(Reprinted from HKCER Letters, Vol.37, March 1996)
The International Role of the Hong Kong Financial Markets
Editor's Note: In January 1996, the Second Biennial Conference of Pacific Rim Allied Economic Organizations, coordinated by the Western Economic Association International, was held in Hong Kong. In a luncheon session organized by the Centre, Mr. Anthony Neoh, QC, JP, Chairman of the Securities and Futures Commission, was invited to speak on the Hong Kong financial markets. Mr. Neoh's speech is reproduced below.
The theme of this conference is "Economies in Transition," and in respect of Hong Kong, I believe that the theme is brilliantly captured by Dr. Richard Wong's foreword in the conference brochure. There, he states: "As 1997 approaches, Hong Kong exemplifies the tremendous potential for economic growth, the challenges, and the uncertainties that major transitions can bring".
1 July 1997 will be a crucial date for us in Hong Kong. In that year, China resumes the exercise of the sovereignty over Hong Kong. On any view, this is major transition, and as would be expected, this has provoked a wide spectrum of forecasts, beginning with the most pessimistic, which predicts "The Death of Hong Kong" (as the Fortune Magazine has done last June) extending to the hitherto most optimistic, which predicts that the Hang Seng Index will top 30,000 by the end of 1998 (as the Guinness Flight Fund Managers have done last December).
As economists, you will no doubt be fully aware of the pitfalls of any prediction, and will readily accept that it is simply impossible to accurately predict the future. However, I believe you will agree that in even an uncertain world, one can still place some reliance on trends and track record, as to which it is beyond doubt that Hong Kong has been no stranger to change.
Since the conclusion of the Second World War, Hong Kong has changed from a relatively insignificant trading port to the thriving cosmopolitan city that it is today. In the course of this transformation, Hong Kong has weathered many storms, physical, economic, and political. It has been amply tested and has thrived.
Both in learned journals and the popular media, much has been written and said about the reasons for Hong Kong's success. In all of this, you will find a common thread--that Hong Kong's success rests upon the openness of all of its markets to the world and its international orientation in all economic and commercial matters.
This openness has translated into a sixfold increase in the market capitalization of the stock market since 1988. By the end of 1995, the market capitalization exceeded US$270 billion, making our stock market the eighth largest in the world. Just over 60 percent of our listed companies are incorporated outside of Hong Kong, principally in Bermuda, while 18 of our listed companies are state enterprises incorporated in the mainland of the PRC.
Hong Kong is now the third largest international banking center in the world, with 85 of the largest banks of the world operating here. As of April 1995, Hong Kong has been rated as the fifth largest foreign exchange market of the world. In the asset management area, Hong Kong has over 1,000 authorized funds and unit trusts domiciled in over a dozen jurisdictions. The Hong Kong Investment Funds Association estimates that Hong Kong fund managers manage in excess of US$50 billion of portfolio investments from Hong Kong into the domestic market, the rest of the region, and the rest of the world. The majority of our fund managers have come from the United Kingdom and the United States. joining a small number of established and successful local managers. Their funds are sourced not only from Hong Kong but from their home jurisdictions as well as from the rest of the region. This means that a large institutional, and international, investor base now exists in Hong Kong.
A 1992 Survey by the Stock Exchange showed that about half of the stock market turnover was accounted for by institutional buyers. Although there is not a more recent survey, there is every reason to believe that this figure may well have increased somewhat, since recent Stock Exchange figures show that the top 65 brokers take up about two-thirds of the market turnover, and those are the brokers who could be expected to engage in institutional business.
The past seven years has seen a twofold increase in the number of registrants, although the number of registered securities businesses have increased by only 13 percent. The major European, U.S., and Japanese securities houses, investment bankers, and fund managers, have joined this increase. So have regional intermediaries, notably intermediaries from the mainland of the PRC who increased from nil in 1993 to 11 by 31 March 1995, and now they number 22.
What we have been experiencing in the past seven years has been increasing internationalization of our market, our market intermediaries, and our investor base. This internationalization of our market has been accompanied by structural changes to our market guided by an international orientation in financial regulation.
The fact that the Stock Exchange now lists about three hundred companies which are incorporated outside of Hong Kong, notably in Bermuda and the mainland of the PRC, and that many initial public offerings through the Stock Exchange are made globally, has been the result of listing rules designed with an international outlook. Issuers of debt now list in excess of US$70 billion of debt in the Stock Market. The majority of these issuers are either supranational bodies, state bodies, or multinational corporations. These issues are almost invariably accompanied by global fund raising, and a listing in the Hong Kong is sought because the mandates for investment portfolios increasingly recognize the Hong Kong market as having the desired standards of regulation.
