Hong Kong and Japan in East Asian Finance

Introduction

I am very honoured to be invited to give a presentation to this illustrious audience on a subject that is of great topical interest. My presentation this morning will be divided into two parts. First, In the first part, I will talk about the forthcoming political transition in Hong Kong and its implications on Hong Kong's monetary arrangements through 1997. Details of this part of my presentation, which is well established through a number of roadshows and conferences held in Hong Kong, London, New York, Frankfurt and Tokyo, are attached as an annex to this paper.

The Sino-British Joint Declaration of 1984 and the Basic Law of 1990 guarantees a high degree of monetary and financial autonomy after the change in sovereignty. In addition, senior Chinese officials have repeatedly given assurances regarding the constitutional safeguards, as summarised in the seven principles governing the monetary relations between Hong Kong and the mainland of China. These will be elaborated in one second. The second part of my presentation will focus on the development of Asian finance, with particular emphasis on the Japan/Hong Kong/China relationship. I would like to place the issue of Hong Kong after the Handover within the broader canvas of historical and strategic trends. In the words of Peter Drucker, I will try to "think globally, but act locally" (Drucker & Nakauchi, 1997). Focusing too much on issues of the moment tend to generate more heat than light, with the result that we often miss what is happening globally with major implications on us all.

Specifically, I shall make several key points:-

• First, technological and managerial changes have created a Virtual Economy, of which Hong Kong is the leading model. This has major implications for East Asian economies, which have built their strength on exports of goods, not services;
• Second, while Asia will remain the fastest growing economy in the world, Asian population is aging, and there will be growing savings that must be mobilized for the huge investments in infrastructure that Asia needs;
• Third, in the 21st century, the euro will emerge as a major reserve currency, challenging the role of the US dollar and indeed, the Yen. This will have far reaching consequences for global finances, and naturally, Asian financial development; and
• Finally, there is considerable synergy in Japan-Hong Kong-Chinese economic and financial development that will benefit the Region as a whole. will also discuss the role of Japan in Asia's development, taking into account Japan's recent Big Bang initiatives are therefore to be welcomed. In fact, the sooner, the better.

Hong Kong: the Virtual Economy

The dramatic transformation of Hong Kong from a leading exporter of light manufactures to a major service economy has been well documented elsewhere (Enright et al, 1997). What has not been well articulated, however, is the fact that Hong Kong is the leading example of the Virtual Economy, an insight of Professor Rosecrance of UCLA. A virtual corporation is defined by him as "an entity with research, development, design, marketing, financing, legal, and other headquarter functions, but few or no manufacturing facilities". "The virtual state (or economy) is akin to the virtual corporation - it is a country which pushes toward a downsizing and relocation of its production capabilities. It performs the headquarters functions and produces its goods within the territory of another state".

From this you can see that Hong Kong is a classic example of the virtual economy, with products made by Hong Kong, but manufactured in Southern China and elsewhere. Hong Kong companies employ an estimated 3-4 million workers in China. By contrast, Japanese firms employ 1.5 million workers in East Asia, compared with 800,000 in 1988 (Hale, 1996). According to the UNCTAD World Investment Report, 1996, Hong Kong is the fourth largest source of outward direct investment in the world, as well as a significant recipient of inflows. In 1995, Hong Kong was estimated to have exported US$25 billion of FDI, compared with US$21.3 billion from Japan.

Hong Kong is the eighth largest trading economy in the world, importing and exporting goods and services worth more than US$441 billion in 1996, or 286% of GDP, with a population less than 5% of Japan's and 0.5% that of China's. Hong Kong achieved this by successfully hollowing out itself, shifting production elsewhere and moving up the value-added chain into the services sector.

Of course, virtual production also exists in Japan, as Japanese manufacturing has hollowed out considerably with the relocation of their production abroad. But Japan is not yet a virtual economy as defined by Rosecrance: "The virtual state could emerge only when the mobility of capital equaled and then exceeded the mobility of goods". Whereas the services sector accounts for 83% of Hong Kong GDP, the equivalent in Japan is 58%. As Professor Rosecrance puts it: "Imperial Britain may have been the model for the nineteenth century, but Hong Kong will be the model for the twenty-first century".

This raises an interesting question. The flying geese thesis suggests that Asian NIEs have historically followed in the wake of Japan, by taking a manufacturing export-led growth path. It is no coincidence that like Japan, a number of East Asian economies are also facing the growth pains of adjustment, attempting to address the imbalances between their underdeveloped services sector, particularly problems in their protected banking systems, and their dynamic export sectors. In contrast, Hong Kong entrepreneurs (including I may add Japanese entrepreneurs in Hong Kong), have flexibly built up their networks throughout the region, creating a dynamic virtual economy through managerial skills supported by free markets, superb infrastructure, free flow of capital and information, low taxation and a business friendly administration. Indeed, the "one country, two systems" principle fits perfectly the advantages of the virtual economy. If Kenichi Ohmae's borderless world is correct, then the Virtual Economy is the wave of the future.

