The impact on other financial indicators has also been relatively minor thus far, including the HKD/USD exchange rate, foreign currency reserves, interest rate, equity, exchange traded funds (ETF), fixed income and wealth management markets. Given the current global economic slowdown coupled with the insecurity surrounding Hong Kong’s political crisis, overall market reactions seem within normal volatility.
2.3 China cannot (yet) do without Hong Kong
The current robust performance of Hong Kong’s financial services accentuates the importance of the city for China. But from Beijing’s perspective the reliance on Hong Kong as a financial gateway was always 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 OFC to strengthen its own economic needs.
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 will become more contested. However, under present circumstances, alternative options would be far less optimal for China.
a) Shanghai and Shenzhen
China’s policy makers have long tried to transform domestic financial centers in Shanghai and Shenzhen to become internationally competitive, giving rise to equally long-running speculation about when they might overtake Hong Kong. Although their domestic role has grown, neither can match Hong Kong’s role in international finance. As failed attempts testify, simply trying to replicate an international financial center through policy experimentation within a pilot free trade zone is easier said than done.
The international financial community’s expectations were once again raised by the 2013 reforms to be enacted 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 lifting internet restrictions, to name just a few. Similar experiments were announced in 2012 for the Qianhai Shenzhen-Hong Kong Modern Service Industry Cooperation Zone which, among others, included plans to use Hong Kong’s common law for commercial disputes and provide flow-back channels for CNY raised offshore by relaxing restrictions for cross border capital flows.
China’s government has experimented with the introduction of selective relaxation of capital controls. Such channels include the Qualified Institutional Investor (QFII) and RMB Qualified Institutional Investor (RQFII) regimes, which enable foreign investors to directly invest in China’s stock markets. The mechanism was first introduced in 2002, and efforts to improve its appeal are continuing. Despite the recent adaptations, the mechanisms still come with a constraining regulatory framework and technical burdens for investors to participate.
However, any liberalization efforts can be withdrawn when deemed necessary by Beijing. The harsh reality was shown by the government’s intervention to cool a giddy stock market rally in 2015 as well as the introduction of stricter capital controls when the CNY was depreciating vis-à-vis the USD. The lack of trust in the commitment to economic liberties is paired with technical restrictions such as different due diligence standards.2 This is reflected, for instance, in the MSCI’s decision to include A-shares in its Emerging Markets Index using the Hong Kong Connect mechanism. The long-delayed inclusion would not have been possible using direct channels via QFII and RQFII regimes due to insufficient flexibility.
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 much more developed. Reports of the planned establishment of a CNY-denominated stock exchange in Macau have fueled speculation about the former colony perhaps taking on a greater role as an OFC.3 However, Macau’s economy is too small, and the city lacks the professional and regulatory experience that Hong Kong possesses. Furthermore, the city continues to be listed as a money-laundering jurisdiction by the United States and was long a major financing center for North Korea.4
There are other limitations: the local currency, the Macau Pataca, uses a currency board system, fixing it to the HKD. Its judicial independence is under question as Macau’s institutions have come under a higher degree of influence from China, even before 1999. Efforts to remove foreign judges participating in rulings on areas of “national security” were made in 2018.5 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 finance 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.
c) Offshore alternatives
Singapore and London are the most notable offshore financial centers with the potential to serve as alternative hubs for China’s activities. China has expanded its financial footprint in an effort to raise capital and boost the internationalization of the CNY.6 London has the world’s largest foreign currency market and significant CNY business and experience, partly because the United Kingdom’s historic links to Hong Kong has generated financial institutions with strong infrastructure there. London handled 85 trillion CNY a day in the second quarter of 2019, equal to 43.9 percent of offshore CNY transactions between April and June, according to a joint report published in November by the City of London Corporation and People’s Bank of China.
Building on the Hong Kong Connect scheme, a similar link between the Shanghai and London stock exchanges launched in June 2019 to facilitate overseas listings, and a further scheme linking Shanghai with Frankfurt has been announced for 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 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 has been a long-standing traditional 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.
China has made diplomatic efforts to expand the role of offshore financial centers in its economy, especially in Europe. However, for China’s leaders the process has limits. It is undesirable for China’s crucial international financing needs to be 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’s aspirations as a rising global power.