Ever since the enactment of the Hong Kong National Security Law, the city has changed beyond recognition. While hardcore pro-Beijing supporters cheered this development as a “victory,” they may not fully grasp the irreplaceable value of Hong Kong to China. There is, after all, a reason why China has not attempted to seize control of the city by force in the past.
Despite accounting for less than 3 percent of China’s GDP, Hong Kong, with its unparalleled institutional advantages, has always played a crucial role as a financial buffer between China and the rest of the world. On one hand, it channels Chinese capital outward to the world. On the other hand, it attracts international investments into China. Without this gateway, China runs the risk of excessive capital outflow and/or hot money inflow, either of which would destabilize the Chinese economy. With no end in sight to the new Cold War with the United States Hong Kong and its own system will become more important than before, financially and strategically, for China.
The Hong Kong Dollar: Quenching China’s Thirst for US Dollars
Despite its rapid economic growth, China is gradually running short of U.S. dollars. Demand for U.S. dollars is rising domestically and overseas, in particular, for funding investments under the Belt and Road Initiative. Meanwhile the supply is contracting with the escalating U.S.-China trade war and relocation of supply chains out of China. In March 2018, China recorded a current account deficit for the first time. Today, China’s foreign currency reserves may look vast, but the net value is about $1 trillion ($3 trillion in reserves minus $2 trillion in foreign debts), only about twice the amount that Hong Kong has.
Hong Kong enjoys a unique position for sustaining the U.S. dollar supply. At the core of its function is the Hong Kong dollar (HK dollar), which is pegged to the U.S. dollar under the linked exchange rate system established during the British colonial era. The strong credibility of the U.S. dollar supports the wide issuance and distribution of HK dollars by local banks; in turn, HK dollars can be freely exchanged for U.S. dollars, making the HK dollar a reliable functional equivalent for the U.S. dollar. This unique status of the HK dollar contributed to Hong Kong’s role as a financial intermediary while a British colony in the past, and now is utilized by Chinese companies to satisfy their desperate need for U.S. dollars to fund overseas developments.
There are two ways for China to acquire “the U.S. dollar equivalent” in Hong Kong – either by letting Chinese companies go public on the Hong Kong Stock Exchange, or by raising debts. As the U.S. is restricting Chinese firms from listing in America, moving away from the Obama administration’s open-door policy (Alibaba’s listing in the U.S. is a product of that era), Hong Kong is a natural safe haven for U.S. dollar-strapped businesses. This also explains why in recent years many Chinese stocks have returned from abroad for a “secondary IPO” in Hong Kong (with Alibaba also being one of them), and why the scale of Chinese companies’ U.S. dollar debt has continued to mount.
The whole operation is almost analogous to “printing cash” in Hong Kong, and relies heavily on the Hong Kong dollar being pegged to the U.S. dollar. Hence, the linked exchange rate system may even be more valuable to China than to Hong Kong and must be protected at all costs by the Chinese government. Last year, despite plentiful foreign currency reserves in Hong Kong, the People’s Bank of China still lent out $100 billion to Hong Kong’s Central Bank in order to stabilize the exchange rate. This move, which protects trillions of dollars’ worth of capital raised by Chinese firms, is in fact an investment with a 10-fold return.
This “one country, two currency systems” model gives China financial stability unmatched by other countries. In particular, both currencies are rather popular – the RMB is the eighth-most traded currency, followed by the HK dollar in ninth place, higher than the New Zealand dollar, South Korean won and Singaporean dollar. Even if Washington restricts China’s trading of the U.S. currency, China can trade in HK dollars with foreign businesses, who can exchange their earnings for U.S. dollars freely in Hong Kong. This would keep the foreign money flowing in, while minimizing China’s exposure to the U.S. dollar.
Hong Kong’s Role in Internationalizing the RMB
In the long run, China has to break free of the world dominance of the U.S. dollar by internationalizing the RMB. However, measures such as opening up RMB trading within Shanghai or Shenzhen would risk a drastic fall in the value of “onshore RMB”; countering devaluation with increasing interest rates would stress the already fragile housing market.
The perfect solution is to make use of “offshore RMB” reserves in Hong Kong. The potential harms from liberalizing offshore RMB would not spread to the mainland Chinese economy because of the firewalls set up by the restricted exchange between the onshore and offshore pools.
Another front China is actively developing is its “digital RMB,” which, unlike privately issued cryptocurrencies, is a digital currency issued and controlled by China’s Central Bank. Its blockchain technology enables traceability and would effectively prevent capital flight, which is a top national security issue for China. However, if the Central Bank distributes the digital RMB in Hong Kong, it would reap a broader range of benefits, such as expanding the offshore RMB pool in Hong Kong; increasing China’s foreign reserve (since Hong Kong’s financial institutes would need to exchange with their U.S. dollars for the digital RMB); and internationalizing the RMB, e.g. via investment in the Belt and Road Initiative.
Hong Kong as China’s Center for Quality Control
The recent fraud committed by Luckin Coffee Inc. has raised doubts internationally about the accounting standards in China. The mainland Chinese company was known for disrupting the coffee market in China by offering affordable coffees delivered quickly through online ordering. After less than two years in business, it rivaled Starbucks and was listed in May 2019 on the Nasdaq exchange. However earlier this year, following investigation by outside parties, the company admitted it had fabricated more than a quarter’s worth of sales.
It is no coincidence that many Chinese firms, which would only need to comply with mainland Chinese standards to go public in Hong Kong, go the extra mile to hire Hong Kong firms for compliance and due diligence work – they want to ensure everything is done to international standards to gain trust from foreign investors.
The U.S. dollar-linked HK dollar and the robust regulatory compliance in Hong Kong explain why Chinese technology firms, in the wake of increasing scrutiny in the U.S., have headed to the city for public listing, rather than the RMB-based Sci-Tec innovation board in Shanghai. As the international community closes in on China, the Hong Kong Stock Exchange will become the de facto Chinese Nasdaq.
If the West dismantles financial links to Hong Kong, which Chinese city can take up its role?
Dr. Simon Shen is the Founding Chairman of GLOs (Glocal Learning Offices), an international relations start-up company. He also serves as an adjunct associate professor and associate director of the Master of Global Political Economy Programme of the Chinese University of Hong Kong, and a visiting scholar of National Sun Yat-sen University of Taiwan. The author acknowledges Michelle King and Chris Wong for their assistance in this piece.