III. The Evolving Financial Integration with Mainland China32
1. Hong Kong SAR’s financial and capital markets continue to grow rapidly, albeit somewhat unevenly. In recent years, Hong Kong SAR has become a world-leading fundraising center, and its equity markets have broadened and deepened. Reflecting this development, as was discussed in last year’s Selected Issues paper (IMF Country Report No. 06/51), equity derivative markets have taken off as well. Conversely, consistent with the structure of capital markets and corporate finance across the region, the growth in fixed income products has been more modest, as has the growth in currency and associated derivatives trading.
2. Recent market growth increasingly reflects Hong Kong SAR’s financial integration with Mainland China. This chapter discusses three key aspects of this relationship in differing stages of development: the now-mature process of equity fundraising via initial public offerings (IPOs); the two-year old renminbi business; and the recently announced Qualified Domestic Institutional Investor (QDII) scheme. Taken together, these point to a more diversified mix of financial intermediation activities in the period ahead.
3. Rapid market development—and strengthening Hong Kong SAR’s role as a regional financial center—presents a number of challenges. The authorities are well aware of these and have, inter alia, recently proposed a financial development strategy to address the issue of deepening financial integration with the Mainland. Also, as discussed more fully in Chapter II, Hong Kong SAR faces competition from aspiring financial centers throughout the region, and must be mindful of an array of competitiveness factors.
4. While Hong Kong SAR’s medium-term role as an “off-shore” financial center for the Mainland seems secure, there are uncertainties about this role over the longer term. Much will depend on: (i) the pace at which the Mainland opens up its capital account; (ii) to what extent the Mainland will need an off-shore financial center as it modernizes its own financial sector; and (iii) whether Hong Kong SAR can move beyond its current Mainland-centric, equity-heavy model to become a full-fledged global financial center.
A. Recent Trends: Three Examples
5. IPOs have taken off in recent years. Hong Kong SAR has become one of the top IPO fundraising centers in the world—and the largest in Asia. Since 2004, IPOs launched in Hong Kong SAR have raised a total of US$67 billion, about four times the total in the previous three years. In 2005, IPOs surpassed the record of the dot-com wave in 2000. Reflecting this, Hong Kong SAR’s stock market has overtaken Spain’s to become the world’s eighth largest, with market capitalization of US$1.5 trillion, up about 50 percent over a year earlier, equivalent to some 800 percent of GDP. More generally, overall market activity has also been buoyant in recent years and market turnover in Hong Kong SAR currently ranks fourth in Asia behind Tokyo, Seoul, and Australia, and fourteenth in the world.
6. The recent IPO wave has been spurred almost entirely by Mainland enterprises. Hong Kong SAR has been the main off-shore listing venue for all major Mainland enterprises since the early 1990s, and in 2005 over 80 percent of IPOs (by the amount of funds raised) were related to Mainland companies; in the first ten months of 2006, this percentage jumped to 90 percent. These listings not only allow the Mainland enterprises to tap international capital markets, but also present an opportunity for foreign investors to buy into one of the world’s fastest growing economies. Indeed, the new stock issuance of Mainland companies has received strong subscription demand from both retail and institutional investors. Mainland enterprises currently account for over 40 percent of total market capitalization in Hong Kong SAR equity markets and more than half of trading value over the first ten months of 2006.
Share of Mainland Enterprises
7. Led by Mainland banks, Hong Kong SAR could have the largest amount of IPOs worldwide in 2006. The record US$11 billion offering of Bank of China was launched in May, followed by the US$21 billion IPO of Industrial and Commercial Bank of China (ICBC) in October. ICBC was the first company to list simultaneously in the Shanghai and Hong Kong bourses. For 2006 as a whole, IPO fundraising in Hong Kong SAR is expected to reach a record about US$40 billion. The success of recent large offerings has sparked debate about whether Hong Kong SAR is overtaking New York as the main world IPO center.
Renminbi business in Hong Kong SAR33
8. The launch of renminbi business in February 2004 marked a milestone in the development of Hong Kong SAR’s financial system.34 Despite the increasing integration with the real economy of the Mainland since the late 1970s, transactions in renminbi in Hong Kong SAR were previously undertaken only through moneychangers. In addition, prior to the introduction of the individual visitor scheme in mid-2003, the renminbi was not widely accepted as a means of payment in local shops. Now, nearly all retail banks in Hong Kong SAR offer the following services in renminbi: (i) deposit taking; (ii) currency exchange; (iii) remittance; (iv) debit and credit cards; and (v) personal checks.
9. Renminbi deposits rose steadily for 1½ years after the reform, but leveled off at over RMB20 billion and constitute only a fraction of the local deposit base. Econometric work by the HKMA shows that the rise was driven by the interest rate differential between the renminbi and the Hong Kong dollar (which was positive until the Linked Exchange Rate System was modified in mid-2005) as well as speculation on a revaluation of the renminbi (which dissipated in the latter half of 2005). Renminbi deposits currently account for only ½ of 1 percent of all deposits in Hong Kong SAR. (The Hong Kong dollar accounts for roughly one-half and the U.S. dollar for one-third.) Currency exchange initially tracked closely the changes in renminbi deposits, although that relationship weakened in mid-2005, suggesting that Hong Kong SAR residents have shifted to banks for their renminbi payment needs.
