The Development of Financial Centres - Policy and Prudential Issues

Speeches

01 Sep 1994

The Development of Financial Centres - Policy and Prudential Issues

Andrew Sheng, Deputy Chief Executive, Hong Kong Monetary Authority

(Speech at "Shanghai-Hong Kong Economic Co-operation Towards the 21st Century" Conference, Business and Professionals Federation of Hong Kong, 12 - 13 September 1994, Hong Kong)
  1. I am very honoured to be asked by Sir Q W Lee and Mr Vincent Lo to address this important Conference. The theme of this Conference is both timely and critical. We are witnessing today not only the historic transformation of the Chinese economy, but also the evolution of East Asia as a major economic and financial force in world growth. Consider this:
    • the countries in the East Asian corridor today account for roughly 40% of the world's official foreign exchange reserves;
    • East Asian financial centres, from Tokyo through Hong Kong and Singapore through to Jakarta, account for three of the top seven international financial centres of the world, measured by market capitalization or trading volume; and
    • More significantly, they are all in the same time zone.
  2. Shanghai will soon join the ranks of major financial centres. The issue is not if, but when and how. I am sure that this Conference will make a major contribution to clarify the way forward.
  3. When Sir Q W Lee asked me to speak on this subject, we agreed that Mr Paul Selway-Swift will talk on the commercial perspectives of evolution of Shanghai as an international financial centre, and the co-operative role of Hong Kong, while I will concentrate on the policy and prudential aspects. To help focus our discussions, I have set out the key financial indicators, comparing Shanghai, Hong Kong and Singapore in Chart 1. As you can see, Shanghai has double the population of Hong Kong, but the size of her financial markets are still relatively small compared to Hong Kong or Singapore.
  4. In my past experience in the World Bank and central banking in Malaysia, I have always been asked how, from a policy and prudential point of view, a country can develop its financial markets. The issues are clearly complex, but a simple way of looking at the problem is to go to basics and ask what makes a successful market. I believe the complex issues can be summed up in what I call the 5 P's: a market comprises PEOPLE trading PRODUCTS, under a POLICY and PRUDENTIAL framework, using an accepted technological PLATFORM.
  5. I have used this framework to compare the stages of development of Shanghai and Hong Kong, and as you can see from Chart 2, Hong Kong is already an established international financial centre, with a free port, free capital flows and currency convertibility, while Shanghai is still developing the whole range of products, systems and institutions.
  6. I will not spend too much time on the People and Products issues (Chart 3), because Mr Selway-Swift is much better qualified to talk about how the Hong Kong banking community can contribute to the development of human skills and financial products. The point I wish to make about the People/Skills area is that from a policy point of view, you cannot train every skill you need internally. In the experience of growth of every international financial centre, the role of foreign banks and non-bank financial institutions has been critical in the skills development and innovation area. This was certainly true for Hong Kong.
  7. With regard to financial products, however, we often forget that all financial products are essentially legal contracts (Chart 4). Financial markets therefore trade legal contracts involving property rights and obligations. This clearly implies that there must be a complete legal framework: the more complex the financial instrument, the greater the need for comprehensive laws, regulations, code of conduct and market practices. Local financial centres can operate with a set of unique domestic rules and regulations, but there can be no internationalization of trading. Fortunately, you do not need to re-invent the wheel in devising new laws and regulations and contracts. Increasingly, with globalization, there are now International Foreign Exchange Master Agreement (IFEMA), the ISDA Master Swap Agreement and Master REPO Agreement that are rapidly being accepted around the world. Hong Kong has good experience with these and can provide advice on their use and adaptation.

Policy Framework

  1. The Policy framework for the development of financial markets is critical to their success. Hong Kong is a clear example of how, with the right policy framework, financial markets evolved naturally to make Hong Kong an international financial centre, without deliberate government intervention. This is not to say that direct government efforts to promote an international financial centre has not worked, such as the efforts in Singapore. However, even in the case of Singapore, several key policy elements were present: these include, a stable macro-economic environment, disciplined fiscal policy; minimal directed credits; and supportive financial and prudential policies that encourage financial discipline, and general policy credibility and consistency (Chart 5). Without these key elements, many attempts to create international or regional financial centres in developing countries have not succeeded.
  2. The experience from Hong Kong is that if you maintain a market-friendly policy environment, the markets can evolve quite quickly on their own account, without the need for subsidies or government intervention. With a clear level playing field, an equitable and credible tax and regulatory regime, the financial markets will respond to the opportunities in the environment.
  3. In certain areas, for example, some market promotion activities which do not involve any subsidies can help give the market a nudge in the right direction. For example, the issue of Exchange Fund Bills and Notes, even though the government has no need to borrow, has helped to create a benchmark for HK$ debt paper and has overall promoted the deepening of the HK$ debt market. Since it was created in 1990, the Exchange Fund Bills and Notes Programme has grown to an outstanding size of HK$45 billion, with a daily turnover of around HK$20 billion, one of the most active government debt markets in the world.

