[Hong Kong ELS Compensation] Sinicized Hong Kong... Concerns Over 'Financial Instability' Emerge

Hong Kong Stock Market Fell 15% Last Year, Continues to Decline Nearly 5% This Year
China's Establishment of Real Control System Increases Influence on Both Finance and Real Economy
Growing Concerns Over China's Economy Urge Cautious Investment

The Financial Supervisory Service has announced compensation standards related to losses from Hong Kong ELS (Equity-Linked Securities), amid analyses suggesting that financial instability in Hong Kong could worsen. As the economic linkage between Hong Kong and China deepens, the economic slowdown in China is rapidly transmitting to Hong Kong, prompting calls for caution in future investments in both China and Hong Kong.

According to the International Finance Center on the 11th, the Hong Kong Hang Seng Index fell by 15% last year alone, and is currently experiencing a decline close to 5% this year as well. This contrasts with the rising stock markets in major countries worldwide, including the United States and Japan, since the beginning of this year.

Continued Decline of Hang Seng Index Amid Deepening Sinicization of Hong Kong

[Image source=Reuters Yonhap News]

The Center identified the Sinicization of Hong Kong as the primary reason for the decline in Hong Kong’s stock market. Following the enactment of the National Security Law in 2020, which banned anti-China activities and established China’s de facto control, the number of Chinese companies in Hong Kong surged, expanding China’s influence in both finance and the real economy.

The proportion of Chinese companies in Hong Kong’s total market capitalization rose from 57% in 2018 to 78% last year, while the share of Chinese direct investment in Hong Kong increased from 66% in 2020 to 83% in 2022. In 2022, the number of company headquarters located in Hong Kong from China (251) surpassed those from the United States (240) for the first time ever.

Kim Kibong, Senior Researcher at the International Finance Center, explained, "As China’s influence grows in Hong Kong, China’s economic slowdown is rapidly spreading to Hong Kong."

Another cause of the Hong Kong stock market decline is the significant reduction in foreign capital inflows, due to the fallout from US-China disputes, including the US ending special treatment on tariffs and immigration for Hong Kong, and rising anti-China sentiment.

With the US tightening regulations on China, companies headquartered in Hong Kong face restrictions on supplying sensitive technology products. As Hong Kong’s investment appeal diminishes, net foreign equity inflows plummeted from $5.1 billion in 2022 to $300 million in the first nine months of last year.

The sluggish real economy in Hong Kong is also a factor behind the stock market downturn. Hong Kong’s exports have declined and consumption remains weak, resulting in an average growth rate of -0.4% over five years from 2019 to 2023, ranking lowest among Asian countries. In particular, the real estate sector, which accounts for 30% of government revenue, has fallen 20% from its peak, with transaction volumes sharply decreasing, reflecting a weak market.

[Image source=Reuters Yonhap News]

The Bank of Korea also expressed concerns about Hong Kong’s fiscal situation. According to the Bank’s representative in Hong Kong, last year’s fiscal deficit reached HKD 173 billion (KRW 29.2 trillion), equivalent to 5.8% of GDP. Due to the ongoing deficit, Hong Kong’s Fiscal Reserves have dropped from about 200% of annual government expenditure to the 100% range, and government bonds, which were rarely issued before COVID-19, have recently been issued in amounts of around HKD 60 to 70 billion.

Kim Mingyu, the Bank of Korea’s representative in Hong Kong, stated, "The Hong Kong government expects a significant reduction in the fiscal deficit going forward, but uncertainties remain due to changing domestic and external conditions. High interest rates in Hong Kong are expected to persist for some time, and domestic demand is likely to remain weak due to the impact of China’s economy, which may limit tax revenue growth from economic recovery."

On the 19th of last month, investors in Hong Kong H Index (Hang Seng China Enterprises Index) equity-linked securities (ELS) are urging for compensation for damages in front of the Financial Supervisory Service in Yeouido, Yeongdeungpo-gu, Seoul.
[Image source=Yonhap News]

Economic Slowdown Amid Rising Money Supply and Declining Foreign Reserves... Concerns Over Financial Instability

While Hong Kong’s role as China’s external financial gateway is growing, warnings have emerged that financial instability could occur as its function as an international financial hub diminishes.

The Center forecasts that Hong Kong’s status as an international financial center has been overtaken by Singapore since September 2022, and that its roles in trade and logistics will weaken compared to the past. The Chinese government’s development of inland cities as alternative hubs is gradually dispersing Hong Kong’s trade, logistics, and financial functions to Shanghai, Shenzhen, and others, which is a negative factor for Hong Kong’s economy.

Despite the economic slowdown, Hong Kong’s domestic money supply (M2) relative to GDP stood at 466% in 2022, a sharp increase of 60 percentage points from 2019, indicating some degree of financial sector expansion, which is also a concern.

The money supply exceeds the global average by more than three times, potentially leading to exchange rate instability and the risk of sudden capital flight. Hong Kong’s foreign exchange reserves have also declined from $500 billion in 2021 to around $400 billion currently, weakening its crisis response capacity.

Senior Researcher Kim emphasized, "Countries operating fixed exchange rate systems like Hong Kong require constant government intervention and thus need substantial foreign exchange reserves. Given the high linkage with China, Hong Kong’s weak financial indicators could potentially become a source of financial instability for China in the future."

Warnings have also been issued to exercise caution in investing in Hong Kong and Chinese stock markets going forward. According to Hana Financial Management Research Institute, since Hong Kong’s handover to China in 1997, the US S&P 500 has risen more than fourfold, whereas the Hong Kong Hang Seng Index has increased by only 5%, indicating a decline in Hong Kong’s investment appeal.

The institute analyzed that the prolonged Chinese bear market since 2021 has led to a decline in the value of Chinese companies listed on the Hong Kong stock exchange, significantly impacting the Hang Seng Index’s decline.

Lee Ki-hong, Research Fellow at Hana Financial Management Research Institute, said, "With ongoing uncertainties about China’s economic direction and concerns over the stability of Hong Kong’s system, there remains a strong possibility of continued investor exodus from China and Hong Kong. Although Chinese authorities are working to stabilize financial markets, caution is necessary when investing in China and Hong Kong."

This content was produced with the assistance of AI translation services.