China tests global diplomacy and economy

New York – Long-repressed contradictions have a way of flaring up in public in times of stress. China is suddenly at the center of two of them, and they could well entail significant global diplomatic and economic consequences.

In the first case, Beijing’s signal on Thursday that it intends to tighten legislative restrictions on Hong Kong under the rubric of national security has brought to the surface the inherent inconsistency of the “one country, two systems” paradigm that has governed the relationship between the two for almost three decades. Underpinned by the 1997 agreement that governed the U.K.’s hand-off of Hong Kong to China, it promised a 50-year transition for many elements of Hong Kong’s economic, financial, institutional and political structure.

With time, this notion of “one country, two systems” has come under increasing pressure, fueling a tug-of-war between China and the pro-democracy movement in Hong Kong that has periodically erupted in street protests. It has also increased tensions between China and other countries. Both would intensify if Thursday’s announcement were to be codified in legislation.

There is a growing perception both in Hong Kong and globally that China is taking the world’s general preoccupation with the COVID-19 crisis to press forward with national, regional and international ambitions. This has included more pressure on Hong Kong, a stepped-up military budget, a more aggressive regional tone and the introduction of “face mask” diplomacy in developing countries aimed at positioning China as the more reliable superpower ally.

While this has resulted in discomfort in some countries in Asia and Europe, as well as the U.S., there has been little effective pushback so far.

That could change with the latest Hong Kong step, depending on how China proceeds and how focused and united other countries are. Already, politicians in both the United Kingdom and the United States have indicated that they are starting to consider possible responses.

The Hong Kong situation also fuels a second narrative that is of more direct relevance to the global economy and markets: that the time has come for Europe and the U.S. in particular to draw a firmer line that signals “enough is enough” when it comes to China’s pursuit of its domestic objectives with little regard to its global commitments and responsibilities.

Many in the West see the Hong Kong signal, as preliminary as it is, as a further illustration of Beijing’s only partial adherence to rules governing intellectual property rights, cross-border trade and investment activities, and the multilateral underpinning of international payments — all while other countries have provided China with greater economic and financial access, including under the auspices of the World Trade Organization agreement, thereby turbocharging its impressive development process.

In addition to exacerbating the challenges facing companies highly exposed to China and Hong Kong, this could well put more pressure on countries, such as Australia, that have pursued a “dual option” strategy — relying on the U.S. security umbrella while also deepening economic and financial relations with China.

It could also ratchet up the risk for the global economy. Specifically, an intensified “cold war” could lead to faster deglobalization, greater fragmentation and intensified weaponization of economic tools — all of which would dampen an already challenged economic recovery from the coronavirus shock.

To maintain the drastic decoupling between financial markets and economic and corporate fundamentals, central banks would be pressured in such a scenario to sacrifice even more future financial stability and efficient market functioning in favor of maintaining elevated asset prices.

Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is the chief economic adviser at Allianz SE, the president-elect of Queens' College, Cambridge, a senior adviser at Gramercy and a professor of practice at Wharton. His books include "The Only Game in Town" and "When Markets Collide."

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