My first five-year term as the Chief Executive of the HKMA is drawing to a close and my second term is about to begin. People come and go but the HKMA’s functions and work continue. I believe the time is right to review the past, hence my last five inSight articles elucidating the rationales behind our work in the past few years. In this article, I wish to set out my aspirations for the coming five years.
Financial Stability: the Cornerstone of Prosperity and Social Stability
As I often said, the financial system is analogous to a human heart that pumps blood (money) to maintain the normal functioning of the various organs of the body (different components of the economy). Financial instability, similar to a heart failure, will seriously upset all sorts of economic activities, and shake the foundations for economic and social stability.
The global financial environment is still in a highly unusual state. The Fed’s “experiment of the century”, with ultra-low interest rates and Quantitative Easing, has reached a crucial moment. Barring any unforeseen circumstances, the asset purchase scheme of the Fed will likely end in the fourth quarter of this year. The market also expects the Fed to start raising policy interest rates around mid-2015. Notwithstanding the uncertainties in the strength of US economic recovery and the timing and pace of interest rates hike, rates will eventually “normalise”, meaning the interest rates will outstrip the inflation rate. The current unusually low interest rate environment around the world will also begin to change, reversing the flows of fund which has flushed the emerging markets in the past five years as a result of Quantitative Easing. Asset prices in the emerging markets may face the risk and pressure of downward adjustments. Hong Kong cannot be immune to this. Over US$100 billion that has flowed into the Hong Kong dollar since August 2008 (including the inflows in the past two months) may flow out as US interest rates normalise, leading to a contraction in liquidity, rising domestic interest rates and possibly falling asset prices.
Nevertheless, the normalisation of interest rates in the US will be a positive development for Hong Kong as our interest rates move in tandem. The most important task is to ensure our financial system will be able to withstand the shocks arising from volatile fund flows in this process. In this regard, the HKMA has launched six rounds of countercyclical macro-prudential measures to tighten residential mortgage lending, as well as other measures to control rapid credit growth and the associated liquidity risks. These measures are designed to enhance the resilience of Hong Kong’s financial system against possible shocks that may hit Hong Kong in the process of interest rate normalisation in the US.
Upholding Prudent Management of the Exchange Fund
As I mentioned in my previous inSight article, the Exchange Fund is the last line of defence for Hong Kong’s financial stability and we will continue to manage the Fund prudently in a professional manner. Without compromising its capital preservation and high degree of liquidity, we will endeavour to maintain the Exchange Fund’s purchasing power. But I wish to highlight two important developments in the coming five years that could affect the performance of the Exchange Fund. The first is the normalisation of interest rates in the US, meaning rates would move up to a level that is higher than the inflation rate. In the past, when US inflation was around the 2%-3% mark, short-term interest rates were, on average, around 4% and the average yield on 10-year US Treasuries was around 6%. As the Backing Portfolio of the Exchange Fund has a substantial holding of short-term US dollar debt instruments, return could improve significantly, an antidote to the current dismal interest income. Likewise, returns from the bond holdings in the Investment Portfolio would be bolstered. However, as the US dollar bond yields pick up, the mark-to-market value of the bond holdings in the Exchange Fund will decline. But this will only be a one-off correction in the process of interest rate normalisation. Needless to say, the overall investment returns of the Exchange Fund will also be affected by the performance of the stock markets, but it is highly unpredictable with its myriad variables and uncertainties.
The second development involves continued progress in the investment diversification of the Exchange Fund. We expect to have fully invested a portfolio of around HK$210 billion in private equity and real estate with an aim to achieve higher rates of return than the traditional bond and equity investments over the medium- and longer-term. As private equity funds generally begin to generate distributions 5 to 8 years after initial investment, the HKMA will need to continuously identify appropriate assets to reinvest the distributed funds in order to maintain the HK$210 billion target portfolio size.
Enhancing Hong Kong’s Status as an International Financial Centre
Hong Kong has already established itself as a premier international financial centre in Asia, but there is no time for complacency or defeatism. With concerted efforts, we could scale new heights in the coming five years. In particular, we should be able to sharpen our edge and improve our competitiveness in the following areas–
Banking Business in Hong Kong: the Nexus of Mainland China’s Financial Links with the World
In the past five years, our banking sector’s financial ties with the Mainland strengthened rapidly, especially in trade and Mainland-related loans and financing. As Mainland China’s economy continues to expand, so will the Mainland operations of Hong Kong and overseas enterprises, creating buoyant demand for financing. Hong Kong banks naturally become convenient financiers for them. This translated to HK$810 billion loans, out of HK$2.6 trillion or 30% of the Mainland-related loans in Hong Kong’s banking system at end of 2013. As the “go global” drive of Mainland enterprises gathers pace, their global outreach continues to expand and they become more actively involved in overseas mergers and acquisitions. This provides another boost to the demand for financing in Hong Kong. At the end of 2013, loans extended by Hong Kong banks to Mainland enterprises for overseas (including Hong Kong) investments and uses amounted to HK$870 billion (34% of total Mainland-related loans). It is worth noting that Hong Kong branches of foreign banks are also active providers of financing services to Mainland customers, taking advantage of Hong Kong’s platform. Together, foreign banks’ Hong Kong branches provided 37% of total Mainland-related loans.
