Hong Kong braces for U.S. downgrade fallout

While global equity markets face a fraught opening in mere hours, Hong Kong looks particularly exposed, tied both to China — the largest holder of U.S. Treasurys — and to the downgraded U.S. dollar through its exchange-rate peg.

Tough talk in Beijing
China’s official news agency, Xinhua, is certainly not downplaying America’s diminished credit standing. “China, the largest creditor of the world’s sole superpower, has every right now to demand the United States address its structural debt problems and ensure the safety of China’s dollar assets,” Xinhua said. China also urged the United States to apply “common sense” to “cure its addiction to debts” by cutting military and social-welfare expenditure.

If the shoe were on the other foot, no doubt Beijing would be quick to roll out its usual “unwanted meddling in internal affairs” line. Perhaps this strident tone just reflects some of the realities of being in hock for so much money. Hillary Clinton when asked about pressing Beijing on human rights was said to have remarked, “How do you talk tough to your banker?” By the same measure, you could foresee some awkward moments in asking for a credit-limit extension to pay for tax cuts or build a bigger military.

Still, we can expect to see less forthright official language from Beijing’s leaders given that China’s fate, and certainly prosperity, remains closely tied to the U.S. as long as its economy is so export-dependent.

Beijing will have to balance calling out the U.S. for its profligacy and resulting credit downgrade with the knowledge that without Washington’s raising the debt ceiling, Chinese exports would have an even harder time finding a buyer. The higher funding costs the U.S. is likely to now face on its debt — J.P. Morgan has estimated this at $100 billion — all means less money to spend on mainland exports.

The reaction of currency markets will also be a key focus this week. The reason for the alarmist reaction in China, whose Treasury holdings are estimated at $1.1 trillion, to the S&P downgrade of U.S. credit to AA+ is that it is expected to trigger further dollar weakness

Still, there is a view that in a world where everyone’s debt is growing and ratings deteriorating, a downgrade is less penal: AA+ is, perhaps, the new AAA. Japan, it is worth noting, was downgraded over a decade ago and still has low interest rates.

But if the U.S. dollar does take another tumble, it is likely to revive tensions in the region over currency levels. Notably last Friday the Central Bank of Japan intervened to weaken the yen.

As a weak dollar tends to drag China’s currency down with it due to the loose peg of the yuan to the greenback, this also makes life uncomfortable for Asian exporting economies. We may see more interventions to devalue currencies in the region. The U.S. downgrade will also keep Hong Kong’s peg to the downgraded greenback in the spotlight.