This paper examines the situation and outlook of Hong Kong's financial centre in respect of the financial system, financial markets and financial institutions since sovereignty handover.

1. Financial System

Over the past 10 years, the most remarkable reform was the relaxation of banking regulations. The 30-year old interest rate agreement¹ was abolished in phases between 1994 and 2001. This relaxed the influence of the Hong Kong Association of Banks on interest rate setting. Additionally, the restriction of establishing branches and sub-branches by foreign banks² as well as the investment threshold for foreign bank to enter the Hong Kong market³ were also relaxed.

Measures have been taken to strengthen Hong Kong's financial infrastructure. For the banking industry, the most meaningful was the successful launch of the Real Time Gross Settlements (RTGS) system⁴ in late 1996. The launch of the 10-year exchange fund notes⁵ helped rationalize the Hong Kong dollar interest rate structure. In December 2000, the introduction of Mandatory Provident Funds in Hong Kong, though for social security purpose, expanded the demand for Hong Kong dollar bonds, thus helped to foster the development of the HKD bond market. In 2004, the Credit Reference Agency⁶ started its operation, enabling banks to better understand the creditworthiness of their clients.

In securities market regulation, reform mainly concentrated on the restructuring of the Securities and Futures Commission (SFC). Segregation of role sbetween the Chairman and Chief Executive Officer⁷ helps better carry out the function of market supervision and market development. Other reforms included enhancing the monitoring of the listing functions of Hong Kong Exchanges (HKEX)⁸ , increasing investigating⁹ as well as cross-border enforcement authorities¹⁰ of the HKEX. Those measures can enhance investor confidence and competitiveness of the Hong Kong securities markets.

Measures were also taken to encourage the development of fund management in Hong Kong, including the abolition of estate duty in 2005, exemption of profit tax for offshore funds in early 2006, enhancement of the authorization regime for guaranteed funds and authorization of retail hedge funds in 2002. The revision of《Code on Real Estate Investment Trust 》(REIT code)¹¹ further broadened the type of investment products in Hong Kong. Currently, Hong Kong is one of the few leading financial centres that allowed the sale of retail hedge funds. With the listing of the Link REIT, the development of REIT also showed positive trend. The broadening of investment portfolio boosted the development of structural products.

All of the above financial system reforms did further enhance the freedom, openness and operation efficiency of Hong Kong's financial markets. According to SFC's statistics, more than 70 legal entities applied for asset management licences in Hong Kong, indicating initial effectiveness of the above reforms.

2. Financial Markets

In the past 10 years, the rapid development of the equity market is the most eye-catching among the financial market in Hong Kong. According to HKEX's statistics¹² , the amount of funds raised in Hong Kong equity market (both main board and growth enterprise market (GEM)) reached HK$505.9 billion in 2006, two-fold the amount of 1997. Among them, HK$333.2 billion was funds raised in initial public offering (IPO), surpassing New York as the world's second largest IPO centre. The daily average transaction volume increased to HK$33.9 billion, 119% or HK$18.4 billion higher than the HK$15.5 billion in 1997. The number of listed companies increased to 1,173, 78% or 515 more than the number in 1997. The market capitalization rose to HK$13.3399 trillion, increasing by 3.2 times or HK$10 trillion in the past decade. The market capitalization of Hong Kong jumped to the sixth largest in the world, surpassing its rivals Toronto and Frankfurt in late 2006.

Hong Kong's equity market has gradually transformed to serve the economic development and corporate fund raising needs in China. Also according to the HKEX's statistics, the number of China companies listed in Hong Kong rose to 367, increasing by 2.6 times or 266 in the past decade. They are now accounting for 31% of the total company listed, the proportion has increased by 16 percentage points over the past 10 years. The market capitalization of China companies reached HK$6.7145 trillion, about 50% of the total market capitalization. Red chips¹³ accounted for HK$2.9524 trillion, 22% of the total market. H-share companies¹⁴ recorded HK$3.3787 trillion, 25% of the total. The amount of fund raised by H-share companies reached HK$306.2 billion, 58.4% of market total, making them the driving force of the market. In 1997, the transaction volume for China related stocks was only HK$1.3443 trillion, 38% of market total. However, this ratio increased to 60% in 2006.

Furthermore, the function as an asset management centre was greatly enhanced. According to the survey by Hong Kong Investment Fund Association¹⁵, the amount of funds managed reached HK$4.5 trillion at the end of 2005, increased by 25.1% over 2004. The average annual growth rate of funds managed reached 24.96% between 2000 and 2005. Among the funds managed, 63% came from overseas, non-real estate related ones amounted to 72%. Among the non-real estate related funds, 53% was managed in Hong Kong. This reflected the strengthening of Hong Kong as an Asian asset management centre.