The sustained economic growth on the Mainland will continue to stimulate investment and commercial activities by Hong Kong and overseas enterprises on the Mainland. Combined with the inevitable trend for the Mainland enterprises to “go global”, the Mainland-related financing needs will keep on increasing. I hope that banks in Hong Kong could exploit the tremendous business opportunities, and in a way consolidate our position as a major banking and financing hub for two-way capital flows between the Mainland and the rest of the world.
While we encourage banks to grasp these business opportunities, we must not lose sight of risk management and the stability of Hong Kong’s banking system, which is one of our mandates. Therefore, we require that banks should prudently manage the associated risks and challenges. In particular, banks must pay attention to these three aspects: (i) they should maintain their usual prudent underwriting standards; (ii) they should ensure that they have sufficient stable funding to support their credit growth and that they are able to withstand the stress arising from liquidity shortage; and (iii) they should maintain adequate capital and conduct regular stress tests to ensure that they are able to withstand the adverse impact arising from a worsening credit environment. Through its day-to-day supervisory work, the HKMA will see to banks’ compliance with these rigorous risk management standards.
Offshore Renminbi Business Centre: Going from Strength to Strength
Under the “One Country, Two Systems” principle and with the support of the Central People’s Government, Hong Kong has developed into the world’s largest and most competitive offshore renminbi business centre since 2009. Not only can we offer a wide range of renminbi services to enterprises and financial institutions based in Hong Kong, we also facilitate the development of offshore renminbi business by other financial centres. But again, there is no room for complacency. We must remain vigilant and work together to further improve our competitiveness and spur the growth momentum. The incremental relaxation of capital controls on the Mainland is set to generate even more business opportunities for Hong Kong. For example, the recently announced Shanghai-Hong Kong Stock Connect is an important milestone in the liberalisation of the Mainland’s capital account, enabling investors from all over the world to invest, through Hong Kong’s platform, in equities listed on the Shanghai Stock Exchange. At the same time, Mainland individual and institutional investors will be able to trade Hong Kong equities through the Shanghai Stock Exchange. Once the scheme is launched, cross-border fund flows will surge, thus accelerating Hong Kong’s offshore renminbi market development, and bringing our offshore renminbi business to a new height.
Asset and Wealth Management Centre: Nurturing Hong Kong’s Brand
In the next five years, the HKMA will put more emphasis on promoting Hong Kong’s asset and wealth management industry. While the sector has seen considerable growth following the abolition of estate duties a few years ago, most (around 70%) asset management activities conducted in Hong Kong involve customer relationship management or sales intermediation. As compared with other financial centres like London and New York, sales and distribution accounts for a much higher proportion and this reflects a sizable and growing investor base in Hong Kong. The rapid rise in the number of intermediaries is also a reason to applaud. However, it also suggests an underdevelopment of upstream value-added chain, such as formulation of investment decisions, asset allocation, research and analysis, product development, risk management, as well as legal, accounting and other professional services, which are high value-added activities in the asset management “food” chain. We need to put our heads together to devise appropriate policies and measures to attract more of these upstream activities to Hong Kong so we can truly become an all-embracing asset management centre.
As for wealth management – it is not new to Hong Kong. The industry has progressed over the past two decades as diversified wealth management services have become another core business for banks apart from lending activities. In the past five years, Hong Kong has seen rapid expansion in private banking business thanks to the brisk economic growth and ongoing liberalisation on the Mainland. Many foreign private banks have established a foothold in Hong Kong, and many local banks have been expanding their private banking or wealth management services targeted at high net-worth customers.
While there is vast potential for growth in wealth management business in Hong Kong, we must be adequately equipped to avail ourselves of every opportunity to maintain and improve our competitive edge. So, the challenge for Hong Kong in the coming five years lies in building “Hong Kong” as a "Brand" for itself as a wealth management hub that stands for "quality", "reputation" and "confidence". To do this, we have to meet three major conditions:
i. The presence of financially robust and reputable banks and financial institutions that can offer a diversified range of wealth management products and services;
ii. The availability of a pool of highly professional wealth management practitioners who are well-versed in different wealth management products; and
iii. The cultivation of a customer-oriented culture at all levels of banks and among their wealth management practitioners in particular, and the strict adherence to regulatory standards on conduct during the product development and sale processes.
