03 Jun 2020 3 min read

Special situations: the US, China, and Hong Kong

By Erik Lueth

What happens if the US withdraws Hong Kong’s special status?



Another front has opened in the cold war between the US and China: Hong Kong.

Following Beijing’s decision to amend Hong Kong’s security laws, Washington has threatened to withdraw Hong Kong’s special status, but has so far avoided the more draconian measures that were touted in the press, like sanctions on Chinese banks or cancelling the phase one trade deal. So what does the withdrawal of special status mean and how do we position for it?

The US treats Hong Kong differently from mainland China in various ways, ranging from visa regulation to extradition rules and tariff regimes. It is not clear whether all of these areas would be affected at the same time if America follows through on its threat. But even if they are, it is not certain that this would have a major effect.

Take the tariff regime, for example. Hong Kong is mainly engaged in re-exports, where it is the country of origin – not Hong Kong – that is relevant for the tariffs imposed. Hong Kong’s domestic exports account for just 0.7% of total exports; direct trade between Hong Kong and the US is in fact negligible.

That is not to say we should be too sanguine about the situation. The biggest blow to Hong Kong would be if its rule of law were undermined. This could lead to a big outflow of talent and capital, deal a massive blow to the finance industry, and cause declines in property prices. At the extreme end of the possibilities, the calculation of Hong Kong’s currency peg could change and it might even be abandoned.

However, these potential outcomes probably depend more on China’s actions than those of the US. Beijing values Hong Kong as a financial centre where, among other things, Chinese companies can raise capital. This seems more pertinent after Washington raised the disclosure bar for Chinese companies listing on US exchanges. Hence, Beijing is likely to tread carefully on this front.

Go with the flow?

The deteriorating narrative has nevertheless prompted capital outflows from Hong Kong, and a spread has opened between Hong Kong and US interest rates.

Countries that peg their currencies to the US dollar also import US interest rates, as different policy rates would trigger capital flows and undermine the currency peg. When interest differentials open up it is usually because the market has started to question the sustainability of the currency peg, for example if the pegging country is running out of foreign-exchange reserves. This is not going to happen in Hong Kong whose currency board prescribes that every Hong Kong dollar in circulation is backed by US dollars.

We are convinced that Hong Kong can and wants to maintain the currency peg. Under this scenario, the interest differential will be arbitraged away in due course.

Where possible, therefore, our dynamic strategies are positioned for the spread to tighten again.

Where do we go from here? While we expect China bashing in the lead up to the US election, we don’t see this being followed by much action. Trump’s best bet of winning the election is an economic recovery; starting a fight with the world’s second-biggest economy is not conducive to that. Beijing has played cautiously so far and is unlikely to change this strategy so near to the US election.

Erik Lueth

Global Emerging Market Economist

Erik identifies investment opportunities across emerging markets. He uses quantitative models, past experience and lots of common sense. Prior to joining LGIM, Erik worked for a hedge fund, a bank, and the IMF.

Erik Lueth