As long anticipated, the trade war between the US and China has finally morphed into a financial war. On May 21, China’s National People’s Congress passed a decision authorizing the creation of a national security law in Hong Kong, following months of protests which had only briefly subsided as a result of the COVID-19 pandemic.

In response, on May 27, US Secretary of State Pompeo declared in a congressionally-mandated report that Hong Kong no longer maintains a “high degree of autonomy” from China. The declaration by itself does not automatically trigger any actions, and the president has a wide variety of countermeasures to choose from, ranging from trade and investment policy to sanctions on individuals. Some reports suggest that he may be considering freezing the assets of Hong Kong officials within the US, as the Magnitsky Act did for Russian officials.

On another front, the US Senate passed a bill providing a three-year timeline to delist Chinese companies from US exchanges, unless China lets them share audit information, which it has refused to do for a decade already. The bill will have to be approved by the House and the President. This development came on the heels of another Chinese corporate accounting scandal: fake sales data from Luckin Coffee. American regulators have been allowed to see the results of Chinese audits, but not their underlying documentation.

Domestic politics in both the US and China, as well as international business decisions, are growing more complex in the wake of the downturn and disruption caused by the pandemic. Nevertheless, it’s becoming increasingly clear that legal custody of financial information will become one of the most important themes in the emerging “New Cold War” between the US and China.

No Friends in Washington

The initial instinct of US President Trump regarding the Hong Kong unrest was to downplay its importance. Trump is typically uninterested in bottom-up social movements, and in 2019, inter-governmental trade war negotiations took precedence over moral support for the protesters.

The pandemic has made it less likely than ever that there will ever be a phase two trade deal. China’s consumer demand, which drives imports, has still not recovered to the extent that its production has, making it difficult for China to live up to the highly target-driven requirements of the phase one deal. In May, China paused purchases of agricultural commodities including soybeans. Any restraint Trump might have once felt in the lead-up to a second trade deal has likely been lost.

In a preview of the types of policy options the US could be considering for Hong Kong, on June 17, Congress passed a bill to sanction human rights abusers in Xinjiang. Specifically, the bill calls for their assets in the US to be frozen, and for the implementation of travel restrictions.

Although in the US, business has turned sharply negative on China, this isn’t the case everywhere. Some businesses with close ties in China have come out in support of the law, and none more publicly so than HSBC. The reasons for its position are complex, and worth exploring.

Whose definition of security?

HSBC’s cooperation with US officials on the case against Huawei’s CFO Meng Wanzhou has earned it persistent skepticism in China. Jiang Shigong, Professor at the Peking University Law School, referred to its colonial past in a recent online essay, and questioned whether Chinese clients would still be willing to do business with it. He asserted that its cooperation against Huawei, arising out of a 2012 money laundering case, “violated the foundational principle of business privacy.” This is not a correct reflection of the current state of international money-laundering laws, but is apparently a widely held view in China, at least when it comes to cross-border compliance.

China has used HSBC as a lever to counter US pressure on Huawei, similar to its treatment of Canada as a whole. In response, the Chinese state tabloid the Global Times hinted that HSBC might be placed on an “unreliable entities” list, which would make its planned China growth strategy more difficult. Its role as a hostage in the Huawei dispute is not limited to the Meng case; this month, the Telegraph also reported that its Chairman Mark Tucker communicated to the UK Prime Minister Boris Johnson that it could face retribution in China if the UK blocks Huawei products from its network infrastructure.

HSBC’s signature in support of the security law came before its detailed contents or mechanisms became known. (They still remain unknown as of this writing). Opponents of the law worry about ‘definition creep. ’ Chinese legislation often leaves definitions as a matter for the policy-driven implementation phase – particularly when national security is involved. One of the main manifestations of these fears in fact has nothing to with civil rights, but the more mundane issue of investor protections.

The reason Chinese authorities have refused requests from American regulators for audit information has been “state secrets.” For cases of ordinary fraud against shareholders, such as Luckin, this stance has contributed to a perception that the government is not interested in upholding the rules of ordinary commerce.

The Iran sanctions behind the Huawei case, on the other hand, involve a more ordinary definition of national security. Here, the US has applied what is known as “long-arm jurisdiction,” based on its dominance of international currency exchange. Enforcement of these rules, in contrast to basic securities regulation, benefits neither party to a transaction, and comes at a cost to the intermediary imposing the rules. The reserve currency status of the US dollar still gives the US the privilege of enforcing such measures (despite the extraordinary recent actions of the Fed), but the US may nevertheless find its capacity to enforce sanctions around the world being challenged in the next few years.

China’s ruminations about Renminbi internationalization in the 2010’s appear to have run into a wall with the realization that it would involve open capital accounts. At the core, China’s main worry about opening is probably not currency stability, but rather this very question of transparency. Thus, it’s notable that it has recently come up with a way to open up incrementally to foreign capital while entirely bypassing the need for corporate disclosure.

Nuclear defense

China’s Digital Currency Electronic Payment (DCEP) scheme, currently in pilot testing, will eventually allow for payments in legal tender without any involvement by banks. It will be tied to platforms, like a central bank-backed version of WeChat pay, and these platforms will eventually expand to include overseas partners. These overseas Renminbi holdings are only tied to real capital investments through intermediation by the central bank.

Rich Turrin, a fintech and AI consultant, described the new innovation in China Banking News as “partial convertibility or partial liberalization.” “Without a digital currency China has always been forced into this concept of having a binary choice between the currency being freely convertible – yes or no. You either open the currency – make it freely tradable on Western markets, or you don’t. There are intermediate measures that they have taken like dim sum bonds and all kinds of other offshore RMB activities. But basically it was a zero or one binary choice.” The DCEP will give it the opportunity to try a new approach, decoupling payments entirely from transparency.

There are two important points to note about this development. First, it gives China insurance in case the US considers using the “nuclear option” in the new financial war – sanctions on Chinese banks attempting to use American payment networks. Last year, it held three Chinese banks in contempt in a case involving sanctions on North Korea, once again for failing to produce relevant documents. Further measures remain an option, and Beijing would like to contain the scope of the potential fallout.

Frequently, opportunity costs in business are greater than realized costs, and the second consequence is something that may not happen. Turrin points to the DCEP as a substitute for dim sum bonds, which are traded on Hong Kong markets. China’s moves in Hong Kong may represent not just an incompatibility with its international outlook, but also the availability of an alternative path to Renminbi internationalization.

Thus, both sides are hardening their positions in preparation for the “financial war.” China’s financial sector will not be integrated with the rest of the world unless it limits the scope of its national security laws. The US, meanwhile, will face a less obvious opposite need to clarify the scope of client privacy. It doesn’t receive feedback on its use of long-arm jurisdiction, so when it oversteps – whether that point is in the past or the future – it will have no direct way of knowing.

The HSBC story reflects the challenges of Hong Kong business, as well China’s international equities as a whole. HSBC has even taken controversial actions on behalf of China; in November, it closed the account of Spark Alliance HK, inspiring protesters to later splash red paint on its iconic lions (which also appear on some Hong Kong banknotes). If HSBC can’t succeed in China, despite being in business in the region before the Chinese Communist Party even existed, it bodes ill for China’s financial sector opening. China had touted opening in this sector as a goodwill measure in the context of the trade war.