The outbreak of the Covid-19 pandemic and the emergence of geopolitical conflicts as well as international economic competition have all strained the global financial sector, and Hong Kong’s financial system is facing complex external risks.
These include the militarization of SWIFT amid the Russian-Ukrainian conflict, the threat of delisting Chinese stocks from US exchanges, and the global impact of rising interest rates.
Hong Kong’s financial risks are part of China’s overall financial risk. Hong Kong’s financial security is closely linked to China’s overall financial security, national security and sovereignty. We recommend several measures to strengthen Hong Kong’s financial security against possible economic and political shocks.
A key measure is the splitting of the Asian operations of Hong Kong and Shanghai Bank into a new entity regulated by Hong Kong rather than UK authorities.
Risk factors
Hong Kong is both a special administrative region integrated into the country’s overall development and an international city connected to the world – China’s most efficient gateway to the country and the world. Hong Kong’s financial security is the foundation of its prosperity and stability, linking Chinese and foreign capital through finance and trade.
Some risk factors require special attention.
First, economic security is a prerequisite for financial security. Hong Kong’s financial security depends on the overall stability of Hong Kong’s economic system and the smooth functioning of various industries. Hong Kong is a small, totally open economy. The financial services industry is the backbone of Hong Kong’s economy, accounting for over 23% of 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 is 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, linking domestic and foreign markets. It also means that Hong Kong’s economic security 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 around 60% of total Hong Kong currency in circulation. HSBC manages the revenue and expenditure of the Hong Kong SAR government from the Treasury and the Exchange Fund. The salaries of civil servants, teachers and health workers in Hong Kong are also paid from HSBC accounts. HSBC’s special role makes it systemically important to Hong Kong’s economic and financial security.
Currently, Hong Kong faces a complex, changing and demanding external environment. Protectionism and unilateralism are on the rise, and Western countries are trying to contain China’s development. Ultra-accommodative monetary policies have increased the volatility of 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 put Hong Kong’s financial security at risk.
Monetary security and the free flow of capital are key to Hong Kong’s financial security, Hong Kong is the world’s largest offshore renminbi center and its foreign exchange reserves exceed $440 billion, more than twice its monetary base . This provides strong support for the peg of Hong Kong’s currency to the US dollar. The Hong Kong dollar exchange rate has been strong since the start of 2020, and inflows into the Hong Kong dollar have since reached $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 affect Hong Kong’s monetary security as well. In the short term, raising interest rates by the Fed will weaken the Hong Kong dollar against the US unit. Interest rates in the Hong Kong market will rise because the pegged exchange rate forces Hong Kong to follow US monetary policy. Capital outflows will lead to increasing pressure on Hong Kong’s financial and property markets.
In the medium to long term, the vulnerability of the financial market is exacerbated by uncertainties such as the Russian-Ukrainian conflict and the Sino-American dispute. In an extreme case of deteriorating geopolitical situation and international market stall, 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 severe currency crisis, characterized by massive international capital flight 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 money issuer, would become the primary source of systemic risk, as its governance and regulatory oversight comes from outside of Hong Kong.
Maintaining an open and globalized payment clearing system is vital for financial security. Today, Hong Kong operates a global payment and settlement network with HSBC at its core. It is also the crux of the huge Chinese capital market and the entry of large amounts of capital into the US dollar payment and clearing system. Hong Kong’s role is to connect domestic and overseas capital markets.
But in the event of increased geopolitical tensions, with the possible application of secondary sanctions in the dollar-centric monetary system, Hong Kong’s payment and settlement system could be threatened.
Just look at Russia, which in the current conflict between Russia and Ukraine is unable to continue using the foreign exchange settlement system with other countries. The volume of trade with countries around the world has dropped significantly, which has greatly slowed down Russia’s economic growth.
In the future, the United States could rely on the dominant position of the American dollar in the international financial system to continue to assert its jurisdiction at a distance, to restrict the access of other countries to the world system of payments and regulation, freezing foreign currencies, restricting international investment and financing, and cutting off access to US dollar markets in various ways.
In this situation, a global financial institution like HSBC would likely have more network resources to mitigate the risk. However, with its business concentration in the Asia-Pacific region, including China, it would be difficult for HSBC to effectively circumvent the 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 shutdown of clearing operations, Hong Kong’s key role in linking domestic and foreign capital would be lost overnight.
How to reduce the risks
Hong Kong should optimize the regulatory regime for the large number of overseas-linked financial institutions, as an institutional safeguard to maintain financial security. Hong Kong has a feature-rich financial ecosystem. More than 70 of the world’s 100 largest banks have a presence in Hong Kong, as well as more than 70 of the world’s 100 largest asset management companies.
HSBC poses a potentially significant risk to Hong Kong’s financial regulation, as its management and regulatory base in the UK subjects it to the long arm of the United States. The regulatory influence that the Hong Kong government can exercise 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 in order to maintain liquidity in the UK, HSBC had to comply regardless of 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 retail investors protesting outside HSBC’s headquarters in Hong Kong.
In early 2022, HSBC again canceled its quarterly dividends. This separation of control and regulation of business operations is unprecedented in the world.
The ideal solution would be for HSBC to split up its Asian operations and register them in Hong Kong as an independent legal entity, in order to avoid the conflicts mentioned above. It could better adapt to Hong Kong’s regulatory and legal environment and more actively seize new development opportunities.
In the future, Hong Kong and the mainland could better coordinate financial supervision and regulation. They should set up a 24-hour inter-market surveillance system and develop contingency plans to counter the impact of turmoil in international markets.
We believe that the new SAR government is fully aware of the seriousness and urgency of the financial security issues we have 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 offshore RMB convertibility and its role as the world’s largest offshore RMB commodity center and capital pool, and open a new chapter in its development.
Wang Jiangyu is a professor at the Faculty of Law of the City University of Hong Kong, and Liu Dian is a researcher at the Beijing Science and Technology Research Base at Beihang University.
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