You will have noticed that even though Hong Kong is a major international financial centre, I have not referred to it as a virtual financial system. This is because even though the technology is now available to achieve virtual banking, with the arrival of Internet banking, cybermoney and the like, the security and regulatory issues relating to virtual finance have not been fully resolved, neither in Hong Kong nor abroad. However, I am convinced that in the 21st century, virtual finance will become a reality, and Hong Kong will play a major role in making this happen. Hong Kong already has one of the highest densities of fibre-optic cabling in any city in the world, and with the installation of the most modern RTGS high value payment system in Asia last December, and the arrival of Mondex electronic money, virtual finance is already beginning to emerge.

With globalisation, and the convergence of technology with telecommunications, we are witnessing a revolution in services in which ideas (content) are more powerful than physical products. Weaknesses in the services sector, in Japan or for that matter in Hong Kong or China, can become major impediments to growth potential. This has strategic implications for education, investment in technology, infrastructure and services that the rise of the virtual economy implies.

Aging East Asia and Financial Development

Asia is the fastest growing region in the world. Since 1960, the region has grown at one and a half times the global average. Under current measurements, Asia accounts for 56% of world population, 27% of GDP and 26% of world trade. Japan's Economic Planning Agency projects that Asia, including Japan, would contribute 31% of world GDP by 2010, while the US share would fall to 24% from 27% over the twenty years to 2010.

East Asia and Oceania alone, as represented by the eleven EMEAP² member economies make a substantial group. Just how substantial can be seen from the following comparisons with the 15 member-country European Union (Table 1):

Table 1 EU versus EMEAP: Selected Indicators
Source: Fraser, 1995

To finance this rapid growth will require massive investment, particularly in social and physical infrastructure. Asia needs to upgrade its education and health systems, housing, transport and communications and its ability to deal with a deteriorating environment, brought about by hasty growth. The World Bank has estimated that the infrastructure needs of East Asia alone amount to US$1.5 trillion in the decade to 2004. The bulk of the huge investment demand in Asia can be funded through domestic savings which are readily available. At present, however, a significant part of Asia's savings is intermediated through markets in the US and Europe, which are generally deeper, more efficient, robust and liquid. We can repo US Treasuries in New York time significantly faster than we can repo JGBs in Tokyo time. Japanese investors prefer to trade and settle Euro-Yen paper in Luxembourg time through Euroclear or Cedel rather than through their own clearing and settlement systems in Asian time.

Because of liquidity and credit considerations, Asian foreign exchange reserves are largely invested in American and European markets. East Asia may hold more than 40% of the world's gold and foreign exchange reserves, but a relatively small proportion is invested in Asian paper. These are vivid examples of the shortfalls in Asian financial market intermediation.

There is one significant trend that must be put into perspective. Along with the high income and savings growth rate in Asia is the aging of the population in Asia (Table 2). According to World Bank (James, 1994) calculations, by the year 2010, Japan will have the highest percentage of population in OECD countries over the age of 60 (29%), compared with Emerging Asia³ (9.5%) and China (12%). This trend is also broadly true for Hong Kong.

Table 2 Population over the age of 60 (percent of total)

Source: JP Morgan, World Financial Markets, March 1997

Although this problem is more pronounced in the OECD countries, where the data are more complete, the fiscal and financial implications of an aging population must be major variables in the long-term calculations. The IMF has estimated that by 2010, the net public pension liabilities of Japan would amount to 17.1% of GDP, as against 1.1% of GDP deficit for the major industrial economies, but by 2050, the corresponding deficits would rise to 399% and 210% of GDP respectively (Chand and Jaeger, 1996). While what appears to be alarming fiscal deficits are subject to considerable errors of estimation, depending on the assumptions used, there is no question that an aging population requires major fiscal and financial adjustment.

Specifically, not only is there need for major reforms in Asian pension and retirement schemes, but the rate of return on such schemes must be commensurate with future old age needs⁴. In other words, you cannot forever generate present growth by taxing future generations. You must provide for old age expenditure today. Japan, with the largest pools of retirement and pension funds in Asia, including at least ?0 trillion in corporate pension funds, have a major role to play in investing in growing Asia. Similarly, as Hong Kong begins to build its Mandatory Pension Fund scheme, there will be growing funds available for investment in the capital markets of Asia, as well as those in the OECD countries. The recent APEC co-operative efforts in studying pension reforms are therefore to be welcomed.

We have much to do to prepare the capital markets in Asia to absorb such large flows of savings, and to utilize these effectively. Just as the Chinese market will require the financial expertise of Hong Kong to assist its massive reforms, Hong Kong will need the financial muscles of Tokyo and Osaka, and other international financial markets to develop jointly the growing financial markets of Asia. We need to build the financial market infrastructure, as well as the regulatory framework, so that these financial markets can intermediate savings efficiently and securely, rather than fueling speculative flows. As Mr. Joseph Yam has said last year at the ADB Annual Meeting, the Asian financial market cannot be built singly: it must be built together. With the largest and deepest markets in Asia, Japanese financial institutions have a major role to play in this area.

