ZHUHAI, CHINA - JUNE 29:  Aerial view of the Hong Kong-Zhuhai-Macao Bridge on June 29, 2016 in Zhuhai, Guangdong Province of China. The Hong Kong-Zhuhai-Macao Bridge will be the world's longest cross-sea bridge when it be completed in the fourth quarter of 2017, it will have a total length of about 55 km, including a 6.7-km underwater tunnel and a 23-km bridge. It took seven years and some 100 billion yuan (about 15 billion USD) to construct the bridge since 2009. As the Hong Kong-Zhuhai-Macao Bridge opens to traffic, connecting Hong Kong with branches to Zhuhai and Macao for the first time, it will greatly shorten the distance between Hong Kong, Zhuhai and Macao, according to China Daily. (Photo by VCG)  (Photo by VCG/VCG via Getty Images)

On the edge of Hong Kong’s Victoria Harbour, workers are building a cavernous station that will be the terminus for one of the most expensive high-speedrail links ever constructed. The $11bn fast train linking Hong Kong to mainland China is meant to be a showpiece for integration between the semi-autonomous territory and its mother country.

Instead, the over-budget and behind-schedule project has turned into a symbol of the deteriorating political and economic relationship between Beijing and Hong Kong. It could be a foretaste of the profound difficulties that lie ahead for the global financial centre.

To smooth rail departures, the Hong Kong government is planning to place Chinese border police inside Kowloon station, much like French police conduct checks on outgoing Eurostar passengers at St Pancras terminus in London. The proposal might have been convenient for travellers but was worrying Hong Kongers, even before the detention last year by the mainland police of five Hong Kong publishers who sold works critical of China’s ruling Communist party.

The apparent abductions have shaken the confidence of the city’s 7m residents — and international investors — in the legal autonomy and civic freedoms that Beijing guaranteed to Hong Kong for 50 years from 1997, the year of the British handover.

The case of the booksellers has crystallised anger over growing interference by Beijing. Opposition legislators have vowed to block the rail project rather than allow Chinese police to operate in the heart of Hong Kong.

“To me it’s unacceptable and it is worrying for the Hong Kong people,” says Kenneth Leung, a lawmaker in the city’s legislative council. “We don’t want integration with China because our style and way of thinking can’t be integrated.”

After delays caused by technical difficulties and cost overruns, the political opposition could mean further problems for the 26km rail line to Shenzhen, just over the border in China. It had been scheduled to open in 2015 but will not be operational before late 2018.

Unfortunately for Hong Kong the battle over its future is coming as its China-dependent economy faces the “worst time in 20 years”, according to John Tsang, the financial secretary.

“Hong Kong is really dependent on China and external trade,” says Lily Lo, an economist at DBS, the Singaporean bank, in Hong Kong. “The Chinese economy is slowing down and this is a structural slowdown so we don’t think there will be a V-shaped recovery any time soon. There’s no quick fix.”

Signals of a slowdown

The rail link and other large infrastructure projects are supposed to secure a place for the city as a hub in the sprawling and wealthy Pearl River Delta region on the southern coast of China. A 30km sea bridge and tunnel is being built to connect Hong Kong with the casino centre of Macau and the mainland city of Zhuhai and is also beset by cost overruns and delays. Escalating tensions, both with Beijing and within Hong Kong, are further complicating these projects and adding to the economic clouds over the territory.

Its traditional pillars of wealth— tourism, retail, trade, financial services and property development — have all been hit by cyclical and structural downturns that have exposed the reliance on China, which accounts for 40 per cent of trade.

Over the past decade, China has opened its economy further and more investors are doing business directly with the mainland, causing Hong Kong to lose its relevance as a gateway. Its container port, which was the world’s busiest in the 2000s, has fallen to fifth place, overtaken by Shanghai, Shenzhen and Ningbo. Facing a severe shortage of space, high costs and Chinese rivals with strong government support, more downward pressure is likely.

Previously Hong Kong benefited from rapid growth in China and low interest rates in the US, given that its currency is pegged to the dollar. Now the situation is reversing, with China facing a period of restructuring and slower growth, while the US Federal Reserve is expected to raise interest rates further, although many investors are betting it will not happen in 2016.

China’s gross domestic product is forecast to grow by about 6 per cent this year. In Hong Kong, the government predicts that it will be lucky if GDP increases by 1-2 per cent.

Ports-activity chart

Mr Tsang and Li Ka-shing, the billionaire whose interests in Hong Kong stretch from ports to property and retail to telecoms, have both warned that the economic outlook is worse than that faced during the Sars epidemic in 2003, which killed 299 people and prompted the last sharp slowdown.

Retail has taken the biggest hit in the current downturn. Sales had been buoyed when wealthy Chinese consumers flocked to the territory to buy luxury goods and cosmetics, but takings slipped 11 per cent year on year during the first five months of 2016 and the number of mainland tourists dropped 12 per cent in the same period to 17m.

Chow Tai Fook, the biggest jeweller in the world by market capitalisation, is seen as a bellwether for mainland demand for Hong Kong’s luxury goods. Its sales in Hong Kong and Macau fell on an annualised basis by 22 per cent in the three months to the end of June. Other companies, such as handbag retailer Coach and watchmaker Jaeger-LeCoultre, which viewed Hong Kong as a cash cow, have been closing stores.