To that end, the HKMA has devoted a great deal of efforts in the past five years to nurture the “Hong Kong Brand” in wealth management. This includes the establishment in 2010 of the Banking Conduct Department and the Enforcement Department to step up the monitoring of business conduct of banking and wealth management practitioners. In addition, we are encouraging the banking industry to develop a customer-oriented corporate culture, and in October 2013, we launched the Treat Customers Fairly Charter signed by all 22 retail banks in Hong Kong. In September last year, we joined hands with the industry to set up the Private Wealth Management Association (PWMA) to promote proper conduct, integrity and professional competence among private wealth management practitioners. The PWMA has just launched in June this year an enhanced competency framework for accredited training programmes and promulgated a code of conduct for its members. The establishment of the PWMA is one example of our endeavours to develop the “Hong Kong Brand”. Looking ahead, our initiatives to promote the professional standards of Hong Kong’s financial industry practitioners will extend to other areas, including treasury markets, credit markets, and risk management and compliance, so that customers can enjoy banking services with “confidence” and the assurance of the "reputation" of Hong Kong banks.
Treasury Management Centre: Unleashing Hong Kong’s Potential
Developing Hong Kong into a treasury management centre has been another major focus of the HKMA in the past two years. With their vast, global business networks, multinational corporations process numerous large-value payments on a daily basis. Under their treasury management systems, it is common for cash management, cash receipts/payments, internal transfers, financing and risk management, etc. to be centralised to facilitate management of these corporate treasury functions. Hong Kong has a clear advantage as a hub for treasury management activities. We are a free and open economy with free flow of funds, bolstered by the presence of many of the world’s largest banks, abundance of financial professionals and a robust legal system. These strengths are particularly appealing to Mainland enterprises. That said, existing interest deductibility rules under our taxation regime may not attract certain corporate treasury activities to be conducted in Hong Kong1. For this reason, the HKMA is working closely with the Financial Services and the Treasury Bureau to review relevant taxation arrangements to encourage more multinational and Mainland corporations to establish their treasury management centres in Hong Kong. Not only will this enhance the development of headquarters economy in Hong Kong, this will also inject further growth impetus into the banking industry and promote Hong Kong’s status as a financial centre.
Leveraging on the Mainland while Engaging the World at large is the Pivot of Hong Kong’s Development as an International Financial Centre
Hong Kong’s ascendance as an international financial centre in the past couple of decades has been described by some as resting on “borrowed time” as capital account controls and restrictions on fund flows are still in place on the Mainland. They argue that this creates a window of opportunity during which Hong Kong can act as a bridge to link trade and financial activities between the Mainland and the rest of the world. However, once the capital controls are lifted and Mainland China can establish direct financial links with the world, Hong Kong’s intermediary role as a financial bridge would be cast into oblivion.
I do not subscribe to this view. Hong Kong has unique advantages in its own right. We have leveraged on our special relationship with Mainland China while engaging the world at large. As 1979 ushered in a new era of reform and opening up in Mainland China, Hong Kong has been playing an irreplaceable role and making crucial contributions to the process. Over the past three decades or so, Mainland China has taken crucial steps to open up its economy – lifting the ban on foreign investments in the 1980s, listing of Mainland enterprises in Hong Kong since 1993, accession to the World Trade Organization in 2001, reforming state-owned banks and listing them in Hong Kong starting from 2004, and permitting the cross-border use and flows of renminbi in 2009. Through each of these key steps, Hong Kong was able to further enhance and fortify its position as an international financial centre. In the same vein, I am confident that recent initiatives by the Mainland such as the Shanghai-Hong Kong Stock Connect and the establishment of Free Trade Zones in Shanghai and other cities will mean even more opportunities to Hong Kong.
Instead of harbouring any pessimistic or defeatist views on the Mainland’s reform and opening-up, we should devote our energy and attention to better equipping ourselves to meet the challenges and opportunities arising from this development. By leveraging on our unique advantage of having Mainland as our hinterland and our unparalleled infrastructure and global network, we can definitely continue to contribute to the sustained development of our country and our city.
Norman T.L. Chan
Hong Kong Monetary Authority
11 August 2014
1The current tax regime in Hong Kong does not have any negative implications for corporate treasury activities conducted through bank financing. However, the deductibility requirements for inter-company loans may have room for optimisation.