The Litmus Test for Hong Kong’s Financial Future

Former U.S. President Donald Trump signed a series of executive orders before his departure from office, dictating that U.S. persons and companies cannot trade shares from 44 allegedly military-linked Chinese companies.

This move has thrown Hong Kong’s stock market and retail investors into hot water, as 12 of the 44 companies, including Xiaomi, China Unicom, and China National Offshore Oil Corporation, are included or listed on Hong Kong’s Hang Seng Index (HSI). Caught in this turmoil is the Tracker Fund of Hong Kong (TraHK), a hugely popular unit trust very closely linked with HSI and managed by the Boston-based bank State Street.

TraHK is a government-founded unit trust fund that invests in all HSI constituent companies in the same weighting they appear on the Index. Launched in 1999 in the aftermath of the Asian Financial Crisis, TraHK was originally a disposal plan after the government acquired $15 billion worth of Hong Kong shares to safeguard the exchange rate peg with the U.S. dollar against shortings from investor George Soros (among others). Between the initial offering in 1999 and 2002, around $18 billion worth of HSI constituent stocks have returned to the market through TraHK.

Initial constituent stocks consisted of “old money” conglomerates and corporations from sectors like real estate and finance. Traditionally, these companies’ owners have had huge political influence and held a major stake in the city’s pseudo-democratic election system, taking a considerable proportion of the 1,200-vote electoral system for the chief executive. During the acquisition, the government purchased up to 10 percent of shares from some of the city’s top property developers, given “too big to fail” status from their sheer size and political power.

As years went by, Chinese companies have been gradually taking over as the main composites of HSI – and subsequently TraHK. Currently, seven out of the top 10 holdings within the fund, are based on the mainland, with the largest holding company being the Chinese conglomerate Tencent at 11 percent. Only two entities, HSBC and Hong Kong Exchanges and Clearing, are truly local. Compared to 1998, where old local money dominated the Index’s top echelon, Hong Kong’s economy is now significantly intertwined with Chinese money and interests.

The tension between the United States and China remains very high after U.S. President Joe Biden’s inauguration. On China policy, Biden largely retained the sanctions and critical attitudes of his predecessor. Top Chinese banking officials have called the United States’ sanction decrees invalid and urged financial institutions in Hong Kong to disregard them and “abide by Hong Kong’s laws and regulations” instead.

Following U.S. laws and regulations, State Street declared on January 13 it would halt new investments in U.S.-sanctioned constituent companies of the HSI for the TraHK portfolio, but made a U-turn two days later. As of now, the U.S. bank is still TraHK’s trustee, and trading for all HSI constituent stocks remains, including for those from U.S.-sanctioned Chinese companies.

Hong Kong’s financial sector seems largely unaffected at this point, as neither China nor the United States is making any drastic move that would fundamentally alter the city’s status as a financial hub.

This ambiguous status allows State Street and most other financial institutions in the city to function according to business-as-usual. Even so, some financial institutions have already decided to move for greener pastures as concerns over the city’s loss of liberty and rights continue to increase. The chief executive of Japanese financial conglomerate SBI Holdings, Kitao Yoshitaka, has already expressed his plans for closing his companies’ operations in Hong Kong, as “without freedom, there is no financial business.”

An official survey from Hong Kong’s government revealed that the number of regional headquarters and regional offices have been dropping since 2019, and 21 percent of companies surveyed are uncertain about their future in Hong Kong. The Heritage Foundation has also recently delisted Hong Kong from its economic freedom index, citing that Hong Kong’s economic policies are “ultimately controlled from Beijing.” Meanwhile, the number of regional offices and headquarters of Chinese companies has been steadily on the rise.

Calls to replace State Street as the fund manager are already brewing after its about-face, as pro-Beijing politicians question the U.S. entity’s ability and willingness to weather the sanctions and perform per local regulations. Likewise, the city’s top financial official has also expressed dissatisfaction with State Street’s abrupt halt on sanctioned constituent companies.

Technically, the government can change TraHK’s fund manager to a non-U.S. entity to bypass U.S. sanctions. Any potential new manager must also adhere to local regulations and be locally licensed, but since the United States’ sanction decrees are applied universally, any corporations wishing to manage TraHK may face heavy pressure about their relationship with sanctioned composites stocks, and will be eventually forced to take a side.

If State Street decides to abandon TraHK, it will send a clear signal to the global business interests in Hong Kong that the traditional “East meets West” advantage can no longer hold, and may intensify the ongoing outflow of capital investment and talent. Hong Kong’s government and financial sector will then face the existential challenge of convincing foreign investments and talents to stay. In fact, neighboring financial hubs like Singapore, Tokyo, and Shanghai have already been benefiting from the influx of regional offices and expatriates since the protests erupted and the national security law was put in place.

Even so, if local banks take over, they will face the same choice: Budge under U.S. pressure to safeguard their global operations and risk Beijing’s wrath, or virtually put all their bets onto the Chinese market. If Chinese corporations take the fund’s helm, they can remain unfazed in the face of U.S. sanction decrees. Still, it would symbolize that Hong Kong’s economic integration into China is complete.

On the other hand, if State Streets stays on, it will face an unwinnable loyalty test. Already on the radar of the city’s financial watchdogs and pro-Beijing politicians, the bank may need to continue disregarding the U.S. sanction decrees to keep Beijing and Hong Kong happy, even if the sanctions list expands to include key HSI constituent stocks. But by doing so, or by doing nothing at all, it will attract the scrutiny of U.S. lawmakers and risk possible expulsion from the U.S. market.

Even if State Street or other global banks are spared locally for honoring U.S. sanctions, they may still not escape Beijing’s legal apparatus. In March, Beijing announced its intention to bolster its legal framework to weaken U.S. sanctions. Earlier this year, it allowed Chinese courts to punish global companies for complying with foreign sanctions. It is possible that State Street can give up the fund and retain its other businesses in Hong Kong, but how Beijing or Hong Kong perceives such a move is also up for debate. If they see it as a lack of loyalty, the political consequence will be hard to calculate in a political culture where loyalty is paramount.

No matter how this turns out, the message is clear: new boss, new rules. State Street’s fate with TraHK is the perfect canary for whether foreign financial institutions in Hong Kong should move on or pledge loyalty.