Competition from Shanghai

During the past decade, challenges to Hong Kong's international financial centre status mainly came from Singapore and Shanghai. Amid the rapid growth of the Chinese economy, the ability to benefit from the "China factor" has become increasingly crucial in sustaining the role as regional economic and financial centre. Hong Kong's competitive pressure from Shanghai has thus intensified. The differences due to "two systems", including separate currency and customs, has inevitably made Hong Kong less advantageous in grasping the Mainland market.

Three fundamental factors have contributed to Hong Kong's status as an international financial centre. The first concerns its political, economic, social and cultural qualities. In particular, Hong Kong's sound legal system, economic freedom and developed market mechanism formed the foundation, further supported by freedom of information and developed infrastructures. East Asia, particularly China, as hinterland, formed another pillar. The third concerns Hong Kong's wide international connections, covering Europe and America in addition to Asia.

Despite these fundamental qualities, Hong Kong can never be free from worries. With China's current pace in opening up, Shanghai, a historically important financial centre located in the most vivid Yangtze River Delta, can certainly catch up with Hong Kong in terms of internationalisation. On the other hand, Shanghai's limitations lie in its economic and legal systems. Reform in these areas has also faced obstacles. The Government's determination to reform, nonetheless, should not be overlooked. It can therefore be envisaged that Shanghai would eventually attain international best practice in these areas. As Shanghai's development prospects should not be doubted, the relative status Hong Kong would attain would depend on how it reacts. Therefore, it is deemed necessary to reconsider Hong Kong's competitive advantages as an international financial centre.

Three Stages of Hong Kong's Advantages

In addition to the fundamental factors, the "China factor" has brought about unique advantages to Hong Kong. This has different characteristics in different periods.

Hong Kong was China's sole open window in the past. Though the coastal area of Pearl River Delta and Fujian was open up at the same time, external channel was focused in the Hong Kong-Macau region, amid the political tension in the Taiwan Strait. Hong Kong became the bridge between China and the world. Even after China fully open up all the coastal area and joined the WTO, the long established unique status and connections rendered Hong Kong the advantages to continue performing the intermediary role. In other words, Hong Kong's unique advantage has long been characterised by its "monopoly" status in China's external connection.

Hong Kong's monopoly advantage has begun to shrink after China open up the coastal cities in mid 90s. With China's step-by-step strategy as well as the central government's support to Hong Kong, however, Hong Kong has been able to benefit from a series of liberalisation policies, e.g. listing of Mainland enterprises, CEPA and offshore RMB businesses. These preferential measures enabled Hong Kong to remain a vibrant financial centre, though still undergoing economic restructuring. "Policy advantage" has become Hong Kong's unique advantage.

It has to be stressed that this policy advantage may lapse more quickly compared with the monopoly advantage. China's recent pace in opening up, amid fast economic growth, suggests policies would be carried out faster than expected. This can be reflected in the reform of the RMB exchange rate policy. Though the exchange rate has remained quite steady, the mechanism has altered substantially and derivative products are launched sooner than expected, demonstrating the authorities aggressive attitude. This should remind Hong Kong people to consider the status of Hong Kong when the policy advantage gradually vanishes.

Experiences of traditional financial centres like London and Switzerland show that persistent financial innovations, including regulatory systems, financial institutions and products, having enabled them to sustain their leading status amid a changing world, have become their core competitiveness. Similarly, Hong Kong's future status would also depend on its core competitiveness. Hong Kong's status as an international financial centre would consolidate should it succeed in transforming to a stage supported by innovative advantage.

Fostering Innovation

In Hong Kong, we have a highly free and flexible market as well as a diversified and open cultural environment, which has been conducive to innovative activities. More importantly, the "China factor" offers new ground for innovation, as reform in China would successively demand innovations in various aspects, from macro to micro. Just situated between the reforming China and the ever-changing international market, Hong Kong should be well positioned to form its own characteristics in financial innovation, compared with other cities in the Mainland and the world.

Hong Kong's recent policy advantage reflects a unique historical background and the implicit innovation opportunity offered by the "China factor". Since the late 90s, China's reform has begun to deepen. A series of major reforms has been put on the agenda, covering the liberalisation of interest rates, exchange rate and capital market. This signifies reform in China has entered a crucial stage, with the major need shifting from capital to fundamental changes in economic systems and economic and financial safety. This offers a new role for Hong Kong, i.e. to become the buffer and testing point for China. In particular, it is to try new measures in Hong Kong through specific arrangements. In this respect, various policies favourable to Hong Kong not only represent "support" or general business opportunities, but also the Mainland's need to innovate, as well as Hong Kong's chance to develop its innovative advantage.

Currently, such opportunity mainly lies in two major issues, offshore RMB businesses and external investment by Mainland funds. While satisfying Hong Kong's demand for RMB transactions, opening offshore RMB businesses in Hong Kong has a greater meaning for the Mainland. It is to pave the way for further liberalisation of the RMB, taking advantage of Hong Kong's matured and internationalised financial markets, accumulating experiences in financial risk management. Similarly, relaxation of Mainland capital in investing overseas is not only aimed at gaining return, but also fostering the development of Mainland capital markets, including the enhancement of regulatory capability and development of institutional investors. Hong Kong should ponder about accommodating these specific needs of the Mainland.

Take overseas investment by Mainland funds (including insurance funds to be implemented, social security funds or QDII) as an example, Hong Kong should not only treat them as capital inflows and remain passive, but also regard them as special clients, offering them comprehensive services covering asset management, financial planning, legal consulting, information supply, human resources training and regulatory cooperation. Special attention should be focused on the two major needs - specific system design and risk management. Financial practitioners can offer them tailor-made products, investment tools and methods, while regulators can cooperate with Mainland counterparts. These would help retain existing investors and generate "demo effect". When Mainland investors enter the world market in future, Hong Kong can continue to act as partner. Hong Kong can further enhance its financial innovation capability, while offering Mainland investors specific products. From a more macro perspective, Hong Kong government and the financial sector can put more effort to strengthen the innovative mechanism, including measures to encourage and protect innovative activities. Emphasis should be put on talents, especially the training of innovative talents, relative to operating talents.

To conclude, the temporary policy advantage represents only a transitional stage. It is a crucial stage for Hong Kong to form new advantage. Should it succeed and build up vital innovative mechanism, it need not worry much about competition from Shanghai. Given China's economic size, it should be able to support the co-existence of two or more international financial centres, each with its own characteristics. Hong Kong can be an "innovative centre".