People’s Republic of China-Hong Kong Special Administrative Region1: Selected Issues and Statistical Appendix

This Selected Issues paper analyzes the long-term fiscal policy in Hong Kong Special Administrative Region (SAR) and the anticipated structural changes in the economy. The paper examines the factors that contributed to the stability of the banking system in Hong Kong SAR by assessing the roles played by banks, equity markets, and debt markets. The study describes a procedure to extract the probability distribution of future exchange rate movements based on currency option data. The paper also provides a statistical appendix report of the country.


This Selected Issues paper analyzes the long-term fiscal policy in Hong Kong Special Administrative Region (SAR) and the anticipated structural changes in the economy. The paper examines the factors that contributed to the stability of the banking system in Hong Kong SAR by assessing the roles played by banks, equity markets, and debt markets. The study describes a procedure to extract the probability distribution of future exchange rate movements based on currency option data. The paper also provides a statistical appendix report of the country.

III. Hong Kong SAR’s Debt Market1

A. Introduction

1. Hong Kong SAR has one of the most advanced financial centers in Asia. The Hong Kong SAR financial markets not only intermediate a significant amount of domestic savings, but also large cross-border flows of funds. The economic importance of the financial markets domestically has increased over the years as Hong Kong SAR transformed itself from a manufacturing-based to a service-based economy. By end-1999, services accounted for 94 percent of GDP, with the share of financial services at 25 percent of GDP. Cross-border financial transactions, at 220 percent of GDP, now rival external trade in goods and services at 260 percent of GDP.

2. Yet, as in most of the region, the banking sector and equity markets dominate the financial system. However, there is now increasing recognition among policymakers and market participants of the need to develop a liquid and active debt market. The reasons being mainly two fold: first, in order to remain competitive as a financial center, Hong Kong SAR needs to offer international investors a wider range of investment vehicles, especially in fixed-income securities; and second, a more diversified set of markets could help strengthen corporate and bank risk management practices through improved disclosure and governance standards, and more effective market discipline.

The aim of the chapter is three-fold:

  • First, assess the roles played by banks, equity markets, and debt markets in financial intermediation in Hong Kong SAR.

  • Second, investigate the possible reasons behind the slow growth of debt instruments.

  • Third, discuss some options that could spur the development of debt markets.

The main findings of this chapter are the following:

  • Hong Kong SAR banks and equity markets have successfully financed the transformation and rapid growth of the economy since the mid-1980s. The most important source of corporate financing is bank credit, followed by equity.

  • While among the most liquid in the region, Hong Kong SAR debt markets remain relatively underdeveloped by international comparison. While the success of banks and equity markets in raising funds may have been an important reason holding back the development of debt markets, there are other potential supply- and demand-side factors that may have played their part.

  • From the supply side, among other factors, weak corporate transparency, difficulties in obtaining accurate credit assessments, a small domestic investor base, and tax distortions have held back the development of the private debt market.

  • From the demand side, the debt instruments traded in Hong Kong SAR market are close substitutes of those available in other advanced financial centers, where many of the aforementioned supply-side concerns are less severe.

  • Consequently, addressing the supply-side shortcomings and developing more debt instruments of varied maturities and credit risk along the yield curve could help in increasing the attractiveness of debt markets in Hong Kong SAR to global investors.

B. Financial Markets in Hong Kong SAR

3. Banks have dominated financial intermediation in Hong Kong SAR. In 1999, deposits of the 285 authorized institutions in the sector (including 156 licensed banks) increased by 18 percent of GDP, while in that year domestic saving accounted for 31 percent of GDP. Like elsewhere, much of this dominance has rested on their ability to profitably provide financing for relatively opaque investments and firms. Moreover, the banks have also adapted well to the financing requirements of Hong Kong SAR enterprises. Most of these businesses are family-owned small- and medium-sized enterprises (SMEs). SMEs comprise over 98 percent of all Hong Kong SAR enterprises, and account for 60 percent of privatesector employment. As in most countries with similar industrial structures, Hong Kong SAR banks have developed specialized lending skills and loan practices to help them meet the financing needs of these diverse firms, spanning both the industrial and service sectors.

