's $46 billion in assets is several times larger than 60% of MCHI's $5.5 billion. The even larger $55.5 billion Vanguard Emerging Markets ETF (VWO) likely has an even larger allocation to Hong Kong listed stocks, given that it has a larger allocation to China due to not counting Korea as an emerging market, as IEMG does. Hong Kong's status as Asia's leading financial center likely touches far more of many Americans' retirement accounts than they realize.

Understanding "One Country, Two Systems"

As described earlier, the split between EWH and FXI could be compared to a split between New York City and the rest of the country, but there are several key differences between the "Two Systems" of Hong Kong versus the rest of China that make this city unique. As I wrote in Nikkei Asian Review last year, these many differences make Hong Kong very difficult to "replace" with any other financial center over any short period of time. Just six key differences include:

1. Currency: the Hong Kong dollar, which has been pegged to the US dollar since 1983 and is fully and freely convertible, unlike the mainland's Chinese Yuan Renminbi, which is subject to capital controls. HKXCY's "stock connect" provides uniquely seamless access for offshore investors into Mainland China and vice versa.
2. Immigration: US passport holders may visit Hong Kong for 90 days' without a visa, while the mainland requires a visa.
3. Taxation: Hong Kong has a maximum personal income tax rate of 15% and corporate tax rate of 16.5%, while the mainland taxes personal incomes up to 45% and corporate profits up to 25%.
4. Business licenses and regulation: Setting up a company is easier for most foreigners to do in Hong Kong than in the mainland, and Hong Kong has separate licensing and regulatory regimes.
5. Legal & Judiciary: Hong Kong has a separate and different legal system based on English law, with English as a primary legal language, and an independent judiciary. This is a key reason Hong Kong is a regional center for contracts, trusts, dispute resolution, and other legal services between companies doing business between different countries in Asia and globally.
6. Unrestricted internet access: While sites like Google, Facebook, and Twitter are blocked in mainland China, all remain freely accessible in Hong Kong, which definitely makes business with markets outside China easier.

The national security law does not directly propose to change any of these differences between the two systems, but commentators worried about Hong Kong's future tend to be most concerned about points 5 and 6. As one journalist explained to me:

Journalists will of course write in opposition to the national security measure, as it is more likely to directly limit what journalists can do in Hong Kong. Business people like are likely to see little or no impact from this, and it may even help business if it stops the civil unrest.

Examples of what this journalist was referring to include the vandalism of many businesses last year, including several Starbucks locations in Hong Kong. Starbucks Corporation (SBUX) is one of around 1,200 American businesses doing business in Hong Kong, and like many American businesses, uses Hong Kong as a "gateway city" for its business in Mainland China. Most American businesses, including Starbucks, have understandably not made public statements for or against the national security measure, likely preferring to focus on just doing business without getting vandalized or arrested. Companies with cross-border businesses are likely to see the national security measures as neutral to slightly positive, since:

• If Beijing wanted to arrest a company's staff members that travel to the mainland, they would do so when those staff members are in the mainland, but meanwhile
• This law seems to protect stores like Starbucks from further vandalism.

My Background and Biases

In case it is not clear by now, I think it is worth outlining a few details of my own perspective and biases: I am a foreigner who has lived and done business in Hong Kong for ten years, and I am one of those foreigners who frequently travel to China to do business. I have become a permanent resident of Hong Kong (a status the mainland does not grant foreigners so easily), and consider Hong Kong to be my home. My main "pro" positions is that I am "pro-business" and "pro-peace" and I opposed the use of violence and restrictions on travel, trade, or investment. I find it very important to try and understand situations the way they are and are likely to be, rather than the way I wish they would be, and invest accordingly. Clearly, my decision to continue living here is a vote with my feet that this city will continue to be a good place to live and access one of the most impressive economic growth stories in human history. Some of the points I mention at the end of this article are points I am watching that might change that view, depending which way things go.

Understanding Hong Kong Politics

I hate the term "Hong Kong politics", as one of the reasons I first moved here ten years ago was how much I loved that this city seemed to be "all business, and no politics". In fact, for most of the first nine years I lived here, politics never occupied even a fraction of the advertising space or conversation time as topics like travel, watches, stocks, apartments, or a dozen other more interesting and business-friendly topics. I often said that Hong Kong was like "the iPhone of political systems, not allowing any apps from outside the App Store, but 'it just works'". By contrast, I compared American politics to Microsoft Windows, which seemed to offer much more choice in which software you could install, but that of course came with more opportunities for viruses and blue screens.