The Rise of the euro and Implications for Asia

While many Asians have been absorbed by domestic issues, there is a looming event in Europe that will have monumental consequences for the world. I refer to the imminent emergence of the euro, the new unified European currency. As in the case of the transition for Hong Kong, the passage of the euro has as many skeptics as believers. During the transition, there will be evident risks. But whether it happens in 1999 or later and whether it comprises 7, 11 or 15 currencies, I have no doubt that the euro will play a major role as a reserve currency in the 21st century.

First, even if the euro is not yet an economic reality, it is already a political reality. As the Finance Ministers of Germany and France put it last year: "Monetary Union will be Europe's strategic response to the globalization of financial markets". In contrast, the diversity in Asian financial markets means that we neither have a strategic response nor a consensus view on this matter.

Second, the economic reality is awesome. At the end of 1995, the market value of financial assets (bonds, equities and bank assets) in EU countries amounted to more than US$27 trillion, roughly the same size as world GDP (Table 3). By comparison, the market value of assets in North America - with roughly the same population and GDP as the EU - amounted to about US$25 trillion (US$23 trillion in the United States). Even if the initial union were to include only the "core" countries⁵, the euro financial markets would equal the size of Japan's domestic financial market (US$16 trillion).

Table 3 European Union (EU), Japan, and North America: Selected Indicators on the Size of the Capital Markets, 1995

Note: EU(15) include Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom.
Source: Schinasi and Prati, 1997

Thus, in aggregate terms, the euro is likely to be greater than the sum of its parts, surpassing existing EU currencies combined as both a reserve currency and a currency for international transactions. As pointed out by Bergsten (1997), EU has a broadly balanced international creditor position with modest trade surpluses. The US has a net debt position of US$1 trillion, and a current account deficit of roughly US$150-180 billion annually. In the long run, Bergsten thinks that the euro may achieve rough parity with the dollar as a reserve currency, accounting for 40% each of international transactions, with the balance of 20% left for the Yen and other minor currencies.

Once the euro consolidates its position as a reserve currency, it will absorb more savings from Asia. Consequently, Asian financial intermediation must respond rapidly to match the improvements in financial intermediation in Europe. I interpret the Tokyo Big Bang as a response to such a challenge.

To my mind, the strength of the dollar as an international reserve currency hinges on the strength of the American economy, the liquidity of American financial markets and the credibility of its low inflation, steady growth policies. However, just as the rise of the dollar against sterling as a reserve currency created considerable turbulence for the world financial markets in the early part of this century, the emergence of the euro and the Yen as challengers to the dollar in the reserve currency role would shape global financial markets in the 21st century. In this world of global capital flows, we have seen that the major currencies can swing against each other by as much as 30% in a matter of months, as in the case of Yen-Dollar rate between April and September 1995.

As I have pointed out elsewhere, fluctuations in the Yen have major implications for the rest of Asia (Sheng, 1996). According to the World Bank Debt tables, total debt outstanding, denominated in Yen, for all developing countries was estimated at US$265 billion, or 12.8% of total debt of US$2 trillion. Total Yen debt outstanding for East Asia and the Pacific Region was even higher at US$111.1 billion or 30.2% of their total debt. Thus a fluctuation of 30% in the Yen rate would add or subtract nearly US$30 billion to the debt burden of Asian economies.

I do not pretend that I have any answers to these monumental issues, but clearly these are issues that will preoccupy policy makers and financial experts in the years to come.

Relationship between Japan and East Asia, Hong Kong and China

Finally, let me turn to the more immediate issues facing us, the dimensions of Japan and East Asian economic and financial relations, with particular reference to Japan, Hong Kong and China. Hong Kong and Japan are very important trading partners. Total trade between Japan and Hong Kong has increased 3.3 times in the past decade, with value reaching US$39 billion in 1996. Japan is Hong Kong's third largest export market, taking up 7% of its total exports. A majority of these Hong Kong products were re-exports from China. At the same time, Hong Kong receives 14% of its imports, or 17% of its GDP, from Japan in 1996.

Besides, Hong Kong continued to be a favourite destination for Japanese overseas investments. About one-fifth of Japan's total direct investments in Asia is placed in the territory. Currently, 2,000 to 3,000 Japanese companies are operating in Hong Kong, including large trading houses which play a significant role in Hong Kong's exports to Japan. In 1995, Japan's cumulative direct investment in Hong Kong reached US$1.14 billion. Furthermore, Japan was the largest investor in Hong Kong's manufacturing sector, accounting for about one-third of total foreign investment.