4. However, even among advanced economies, where markets play a larger intermediation role, the relative importance of bank versus market finance varies considerably. Hong Kong SAR banks’ assets are a larger share of GDP than even bankintensive advanced industrial economies such as Germany. However, Hong Kong SAR banks’ assets are a smaller share of GDP compared to Singapore’s.

Banking System Assets and External Liabilities


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5. The equity market in Hong Kong SAR is among the largest in the world. The market capitalization of the Hong Kong Stock Exchange (HKSE) was HK$4.8 trillion (377 percent of GDP) at the end of 2000; daily turnover volume averaged about HK$12.4 billion in 2000, and 736 companies were listed on the HKSE, including 47 Chinese state-owned enterprises (H-shares). The well developed equity market reflects, aside from high domestic saving and rapid, sustained economic growth, the authorities’ traditional laissez-faire approach to regulation, and the absence of exchange and capital controls.2 Unlike some other financial centers, onshore and offshore financial activities and nonresident and resident activities have been treated the same in Hong Kong SAR, attracting issuers and investors and thereby helping to expand market liquidity.

6. The equity market has been the second largest source of financing for firms. In particular, equity markets remained active even as bank lending continued to contract in the aftermath of the Asian crisis in 1997. In recent years, Mainland enterprises and Hong SAR-based “new economy” internet-related businesses have been noticeably active in raising funds through initial public offerings in Hong Kong SAR equity markets.

Financing Activities of Hong Kong SAR Corporations

(In billions of Hong Kong Dollars)

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Source: HKMA

Includes initial public offerings, rights issues, and private placements.

7. Hong Kong SAR’s debt market, although one of the most liquid in the region, has played a considerably lesser role in intermediation. Although, the debt market increased 40 fold during the last decade, it remains small with limited secondary market liquidity. The Hong Kong dollar market is dominated by debt issued by the Exchange Fund, authorized institutions, and multinational development banks, accounting for 83 percent of total debt issued in 1999.

Bond Market Size


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8. Private debt market has gained in importance since the Asian crisis. Demand by banks for fixed income securities has been relatively high since the crisis because of banks’ perception of poor lending opportunities. As bank lending contracted during the two year period following the Asian crisis, new private sector corporate debt issues grew to help meet the financing requirements of those few firms with access to the credit market. Nevertheless, at end-1999, outstanding Hong Kong dollar debt securities remained small (36 percent of GDP), relative to bank loans (128 percent of GDP) and equity capitalization (383 percent of GDP). The strong presence of banks and equity markets, and the lack of a well-developed private debt market, present firms with limited choices—they can either borrow through banks or share equity interest with investors.

9. The pre-eminence of banks in financial intermediation is also reflected in the importance of bank credit in domestic investment. As in other countries, expectations of profit growth (approximated by the change in GDP growth) and the cost of financing (proxied by the real interest rate) are important factors in determining investment in Hong Kong SAR. However, the bank credit channel is statistically more important than the cost of capital. The estimated elasticity of loan growth on investment is an order of magnitude larger than the elasticity of the real interest rate. Also striking is the effect the property market has on investment, independent of the credit channel—a 1 percentage point rise in real property prices has the same impact on investment as a 1 percentage point increase in loan growth. Moreover, once the credit channels and property prices are included, the real interest rate was found not to have a significant independent impact on investment.

Investment Equations

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Source: Staff estimates.Dependent variable is the log of the share of the respective investment category in GDP. The independent variables (except the real interest rate) are logs of the respective variables deflated by the investment goods deflator. The real interest rate was estimated using an ex ante expected inflation series constructed by the HKMA. “***,” “**)” and “*” denote statistical significance at 10,5, and 1 percent levels, respectively.

10. Bank credit appears to be strongly affected by property market conditions. Several factors were found to affect bank loan growth—notably the lending rate, and GDP growth.3 While it was not surprising to find that the behavior of property prices are key to determining property-related loans, their role in determining the availability of bank credit to less closely related activities, such as manufacturing, was unexpected. The estimated elasticity of property prices dwarfs those for the other factors for both construction and manufacturing loans. The only loan category where property prices have no measurable effect was in credit card loans; as expected, income growth (proxied by GDP growth) was the main determinant of credit availability.

