• Hong Kong should maximise its strengths in equity capital market and asset management sectors and carve out specialist niches in alternative investments to enhance its position as an international financial centre.

The financial services industry is one of the four pillar industries that have been identified by the government as key drivers of Hong Kong's future economic growth. In his speech at the Economic Summit in September and through the Policy Address, the Chief Executive of Hong Kong has emphasized the need "to consolidate and enhance Hong Kong's position as an international financial centre in the Asian region".

Hong Kong continues to be the target market for many Mainland enterprises looking to raise funds through an initial public offering (IPO). The financial system's ability to deal with the huge influx of related funds, and to handle the increasing level of international financial transactions for Mainland-related enterprises in general, have helped Hong Kong maintain a leading edge in equity capital markets. Nevertheless, the territory's position as an international financial centre is increasingly under challenge from other financial centres located in and outside the region. The call for new ideas to enhance Hong Kong's leading edge is thus justified.

Status Check

Chart 1 shows the relative potential of several key financial sectors in Hong Kong, namely, equity capital market, asset management (including alternative investments and private equity), commodities and RMB financial services.

The equity and asset management sectors are growing rapidly and Hong Kong holds a significant market share in these areas in both Asian and global financial arenas. These sectors should continue to drive growth in Hong Kong in the short term.

However, while the alternative investments sector is expanding fast at a global level, Hong Kong has not yet built up a significant share of the market. The same is true for commodity derivatives. Given the growing interest in alternative investments and the huge prospective demand arising from mainland China with respect to commodities futures, the potential of these two sectors over the medium term should not be overlooked, particularly if Hong Kong can identify a niche that enables it to make best use of its natural strengths.

The RMB financial services sector in Hong Kong is relatively small as the RMB is still not fully convertible. The pace of growth in this sector continues to be highly dependent on the speed of capital control liberalisation on the Mainland.

Equity Market - Maximising Current Strength

Hong Kong has a deep and liquid capital market. In July 2006, the Hong Kong stock market was the eighth largest in the world in terms of market capitalisation, only slightly behind the Deutsche Borse, and the second largest in Asia, behind only Tokyo. In terms of equity funds raised through IPOs, Hong Kong fares even better, ranking third in the world and first in Asia in both 2005 and the first seven months of this year. With the recent Hong Kong listing of China's largest bank, which was also the world's largest-ever IPO, there is a good chance that Hong Kong will make it to the top of the global IPO rankings this year.

To achieve this would be significant for at least two reasons. First, it would further highlight the size and liquidity of Hong Kong's equity capital market. Second, it would demonstrate the strength of the financial system through the smooth handling of massive flows of funds - the recent record-breaking IPO alone involved about USD16 billion for the Hong Kong portion.

There continues to be considerable growth potential for Hong Kong's equity market in its role as the primary channel through which Mainland enterprises reach international investors. In 2005, Mainland enterprises accounted for over 90% of IPO funds raised in Hong Kong; seven of the 10 most actively traded stocks in Hong Kong so far this year are Mainland companies; and of the 200 largest stocks in the Hong Kong market forming the Hang Seng Composite Indexes, 103 companies derive the majority of their revenue from the Mainland and account for about 45% of the market capitalisation.

In the short term, this will continue to drive the growth of the equity capital market. But Hong Kong should look beyond this by extending its success with Mainland companies to other companies in the region. For instance, a number of Taiwanese companies have already taken advantage of Hong Kong's well developed market to obtain a listing. A broader focus in this regard will help drive next-stage growth.

Alternative Investments - Further Investigation and Investment Needed

Hong Kong has not yet built up a significant share in the fast-growing alternative investments sector, although there are some encouraging signs of change. While equities and fixed income products remain the mainstays of the global financial market, the alternative investment sector has grown significantly in recent years. Wealthy investors, who often pick up on new investment structures ahead of the mass market, have been placing an increasing share of their wealth in alternative investments, particularly private equity and hedge funds (Chart 2).