Prudential Framework

  1. The international experience, including that of Hong Kong, is that financial markets work well where there is a firm legal and prudential framework that protects property rights, and market participants from unfair practices. This calls for not only a good set of contract, commercial, banking and land laws and regulations, that are accepted by all market participants as open, fair and equitable, but also a court and arbitration system that will enforce contracts firmly and fairly (Chart 6). Hong Kong has all these laws - the Common Law - and systems in place, which have made domestic and foreign market participants - investors, issuers, intermediaries and the general public - confident that contract disputes will be dealt with fairly and expeditiously, while illegal and unfair practices would be punished according to the law. This set of laws is well understood and accepted by all international market participants.
  2. In addition, the supervisory framework for different markets should be in place for the banking, insurance and the securities sectors. Hong Kong applies the highest international prudential standards in ensuring that all financial market participants can trade in Hong Kong under protection of the law, without fear or favour. We have struck a clear balance between the need for prudential regulation without stifling the innovative and entrepreneurial spirit of the market place.
  3. In this regard, it is particularly important that the regulatory bodies are strong professionally and are able to exercise their enforcement action without any market perception of political interference. The policy commitment to this aspect of the regulatory framework cannot be underestimated, as the market cannot succeed well in an unlevel and non-transparent playing field.
  4. We are indeed fortunate that the constant process of market consultation, both formal and informal, between the market participants and the regulatory authorities in Hong Kong have ensured that the regulatory framework is responsive to changes in the market place, without sacrificing the need to protect the public interest.

Technological Platform

  1. Before I end this presentation, I would like to say a few words about the technological platform (Chart 7), by which I mean the manual, mechanical or electronic procedures and systems that are needed to facilitate trading, clearing and settlement. The core element of this is the payment system. The subsidiary elements are the securities trading, clearing and settlement systems that are increasingly being automated. In many developing countries, the market cannot develop because of outdated processing and delayed payments which stifle trading and create opportunities for fraud. A clear example is the securities problems in Bombay a few years ago.
  2. In international financial centres, it has become recognized that in a global trading environment, payment and securities system - i.e. the technological platform - cannot afford to fail. They have to be both efficient and robust, and because of international linkages, they must not only comply with international standards, but also be fail-proof. Otherwise, failures in one centre because of platform disasters could have chain-reaction effects on other financial centres. Markets will shift clearly to those centres that offer both efficient and robust technological platforms. Even though Hong Kong has a highly automated and effective payment system, we have recently decided to move towards Real Time Gross Settlement (RTGS), to meet the latest international standards, so as to facilitate Delivery versus Payment (DvP) and Payment versus Payment (PvP), in readiness for global 24-hour trading and payments. We are delighted to know that by 1996, China would also have RTGS, which should benefit Shanghai significantly.

Challenges

  1. I should like to end this survey of the policy and prudential aspects of financial market development by giving a few personal observations about Shanghai and Hong Kong co-operation in the years ahead.
  2. First of all, I do not see the rise of Shanghai as a threat to Hong Kong, more as an opportunity (Chart 8). As Shanghai grows in strength and stature, there will be an acceleration in inter-financial centre trading in the same East Asian time zone, since finance always follows the growth in trade and investments. The growth of the East Asian financial centres can only be complementary to each other, not competitive. In our eagerness to compete, we tend to forget that trade in financial products is no different from trade in physical goods: it is mutually beneficial and is not a zero sum game. We are looking at trade creation, not trade diversion. You always need a counterparty to trade in financial products, be it shares or foreign exchange. What better counterparty is there for Shanghai than Hong Kong?
  3. From a policy perspective, it is my personal belief that for some time to come, Shanghai will be different from Hong Kong. Hong Kong will retain, and indeed, enhance its role as an international financial centre, because of its solid commitment, through the Joint Declaration and the Basic Law, to its free market economy. On the other hand, Shanghai has to play a major role in the transformation of the Chinese economy, particularly in the reform, restructuring and upgrading of the enterprise sector into internationally competitive firms, and to assist in mobilizing domestic RMB finance for the huge investments required for infrastructure development. All these will require policy considerations that may involve policy-based lending or pricing issues that has to take into consideration the needs of the whole economy, and not just one financial centre. I see these issues not as constraints, but as major challenges for Shanghai.
  4. In the desire for fast growth, certain choices have to be made. It would certainly not be possible to develop the full range of financial products, institutions, prudential framework and policy credibility overnight. Even Singapore has taken nearly 30 years to reach its status today. The comparative advantage of Shanghai will be its RMB business, and it is well known that corporate or enterprise finance and infrastructure finance have huge demands that have to be met. My humble opinion is that one of the biggest, if not the biggest, challenge in domestic financing in China in the years to come is the housing finance market. As national income increases, so does the growth of home ownership and the need for residential home finance. In the United States, residential mortgages account for just under 50% of GDP, while in Hong Kong, the equivalent is 30%. In China, the residential mortgage market - a RMB market - is only just beginning. If this reaches 20% of GDP, for example, that is a RMB630 billion (US$73 billion) market. Shanghai's role in this will be unrivalled.
  5. In the challenging years ahead, I would just like to say that the HKMA, and the financial community in Hong Kong, would be quite pleased to provide whatever advice we can in our respective fields in making both cities amongst the strongest and most vibrant financial centres in the world.
  6. Thank you for giving me an opportunity to participate in this stimulating and important occasion.

