If you were to ask a global luxury CEO what, these days, keeps them up at night, the escalating unrest in Hong Kong sparked by a now-withdrawn extradition bill is likely to be up there with the trade war between China and the United States or the Brexit impasse between the UK and the European Union.

How can a city of 7 million people be of such vital importance to the luxury industry? It’s a fair question to ask, especially for those unfamiliar with Asia and the role that Hong Kong has long played as a gateway to China and the rest of East Asia for companies entering the region’s thriving retail market.

While the ultimate goal of global brands is to make it big in China, they’ve always used Hong Kong as a springboard, testing the waters in the city before expanding to China with physical stores or even just a presence on e-commerce platforms such as Tmall. (Tmall is a unit of Alibaba Group, which owns the South China Morning Post.)

Thanks to its welcoming and transparent business environment, relatively low taxes and efficient infrastructure, not to mention its mall culture, Hong Kong has attracted luxury stores – as well as the Asian headquarters of Western luxury groups – for the past three decades.

The rise of the Chinese middle class has played a significant role in the growth of the city’s retail scene.

When Chinese tourists began to travel overseas in droves in the early 2000s, they went to nearby Hong Kong before venturing to places further afield such as Japan and South Korea, and eventually Europe and North America.

The commercial hubs of Causeway Bay on Hong Kong Island and Tsim Sha Tsui in Kowloon have become prime destinations for Chinese visitors looking for the latest Gucci bag, SK-II skincare products or even basic items such as infant milk powder.

Attracted by the variety of stores, good customer service, not to mention bargain prices when compared with those in their home countries (Hong Kong is a free port and levies no customs tariff on imported goods), Chinese travellers, as well as wealthy tourists from neighbouring places such as the Philippines, Taiwan and Vietnam, have made Hong Kong the de facto shopping mecca of Asia.

Until recently, international luxury brands’ stores in malls such as Harbour City in Tsim Sha Tsui were their top-performing or second-best-performing outlets in the world. Now they have to contend with a plunge in foot traffic and frequent store closures because of the unrest.

“For many luxury brands, Hong Kong [historically] has represented over 5 per cent of their global sales, which is a significant portion, [and even more for watches and jewellery], so it made sense to have such a large retail footprint in the city,” says Mario Ortelli, managing partner of the luxury advisory firm Ortelli&Co.

“But if tourist arrivals drop and the Chinese stop coming, that kind of retail footprint becomes excessive and three to four stores for a luxury brand would be enough.”

To provide some context, Louis Vuitton has eight stores in Hong Kong but only three in Shanghai, a city of 24 million people, and four in Beijing (population 21 million).

So how will the disruption impact global luxury groups and the luxury industry in the long term? According to Ortelli, for the next few months, brands will take a wait-and-see approach and see how they can make up for lost sales in Hong Kong in other parts of Asia, such as Singapore, Japan and Macau.

The former Portuguese colony, whose retail industry is also dependent on Chinese visitors, picked up the slack in 2014, when the “umbrella revolution” occupation of key roads caused a similar crisis in Hong Kong retailing.

“Luxury sales in Hong Kong are mainly driven by tourists, and mainland Chinese shoppers account for 70 per cent of purchases in the city,” says Ortelli. “The implications of this turmoil are very important, especially when it comes to retail, because brands have made large investments in the city.

“In the short term, there won’t be any closures, so brands will wait till the end of the year or Chinese New Year to see how the situation evolves, and if there’s a significant drop they will take measures such as renegotiating leases, selective reduction of selling space, closures …”

Hong Kong is notorious for having the most expensive retail real estate market in the world. While in the past landlords have been unwilling to negotiate more favourable lease terms with tenants, the worsening situation is starting to change that.

Prada recently announced that it will close its 15,000 square foot store on Russell Street in Causeway Bay, for which it pays HK$9 million (US$1.15 million) per month. The building’s owner subsequently said that it would slash the rent on the property by 44 per cent for a new tenant.

The impact of the Hong Kong protests was a hot topic during the recent Paris Fashion Week. A top LVMH executive who is very familiar with the region didn’t mince his words at an event in the French capital, explaining that if the situation doesn’t improve and if Chinese tourists keep shunning the city, Hong Kong risks becoming “just like any other second- or third-tier city in China”. (Hangzhou, Wuhan, and Chengdu are examples of second-tier cities in China, while Fuzhou, Harbin, and Zhengzhou are examples of third-tier cities.)

LVMH this week reported sales in Hong Kong fell by 25 per cent year on year in the three months to the end of September.
Such a scenario would have been unthinkable as recently as April, but if global brands start closing stores and rein in investment in Hong Kong, it’s not so far-fetched.

One way for stores to make up for fewer international customers is to focus on their local clientele. Hong Kong residents are avid shoppers and represent some of the top clients at local luxury stores, but they are more price conscious than visitors from mainland China and tend to gravitate to online retailers such as Net-a-Porter, Matches Fashion or Farfetch.

Furthermore, the local population can’t possibly sustain the high number of stores fashion brands have in the city. In tourist areas such as Causeway Bay and Tsim Sha Tsui, non-locals make the bulk of luxury purchases, especially big-ticket items such as fine jewels and expensive watches.

Recent data shows that retail sales fell in value by 23 per cent in August from a year earlier, while visitor arrivals declined almost 40 per cent in August from a year earlier, to about 3.6 million visitors, the worst performance since the 2003 severe acute respiratory syndrome epidemic.

According to Bloomberg, about 6 per cent of luxury group LVMH’s sales were registered in Hong Kong dollars during the first half of the year. “We believe that the bulk of the Hong Kong weakness has been compensated in other markets,” Citi analyst Thomas Chauvet told Bloomberg after LVMH reported a 19 per cent rise in third-quarter sales of fashion and leather goods on October 9.

Outerwear maker Moncler, jeweller Tiffany & Co and luxury group Richemont, which focuses on hard luxury goods, are even more reliant on Hong Kong for their global sales and they have all mentioned the deteriorating situation in Hong Kong in their most recent earnings reports.

While it’s too early to say if this is the new normal, such volatility in Asia’s retail hub, and mounting fears of an imminent recession, are likely to make luxury CEOs think twice before they make any further investments in the city.

Hong Kong’s luxury landscape, from five-star hotels to glitzy malls, could look very different in a year’s time.