Renminbi Currency Exchanges
10. Renminbi remittances and card use have also risen steadily. As Hong Kong SAR residents have adapted to the use of remittances to transfer funds for use on the Mainland, this service has grown steadily to over RMB100 million per month by mid-2006; remittances in the opposite direction have been negligible. Fueled by tourists, the use of Mainland-issued credit cards in Hong Kong SAR has risen steadily to (and stabilized at) almost RMB1 billion per month. The use of Hong Kong-issued renminbi cards on the Mainland has also grown steadily, albeit on a much smaller scale.
11. Reflecting the favorable response to the reform, the scope of renminbi business in Hong Kong SAR has been widened, and the financial infrastructure improved. In late 2005, the types of merchants allowed to open renminbi accounts was expanded, the limits for currency exchange and remittances were raised, the cap on renminbi credit cards was removed and renminbi checks were introduced for use in neighboring Guangdong province by Hong Kong SAR residents. In order to facilitate the expanded renminbi business, in March 2006, a new Renminbi Settlement System was launched.
The Mainland’s QDII program
12. The much anticipated QDII program was launched in April 2006. The People’s Bank of China and the State Administration of Foreign Exchange (SAFE) announced a series of measures to further liberalize foreign exchange regulations: (i) commercial banks will be allowed to sell financial products denominated in renminbi to domestic customers, and pool the funds to buy foreign exchange and invest in offshore fixed income products; (ii) qualified securities agencies will be allowed to issue foreign currency investment products in the Mainland and use their clients’ foreign currency to invest in overseas securities (including equities); and (iii) insurance companies will be allowed to convert a limited amount of their own renminbi funds to buy foreign fixed income products and money market instruments.
13. Despite some market hype, the QDII quotas are likely to be small initially. While no formal allocation of QDII quotas has thus far been issued to Mainland insurers, SAFE has approved thirteen international and domestic banks to raise up to US$12.6 billion of funds in renminbi from individuals and companies, and one local fund management company to pool US$0.5 billion worth of foreign currency deposits from local residents and institutes to buy securities overseas (text table). Although the QDII scheme is slated to be the largest authorized outflow of Mainland portfolio investment in recent times and could help offset persistently large capital inflows, it remains small compared with US$1.9 trillion in household deposits, and over US$200 billion per annum in reserve accumulation since 2004.
|QDII Licensees||US$ bn||Number|
|Fund managers : Domestic||0.5||1|
|Total (As of Nov 15, 2006)||13.1||14|
14. Over the medium term, there is strong potential demand by Mainland investors to increase their exposure to off-shore assets and increase yield. However, the QDII scheme has received a lukewarm response so far, selling only 3 to 7 percent of quotas. This reflects strong domestic stock markets and expectations of a rising renminbi. Of note:
- There are 300,000 individuals on the Mainland with assets of over $1 million, who on average have very cash-heavy portfolios of 71 percent. Moreover, they hold only 1 percent of their wealth offshore; this compares with 10–20 percent for U.S. and Japanese investors, and 20–40 percent for small OECD and other Asian investors.
- Foreign assets account for only 5 percent of total assets of the insurance industry as against 40 percent in bank deposits and 35 percent in domestic bonds. In contrast, foreign insurers typically allocate 60 to 70 percent of their portfolio investments to bonds and 30 percent to equities and alternative investments.
- The Chinese National Social Security Fund (NSSF) and mutual funds would also constitute a natural source of demand for overseas assets as they seek to diversify their portfolios. Compared with pension funds of OECD countries, the NSSF’s deposit share in total investments is relatively large (23 percent versus 5 percent).
15. The QDII scheme would help strengthen Hong Kong SAR’s role as a regional financial center, particularly in the asset management and banking industries. Hong Kong SAR is likely to be the preferred overseas market for Mainland investors, given its world-class infrastructure, efficient, well-regulated and transparent market, and proximity and cultural affinity with the Mainland. Analysts estimate that 10 to 20 percent of Mainland overseas investment would be placed in Hong Kong SAR.35 In addition, its H-shares and red chips have the advantage of being natural hedges against renminbi appreciation. The QDII program will help Hong Kong-based banks located on the Mainland to expand beyond the traditional banking business, enhance competitiveness in the midst of the opening up of the banking sector on the Mainland under WTO rules, enlarge their customer base, and earn non-interest income.
