Hong Kong as an International Financial Centre to 2010

Hong Kong as an International Financial Centre to 2010 1

Hong Kong has many advantages as an international financial centre, not least of which is its strategic geographical position as a major hub and gateway to China. With the changing financial landscape and the recent currency turmoil, Hong Kong may face greater competition both regionally and globally. Elements such as effective risk management, prudential regulation, world-class financial infrastructure and high degree of integrity and transparency are important in keeping Hong Kong competitive in the 21st century as an international financial centre.

I am honoured to have been invited to this seminar to discuss a subject of such crucial importance to Hong Kong. Talking about what will happen in the next millenium - the next 1,000 years - must be the easiest of subjects. What I find most difficult is to predict what will happen tomorrow. To quote the eminent British scientist: JBS Haldane: "This is my prediction for the future: whatever hasn't happened will happen and no one will be safe from it."

After the Asian crisis, which we can safely say no one predicted as late as last July, how dare we predict even the next millenium? Allow me therefore to address a simpler and more modest question: is Hong Kong adequately equipped as an international financial centre to the year 2010? Our Australian friends considered the future of the financial system so important that they devoted not only a Conference, but also a whole Inquiry on the subject 2. Or, as Bill Gates is reputed to have said, "In the 21st century, banking will be important, but not necessarily banks".

Before we launch into this question, it is useful to summarize what the Wallis Inquiry has to say about the changing financial landscape to the year 2010 3. There are four main elements:-

  • Increased focus on efficiency and competition - changing consumer behaviour and technology driven innovation will erode old franchises, create new products and change the structure, costs and operations of the financial landscape.
  • Further globalization of markets - deregulation, market reforms and improved communications will create global markets, intensify competition and complicate regulations.
  • Conglomeration and market widening - product and institutional boundaries are blurring, as non-financial intermediaries invade the turf of financial institutions.
  • A further shift from intermediaries to markets - markets are developing to meet the financial services needs of a wider range of users, with the evolution of derivatives. As such, markets can manage risks more efficiently.

 

Are international financial centres necessary in the 21st century?

The above scenario suggests that as technology allows markets to cut out the intermediary, by connecting the consumer directly with the producer, the role of international financial centres becomes threatened in the 21st century. The triumph of markets over central planning is that technology makes the past obsolete, destroying old franchises and creating new value. What Hong Kong can do today, someone with an access to Internet can do tomorrow, with the same speed and at lower cost. Thus, despite her past and present success, the future of Hong Kong's role as a leading international financial centre is by no means assured. In short, we must not be complacent.

Of course, Hong Kong's achievements as an international financial centre speak for themselves (see Annex). Hong Kong is home to Asia's second largest stock market and a rapidly growing debt market. Our stock market is ranked the world's ninth largest in market capitalization and eighth in total turnover.

Hong Kong's forex market is the fifth largest in the world and its derivatives market the seventh largest. With more than 80% of trading between foreign currencies other than the Hong Kong dollar, and no less than 70% of turnover done with forex dealers abroad, our forex market is clearly outward-looking.

As an international banking centre, Hong Kong is the fourth largest in terms of external assets of banks. The strength of this market has also created a critical mass of the world's top financial services firms. More than 500 banking institutions from over 40 countries, including more than 80 of the world's largest 100, are located here. The external liabilities and claims accounted for an average of 56% and 57% respectively of the total liabilities and asset of all authorized institutions.

Hong Kong has many advantages as an international financial centre, not least of which is its strategic geographical position as a major hub and gateway to China. Other advantages that have often been mentioned are, to quote Professor Y. C. Jao (1997):-

Internal Factors -

  • Political and Social Stability
  • Economic Freedom
  • Sound Legal System and the Rule of Law
  • Good and Responsive Government
  • Unrivalled Record of National Treatment
  • Favourable Tax Regime
  • Low Regulatory Costs
  • Efficient and Modern Infrastructure
  • Freedom of Information
  • A Skilled Population
  • Use of English

 

External Factors -

  • Location and Time Zone Advantages
  • The China Factor
  • Robust Economic Growth in the Asia-Pacific Region
  • Globalization of Banking and Finance

 

These factors are necessary but not sufficient conditions of success, as we learnt from the Asian financial turmoil. It is easy to be an international financial centre when the going is good. When capital flows reverse, problems surface. In the section below, we shall attempt to draw lessons from the Asian crisis to reflect on how to enhance Hong Kong's competitiveness in the next decade or so.

 

Asian Financial Turmoil

There is now a new growth industry globally, which are conferences dedicated to the analysis of the Asian financial crisis. The list of reasons for the Asian turmoil can include everything from Asian values to the El Ni Effect. The most elegant expositions are those by Professor Krugman of MIT and Professor Sachs of Harvard. Crudely put, the former attributes the problems to Asian crony capitalism and the latter to market panics. They may both be right. IMF Managing Director Michel Camdessus is almost certainly correct to say that this is the first financial crisis of the 21st century. I shall not add to the confusion here. My own simplistic explanation is that decision-makers at all levels, investors, corporations, borrowers, lenders, policy-makers and the international financial community failed to manage their risks properly in an age of global capital flows. The rapid process of financial liberalization in emerging markets in Asia led to a process of overborrowing by the private sector, caught up in the headiness of strong economic growth. Overinvestment in asset markets, despite the high domestic savings, and undermanagement of interest rate, exchange rate and credit risks caused many domestic financial systems to be much more vulnerable to contagion than before.