To support such trade and financial transactions, Japanese financial institutions have increased their offices in Hong Kong. By the end of last month, there were 91 Japanese-owned authorized institutions in Hong Kong, constituting the largest group of foreign banks in the territory. They accounted for HK$3.5 trillion in assets, the largest concentration of Japanese financial institutions outside of Japan. Oover half of the external liabilities of banks in Hong Kong reflects deposits and inter-bank placements from Japan. Many large Japanese securities trading firms are also active in Hong Kong. In 1996, there were 39 Japanese securities dealers in Hong Kong, which was the largest among overseas participants.

In addition, as a result of China's continual economic progress, and investment in the infrastructure, new business opportunities would arise. The trade between Japan and China reached US$62 billion last year, compared to no more than US$1 billion in 1972. Today, Now China is became the second largest trading partner for Japan.

By any standards, China's resurgence into the global economy has been astounding. Over the last 15 years, China has grown on average by 10.2% per annum. Between 1980-95, trade has grown on an annual average of 15%, twice the world annual average growth of 7.4%. China is today the 11th largest trading economy, with a share of 2.8% of world trade, compared with 1.0% in 1980.

Over the years, Japanese has moved their production base to China and other economies, the so-called 'hollowing out" of Japanese industry. "Hollowing out" actually strengthens Japan's manufacturing base, as unproductive operations are transferred to other parts of the world where resources, technology and costs are more favourable. Some may argue that moving production overseas may lead to a decline in exports. However, in practice it rather leads to a substantial increase in exports. Overseas investment substitutes exports with high-skilled and high-value-added goods. Moving production offshore should be seen primarily as a way to establish offshore markets as businessman gather more information about the opportunities and develop good business relationship. With population of 1.2 billion, China is a huge market.

On various assumptions, a number of forecasters, including the World Bank, have suggested that China would become one of the world's largest economies (if not the largest) by roughly the year 2020 (Boltho et al, 1994). The World Bank has in fact estimated that the Chinese Economic Area (China, Hong Kong and Taiwan) would in purchasing power parity (PPP) terms, be larger than the US by the year 2002 (Table 4). In 1993, the CEA's GDP as a group amounted to US$875 billion or less than one-fifth that of Japan, but the combined trade (imports + exports) of the CEA exceeded that of Japan (Nomura, 1995).

Table 4 Emergence of Chinese Economic Area (Gross Domestic Product) (in US$ trillion)

Assuming that China would grow by 8.5% and 7% for the period 1990-2000 and 2000-2010 respectively, 5.0% and 4.5% respectively for Hong Kong and 6.5% and 6.0% for Taiwan, the World Bank staff forecasts that the CEA would account for 17.1% of world output and 10.3% of world exports of manufactures. The validity of the growth assumptions are supported by other sources. For example, the Japanese Economic Planning Agency has projected that China will grow at an annual average of 8.2% in real terms during 1990-2010 (JEPA, 1997)

The potential of the Chinese financial market is mind-boggling. Hong Kong, with the world's seventh largest stock market in terms of market capitalization, has an active investor population of around 350,000. The Chinese stock markets of Shenzhen and Shanghai, open only since 1990, have investor accounts of 20 million. In contrast, the big US market has 57 million individual investors. It is not difficult to see that in the 21st century, the largest mortgage market in the world will be Chinese, with a population base of 1.2 billion. Clearly the opportunities to invest in China are huge, but the risks are equally challenging. This is where Hong Kong has unique advantages relative to other cities. Japanese and international capital already invest in China through H-shares, red-chips and via companies based in Hong Kong. Hong Kong is already the regional headquarters of nearly 2,000 multinationals, and another 2,000 mainland companies with extensive distribution and manufacturing networks in China and the region. The task of risk management, marketing, financing and packaging is one in which the Virtual Economy of Hong Kong is uniquely equipped to handle.

Modernization of distribution systems in China help avoid concentrating commodities in certain areas and thus eliminate social imbalances. Distribution-led development, because it creates hundreds and thousands of small businesses, creates human resources and human competence. And people, rather than money, develop an economy. Japanese entrepreneurs can help modernize China's distribution system, contributing to the creation of affluence.

Hong Kong particularly enjoys the strategic advantage of being the gateway to China and the regional economies. Hong Kong's proximity to China and its understanding of Chinese businesses and the Chinese culture, including the language, gives Hong Kong a clear advantage to serve as the window to China. Hong Kong's unique position under the concept of "one country, two systems" makes it the most ideal place for facilitating foreign investments in China.

Despite the growing size of the rest of Asia, Japan is a giant by any standards. East Asian economies (excluding Japan) only account for 7% of world GDP, while Japan alone accounts for 17% (Gyohten, 1996). Private financial assets in Japan amounted to 6.3 times of non-Japan Asian GDP. Japan has not only the largest banking and capital market by size, but also the strongest lead in manufacturing technology, and the most sophisticated research and development capability in Asia.

Given its lead, the rest of Asia has become more important fFor Japan both as a market and as a site for overseas investment. In fiscal 1994, Japanese investment in Asia rose by 47% to overtake Europe as the second largest recipient area of Japanese investment, behind North America. In the year to March 31, 1995, new Japanese direct investment in Asia totaled US$9.7 billion or 24% of Japan's total overseas investment.

