The outbreak of the Covid-19 pandemic and the emergence of geopolitical conflicts along with international economic competition have all put stress on the global financial sector and Hong Kong’s financial system is facing complex external risks.
Among these are the weaponization of SWIFT in the context of the Russia-Ukraine conflict, the threat of de-listing of Chinese stocks from American exchanges and the global impact of rising interest rates.
Hong Kong’s financial risks are part of China’s overall financial risk. The financial security of Hong Kong is closely related to the overall financial security, national security and sovereignty of China. We recommend several measures to buttress Hong Kong’s financial security against possible economic and political shocks.
A key measure is the spinoff of Hong Kong and Shanghai Bank’s Asian business into a new entity regulated by Hong Kong rather than UK authorities.
Hong Kong is both a special administrative region integrated into the overall development of the country and an international city connected to the world – China’s most effective gateway to the country and the world. Hong Kong’s financial security is the foundation of its prosperity and stability, connecting Chinese and foreign capital through finance and trade.
Some risk factors require special attention.
First, economic security is a precondition for financial security. The financial security of Hong Kong depends on the overall stability of Hong Kong’s economic system and the orderly operation of various industries. Hong Kong is a small and fully open economy. The financial services industry is the backbone of Hong Kong’s economy , accounting for more than 23% of the local GDP.
According to the Hong Kong Monetary Authority (HKMA), the banking sector has total assets of HK$26 trillion and the asset management sector has total assets of HK$29 trillion, which are 9.5 times and 10 times Hong Kong’s GDP, respectively.
Hong Kong as an international financial center has a massive financial system. With a high degree of international capital participation, Hong Kong is an important node for the integration of Chinese and foreign capital, connecting domestic and overseas markets. This also means that the economic security of Hong Kong is particularly vulnerable to the external political and economic environment.
For example, HSBC, a British bank, controls half of the retail banking market in Hong Kong and is the largest currency issuer in Hong Kong, with about 60% of the total Hong Kong currency in circulation. HSBC manages the Hong Kong SAR government’s revenue and expenditure from the Treasury and the exchange fund. The salaries of Hong Kong’s public servants, teachers, and health care workers are also paid from HSBC accounts. HSBC’s special role gives it systemic importance for Hong Kong’s economic and financial security.
At the moment, Hong Kong is facing a complex, changing and challenging external environment. Protectionism and unilateralism are on the rise, and Western countries are trying to contain China’s development. Ultra-easy monetary policies have increased volatility in economies and financial markets.
The risk is that the global debt cycle will lead to higher unemployment and lower consumer spending and investment, with financial consequences that would endanger Hong Kong’s financial security.
Currency security and free capital flows are key to Hong Kong’s financial security, Hong Kong is the world’s largest renminbi offshore center, and its foreign exchange reserves exceed US$440 billion, more than twice its monetary base. That provides solid backing for Hong Kong’s currency peg to the US dollar. The Hong Kong dollar exchange rate has been strong since the beginning of 2020, and the inflow of funds into the Hong Kong dollar since then reached US$50 billion. A safe, open and liquid monetary system can provide a stable and reliable business environment and investment conditions for people at home and abroad.
However, as central banks raise interest rates in response to rising inflation, the US dollar shock will inevitably also affect the monetary security of Hong Kong. In the short term, the Fed’s raising of interest rates will weaken the Hong Kong dollar against the US unit. Interest rates in the Hong Kong market will rise because the pegged exchange rate requires Hong Kong to follow US monetary policy. Capital outflows will lead to rising pressure on the Hong Kong financial and real estate markets.
In the medium to long term, the vulnerability of the financial market is exacerbated by uncertainties such as the Russia-Ukraine conflict and the Sino-US dispute. In an extreme case of a deteriorating geopolitical situation and a blockage of the international market, Hong Kong’s monetary security will face the challenge of frozen foreign exchange reserves and the possible demise of the pegged exchange rate system.
In a serious currency crisis, characterized by massive flight of international capital and panic selling of Hong Kong dollar assets by international investors, Hong Kong’s financial security would be compromised. In such a conflict, HSBC, as a central bank-like issuer of currency, would become the main source of systemic risk, as its governance and its regulatory supervision come from outside Hong Kong.
Maintaining an open and globalized payment clearing system is vital for financial security. At present, Hong Kong operates a globalized payment and settlement network with HSBC at its core. That is also the node for China’s enormous capital market and for large amounts of capital to enter the US dollar payment and clearing system. Hong Kong’s role is to connect domestic and foreign capital markets.
But in the event of heightened geopolitical tensions, with the possible application of secondary sanctions in the dollar-centered monetary system, Hong Kong’s payment and settlement system could be at risk.
Just look at Russia, which, in the present Russia-Ukraine conflict, is unable to continue to use the system for foreign exchange settlement with other countries. The volume of trade with countries around the world has dropped significantly, which in turn has severely slowed down Russia’s economic growth.
In the future, the US may rely on the dominant position of the US dollar in the international financial system to continue to assert jurisdiction at a distance, to restrict other countries’ access to the global payment and settlement system, by freezing foreign exchange, restricting international investment and financing and cutting off access to the US dollar markets in various ways.
In this situation, a global financial institution like HSBC presumably would have more network resources to mitigate the risk. However, with its business focus in the Asia Pacific region, including China, it would be difficult for HSBC to effectively circumvent sanctions. In addition, HSBC is currently the only US dollar clearing bank in Hong Kong. In the event of a major geopolitical event, followed by the passive or active closure of clearing operations, Hong Kong’s key role in linking domestic and foreign capital would be lost overnight.
How to reduce risk
Hong Kong should optimize the regulatory regime for the large number of foreign-related financial institutions, as an institutional safeguard for maintaining financial security. Hong Kong has a feature-rich financial ecosystem. More than 70 of the world’s top 100 banks are present in Hong Kong, as well as more than 70 of the world’s top 100 asset management firms.
HSBC is a potentially significant risk to Hong Kong’s financial regulation because its management and regulatory base in the UK make it subject to the long arm of the US. The regulatory influence that the Hong Kong government can exert over HSBC is relatively limited at present.
During the 2020 pandemic, when the UK Financial Services Authority forced HSBC to cancel its dividends for the year to maintain liquidity in the UK, HSBC had to comply without any regard to the position or attitude of the Hong Kong government, or the interests of small and medium investors. This dividend cancellation caused an uproar at the time, with thousands of small investors demonstrating in front of HSBC’s Hong Kong headquarters.
In early 2022, HSBC again canceled its quarterly dividends. This separation of control and regulation from business operations is unparalleled in the world.
The ideal solution would be for HSBC to spin off its Asian business and list it in Hong Kong as an independent legal entity, to avoid the conflicts mentioned above. It could better adapt to the regulatory and legal environment in Hong Kong and embrace new development opportunities more actively.
Going forward, Hong Kong and the Mainland could better coordinate financial supervision and regulation. They should introduce a round-the-clock, cross-market monitoring system, and develop contingency plans to counteract the impact of international market turbulence.
We believe that the new SAR Government is fully aware of the seriousness and urgency of the financial security issues we mentioned, and will make appropriate plans for Hong Kong’s long-term stability.
With the right safeguards, Hong Kong can leverage its advantage of free convertibility of offshore RMB and its role as the world’s largest offshore RMB product center and capital pool, and open a new chapter in its development.
Wang Jiangyu is a professor at the School of Law at City University of Hong Kong, and Liu Dian is a research fellow at Beijing Science and Technology research base at Beihang University.