Going with the flow

Exposure to China is rising but the biggest risk comes from America

IF INVESTORS are worried about the cloud of political uncertainty looming over Hong Kong, they have a curious way of showing it. Over the past five weeks, as a rancorous debate over the city's democratic future spilled onto its streets, there has been a flood of demand for its currency. The territory's de facto central bank, committed to a 31-year-old dollar peg, bought the $9 billion that streamed its way, to prevent the exchange rate from rising.

And then came an intriguing Vladimir Putin effect. Wary of financial sanctions over the Ukraine conflict, Russian companies, including OAO MegaFon, a mobile-phone operator, and Norilsk Nickel, a metals producer, moved some of their cash reserves into Hong Kong dollars—where, they believe, their money will be more insulated from American pressure.

A common thread runs through both the politics and the economics. The uneasy balance that has fuelled Hong Kong's protests is the same thing that has made its financial system so attractive to global businesses and investors: the city boasts deep connections to China within a decidedly non-Chinese framework. Hong Kong is the best place for foreign investors to buy Chinese shares and bonds or lend to Chinese companies. It offers a wider choice of Chinese assets than anywhere else outside the mainland. In Hong Kong, unlike the mainland, investors are protected by a mature legal system and can move money in and out, unimpeded by capital controls.

For Russians keen to dodge sanctions, the Chinese-but-not-Chinese character of Hong Kong is also the big draw. Thanks to its peg, the Hong Kong dollar is a direct substitute for the American one. Yet the Chinese banks at which the Russians deposit their cash are seen as strong enough to resist Washington's lawmakers.

It is certainly not the first time that Hong Kong has had to defend its peg. With the currency allowed to float within a range of HK$7.75-7.85 per US dollar, inflows have regularly tested the strong side of the band in recent years. The Hong Kong Monetary Authority has met the challenge and absorbed the incoming cash. Hedge funds have no appetite for taking it on. Until the yuan is freely convertible, which may not happen for years, the dollar peg looks safe.

Yet this picture of stability is changing as Hong Kong is drawn more closely into China's economic orbit. One-tenth of deposits in its banking system are now denominated in yuan, up from less than 1% five years ago. Loans to Chinese corporate borrowers now account for one-fifth of Hong Kong bank assets, up from 5% in 2007. This change has led some to conclude that the territory's links to China are becoming an economic liability rather than a selling-point. Moody's, a credit-rating agency, has given Hong Kong banks a “negative outlook”—a warning that it may downgrade them. The IMF has warned of spillovers from a Chinese slowdown.

But if Hong Kong has one foot more firmly planted in China than before, it still has the other foot very much in the torrent of global capital flows. It is this non-China side of the picture that is the pressing concern. With its currency peg, Hong Kong has no choice but to import monetary policy set by the Federal Reserve according to America's needs. Five years of exceptionally low interest rates have turbocharged Hong Kong's banks by making it cheaper to borrow the money they go on to lend.

Last year's “taper tantrum”, when investors fretted about a rise in American interest rates, provided a taste of how cash flows into Hong Kong can easily turn to outflows. More than China's growth, Russian sanctions or Hong Kong's own politics, the Federal Reserve will have the biggest hand in shaping Hong Kong's financial fortunes in the coming months.