Hong Kong braces for global downturn

Institutional Investor, April 2008

Ten years ago, Hong Kong’s days were numbered. Or that was the theory. Newly returned to China, and in the midst of a financial crisis, there seemed little reason to expect the city state to flourish anymore: China’s financial centre would become Shanghai, and nobody would need Hong Kong anymore.

Today, though, Hong Kong is as strong as ever – though it faces the same headwinds as every other financial centre with the US slowdown and credit crunch. Invest Hong Kong, the state-funded agency tasked with assisting international and Chinese businesses set up in Hong Kong, helped 253 companies do so in 2007, a record. Its predicted level of real GDP growth, at four to five per cent, is dwarfed by China’s but is more than healthy for a developed market, particularly in today’s global environment. When financial secretary John Tsang announced the budget at the end of February, it featured a staggering HK$115.6 billion surplus, allowing the government to announce HK$35 billion-worth of tax breaks for households. If Hong Kong is flagging, it isn’t showing yet.

But Hong Kong’s mettle will be tested in the year ahead; any international financial centre is obviously vulnerable to external shocks, particularly those involving the USA. “We are entering a cyclical phase of slowdown in the global economy,” says Professor KC Chan, Secretary for Financial Services and the Treasury. “The financial market no doubt will be affected; it will hit Hong Kong just like any financial market.” Ronald Arculli, chairman of Hong Kong Exchanges and Clearing, which runs Hong Kong’s stock exchange, is similarly cautious. “Being the international finance centre that we are, Hong Kong hasn’t escaped the market reassessment of the global economy,” he says.

But there are certainly worse places to be.  “All Hong Kong’s financial institutions have very healthy balance sheets and if you look at their earnings – HSBC, for example – the bright spot is Asia,” says Chan. “Many banks are telling us that while their US and European operations are provisioning for bad loans, Asia has been doing well.

“I won’t call it decoupling,” he adds. “There’s no decoupling in a global integrated world. But relatively speaking Asia still has a lot going for it.”

It is even possible to argue a positive picture for Hong Kong with a US slowdown. Robert Horrocks, head of research at Mirae Asset Global Investments in Hong Kong, believes the US is likely to go into recession, and when it comes out, find itself in a period of low economic growth which makes it vulnerable to shocks. “I can see a period of years when US monetary policy is going to be relatively loose, or biased towards easing,” he says. And, given the fact that the Hong Kong dollar is pegged to the US dollar, that translates into a loose monetary policy in Hong Kong despite a robust economy. That, in turn, should force asset prices up. “In that scenario, Hong Kong has a good chance of having a very strong property market, strong wage growth: it’s a fairly positive environment for asset prices. That’s probably good for banks as well.”

For Hong Kong, the big story clearly remains China. And while China has in some measure seemed a threat to Hong Kong, it has not yet diminished the need for what Hong Kong has always been – a conduit for trade between China and the world. “The beauty of this place continues to be as an open platform,” says Andrew Look, managing director and head of Hong Kong research at UBS. “You can TT a billion dollars in, no questions asked, you can TT it out, no questions asked. That’s a key ingredient of a successful financial centre.” Things are still different in China. “The renminbi is not convertible, so no matter how robust the economic growth, Shanghai isn’t going to be the New York of China anytime soon,” he says. “You TT money in, no problem. You TT money out, you’ve got a serious problem. So Hong Kong will continue to be the New York of China.”

There is, though, great momentum in China to do things domestically that once would automatically have been done in Hong Kong. The increased attention paid to the A-share market (domestic shares trading in Shanghai and Shenzhen) is an example: last year the government made it clear that for all but the biggest companies, they should list domestically first rather than launching H-share listings in Hong Kong as had previously been the case. Given the impact Chinese companies have on the Hong Kong market – they represent about 55% of market capitalisation – this caused some people to worry that the Hong Kong stock market would become, if not defunct, then certainly less essential than it used to be.

“We’re quite comfortable with that,” says Arculli. “Companies will do what companies need to do, and a number of them have sought funding on the mainland. It’s obviously a competitive market globally and we’re not resting on our laurels, we’re out there hustling away like any other exchange.” That’s the truth: senior representatives of the exchange and the government have been pitching in places as far afield as Russia, South Korea, Vietnam and the Middle East, and in particular India, in an attempt to diversify the range of countries that think it practical to list in Hong Kong. But on the day Institutional Investor interviews Arculli, a remarkable HK$236.6 billion of bids come in for the IPO of China Railway Construction, logging a 291 times oversubscription for retail investors and 80 times for institutions. It’s a handy demonstration that Chinese companies aren’t abandoning Hong Kong yet.

