Moody's Investors Service has downgraded Hong Kong's local currency and foreign currency issuer ratings to Aa2 from Aa1 and changed the outlook to stable from negative.
The downgrade in Hong Kong's rating reflects Moody's view that credit trends in China will continue to have a significant impact on Hong Kong's credit profile due to close and tightening economic, financial and political linkages with the mainland.
Hong Kong's local currency senior unsecured debt ratings are downgraded to Aa2 from Aa1.
In a related rating action, Moody's has downgraded the senior unsecured foreign currency ratings of the Trust Certificates issued by Hong Kong Sukuk 2014 Limited and Hong Kong Sukuk 2015 Limited, special purpose vehicles established by the Government of Hong Kong, to Aa2 from Aa1.
The payment obligations associated with these certificates are direct obligations of the Government of Hong Kong, and their ratings automatically reflect changes to Hong Kong's sovereign ratings.
Hong Kong's local currency bond and deposit ceilings remain at Aaa. The foreign currency bond ceiling remains at Aaa. The foreign currency deposit ceiling has been lowered to Aa2 from Aa1. Hong Kong's short-term foreign currency bond and bank deposit ceilings remain Prime-1 (P-1).
Tight link between Hong Kong and China
The economic and financial linkages between Hong Kong and China are close and broad-based. Combined with political linkages, this means that any erosion in China's credit profile, such as that reflected in the 24 May downgrade of China's rating to A1 with a stable outlook, will ultimately affect Hong Kong's credit profile and will be reflected in the Special Administrative Region's (SAR) rating.
Directly, China accounts for more than half Hong Kong's exports of goods, three quarters of tourist arrivals and 40% of exports of services in general. Indirectly, Hong Kong is a very open economy with exports, the vast proportion of which are re-exports, accounting for nearly 190% of GDP.
Combined with China's rising share in world GDP and global trade, Hong Kong's very high openness to global trade intensifies the effective economic links between Hong Kong and China.
Financial linkages between Hong Kong and China are broad in nature and large in the size of the assets involved. The Hong Kong banking sector's exposure to mainland China increased further in the second half of last year.
Total mainland-related lending rose to HKD3.6 trillion at the end of 2016, up 3.5% compared with last June, while other non-bank exposures also increased by 11.4% to HKD1.2 trillion.
High capital and liquidity buffers and strong supervision mitigate but do not obviate the risks related to banks' mainland exposure. At present, however, asset quality is high, with a decline in the share of mainland-related loans classified as "substandard", "doubtful" or "at loss" to 0.8% of total loans in December 2016.
Financial linkages are also being deepened through new financial market infrastructure that is contributing to closer ties between Hong Kong and China.
The Shanghai-Hong Kong stock connect was launched in November 2014; the Shenzhen-Hong Kong stock connect started in December 2016; and a bond connect between China and Hong Kong is to open by the end of 2017.
While these connects bring benefits including, it is hoped, enhanced liquidity, they also risk introducing more direct contagion channels between China's and Hong Kong's financial markets.
Through its involvement in various projects, including "One Belt One Road" investments, Hong Kong's economy and financial system will become increasingly closely related to China's.
The political linkages between Hong Kong and China are set out in Hong Kong's Basic Law. The Hong Kong Chief Executive is accountable to both the Central People's Government and the Hong Kong SAR in accordance with the provisions of this Law.
Even in the absence of close contemporary economic and financial linkages, Hong Kong's status as a Special Administrative Region of China would imply close credit linkage and near proximity of ratings.
The institutional features which grant Hong Kong, at present, a degree of political and economic independence -- together with the SAR's intrinsic credit strengths -- allow Hong Kong's rating to exceed that of China. But the two ratings, like the two regions, remain closely linked.
Indeed, the closer the linkage becomes, whether through rising political influence or ever closer economic interdependence, the more closely the two will converge.
Looking much farther ahead, in the latter phase of the 50-year period envisaged in the "One Country, Two Systems" policy (Article 5 of the Basic Law), certainty regarding the legal and institutional arrangements that will apply post-2047 will increasingly influence Hong Kong's institutional strength and competitiveness.
During this period, increasing convergence of key institutional features, including the evolution and execution of public policy, would in turn lead to the credit profiles of Hong Kong and China converging.
Hong Kong's financial and institutional strengths support the stable outlook on Hong Kong's rating. Large fiscal and external buffers and a strong track record of effective fiscal and economic policy provide ample flexibility to cushion the economy and financial system against negative shocks.
In particular, Hong Kong's fiscal reserves rose to 38.3% of GDP in March 2017, providing ample buffers against potential negative shocks to GDP growth.
Moreover, foreign exchange reserves, covering more than seven times the currency in circulation, consistently preserve the credibility and viability of the Hong Kong dollar peg to the US dollar, thereby contributing to financial stability in Hong Kong.
Furthermore, Hong Kong's Worldwide Governance Indicators are very strong, with government effectiveness in particular ranked third highest amongst the governments that we rate. A track record of policy effectiveness, transparency and flexibility of economic and fiscal policy support our view that the SAR's authorities would remain vigilant and responsive to potential negative shocks.
Consistent with Moody's view on linkage to China, the stable outlook on China's rating also supports that on Hong Kong's.
What could change rating
The stable outlook denotes that the risks to Hong Kong's rating are balanced.
Hong Kong's stand-alone credit profile would, absent linkage to China, already merit a higher rating. Since it is the linkage to China that constrains the rating, an upgrade would only be likely were China's credit profile to improve, or were Moody's to conclude that the linkage between the two ratings had diminished, which is unlikely.
Conversely, Hong Kong's rating could be downgraded were China's credit profile to continue to erode -- which the stable outlook on China's rating suggests is unlikely in the near-term. Or were Moody's to conclude that the linkage between the two credits had increased, and Hong Kong's independence further eroded, for example on the basis of evidence of increased intrusion from the mainland in Hong Kong's political institutions and policy formulation process.