Offshore Market and Offshore Financial Centre

Financial business can be onshore or offshore. In the early days the two differed in that onshore business referred to those conducted within the issuing country of the currency concerned and under the regulation and jurisdiction of that country, while offshore business covered those that were not. The later emergence of offshore banking facilities in New York and Tokyo, however, narrowed the difference to cover only the applicability of the issuing country's jurisdiction. (International banks in these two cities are allowed to conduct offshore businesses of currencies issued by their residential countries while not subject to those countries' regulations, as long as those offshore businesses are isolated from onshore ones.)

Offshore financial business was originated in Europe. The term "Euro-currency" covered all offshore currencies in general. In early days, it referred to Eurodollar, Euroyen, Eurosterling, Eurofranc as well as major European currencies already replaced by the Euro, such as Deutsche Mark, French Franc and Dutch Guilder.

Since offshore business is not conducted within the territory of the currency-issuing country and does not come under the country's jurisdiction, its operation does not require the country's approval. There are, however, some pre-requisites. The most important of all is that the currency has to be an international currency used in international pricing, settlement, purchase and payment. This is why the U.S. dollar has remained hitherto a major offshore currency.

For an offshore currency market to come into being, demand and supply also have to be material. This can be illustrated in the emergence of Eurodollar. Early in the 1950s, trade of the former USSRwith the Western world mainly involved the sale of gold and the purchase of cereals. The mismatch in the timing of gold sales and cereal purchases created thenecessity to place USD deposits. For fear of deposits in U.S. banks being frozen by the U.S. government during the cold war, deposits were placed with British and French banks in Europe. In addition, the external military expenditure together with the trade deficit of the U.S. provided major supply sources of Eurodollar. The demand was mainly from business enterprises, governments and multi-national companies. Raising funds through the Eurodollar market enabled them to obtain better borrowing terms as well as to avoid the control of the currency-issuing country.

Though the absence of regulation by the currency-issuing country is an important condition for the emergence of the offshore market, it is not the sufficient condition. In fact, starting in the 1970s, major countries have gradually relaxed controls that contributed to the rise of the Eurodollar market, but the market has continued to develop rapidly. The deepening of financial liberalization and the competitive relaxation of financial regulations among countries in the 1990s faded the original advantages of offshore markets, and further blurred the distinction between onshore and offshore markets. This, yet, has not halted the development of offshore businesses.

Currently, offshore business and offshore markets exist in nearly all countries. Strictly speaking, all transactions denominated in foreign currencies are offshore businesses, and the market where such transactions are conducted is an offshore market. To become an offshore financial centre, nonetheless, requires more. Only those with the presence of a vast number of operating institutions, the availability of a comprehensive range of services and a high volume of business, while also acting as a major intermediary of offshore currencies, can be regarded as offshore financial centres. Despite worldwide efforts to boost offshore business in the past two or three decades, only a few are now qualified as offshore financial centres. Among them, London, New York and Tokyo are the largest three, while Luxembourg, Zurich, Frankfurt, Hong Kong, Singapore, Sydney and Bahrain are secondary or regional ones. This suggests that there are some preconditions to become an offshore financial centre, including political and social stability, economic freedom and free flow of information, the rule of law and a sound legal system, high administrative efficiency, the availability of talents, modern infrastructures as well as relatively preferable geographical location.

Hong Kong's Offshore RMB Business

While the cooperation memorandum would foster the development of Hong Kong's offshore RMB business, it is far from sufficient to make Hong Kong a full offshore RMB market, not to mention the possibility of becoming an offshore RMB centre at once.

According to the Basic Law, the Hong Kong dollar is the legal tender in the Hong Kong SAR (implying that the RMB is a "foreign currency" in Hong Kong). The new arrangement provides that Hong Kong's RMB business can be operated free from the control of Mainland regulations (mainly reflected in the free determination of deposit interest rates by banks and the waiver of minimum reserves requirement). This makes the RMB business to be conducted by Hong Kong banks satisfy the criteria of offshore business. In fact, Hong Kong has been operating RMB business for a long time, but limited to cash exchange. Though the estimated volume of business is rather huge, it can only be regarded as a non-regular or "grey" market. Nevertheless, the signing of the cooperation memorandum would bring about quality as well as quantity changes. The former refers to the regularization of existing business while the latter concerns the introduction of a variety of services, including deposits, remittances, foreign exchange and credit cards. Amid these changes, an offshore RMB market will be formed in Hong Kong.

