Big trouble in little Hong Kong?

I came across a couple of news items that appeared to be disturbing on the surface to which the markets haven't really reacted. First, there was this Reuters report of the meeting between China's representative with pro-democracy advocates in Hong Kong (emphasis added):

The setting at the Aug. 19 meeting was calm: A room with plush cream carpets, Chinese ink brush landscape paintings and a vase of purple orchids. The political mood outside, however, was fraught. Democratic protesters were threatening to shut down the global financial hub with an "Occupy Central" sit-in if Beijing refused to allow the city to freely elect its next leader.

After the formal smiles and handshakes with Zhang Xiaoming, the head of China's Liaison Office in Hong Kong, the mood soured. Pro-democracy lawmaker Leung Yiu-chung asked Zhang whether Beijing would allow any democrat to run for the city’s highest office.

Zhang, 51, dressed in a black suit and a navy blue striped tie, delivered a blunt response. “The fact that you are allowed to stay alive, already shows the country's inclusiveness," he answered, according to two people in the room who declined to be named.

The truth of the matter is that Hong Kong's share of Chinese GDP has been falling for years and it isn't as important to China as it was in the past.

Under the circumstances, China's leadership is probably in no mood on treating Hong Kong residents with kid gloves.

At the Aug. 19 meeting, Zhang said Beijing had been generous even allowing democrats such as Leung to run for legislative seats. He insisted that the next leader had to be a "patriot".

"We were shocked," said one person who attended the meeting. "But Zhang Xiaoming is only an agent who delivered the stance of the central government without trying to polish it."

Few were surprised, though, when China's highest lawmaking body, the Standing Committee of the National People's Congress (NPCSC), announced an electoral package on Aug. 31 that said any candidate for Hong Kong's chief executive in the 2017 election had to first get majority support from a 1,200-person nominating panel – likely to be stacked with pro-Beijing loyalists.

For now, the markets have shrugged off this development. The Hang Seng Index is currently testing an uptrend and other regional indices, such as the Shanghai Composite, South Korea and Taiwan indices remain in uptrends.

A march to war?
In addition, the FT reported that a majority of the Chinese population believed that war with Japan is inevitable:

The Genron/China Daily survey found that 53 per cent of Chinese respondents – and 29 per cent of the Japanese polled – expect their nations to go to war. The poll was released ahead of the second anniversary of Japan’s move to nationalise some of the contested Senkaku Islands in the East China Sea.

I have written about how the Chinese and Japanese hate each other, but this latest poll indicating a belief of the inevitability of war is a serious matter. The combination of such attitudes in China and a scenario of rising tensions in the South China Sea would seriously freak out the markets worldwide.

At this point, these kinds of worries are highly speculative, but they have a way of not mattering to the market until they matter. Should Chinese growth weaken in the near future, there will be a temptation to play the nationalism card to distract the populace. In that case, the risk of rising geopolitical tensions will present tail-risk that is probably not in too many analysts' spreadsheet models.