Mainland companies are among the most sought-after investment targets for private equity firms and hedge funds. Many large private equity firms (mostly buyout firms from the US and Europe) have come to China in the past two years. However, putting together successful private equity deals on the Mainland can be challenging and requires excellent local knowledge and experience. Private equity professionals in Hong Kong have a solid track record of being able to raise additional capital for business and for finding Mainland companies that offer good investment prospects at reasonable prices.

Hong Kong is now the second-largest private equity centre in Asia, although the absolute size of the industry is still small. Given the rising interest among global investors, Hong Kong is well placed to carve out a specialist niche in the private equity sector and capture a more prominent share of the global market.

A growing number of hedge funds are also making inroads into Asia. Globally, there are approximately 8,800 hedge funds managing about USD1.2 trillion in assets. Although about 60% of hedge funds are still based in the US, the number of Asia-headquartered hedge funds has quadrupled to more than 700 since 2002, with a near 10-fold increase in assets under management to about USD120 billion. Five of the top 10 largest hedge funds in Asia are based in Hong Kong (Table 1).

Some regulators have voiced concerns about the increased potential for financial market volatility that may be created by hedge funds. However, such challenges to the market must be weighed against the opportunities that may be generated by growth in this sector. Hong Kong should balance the potential risks and rewards in exploring how best to proceed.

China's needs are evolving and there is a growing demand for increasingly sophisticated financial services support. The country is now the largest and fastest growing market for many commodities. It consumes between 25% and 30% of the world's alumina, iron ore, zinc, copper and stainless steel production. A growing share of this demand is met by imports at prices integrated into the global market. The country's need for resources is already having a significant impact on global commodities prices, making it increasingly important for the Mainland to hedge its risk through derivatives markets.

The three commodity exchanges on the Mainland are now among the world's most active players in terms of number of commodity futures contracts, although the total notional value of these remains small. In the global commodity derivatives market, large players are consolidating to become giants that are able to extend their trading hours to cover several time zones. Asia does not yet have a well-established commodity futures market of its own. Hong Kong could seize this excellent opportunity by exploring the feasibility of establishing a futures trading platform for various commodities.

RMB Business - Prepare and Nurture

After two years of providing selected RMB financial services (most notably, RMB deposit services), the financial community in Hong Kong is pushing for the further expansion of the scope of RMB services it can offer.

Riding on the strength of the RMB exchange rate and the sustaining rapid growth of the Mainland's external trade and economy, there is growing demand offshore for various kinds of RMB services. In addition to its status as an international financial centre, Hong Kong's close proximity to and strong economic linkages with the Mainland mean that it should prepare itself to take a prominent role as the RMB moves along the road to full convertibility and emerges as an international currency.

The latest push has focused on developing an RMB bond platform in Hong Kong and to allow Hong Kong importers to settle payments for direct imports from the Mainland in RMB. However, there are many hurdles to overcome, particularly with regard to the relaxation of China's capital controls to allow these financial services to take place in Hong Kong, which has no restrictions on capital movements.

The key issues lie in how to maintain or establish certain kinds of necessary restrictions - such as who can be allowed to purchase how much RMB and through which channels - without putting too much risk on the Mainland currency and interest rate regime.

The structure that has been put in place for RMB deposit services in Hong Kong proves that such challenges can be overcome. However, the community needs to recognise that given the restrictive nature of the RMB business that can currently be introduced into Hong Kong, the volume of this business and its benefits in the short-to-medium term should not be overemphasized.

Conclusion

The financial services industry has demonstrated strong growth in the past few decades. While accounting for about 6.5% of the workforce in Hong Kong, the sector contributes over 12% of the output of the economy. If the relative size of Hong Kong's financial services industry is compared to those in other international financial centres such as New York and London, there appears to be considerable room for further growth. There are still many areas of potential new business that have yet to be explored. It is important for all participants in the financial services industry to use Hong Kong's natural market strengths to further develop the financial services sector and achieve sustainable long-term growth.

MAJOR ECONOMIC INDICATORS