The permission to accept deposits has significant meaning. In the past, the function of the RMB has basically been limited to payment, or a medium of exchange. Retail spending in the Mainland or meeting corporate needs has been the major outlets of residents' RMB holdings. With the launch of deposit business, RMB would extend its functions to become also a store of value, greatly stimulating the demand for the currency. The higher interest rates offered, together with the revaluation expectations of the RMB would make deposits particularly attractive. The expansion of RMB exchange limit to 20,000 from 6,000 yuan would serve to enhance such effect.

Remittances and credit card business also have rather huge potential. The lower charges so far offered by moneychangers for "underground remittances" have enabled them to capture a major portion of business. Nonetheless, the launch of RMB deposits, allowing banks to directly debit customers' deposit accounts for remittances, would enhance the competitiveness of banks. Banks would also benefit from the increase in credit card business amid the absence of upper limits on credit/debit card spendings and permission of ATM withdrawals in Hong Kong by Mainland visitors.

An even more significant development under the new arrangement would be the creation of a RMB clearing system in Hong Kong. Still not convertible freely and lacking overseas settlement facility, the RMB has not been a "real" offshore currency. Now, a bank will be selected as the RMB settlement bank according to the new arrangement. This bank will open a RMB settlement account in the Shenzhen Sub-Branch of People's Bank of China and provide clearing service for other banks participating in personal RMB business. It will also provide services including remittance diversion, position covering (as permitted), sale and purchase of RMB through China's National Foreign Exchange Centre and supply of related information. All these signify the commencement of partial convertibility for offshore RMB. Through the creation of the first offshore RMB settlement system in the world, Hong Kong would secure a preferred position, laying the foundation towards an offshore RMB centre.

Nevertheless, Hong Kong's offshore RMB market currently designed is still far from a standard one, not to mention the offshore RMB centre. Compared with offshore businesses of other currencies, there exist essential differences in both customer and business profiles. Hong Kong's RMB business is restricted to individual customers, with deposit business offered solely to Hong Kong residents (holding Hong Kong identity card), excluding business entities and non-residents. Offshore business for other currencies, on the other hand, targets companies and institutions as well, with non-residents as major customers. This implies that Hong Kong's business is only of retail scale. Besides, while Hong Kong is restricted to conduct the above four businesses, offshore markets for other currencies engage in many other businesses including lending, securities and derivatives, etc.

The control from the state government has limited the scope of Hong Kong's offshore RMB market, whereas Hong Kong also has to obtain the consent of the People's Bank of China to operate RMB business. The reason is that the RMB is still not fully convertible and the current arrangement is only a preferential treatment for Hong Kong. It is quite obvious that although Hong Kong's offshore RMB market would grow steadily, Hong Kong will still be far from an offshore RMB centre before the RMB becomes fully convertible.

Great Potential to Become an Offshore RMB Centre

Nevertheless, the establishment of the offshore RMB market would make Hong Kong well prepared to evolve into an offshore RMB centre. Once the RMB becomes fully convertible, the offshore markets for the currency would appear like mushrooms after rain. But Hong Kong would take the lead, further enhancing its status as international financial centre.