Even Hong Kong’s humble tea shops — known as Cha Chaan Teng — have seen a slide in sales of their cheap noodles and milk tea. At Tsui Wah, a popular chain, profits for the year to March fell by more than half to HK$72m ($9.3m).

‘At the low end of expectations’

Shaun Rein, who runs China Market Research in Shanghai, warns that the slump in retail is not simply the result of the Chinese slowdown or the crackdown on extravagance and corruption by President Xi Jinping. “There is a deep-seated animosity to mainlanders in Hong Kong,” he says. “So why would they want to go somewhere they are not welcome when there are so many other choices?”

Retail, tourism and associated sectors such as transport account for 35 per cent of Hong Kong’s GDP and employ 1.4m people. Other key parts of the economy such as banking, property and trading services are also suffering. Declining interest from mainland buyers has contributed to falling house prices, although Hong Kong still has the most expensive housing in the world as a proportion of median income.

Rallies calling for Hong Kong's independence on Handover Day on July 1, 2016

Yu Kam-hung, managing director of investment properties at CBRE, an estate agent, predicts that prices could fall up to 10 per cent over the next year, and they are already 10 to 15 per cent off their peak of 18 months ago. Some developers are taking aggressive measures to close deals, such as offering buyers top-up financing to cover the initial deposit and other costs excluding a bank mortgage.

“We think it’s a sign of desperation and a negative reflection on the market,” says Denis Ma, the head of research in Hong Kong for JLL, another property company. He says the situation is likely to get worse before it gets better, with a glut of new supply still coming on to the market. “A lot of land sales are going through at the low end of expectations . . . so developers aren’t that optimistic about the market outlook,” he adds.

Hong-Kong-growth chart

Banks with exposure to the mainland are starting to feel the fallout as Beijing allows some defaults from state-owned companies, as well as private enterprises, in an attempt to manage the huge debt overhang that threatens to undermine growth and stability. Bank of East Asia, which is one of the local lenders most exposed, saw its impairment losses double last year to HK$2bn because of China’s woes. It recently laid off 180 staff.

Unemployment is running at 3.4 per cent, and Ms Lo says the rate is likely to increase next year, feeding back into further weakness in property, retail and banking, and adding to the feeling of resentment.

Moody’s, the credit rating agency, says the headwinds facing Hong Kong’s banks “will pressure the system’s asset quality and profits, and test its resilience, given the territory’s elevated property prices and the banks’ growing linkages with mainland China”.

The concerns about Hong Kong’s economy have been compounded by fears over the city’s autonomy and legal independence, which are at the core of its attraction for international companies. Since 1997, global investors, from banks to retailers, have put their faith in Hong Kong’s British-style legal system, which contrasts sharply with the capricious, Communist-party controlled system in the mainland.

Hong-Kong-retail-sales chart

Suspicions that Beijing has been meddling more in Hong Kong have been increasing since Mr Xi came to power in 2012 and launched a crackdown on dissent that has been slowly extending beyond the mainland’s jurisdiction.

These misgivings intensified after the five booksellers vanished between last October and December, before appearing in mainland police custody accused of distributing politically sensitive works.

One of the five — British citizen Lee Bo — disappeared from Hong Kong, leading many to believe he had been abducted by Chinese agents in violation of local law. He later claimed, under apparent duress, that he had gone to the mainland of his own volition.

The British government said the incident “unnerved” the business community. Executives are reluctant to speak on the record about their concerns for fear of upsetting Beijing but, in private, they are anxious.

“For many businesses, the incident has raised questions about the rule of law, which is one of the absolutely key aspects that makes Hong Kong work and gives people the confidence to do business here,” says an executive from one foreign chamber of commerce in Hong Kong. “The rule of law is not an abstract. People care about how it works in practice.”

Damage control

The Hong Kong government, caught between its masters in Beijing and an increasingly divided population at home, has struggled to respond convincingly to its troubles.

Economically, the government has always taken a laissez-faire approach and the currency peg means Hong Kong is unable to implement its own monetary stimulus. The government has offered some tax breaks to boost consumption and investment, while property developers are calling for it to reduce stamp duty on non-residents to boost the sector. Economists, however, say the effect of such measures is likely to be limited.

Opinion polls suggest the public has little faith in CY Leung, Hong Kong’s chief executive, who was elected by a 1,200-member body dominated by pro-Beijing elites. He was heavily criticised for his main policy speech at the start of the year. This offered few solutions to problems such as widespread social inequality and unaffordable housing, but paid homage 48 times to One Belt, One Road, Mr Xi’s lofty but vague plan to build a Eurasian infrastructure network that will not pass through Hong Kong.

“I feel our government is only trying hard to please the central government but is neglecting the actual needs of Hong Kong people,” says Leung Wai-faat, a 23-year-old project co-ordinator for a construction company.

It is possible that elections for the partially democratically elected legislative council in September could alter the balance of power in Hong Kong, if only slightly. Most analysts, though, expect the deadlock between opposition lawmakers and the pro-Beijing faction to continue.

If that happens and relations with Beijing remain tense, it will be very difficult for Hong Kong to mitigate the impact of its structural and cyclical problems.

“I’ve already told my son that he should make sure he has his own career because he cannot presume that our family business will be thriving in Hong Kong when he grows up,” says one tycoon close to the government. “The trust gap between Beijing and Hong Kongers keeps growing and that is very worrying at a time when our economy is already facing so many challenges.”

Additional reporting by Gloria Cheung

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