Add to this generally loose monetary policy and higher savings due to an aging population in the OECD economies, particularly in Europe and Japan, and you get a potent mixture of large capital flows in search of high returns, herding into Asia. The borrowers were egged on by willing lenders who perceived little risk in investing in the fastest-growing region in the world. To be fair to the borrowers, in their anxiety to get quick returns, many investors and lenders ignored the bad accounting, non-transparent cronyism and other blemishes that have always been here in Asia for all to see. As some of our Southeast Asian friends complained: "one minute you are Miss Universe, the next you are the Ugly Sisters!".

However, who are we to complain about markets? What we find much more interesting in the Asian crisis story is not what happened, but what did not happen. Why is it that the Hong Kong dollar stood firm despite all the turmoil in the region? To answer this question, we shall have to delve into the factors that led to Hong Kong's success as an international financial centre.

 

Effective Risk Management and Resource Allocation

An important function of financial intermediation is to enable both counter-parties (borrower-lender, investor-issuer) to manage their risks better. Thus, a key criterion of an international financial centre is the provision of facilities for investors to prudently manage their risks and allocating their scarce resources. The sophisticated investors today are continuously calculating and evaluating their risks versus returns, allocating their assets and managing their liabilities to those markets that offer an optimal risk-return frontier - the highest returns with lowest risks/volatilities. To do this effectively, they will need superior information, and they will be looking at the standards of prudential regulation, the degree of integrity and transparency in the financial markets. Hong Kong possesses these elements, which explains why it has withstood the financial turmoil relatively well. The elements that help the investor to use Hong Kong would include the following:

  • The linked exchange rate regime - In the words of Michel Camdessus, Managing Director of the International Monetary Fund, the linked exchange rate is "a pillar of stability" at a time of turbulence. The fixed exchange rate regime, reinforced by the automaticity of the Currency Board is a discipline on both the public and private sectors. The Currency Board regime forbids fiscal laxity, and the fixed exchange regime with ample reserves backing not only protects the investor, but also ensures that the private sector must adjust to the exchange rate through productivity, rather than gaining competitiveness through devaluation. I would argue that it is the clarity, simplicity and discipline of the linked exchange rate regime that creates in Hong Kong the flexibility to adjust to external shocks. As the experience in Asia has shown, no exchange rate regime is perfect, but there is no question that the present system has served Hong Kong well.
  • High prudential standards - Hong Kong already has a financial supervisory framework that ranks well with the best internationally. By and large, it is market-friendly without sacrificing the need for supervisory authorities to monitor developments and be in a position to deal with shocks to the system. With an average capital adequacy ratio of more than 17%, locally incorporated banks have ample cushions to absorb the shock induced by the Asian turmoil. We have just hired a consultant to undertake a review of future banking trends and how we can enhance the competitiveness of the banking sector.
  • Noninterventionist approach and competition policy - Paul Krugman has attributed the Asian financial crisis to overguarantee and underregulation by the government. In essence, creditors had not priced their loans properly to fully reflect their risks, because of the moral hazard of government intervention.
  • Hong Kong has succeeded as an international financial centre because it has, by historical accident or deliberate policy, followed the sound principles of the free market with minimal government intervention.
  • Legal Framework - Financial products are essentially legal contracts involving property rights and obligations. They therefore require a complete legal framework. The public must have confidence that contracts will be fairly enforced. Hong Kong*s common law framework, backed by the highest concentration of international lawyers in the region, offers the surety of recourse action.
  • Financial Infrastructure - As the boundaries for banking, securities and futures markets become blurred internationally, supervisory authorities must also look closely at systemic and cross-border payment and settlement risks. The development of global financial markets depends heavily on the availability of efficient telecommunications and a robust technological platform. Hong Kong has the potential of being the first to exploit the true benefits of seamless global financial trading, where global financial products can be traded, cleared and settled at the lowest transaction costs and the lowest trading and settlement risks.
  • The HKSAR government aims to build a world-class infrastructure in Hong Kong. Last year, we formed an Informal Working Group (IWG) comprising experts from the private sector, the HKMA and the government to develop a vision of Hong Kong as a Financial Technology Supercity for the 21st century. As a first step in that direction, we implemented the most modern Real-Time Gross Settlement inter-bank payment system in Asia in December 1996, well ahead of the competition. Linkages with RTGS systems in the region will enable regional and global flows to be conducted in real-time with minimal payment and settlement risks.
  • Fiscal policy - Hong Kong's success has also been founded on a low tax framework and a sound fiscal policy. The government has no debt. In fact, it has enjoyed budget surpluses averaging 2% of GDP per year over the last 14 years.
  • High level of transparency - Our disclosure standards are now world-class. As late as 1992, data on the size of the Exchange Fund was secret. The frequency of disclosure has gone from annual to six-monthly to currently monthly. Similarly, we have made big strides in the disclosure of the banking data. There is of course always room for improvement.