If I were to try and summarize what divides Hong Kong politically, it seems to me to be a division between those who see greater integration with mainland China as an opportunity or as a threat. Business owners who have made their fortunes on mainland China's rising wealth tend to welcome development of "the Greater Bay Area", while recent graduates facing lower wages and rising apartment costs due to mainland competition are more likely to be the ones protesting. I have found the same division among foreigners living here: those who frequently travel to mainland China are far less concerned about the national security measures than those who almost never cross the border. In many ways, this division could be compared to the political divisions used to describe Brexit in the UK or the election of Donald Trump in the US: those who benefit from globalization (and especially the rise of China in that globalized world) versus those threatened by globalization.

As I wrote in the Brexit article, I believe US and UK politics would be far more harmonious if the big cities, which tend to vote opposite the rest of the country, had their own "second system". Imagine if New York City and San Francisco could be carved off into "Special Administrative Regions" with their own tax, immigration, and business policies which they could completely opposite to how they complain the current US president and senate are managing issues. This is an oversimplification of course, but I have yet to see many counterexamples to it.

Events and risks to watch out for

As expected, the US has so far been quick to react to the national security law, with US Secretary of State Mike Pompeo has already announced that Hong Kong no longer meets the autonomy condition of the 1992 US-Hong Kong Policy Act. The next step is up to the White House, and whether the US wants to step up sanctions or tariffs on Hong Kong. President Trump already ordered US government pension funds to not invest in Chinese stocks (which could be a challenge if they held IEMG or VWO for their emerging markets exposure) in addition to another US law that threatens to delist many US-listed Chinese companies. Below is a quick summary of how EWH and FXI have moved so far this year, relative to the Vanguard Total World Stock ETF benchmark:

Some specific future events, scenarios, and risks to watch out for include:

1. The US imposes tariffs and sanctions on Hong Kong. Hong Kong has so far benefitted from a favored nation trading status that has exempted Hong Kong business from many of the tariffs slapped on goods coming straight from mainland China so far in this trade war. If tariffs and sanctions are applied on Hong Kong, another level of detail will be whether any exemptions or reduced rates are extended to certain industries, or the 1,200 American businesses here.

2. Watch details how many people gets arrested under the new law, who they are, and what they are arrested for. With any law, there can sometimes be significant differences between how a law is perceived in principle, versus what actual effects or enforcement of it we see in the real world. The significance of this law years from now will be seen very differently if 0-10 vs 1,000-10,000 arrests are made under the law, whether those arrests are of store bombers versus of journalists or executive. The US response will also likely be different if a US citizen is involved in any of these arrests.

3. Watch Hong Kong Government Bond yields. A key indicator of Hong Kong's status as a financial center is whether capital is flowing into or out of the city. Given the Hong Kong dollar's peg to the US dollar, I have long measured the outlook of that peg, and Hong Kong's relative position as a financial center, by looking at the spread between Hong Kong Government Bond yields and same-maturity US Treasury yields. The 25bp rise in 3yr HKGB yields in May 2020 seems to signal one of the most significant capital flights I've seen since moving to this city ten years ago. The 10yr HKGB still trades at a yield 5bp below the 10yr US treasury, also one of the narrowest spreads I've seen in 10 years. HKGB yields have long been lower than US treasury yields, despite the peg, as the Hong Kong government has very little debt (3rd lowest debt/GDP according to the CIA World Factbook vs the US at 36th highest), and any de-peg of the Hong Kong dollar has been expected to be up not down.

4. Watch how many business leave vs come to Hong Kong. If no more than an average year's number of international businesses will have moved out of Hong Kong by this time next year, that would likely be a sign that the death of Hong Kong as Asia's financial hub was greatly exaggerated. The earlier mentioned US law, which may reduce the number of Chinese or China-allied companies listed on US exchanges, could potentially mean more companies list on the Hong Kong exchange rather than less.

5. Watch the "Belt and Road" and "Greater Bay Area". I continue to see Hong Kong's future, perhaps more than anything else, tied to two specific key words worth a Google alert for any China watcher:

• The Belt and Road initiative, which is Beijing's vision to develop an economy sphere of influence across the Eastern hemisphere surpassing the US's or Russia's, and
• The Greater Bay Area, a narrower development of a greater integrated region including Hong Kong, Macau, and Guangdong province.

