Hong Kong Special Administrative Region remains locked in a state of political havoc.
Hundreds of thousands of citizens engage in repeated acts of protest, bringing disruption to the city's transport infrastructure and unfamiliar scenes of violence to the screens of the watching world outside. In particular, the world is observing closely the response of the authorities.
The initial protests were triggered by the regional government’s proposal of a bill allowing extradition to Mainland China, but it was clear from the outset that the bill merely surfaced far deeper concerns about the application of the “one country, two systems” principle that was promised at the handover of the territory from the UK to Mainland China in 1997.
The "one country, two systems" model laid out promises to the region, including commitments to independent courts, freedom of speech and open capital markets.
The extradition bill, which critics claimed would erode the independence of the region's court system, has flushed a far broader discontent into the public realm.
Protesters' toll on the market
Hang seng Index
Source: Thomson Reuters, Cazenove Capital
The immediate fallout
As a small, open economy which is heavily reliant on the services sector, Hong Kong faces significant headwinds due to persistent protests that are especially disruptive to retail and tourism. Travel warnings and global media coverage have resulted in tourist numbers falling by 30% in the year to August, and hotel prices in some areas have fallen by 50% or more.
Retailers have felt a knock-on effect, with revenue falling by over 11% in the year to July. Sales of luxury goods, a sector heavily supported by mainland Chinese travellers who flock to the SAR on shopping trips, fell by 24%. Domestic demand has also been weaker as key business and leisure areas have been the focus of much of the disruption. Local media suggests small businesses – already precarious given the sky-high rents in the city – are closing down and laying off staff.
Despite a range of stimulus measures announced by the government, we think further falls in tourism will deepen the retail crisis and push Hong Kong into a recession. Business confidence is also waning.
Luxury brand Prada announced in August the closure of a 15,000-square-foot store in Hong Kong's prestigious Plaza 2000 mall, for which it pays HK$9 million (US$1.1 million, or £920,000) rent per month. Highlighting the challenge in retail, the landlord has reportedly offered to cut the rent by 44% as it seeks a new tenant.
We think commercial property prices will see downward adjustment. Residential property prices are likely to be supported by continued shortage of supply, although some negative impact is likely as potential buyers switch to a wait-and-see attitude.
In terms of financial market impact, the Hang Sang Index has underperformed both global developed market equity indices and local China equity indices.
Despite these jitters in investor confidence, there are scant signs of significant Hong Kong dollar outflows as of end-July. However, banks appear more cautious, with both HSBC and Standard Chartered raising mortgage rates in August, contrary to the backdrop of declining interest rates.
A "bargaining chip" in the US's favour?
The region is a potential stress-point in the ongoing trade dispute between China and the US.
Some commentators see the treatment of Hong Kong SAR by the Chinese authorities as a bargaining chip for President Trump, who says he wants a peaceful resolution of the conflict as part of any trade deal. A deal may become less likely if China takes offence at perceived interference in an area of its sovereignty.
While the short-term economic impact is already measurable, the longer-term implications depend on a range of political outcomes. The crucial question for international investors and businesses is whether the “one country, two systems” principle will be upheld.
We think recent developments suggest the Chinese government is keen to maintain Hong Kong’s current status. Hong Kong Chief Executive Carrie Lam has formally withdrawn the extradition bill in concession to protesters. Secondly, the Chinese government has so far shown restraint, leaving Hong Kong to resolve the matter alone.
Whatever happens, some longer-term conflict appears inevitable. This is because one of the key requirements of pro-democracy protesters is universal suffrage, something which China has made clear will never be granted.
Is the region's status as a global financial hub in jeopardy?
The Chinese hubs of Shanghai and Shenzhen are developing rapidly and undergoing systemic reform. However, they are not perceived by international investors as enjoying as high a degree of freedom and rule of law as Hong Kong SAR.
Hong Kong may lose some competitiveness to Singapore, but its geographical advantage makes it likely to remain a store of wealth for offshore Chinese money and act as a counterpart to China’s rapidly expanding financial marketplaces. It is in China’s interest to support the SAR if only to showcase its determination to move toward a more market-oriented economy.
Barring any material change in political outlook, we believe Hong Kong SAR will remain competitive and attractive. It is crucial however for the Hong Kong Monetary Authority to defend the linked exchange rate system, which pegs the Hong Kong dollar to the US dollar.
Thanks to years of fiscal prudence Hong Kong’s current account has been in persistent surplus. Its foreign reserves are more than adequate for the Hong Kong Monetary Authority to defend the peg, if necessary.