Hong Kong’s status as the financial gateway to China has a shelf life. And it may be coming due soon.
The city that has been the favoured hub for mainland company listings, and the centre of the offshore renminbi, is poised to see its status diminish in a matter of years.
Hong Kong’s predicament lies in its relationship with the mainland. As China liberalises its capital account, and its debt and equities markets become increasingly accessible to foreign investors, the role of the special administrative region as China’s financial intermediary may well reduce.
Even until recently the idea that Hong Kong woul d lose its favoured-son status as a financial centre seemed unfathomable to many. But in the past few months Beijing has conducted a slew of currency liberalisation measures. The Chinese government is evidently very serious about truly internationalising its currency and economy, and sooner rather than later.
For Hong Kong this presents many opportunities in the short term. But over a longer time frame it may not be so beneficial for the city.
“I think it’s inevitable that Hong Kong will have to stand increasingly alone over time,” says Mark Walton, a senior economist at CLSA based in Hong Kong. “Its advantage right now is being a Western city in a Chinese framework, and it’s a gateway from China to the West and from the West to China. But as China’s capital account opens, that role for Hong Kong won’t necessarily be there.”
Barring China’s unlikely financial collapse, it’s only a matter of time before its communist leaders open up the mainland’s capital account. Until it does, Hong Kong still has a real opportunity to take advantage of its position and benefit from the renminbi’s rise to global prominence.
But that opportunity will not last forever. It may only linger for a handful of years. China’s opening account offers a real money-making opportunity for Hong Kong, but it also has the capacity to render the city insignificant as business floods onshore.
A financial gateway
One key factor above all accounts for the health of Hong Kong’s financial industry, and it’s one over which the city has no control: China’s economy.
For more than two decades, this has not been much of a concern. Beijing has been unwilling to open its market directly to the vagaries of global market forces. Instead Hong Kong served as a conduit, helping funnel money in and out of China.
The city first cemented this role as intermediary in 1991 by introducing investors to mainland equities through H-shares (Chinese-incorporated companies traded in Hong Kong) and red chips (companies based in China, incorporated internationally and listed in Hong Kong). The equities were popular as investors saw them as a means to tap into China’s then-10% annual economic growth rate without shedding the comforts of Hong Kong’s regulated and respected stock market.
Beijing has since chosen Hong Kong to be the proving ground for other products. In 2007, it gained particular fame for becoming the centre of the offshore renminbi, otherwise known as the CNH.
Creating the CNH was a smart move for China’s control-obsessed leadership. The government used Hong Kong to conduct a controlled internationalisation of the renminbi, exposing more companies and governments across the world to the Chinese currency yet minimising the impact of this on the economy of China. It was as close to having your cake and eating it as you can get in macroeconomics.
In the years since, Hong Kong has become the centre for settlement of the currency and related investment products denominated in CNH, principally bonds. The city now holds Rmb566 billion (US$89.83 billion) in deposit accounts, according to the Hong Kong Monetary Authority (HKMA), more than any other city that has released deposit figures. Hong Kong-based banks were authorised to begin lending select amounts to approved Chinese corporates, and Hong Kong residents have been approved to convert up to Rmb20,000 per day.
The city continues to receive new renminbi-linked products and programmes. In November 2002 Hong Kong became the hub for the qualified foreign institutional investor (QFII) programme, which lets authorised foreign asset managers buy local Chinese stocks up to a certain quota.
Beijing followed this with the renminbi qualified foreign institutional investor (RQFII) scheme last year, which lets the offshore divisions of Chinese asset managers raise funds for investment into the mainland.
Because Hong Kong and Macau are home to the only offshore renminbi clearing bank in the form of Bank of China International, they have a powerful advantage over would-be rivals. London, Singapore, Taipei and Tokyo are among the cities that are also vying for offshore renminbi clout (see box below).
Arbitrage eradication
But the very definition of China’s ambition – to globalise usage of the renminbi – means that Hong Kong’s days as the paramount international facilitator of the currency are numbered.
The efforts of China and Hong Kong to internationalise the renminbi have been deemed to be so successful that the People’s Bank of China (PBoC) has said that it wants to make the CNY convertible by 2015.
