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Don’t write off Hong Kong as a financial centre just yet

Humans seem able to ignore many great crimes against each other, but woe betide the individual who brings harm to a small, cuddly animal. Hong Kong is astir after the city passed a death sentence on thousands of hamsters, following three human cases of Covid-19 linked to a pet shop, where several of the rodents also tested positive.

Hong Kong’s draconian pursuit of Covid elimination, with three-week quarantines for returning residents, has left the city cut off from the rest of the world. Coming on top of the crackdown on democratic opposition, that isolation has led to real concerns about the city’s survival as a financial centre.

But those who raise such doubts about Hong Kong are mistaken. For hard economic reasons, the future of the Chinese territory, which retains some separation from the mainland under the principle of “one country, two systems”, is more secure than any global rival except for New York. That is because China has capital controls.

China uses a range of quantity-based limits to keep its financial system fenced off from the rest of the world. Chinese citizens, for example, need a permit to exchange more than $50,000 a year into foreign currency. There is enormous pent-up appetite both from mainland Chinese wanting to diversify their savings into international markets, and foreign investors wanting to buy assets in the world’s biggest source of economic growth.

To the extent that either of these demands can be satisfied, it is via Hong Kong, which retains an entirely separate and fully convertible currency pegged to the US dollar. A series of so-called Connect schemes in the city allow foreigners to access Chinese markets and Chinese investors to place money abroad. With Chinese companies no longer welcome on US stock markets, the Hong Kong exchange is the natural venue for them to seek international capital.

It is a phenomenal, structural source of financial business, with few parallels anywhere in the world. As the de facto capital of global finance and home of its reserve currency, New York has a similar structural power. But almost every other financial centre must survive on its merits. London is in some ways the inverse of Hong Kong: whereas the EU is out to displace the UK capital as Europe’s financial centre, officials in Beijing are sending ever more business Hong Kong’s way.

All this could change if China dropped its capital controls and made the renminbi fully convertible. But that day is still a long way off. The classic trilemma of international finance says you must choose two from an independent monetary policy, a controlled exchange rate and the free movement of capital. You cannot have all three.

Independent monetary policy is indispensable to manage an economy of China’s size. The choice, then, is a dilemma: drop controls and risk periods of disorderly capital flight, as began to happen during the mini-crash of the Shanghai stock market in 2015, or keep a tight grip on the exchange rate with controls in place. China is likely to liberalise its capital account slowly, to Hong Kong’s benefit. But to surrender all control will go against every instinct of the Beijing government.

What happens if capital controls do go? Until it returns fully to Chinese control in 2047, Hong Kong will still have other advantages, such as low tax rates, critical mass and decades of legal expertise. Economic geography is remarkably durable and the legacy of 200 years as a trading centre will not die easily. Most cities that are financial centres today were financial centres a century ago. It takes a lot to destroy one.

None of this implies Hong Kong must be as pleasant or vibrant as it was in the past. Without freedom, it is hard to innovate. Banks may well choose to park their traders somewhere else and if senior management think there is legal risk then they will follow. In any undemocratic jurisdiction, there is the risk of a descent into outright gangsterism, if those in power are corrupt or erode the rule of law. Certainty of contract and ownership is the foundation of capitalism. Its loss would be the death knell for any financial centre.

For the foreseeable future, however, people who want to move capital into and out of China are likely to find themselves doing so in Hong Kong. The Covid-19 quarantines are oppressive, but when they do eventually end, the foreign bankers will find that China is still where all the money is. The Hong Kong government could graduate from hamsters to golden retriever puppies and it would not make much difference. Money flows. And China’s money will flow through Hong Kong.

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