Hong Kong Tensions Likely to Return

After Chief Executive Lam announced the withdrawal of the extradition bill, Hong Kong asset markets jumped. We think markets should not get too optimistic here, as we see the move as simply too little too late. We expect the protests to continue and tensions to remain high.


Protests leader are saying they want all five key demands met. We don’t think Lam or the mainland China government will meet them. Here are the HK protestors’ five demands in a nutshell, followed by what Lam has to say about each of them. Arguably, 1 was the easiest and should have been done weeks ago. 4 is another easy one, while 2 is a more distant possibility. We think 3 is very unlikely and 5 is downright impossible. Bottom line: protests are likely to continue.

1) Withdraw extradition bill: Previously, the bill had only been suspended. Now, it has been withdrawn altogether. With protests intensifying, this is no longer sufficient to quell them.

2) Independent inquiry into police brutality: Lam has asked the Independent Police Complaints Council (IPCC) to investigate the police response to protests. Lam fell short of appointing an independent commission, and the IPCC is seen as stacked with her loyalists.

3) Amnesty for those arrested: Those arrested are facing up to ten years in prison under a colonial era rioting charge. Lam said she couldn’t give amnesty to demonstrators charged with crimes because it ran contrary to the rule of law.

4) Stop calling them rioters: Mainland officials have softened their tone recently, drawing a distinction between what they see as radicals and moderates by noting that the “majority of Hong Kong’s citizens, including many young students, are taking part in peaceful demonstrations.”

5) Universal suffrage: Lam said that any discussions would need to take place “without further polarizing society.” However, full democracy is something Beijing has explicitly ruled out.

To her credit, Lam said the withdrawal of the extradition bill was only “the first step to break the deadlock in society.” More dialogue is needed but as we noted above, the authorities are unlikely to grant everything that is being demanded by the protestors. More protests are planned for this weekend, focusing again on transport systems such as the subway and airport.

Cathay Pacific Chairman John Slosar followed CEO Rupert Hogg through the exit door. This is a big reason why confidence in Hong Kong won’t come back immediately. Mainland China basically strong-armed a private Hong Kong company into firing its top management for not doing enough to stop its workers from supporting the protest movement.

Investors have bought into the notion that “one country, two systems” will be maintained until 2047 (see A Brief History Lesson below). Any heavy-handed efforts by the mainland to crack down on the Hong Kong protests will directly feed into investor concerns that those two systems can’t or won’t be maintained by China. That in turn will call into question the entire rule of law in Hong Kong. Once lost, trust and credibility may never be regained.



The UK gained control of parts of Hong Kong via three treaties with China. Because these agreements were signed under duress, China came to call them the “unequal treaties.” In 1842, the Treaty of Nanking ended the First Opium War and ceded control of Hong Kong to Queen Victoria. In 1860, the Convention of Peking ended the Second Opium War and ceded control of Kowloon to the UK was well. Lastly, China’s defeat in the First Sino-Japanese War gave the UK to squeeze further concessions with the Second Convention of Peking in 1898. This leased the New Territories to the British for 99 years.

After China gained a seat at the United Nations in 1971, it embarked on the long and winding road of regaining sovereignty over Hong Kong and Macao. No progress was really seen until 1979, when then-Governor of Hong Kong Murray MacLehose traveled to Beijing to discuss Hong Kong’s status with then-leader Deng Xiaoping. In 1982, former Prime Minister Heath was asked by Prime Minister Thatcher to meet with Deng. It was then that Deng first outlined his plan to make Hong Kong a special economic zone that would retain its capitalist system. Thus, the notion of “one country, two systems” was born.

Thatcher visited China in October 1982 to meet with Deng. The UK was pushing to maintain its presence in Hong Kong. On the other hand, China was taking a hard line, refusing not only to extend the 99-year lease but also refusing to recognize the so-called “unequal treaties” that had ceded Hong Kong and Kowloon sovereignty to the UK.

By all accounts, these talks were testy. It is said that Deng even hinted at the possibility of taking Hong Kong by force. Thatcher then traveled to Hong Kong, becoming the first Prime Minister to visit the colony whilst in office. She stressed that all three treaties were valid and must be respected. At around the same time, the National People’s Congress was in session and passed the Article 31 amendment that allowed for the establishment of Special Administrative Regions (SARs) when necessary.

Markets began to take notice of the difficult situation. The Hang Seng Index fell over 60% from its July 1981 peak to its October 1983 trough. With HKD freely floating then, it weakened from around 5 per USD in early 1981 to almost 9 per USD in September 1983 before the peg was introduced in October 1983.

By late 1983, the UK had backed away from its intent to administer Hong Kong after 1997. This led to the signing of the Sino-British Joint Declaration in May 1985. China would regain sovereignty over Hong Kong, Kowloon, and the New Territories effective July 1, 1997. In return, China pledged to maintain “one country, two systems” for a period of 50 years until 2047.



Under the original peg arrangement, HKD could not trade on the weak side (above) of the 7.8 peg rate but could appreciate without limit to the strong side (below 7.8). It has only been seriously challenged once, during the Asian Crisis that started in 1997. When the crisis deepened in 1998, interbank rates soared as foreign reserves fell, and the domestic monetary base shrank. The HKMA took some unorthodox steps then, such as buying Hong Kong stocks as the Hang Seng plunged. Ultimately, the HKMA prevailed and we would expect similar success if the HKD were to come under sustained pressure again.

