Shanghai sizes up Hong Kong's market heart

FT.com

Joy Yang is not quite a haigui yet. The far-ranging sea turtles lend their name in Chinese slang to people who return to the mainland after studying abroad. But Yang, a young Shanghainese economist at Mirae Asset Securities, has returned only as far as Hong Kong and, like many of her generation, does not see the value in going back to Shanghai – for now.

That is a blow to Shanghai. If it is to cut it in the big league of cities specialising in financial services, it needs people with international experience.

Yang's reasons for not returning echo a refrain common among her peers and financial recruiters. "Salaries on the mainland are still much less than international equivalents and personal tax rates are too high – especially compared with Hong Kong,” she says. Schooling and hospitals also leave much to be desired.

Beijing's ambition is to make Shanghai a fully fledged global financial centre by 2020. That aim is regarded nervously by Hong Kong professionals, who fear it will threaten their role as keepers of the gateway to China.

Hong Kong is the laboratory for Beijing's experiments in opening up China's financial system. As local trade in domestic stocks, bonds and the offshore version of the renminbi has grown, so has the appeal of Hong Kong, which offers global banks and investors the quickest and easiest way to bet on China. But a fully open and competitive Shanghai would provide a much more direct route for many of the financial flows behind trade and investment.

Shanghai's battle for supremacy with Hong Kong lies at the heart China's struggle to turn itself into something greater than a mighty export-based manufacturer. If it is to avoid falling into the so-called middle income trap, it needs to develop far deeper financial sophistication to power its own growth.

But this is not easy. For now, mainland China remains a legally turbid and punishingly bureaucratic place for financial professionals. Investors are unable to transfer funds easily. The onshore and offshore versions of the renminbi are not freely exchangeable. Large institutions need to run through a tortuous process of winning qualified investor status before trading there. Many foreign banks have invested a lot without seeing much in return, particularly given relatively lacklustre performances by the stock market and the fall in initial public offerings of big state banks.

Companies and investors will also remain nervous about their long-term involvement in China, and the potential for corruption, until it has established a reliable and more independent legal system.

"Hong Kong's legal system is the best asset it has,” says Zili Shao, chief executive of JPMorgan's operations in China.

While Shanghai's threat may not be immediate, Hong Kong also faces competition from Singapore for the position of Asia's leading financial hub. Still, part of Singapore's strength lies in specialisation. The city-state has historically fared better in wealth management, currencies and commodities.

Closer at hand, there is the challenge of Shenzhen on the Pearl River Delta, a rapidly expanding centre for trading in goods and services, and home to China's second stock exchange.

However, China is, for now, supporting Hong Kong in its global role. A wave of initiatives bolstering Hong Kong's position in trading the renminbi outside the mainland, and promoting co-operation between its stock exchange and those of Shanghai and Shenzhen, was introduced this month, coinciding with pro-Beijing Leung Chun-ying becoming Hong Kong's new chief executive.

The most significant initiative is the creation of a special zone in Qianhai, just outside Shenzhen in the province of Guangdong, which borders Hong Kong. This will lead to freer movement of renminbi from the outside world and allow Hong Kong banks to lend directly to Chinese companies.

In another example of how renminbi will be channelled back into China, Hony Capital, a Chinese private equity firm, says it will use the zone to invest funds raised offshore directly into the mainland.

This will tie the city more closely into the greater Pearl River Delta zone – a region where economic growth remains much faster than most of the developed world.

While many ordinary Hong Kongers are concerned about closer ties to the mainland, the business and financial elite see it as the city's strength. Ron Arculli, former chairman of the Hong Kong Stock Exchange and a director of several companies, says mainland institutions in banking, securities and private equity already have an important presence. "It's complementary to the mainland but it's also competitive,” he says. "This is really the melting pot, and Hong Kong is all the richer and all the better for it.”

Many leading business figures there do not see Chinese cities as a threat to Hong Kong in the near term. As well as acting as an inroad to a great economic hinterland, international financial centres provide a site where banks headquartered elsewhere can mediate transactions between companies and institutions also based externally elsewhere. That means having both significant outside investment in local markets and foreign companies listing their securities in those markets. Hong Kong and Singapore are the only cities in Asia that have this. Many financial professionals say Shanghai and Shenzhen are a long way from it.