B. Challenges Facing Hong Kong SAR’s Position as a Financial Center
16. Hong Kong SAR’s main challenge is to maintain its role as the “middle man” between Mainland China and the rest of the world, while playing a greater role in direct financial intermediation in the Mainland. To this end, the authorities recently outlined a financial development strategy to enhance Hong Kong SAR’s role in the Mainland’s financial intermediation. The strategy builds on the notion that the relatively efficient financial system of Hong Kong SAR can be utilized to help improve the financial system on the Mainland (Yam, 2006). The objectives are to strengthen and continue to develop an efficient channel for foreign savings to meet the demand of Mainland fundraisers, provide investment tools for Mainland savers to invest abroad, and develop a low-risk platform for bringing together Mainland savers and investors.
17. At the supervisory level, it will be important to continue to deepen cooperation with Mainland counterparts. The framework for the relationship with the Mainland is a series of MOU’s in the banking, securities and insurance sectors. Hong Kong SAR regulators also provide extensive training to their Mainland counterparts. While there are some concerns that the quality of Hong Kong SAR’s supervisory apparatus may be compromised by deeper financial integration with the Mainland, these fears appear to be largely misplaced. Indeed, Mainland regulators and corporates reportedly want Hong Kong SAR’s standards to remain high in order to further spur Mainland reform and provide an imprimatur to foreign investors.
18. For a number of reasons, Hong Kong SAR’s financial development remains relatively unbalanced. In terms of country exposure, Hong Kong SAR is quite dependent on the Mainland. In terms of asset classes, Hong Kong SAR has a heavy concentration in equities and related derivative products. Fixed income and currency markets are relatively small. Regarding the types of financial activities, according to recent work by the HKMA (2006b), Hong Kong SAR compares favorably on employment and output measures with New York City in terms of banking, but lags behind in insurance and securities.
A comparison with New York City
19. Competition amongst cities in the region aspiring to be financial centers will necessitate continued reform across a spectrum of issues. While Hong Kong SAR scores well on most competitiveness measures as a financial center (SFC, 2006b) the authorities remain quite cognizant of the need to continue to move forward. Hong Kong SAR currently finishes at or near the top in the areas of availability of skilled personnel, regulatory environment, access to international capital, tax regime and business infrastructure, while there appears to be room for improvement in quality of life issues and the environment.
C. Assessment and Prospects
20. The authorities have been proactive in ensuring that Hong Kong SAR is well positioned to benefit from ongoing financial integration with the Mainland. This applies to both “hardware” and “software.” On the former, payment links with the Mainland have been progressively strengthened in recent years (HKMA, 2006a); moreover, the groundwork for introducing the renminbi into Hong Kong SAR’s real time gross settlement system has already been completed, and the mechanism for issuing renminbi bonds is also ready. On the latter, as noted above, the authorities have recently introduced a multi-pronged financial development strategy and continue to work with their Mainland supervisory counterparts on both policy and training issues whilst maintaining a commitment to preserve the integrity and international character of Hong Kong SAR’s financial system.
21. However, the pace and breadth of future financial integration with the Mainland—and the associated benefits—are largely exogenous to Hong Kong SAR. While there are no policy obstacles in Hong Kong SAR to implementing the proposed financial development strategy, the decision on whether and when to move forward with the various liberalization measures lies solely with the Mainland. Given this reality, the appropriate policy would appear to be the current one: be proactive and strive to anticipate (and, if possible, facilitate) any measures by the Mainland.
22. Broadening the types of financial activities undertaken in Hong Kong SAR is also needed. Given the current limited possibilities for gaining exposure to other countries’ assets,36 efforts could be made to further facilitate (i) the listing of companies outside of Greater China, which has recently attracted consideration from the authorities and (ii) the trading of a broad spectrum of claims on these countries in Hong Kong SAR’s markets. Regarding asset classes, the growth of fixed income products is likely to remain modest, although the HKMA has taken a leading role in designing and launching the Asian Bond Funds. At the same time, currency trading could pick up with progressive liberalization of the renminbi.
Corporation of London (2005) “The Competitive Position of London as a Global Financial Centre”November.
Deutsche Bank (2006) “China’s QDII and Outlook for Overseas Investments”April.
Hong Kong Monetary Authority (2006a) Annual Report 2005.
Hong Kong Monetary Authority (2006b) “Financial Sector Output and Employment in Hong Kong and New York City” Hong Kong Monetary Authority Quarterly BulletinJune pp.22–29.
Hong Kong Monetary Authority (2006c) “Hong Kong’s Renminbi Business Two Years On” Hong Kong Monetary Authority Quarterly BulletinJune pp.38–43.
Hong Kong Monetary Authority (2006d) “Outward Portfolio Investment from Mainland China : How Much Do We Expect and How Large a Share can Hong Kong Expect to Capture?” Research Memorandum 13/2006September.
Hong Kong Securities and Futures Commission (2006a) “Positioning of Hong Kong Amid Reforms in the Mainland Financial Markets” Research Paper No. 30June.
Hong Kong Securities and Futures Commission (2006b) “Hong Kong as a Leading Financial Centre in Asia” Research Paper No. 33August.
MerrillLynch and Capgemini (2006) World Wealth Report (10th edition).