Bad idea, Beijing: Crackdown may kill golden goose

China's recent move to tighten control over Hong Kong's political process could turn out to be a very costly move for Beijing.

Pro-democracy demonstrators protest in front of the Government Complex in Hong Kong on Oct. 2, 2014.
Thomas Campean | Unified ED | CNBC
Pro-democracy demonstrators protest in front of the Government Complex in Hong Kong on Oct. 2, 2014.

For more than a century, Hong Kong has enjoyed an outsized role in the global financial system, thanks to its freewheeling capital regulations, relatively high quality of life, rule of law and political independence from mainland China. It's helped make Hong Kong the most important banking center in China.

But the announcement late last month that Beijing will now vet all political candidates running for Hong Kong's leadership has sparked mass protests that have paralyzed the local economy and threaten to upend its carefully crafted reputation as a haven for global investors.

The political interference and the protests are "potentially fairly devastating," said Mark Yeandle, a financial consultant at London-based Z/Yen Group.

Capital has long favored Hong Kong over Chinese cities like Shanghai and Shenzhen because those mainland financial centers come with currency and capital restrictions that don't apply in Hong Kong.

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"That's a key selling point at the moment for Hong Kong," said Yeandle. "If Hong Kong becomes tied to that system and is not allowed to operate more freely, what would be the attraction for investors?"

Over the weekend, riot police used tear gas, pepper spray and batons to try to disperse the swelling crowds, but there were few reports of serious injuries. Students leading the protests have vowed to occupy more government buildings unless the Beijing-backed chief executive, C. Y. Leung, resigns by Thursday night.

The turmoil has already inflicted short-term financial damage. The local stock market index has dropped 7.3 percent in the last month. Some banks have reportedly shifted operations to the outskirts of the city to keep the growing unrest from disrupting trading.

Further turmoil could also hit local real estate prices—which have more than doubled since 2009—hurting Hong Kong banks with large real estate loan portfolios, said Gareth Leather, Asia economist for Capital Economics.

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The standoff, playing out globally on both traditional and social media, is the widest and most visible since the 1989 pro-democracy protests in Tiananmen Square, which were brutally suppressed when hundreds of protesters—perhaps thousands—were killed by Chinese troops.

But the protests have already upset the uneasy pairing of Hong Kong's political and financial freedoms with Beijing's state control over China's political and financial systems on the mainland, a policy known locally as "one country, two systems."

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The policy dates to 1997, when Hong Kong ceased to be a British colony in a "handover" to Beijing. Since then, China's leaders have walked a political and economic tightrope, balancing the conflicting goals of gradually tightening state control over Hong Kong while maintaining the free flow of Western capital needed to fuel China's breathtaking economic expansion.

Hong Kong warily accepted Beijing's approach, and Western money continued to flow. In the last decade, the market cap of shares listed on the Hong Kong stock exchange have more than tripled. So has the value of Hong Kong's notoriously pricey real estate market.

"The more Hong Kong's status as a global financial hub suffers, the greater the damage will be to China." -Gareth Leather, Asia economist, Capital Economics

Now, as China seeks to tighten the noose on Hong Kong's political process, Beijing's desire to exert more control threatens to kill the golden goose that has helped pay for decades of massive investment on the mainland.

"Having Hong Kong as a gateway has provided enormous benefits to China's economy over the past few decades," said Leather. "The more Hong Kong's status as a global financial hub suffers, the greater the damage will be to China."

And as the global financial system has become more tightly connected, capital flows can now shift course quickly. Uncertainty about Hong Kong's future already has helped Singapore capture a growing share of Asia's finance market, thanks to its business-friendly rules, vibrant city life and cosmopolitan outlook, said Yeandle.

His firm publishes an annual ranking of financial centers that tracks more than 100 indicators, including nonfinancial measures like crime rates and air pollution.

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Beijing also faces risks if it appears weak as the political upheaval widens; Communist Party leaders also fear that calls for democracy could spread across the nearby border to the mainland. That's one reason they've been aggressively censoring news and social media comments about the Hong Kong protests.

More broadly, the turmoil in Hong Kong is a reminder of the long list of challenges faced by President Xi Jinping and a new regime chosen by the Communist Party leadership just two years ago.

"The conventional wisdom is that China is going to march inexorably upward, solving all the major problems along the way very efficiently and very smoothly," said Evercore Partners Chairman Roger Altman. "When you look at Hong Kong, you see it as a symbol of the degree to which this isn't going to be as smooth and necessarily as successful as the conventional wisdom suggests."