By Chuin-Wei Yap and Jing Yang
HONG KONG--Markets faltered and businesses braced for more instability as China set out plans for national-security laws to tighten its control over Hong Kong, piling stress on the global finance hub already battered economically by a year of violent demonstrations and the coronavirus pandemic.
Investors on Friday signaled broad pessimism about the move that will likely escalate tensions with the U.S., pushing the city's benchmark stock index down by nearly 6%, its worst one-day fall since July 2015. Property and infrastructure stocks led the fall.
Many business observers had expected Beijing to pre-empt a revival of street protests as the viral outbreak stabilizes. But the plans disclosed late Thursday to tackle what Beijing views as subversion, sedition and foreign interference in the city were seen by some as a dramatic repudiation of longstanding policy to allow Hong Kong to craft key laws itself.
Businesses say a lack of clarity about the limits of such a national-security law might jeopardize future prospects for international business, spur a tit-for-tat battle with the U.S. and make it harder for companies to recruit talent.
"No one wins if the foundation for Hong Kong's role as a prime international business and financial center is eroded," said Robert Grieves, chairman of the American Chamber of Commerce in Hong Kong.
Many are waiting to see the actual details of China's legislation. A resolution, which would allow the drafting of such a law, is expected to be voted on by China's parliament when its annual conclave ends next week, after which the central government will work on the specific language.
"I'm still digesting it--it's not what most people would like," said Bob Dodds, founder of investment bank DRP Capital Ltd. and a longtime adviser on big China-related acquisitions. "No matter what happens, Hong Kong will still have a unique position. It's just a question to what extent."
Hong Kong's Basic Law, its mini-constitution, also provides for freedom of assembly and the media, and has helped the city prosper as a major hub for international banks, investment firms, hedge-fund managers and other financial players. For many institutions, the city is a conduit for investment in and out of mainland China and much of Asia. Foreign executives often cite its independent legal system and Western-style freedoms as an attraction, along with low taxes and a lack of capital controls.
Hong Kong's Chief Executive Carrie Lam said Friday that the proposed law only targets crimes such as secession, subversion and "activities interfering [in] Hong Kong's internal affairs." She said these have been a concern of businesses in the past year.
Some executives fear the longer term damage to Hong Kong's autonomy will dilute its appeal as a financial center that helped underpin China's growth.
"If the law can be passed by promulgation, not by a local legislative body, it will put the Basic Law under the spotlight, [and] it will be a huge retraction of Hong Kong as an investment conduit," said Benjamin Quinlan, chief executive of strategy consulting firm Quinlan & Associates. "The rule of law is fundamental for Hong Kong to operate as a financial center. It is what makes the city so special."
China "has torn apart the whole pretense of 'one country, two systems,'" said Lee Cheuk-Yan, general secretary of the Hong Kong Confederation of Trade Unions, referring to the governing compact Beijing promised in 1997 to preserve Hong Kong's autonomy for 50 years when Britain handed over the former colony.
Benjamin Quinlan said new laws could drive discussions about whether it made sense to move some banking business to mainland China. And loser ties to the mainland legal system could prompt some wealthy investors to move assets to Singapore or Western financial centers instead, he added. "The structural outlook for Hong Kong is bleak." And closer ties to the mainland legal system could prompt some wealthy investors to move assets to Singapore or Western financial centers instead, Mr. Quinlan added. "The structural outlook for Hong Kong is bleak."
Evidence on capital outflows so far is mixed. Last summer, some businesses said they were seeing money move abroad, and several individuals said they had swapped money into other currencies or were considering doing so.
Data from the Monetary Authority of Singapore shows a near-tripling in foreign-currency deposits at the country's banks since the Hong Kong protests began last summer.
However, the Hong Kong Monetary Authority said it had seen "no significant outflows from the Hong Kong dollar or Hong Kong's banking system" in the six months to the end of February.
Christopher Cheung, a pro-Beijing lawmaker who represents brokerages in Hong Kong, said the city's advantages as a financial center wouldn't be diminished.
"Many countries have national-security legislation," he said, "I don't think it will trigger a retreat of foreign investments. On the contrary, it will bring social stability, which helps economic development."
There are potential land mines ahead for financial institutions, both in Hong Kong and farther afield.
Banks could be affected by potential U.S. countermeasures, with senators introducing a bill that would sanction Chinese officials and entities who enforce the new national-security laws, and penalize banks doing business with the entities.
Companies operating in Hong Kong already have to tread carefully to try to avoid offending local staff and Beijing. Some of the companies worst affected in Friday's selloff rely heavily on Hong Kong customers for revenue such as property developer Swire Pacific Ltd. and insurer AIA Group Ltd. In January, HSBC Holdings suffered a backlash over an account closure in Hong Kong, with protesters vandalizing branches and cash machines. The city is the U.K.-headquartered bank's largest market by both revenue and profit.
The monthslong street battles between police and Hong Kong antigovernment protesters tipped the territory's economy into recession last year, even before the novel coronavirus deepened the malaise in the first quarter.
Almost one-third of businesses surveyed by the Hong Kong General Chamber of Commerce expressed concern that they might only be able to survive for up to six months in the current recession due to Covid-19, the chamber said this week. Nearly 90% of the survey respondents said their business activities in Hong Kong had either been significantly or moderately disrupted by the pandemic, which shut down many sectors and resulted in social-distancing measures, some of which are still in place.
The threat of social unrest hovers if those restrictions are fully lifted, a prospect given Hong Kong has reported just a handful of locally transmitted cases in recent weeks. Activists have called for a return to the streets as early as this weekend to protest the impending law, which they see as regalvanizing the movement.
Joanne Chiu contributed to this article.
Write to Chuin-Wei Yap at email@example.com and Jing Yang at Jing.Yang@wsj.com
Corrections & Amplifications
This srory was corrected May 26, 2020. The original incorrectly attributed Mr. Benjamin Quinlan's comment in the thirteenth paragraph.