Loan Growth Equations

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Source: Staff estimates.Dependent variable is the log of loan growth (total, manufacturing, and real estate-related—including mortgages) deflated by the investment goods deflator. The independent variables (except the real interest rate and stock market volatility) are log changes, and property price changes are relative to the investment goods deflator. The real interest rate was estimated using an ex ante expected inflation series constructed by the HKMA. “***,” “**” and “*” denote statistical significance at 10, 5, and 1 percent levels, respectively.

11. The dominant influence of the property market on bank credit underscores the relative paucity of quality information about firm operations. The pervasive influence of the property market on non-real estate bank lending is explained by the widespread use of property as collateral in lending. Despite the collapse of Hong Kong SAR property prices since the Asian crisis, and global industry trends toward more risk-based lending practices, anecdotal evidence suggests that collateral-based rather than risk-assessment-based lending remains an important if not dominant practice among many Hong Kong SAR banks.4 Two surveys by the HKMA of SME financing practices and bank lending policies indicated that almost all companies that borrowed from banks had their credit facilities secured almost fully by collateral—usually real estate.5 There was a consensus among banks that SMEs were not sufficiently transparent and had poor accounting and corporate governance standards. Banks claimed that these difficulties warranted the use of collateral as an important criterion for approving business loans.

C. Factors Holding Back Debt Market Growth

12. Among the factors that have impeded the development of Hong Kong SAR’s debt market are: (i) inconsistent tax treatment of government and private debt securities; (ii) inadequate issuance of Exchange Fund bills and notes at various maturities to provide a reliable benchmark yield curve; (iii) difficulties in obtaining accurate credit assessments coupled with restrictive credit rating requirements under the Bank Ordinance for certain securities to be considered liquefiable assets or eligible to be counted as bank capital; and (iv) the lack of sufficient details in most firms’ corporate disclosure practice. Low secondary market liquidity, limited investor interest particularly among institutional investors, and cumbersome listing and issuance procedures have also been contributing factors.

13. Tax distortions arising from the special status of some debt issuers have also slowed the development of segments of the debt market. In particular, income earned on Exchange Fund papers, multilateral development bank papers, and certificates of deposit issued by local authorized institutions that are held by nonfinancial institutions are exempt from profit tax. Also, interest and dividend earned by institutional investors (other than authorized institutions) on bank deposits and stocks are tax exempt. In contrast, exemptions on corporate debt instruments is more restrictive.6 Such distortions have biased issuance in favor of Exchange Fund bills and multilateral development bank papers and retarded the growth of the corporate debt market.

14. Anecdotal evidence suggests that Hong Kong dollar debt issues are also limited by the ready access to the U.S. dollar market for the larger local corporations. As the U.S. dollar market is wider and deeper than the Hong Kong dollar market, larger and longer maturity issues can be used with proceeds readily swapped back into local currency. Indeed, the secondary Hong Kong dollar debt market is considered by many financial market participants as unattractive because it is relatively illiquid, especially for corporate debt.

15. In some countries, the development of securities markets has also been impeded by the dominating presence of banks and the lack of institutional investors. In bank-dominated financial systems (such as France, Germany, and Japan), banks often exercise direct control over securities markets by limiting access (through control of distribution channels or with access to payments systems) for nonfinancial firms. This allows banks to use the securities markets to fund themselves. In Hong Kong SAR, market makers are also the largest banks. It would be reasonable to infer that insofar as there is incipient demand for specific fixed-income products (of certain maturities or generating certain cash flows), banks would issue their own securities to satisfy that demand (capturing both implicit underwriting fees and pricing gains) before underwriting third-party issues. In the United States, historical divisions in the financial industry allowed more specialized financial firms (separate commercial and investment banks) to compete and thus develop the securities markets. The introduction of the Mandatory Provident Fund will attract institutional investors with sufficient appetite for fixed-income investment papers. This will allow nonfinancial firms more opportunities to bring corporate paper to the markets.

