(Reprinted from HKCER Letters, Vol.46, September 1997)
Some Issues in Developing
Hong Kong's Financial Markets
During the past three decades, Hong Kong has emerged as one of the major international financial centres (IFCs) of the world. While this is undoubtedly a great achievement, Hong Kong's ranking among the IFCs has been, until recently, largely a matter of conjecture. There is a belief, widely held in Hong Kong and China, that the territory is somehow the third largest IFC of the world. Even some foreign observers have apparently subscribed to this view.
I have always been sceptical about this popular but unsubstantiated claim. In my recent book (Jao, 1997), I estimate that Hong Kong is between the sixth and seventh largest IFC of the world, on the basis of a comprehensive set of banking and other financial indicators. Hong Kong is very strong in banking, and can be considered as the fourth largest international banking centre (IBC) of the world. But an IBC is not equivalent to an IFC. Due to the growing trend of securitization, financial markets of all kinds (equity, bond, derivatives markets etc.) should be included for a more balanced and comprehensive ranking. More concretely, I used the following weights for my assessment:
Banking 40 percent Forex market 20 percent Equity and debt markets 25 percent Derivatives 10 percent Others 5 percent
According to this calculation, Hong Kong's weighted world ranking in 1995 was 6.47. Although Hong Kong was very strong in international banking, its relatively poor showing in other financial markets pulled down its overall ranking.
If Hong Kong wishes to maintain its status as an IFC after its reunification with China, it must strive to develop and internationalize further its financial markets. Owing to space constraint, I will confine myself to the bond market and the forex market.
By general agreement, the bond market is the weakest segment in Hong Kong's financial sector. The World Bank (1995) estimates that Hong Kong's bond market was the second smallest in non-Japan Asia. It cites the Hong Kong Government's conservative fiscal policy, the lack of a benchmark interest rate, the preference of the public for equities and the preference of debtors for bank borrowing as the principal reasons for the under-developed state of the bond market.
Conscious of this shortcoming, the government has been taking active measures to encourage the development of fixed-income debt market, including some tax concessions announced in last year's budget. Since 1990, the Exchange Fund has been issuing bills and bonds whose maturities have lengthened from 7 days to 10 years. Unlike Treasury bills and bonds in other countries, the Exchange Fund obligations are not issued for covering fiscal deficit, but to serve two main purposes: to foster the capital market by providing benchmark rates, and to facilitate monetary policy operations by providing an additional instrument.
It is interesting to note that the yield differentials between Exchange Fund obligations and their US Treasury counterparts had tended to narrow earlier this year, despite the approach of the date of reunification. As an illustration, the average daily differentials (in terms of basis points) for the months of January and February, 1997 were as follows:
1997 January February 2-year -32.1 -24.4 3-year 3.9 -3.1 5-year 38.5 22.9 10-year 65.0 47.8
As may be seen, the average differentials for the 2-year obligations were actually negative, while that for the 3-year obligations were negligibly small, implying that the market was very bullish about Hong Kong in the short run. For longer maturities, the differentials became more significant. Even so, the average differentials for 10-year obligations were only 65 and 47.8 basis points respectively for January and February. For a territory whose future is conventionally regarded as "uncertain" after July 1, 1997, such differentials must be regarded as surprisingly small.
It is against this background that China's intention of issuing bonds denominated in Hong Kong dollars has attracted attention. According to press reports, Mr. Wang Xue-bing, Chairman and President of the Bank of China, announced in New York in February that China's Ministry of Finance would issue Hong Kong dollar bonds later this year, and this news was coolly received by the Hong Kong Monetary Authority (HKMA). As press reports are not always clear and accurate, some clarification is necessary.
In principle, China's intention to issue bonds in Hong Kong denominated in major international currencies should be welcomed, since this would help our fledgeling bond market. However, bonds denominated in Hong Kong dollars are a different matter, since this may have some monetary and fiscal implications for the territory.