Asia is the fastest growing region in the world. Since 1960, the region has grown at one and a half times the global average. Japan's Economic Planning Agency projects that Asia, including Japan, would contribute 31% of world GDP by 2010, up from 25% in 1990, while the U.S. share would fall to 24% from 27% over the same period.

To finance this rapid growth will require massive investment, particularly in infrastructure. The World Bank has estimated that the infrastructure needs of East Asia alone amount to US$1.5 trillion in the decade to 2004. The bulk of the huge investment demand in Asia can be funded through domestic savings which are readily available in sufficient amount. At present, however, a significant part of Asia's savings is intermediated through markets in the US and Europe, which are generally deeper, more efficient, robust and liquid. Asian foreign exchange reserves are largely invested in these markets. Asian governments and credit-worthy corporations tend to issue their debt there, clearing their paper through European central securities depositories, such as Euroclear and Cedel in European time. These are vivid examples of the shortfalls in Asian financial market intermediation.

Along with the increase in incomes and the aging of populations in Asia, there will be an increasing role for retirement funds. Tokyo as an international financial centre can face it as an opportunity for more businesses and a challenge to its inefficient and over-controlled financial markets.

The role of Japan in the region, as for or of any other developed country, is to in encourageing the development of markets and trade as active private enterprise to be active as partners in developmenting countries. The enormous savings in Japan, and the depth of its capital markets, as well as the strength of its industries and technology, have a major role in the development of Asia for the benefit of all.

It is private initiative, the leadership of people, the example of people, the development of the human resource in which a developed country can inspire and in which it can discharge its responsibility towards the developing world.

I therefore interpret The recent Big Bang Initiative on the revitalization of the Tokyo Financial Market by 2001 as a necessary and vital is a big step to play its role regionally and globally. Deregulation in Tokyo will strengthen domestic yen business, but given an aging population and slower domestic growth, profit opportunities will continue to be outward driven. That is, Japan will continue to export capital in search of higher yields for pension and retirement funds. Given strong growth in Asia, we see a large share flowing to the Asian region. Hong Kong will continue to be an important intermediary in that flow.

In short, further enhance the role of Japan. Hong Kong does not see the Big Bang as a threat, but as an opportunity. In the short run, somethere will be very little impact on financial institutions may consolidate their activities back to Japan, largely from the need to adjust to competition.and their business activities in Hong Kong, arising from the deregulation, which is expected to proceed more slowly than announced because of resistance from vested interests. In the long term, the de-regulation will increase competitiveness of Tokyo's financial markets and hence their efficiency. Freer markets, as the lesson of Hong Kong shows, bring more business, not less. The Big Bang therefore Nevertheless, it is beneficial not only to Japan itself, but also to Hong Kong and the Region. The experience of deregulation is that the cake gets bigger, rather than smaller, to be shared by more players.

Tokyo sees the threat to itself coming not from Hong Kong, but more from Singapore. The JCIF Opinion Survey of Foreign Financial Institutions in Tokyo in December 1995 reports that it expects Singapore to overtake Tokyo in 5 years. The Survey sees the relationship between Hong Kong, Singapore and Tokyo as complementary, since one market's strength reflects the others' weakness. While Tokyo has large markets, Hong Kong and Singapore rank higher in terms of profit opportunities.

Conclusion

Hong Kong's transition must be seen within the wider canvas of regional and global changes. The strategic advantages of Hong Kong, at the geographical centre of the fastest growing region in the world, the finest deep seaport and telecommunications, the lowest tax and most business-friendly and fair regulatory regime: all these will not change through 1997. Strategically, the potential of the Chinese and Asian markets, with their rising middle class prosperity, is too big to ignore. Hong Kong will continue to function as a Virtual Economy, at the heart of cross-roads of Asia.

The greater challenges come from the need to understand that global markets are changing, with improving technology and competition by the day. Unless we all work together to respond to such challenges, in a spirit of free trade and co-operation, then Asia will slip in competitiveness relative to the other continents.

As I have tried to show, in the Virtual Economy of the 21st Century, hollowing out is not a vice but a virtue. The Japanese experience shows that ultimately markets prevail. In the Global Virtual Economy of the 21st century, the Hong Kong experience has much to offer to the rest of the world.

12 May, 1997 Hong Kong

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Annex
HONG KONG MONETARY AUTHORITY
HONG KONG'S MONETARY ARRANGEMENTS THROUGH 1997¹

I. Introduction

Under the Sino-British Joint Declaration of 1984, China will resume its exercise of sovereignty over Hong Kongthe sovereignty over Hong Kong will revert to China on 1 July 1997. After that date, Hong Kong will become the Hong Kong Special Administrative Region (HKSAR) of the People's Republic of China, governed by the Basic Law, the applicable constitution of Hong Kong.

