Market Views: Could Hong Kong be a black swan event?

Aug 14, 2019

If the Hong Kong crisis escalates and Beijing intervenes, what would the repercussions be?

Market Views: Could Hong Kong be a black swan event?

In some parts of the world, black swans are actually quite common – for example, in southern Australia. But in the investment world they are a metaphor for a rare and potentially cataclysmic global financial event – such as the US housing crisis that triggered the global financial crisis of 2008.

Could the troubles that have flared up in recent months in Hong Kong – historically one of the world's most stable places – turn out to be such a Black Swan event?

It's very difficult to tell. What's clear though is that, with China's leaders holed up for the time being at their annual Beidaihe seaside break, the Hong Kong crisis remains unfinished business.

So with market nerves already fraying due to the creeping prospect of a global recession, Hong Kong finds itself in the eye of the storm, overshadowing even Brexit.

So what happens next, given the Chinese slowdown we're already seeing as the US-China trade dispute drags on and the shadow of Tiananmen Square that is cast over the city as Beijing mulls whether to intervene?

And given China's importance to the global economy and Hong Kong's importance as a global financial centre, what might the knock-on effects be?

AsianInvestor asked several investment experts, both on the buyside and on the sellside, for their views on the current situation. Their responses follow below.

The following extracts have been edited for brevity and clarity.

Alicia García Herrero, chief economist for Asia Pacific

Natixis, Hong Kong

An escalation in Hong Kong could result in economic recession and an attack on the currency board of the city.

Alicia García Herrero

There are already hedge funds betting against the Hong Kong dollar by selling the currency and changing it to US dollars, she said. However, these greenback deposits are susceptible to be withdrawn from Hong Kong because of a lack of capital controls as most are owned by offshore investors.

If Hong Kong does impose capital controls to control these deposits, the city will lose its relevance as an offshore centre.

Hong Kong’s foreign exchange reserves of $448.5 billion at the end of July only cover a small amount of the city's more-than-$3 trillion in deposits, [representing some] 850% of its GDP. That could leave in a day. Iceland is the only other country with that level of deposits.

The offshore bond market is also very large and it could easily dry out if there is no demand from foreign investors to buy paper from the Hong Kong market, especially from Chinese corporates.

Hong Kong is also a large IPO market for China. Chinese companies will also have a harder time finding US dollar financing from Hong Kong’s US dollar bond market.

Kit Juckes, macro strategist

Société Générale, London

The black swan event would be if what markets see as a domestic argument that has limited wider economic or geopolitical impact, started to significantly affect global diplomatic relations.

So far, the protests have been no more violent than, say, the Gilets Jaunes protests in France, which have also had little wider economic or political impact. A significant escalation would be needed before markets more broadly started to worry.

Trade wars, slowing global growth and a downturn in corporate earnings growth dwarf localised politics as a market driver, so far. That’s partly because the former issues have, globally, more economic significance as long as major escalation is avoided in Hong Kong.

Brock Silvers, managing director

Kaiyuan Capital, Hong Kong

Hong Kong’s economy is problematic, being buffeted by a deep and persistent Chinese slowdown, worsening trade situation, and wobbly real estate market. Hong Kong’s recent unrest only worsens matters and perhaps with devastating effect.

Brock Silvers

Increasing levels of violence and the disruption of crucial infrastructure are inviting a dramatic response from Beijing. Overt military action remains unlikely, as it would devastate Hong Kong’s economy and risk Hong Kong’s raison d’etre – its global “special status” ... But even under more likely circumstances, the failed extradition law and the resulting social unrest have significantly impacted Hong Kong’s attractiveness as a regional financial and trading hub.

Capital seeks stability and a time when the US is strongly encouraging supply-chain relocation away from China, Hong Kong is adding new urgency to those efforts. Over the medium term, it’s hard to see a Hong Kong resolution that doesn’t favour other Southeast Asian economies, particularly Singapore and Vietnam.

And in the short-term, with faltering global growth and a newly inverted US yield curve, Hong Kong is further increasing global recessionary risks.

Michael Every, Asia-Pacific head of financial markets research
Rabobank, Hong Kong

Michael Every

China has been pushed into a corner. It is just trying to decide how it responds – and when it does it will go hard. Let’s see what happens when President Xi Jinping re-emerges from Beidaihe.

Protests in Hong Kong and a possible hard reaction from Beijing could risk US and Western sanctions and action on China's access to the US dollar through Hong Kong.

This could have a huge spillover effects on debt repayments (for Chinese companies) and Chinese access to foreign currency for imports and other requirements.

Global markets could be threatened by a further slump in equities, a tumble in bond yields into negative territory, and the risk of a real collapse in the Chinese renminbi and subsequently other emerging market currencies. They are all too real a threat.

Paul Sandhu, head multi assets quant solutions for Asia Pacific

BNP Paribas Asset Management, Hong Kong

Paul Sandhu

The US-China trade negotiations have definitely put an extra layer of risk on the global market resulting in increased volatility starting in the latter half of last year. Added to that, the recent turmoil in Hong Kong has put investors in Asia in a cautious stance.

A very direct result of this investor anxiousness is the rise in gold price beginning almost simultaneously with the persistent return of volatility in the equity market in the third quarter of 2018.

It is important to note that this effect may seem to imply that gold is a volatility hedge, but more precisely it is a hedge against an anticipated bear market. As volatility continues to return to the equity markets and with further turbulence in the geopolitical landscape, I see both equity volatility on the rise and lower-volatility asset classes such as developed market bonds and real assets such as gold being a defensive position for many investors.

Positioning portfolios to lower correlated asset classes and defending against downside risk using hedge strategies is going to be key to navigating the market turbulence ahead.

Iris Pang, economist for Greater China

ING, Hong Kong

Iris Pang

The worst-case scenario is that protest activities last long enough to deplete economic activities. For now ... the damages are around one-fifth [of what was incurred at] the time of the 2003 SARS epidemic.

If the protests last longer, are more frequent and more violent, then it will come closer to the damages done by SARS in Hong Kong (when nominal GDP fell by 2.0%).

The peg of the Hong Kong dollar to the US dollar will continue to be here until 2047 as this is written in the basic law (constitution).

The Hong Kong Monetary Authority is expected to defend the peg in normal times but especially in bad times ... This will keep at least the financial system stable.

Philip York, managing director

Alt 224 Group, Hong Kong

If Chinese troops enter Hong Kong then the Hong Kong economy will collapse, as much of it is based on the sanctity of the 'one nation, two systems' policy ... [But] it is highly unlikely that China would mobilise major forces because the Chinese government understands the need for Hong Kong to stay independent as many Hong Kong businesses control significant resources in China.

Also, any escalation of the conflict by the authorities is not only going to strengthen the resolve of the protesters but increase dissent against China globally. After the backlash from the Tienanmen Square incidents, the Chinese Government are ... likely to focus on threats more than action.

How should investors respond? Unlike casino games where every turn is independent, market panic as with greed tends to feed on itself and cause volatility to quickly escalate. Downside moves in financials are especially prone to this kind of panic that can just as quickly reverse, so unless you are adept at short-term trading the best alternatives are either to ride it out or make a strategic long-term decision to allocate more to elsewhere in the region ...

A significant portion of investors are reducing exposure as indicated by the recent decline in the Hang Seng Index. That aside, the Hang Seng Index still looks bullish in the long-term and with the West plague with a sovereign debt crisis we appear to be lining up for massive capital flow into Asia once the rally in the US dollar finally runs out of steam in the coming years.