Hong Kong’s International Financial Centre: Retrospect and Prospect

26 January ,2011

In any listing of the world’s top international financial centres, Hong Kong takes a prominent place. How secure is that place, and what factors increase the odds that it will remain in the first tier of IFCs?

This commissioned study conducted by Professor Louis Pauly places in a larger context the contemporary challenges facing Hong Kong as it seeks to build on past success and strengthen its IFC.

Executive Summary

- In any listing of the world’s top international financial centres, Hong Kong takes a prominent place. How secure is that place, and what factors increase the odds that it will remain in the first tier of IFCs? This study places in a larger context the contemporary challenges facing Hong Kong as it seeks to build on past success and strengthen its IFC.

- The growing role of Hong Kong’s financial sector needs to be viewed as the consequence of a long-term transformation. Although finance has long played an important role in Hong Kong’s development, it is today only one of the four pillars of the local economy. Even though finance accounts for over 16% of Hong Kong’s GDP, however, it provides only 6% of total employment.

- External surveys now routinely place Hong Kong third among global financial centres. In terms of overall market breadth and depth, only London and New York exceed it. A primary entry and exit point for Mainland trade and investment financing, Hong Kong has particular strengths in banking, equity markets, funds management, and, increasingly, insurance. Various activities related to the growth of offshore RMB markets are bright spots at present. Singapore remains a strong competitor, especially in foreign exchange and derivatives trading, international banking, and bonds.

- Significant shifts can be expected as China’s system of capital controls erodes. But the associated and much-hyped eclipse of Hong Kong by Shanghai is likely decades away. In the meantime, Hong Kong has the ability to adjust and remain prosperous. Principal home base for multinational corporations with important Asian regional strategies, one of several financial gateways into China, prominent gateway out of China, connector of Chinese and foreign business networks—Hong Kong’s unique position can endure and strengthen.

- Joint agreements to develop the Pearl River Delta as a coherent economic region, a new framework agreement on Guangdong-Hong Kong Cooperation, and plans to make Qianhai, near Shenzhen, a southern China hub for service industries pose challenges to narrowly focused strategies to defend Hong Kong’s existing advantages.

- Keeping Hong Kong’s financial markets competitive and stable is complicated by an array of new factors. The complex interaction of new political and economic risks brings with it the need for continuous review and reform in the structures and practices of financial regulation and supervision.

- Relative to the recent experience of the United States and much of Europe, and to its own experience ten years earlier during the Asian crisis of the late 1990s, in 2008 Hong Kong’s crisis management system proved reasonably robust. The bankruptcy of Lehman Brothers, however, and widespread allegations that the risks and fees associated with so-called mini-bonds bearing the Lehman name had been misrepresented by many Hong Kong intermediaries, revealed serious flaws in governance at a number of levels.

- Across the advanced economies of the world, including Hong Kong’s, the crisis of 2008 suggested the need for more pro-active and less reactive government. But balancing the competitive impulses required for continuing prosperity in financial markets and durable expectations of overall stability and safety requires subtlety. For Hong Kong it also requires the maintenance of relative autonomy both internationally and inside greater China.

- At the global and regional levels, Hong Kong’s government has already proven its ability to think strategically and act constructively as financial regulatory and supervisory policies are adjusted. The joint work of FSTB and the HKMA during and after the crisis of 2008 suggests that to strengthen today’s IFC in Hong Kong a single entity ‘above the fray’ needs to be in a position to think strategically about healthy financial markets in Hong Kong and their relationship with the broader economy. It should be a permanent secretariat and long-term think-tank for the Council of Financial Regulators.

- Closer to the markets, a version of the UK’s planned Prudential Regulatory Authority, as a distinct and distinctly mandated subsidiary of the HKMA, should be considered. Under its stability mandate, the HKMA should remain in a position continually to re-assess and guide macro-prudential policies, especially as they apply to systemically significant banks and the migration of systemic risks, arising, for example, from institutional scale, cross-border links, and interconnectedness, ostensibly outside the banking system. International comparators should also inform continuing reconsideration of the relationship between the SFC and the HKEx. Similarly, comparative analysis should influence continuing debate on moving beyond arbitration procedures to the establishment of a separate, cross-sectoral agency for consumer protection.

- There is no reason to tamper with the HKMA’s primary responsibility for managing the Exchange Fund. But the current scale of reserves and the expansion of cooperative facilities with China and regional partners call for reconsideration of very conservative investment practices. A sovereign wealth fund may not need to be explicitly carved out, but the return on a serious portion of existing and future reserves could reasonably be benchmarked against the performance of SWFs in comparable jurisdictions.

- Higher investment returns on the Exchange Fund would provide the government with greater fiscal capacity. With the same goal in mind, the current low tax policy, and the related policies associated with land use, should not be out of bounds for comparative analysis and open debate. Fiscal flexibility would facilitate necessary investment in public infrastructure and human resources to sustain a resilient IFC and build a more broadly diversified economy.

- Continuing to attract the regional head office functions of multinational firms remains important. In this regard, the role of personal tax incentives may be exaggerated, especially because of the counter-balancing implications of rapidly rising housing costs. High-quality elementary and secondary schools, new resources to upgrade the linguistic abilities (English and Mandarin) of the general labour force, better air quality, improved public health services, and the kind of cultural amenities long promised by the West Kowloon Complex—all are arguably more significant.

- Maintaining an IFC in the top global tier will not likely generate the quantity or quality of jobs needed to ensure the future vibrancy of Hong Kong’s overall economy. New industries will be needed. Finance will remain a key piece of the economy, but none of the world’s leading IFCs are disconnected from real economies and distinct systems of industrial innovation. Deepening financial-industrial linkages between Hong Kong and the Mainland is not inconsistent with enhancing the conditions for innovation and knowledge-based development within Hong Kong itself. Continuing strategic investments are required, not least in the university system.

- With regard to the financial sector, a two-track strategy has much to commend it. Hong Kong can offer its experience and expertise to Mainland cities seeking to build modern financial markets, while also keeping its internal focus on the challenge of continuously enhancing the globally competitive advantages of its IFC.

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