The HKMA runs a strict currency board. This means that the entire HKD monetary base must be backed by an equivalent amount (at the official exchange rate) of USD. Currently, foreign reserves are more than twice the monetary base. When run correctly, such a peg cannot be broken. Argentina’s peg was broken because it violated several of the basic tenets of a currency board, including central bank financing of the budget deficit.

A minor adjustment was made in May 2005, when a trading band of 7.75-7.85 was introduced around the peg rate. The Hong Kong Monetary Authority (HKMA) is obliged to buy and sell USD to prevent the HKD from breaching either side of the band. It did not have to do so until April 2018, when USD/HKD first started to bump up against the top of the trading band. Yet the mechanics of the peg remain intact. That is, intervention will shrink the money supply, which will then boost local interest rates and support HKD.

We continue to believe that it is realistic scenario to expect a re-pegging of the HKD to the Chinese yuan at some time in the future. The “one country, two systems” framework is in place until 2047, but one can imagine convergence of the exchange rates before that. It seems that when conditions merit (full yuan convertibility, continued integration of Hong Kong into mainland China, etc.), then the Chinese authorities could eventually link or perhaps even unify the Hong Kong dollar with the yuan. This is a long-term proposition, and there will likely be ample warnings and leaks during the process so that investors are not caught unaware. For now, we see no change to the HKD peg.



The Hong Kong economy is likely headed for recession. GDP growth is forecast by the IMF to decelerate to 2.7% in 2019 from 3.0% in 2018 before accelerating to 3.0% in 2020. GDP rose only 0.5% y/y in Q2, the slowest since Q3 2009 and the fifth straight quarterly deceleration. Note GDP shrank -0.4% q/q in Q2.

With trade tensions persisting and tourism and local activity dampened by the protests, we see clear downside risks to the growth forecasts. Retail sales by volume contracted -13% y/y in July, the weakest reading for this cycle and likely to worsen further. Elsewhere, exports have contracted y/y for nine straight months through July.

Price pressures may be rising. CPI rose 3.3% y/y in both June and July, the highest readings since August 2016. The Hong Kong Monetary Authority (HKMA) does not have an explicit inflation target nor does it run an independent monetary policy due to the HKD peg to USD. The HKMA raised the base rate nine times since December 2015 to 2.75% before cutting it last month to 2.5%, all in lockstep with the Fed.

Hong Kong commercial banks do not always adjust their Prime Lending rates in response to changes in the Bank Rate. Indeed, the Prime rate has been kept pretty much at the 5% trough by the two largest commercial banks despite the 225 bp of Fed tightening seen since December 2015, followed by the 25 bp of easing in July. Hong Kong liquidity remains ample, keeping most local interbank rates low.

The external accounts remain in good shape. Hong Kong has run a current account surplus since 1998. The IMF expects that surplus to be around 3.2% of GDP in 2019 and 3.4% in 2020. Hong Kong runs a large positive Net International Investment Position (NIIP) that’s nearly four times GDP. HKMA foreign reserves stood at a record high $448.5 bln in July. Clearly, Hong Kong has very low external vulnerability across virtually all metrics. This supports our view that any selling pressures on HKD are likely to remain under control.



The withdrawal of the extradition bill has helped boost market sentiment globally. Yet we think this period of calm will be a short one, as protests are likely to continue. If mainland China police forces go into Hong Kong, then all bets are off. That is not our base case and so our investment outlook hinges on some sort of negotiated political settlement occurring. We are hopeful that Lam’s withdrawal of the extradition bill will be followed up by true dialogue between all sides. However, we are not optimistic near-term and we look for a return of tensions.

Markets are breathing a sigh of relief on perceived easing of tensions in three key areas: 1) Brexit, 2) Hong Kong, and 3) US-China trade. None of the underlying issues have been addressed. Rather, all three have seen attempts at can-kicking. We think all three will come back to haunt the markets but this feel-good atmosphere may prevail for a little while. How long is anyone’s guess.

USD/HKD continues to trade near the weak end of the band. Back in July, USD/HKD briefly traded below the 7.80 mid-point. Recent HKD weakness should be seen within the context of overall EM FX weakness. With much of EM likely to come back under greater pressure as well as a likely return of local political risk, we suspect USD/HKD will continue to trade largely within the upper half of the trading band above 7.80.

Back in May and June, local liquidity conditions tightened as the HKMA intervened to support HKD at the weak end of the trading band. Interbank lending rates moved higher, as one would expect under the currency board. As the HKD firmed, local liquidity rose, and interbank rates eased.

Hong Kong equities are underperforming with MSCI World. In 2018, MSCI Hong Kong was -10.8% and compared to -11.6% for MSCI World. So far this year, MSCI Hong Kong is up 5.1% and compares to 16.8% YTD for MSCI World. This underperformance should continue, as our DM Equity model has Hong Kong at an UNDERWEIGHT position.

Hong Kong bonds are in the middle of the DM pack. The yield on 10-year local currency government bonds is -90 bp YTD. This is compares well to the worst performers Japan (-26 bp), Singapore (-37 bp), Norway (-62 bp), and Switzerland (-65 bp) but lags the best performers Greece (-274 bp), Italy (-181 bp), Portugal (-147 bp), and Australia (-135 bp). We see upward pressure on Hong Kong rates ahead, which may lead to bonds underperforming more ahead.

Our latest DM sovereign ratings model update had Hong Kong’s implied rating steady at AAA/Aaa/AAA. This compares to actual ratings of AA+/Aa2/AA+ and so upgrades are warranted.