This recognition reflects the fact that in all areas of financial regulation in Hong Kong, the accent is on the application of internationally recognized standards giving international investors the regulatory comfort they can expect from a maturing market. That is also why, in all areas of financial regulation, there is active participation by Hong Kong in international regulatory and market fora, such as IOSCO, the FIBV, and FIA.
Application of international standards in regulation has been accompanied by the institution of market infrastructure which promotes transparency, efficiency, and risk management. Both the Stock and the Futures Exchanges have established trading, clearing and settlement, and risk management systems which have received worldwide industry acclaim. Both exchanges have developed a much wider range of products to their members than was available seven years ago. In the Stock Exchange, investors can trade not only stocks but derivative warrants as well as stock options. In the Futures Exchange, investors may trade index futures, options on such futures, foreign exchange futures, and sometime this year, foreign currency options. There is a vital program in both Exchanges for product development and for improving the system of regulation within their self-regulatory spheres.
The best testament to the benefits of these structural changes have of course been the increased participation of international investors in our markets, and the continuing inclusion of Hong Kong in international investment portfolios, making Hong Kong the international market that it is today, six times the size of what it was in 1988. In this process, both international and domestic intermediaries and investors have benefited from this increased size, and hence, liquidity of the market.
Local investors and intermediaries have also benefited from the infrastructural improvements. Today, the automatic trade matching system of the Stock Exchange matches all buy/sell orders regardless of which broker the order came from, and the risk of settlement is taken by a central clearinghouse which also performs the function of a central depository of shares. This, at once, levels the playing field between all brokers and, at the same time, promises security to all. It also means much-enhanced efficiency. The Futures Exchange too has been able to establish new trading and state-of-the-art clearing and risk management systems, also equalling the playing field for all and improving risk management and efficiency for all. The financing of all this was, it must be borne in mind, only made possible because of the much increased revenues of the Exchanges over the past few years brought about by the increased participation of international investors in our markets.
But change brings not only opportunities but also pain. It has been stated in some quarters that this internationalization of our markets has created undue strains on our markets, to the detriment of local investors and intermediaries.
It has been suggested that international investors are able to use the sheer size of their capital to move the Hong Kong market to their advantage, and by implication, to the detriment of local, retail investors. It is a trite proposition that the function of any market is to find an equilibrium between supply and demand, thus capital is of no use unless there are sellers. Furthermore, we now have both cash and derivative markets which interact with each other, and it takes skill as well as capital to exploit windows of opportunities, particularly arbitrage opportunities, where they exist between these markets. International intermediaries are clearly bringing their skills, technology, and capital. We cannot expect them not to do so since they, like everybody else, must remain competitive. Local intermediaries must therefore either catch up or develop their own niche in the market.
With the introduction of international standards come new ways of management of securities businesses and the consequent need for acquisition of new skills. No broker today can operate without some computer knowledge, and all brokers have had to make varying degrees of investment in information technology and staff training or, in some cases, rehiring higher skilled staff. To be successful, intermediaries must be able to quickly devise and execute trading strategies straddling the cash, futures, and options markets. The introduction of "fit and proper criteria" and the "code of conduct" has meant additional investment of time, effort and cost, including opportunity cost, in compliance. If this cost is not commensurately rewarded through additional revenues, then it follows that profitability suffers. Thus there has been a continuing trend toward consolidation as securities businesses seek economies and concentrate skills. In 1988 there were, on average, five registered persons per firm, and in 1995, 11 registered persons per firm. In an open and free economy, only the fittest survive. Hong Kong is no stranger to this phenomenon. In the past 50 years since the end of the Second World War, Hong Kong's community has shown its enterprise and its resilience, time and time again.
But whilst the internationalization of our markets has meant adjustment for our local participants, it is because of this internationalization that we are now best placed to exploit the opportunities in the horizon. Many of these opportunities are patently obvious.
We now live in a region of unprecedented economic growth. By all credible accounts, the economies of East Asia will grow for the next decade at an average rate of 9 percent. This is a region with the highest savings rate in the world. The need for physical infrastructural capital is estimated to be US$1.5 trillion in the next decade. Hong Kong is already part of the economic miracle of China, and yet, that miracle is only just beginning. Within the past three years alone, tremendous strides have been made in China to build the financial, fiscal, and legal institutions for further growth. The most important of these have been central and commercial banking and company laws, the introduction of a national taxation system, and the building of a commercial banking system run on market principles. Both in the 1995 Five-Year Plan and in the 2010 Strategic Vision published late in 1995, there are farsighted statements on enterprise reform. These statements have been based on experience and continuing work on the ground, the most important of which has been the continuing clarification of property rights and lines of management between the state and the enterprises themselves. China is developing a new cadre of professional managers, lawyers, accountants, and technologists in every field. It is well possible that before too long a critical mass of manpower, regulatory conditions, and capital is attained for the Chinese economy to take another quantum leap, changing the landscape of the Chinese industrial and financial scene.