 

Regional Bond Market

However, the strength of an IFC depends not only on the above elements, but also the range of products traded and the quality of financial services and products. Of the eight broad classes of products in Asia: banking, equity, debt, foreign exchange, derivatives, commodities, asset management and insurance, the domestic-currency debt markets for historical reasons have been the slowest to develop. The Asian crisis has highlighted the need for Asians to mobilize more efficiently their high level of domestic savings for better investment through long-term bond markets. This would avoid both the maturity and currency mismatches that have plagued Asian borrowers.

Under careful but step-by-step nurturing, particularly through the creation of a benchmark yield curve and an efficient infrastructure, we have developed the debt market in Hong Kong into one of the most liquid in Asia. With the institutionalization of savings in Hong Kong through the introduction of Mandatory Provident Fund schemes and the securitization of bank assets such as home mortgages through the creation of the Hong Kong Mortgage Corporation, the debt market is poised to take off.

The Hong Kong stock market has a long history and considerable liquidity, and has already proved to be a very successful springboard for Chinese enterprises to tap international capital. The Stock Exchange is already studying the question of an OTC market and other innovations that would ensure that Hong Kong remains the premier financial services centre for the mainland of China as it modernizes its corporate and financial sectors.

It is not the role of the public sector to conceive and develop the new products and services that Hong Kong should offer as an international financial centre. What we have done is to ensure that the fair and business-friendly regulatory and tax framework, together with robust and efficient financial infrastructure, exist to allow entrepreneurship to take where the market points the way. In this regard, the legendary flexibility, creativity and drive of Hong Kong's entrepreneurs and workers are the wave of the future.

 

Conclusion

When we look back on the Asian currency turmoil in the next decade, I am convinced that the episode will be diagnosed not as a tragedy, but as part of Asia's growing pains. As Asia grew by opening up to global trade, especially in exports of manufactures and commodities, some economies neglected the fact that even the service sectors must match global standards. Those economies that ignored this simple fact are paying a high price of change and reform. The two economies least affected were Hong Kong and Singapore, the most internationalized economies in Asia. Both do not have large natural resources, huge domestic markets or cheap labour. But both have highly flexible and productive workforces with the right set of policies tailored to meet the challenges of globalization.

The French have a good saying: "Plus c change, plus c meme chose" - "the more things change, the more they stay the same". Once Asia learns from her mistakes, she will build from all the basic ingredients for economic success that are still there -- a high savings rate, young and educated workforce and a highly efficient export sector. But when Asian economies rebound and reform their financial sectors, they would present also greater competition for the financial services provided by the present international financial centres such as Hong Kong and Singapore. Whilst we will benefit from regional growth, we will face leaner and meaner competition both regionally and globally.

To cut a long story short, my personal view is that what keeps Hong Kong competitive in the 21st century is not just all the factors that we have listed above, but the resilience, creativity, entrepreneurship and competitive spirit of her citizens. In this, the education community, especially universities such as Lingnan College, has a crucial role to play. This is because the policies and teaching that we conduct today will affect the next generation of Hong Kong*s entrepreneurs and labour force. If they lose their competitive edge, no amount of policies will secure Hong Kong*s role as an international financial centre, let alone a regional one. We believe the free market works in Hong Kong because everyone understands that there is no free lunch. Once we teach that there is a free lunch, there won't be one.

References

Commonwealth of Australia, (1997) "Financial System Inquiry Final Report" - the Wallis Report.

Edey, Malcolm, ed. (1996). "The Future of the Financial System", Reserve Bank of Australia.

Jao, Y.C. (1997) "Hong Kong as an International Financial Centre: Evolution, Prospects and Policies", City University of Hong Kong Press

Yam, J. (1995). "Hong Kong as an International Financial Centre," in Money and Banking in Hong Kong. Hong Kong: Hong Kong Monetary Authority, pp. 25-31.

 

FOOTNOTE

1 This is the text of the speech by Andrew Sheng, Deputy Chief Executive of Hong Kong Monetary Authority, at seminar on "Hong Kong Towards The Next Millennium: The Way Forward" in Hong Kong on 15 April, 1998. The author is grateful to his colleagues Julia Leung and Cynthia Leung for assistance in preparing this paper. All errors and opinions are those of the author and not necessarily those of the Hong Kong Monetary Authority.

2 Edey, Malcolm, ed. "The Future of the Financial System", Reserve Bank of Australia, 1996 "Financial System Inquiry Final Report" - the Wallis Report - Commonwealth of Australia, 1997

3 Wallis Report - Chapter 4, PP 139-140

Last revision date : 01 May 1998