Can Hong Kong afford a credit rating cut?

Financial analysts warn that if a downgrading occurs, it will erode the SAR's economic competitiveness

In its latest credit rating report on Hong Kong, Standard & Poor's Financial Services LLC said that "although the political polarization surrounding Hong Kong's (chief executive) election reform has sometimes made decision-making in the Legislative Council lengthier and more contentious than before, in our base-case scenario, we do not expect the tension to significantly affect the effectiveness of governance, given the government's strong record and the likely pragmatic approach of most politicians".

However, the global credit ratings agency said: "We could lower the ratings if Hong Kong's political polarization becomes much worse than we expected and significantly compromises policymaking (decisions) and the business environment. The issue of political polarization could amplify external risk if volatility in global financial markets increases sharply."

Hong Kong recently has witnessed heated debate over the nomination process for the chief executive election in 2017, triggering calls to "Occupy Central" and carry out a civil disobedience campaign to paralyze business in the city's prime financial district.

In addition to the risk of political polarization, there are other factors that can weigh on the special administrative region's creditworthiness, including limited monetary flexibility under the city's long-established linked exchange rate system and the risks associated with weaker institutions on the mainland, according to S&P.

The ratings agency stressed in its report that "the increasing economic and administrative integration with the mainland has also increased Hong Kong's exposure to changes in administrative policies and weaker civil institutions on the mainland. As Hong Kong is a special administrative region of China, movements in the mainland ratings may affect Hong Kong's ratings. Hong Kong cannot be completely insulated from less-developed mainland institutions while economic integration with the mainland continues".

Chong Tai-leung, an economics professor at the Chinese University of Hong Kong's Institute of Global Economies and Finance, said: "If Hong Kong's credit rating is downgraded, it will send a negative signal indicating the investment environment in the city may turn bad in the future.

"Downgrading Hong Kong's sovereign rating may compel the government to pay more interest when issuing government bonds, but the city's corporate bond market fundamentals should not be affected," Chong said.

Billy Mark, associate professor at Hong Kong Baptist University's Finance and Decision Sciences Department, disagreed. "We have to watch out for the political risk factor as this may have spillover effects on the real economy. When this happens, the sovereign rating will be lowered. If the sovereign rating is downgraded, Hong Kong's corporate rating will also inevitably be downgraded, leading to interest rate hikes on corporate loans that would be detrimental to corporate profitability in the city."

Beyond the political risk, Hong Kong's slowing economy will also take a toll on the city's credit rating. The SAR government has cut its gross domestic product growth forecast for this year from the initial range of 3 to 4 percent to 2 to 3 percent, due to a fall in mainland tourist spending and weaker domestic demand.

Australia and New Zealand Banking Group Ltd said that the political deadlock and "inappropriate government policies" will pose risks to the city's long-term economic competitiveness. "In our view, inappropriate government policies (reducing the scale of the Individual Visit Scheme and tight stamp duty policy) pose bigger risks to the economy as Hong Kong will lose its unique advantage that allows it to benefit from growing cross-border flows," ANZ Bank said in a note.

Ryan Lam, a senior economist at Hang Seng Bank Ltd, said that the bank had revised its estimate for Hong Kong's 2014 full-year economic growth from 3.3 percent to 2.8 percent.

Tiffany Qiu, an economist at Royal Bank of Scotland Group Plc, said that Hong Kong's economic growth will to be modest, as the global trade outlook has been tepid the past two months. Qiu noted subdued mainland tourist spending and pointed out that the city's commercial property sector is facing major headwinds. The investment bank cut Hong Kong's economic growth forecast for 2014 from 3.2 percent to 2.4 percent.

Despite the warnings, S&P affirmed the city's "AAA" long-term and "A-1+" short-term ratings, with a stable outlook, reflecting the city's above-average growth prospects for a high-income economy, consistently healthy fiscal performance, sizable fiscal reserves and strong external position over the next 24 months.

S&P estimated Hong Kong's 2014 per capita GDP at $40,500.

As of June 30, the SAR's fiscal reserves stood at HK$735.8 billion ($95 billion).

S&P said that the city's strong external creditor position will be supported by its sustained current account surplus.