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The death of Hong Kong? Gauging the impacts of the National Security Law on Hong Kong’s Economy

Updated: Sep 4, 2021


On the night of May 21 2020, it was revealed that the National People’s Congress, the Chinese parliament, would impose National Security Law in Hong Kong, bypassing the territory’s de-facto parliament. The people of Hong Kong fell into panic as the concerned law is simply a tweak of the infamous Article 23, a regulation deemed as a direct infringement of freedom by the people of Hong Kong. Although Article 23 was proposed by the HK government in 2002, it was later retracted in 2003 after more than half a million people marched against it.

Facing the new National Security Law, people fear the loss of freedom of expression, speech and publication in the territory. More importantly, people fear that common law practices such as private property rights and presumption of innocence would no longer be upheld. Confidence of Hong Kong as a global financial hub dwindled. To understand more about the background, you could visit here or see this video by the Financial Times.

International response

Because of the National Security Law, the U.S. has announced that Hong Kong is no longer autonomous, and the United States – Hong Kong policy act would have to be reviewed: Hong Kong might not be able to receive special tariff treatment, buy “sensitive technologies” or even freely trade US dollars with HK dollars. Related officials and Hong Kong itself might be subject to future sanctions by the U.S. .

Countries like the U.K., Canada, Japan and Taiwan have also reacted to the news and promised further actions which might affect Hong Kong’s status as a financial hub.

Debates around its implications

Some viewed the law as the starting point of the demise of Hong Kong because confidence in the market is diminishing. They believe that such enactment of the National Security Law puts Hong Kong’s well trusted common law system under scrutiny, further reducing Hong Kong’s competitive edge over other Chinese cities as the gateway to China. To them, the current situation begs the question: why do I not invest in Shanghai instead?

On the other hand, the Chinese and Hong Kong government have defended the Law, proposing it as the only solution to the recent turmoil in the city and with stability, Hong Kong is poised to become even better with greater investor confidence in the city where 7.5 million inhabitants call home.

With two polarising stories, this article aims to shed some light on how the National Security Law is impacting Hong Kong’s economy using the Hang Seng Index (HSI), the composite index of Hong Kong’s stock market.

The model

There are a few drawbacks using the HSI to gauge the impacts on the economy. Firstly, the HSI has an inherent bias to certain industries, for example, financial sector accounts for approximately 48% of the index, while it only contributes to around 20% of the city’s GDP (Census and Statistics Department, HKSARG, 2018). Secondly, some view that the stock market is decoupled from the economy due to quantitative easing. Thirdly, this model is based on efficient market hypothesis, meaning that share prices reflect all information in society and hence the market outcome is the consensus.

When constructing this model, it is noted that there is a high correlation between US stock market indices and HSI. Therefore, the three most popular stock indices in the US, namely, Dow Jones Industrial Average (INDU), NASDAQ Composite (CCMP) and S&P 500 (SPX), are taken into account. The correlation is seen in the graph below.

Figure 1: Dow Jones Industrial Average, NASDAQ Composite, S&P 500 and Hang Seng Index normalised gains from 31 MAY 2000 to 28 FEB 2020, Source: Bloomberg Terminal

Historically, US stock market indices are highly correlated to the HSI because Hong Kong is a very trade reliant and globalized city, meaning that any changes in the world’s largest economy would impact the companies listed on the Hong Kong stock exchange. More importantly, due to the HKD-USD peg, there is little currency risk when trading HK stocks for US investors, vice versa: if the stock market performance deviates too much, arbitrage would occur, reducing the difference in the performance. Based on such reasons, the HSI closing price could be predicted using a regression of the 4 indices.

By regressing the HSI against INDU, CCMP and SPX, a formula could be derived to predict what the HSI should be. In this particular regression, the weekly closing price of the 4 indices from 30 JUN 2000 to 1 MAY 2020 are considered, with a total of 1,036 observations. The data from 1 MAY 2020 onwards is not calculated in this prediction model because it would include the shock from the enactment of the National Security Law. The model is as follows:

Where NASDAQ, INDU and SPX are denominated in HKD

The coefficients are all significant and 0 falls outside of their 95% confidence interval. Therefore, this model should stand. (Regression and raw data set are in the appendix)

The following graph shows the similarity between HSI and the predicted HSI from the model over the past 20 years.

Figure 2: Comparison between HSI and the constructed HSI regression model from 2000 to 2020

When looking at the difference between HSI and the predicted figures from the start of 2019, it could also be seen that it mainly fluctuates around +1000 to +3500 points. The sudden widening of the gap could be explained by the start of the anti-extradition protests around June 2019, while the closing of the gap occurs as Hong Kong has been able to tackle the coronavirus around March 2020.

Figure 3: Backtest of HSI regression model minus HSI from JAN 2019 to MAY 2020

Based on historical data, this model has been able to provide consistent results and therefore any change in the spread of the predicted figures and the actual figures might suggest a change in market confidence in Hong Kong’s stock market.

Putting the model to the scenario

To evaluate market reaction to the National Security Law, the daily closing price of the HSI from 5 MAY 2020 to 12 JUN 2020 is plugged into the model.

Figure 4: Daily comparison between HSI prediction model and HSI from 5 MAY 2020 to 6 JUNE 2020

On the graph, the dotted line signifies 22 MAY 2020, when the National Security Law shock is priced in. It could be seen that after the enactment is revealed, the market has reacted negatively, showing concerns for Hong Kong’s future. It should be noted that the spread between HSI prediction and HSI has remained widened with few signs of closing the gap till 12 JUN 2020. This implies that the market remains pessimistic about the National Security Law and potential U.S. sanctions against Hong Kong.


In the short term, Hong Kong’s economy has surely taken a hit. The narrative painted by the stock market, until now at least, has been reflecting that Hong Kong might no longer be the financial hub we know it as. Unfortunately, the people’s worst fear might have come true.

The million-dollar question, however, would still be what lies ahead of Hong Kong’s murky future, and that, should be left for the readers to decide.


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