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China cannot (yet) do without Hong Kong

Hong Kong is still crucially important for China to access global financial markets. But Beijing’s reaction to the protest movement is increasingly putting this system at risk. Other financial centers, like Singapore or London, have been named as possible alternatives. But China cannot yet do without Hong Kong, argues Max J. Zenglein.

Hong Kong has long occupied a crucial intermediary role for China’s economic development. Its companies were pioneer investors during China’s initial economic reforms and opening up in the early 1980s, and the city then became a vital trading hub for China’s exports. Nowadays, Hong Kong is first and foremost an essential financial gateway providing access to foreign currency and playing a crucial role in integrating China’s financial system with global markets.

For foreign and Chinese investors, Hong Kong’s distinct institutional characteristics under the Special Administrative Region’s autonomous status provide a convenient workaround to the limitations of China’s institutional and economic framework. The current robust performance of Hong Kong’s financial services makes the city all the more important for China.

But from Beijing’s perspective the reliance on Hong Kong as a financial gateway was always intended to be just an interim solution. For nearly 20 years the Chinese government has sought to develop alternative domestic mechanisms needed to tap into global financial markets. This trend is likely to continue but, for now, China very much still depends on Hong Kong as a functioning offshore financial center (OFC) to meet its economic needs as the alternatives are far from optimal compared to what Hong Kong has to offer.

Shanghai and Shenzhen: can China’s domestic financial hubs match Hong Kong?

The international financial community’s expectations were raised back in 2013 by the announcement of reforms within Shanghai’s China Pilot Free Trade Zone. Initially, the plans envisioned far-reaching liberalization efforts including a fully convertible capital account, interest rate liberalization as well as the removal of internet restrictions, to name just a few. Similar experiments had been announced the previous year for the Qianhai Shenzhen - Hong Kong Modern Service Industry Cooperation Zone. These included plans to use Hong Kong’s common law for commercial disputes and provide flow-back channels for yuan (CNY) raised offshore by relaxing restrictions for cross border capital flows.

Since then, the financial hubs in Shanghai and Shenzhen have overtaken Hong Kong in terms of market capitalization. However, they still primarily serve a domestic market purpose. Despite ongoing reform of its financial markets in 2019, China lacks the institutional environment needed to establish a truly international financial center within its own borders.

The main stumbling blocks are China’s lack of a fully convertible currency, strict capital controls and the absence of rule of law. Another major factor is that any liberalization efforts can be withdrawn whenever Beijing deems it necessary. The harsh truth was revealed in 2015, when the government intervened to cool a giddy stock market rally, and introduced stricter capital controls to stop the CNY depreciating further against the USD. It has become clear that trying to create new international financial centers is easier said than done; simply changing the policies is not enough if there is an underlying lack of trust in the commitment to economic liberties.

Macau: why can’t the neighboring city replace Hong Kong as a financial hub?

Macau is the PRC’s other Special Administrative Region, regained from Portugal in 1999. In Macau, institutional convergence and acceptance of China’s political and economic system are far more developed. Reports of the planned establishment of a CNY-denominated stock exchange have fueled speculation about the former colony perhaps taking on a greater role as an OFC.[1] However, Macau’s economy is too small, and the city lacks the professional and regulatory experience that Hong Kong possesses. Furthermore, the city has a bad reputation: it continues to be listed as a money-laundering jurisdiction by the United States and was for a long time a major financing center for North Korea.[2]

There are other limitations: the local currency, the Macau Pataca, uses a currency board system which fixes it to the Hong Kong Dollar. Furthermore, the independence of Macau’s judiciary is questionable given the higher degree of influence from China on its institutions, even prior to 1999. In 2018, efforts were made to remove foreign judges participating in rulings on areas of “national security”. Their participation is one of the safeguards of judicial independence in the handover agreement with Portugal and was modeled on the UK’s arrangement regarding Hong Kong.

Fostering Macau as a major international financial center would entail major reputational and technical challenges. Macau can certainly take over some international financing activity, but the institutional barriers are too high to make it a credible alternative to Hong Kong.

Europe: will investors pull out of Hong Kong and move to London?

China has made diplomatic efforts to expand its financial footprint in Europe in an effort to raise capital and boost the internationalization of the Chinese Yuan.[3] A key example is the expansion of the Stock Connect mechanism, which connects China’s stock markets with overseas markets.

First introduced between Hong Kong and Shanghai in 2014, a similar link between the Shanghai and London stock exchanges was launched in June 2019 to facilitate overseas listings, and a further scheme linking Shanghai with Frankfurt were announced in November. However, the mechanisms remain extremely small in scope, currently limited to Global Depositary Receipts (GDR), which are traded independently of the underlying stock.

More worryingly, such fledging schemes may not be immune to political brinkmanship, as a recent controversy suggests. The Shanghai Stock Exchange has denied reports the scheme was being suspended in retribution for UK criticism of how the PRC has handled the Hong Kong protests.

Singapore: is the city state the strongest competitor for Hong Kong?

Singapore has been a long-standing rival to Hong Kong, both in the Asian financial sector and in other respects. In the area of financial services, the city state currently has a complimentary role. Hong Kong is particularly strong in equities and offshore CNY, whereas Singapore has a stronger position in fixed income and commodity trading.

Singapore is likely to boost its already strong position in wealth management for PRC citizens. It may also become a more favorable destination for setting up Asia Pacific headquarters of multinationals, should companies decide to make operational changes due to the situation in Hong Kong. There is already some evidence that senior expat personnel are beginning to move their families to Singapore.

Major damage to Hong Kong as an access point to international financial markets would come at an inopportune time for China. Hong Kong’s niche is already more contested. However, under the present circumstances, the alternatives are far less desirable for China. It does not want its crucial international financing needs to be located within a foreign jurisdiction and vulnerable to the decisions of foreign governments. This is unappealing for any government, but it poses a particular risk to the PRC given its aspirations as a rising global power.

This article is part of the latest issue of the MERICS Economic Indicators, a project monitoring China's economic development.

Related MERICS China Monitor: Financial hub at risk - How China's reaction to protests jeopardizes Hong Kong's status