Trouble Ahead for Hong Kong

Hong Kong’s run of good luck is running out. One obvious sign is the increasing interference of Beijing in its domestic affairs, most recently using tame Chief Executive C.Y. Leung and a clique of yes-men to interfere in a senior academic appointment at the University of Hong Kong.

But beyond that, there is a convergence of unwelcome news. One of the broader dangers is the diminishing value of the territory’s role as a tax shelter and money-laundering center. The threat comes from two directions. The first is the mainland, which has hitherto been indulgent over the use of Hong Kong by mainland firms – not least major state enterprises – to generate profits which in reality arise on the mainland or elsewhere where tax rates are significantly higher.

In its crackdown on corruption and money-laundering in Macau, Beijing has shown no great concern for its impact the economics of the gambling and entertainment enclave. Hong Kong, just at the other side of the mouth of the Pearl River, may be next. Beijing may well feel that Hong Kong is even less deserving of sympathy because of its autonomous attitudes. As it tries to boost the yuan as an international currency and SDR component, greater control on money flows through Hong Kong may be put in place.

Transfer Pricing, Hong Kong’s Cash Cow

The bigger danger, however, may lie in the territory’s dependence on the tax revenue it accrues from transfer pricing via Hong Kong-based entities. Despite its low level, corporate tax is by far the biggest direct tax source for the Hong Kong government and accounts for 27 percent of total revenue and one third of recurrent revenue. How much of that is genuinely generated in Hong Kong can only be guessed at but trade data reveal that re-invoicing in Hong Kong without value-added amounts to 15 percent of re-export turnover.

This could now be under threat not only from the mainland but from the Organization for Economic Cooperation and Development, the 34-member group of major developed countries including the US, EU and Japan. Political as well as budget pressures in these countries have led to an outcry against tax avoidance on a mega scale by the likes of Apple and Google, and many more, artificially to route profits through places where they have little or no business, ranging from Ireland to the Cayman islands, with low or non-existent taxes on profits.

Last week, OECD ministers meeting in Peru for the World Bank annual meeting concluded an agreement on profit tax recognition which seeks to address the issue. Even if only partly successful it will hurt offshore profit-booking centers. China indicated its support for the move.

Hong Kong is far from being a leading player in the avoidance business as its taxes are not negligible and the city generates a huge amount of genuine trans-border trade in goods and services. Nonetheless it is under increasing scrutiny with some tax authorities in Europe reportedly now treating Hong Kong as part of China for tax purposes.

Hong Kong also has tax treaties with several important countries. These are a two-edged sword. On the one hand they encourage business which can use them to avoid double taxation. On the other they open up Hong Kong to scrutiny. As it is, the US effort to tax its foreign-resident citizens through FATCA (Foreign Account Tax Compliance Act) is already making it more difficult to enjoy the tax and currency freedoms of Hong Kong.

Other countries may well follow suit. Anti-money laundering moves are also a threat to some of Hong Kong’s activities. So far Hong Kong has prosecuted a few small fry – old ladies used as conduits for cash transactions – while large-scale laundering proceeds almost unimpeded via invoicing.

Yet another hurdle for Hong Kong may now be China’s exclusion from the Trans Pacific Partnership. The TPP may well fall yet at legislative hurdles in the US and perhaps elsewhere. Its benefits to members may anyway not be as great as promised. Yet at a time when China’s exports are under pressure – and particularly the light industrial ones for which Hong Kong has long been the trading hub – TPP could be a further setback.

It is also a reminder that by signing up its Closer Economic Partnership Arrangement (CEPA) with the mainland in 2003 it entered into a preferential arrangement which not only made a small dent in its free-trade status but encouraged business to focus more on the mainland than on the wider world. The drawbacks of that are becoming clearer.

That Hong Kong otherwise remains a very attractive place to do business cannot disguise the new obstacles that it faces and hence the need for new ideas, and not ones made in Beijing.

Attacking the Colonials

Another is a sudden urge on the part of ministers obedient to Beijing to attack colonial symbols, in the latest case a move to cover up the old royal insignia on post boxes. This is seen as an another attempt to re-write history and hence an attack on Hong Kong’s sense of identity – quite clearly a Beijing goal now that it recognizes that last year’s Occupy movement was as much about that identity as about democracy.

But economic luck may be running out too for several reasons. The most obvious is the cyclical nature of asset markets. Hong Kong’s sky-high property prices are not in danger of a fall like 1997-98 thanks to the prospect of many months more of near zero interest rates. But they have almost certainly plateaued as economic slowdown locally and in China plus a currency which has appreciated against almost all other in Asia, puts a dampener on the market. The threat of a future significant rise in interest rates remains.

The next dampener is the Beijing criticism of property and ports tycoon Li Ka-shing, Asia’s richest man, for supposed lack of patriotism. This may suit the interests of the mainland companies which want to gain the high ground in the local economy in the same way that Li and others superseded the once dominant British groups after 1975. But the closer Beijing keeps an eye on Hong Kong business, the more reluctant may mainland individuals and private companies be to see it as a haven. Those looking for safety from political as well as economic dangers will look well beyond the shores of the PRC.