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Hong Kong-China Relations on the Eve of the Handover

by Joseph Yam, Chief Executive, Hong Kong Monetary Authority

(Speech at the International Monetary Conference, Interlaken, Switzerland, reprinted in the HKMA Quarterly Bulletin Issue No.12)

3 June 1997

Hong Kong in Transition

  1. I feel very honoured indeed to be invited to address such a distinguished audience. It has been suggested to me that I should speak on the relations between Hong Kong and the Mainland of China, given that China will resume the exercise of sovereignty over Hong Kong on 1 July 1997.
  2. You may have seen and heard a lot of stories in the popular media on the "handover". Many paint a rather pessimistic scenario for Hong Kong after 1 July 1997, highlighting and in some cases exaggerating a few areas of political disagreement. However, these stories show you only one side of the picture, and a distorted one at that. They ignore the great care that has been taken by the various parties concerned in handling this historic event and in devising arrangements which will preserve and maintain the system that has made Hong Kong an economic miracle.
  3. They also ignore the confidence expressed by international investors in Hong Kong, particularly the international financial community who have a considerable stake in Hong Kong's continued development as an international financial centre. As the handover approaches, they are showing their confidence in a practical way by doing more business and making substantial investments in the territory.
  4. Hong Kong is currently looking good with sound basic economic fundamentals - a stable currency, low unemployment, rapid economic growth and strong public finances. But there is understandably much international attention on the transition, notably on the current state of relations between Hong Kong and the Mainland of China and on the arrangements which will apply after the handover. And to this audience, I imagine there is particular interest on issues on the monetary front. As Chief Executive of the Hong Kong Monetary Authority, I have some responsibility over these matters and I am therefore glad to have this valuable opportunity to address you.
  5. In this presentation, I will first review the economic, in particular the financial and banking, links between Hong Kong and the Mainland of China, which have expanded rapidly over recent years.
  6. Second, I will show you that, in spite of the growing economic relations, Hong Kong and the Mainland of China are still very different, with respect to the economy, financial systems and policies.
  7. Third, I will elaborate on how the principle of "One Country, Two Systems", designed to preserve the stability and prosperity of Hong Kong as an international financial centre, would be manifested in future monetary and banking relationships between Hong Kong and the Mainland of China.

Economic Links

  1. Since 1979, with the beginning of China's economic reform, economic ties between Hong Kong and the Mainland have grown exponentially. China has made extensive use of Hong Kong's markets and institutions to meet its growing financial needs. Hong Kong has benefited enormously from providing such services. I am sure this mutually beneficial relationship will continue in the future.
  2. In In trade, the Mainland is now Hong Kong's largest export market, accounting for more than one third of the territory's total exports. At the same time, about two-fifths of Hong Kong's imports come from the Mainland. Hong Kong also serves as the entrepot between the Mainland and the rest of the world. In 1996, more than 40% of the Mainland's exports and more than one third of China's imports passed through Hong Kong.
  3. In investment, Hong Kong is the largest direct investor in the Mainland. Hong Kong's total cumulative investment in the Mainland amounts to around US$100 billion, or more than half of total foreign direct investment the Mainland has received. Hong Kong entrepreneurs have invested in a wide range of projects, covering manufacturing to power plants and port facilities to urban re-development. Likewise, the Mainland has also invested significantly in Hong Kong. It is Hong Kong's third largest direct foreign investor, accounting for about 20% of Hong Kong's total.
  4. In finance, Hong Kong is an important centre for financial intermediation for the Mainland of China in both the regional and global dimensions. The World Bank estimates that China requires infrastructure investment of some US$800 billion over the coming decade. Hong Kong is also an important funding centre to finance such needs. source of finance for China's enterprises Chinese companies have been raising funds, as well as operating, in Hong Kong for a long time. In the past two years, more than two dozen Chinese state-owned enterprises have made their initial public offerings in Hong Kong. These are known as the "H" shares and have already raised more than US$3 billion. Many more are expected to join them. Listing in Hong Kong provides an efficient way for Chinese enterprises to raise capital. It also helps broaden and diversify the Hong Kong stock market.