Both the Joint Declaration and the Basic Law enshrine the principle concept of "one country, two systems". Under this framework, Hong Kong shall enjoy a high degree of autonomy after 1997, except in foreign affairs and defense matters. This concept of "one country, two systems" will also apply to the monetary and financial arrangements between the mainland of China and Hong Kong.

The practical issues under the legal framework have been translated into a set of comprehensive principles, which senior Chinese officials have clarified in different occasions. These principles define the post-1997 monetary relations between the mainland of China and Hong Kong as "one country, two currencies, two monetary systems and two mutually independent monetary authorities". Mutually independent means that one does not have precedence over the other, one is not superior to the other and one does not take instruction from the other.

There are practical and sound reasons why two separate currencies will be maintained. The Hong Kong dollar is an established, freely convertible currency that is widely accepted for trade and investment purposes. It is more than five times backed by foreign exchange reserves. It is the only legal tender in Hong Kong and is treated as a foreign currency in the mainland of China. The Renminbi is convertible for current account purposes but is not yet convertible on the capital account. It is the only legal tender in the mainland, and is treated as any other foreign currency in Hong Kong.

Significant structural differences between the economies in the mainland of China and Hong Kong also support monetary segregation. The Chinese Government recognizes that corresponding to two currencies will be two monetary systems, reflecting the differences between the two economies. Both monetary systems are of equal importance to China in its reform and liberalization. The close trade and investment ties between the two economies would be facilitated by close cooperation in such areas as development of financial markets, financial infrastructure and prudential supervision.

II. Constitutional Safeguards

While the Joint Declaration elaborates the basic policies of the People's Republic of China regarding Hong Kong after 1997, the Basic Law prescribes the systems for implementing such basic policies in the HKSAR after 1997. Regarding financial and monetary affairs, both legal documents secure a high degree of autonomy. These are outlined in Parts V and VII of Annex I of the Joint Declaration and Articles 109 to 116 of the Basic Law². Specifically, it is provided that, after the transition, the HKSAR Government (HKSARG) may decide its monetary and financial policies on its own. As to currency arrangements, the existing system will continue, and the Hong Kong dollar shall continue to circulate and remain freely convertible. Furthermore, Hong Kong's foreign exchange reserves, namely the Exchange Fund, will be managed and controlled by the HKSARG, primarily for regulating the exchange value of the Hong Kong dollar.

Under the Basic Law, there will be an even higher degree of monetary autonomy. Currently under the Royal Instructions, the Governor shall not assent to any Bill relating to the currency or any banking association without having obtained approval from the Secretary of State. However, the Basic Law only requires that laws enacted must be reported to the Standing Committee of the National People's Congress for the record, while such reporting for record will not affect the entry into force of these laws. Furthermore, powers of the Secretary of State have been localised, so that the authorities over areas such as Exchange Fund's investment in securities and the borrowing limit for the Exchange Fund have been brought entirely into Hong Kong.

Hong Kong will enjoy an equally high degree of fiscal and financial autonomy after the change in sovereignty. The legal framework safeguards that the HKSAR shall use its financial revenues exclusively for its own purposes, and they shall not be handed over to the Central People's Government. There are also provisions stating that the Central People's Government shall not levy taxes in the HKSAR.

A distinctive feature of the Basic Law is that it specifically lays down that the HKSARG "shall provide an appropriate economic and legal environment for the maintenance of the status for Hong Kong as an international financial centre". It is also the responsibility of the HKSARG to safeguard the free operation of financial business and financial markets, and regulate and supervise them in accordance with the law. Under the Basic Law, Hong Kong's common law framework and courts system will be retained. The existing capitalist system will be retained in Hong Kong, whereas the mainland socialist system and policies will not be practised in Hong Kong. Moreover, Hong Kong will maintain its status of a free port and a separate customs territory with free flow of capital. Such constitutional framework is conducive to maintaining and enhancing the competitiveness of Hong Kong's financial markets.

There are also provisions in the Joint Declaration and the Basic Law that Hong Kong may, on its own, maintain and develop relations and conclude and implement agreements with other countries, regions and international organisations, using the name of "Hong Kong, China". For example, Hong Kong is a member of the Asian Development Bank, the World Trade Organization, and Asia-Pacific Economic Cooperation (APEC), and the Hong Kong Monetary Authority (HKMA) is a member of the Bank for International Settlements and a participant of the New Arrangements to Borrow (NAB). Such provisions help maintain and promote Hong Kong's international monetary relations and hence its status as an international financial centre.

III. Principles governing the monetary relations between the mainland of China and Hong Kong after 1997

On the basis of the legal framework, there are seven principles governing the monetary relations between the mainland of China and Hong Kong after 1997, as enunciated by Mr. Chen Yuan, Deputy Governor of the People's Bank of China³. These principles cover the full range of monetary and financial affairs and elaborate the framework of "one country, two currencies, two monetary systems and two mutually independent monetary authorities".

