Protests are the tip of the iceberg for Hong Kong

Apart from protests, HK needs to watch out for this
Apart from protests, HK needs to watch out for this   

Pro-democracy protests put Hong Kong in the spotlight recently, but political risk is just the tip of the iceberg, Capital Economics says.

"Even if the protests die down, the ongoing corruption crackdown in China and the prospect of higher interest rates in the U.S. means the next year is likely to be far from plain sailing for Hong Kong," Gareth Leather, Asia economist at Capital Economics, wrote in a note published Monday.

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Pro-democracy protests entered their third week on Monday and mark Hong Kong's worst period of unrest since the 1960s. Tensions heightened in the early hours of Wednesday, when hundreds of Hong Kong police used pepper spray on protesters to clear a major road that had been barricaded with concrete slabs.

Protesters seek full democracy; residents are currently allowed to vote, but the choice of candidates is strictly controlled by Beijing.

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The disruption to everyday life in Hong Kong is taking its toll on the economy. Retail sales - which make up 25 percent of the territory's $250 billion economy - were down sharply in the first five days of October, according to a Hong Kong Retail Management Association survey. Jewelry, fashion items and catering sales were down around 50 percent on year.

Crackdown

Even if protests eventually peter out, Hong Kong faces a difficult period ahead, Leather said.

"With the corruption crackdown in China showing no sign of losing steam, the retail sector is likely to remain fairly weak even if the political situation in Hong Kong returns to normal soon," he said.

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China's anti-graft crackdown has hit sales of luxury goods across China, as officials have stamped down on the time-old practice of gifting government officials with expensive items.

Hong Kong's economy contracted 0.1 percent on-quarter in the second quarter of this year as shoppers cut back on spending, particularly on watches and jewelry. Year-on-year, the economy expanded 1.8 percent, its slowest pace in nearly two years.

Scuffles break out between police and 'Occupy Central' protesters in front of Pacific Place shopping mall
Lucas Schifres | Getty Images News
Scuffles break out between police and 'Occupy Central' protesters in front of Pacific Place shopping mall

Risk of higher rates

The prospect of higher U.S. interest rates in 2015 is another risk, Capital Economics said.

The Hong Kong Monetary Authority uses U.S. monetary policy as a benchmark for its own policy, while the Hong Kong dollar is pegged to the greenback.

"At a minimum, higher interest rates are likely to weigh on consumer spending and investment, which will act as a drag on growth," said Capital Economics' Leather. "However, there is also a risk that higher rates will trigger a collapse in Hong Kong property prices, which look significantly overvalued relative to earnings."

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Property risk

A potential property market crash is a much more significant risk to Hong Kong than the pro-democracy protests, said Alaistair Chan, economist for China, Hong Kong and Australia at Moody's Investor Services.

"There is a chance that a Fed rate hike will be a factor that triggers steeper declines. This isn't our base case scenario but there is a chance of a wider bust," added Chan.

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When Hong Kong property prices fell sharply during the Asian financial crisis between 1997 and 1998, "the impact on the wider economy was severe, with non-performing loans rising sharply, and private consumption and construction being hit hard," Capital Economics' Leather.

"We see a big risk of a similar outturn again in the event of another sharp fall in property prices," he said.