How would a China crisis affect Hong Kong?

Bryane Michael April 28, 2015 10:15

By many estimates, China has more than a 50 percent chance of experiencing a banking crisis and sharp economic contraction in the next five years.

What effect will such a crisis have on Hong Kong’s economy?

In a series of working papers I have contributed to over the years, I set out to answer that question.

Drawing on International Monetary Fund, Hong Kong Monetary Authority and other sources, I find significant effects coming via the banking sector and the real estate sector.

Hong Kong’s banking system remains very exposed to the mainland.

According to recent estimates, if a crisis happened in China tomorrow and its economy contracted, the deposits in Hong Kong’s financial system relative to gross domestic product would fall to Japanese levels.

A severe crisis could result in up to a 5 percent loss on loan portfolios in Hong Kong.

Default on mainland local government loans would cause earnings declines in Hong Kong of up to 30 percent.

A corporate crisis in the mainland would cause a 15 percent drop in the Hang Sang Index, while a banking crisis would cause roughly a 5 percent drop.

A severe mainland recession would cause the loss of more than 10,000 jobs in Hong Kong's financial sector.

How remote is such a possibility?

Everyone sees reports in the media about China’s “debt mountain” (280 percent of GDP) and the US$1 trillion in local government loans – many of questionable quality.

But the media rarely seizes on three other facts.

First, we know that “special mention loans” have grown quickly, mostly as a replacement for the label “non-performing loans”.

Second, China could enter into a full recession when local-debt-to-GDP ratios reach 72 percent (they are about 30 percent now).

Third, a real estate slowdown would double the number of companies across many sectors reporting negative earnings (that is, losing money).

The Shanghai Stock Exchange would also lose 10 percent of its value (with newfound repercussions in Hong Kong thanks to the Stock Connect program).

What can Hong Kong do to protect itself from spillover effects from a mainland crisis?

I have been marginally involved in reports highlighting a number of things the government can do.

First, we can reform our regulators to make detecting such a crisis easier.

Second, we can expand our integration into the wider region covered by the Association of Southeast Asian Nations.

Once our stockbrokers and bankers have access to the Indonesian, Malaysian and Philippine markets, they will have far less vulnerability to the mainland.

Third, I have argued for an association to help coordinate shareholders and more institutional oversight over family-owned firms where ownership is highly concentrated.

Such corporate governance activity should help defragilize Hong Kong.

Fourth, we can encourage regulators to make markets deeper – by setting up a “euroyuan” zone and providing for the clearing mechanisms needed to make Hong Kong banks excellent interbank lenders for the mainland.

If it worked for New York and London, it can work for us, too.

That being said, everything will probably be OK for Hong Kong, which boasts some of the most prudent banking and securities regulation among upper-income jurisdictions.

But shouldn’t we have a Plan B – just in case China faces a Lehman Brothers-style crisis?

Opinions expressed here are the author's and do not necessarily reflect those of the institutions to which the writer is affiliated or co-authors he has published with.

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Bryane Michael

The writer is a fellow at the Asian Institute for International Financial Law and formerly held posts at the World Bank, OECD, and Columbia University.