(a) Monetary Autonomy

The first principle states that the Renminbi and the Hong Kong dollar will remain two different currencies, circulating as legal tender in the mainland of China and Hong Kong respectively. The Hong Kong dollar will be treated as a foreign currency in the mainland. Likewise, the Renminbi will be treated as any other foreign currency in Hong Kong.

Corresponding to the "two currencies" will be "two monetary systems". The current note-issuance by three note-issuing banks in Hong Kong will continue to exist, with 100% backing by US dollars under the linked exchange rate system. The objective of monetary policy in Hong Kong is currency stability, in terms of the Hong Kong dollar's link to the US dollar at the fixed exchange rate of 7.80 to the US dollar. Exchange rate stability and hence confidence in the currency is crucial to the maintenance of stability and prosperity in Hong Kong before and after 1997.

The Hong Kong dollar's link with the US dollar follows the currency board system, which is a strong form of the fixed exchange rate regime. Since its adoption in 1983, the link has remained resilient to a number of external shocks. For an open and highly externally oriented economy, the maintenance of a stable external value of the currency has proved to be a successful policy. Over the past ten years, a number of monetary reform measures have been introduced to strengthen Hong Kong's monetary system and to put the authorities in a strong position to ensure exchange rate stability.

The linked exchange rate system has received support from both the United Kingdom and the Chinese Governments, as well as the international community including the International Monetary Fund⁴ and the Bank for International Settlements⁵. Indeed, the People's Bank of China (PBoC) has pledged to support the currency stability of Hong Kong, as the fourth of seven principles laid down above. In February 1996, the PBoC entered into a repurchase agreement on US Treasury papers with the Hong Kong Monetary Authority (HKMA), to enhance the liquidity of each other's official reserves and to preserve exchange rate stability. The PBoC has also pledged its readiness to use China's foreign reserves to support the Hong Kong dollar when necessary at the request of the HKMA. However, it has been emphasised many times that China will not draw on or resort to Hong Kong's Exchange Fund or other assets in any way and for any reasons. China is currently the world's second largest foreign reserves holder, with reserves of US$105 billion as at the end of 1996.

The second principle relates to the relationship between the two monetary authorities. With two currencies and two monetary systems, the two monetary authorities will also be mutually independent, as defined in paragraph 3. The PBoC will not take the place of the HKMA and will not set up any branches in Hong Kong. The HKMA is responsible for monetary affairs in Hong Kong and it will be accountable solely to the Hong Kong government.

(b) Co-operation in prudential supervision

As a major international financial centre, Hong Kong will maintain its high level of prudential supervision over financial institutions operating in Hong Kong, and a clear level playing field in accordance with international rules and practices. Hong Kong's high financial regulatory standards will be maintained in line with the best international practices and standards. These are illustrated in the third principle.

In particular, the supervisory policies and practices of the HKMA are in line with international standards. The supervisory standards recommended by the Basle Committee on Banking Supervision are fully met in Hong Kong. Indeed, the supervisory framework is clear, transparent and accountable, with the Banking Ordinance clearly defining the powers and responsibilities of the HKMA as the regulator. Moreover, the HKMA is transparent on how it interprets and applies the statutory framework and it maintains a close dialogue with the banking industry. There is also a clearly defined mechanism for reaching supervisory decisions and judgments within the HKMA for appropriate checks and balances. Furthermore, the HKMA offers guidance to the banking industry through statutory guidelines issued under the Banking Ordinance and a Code of Banking Practices.

The co-operation in licensing procedures and supervision of financial institutions from the mainland of China and Hong Kong will follow these guidelines:-

• Financial institutions from the mainland established in Hong Kong shall not enjoy any privileges. They shall abide by the law of Hong Kong and be regulated by the relevant supervisory authority in Hong Kong.
  Financial institutions based in the mainland and Hong Kong setting up offices in each other's territory shall be approved on the same basis as foreign financial institutions. .
  The offices of Hong Kong based financial institutions in the mainland shall continue to enjoy the same preferential treatment in the mainland as other foreign financial institutions. .

In addition, the HKMA has agreed with the PBoC to coordinate the applications for cross-border licences by banks from their respective territories. They will also allow one another to conduct examinations of the cross-border operations of banks in their respective territories and to exchange information on such operations.

The fifth principle relates to the treatment of financial business between the mainland of China and Hong Kong. After July 1 1997, all financial business and even commercial disputes between the two places will be handled according to the rules and practices of international financial activities. Claims and liabilities between banks and companies from the mainland and those in Hong Kong will continue to be regarded as external claims and liabilities.

The sixth principle relates to the standing of financial institutions from the mainland in Hong Kong. The HKMA will continue to supervise all financial institutions in Hong Kong, including financial institutions from the mainland. The Bank of China group, though being one of the three note-issuing banks and a leading commercial bank in Hong Kong, shall not be treated more favorably than other banks. It shall not carry out activities beyond the role of a commercial bank.