Chart 1 - Key Financial Indicators, 1993

Unit Singapore Hong Kong Shanghai
Population mn 2.851 5.92 12.94
GDP US$ bn 55.6 108.7 17.4
GDP per capita US$ 19,500 18,364 1,343
Share of financial services (including insurance) in GDP ---- 9.4%2 7.6%
Percentage of persons employed in financial services (including insurance) ---- 6.0%6 0.6%3
No. of Foreign Banks 118 140 284
Exports US$ bn 74.7 134.1 7.38 (ex Shanghai)
14.0 (via Shanghai)
Imports US$ bn 86.0 137.5 5.34 (to Shanghai)
17.0 (via Shanghai)
StockMarket Capitalization US$ bn 150.6 298.1 22.05
Average Daily Foreign Exchange Transcations US$ bn 85.4 60.97 0.15-0.208
Government Bonds
- Outstanding
- Average Daily Turnover
US$ bn
US$ bn
10.6
0.23
6.39
3.011
6.010
0.112
  1. Resident population which includes only Singapore citizens and permanent residents
  2. 1991 figure
  3. 1992 figure
  4. As of mid-1994. Include only foreign bank branches, but not representative offices.
  5. July 1994 figure
  6. Includes only private sector
  7. April 1992 figure
  8. August 1994 figure
  9. August 1994 figure. Include government bonds, Exchange Fund Bills and Notes
  10. 1992 figure
  11. August 1994 figure
  12. For the first half of 1994

Chart 2 - Financial Centres: Hong Kong vs Shanghai

Hong Kong Shanghai
People/Skills Developed Developing
Products Full range Evolving
Policy Free Market Planned
Prudential Framework International Standards Evolving National Regulations
Platform (Technology) In place Building

Chart 3 - People

  • Need full range of skills - financial, legal, accounting, trading, regulatory, and support services
  • Develop specialist skills - brokers, dealers, underwriters, actuaries, asset management etc.
  • Need training and manpower planning programme
  • Cannot do this wholly in-house - need input from foreign financial institutions

Chart 4 - Financial Products

  • All financial products are LEGAL CONTRACTS, e.g. deposit contract, loan contract, leasing contract;
  • Hence importance of LEGAL and PRUDENTIAL FRAMEWORK;
  • GLOBALIZATION requires global contract standards, e.g. IFEMA, ISDA Master Agreement, Master REPO Agreement etc.;
  • Cannot develop all product range at the same time.

Chart 5 - Policy Framework

  • Financial Development needs Stable Macro-economic Framework
  • Disciplined Fiscal Policy
    • No tax or stamp duty distortions
    • No unequal tax rates against any sector
    • No excessive borrowing by state
  • Supportive Financial Sector Policy
    • Minimal directed credit/interest subsidy policies
    • Encourage financial discipline, e.g. allow bankruptcy of failed firms
    • Establish benchmark pricing for government bonds
    • Allow free markets to determine prices of financial products
  • Level playing field - no discriminatory restrictions against foreign investments, either portfolio or direct investments in financial or non-financial institutions
  • Encourage freedom of entry and exit
  • Transparent and Timely Information Disclosure
    • Accounting and auditing according to GAAP & IAS
    • Timely disclosure of financial statements of listed companies and major financial institutions
  • Policy credibility

Chart 6 - Prudential Framework

  • Adopt laws and legal system that protects property rights, right to contract, sell or trade, and enforce contracts
  • Need for efficient and fair court/arbitration system to cope with contractual disputes, bankruptcies
  • Adopt international standard codes of conduct and market practices
  • Apply international standards of prudential supervision, e.g. Basle Capital Adequacy, IOSCO standards
  • Create professional and strong regulatory bodies that are free from political interference
  • Create close dialogue between financial sector and regulators to ensure market-friendly development in sound, safe and equitable manner

Chart 7 - Technological Platform

  • Efficient telecommunications and information network linked internationally
  • Robust and efficient payment and settlement system
  • Robust and efficient securities trading, clearing and settlement system
  • Software/Hardware for front office/back office
  • Compatible standards with international networks, e.g. SWIFT

Chart 8 - Challenges

  • Hong Kong complements Shanghai growth, not a competitor
  • Role of Shanghai in enterprise financing and reform
  • Priority development areas - policies, products and institutions
  • Concentrate on strengths - develop RMB business
  • HKMA can help in developing prudential framework
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Last revision date : 01 September 1994