The banking industry also underwent marked transformation. Amid the retreat of Japanese banks, stagnant property, imports and exports trade industries, relocation of manufacturing activities and the disintermediation in corporate financing etc, the traditional banking business in Hong Kong remained sluggish over the past 10 years. Between 1997 and 2006, the outstanding deposits balance for banks only increased by 6.5% annually, outstanding loans balance was only 60% from the peak in 1997. As the room for developing interest-bearing business was rather narrow, banks in Hong Kong started to develop wealth management and financial planning businesses. The organization structure, risk management system, branch networks and back-office operations all underwent major transformation and adjustments. Banks are now becoming more "customer-centric" and cost conscious as they face intense competitive pressure after the abolition of the interest rate agreement. In 2006, the proportion of non-interest income for banks increased to around 40%, more than 10 percentage points compared with 1997.

The bond market is the weakest link in the financial market in Hong Kong. After 10 years of effort, together with the support of a low interest rate environment, the development of bond market turned positive lately. According to Hong Kong Monetary Authority's (HKMA) statistics¹⁶, the outstanding amount of Hong Kong dollar debt instruments was HK$748.1 billion at the end of 2006, 89% or HK$351.5 billion more than the 1998 level. The average annual growth rate reached 8.2% between 1998 and 2006. When compared with the equity market, bank deposits or investment funds, the scale of bond market remains rather small. However, there exists new opportunities for development as it is expected that Hong Kong will be allowed to issue RMB bonds in the future.

3. Financial Institutions

The number of authorized institutions in Hong Kong was reduced from the peak of 381 in 1996 to 202 in 2006, 47% or 179 fewer. Licence banks were reduced from 186 to 138. Restricted licenced banks were decreased from 63 to 31. Deposit taking companies were reduced from 132 to 33. In terms of country/region of ownership, banks incorporated locally in Hong Kong were reduced by one-third from 32 in 1997 to 24 in 2006. The number of finance and investment companies reached 3,654 at the end of 2006, slightly more than the 3,538 in 1997. The number of stock, commodity and bullion brokerage firms also reduced 142 or 17% from 989 in 1997. Accordingly, the number of people employed in the financial industry declined by 9,144 or 7% from 130,643 at the end of 1997. The reasons for the decrease in the number of financial institutions were mainly because of the contraction of Japanese banks, technological advancement, automation of banking services, as well as merger and acquisitions of the smaller peers.

It is worthy to point out that (1) even though the number of financial institutions has greatly reduced, its density remains high. Currently, there are 202 authorized institutions operating 1,313 branches in Hong Kong, on average around 5,200 people are served by one branch.（2）The internationalized nature remains unchanged. Among the top 100 largest banks in the world, 69 have branches or sub-branches in Hong Kong. The authorized institutions come from 30 different countries and Hong Kong remains one of most concentrated international banking centres.（3）European and American-based large investment banks continues to strengthen their regional headquarters in Hong Kong. They aggressively develop investment funds, corporate listing, private banking and asset management business in Hong Kong or other Asia Pacific region. To conclude, even though the number of authorized institutions decreased in the past 10 years, their strength, business coverage as well as quality are greatly enhanced.

Reviewing the past 10 years development, there are three areas which worth our appreciation:

1. The Financial System Reforms and Market Openness

The development of Hong Kong as an international financial centre basically follows the process of gradual relaxation of financial regulations as well as enhancement of supervision. The development of Hong Kong's financial centre originated from its vigorous re-exports trade activities in the 1950s and 1960s which led to the rise of various commercial and banking activities. It was the case of a typical market-oriented financial centre development (different from the government-led type in Singapore and Tokyo). The Hong Kong Government relaxed a number of key financial regulations in the 1970s, including the abolition of foreign exchange control in January 1973, the removal of gold imports restriction in January 1974, and the relaxation of branch opening by foreign banks in March 1977. The financial supervisory system was also rationalized after a series of bank crises and securities scandals in the 1970s and 1980s. Therefore, we should not underestimate the importance of the government's role in financial policy formulation. Over the past 10 years, the HKMA further relaxed the financial regulations and invited more competition amid sluggish corporate financing needs. In the securities market, emphasis has shifted to strike a balance between supervision and development instead of mainly the former. The new policy direction will lead to the development of a more free, open and resilient market which can attract more overseas capital, talents and institutions. Its contribution to the sustainable development of Hong Kong's financial centre should be appreciated.

2. The Enhancing Position of the Capital Market

The banking industry has long been the pillar of Hong Kong's financial sector. The outstanding loan balance of authorized institutions marked a record of HK$4.1217 trillion in 1997. This amount was about 302% of its GDP at that time and much higher than the equity market capitalization of 235% of GDP. However, the financing and investment structure underwent huge transformation over the past 10 years with more large-scale China companies raising funds in Hong Kong. This enhanced the fund raising function as well as fostered its rapid development. At the end of 2006, the equity market capitalization was 906% of GDP in Hong Kong, much higher than the shrinking bank loans balance of 173% of GDP. This reflected the enhancing position of Hong Kong equity market, which appears to emerge as the pillar of Hong Kong's financial markets, taking over the role of banking.