16. In Hong Kong SAR, there does not appear to be any obvious regulatory constraint that may have held back debt market development.7 In fact, the money market in Hong Kong SAR is considered fairly well developed.8 Moreover, active derivatives and futures markets also exist. A factor that may have held back debt market development, including the use of repos, was the lack of a government bond market, which has only begun to develop lately.9 Government bonds are typically used as collateral in repo arrangements. It was not until 1993 that the government began addressing these concerns, by raising medium-term funds with five-year maturity through the issue of the Exchange Fund Notes. The government extended the maturity term to ten years in 1996 to help develop a benchmark long-term yield curve.

17. Obtaining accurate credit ratings for local businesses has been a major obstacle in encouraging increased use of debt issues. There are two factors contributing to difficulties in assessing the financial conditions of firms to determine who qualifies as a high-rated debt issuer. One aspect peculiar to Hong Kong SAR is that credit ratings of even Hong Kong SAR’s best firms are disadvantaged by the assessment practices of international rating agencies. Corporate credit ratings are capped by the rating of Hong Kong SAR sovereign debt, which in turn is arguably held down by the Mainland’s lower credit rating. Some market observers have noted that the sovereign rating artificially raises the cost of funds for credit-worthy medium-sized enterprises and is one reason they are denied access to credit markets. This aspect of the general problem of obtaining accurate credit assessments for a wider range of Hong Kong SAR businesses may improve with better understanding of the “one country, two systems” principle by rating agencies. Recent initiatives by the HKMA to promote a commercial credit reference agency are expected to help improve the availability of information and assessments about corporate borrowers.

18. Weak corporate transparency by international standards among many Hong Kong SAR businesses has also impeded more extensive use of debt instruments. Even banks, who arguably have developed specialized lending skills, require credit enhancements (collateral) in almost all lending to SMEs. To be sure, SMEs generally do not require extensive direct access to capital markets for external financing, and over 95 percent of all corporations had profits of under HK$10 million (US$1.3 million). Moreover, larger firms, especially banks, have scored high among their peers in the region for disclosure practices, but even these instances have been criticized as not having adopted global best practices.10

D. Some Policy Options to Support Debt-Market Development

19. Over the years, the authorities have taken several steps to encourage the growth of Hong Kong SAR’s debt market. As noted, the benchmark yield curve was extended in 1996 with the issuance of 10-year Exchange Fund Notes.11 Mortgage and asset-backed securities market activity has been promoted by the government-owned Hong Kong SAR Mortgage Corporation. Improvements to the financial infrastructure have included: (i) the introduction of real-time gross settlement (RTGS) payment systems in 1996; (ii) the integration of the HKMA’s Central Money Markets Unit with the RTGS system to allow electronic securities settlement and clearing; and (iii) implementing a U.S. dollar clearing system in 2000, which enable Hong Kong SAR markets to settle U.S. dollar transactions within the Asian time zone.

20. However, several areas for public policy reforms and further infrastructure building remain. To address inconsistent tax treatment of government and private debt securities, cumbersome listing and issuance procedures and an inadequate benchmark yield curve, specific changes in tax, regulatory, and public debt management policies to reduce the tax bias against corporate debt issuers, to streamline listing and other documentation requirements for debt issuers, and provide market participants with regularly scheduled and reasonably sized debt issues at key benchmark maturities are needed.12 Documentation requirements for new issuers in general, not just debt, are under review by the Securities and Futures Commission and related agencies with the objective of streamlining procedures and reducing issuance costs. Many global market participants have demanded that countries adopt a firm pre-announced issuance calendar to provide institutional investors with greater certainty about issue dates and amounts—thus enabling them to more easily structure portfolios with desired maturities.

21. Recent initiatives to bring Hong Kong SAR’s financial legislation at par with international standards will help, but additional steps are needed. Refining legislation, codes, and standards, that inter alia, reduce the cost of issuing securities, are only some of the changes to the financial infrastructure necessary for developing deeper and more liquid markets. The disciplines of better financial disclosures and high standards of corporate governance will deepen the commercial debt market. Financial policymakers, therefore, need to set incentives for companies to produce high quality information required by investors, and put in place mechanisms for ensuring the implementation of high standards of corporate accountability and responsibility (especially to minority shareholders) to complement those arising from market discipline.13


This chapter was prepared by William Lee (Resident Representative, Hong Kong SAR Sub-Office). Jahangir Aziz (ext. 37693) is available to answer any technical questions.