This goes hand-in-hand with the plan of the country’s State Council, a high-level policy-making body, to position Shanghai as a fully-fledged financial centre by 2020 to shepherd the global renminbi market.
Further moves will become apparent. In recent months China has expanded investment quotas for the QFII and RQFII programmes; allowed approved corporates to tap cheaper offshore lending in Hong Kong; and perhaps most importantly on April 16 it broadened the offshore renminbi’s trading bandwidth to 1% from 0.5%. It has also expanded trade regulation to allow most Chinese companies to settle their overseas bills in renminbi.
More and more renminbi is becoming available internationally. It’s just a matter of time before other cities are allowed to clear the currency and stockpile it. And eventually Beijing will make the CNY fully convertible and open up its capital account, effectively making the renminbi open to all and ending the pricing difference between the CNH and the CNY (see box on page 22).
When that happens, Hong Kong’s competitive advantage will have effectively ended.
How much time does the former British colony have to retain its functioning monopoly on the CNH? Some market experts believe it only has a handful of years. CLSA’s Walton forecasts that the CNH will fully converge into CNY in just five years. Paul Gooding, head of European renminbi business development at HSBC, projects three to five years.
Others take a longer-term view. Stuart Fraser, policy chairman of The City of London Corp., and Adam Gilmour, head of corporate sales and structuring at Citi, guess it will take five to eight years. Dariusz Kowalczyk, senior economist and strategist at Crédit Agricole, and Peter Leung, deputy chief executive and chief financial officer at the Industrial & Commercial Bank of China (ICBC) (Asia), estimate it will take upwards of 10 years.
On the far end of the spectrum Jason Mortimer, a rates strategist at J.P. Morgan, forecasts that “a perfectly convertible renminbi without any restrictions may never happen – or maybe it’ll take 50 or 100 years”. With his longer-term view of the currency he avers that “fears that the CNH is going to disappear in the blink of an eye are not accurate, and business is not going to go away”.
Open-ended
Hong Kong’s dominance in offshore renminbi activity will ultimately depend on how long it takes Beijing to deliver a capital account that is regulated, credible and entirely open to the global market.
“Once Shanghai starts as an offshore trading hub, I don’t see any usefulness in Hong Kong retaining its role,” says Woon Khien Chia, an emerging markets strategist at Royal Bank of Scotland. “Why would you want to trade renminbi with a Hong Kong bank – which has no access to the central bank printing the renminbi – when you can trade directly with a Shanghai bank, which has the direct access?”
To go by the government’s self-set targets, the future of the CNH looks short indeed. Mainland regulators may have set a 2015 target to open its onshore account.
And the country’s commitment to this appears deliberate. In the first two weeks of April alone, China approved an additional US$700 million of QFII quotas to five foreign investors. Also during the month, Beijing announced the implantation of the China International Payments System (CIPS), which it hopes will be operational in two years.
Yet for all such liberalising moves, the mentality of regulators remains obviously protectionist. Another step of Beijing’s in April was to raise the total RQFII quota, yet it only moved the limit from Rmb20 billion to Rmb50 billion – just 8.8% of Hong Kong’s renminbi deposits.
Meanwhile the Financial Times reported that Beijing has invited investors such as the Kuwait Investment Authority and US-headquartered multinational investment company BlackRock to set up offices in the mainland. But it has only granted them quotas of US$100 million-US$200 million to invest into the country, far less than the US$1 billion target each was seeking.
But China can be speedy when it wants to be, and with a new government regime set to come into power at the end of the year there’s a sense that the market’s liberalisation will pick up.
This will be the turning point for China – and could mark the beginning of the end of Hong Kong’s advantage.
Changing times
There is only one thing that Hong Kong’s financial industry can do to try and maintain its importance as a renminbi hub: innovate.
“At the point that the renminbi becomes internationally traded, it’s the case that Hong Kong may be marginalised,” says Leung. “Hong Kong should position itself as a financial services centre alongside a banking centre. Financial service managers have to understand what their clients want – and their clients will want China.”