Having been operating offshore businesses for other currencies, Hong Kong's basic qualities to become an offshore Renminbi centre should not be doubted. Indeed, in light of the RMB non-deliverable forwards currently traded in some Asian cities and the deposit facilities linked with the RMB exchange rate offered in the U.S., it is anticipated that offshore RMB markets would also emerge in other major cities in the world. However, Hong Kong's unique advantages would enable her to maintain the lead in the world. Under "one country, two systems", Hong Kong has been maintaining close economic ties with the Mainland. CEPA would further enhance economic integration between both sides. Other economies could hardly attain the scale of bilateral flows of people, merchandise, capital and information between Hong Kong and the Mainland. The largest offshore RMB demand and supply would be generated in Hong Kong, with her status as the external window in China's open up as well as the major stepping stone for foreign investors targeting the China market. Moreover, the early operation of offshore RMB business in Hong Kong, bringing about the creation of the clearing system, related rules and framework as well as the early development of the market, would shape customary market practices in favor of Hong Kong against her competitors. Together with her basic strengths, Hong Kong has the best potential to become the largest offshore RMB centre in the world.

In the long-term, Hong Kong enjoys bright prospects as an offshore RMB centre in light of the followings:

1. The RMB has the potential to become a major international currency, thereby also becoming a major currency for offshore transactions. Currently, the RMB has already been circulating in neighboring regions in increasing volume. Some commercial banks and central banks have even treated RMB as a reserve currency. During the 2002 World Cup, the RMB was given the same status as the U.S. dollar, Yen and Euro in money-exchange by Korean banks. An executive of Korean Exchange Bank further stated that these four currencies were major international currencies, and reserves in these currencies occupied a major portion in Korean banks.
   
   Various developments reflect the maturing status of RMB as an international currency. (1) The Chinese economy is expanding rapidly. In 2002, it has the sixth largest GDP in the world, having become a growth engine of the Southeast Asian economies. By 2010, its GDP is estimated to double that of 2000, advancing to the third position in the world. Further advancement to the second position is possible by 2015. China's ever growing economy will support the RMB to become an international currency. (2) The RMB is enjoying relatively high and improving international credibility. The RMB exchange rate has been maintained stable since the unification of the exchange rate systems in the 1990s. During the Asian Financial Turmoil, the Chinese government did not opt to depreciate in order to prevent competitive devaluation. This year, on the contrary, it has not yielded to appreciation speculation, further demonstrating its concern about the interests of all parties and commitment to stability. Also, China's over USD400 billion international reserves, which is the second largest in the world, works to boost its capability of maintaining exchange rate stability and hence international credibility. (3) While problems of China's banking system still linger, the authorities have proposed an overall reform, including capital injection, bad debts write-off, listing, introduction of foreign investors so as to strengthen corporate governance, etc. It is generally expected that when the reform come into effect, full RMB convertibility will take place.
   
   
2. China's overall international trade position is estimated to maintain balance or slight surplus. This is also favorable for Hong Kong's development as the largest offshore RMB centre. Forces of economic globalization have produced an international division of labor with China as the primary world factory, importing huge volume of raw materials and spare parts and exporting manufactured products to the U.S. and European markets. This has resulted in China's trade deficits against Asia, particularly East Asia such as Japan, South Korea, Taiwan, Singapore, Malaysia, Thailand and the Philippines, but surpluses against North America and Europe. During the first 9 months this year, China's trade deficit against Asia reached USD39.27 billion, while surpluses against the U.S. and Europe were USD40.89 and USD9.67 billion respectively. As such a pattern continues, large volume of RMB supply for the offshore market would arise from East Asia. As for services trade, travels abroad by Mainland visitors have already exceeded 16 million, growing at double digits, with East Asia as their main destination. This would be another source of supply of RMB. Many East Asian cities would therefore operate RMB business, but Hong Kong would become the centre among them.

Since the outbreak of the Asian Financial Turmoil, Hong Kong's role as an international financial centre has somewhat declined, as demonstrated in the decrease in the number of banks, contraction of external assets and liabilities of banks, shrinkage of offshore lending business and declined foreign exchange transactions. There are many reasons, and business diversion due to the rise of offshore markets in Asian cities should be one of them. Nevertheless, the commencement of offshore RMB business in Hong Kong would mean the early development of new businesses concerning another currency. After the RMB becomes fully convertible, Hong Kong can operate various RMB products and become the primary offshore RMB centre in the world. By that time, the scale of Hong Kong's offshore business would be enhanced, lifting Hong Kong's status as an international financial centre.

Hui Wing Fu
Senior Economist