These are just five of many variables I believe are worth watching in the Hong Kong story over the next year, and hope these make it clear that Hong Kong's status as a leading financial center is far from binary. I believe a simple explanation for why American politicians and journalists may paint the situation as binary could be:

• This year is an election year in the US
• The rise of China was one of the reasons Donald Trump was elected in 2016, and how well he protected American workers from China was going to be a key 2020 election issue even without the outbreak.
• US cities have, in general, seen far higher death rates from COVID-19 than Chinese cities, especially Hong Kong.
• Both parties will find blaming China for 2020's problems is likely to be popular with voters, and most American voters are unlikely to go into any details on how Hong Kong really works.
• Even though Hong Kong never was a democracy (especially not under British rule), US politicians will likely try and frame their stance as "fighting for democracy".

What This Means For EWH and FXI Investors

I have long been bullish on select Hong Kong listed companies, and it should not surprise anyone who has known me for any length of time that I see dips like this year's as a buying opportunity. Chinese investors, at least according to this Bloomberg article, seem to agree. Although I prefer cherry picking components from within EWH and FXI rather than simply buying the whole ETFs, this article has hopefully helped clarify some of the exposures in the Hong Kong-listed portions of your ETF holdings that overlap with EWH and FXI. As mentioned earlier in this article, HKXCY is just one example of such a name I believe will benefit from both, as EWH's and FXI's holdings are both listed there.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I am/we are long HKXCY, VWO, IEMG, SBUX. 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.

Comments

[deja vuuu]

HK money and international money are fleeing as Chinese money coming in. I think the story of Ant Group and what happened to Jack Ma show you the way how business is run when the Chinese communist party is in rule. By the way, be careful if you want to be bearish on HK market or Chinese market while you are in HK, because you may be arrested under the "national security law" if you do so. If you think I'm making this up, you do not understand the CCP well enough or you are viewing it through your "western lens". 47 candidates in HK running in primary election were arrested for subverting the country. They are still in custody, most of them denied bail by the HK Courts - yes, HK Courts. To be fair, you wrote this article before all these happened. About "greater bay area", I don't even know where to start. Let's just say it's an idea to use fake HK entities (companies/universities) to acquire foreign technologies. As for HK markets, good luck! Everyone is pulling their money out lol.

[Piggybank0626]

Hong Kong no longer has the autonomy like before. Obviously you can't 'feel it' now but this is how power works. They push the bottom line bit by bit until they gain absolute control. Like the crack in a dam, they have reached a breaking point. It is only wise to treat Hong Kong like mainland China or you will be making the same mistake the West has made 40 years ago.

[Tariq Dennison]

Hong Kong never had "autonomy" (especially not under British rule), and that's exactly what I think most Anglophone critics missed if they pretended otherwise. There's a reason it's called a "Special Administrative Region" rather than anything with the word "Autonomous".

As I tried to describe in the article, greater integration with the Greater Bay Area and mainland is something many businesses welcome, but in many practical ways, I see important differences that are likely to persist even beyond 2047. It's the binary view that misses all the nuances that I think is most mistaken.

[Tariq Dennison]

Also worth reading are the comments of our local AmCham president Tara Joseph published in the SCMP over the weekend: www.scmp.com/...

[nicholas davout]

In a post-Trumpian America there will never be the stomach to go toe-to-toe against the Chinese
monstrosity so its a certainty that HK will be submerged under the mainland tyranny at some point. Anyone in HK with any brains knows that and is moving out asap with their assets.In retrospect the ending of the British Empire was the death knell for Asia & Africa as the US short term presidencies do not allow for any consistent resistance to tyrannical entities like China which is busy buying or influencing or bullying those continents. Truman's mistake was not threatening to nuke North Korea when Chinese troops were not withdrawn in the Korean War.

[Paul Wong]

Thanks for the level-headed article.
We aspire to be independently objective in our views and to learn about world financial history of the past 600 years. Prosperity for all people with respect is the ultimate journey for us to strive for.

[New Low Observer]

"...for most of the first nine years I lived here, politics never occupied even a fraction of the advertising space or conversation time as topics like travel, watches, stocks, apartments, or a dozen other more interesting and business-friendly topics."

This depends on who you associate yourself and what you chose to talk about. Since the handover 23 years ago (and many decades before), there has been significant political discussion. This remark reads as though the issue of politics was created in a vacuum...it wasn't.