(c) Hong Kong as an international financial centre

Hong Kong's continued autonomy as a financial centre after 1997 requires that it should retain its own links with monetary and financial authorities abroad and continue to participate in the activities of international and regional financial institutions, such as central bank forums and working groups. China has supported Hong Kong's continued membership of a number of international bodies. The international financial community also acknowledged the "mutually independent" relationship between the PBoC and the HKMA, as demonstrated by separate membership of the two in the Bank for International Settlements.

To cope with the growing financial integration, there should be an efficient and robust market infrastructure linking the financial markets. The HKMA and the PBoC have agreed in principle to the linkage of their high value inter-bank payment systems. The HKMA introduced its Real Time Gross Settlement (RTGS) interbank payment system in December 1996, while the PBoC is expected to complete its RTGS China National Automated Payment System in the near future. Further linkages of payment systems around the region and with other international financial centres would enhance both regional and global financial integration.

The seventh principle of Hong Kong's monetary arrangements through 1997 relates to the complementarity between Hong Kong and Shanghai. While Shanghai is currently China's major financial centre, the governing principle is that Hong Kong and Shanghai will have a complementary and mutually reinforcing relationship, developing together with their own unique features and under different comparative advantages. It has been pointed out by several senior Chinese officials that in the short run, and at least before the Renminbi becomes fully convertible, it will not be possible for Shanghai to become an international financial centre. In the longer-term, the role of Hong Kong as an international financial centre will serve to expedite the development of Shanghai as the main centre for Renminbi business. At the same time, Shanghai will support Hong Kong's further development as an international financial centre, and gradually become an international financial centre itself. Given the size of China's economy, there are ample business opportunities for more than one financial centre.

IV. Economic foundations of the monetary relations

The strong economic fundamentals in the mainland of China and Hong Kong also argue for a smooth monetary transition through 1997. The sound economic fundamentals of Hong Kong, characterised by continued strong growth and moderated inflation, are the bases for continued prosperity and stability. In addition, its unique advantages, such as openess, strategic geographic location, excellent communications and financial skills, will not change as a result of the change in sovereignty. Moreover, the Hong Kong government follows strict fiscal discipline that underpins its monetary policy and enhances the credibility of its monetary stance.

Equally, the continued economic development and financial reforms in the mainland of China has created excellent opportunities for Hong Kong. China's economy continues to grow strongly, generating a strong demand for funds. Given the strategic position of Hong Kong, it will continue to be the major funding centre for the mainland after 1997, as it has been in the past. Stability in the mainland is the very basis for Hong Kong's stability while Hong Kong's stability will certainly enhance economic reform and developments in China.

As an indication, the market has its vote of confidence on Hong Kong's monetary arrangements through 1997. The inaugural issue of 10-year Exchange Fund note in October 1996 was well received, with oversubscription rate of over 13 times. The paper currently shows a yield with only 40 basis points above US Treasuries, indicating no risk premium associated with 1997 and beyond.

V. Conclusion

With the mutually beneficial relationship between the mainland of China and Hong Kong, it is of China's strategic interest to retain the present monetary and financial policies that have served both well. Nevertheless, there is also the need for close cooperation between the two places to derive the most benefits out of their close ties.

The "one country, two currencies, two monetary systems and two mutually independent monetary authorities" principle is both visionary and pragmatic way of defining the monetary relations between the mainland of China and Hong Kong after 1 July 1997. Indeed, this is well secured by the legal and constitutional framework, which has been translated into a set of governing principles publicly announced by the senior Chinese officials. At the same time, the economic developments in the mainland and Hong Kong also provide a favourable environment for the legal provisions to be realistically observed. Through 1997, there will be the right legal, constitutional and economic framework for a smooth monetary transition in Hong Kong.

Hong Kong Monetary Authority
Mar 1997

1. I am grateful to Carmen Chu for research assistance in preparing this paper. The views expressed here are entirely personal and do not necessarily reflect the views of the HKMA.
2. Executive Meeting of East Asia and Pacific central banks and monetary authorities, comprising Australia, China, Hong Kong, Indonesia, Japan, Korea, Malaysia, New Zealand, Philippines, Singapore and Thailand.
3. East Asia, excluding Japan, plus India
4. The return on equity of US corporate sector was 19.2% in 1995, compared with 2.7% in Japan, 12.6% in Hong Kong, 11.3% in China, 14% in Malaysia and 19.2% in the Philippines (Hale, 1996).
5. Include Austria, Belgium, France, Germany, Luxembourg, the Netherlands.

ANNEX Footnotes:

1. This paper was prepared by the Hong Kong Monetary Authority staff for the Conference on Financial Integration in Asia and the Role of Hong Kong, to be held in Hong Kong on March 7, 1997.
2. The key excerpts from the Joint Declaration and the Basic Law are attached as Annex 1 of the paper.
3. Speech at an Bank of England seminar held on September 10, 1996 in London
4. In the IMF's annual Article IV consultations with Hong Kong.
5. The BIS stated that the sheer size of Hong Kong's international reserves "has given this commitment (to exchange rate link) almost unparalleled credibility"