The Taiwan Banker

China never intended for its regionalized economic model to become a permanent arrangement. Although Hong Kong was controlled by the UK at the time, it fit well into Deng Xiaoping’s plans during his 1992 Southern Tour. At that time, he named Shenzhen as a Special Economic Zone, initiating its meteoric rise. It is difficult to find intellectual support for a Chinese economic model whereby the central authority deliberately devolves authority to a peripheral territory, hoping to let an experimental policy take root. Instead, the plan seems more like an act of desperation, a brilliant gambit by Deng to ward off both threats within the bureaucracy and the possibility of a collapse like that of the Soviet Union, fresh in his mind. The closest analogy that comes time mind is from guerilla warfare: Mao’s “use of the countryside to surround the cities.” For decades to come, investors learned that facts on the ground would depend strongly upon the individual region. They subdivided Chinese cities into tiers, and Hong Kong was originally understood to be “Tier 0,” free from political influence. That perception may be now coming to an end, as the recent protests over a proposed extradition law to mainland China have reignited the question of its autonomy. The US is now threatening to revoke its acknowledgement of the de facto independence of the region, which recently ranked 3rd place in the widely-cited Global Financial Centers Index (behind only New York and London) and topped world IPO rankings in 2018. This move would only acknowledge what China already claims to be the case.A Flexible OptionThe US took the Chinese promise of “one country, two systems” seriously, and enshrined it into its own law at the time. The 1992 US-Hong Kong Policy Act treats Hong Kong as if it were not a part of China for purposes of economics and trade. It has generally friendly relations with Hong Kong, although overshadowed by its relationship with the mainland. Hong Kong has the 10th largest goods export market of the US in 2018, and was the home of 290 American regional headquarters and 434 regional offices. It is also not afraid to use Hong Kong as a bargaining chip. President Donald Trump brought up the recent protests in his meeting with Chinese President Xi Jinping at the G20 meeting in Japan, in the lead-up to a long-awaited trade truce. Trump has no ideological connection to Hong Kong, but he does have strongly zero-sum views on international relations, and particularly towards China, which he has identified as the chief competitor to the US. In the future, it is likely that he will dangle the threat of changes in Hong Kong’s status as the situation requires.Any change in the status of Hong Kong would likely be mostly symbolic, but the symbolism is very important. The US grants it a variety of special exemptions, including access to sensitive technologies, visa privileges, exemptions from tariffs on China, and much more. It could decide to rescind any or all of these – so there is not necessarily a threshold for its use. Regardless of any questions of human rights, it may need to address the Hong Kong diversion, through which goods from China are re-exported in order to avoid tariffs from the trade war.Senator Marco Rubio, from Florida, has sponsored a bill requiring the US to re-evaluate Hong Kong’s autonomy on a yearly basis. This option would apply continuous pressure, and seems like the most likely course forward – especially given the direct business interests the US has in Hong Kong. Nevertheless, the US-Hong Kong Policy Act is separate, and would remain on the books. It allows the executive to take action directly, without consulting Congress, making it perfect for threats delivered over Twitter.The Power of MomentumDespite its ideological inclinations, Beijing cannot let Hong Kong fail too fast. For one thing, the protestors have a degree of hard power. They form the most potent challenge to Xi’s efforts at centralization. Well-organized, and connected to international media and even financial markets, they could inspire similar action in other regions Beijing hopes to control, such as Xinjiang and Taiwan. Taking away rights that previously existed will spark much more resistance than denying those rights in the first place.Furthermore, China is currently not in a place to simply ignore the demands of international investors. Its years of capital surplus are over: it posted its first current account deficit in several decades, forcing it to either let the RMB depreciate or import capital. Its foreign reserves are at risk from the trade war. Meanwhile, it faces a domestic interbank liquidity scare after the Baoshang bank seizure, in which investors learned that bank bonds are not being entirely guaranteed. Recent regulatory developments, which speak to Hong Kong’s core value as a financial center, can help illustrate China’s strategy. In May, the (mainland) Ministry of Finance and Hong Kong’s Financial Reporting Council signed an MOU allowing the latter to access audit records of mainland companies listed in Hong Kong. These records had previously been unavailable due to a vague “state secrets” law. Based on previous experience when this law has been invoked, these “secrets” presumably involve fraud which could affect company valuations, as well as information that could potentially reveal the wealth of officials and other details of China’s financial system. Given the resistance China has had to their disclosure, it is reasonable to assume that some of the information involved is substantial. Accounting firms, caught in the middle, have been held liable for failing to produce related documents.This new development contrasts strikingly with a similar dispute with the US. In that case, no such agreement is on offer, and the situation has deteriorated to the point that (once again) Senator Marco Rubio has proposed a new bill to delist Chinese companies listed in the US whose audits cannot be verified by US authorities. Ironically enough, this plan by Rubio would support Hong Kong’s role as a financial center, forcing the affected Chinese companies to list there, and partially counteracting his other plan. More surprisingly, through its information sharing, Beijing appears to support the role of Hong Kong. It could have kept this information from leaving the mainland, which would have supported the status quo, promoted Shanghai as an alternative investment center, and fit in better with its ideological inclinations. The Party still has a pragmatic streak, however. Continued support for Hong Kong as a financial center is convenient for it. Whether or not such incremental reforms will be enough to maintain investor confidence in Hong Kong remains to be seen. Financial centers around the world still lean towards British-inspired civil law. China’s legal system, which repudiates the Western legal notions of “constitutional democracy,” “separation of powers,” and “judicial independence” was never one of its selling points.It is not as easy as it might appear to create a financial center from scratch. The process is deeply connected to all aspects of a region’s history. The most difficult part is probably the creation of a diverse, mutually complementary talent pool – which in turn brings into play second-order factors like academic freedom, protection of personal rights, and internationalism, besides just the frequently cited business law framework and freedom of the financial media. Is Geography Destiny?Human rights issues have long taken a backseat to other concerns in US policy. There are a couple of reasons why this stance could change now. First, in the past, China was able to effectively frame them as “internal affairs.” This is becoming harder as its influence abroad increases rapidly; when the rights violations occur on foreign soil, they become a matter of national defense. In particular, Hong Kong is being used as a staging ground for many of China’s overseas operations, such as the Belt and Road. Second, connections are increasingly being made between human rights and investor rights. In the past, business in China involved production of simple goods, and companies accepted that their Chinese operations were always going to be a management headache. Now, as business becomes more complex, and more funds keep being raised, the backwardness of China’s legal system is being further exposed. Washington’s “human rights” translate to Beijing’s “Party control.” China is finding that despite its success at consolidation at home – and there is some sense that guanxi doesn’t play the role in business that it once did – there are still limits to its influence. It is usually able to accept this fact to a greater degree for locations far from Beijing. In that sense, Hong Kong may end up playing the role that it always has. The mainland won’t be able to crack down too heavily, while the US will use it as a lever for pressure on China. Meanwhile the main source of leverage for Hong Kong itself will be its financial competence.