Happy New Year.

Hong Kong as a Financial Capital

Due to the disproportionate coverage of the current social disruption in Hong Kong being the tip of the iceberg for cooling U.S.-China relations, investors are curious about what this means in terms of China as an investable market. As well, our readers are curious to know about what this entails for Hong Kong as an investment banking hub.

Hong Kong is probably the 3^rd most important financial centre in the world after New York and London – primarily owing to its role as a conduit for capital raising for Chinese companies. China is already the largest economy in the world when measured by GDP on a purchasing power parity basis and is second to the U.S. on a nominal US$ basis.

China will probably overtake the U.S. on a nominal basis some time this decade – all the while, Chinese corporates both State Owned Enterprises and private firms will become more and more relevant on the global stage.

Financial markets will grow along with the economy, and in theory, China’s financial capital, Hong Kong, should in theory end up becoming the most important financial capital in the world.

As with any other financial capital, the middlemen are investment banks. Hong Kong currently has one of the largest banker populations on the planet, and one of the worst reputations.

Does the recent protest activity change any of this?

The short answer is – No. However, the Hong Kong financial centre that ends up spearheading China’s capital markets push may look very different from what it is at current and certainly very different from what it looked like 10 years ago.

Brief Backgrounder on the Hong Kong Protests

A Hong Kong man flew to Taiwan with his girlfriend and killed her. He flew back to Hong Kong before he could be arrested. Hong Kong and Taiwan do not have an extradition agreement, and therefore he could not be arrested and be sent to face justice in Taiwan.

As fallout, Chinese nationals can no longer watch the Houston Rockets (that easily). This is the butterfly effect.

In between these two events, Hong Kong’s autonomous government tabled an extradition bill that included the separately administered People’s Republic of China as a counterparty. Fears of extrajudicial deportation spread and resulted in widespread protests with participants across the social spectrum.

During the last few months, the protests have morphed into large scale riots and violence while the original bill is largely forgotten – protestors have demands that include the release of all arrested during the protests, universal suffrage, an independent inquiry on police brutality and occasionally include dissolution of law enforcement altogether.

Hong Kong has now split into two primary camps – one wing that represents the will of the protestors and their radical faction, and another group that rejects their demands and would like a return on the status quo. This is obviously an oversimplification of a complex and extremely stratified city.

The protests are not over – when a society is so polarized there needs to be either a strategic de-escalation or a decisive result. The current détente cannot last because none of the underlying problems have been addressed.

Which side is morally right? The answer is it does not matter – virtue signalling helps no one and is not constructive in making a career or investment decision, and it is impossible to look at a complicated issue as a black and white judgment.

Aftermath of the Hong Kong Protests

What is relevant is looking at what hand each player holds in a political poker game.

There are four parties to this game and a few outside observers (who depending on who you ask, may want to interfere).

1. The protestors
2. The part of society that is opposed
3. The autonomous government
4. The Chinese government

The only party that really has a say is the Chinese government because they have the political power. Political power grows from the barrel of a gun. For right or for wrong, they see the protests as a thinly veiled sedition and secession movement. Accordingly, they will not allow the autonomous (or autonomous within limits) government to accede to certain demands. Ultimately it does not matter what the other groups think, but it may be beneficial for the Central government to let the other parties feel like they are part of the decision making process.

However, the latitude they have in choosing to react is wide. The central government has, other than making hawkish noise, let Hong Kong govern itself. Any changes they make to address the issue will take place outside of Hong Kong.

As such, within Hong Kong, the ball falls in the court of the autonomous government.

If the situation becomes more violent and unstable, they may choose to accelerate the promotion of Shanghai and Shenzhen as financial capitals instead of Hong Kong. Hong Kong is still necessary today because of established legal systems and the enforceability of rule of law and high level of trust in business dealings.

They may apply the same legal frameworks in Shenzhen with some changes plus a loosening of capital controls in the city to make a de facto Hong Kong.

Macau’s financial industry has been promoted as another way to not put all of China’s financial eggs in one basket – it is now being designated a bond trading hub, a start-up hub as well as a Portuguese version of Dubai (for Brazilian, Portuguese, Angolan and other markets).

Hong Kong Protests and Capital Markets Activity

There is a popular theory where China is willing to let Hong Kong burn to the ground to highlight the hypocrisy and selective reporting of CNN, BBC, The New York Times and other western media and as a warning about the dangers of populism and mob rule. However, they have already won this PR campaign for their internal audience – Hong Kong is still a great capital markets platform.

And as such, Hong Kong will continue to be a leading financial centre, because Hong Kong’s financial market does not reflect Hong Kong – it reflects Chinese equities and Chinese fixed income. The Hong Kong conglomerates that have controlled the city for so long, both local and otherwise have long seen their market weight on traded indices shrink. Trading volume will continue to increase, driven by Mainland China H-Shares.

Hong Kong’s domestic economy is too small to have any real representation and its influence on the broader indices will continue to fall. There will accordingly be a decoupling where Hong Kong may be in a serious recession and experience severe economic decline while its markets boom. Looking at the recent market weighting, the Hang Seng index is dominated by Tencent and large State Owned Enterprises. Tencent dwarfs everything else out there.

Of the historically powerful conglomerates, more and more of their revenues and cash flow growth is attributable to Mainland or international operations. With the recent IPO of Alibaba on HK markets, the stock being fully exchangeable with the NYSE listed version, once BABA or SEHK: 9988 is included in relevant indices, this trend will become much more prominent.

So long as current trading multiples are not too high and Chinese GDP continues to grow at 6% per year, the index should rise while the Hong Kong economy falls.

Investment banking activity will continue to grow (although not M&A, revenues will be driven in the foreseeable future by equity and bond issuance, structured and project finance and corporate banking). Chinese M&A is muted owing to national security concerns in regards to outbound and inbound M&A (for example the U.S. government may block technologically or politically sensitive acquisitions) while the Chinese government has looked to shift spending and expansion inwards and keep capital flight down.

However, Hong Kong’s economy is in recession and we believe it will continue to see stagnant growth until the social unrest abates – which may take a long time. Hong Kong used to be a Mainland Chinese tourism hotspot owing to tax free shopping.

Especially for large ticket items such as an Hermes handbag, the lack of value-added tax can be substantial. This also applies to large volumes of small ticket items, making parallel trading attractive. Localists have made the city unwelcome for this class of tourists and year-over-year tourist figures have fallen ¬60% while protest violence has massively reduced foot traffic in entertainment and retail venues. Concerts have been cancelled en masse and tenants are widely asking for rent relief.

Investment Banking Jobs in Hong Kong in 2020

There is currently a slowdown in China as GDP growth slows and the exuberance pertaining to valuations especially in technology companies (China is not immune to WeWork syndrome) pares back.

Various headhunter friends have disclosed that hiring is severely more limited. Headquarters are looking to freeze hiring until they have more clarity while considering downsizing or even moving regional headquarters away to Shenzhen or Singapore. This, compounded with weak M&A and capital markets activity, means that it is difficult to score a job at this moment.

Additionally, potential expat hires are not attracted to moving to Hong Kong due to the uncertainty of the social situation as well as asymmetrical risk in regards to a further escalation of tensions.