On June 30, Beijing imposed a harsh new security law to ostensibly prevent sedition, collusion with foreign powers and terrorism in the territory. But its 66 articles carry far deeper implications for Hong Kong.
Western governments and rights groups say the law represents a de facto dismantling of the "one country, two systems" formula, which is supposed to keep Hong Kong largely autonomous until at least 2047 and has underpinned the city's role as one of the world's major financial centers.
Some businesses are also reassessing their presence in the territory. "There are already indications that some are voluntarily withdrawing from Hong Kong," Heribert Dieter, an expert at the Berlin-based German Institute for International and Security Affairs (SWP), told DW. He pointed to the imminent relocation of the office of the Asian head of Deutsche Bank from Hong Kong to Singapore as an indication of how businesses could adapt to the new situation.
Hong Kong activists at a loss
Fears abound about the new powers under the law of surveillance, the freezing of assets and demands for information. The decline of free speech may also hit the efficiency of the city's financial market. "Bank employees and financial analysts who evaluate the Chinese economy run the risk of being accused of subversive activities and, in the worst case, of being sent to prison," Dieter said.
"At the moment, it is not yet clear how exactly the government will enforce this, but the law allows for it."
Key finance gateway
Political tensions and protests, in addition to the damage wrought by the coronavirus pandemic, have taken a toll on the city's economy, with GDP in the second quarter contracting by as much as 9% from a year. It was the fourth consecutive quarter of contraction for the economy. The health emergency weighed heavily on consumer spending, trade and tourism in the financial hub.
Hong Kong is one of the world's most important financial centers, second only to New York and London in terms of global significance. The territory boasts over 150 licensed banks and more than 1,600 asset managers as well as associated professional services.
Although Hong Kong accounts for less than 3% of entire China's gross domestic product (GDP), the territory is the nation's most important offshore fundraising location.
Despite the growing significance of places like Shanghai and Shenzhen as China's financial centers, Hong Kong remains a key gateway connecting mainland China with global financial markets.
It is a leading offshore center for both US dollar and renminbi funding. Chinese businesses, including tech giants and state-owned firms, have often turned to the city's capital markets to raise funds through IPOs, loans or bonds.
"Hong Kong is the only financial center in the People's Republic of China that has no restrictions on the movement of capital," Dieter said.
Besides any lack of capital controls, Hong Kong owes its status as a flourishing financial hub to a number of other factors, like the region's rule of law, independent judiciary, relatively low taxes as well as huge concentration of financial and legal service providers.
Hong Kong is also attractive as a financial center because the currency there, the Hong Kong dollar, is more or less firmly pegged to the US dollar, Dieter said, noting that this means that "there is almost no exchange rate risk" for companies and financial market players. "A changeover to yuan [China's currency] would make everything more difficult and more expensive."
Decoupling from the rest of the world?
Mainland China has extensive capital controls and often intervenes in its financial system, while Hong Kong has one of the most open economies in the world and a big market for equity and debt financing. As a result, international firms often use Hong Kong as a base to expand into mainland China.
China also uses Hong Kong's financial markets to attract foreign funds. "Chinese companies are by far the most important USD issuers in the Hong Kong offshore market, so most of Hong Kong's external debt is actually debt from Chinese subsidiaries operating from Hong Kong," chief economist for Asia-Pacific at Natixis, an investment bank, and a senior research fellow at Bruegel, told DW.
"Having access to USD financing is key for China to continue to buy foreign companies without hard currency financing constraints," she added.
Given the city's enormous importance as a financial hub, even for Beijing, many analysts in the West appear perplexed by the Chinese government's actions toward Hong Kong.
"I am thinking about it a great deal," said Dieter. "Why is the government in Beijing currently prepared to seek conflict with almost all players? These range from Australia, India, the United States and the European Union.
"It only makes sense if we assume that the central strategy of the Communist Party is to decouple China from the rest of the world," the expert noted, stressing that "it is only a supposition and there is no document that proves it."
Hong Kongers flee to Taiwan
Forcing EU's hand
Beijing's Hong Kong moves have also compelled the EU to act, with the bloc deciding to limit tech exports to Hong Kong that may be used for repression or surveillance.
Expressing "grave concern," the 27 EU states recently agreed to a series of sanctions, including trade curbs and a review of visa agreements with the territory.
But observers like Dieter say the EU remains hesitant to take strong action against Beijing, partly because of divisions within the bloc that prevent a joint foreign policy response.
Germany, for instance, exports more goods to China than the next eight EU countries combined, so Chancellor Angela Merkel has always sought close cooperation with Beijing and she has been restrained in her criticism of the Chinese leadership, Dieter pointed out.
"But given Germany's history, I believe it's important that we do not chum up to dictatorships," he said. "We should state clearly that this is a breach of international law, and we should also consider sanctions against China."