Hong Kong remains the city in Asia that attracts premium initial public offerings. Prada, L'Occitane and Samsonite have all chosen to list there in recent years over the alternatives of Milan, Paris, London, New York or Singapore. Along with a flood of Chinese companies, these names helped to make the city the leading market for selling new shares for the three years from 2009 and 2011.

Formula One, the motor racing business, preferred Singapore over Hong Kong for its planned listing, but that was mainly because it runs a race there, bankers say.

Big listings have not all been good news for Hong Kong. Poor performance and some scandals – such as a recent one involving fabric maker Hontex – among the hundreds of Chinese stocks listed in Hong Kong have prompted regulators to tighten oversight of the investment banks that bring companies to market. They are threatening to make it easier to prosecute underwriters for lax work in preparing listings. Singapore could have looked to capitalise on this with a lighter touch regime, but last week it also tightened its listing requirements to ensure only larger, more profitable companies qualify to sell shares.

Talk is increasing that Shanghai could attract international companies to its market. Ken Brown, global head of equity capital markets at Nomura, based in London, says a number of European companies are seriously debating whether to pursue listings in Hong Kong or to wait until Shanghai is ready to accept them.

Bankers in Shanghai and Beijing say much groundwork has been done and local regulators have clear ideas on how it would work. Some say the first listing could come next year. HSBC is expected to be among the first groups that would try, given its historical and current links. But one Shanghai-based banker says it is unlikely that any company will list there soon. adding: "I think it's an important project for the development of Shanghai as a stock market and as an international financial centre, but there are many projects and this is not number one”.

In banking, China has begun to loosen its hold over the interest rates at which banks can both lend money and pay depositors. This is an important step that – alongside the opening given to Hong Kong's banks in Qianhai – should stimulate competition in the industry. The idea is that they will have to make some riskier loans at higher rates as they fight to attract savers' deposits.

Yang, the Mirae Asset economist, says these would lay the ground for further reform. After that, China could allow its currency to trade freely and remove capital controls, which would open its banking sector to international competition. "Internal competition between banks and the development of deeper capital markets must come first, before opening up,” she says.

For a banking system that has spent years lending to state-backed enterprises where the risk of losses is ultimately the government's problem, this kind of evolution could take a long time.

Liu Mingkang, the founder chairman of the Chinese banking regulator, who stepped down last year, reckons this and other factors means it could take 20 years before Shanghai and Shenzhen become big centres.

"Gathering experience internationally has no shortcuts ... We hope we can move forward in line with Hong Kong, but I think that still they are far away from [being] international financial centres.”

Liu says international talent is crucial, adding the government must consider lowering personal income tax rates.

In the west, a heavy regulatory crackdown after the financial crisis has left many asking whether lighter touch regimes in Hong Kong and Singapore will attract companies away from New York and London. This is partly true in some areas, such as Singapore's drive to attract more hedge funds with tax breaks and limited regulatory interference. But all of Asia still accounts for just 4 per cent of total hedge fund assets and that share is dominated by the Chinese industry, according to Hedge Fund Research. But both cities are tightening stock market rules, while in banking they have no choice but to implement Basel III rules. There is some freedom around the fine points of implementation but overall capital requirements and ways of measuring risk are tightly defined.

Financial companies could still find Hong Kong and Singapore attractive because of relations with regulators. Arculli agrees there are more constructive conversations between all parties in Hong Kong. "But that doesn't mean the regulator or the exchange is going soft,” he cautions. "Don't misunderstand consultation to mean that we are creating opportunities for regulatory arbitrage.”

For Yang, even if Shanghai does overtake Hong Kong, that does not spell the end for the city's role because the volume of international financial business will be many times larger than it is today.

"Maybe Hong Kong will to have to share the cake with Shanghai or Shenzhen, but so long as it is getting bigger in absolute terms Hong Kong will still benefit.”