    In the coming years, China's demand for funds will remain very strong. The World Bank estimates that China requires infrastructure investment of some US$800 billion over the coming decade. In its current Five-Year Plan, China also expects to invest US$1.6 trillion in fixed assets by the year 2000. The reform of state-owned enterprises in China will create many more joint-stock companies which need to raise new equity finance, a large part of which will come from Hong Kong.
  5. In banking, the links have become much closer as the Mainland of China continues in its process of reform and liberalisation. Banks from Hong Kong have been expanding their business in the Mainland. The number of their bank branches in the Mainland has more than doubled in the past five years to about 30. The situation is the same for representative offices of Hong Kong incorporated banks in the Mainland. At the same time, more financial institutions from the Mainland have set up operations in Hong Kong. In 1996, there were 35 Chinese-owned banking institutions operating in Hong Kong. These institutions currently account for 23% of total customer deposits and 9% of total loans extended by the banking sector of Hong Kong.

Economic Differences

  1. Economic links between Hong Kong and the Mainland are thus large and growing. But even so the two economies and financial systems are still very different and will remain so for quite some time.
  2. In terms of economic freedom, Hong Kong is consistently ranked by outside commentators as one of the most free markets in the world. The Mainland of China has obviously come a long way since 1979 towards developing a more market-based economy, but as of today its approach is still based to a large extent on central planning.
  3. In terms of public sector involvement in the economy, Hong Kong is well known to have one of the smallest public sectors in the world. Whilst the relative size of the state sector in the economy has fallen sharply in the Mainland in recent years as economic reform and liberalisation progressed, the state sector is still predominant.
  4. In terms of the public finances, Hong Kong is again well known for its fiscal discipline. Budget deficits are rare. These occurred in only four out of the past 25 years. The Mainland of China is making good progress in the reform of its public finances, amongst other things, but there is still quite heavy reliance on deficit financing. Even excluding deficits of the state enterprises, the Mainland's budget deficits still averaged about 2% of GDP over the past ten years. Hong Kong has no external debt, but the Mainland has external debt amounting to 14% of GDP.
  5. There are also important differences in policies on monetary issues. In Hong Kong, there are no exchange controls of any type, interest rates are market determined and there are no direct credit controls. In the Mainland of China, there are still controls on capital account transactions, although they are being gradually liberalised. Interest rates are still administratively set and considerable credit controls are still practised.
  6. On the banking side, Hong Kong, as an important international financial centre, is host to around 500 foreign banks from over 40 countries. And we have fully met the supervisory standards recommended by the Basle Committee. China's banking system is still at a relatively early stage of development and commercialisation. A number of important reform and modernisation measures have been implemented, including the introduction of the Law on the People's Bank of China and the Commercial Banking Law, paving the way the establishment of a national interbank market with more liberalised interest rates, and the use of open market operations. These have laid the foundation for the sound development of the monetary and banking system in China.
  7. On financial markets, those in Hong Kong are generally significantly bigger than those in the Mainland of China, although in terms of population Hong Kong is only half a percent of the Mainland. Hong Kong ranks fifth globally in terms of the size of the foreign exchange market and the size of the banks' external assets. Total assets of Hong Kong's banking system are about the same as that of the Mainland of China. Stock market capitalisation in Hong Kong is about 2.5 times that of Shanghai and Shenzhen combined. And the financial infrastructure of Hong Kong in the form of clearing and payment systems for money, debt and other securities is considerably more advanced than that of the Mainland.

One Country, Two Systems

  1. These important differences existing between the two economies are likely to persist for a long time, notwithstanding the rapid pace of economic reform and liberalisation in the Mainland. It was in recognition of this situation that the "one country, two systems" concept was originally formulated and embodied in the Sino-British Joint Declaration and in the Basic Law which has established the constitution of Hong Kong after 30 June 1997. Specifically in the monetary area, "one country, two systems" means that there will be one country, two currencies, two monetary systems and two monetary authorities and that they are to be mutually independent. Being mutually independent means that one currency or monetary system or monetary authority does not have precedence over the other, one is not superior to the other, and one does not take instructions from the other.
  2. Unlike the situation in Europe therefore we have opted for monetary segregation rather than monetary union. If I were to apply the Maastricht convergence criteria to the case of Hong Kong and China, you would see that this approach is the only sensible option. 21. Let me go on to explain in a little more detail what this will mean for monetary and banking relations between the two economies.