The heart of the matter is sovereign rating. As is well known, China's sovereign rating is at least a notch lower than that of Hong Kong. With the approach of the reunification, there is a tendency on the part of international rating agencies to equate Hong Kong's rating with China's, which of course would be a severe setback for the territory. Sensing this danger, the government proposed, two years ago, the slogan of "One Country, Two Ratings", which it argued, should be the logical financial market counterpart of the guiding principle "One Country, Two Systems".
Some international agencies, such as UK's IBCA and Japan's JBRI, are sympathetic to Hong Kong's stand. But US-based agencies, especially Moody's, tend to adopt a more hard-line approach. If China issues HK$-denominated bonds in Hong Kong in large quantities, there will be two consequences. One is that international investors will confuse such bonds with Hong Kong's own bonds. The second is that an over-supply situation will arise. The end result will be to drive down the market prices of Exchange Fund obligations, with all its adverse monetary and fiscal consequences.
The matter should, however, be viewed in its proper perspective. There is no question of Hong Kong being opposed to China's participation in our financial markets. The HKMA's concerns relate to timing, pricing, size, and currency denomination only. There is no reason why such technicalities cannot be resolved by frank but friendly consultations.
Prior to 1992, there were no official statistics of any kind on forex market turnover. In 1992, the Bank for International Settlements (BIS) coordinated a joint survey by central banks or monetary authorities of various countries and regions of forex market activity. This exercise was repeated in 1995. In 1992, with a daily net turnover of US$60 billion, Hong Kong ranked 6th in the world. Three years later, Hong Kong's forex market had grown by 50%, and surpassed that of Switzerland to become the 5th largest in the world. However, Hong Kong remained one rank behind Singapore in both years.
The puzzling question is: how does Singapore manage to have a larger forex market when its economy is half the size of Hong Kong's? The usual answer is that the central banks/monetary authorities of the ASEAN countries routinely conduct their forex operations in Singapore. This is an advantage which few other centres can match.
No central bank/monetary authorities other than the HKMA, for example, regularly conduct forex operations in Hong Kong. It is true that China routinely converts its huge earnings (export surplus, profits, remittances, tourist expenditures etc.) in Hong Kong dollars into other hard currencies in Hong Kong. But the People's Bank of China (PBOC) is not known to have conducted forex operations in the sense of buying and selling foreign currencies against Renminbi (RMB) in Hong Kong.
At a joint HKMA-IMF conference recently held in Hong Kong, the Governor of the PBOC, Mr. Dai Xianglong, and his deputy, Mr. Chen Yuan, disclosed that China was actively considering how to manage part of its forex reserves, which stood at US$110.3 billion at the end of February 1997, in Hong Kong. However, the PBOC will maintain its policy of not establishing a branch in order to avoid the impression that it seeks to influence the running of Hong Kong's monetary policy.
Because the Chinese central bankers' remarks were very tentative, it is still too early to assess their implications in concrete terms. Although China has fully liberalized exchange controls on the current account with effect from December 1, 1996, it has retained such controls on the capital account. After all, even highly developed countries, such as the UK and Japan, removed such capital controls rather late in their development. Hong Kong bankers' hope that China will allow an inter-bank wholesale market in RMB to be set up here therefore seem to be premature. Moreover, China wants to make sure, with justification, that an offshore market will not be used for destabilizing speculation against the RMB. Nevertheless, the dramatic five-fold rise in China's forex reserves during the past five years, and China's growing interest in Hong Kong's financial markets augur well for the territory.
Both the Chinese Government and the Hong Kong Government take the territory's future as an IFC very seriously. Given this common objective, there should be no technical or practical problems that cannot be resolved by consultation and cooperation. But these problems should not be under-estimated either. Both China and Hong Kong need to understand each other's special circumstances, and to respect each other's legitimate interests.
Y.C. Jao is Professor in the School of Economics and Finance, the University of Hong Kong.