The new Cold War: China’s crackdown on Hong Kong

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Markets are efficient. But they have a habit of having too much faith in the status quo. The idea that Hong Kong could remain a democracy under the ownership of China, for example, was always a stretch. Now China has made its most explicit challenge to the status quo yet.

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And while the immediate effects have been mostly felt in Hong Kong’s markets, the potential ramifications are a lot wider.

China’s new plans for Hong Kong

China plans to write a new national security law into Hong Kong’s constitution. This will bypass the territory’s Legislative Council. So it’s imposed directly by Beijing.

According to Bloomberg’s summing up of local media reports, “the regulation would curb secession, sedition, foreign interference and terrorism in the former British colony”. So not even pretending to be a democracy then.

The long and the short of it is that, as Bill Bishop of the Sinocism newsletter puts it: “this move affirms that Hong Kong as we knew it is gone and rule of law is now rule by law, with the Chinese Communist Party determining what the laws are and how they will be enforced”.

Clearly this has been coming for a while. Last year, before the Covid-19 outbreak, Hong Kong was the centre of massive pro-democracy protests, which came about partly as a result of attempts to pass an extradition bill which “would have allowed criminal suspects to be transferred to mainland China for the first time”, as the FT put it.

That bill was cancelled as a result of the protests but clearly, and despite the promises of Hong Kong’s chief executive Carrie Lam, it was only a matter of time before Beijing decided to press the issue. And it seems that the chaos of coronavirus looked like a good opportunity.

Obviously, if you have direct investments in property, or relatives in Hong Kong, then this is more directly concerning. But for the purposes of today’s email, I’m going to assume that the majority of our readers have relatively little direct exposure.

So what does it mean for the rest of us?

Hong Kong is a big financial centre of course. Indeed, it was this particular strength that made lots of people assume (against all lessons of history) that China wouldn’t mess about too much with the system, so as to preserve its status.

But when I’ve spoken to investors who specialise in that region, a lot of them make the point that Hong Kong is nowhere near as important as it once was.

The real issue is that this is another, more assertive step in the Cold War between China and the US, and odds are it’s only going to get worse from here.

The biggest risk of all

We keep hearing about “the Thucydides trap”. You don’t need to know anything about classic Greek to get the point: if you have an incumbent power, and a rising power, they’re almost certain to go to war because the incentives all lead them in that direction.

The risk is that this is the path that the US and China are on. Both countries’ economies are going to take a hit from the coronavirus. That means their leaders both need distractions for their populations.

It’s election year in the US. Talking about China as a threat has been seen as a vote winner for quite a few election cycles now (for both Republicans and Democrats, to be clear) and I can see Donald Trump making it a key part of his re-election campaign.

As for China – if you run a dictatorship then you need to keep your people either pacified by a rising standard of living, or angry at someone other than you. When China’s growth was soaring, the former option worked. Now that it’s not – and now that the country also feels it has wrung most of the benefits out of globalisation – the latter option looks a better bet.

I don’t know any more about this than you do, and Lord knows I hope it doesn’t come to an actual “hot” war. But it’s clear that there are tensions everywhere: from trade to technology to territory (the South China Sea is only going to get ever more crowded).

If you’re looking for just one indicator to keep an eye on, I think it’s probably the yuan-dollar exchange rate. I look at this every weekend in Saturday’s Money Morning, but here’s a quick snapshot.

In the chart above, when the line rises, the yuan is getting weaker. The red line is at ¥7 to the dollar. That was widely viewed as a “line in the sand” by traders, right up until China allowed the yuan to cross it about nine months ago.

A weakening yuan would be a trade war tool for China (weaker currency means more export demand) and it would also be potentially deflationary for the world in general. So a weakening yuan is one indicator that US-China tensions are getting worse.

As you can see, the yuan has been getting weaker in recent weeks (ie, the black line is rising). I’ll keep an eye out for more useful indicators, but this is certainly one to watch.

Meanwhile, as always, stick to your plan. This is just yet another long-running theme that Covid-19 has accelerated, rather than transformed.

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