Two currencies

  1. There is particular interest among the financial community about what will happen to the Hong Kong dollar after 1997. The "two currencies" concept means that the Hong Kong dollar will continue to circulate as the only legal tender of Hong Kong. It will not be replaced by the Renminbi which will continue to be regarded as a foreign currency in Hong Kong. The Hong Kong dollar will also be regarded as a foreign currency in the Mainland.
  2. I can also assure you that the Hong Kong dollar will continue to be linked to the US dollar under the currency board system which has served Hong Kong extremely well since it was put in place in October 1983. It requires the issue of Hong Kong dollar bank notes to be 100% backed by US dollars at the fixed exchange rate of HK$7.80 to US$1. In practice, given our very substantial foreign currency reserves of US$63 billion, the Hong Kong dollar is currently more than five times backed by such reserves. Furthermore, this policy is supported by Hong Kong's strong economic fundamentals and a robust monetary and banking system with a sophisticated financial infrastructure.
  3. The current exchange rate regime in Hong Kong has lasted for almost 14 years. During that time the link with the US dollar has remained rock solid and confidence in the local currency has remained strong. This has been despite various external events which might have been expected to cause fluctuations in our exchange rate. I am fully confident that this situation will continue in the future. I also believe that given the differences between the economies of Hong Kong and the Mainland I described earlier, which obviously do not meet the convergence criteria for EMU, it is perfectly feasible, and indeed necessary, for there to be monetary segregation, in other words, for the two currencies to co-exist alongside one another. And this will apply whether or not the Renminbi becomes fully convertible at some stage in the future.

Two monetary systems

  1. Corresponding to the two mutually independent currencies will be two mutually independent monetary systems with mutually independent policies determined independently in the best interest of the two economies. I have talked about the macro monetary policy objective of Hong Kong which is to maintain a stable exchange rate or a stable external value of the currency. This is sensible given the extremely externally oriented nature of the Hong Kong economy. The corresponding policy in the Mainland is currency stab
  2. The mutually independent relationship between the two monetary systems also means, among other things, that the two banking systems will remain separate. On the basis of the principles which have been agreed with the Mainland authorities, banks from the Mainland will be treated as foreign banks in Hong Kong, and the same status will apply to Hong Kong banks in the Mainland. It is clearly understood that Mainland banks operating in Hong Kong will be subject to the prudential rules which apply in Hong Kong and will not receive any special treatment or privileges.
  3. Of course, more banks from the Mainland may wish to be in Hong Kong in one form or another. This would be natural in view of the trade and financial links between the two economies, and the fact that Hong Kong is a major international financial centre sitting on the doorstep of the Mainland. This provides a means for Mainland banks to gain experience of operating within a competitive banking environment, which will assist them in the process of becoming more fully fledged commercial banks.

Two monetary authorities

  1. In granting licences to Mainland banks, it is essential that we do not sacrifice our prudential standards. This will be assured by the mutually independent relationship between the two monetary authorities - the People's Bank of China and the Hong Kong Monetary Authority. China has made it clear repeatedly that the People's Bank of China will not take the place of the Hong Kong Monetary Authority after 1 July 1997. The two monetary authorities are independent members within the central banking fraternity. We are, for example, both members of the Bank for International Settlements and a number of central bank forums.
  2. With two mutually independent monetary authorities, the responsibility for the bank licensing regime in Hong Kong and for the application of prudential standards will obviously remain with the Hong Kong Monetary Authority. In banking supervision, Hong Kong's guiding principle is to follow international standards. This is in keeping with the need to ensure that Hong Kong retains its status as an international financial centre. This is more than an aspiration - it is a requirement laid down in the Joint Declaration and the Basic Law. We know that we will only achieve this objective if foreign banks feel that they are operating in a jurisdiction where the supervisory standards are in line with international practice and are applied in an open, fair and consistent manner.
  3. It is also however in keeping with Hong Kong's status that nowadays we do not simply follow international standards but also help to formulate them. We were proud for example to have been one of the supervisory authorities which was invited by the Basle Committee to participate in the drafting of the Core Principles for Effective Banking Supervision. These are intended to set the minimum requirements for effective supervisory systems in all jurisdictions and thus represent an important step forward in global regulation. We are also pleased that the final version of the Core Principles will be promulgated at the IMF/World Bank Meetings to be held in Hong Kong in September of this year.
  4. I hope that many of you will be able to attend this important event to see for yourselves that Hong Kong has not only "survived" the handover, but has put in place the arrangements which will enable it to go from strength to strength.
Last revision date: 1 August 2011
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