The authorities introduced several reforms after the stock market crash of 1998, contributing to the stock market’s strong performance over the past decade. A Securities Review Committee (now the Securities and Futures Commission) was created to regulate companies listed on the HKSE; internationally accepted regulatory standards conducive to market transparency and fairness have been introduced and upgrading market technology infrastructure with regard to trading and settlement systems in order to improve risk management practices, price discovery, and market liquidity.


Faster GDP growth tends to decrease bank lending, especially in manufacturing, because rapid growth is initially associated with rising cash flow, which serves to fund investment demand during the early stages of the business cycle. The demand for external financing rises during latter stages of the cycle when GDP and cash flow growth slows and desire to expand capacity rises. Although the equity market is an alternative to bank lending, neither the level nor the volatility in the stock market had significant effect on loan growth.


Hong Kong SAR bank supervisors and regulators have been encouraging banks to perform more risk-based lending, and have issued letters to all banks citing specific credit principles that they are expected to follow, including the need to evaluate borrowers’ debt-service capabilities. Promoting such lending practices would also increase the marketability of bank assets and could help develop a secondary market for such assets. At the very least, improved risk classifications would allow bank management and supervisors to better assess the conditions of bank balance sheets.


See “Survey of Financing Situation of Small and Medium-Sized Enterprises,” Hong Kong Monetary Authority Quarterly Bulletin, No. 24, August 2000, pp. 33–38.


A 50 percent tax concession for income earned on qualifying debt instruments is available for corporate debt. Qualifying debt securities (QDSs) are Hong Kong dollar debt securities issued by the private sector which: (a) have a rating higher than the minimum credit rating set by the HKMA (currently at BBB-from S&P’s); (b) have an original maturity not less than 5 years; (c) have a denomination not less than HK$50,000; (d) are issued to the public; and (e) are cleared through the CMU. Hong Kong dollar debt securities issued by statutory and government-owned corporations, such as Mass Transit Railway Corporation, Airport Authority, Hong Kong Mortgage Corporation and Kowloon-Canton Railway Corporation, will also qualify as QDs if they can meet the above requirements, except condition (a).


However, as discussed earlier there are distortionary taxes that have contributed to the underdevelopment of the corporate debt market.


Hong Kong has a sizable and active interbank market, which has served as a major source of Hong Kong dollar funding or investing short-term deposits for the banking system. Interbank funds account for about one-fourth of the total Hong Kong dollar liabilities of all banking institutions, mirroring the market’s key role in financial intermediation.


Money markets are critical for the development of liquid debt markets as they anchor the short-end of the yield curve by pricing liquidity. In addition, they facilitate cash management and can be used to finance position taking. A well-functioning money market encourages investors, brokers and dealers to trade and take positions, necessary activities to enhance market liquidity. To this end, an active repo market would also help facilitate increased dealings in OTC markets where most debt is traded. Without such collateralized borrowing arrangements, trading and position financing would have to resort to usually more costly uncollateralized bank lines of credit.


Two studies by consultants Deloitte Touche Tohmatsu and KPMG assessed disclosure practices of major Hong Kong SAR banks and noted that while disclosure standards comply with best practice guidelines of the HKMA, additional disclosures were needed to meet global best practices as recommended by the Basel Committee on Bank Supervision. These additional disclosures included more detailed accounting policies and key assumptions for provisions, a geographical analysis of loans, concentrations of credit risk, interest rate exposures from loans, “fair value” of loans, and better information on loan exposures and credit-risk management.


Since August 1998, the HKMA limited the issuance of Exchange Fund Notes to the volume of capital inflows to strengthen credibility in the currency board.


It should be noted that since November 2000, the HKMA has decided to adjust the Exchange Fund Bills and Notes issuance programs with more longer term papers in place of the ones with shorter maturities that retire.


According to a 1999 survey by Credit Lyonnais Securities, investment firms with superior corporate governance have outperformed other emerging market companies in rising markets and have less volatility in down markets.