This transformation is a reflection of the importance of Hong Kong's financial centre: (1) Based on the development trend of the financial system, the development of a financial centre should always (but not necessary) go through three stages: the banking-oriented stage (financing needs mainly from Small-Medium Enterprises ), equity market leading stage (companies grow and start to raise funds in stock and debt markets) and securitization stage (more efficient fund raising and investment vehicle). Over the past 10 years, as wealth accumulated rapidly in Hong Kong and China, the demand of capital market services intensifies, fostering the financial system to transform to the third stage. It is a sign of mature development. （2）In term of the characteristics of global financial centres, the US and UK have already entered the securitization stage. They are regarded as securitized financial system. According to Bank of Japan's statistics, 70% of corporate financing needs for both US and UK are satisfied by their securities markets, 80% of their personal financial assets are managed by securities companies, investment funds and insurance companies. As compared with them, 60% of Japanese personal financial assets are still bank deposits while corporate financing still relies on banks. Their financial system is still banking-oriented. Additionally, Germany and France also have a similar financing and investment pattern as Japan. Their financial systems are also banking-oriented. Hong Kong's legal system is a heritage from British, and its financial system is similar to that of the Anglo-Saxon's, this is the demonstration of the financial advancement. The Corporation of London reported the Global Financial Centre Index (GFCI) in March 2007, with Hong Kong ranked third among all the 46 financial centres in the world. One of the reasons was the recent development of Hong Kong's capital market and securitization business.

3. Improvement of Financial System Efficiency

The reforms over the past 10 years have, no doubt, fostered the free competition of the financial market, further improved the financial regulations, and enhanced the efficiency of Hong Kong's financial system. In terms of capital efficiency, the development of capital markets broadened the corporate financing channels. The abolition of interest rate agreement enabled banks to price their loans and deposits more competitively, benefiting both corporate and individual borrowers. In terms of operational efficiency, the lowering of market entry threshold and improvement of financial infrastructure both lowered transaction cost and risk, while also enhanced market efficiency and transparency.

However, the financial centre of Hong Kong still has weak areas to improve, among them, HK's financial innovation capability deserves most of the attention. Currently, the competition of financial centres mainly lies on their innovativeness in financial instruments, including the development of financial derivatives and asset securitization. The room for innovation in asset securitization is mainly in the secondary securities market, e.g. the CDO¹⁷ 、MBS¹⁸ 、ABS¹⁹ and other type of debts. In addition, the development of multi-link structural products is also the key area of innovation. In financial innovation, Hong Kong faces two bottlenecks, namely insufficient market or investor size and the lack of financial institutions and talents. Currently, it is the European or American-based financial institutions which carry out the development of these financial products. They are mainly based in London or New York. Hong Kong only acts as their Asia Pacific distribution centre. Even though Hong Kong has slowly accumulated the competencies and talents in developing new financial products in recent years, it is still far from a regional centre of financial product development. Furthermore, the lagged bond market and the limited number of large scale international banks taking roots in Hong Kong also affected its ability to innovate.

Additionally, the reform of the current three-tier banking system has long been discussed. However, no concrete answer is formulated. The related reforms worth our further investigation in order to better enhance our financial system.

All in all, Hong Kong's financial industry has remarkable success over the past 10 years. Investors have learnt from frustrations and experiences. They understand how to grow with care and overcome the over-aggressive sentiment in most emerging markets. The regulatory authorities, financial institutions and investors are now becoming more rational and steady, demonstrating the maturity necessary for long-term success. This can also enable Hong Kong become the "market benchmark" to our China's counterparts and assume the role as a "stabilizer".

Looking ahead, Hong Kong envisions to ride on the rapid development of Chinese economy and capture these historic opportunities to be China's financial centre, and further, to be one of the three global financial centres, alongside with London and New York. Though Hong Kong faces such opportunity, it also needs to tackle a number of problems, including how to maintain its financial market freedom, openness and internationalization while having to integrate with China's financial markets and extend its market size; how to maintain the stability of Hong Kong dollar exchange rate against the RMB under the currency board regime, which is important for Hong Kong to develop as an asset management centre for China; how to align the pace of RMB convertibility and internationalization by increasing capability to carry out RMB-based transaction and settlement activities, and how to better cooperate with other China's financial centres, etc. All these challenges show that while Hong Kong's internationalized status does not conflict with its role as China's financial centre, there are still technical and policy obstacles to overcome.

Tse Kwok Leung
Senior Economist