Last month, China announced plans to enact a new national security law in Hong Kong, giving Beijing broad, new powers over civil liberties in the special administrative region. Soon after, the United States vowed to strip the semi autonomous region of its special status.

Hong Kong’s financial markets hardly flinched. 

Share prices on the Hong Kong Stock Exchange actually climbed modestly, after dipping sharply immediately after Beijing’s announcement. And the city’s banking system continues to process billions of dollars in transactions each day, a sign that few investors believe the new law poses a serious threat to Hong Kong’s position in the region. 

But what investors fail to understand is that once that new law goes into effect, there’s a high likelihood that it will fundamentally alter Hong Kong’s banking system, shifting power from the local officials in a system that prides itself on the rule of law over to China’s powerful state security apparatus, which operates without any checks outside of the Chinese Communist Party.

With that authority, Beijing will be able to intervene in a wide range of banking transactions in Hong Kong, including stock and bond deals. And by invoking national security, China could seize assets, freeze bank accounts and direct the courts to side with its decisions. Before long, the frictionless transactions that have made Hong Kong one of the world’s preeminent financial centers may well come to an end. 

By invoking national security, China could seize assets, freeze bank accounts and direct the courts to side with its decisions.

To understand what is at stake in Hong Kong, consider this: China has used Hong Kong’s system to raise trillions of dollars in assets from offshore lenders over the past two decades. This has made it possible for China’s state banks and private enterprises in the world’s fastest growing major economy to raise huge sums of money — in dollars, euros and other currencies — while adhering to Beijing’s strict capital controls on money flows and helping Beijing keep the value of the Renminbi relatively stable.

How has Hong Kong been able to do this? 

First, Hong Kong has a global payment and clearance system, the Hong Kong Interbank Clearance Limited (HKICL), which can send and receive dollar denominated payments from the world’s largest banks. This means that member banks, including major state-owned banks in China, can directly and instantaneously receive foreign currency from global counterparties. Although China’s Central Bank has tried to develop its own global payment system, China actually does not need one because it already has a successful one in Hong Kong.

Using the Central Moneymarkets Unit (CMU), Hong Kong’s interbank market, Chinese member banks and even the securities regulator in China can directly borrow funds from foreign and Hong Kong banks via direct interbank borrowing or through the issuance of foreign currency denominated bonds. Besides the convenience, international investors, including Chinese investors with offshore accounts, take comfort in the ease in unwinding securities purchased in Hong Kong, along with the protections afforded by the Hong Kong courts, which have a reputation for protecting the rights of creditors. 

Institutions in mainland China have been huge beneficiaries of the system, borrowing hundreds of billions of dollars through Hong Kong’s interbank market, according to the Bank for International Settlement. They also raise huge amounts of capital through international bond issuance by Chinese and Hong Kong financial institutions, which is mainly done in Hong Kong. In other words, without the Hong Kong banking system’s direct connections with the rest of the world, China would have had a much more difficult time borrowing the roughly $2.7 trillion that it owed the rest of the world at the end of 2019.  

As China and the Hong Kong governments implement the new national security provisions in Hong Kong, how might they affect Hong Kong’s financial system? On the surface, not much will change. What special status Hong Kong was granted by the U.S. mainly pertains to trade, tourist visas, and technology transfer. Foreign banks participate in Hong Kong’s payment system and the CMU voluntarily in order to facilitate business activities in Hong Kong. An American decision to end special treatment of Hong Kong should not affect it.

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And even if U.S. banks were to pull out of Hong Kong’s payment system or the CMU, European, Japanese, Korean, and banks from the Middle East may well remain and lend to Chinese institutions with funds they raise domestically or from the other global money markets. Again, the enticement of profit provides a compelling reason for the current participants in the Hong Kong interbank market to stay put. 

But over the next year or two, investors may come to realize that the institutions governing Hong Kong’s financial system are being fundamentally altered, which will likely affect the liquidity and risk profile of banking in the former colony. Both the clearance system and the CMU are governed by the Hong Kong Monetary Authority, which is answerable to Hong Kong’s Financial Secretary. The ultimate guarantee of this monetary system comes from Hong Kong’s separate administration from mainland China, as stated in the Basic Law. Similar to protests on Hong Kong’s streets, the lack of executive agencies in Hong Kong has prevented forceful interventions by the Chinese government. Up to this point, even if mainland agencies had wanted to intervene in Hong Kong’s financial markets, they currently have no direct means of doing so and must indirectly pressure regulators in Hong Kong.

The new national security law, however, provides the means for the Chinese government to directly intervene in the financial markets of Hong Kong.  

How? First, the new law calls for “the establishment of organizations in the Hong Kong SAR by relevant national security related agencies of the Central People’s Government according to the needs.” In essence, multiple agencies with plenipotentiary powers will be established in Hong Kong, whose authorities will supersede those of the Hong Kong SAR government and the city’s monetary authority. Furthermore, the new National People’s Congress law empowers mainland security agencies to “carry out duties according to the law to safeguard national security.”  

What investors may not realize is that the People’s Republic of China’s national security law defines financial security and stability as key components of national security and compels every person and organization in China to “provide all necessary support and help to national security, public security and relevant military organs.” With the formation of mainland Chinese security agencies in Hong Kong, Hong Kong’s banking system will no longer only be required to comply with the regulatory demands of the HKMA.  Mainland security agencies will also be empowered to intervene in any financial institution in Hong Kong, including the payment system and the CMU, as long as there is a national security justification. In essence, the banking system will have to answer to multiple agencies instead of just one. 

Of course, when the financial market is functioning well, these agencies may see no reason to intervene much. But in times of economic stress, they could be compelled for national security reasons to curtail or stop outward payments in the HKICL, thus freezing trillions of dollars in investors’ assets in Hong Kong. In theory, they might also have the power to order market participants to stop selling securities, or to buy securities or lend funds, as long as these actions are necessary for the safeguard of national security.

The potential power of these new agencies will fundamentally alter the bedrock of the Hong Kong banking system and potentially deprive investors of their freedom to allocate funds as they see fit. For that reason, Hong Kong is facing an entirely new future.

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