The city needs to add cutting-edge developments in renminbi-related derivatives, bonds, and all other types of financial instruments. Develop enough liquidity and enough trust with investors in some financial instruments, and the city may be able to retain its dominance of them even when Shanghai opens its doors to the world.
The city appears to understand this. On April 19, one day after London announced its plans to become a trading hub for offshore renminbi (see box on previous page), Hong Kong Exchanges & Clearing (HKEx) announced that it would introduce exchange-traded renminbi-denominated currency futures in the third quarter of the year.
Hong Kong’s financial community welcomed the introduction, and awaits more. Derivatives give investors another product to filter their deposits, and they allow Hong Kong to take advantage of changes instituted by Beijing. Now that the renminbi has more bandwidth to move up and down, investors and companies will be keener to hedge their bets on the currency.
Another example would be for Hong Kong to develop its credit default swap (CDS) market for Chinese borrowers, a nascent industry in China. Additionally the city can create incentives for retail investors to attract more deposits, introduce tax incentives to get corporates borrowing in the debt market, loosen capital reserves to encourage investment, and bolster its equities market to invite renminbi-denominated IPOs.
It can also appeal to a new cache of investors. Other international centres may operate in different time zones, but Hong Kong can still pursue wealthy regional sovereigns and Middle Eastern investors, the latter of which have been participants in Hong Kong’s dim sum bond market.
“Hong Kong has to be less strict about what it rolls out. It has to be on a level playing field to places like London, and it has to do more to boost liquidity,” says ICBC (Asia)’s Leung. “A Rmb500 billion-Rmb600 billion market for funding cannot support a sizable bond market. This is why it has to grow.”
Flexibility is key
Yet all such developments will continue to depend on Beijing’s say-so, and it may yet choose to de-emphasise Hong Kong in favour of Shanghai once its own economy is more open.
“When you talk to Hong Kong market movers, they’re clearly motivated to roll out more and more products. But we must remember that the people calling the shots are on the mainland,” says J.P. Morgan’s Mortimer. “I’m 100% positive that the Hong Kong government will want to move this market forward as quickly as possible to capture financial flows. But at the end of the day they’re on Beijing’s leash, and the real question is what these authorities will allow.”
This is true of Hong Kong’s broader capital markets too. They have become increasingly dependent on unique access to the mainland, but the end of this relationship is coming into sight. Little consensus exists as to what Hong Kong’s exact competitive advantage will be following the opening of China’s account.
Could the city become a Chicago to Shanghai’s New York, in which it acts as a hub for fund managers rather than the centre of trade and business? Will it be like Singapore, drawing in peripheral businesses in sectors such as the pharmaceutical or technology industries? Or will it be like Frankfurt, a regional hub that is the shepherd of business in its native currency?
Asiamoney’s guess is that it will be a Chicago to Shanghai’s New York: Shanghai will have to overhaul its financial regulation, taxation system and ramp up its liveability standards to entice senior management and their families to move there and fulfil its potential to be a fully functioning centre, but this won’t be impossible for a city that’s made so much progress already.
Look to the labour force
For more than 20 years, Hong Kong’s financial industry has prospered from its proximity and unique relationship with China.
For the city to ensure its financial future, it must build services in financial sectors that extend beyond opportunities in China company listings and the renminbi.
Some of this already exists. Hong Kong has a world-class financial and banking infrastructure, and reliable rule of law. It is a leader in foreign exchange trade of all currencies, and its status as a major equities hub will not go anywhere. It’s notable that global brands such as Italian fashion label Prada and premium luggage producer Samsonite have made their public offerings in Hong Kong – and not Shanghai – to tap into a diversified investor base.
Hong Kong still appeals to the worldwide investor community, and the city’s bankers can leverage on their relationships with their global networks to remain relevant.
Ultimately the city’s greatest asset is likely to be its financial workforce. Hong Kong’s financial regulators and the government must work to ensure that these professionals continue to provide unique insight into Asia’s maturing financial markets, and deliver required services.
Succeed and Hong Kong could yet diversify its strengths away from China, perhaps becoming North Asia’s key asset management hub and derivatives centre in addition to its standing as a leading equities venue.
Fail and the city could become a financial footnote when China eventually opens its doors to the world at large.