[Update: The President said he had signed the Hong Kong Autonomy Act into law.]

Will the fissures turn into a gorge?

The question is whether the fissures may coalesce into a deep gorge dividing the financial systems of the 2 largest economies of the world.

Quagmire for financial institutions

Less than 2 weeks ago, on 7/2/2020, the US Congress unanimously passed the Hong Kong Autonomy Act (HKAA), which was the Congress’ response to the HK National Security Law (HKNSL) that the Chinese government enacted a few days prior on 6/30/2020 (see my previous post). The legislation should become a law soon, likely by midnight today.[1]

The HKAA generally will ban financial institutions (FIs)[2] from engaging in certain transactions with those foreign FIs (primarily Chinese FIs, but can be any non-US FIs) that have done “significant” businesses with certain sanctioned persons who have “materially” contributed to the erosion of autonomy in HK. (For more info about the definitions of the terms under HKAA, please see here.) To comply with such sanctions, however, a FI may run afoul of Article 29 of the HKNSL, which makes it a crime for any person (anyone in the world) to “conspire” with a foreign country to impose such sanctions. (See, also, here.) Hence, a FI can be penalized in US if it does not comply with US sanctions[3], but face the quagmire of being prosecuted in HK/China if it so complies.[4]

Picking side, US or China, but not both – a Hobson’s choice

For FIs currently having exposures in both US & HK/China, this quagmire may force them to decide whether to conduct business in either US or HK/China, but not both. For example, consider a Taiwanese bank (or a German, British, French, Canadian, Japanese, S Korean, Indonesian, Brazilian or any foreign bank) that conducts banking in both US and HK/China. If its HK/China operations are identified as having conducted significant transactions with sanctioned persons under HKAA, its US operations may be prohibited from engaging in transactions with its HK/China operations, or even with the bank headquarter. But, by complying with the US prohibitions, the US operations of the Taiwanese bank may be found to have violated Article 29 of the HKNSL, and hence the bank’s HK/China operations may be prosecuted, because both the US operations and the HK/China operations belong to the same bank. Under such circumstances, the Taiwanese bank may have no choice but to pick where it wants to do business in, either US, or HK/China, but not both.[5] That may be a Hobson’s choice that is not a choice at all.

An outlier black swan

In a US election year, and amidst the fallout from the COVID-19 pandemic, tensions between US and China have escalated. Financial sanctions such as the HKAA & national security laws such as the HKNSL are but a part of the complicated web of conflicts and brinkmanship involved in this new cold war. However, the Hobson’s choice facing down global financial institutions and the potentially unfathomable impact on the global financial systems may tamper the practical effects of these laws and orders.

For example, after the HKAA becomes law, the President has up to 120 days to identify the foreign financial institutions to be subject to sanctions, and up to 1 year to implement the sanctions. That means in the short run, no sanctions under HKAA will likely be enforced before the US election. After the US election, the political tensions may ease, allowing fine-tuning of the laws & regulations and their implementations, which may reduce the risks involved.

On the other hand, the severe erosion of HK autonomy and civil liberties under the HKNSL are frighteningly real for the people of HK. The prospect of great disruptions to the current financial systems arising from the US-China tensions, even if a low-probability outlier at this point, can also be real. It can be a black swan testing humanity’s ingenuity!

[1] The legislation has been sent to the President, who is required to sign the legislation within 10 days (except Sundays) or return it to the Congress. (“If any Bill shall not be returned by the President within ten Days (Sundays excepted) after it shall have been presented to him, the Same shall be a Law”, US Constitution, Article I, Section 8, Clause 2). If the president takes no action by the 10-days deadline, the legislation automatically becomes a law. On the other hand, if the President returns it, the Congress should have the 2/3 votes required to override the veto, required under the same Section of the Constitution.

[2] “Financial Institution” under HKAA has the same definition as in FDIC (31 USC 5312(a)(2)), which includes a broad spectrum of institutions, including insured banks, commercial banks or trust companies, securities brokers & dealers, foreign bank branches or agencies, etc.

[3] Violations of HKAA can carry civil penalties of the greater of $250k or twice the amount of transaction. Criminal penalties include fines up to $1m, or imprisonment for up to 20 years for a natural person, in addition to the fine. (50 USC 1705)

[4] Penalties under HKSNA generally implicate imprisonment of various terms, up to 10 years, and/or fines.

[5] It’s not clear whether compliance of sanctions by US subsidiaries of the Taiwanese bank (not branches or agencies) may subject the HK/China operations or the parent bank to prosecutions under HKNSA. However, because the US subsidiaries may be subject to the prosecution, meaning its personnel may be at risk if they enter the “influence zone” of HK/China, it will be difficult for the Taiwanese bank to communicate with and maintain control of the US subsidiaries, even if its HK/China operations and headquarter are not implicated.