How can Hong Kong benefit from all of this? Here, I again return to our international orientation. Because of the international orientation of our markets, Hong Kong now has market infrastructure and a regulatory environment which holds the confidence of international investors. In fact, when Hong Kong resumes its former position one hundred and sixty years ago, as part of China, Hong Kong's markets will constitute the developed market within the still emerging and still strongly performing economy of China.
It is contrary to logic, reason, or experience that the developed market structures and regulatory culture of the Hong Kong markets will change when they have stood the test of time. In all my encounters with Chinese officials, not one gave me any inkling that they thought Hong Kong's international financial orientation should change. Indeed, they stress that Hong Kong's position as an international financial center should not only continue but should be further developed. That, in fact, is the duty placed upon the Special Administrative Region of Hong Kong by the Basic Law which contains many detailed provisions, too numerous to repeat here, ensuring that the regulatory systems and laws requisite for an international financial center, as we know it today, should continue, and continue to be developed.
But the most important strategic asset we have is the critical mass of financial intermediaries and professionals we have in Hong Kong. They will be here so long as Hong Kong remains a congenial place to stay. Together they manage the largest concentration of international capital outside of Japan. The accumulated experience of these professionals means that there is no other market in the world which can access information about China, and react to such information, as quickly as Hong Kong. No pool of retail investors has the same knowledge and, hence, appreciation of Chinese enterprises and the Chinese economy than Hong Kong's own. Because of Hong Kong's cultural, political, and geographic ties to China, no other market can duplicate Hong Kong's position as the gateway to China.
It is also trite that the success of any market lies with its usefulness to those who use it or might potentially seek to use it. That is why we should, on one hand, seek to capitalize on the strengths of our markets, and on the other, seek to remedy our weaknesses.
As to the strengths, I have just given you a glimpse. We are already well on the way to developing them. Our internationalization orientation tends to lead us to envision our strategic position in not only domestic, but also national, regional, and global terms. That is, in fact, the positioning we have adopted in relation to regulation. Domestically, our regulators always regard dialogue and consultation with our local exchanges and practitioners to be of great importance. As far as the Securities and Futures Commission is concerned, we pride ourselves in being an organization which seeks to bring regulatory services to the financial community on the strength of knowledge, which is multijurisdictional and multidisciplinary and from a practitioner's point of view. In fact, the bulk of our professional staff come from the industry.
Nationally, we have two Memoranda of Understanding with the PRC, one on securities and the other on futures regulation. These are not mere pieces of paper but have been firm foundations upon which we and the China Securities Regulatory Commission have built firm relationships in the past three years.
Regionally, we have formal regulatory cooperation arrangements, with the regulatory agencies in Australia, Malaysia, Indonesia, and Thailand. We are seeking to increase this list. On both sides of the Atlantic, we have formal agreements with the regulatory agencies in France, the U.K., Canada and the U.S.
What dividends have these regulatory ties paid for the Hong Kong market? From a regulatory sense, these ties have enabled all the counterparts to more effectively police their own markets, both in preventative and enforcement terms. From a market development sense, this has enabled our counterpart regulators to permit access of Hong Kong products and intermediaries to their markets. It also permits access to the Hong Kong markets. The most successful example of this regulatory cooperation has been in the listing of "H shares." Another example has been the SEC and CFTC approval of the Hang Seng Index and options to be marketed in the U.S.
This network of regulatory cooperation holds even more potential if one is able to envisage strategic alliances of the markets. The Investment Services Directive of the European Union is a formal pan-European regulatory framework which lays out the ground for financial integration if the markets were ready and willing to attempt that. Already, we see the DTB and Matif are entering into a strategic alliance so that their members can mutually trade in these markets. Through this link-up, an investor in France can, through a French broker, buy an investment in the DTB, and vice versa. That actually immediately broadens the investor base for both markets and deepens the market for each of the products traded. Likewise, we have the strategic alliance between the Hong Kong Futures Exchange and the Philadelphia Stock Exchange with respect to their currency options contract. Once this alliance is implemented, the Hong Kong currency options market becomes part of the Philadelphia currency options market, and both markets immediately deepen.
As the regional and global financial markets grow, strategic alliances are inevitable, as they enable markets to mutually improve their competitive edge. The challenge for us in the Hong Kong market is to seek out those alliances which mutually benefit Hong Kong and its partners. That is the challenge that the future sets for us. On the part of the Securities and Futures Commission, we shall do everything in our power to foster the regulatory links within the nation, within this region, and around the world, so as to make possible any strategic alliances that our markets seek to strike in the future.