Chinese companies still need Hong Kong because it offers a quite different market to sell to: namely, the rest of the world “I understand why regulators want to increase the A share market,” says Chan. “But that doesn’t mean that Hong Kong will lose out all its business to the Shanghai market. Fundamentally, Hong Kong serves in a way the A-share market cannot because of its international investor base.”

And it’s not all about foreign money coming in to China. Mark Michelson, associate director-general of Invest Hong Kong, says about 23% of the companies it advises are mainland companies, considerably up from recent years. “The big surge is from mainland Chinese companies using Hong Kong as a base to expand into the region and the world,” Michelson says. “The state-owned enterprises mostly are here already. But now there are private companies of various different kinds, a lot of them in the services sector.” InvestHK has helped give mainland law firms set up in Hong Kong in the last year or so.

The movement of Chinese capital will also have a big impact on Hong Kong – once it is permitted to move. The earliest steps of this process have been taken with the Qualified Domestic Institutional Investor (QDII) program, which allows selected mainland asset managers to invest in overseas markets, with a particular focus on Hong Kong. Much attention has been paid to the so-called through train initiative, which was intended to allow mainland citizens to buy share s on the Hong Kong stock exchange by using a designated account. This idea, announced by the State Administration of Foreign Exchange in August, appears to be on ice while the government conducts further study into the implications. But at some stage greater capital flows out of China and into Hong Kong are inevitable.

The impact when it happens is hard to quantify. Many in Hong Kong appear to believe the flood of money would boost stock markets there, but others think the euphoria is overdone. “When people ask how bullish I am on through train, I think it’s a non-event,” says Look. “It doesn’t matter if you open the floodgates or not, it’s not going to move the market.” Chen says: “The Hong Kong market is very deep. We have capital flows from everywhere in the world. We are very welcoming to investors from China but it’s not government policy to boost our market; basically government policy is to develop a good market so investors from anywhere can invest in it.”

In the longer term, one day China will allow full convertibility of the renminbi; that, too, will have ramifications for Hong Kong. Chen takes a positive view. “The power of China as a financial power by then will be tremendous, and Hong Kong very much wants to help them manage a lot of these investment flows,” he says. “Hong Kong wants to be the middle man.”

Look thinks that at that point, there will no longer be a need for the Hong Kong dollar at all. “One day the renminbi will become convertible, eight to 10 years from now,” he says. “And overnight Joseph Yam [governor of the Hong Kong Monetary Authority] or his successor will say: tomorrow you go to HSBC and change your Hong Kong dollars for renminbi and we’ll use one currency.”

Chen gives this short shrift. “It’s in the Basic Law Hong Kong will always have its own currency so that’s not an issue, he says. (The Basic Law is the mini-constitution that came into effect in Hong Kong for 50 years from the transfer of sovereignty from the UK to China in 1997.) But Hong Kong’s currency is a matter of debate at the moment, because of the peg to the plunging US dollar. Some have called for a freely trading Hong Kong dollar.

Is the dollar peg still in Hong Kong’s interests? “Very much so,” says Chan. “The dollar peg has been with us since 1984. It’s an arrangement that has stood the test of time and has served us well. It is here to stay, we have no intention of ending it.” Look agrees, at least in the medium term. “I don’t think Hong Kong has a choice to be honest,” he says. “It was a good move back in the early 80s, when people were losing confidence on the free floating Hong Kong currency; but the price we paid was to surrender our monetary policy.” He adds: “But the long term future is one country, one currency.”

What really protects Hong Kong from incursions from Shanghai, though, is the infrastructure – human, legal, physical. “A lot of it has to do with Hong Kong’s systems: the role that it plays as a risk manager,” says Michelson. “The rule of law, the free flow of information, the level playing field, the availability of an enormous number of service providers who know China and the region and are well established and reliable.” There’s tax, too; the budget brought salaries tax down to a maximum of 15%, and 16% on profits, although some feel Hong Kong would be better served for the long term by a broadening of the tax base.

Shanghai isn’t Hong Kong’s only competitor: there’s also Singapore, which has made great grounds in establishing itself as a centre for private banking, foreign exchange and oil trading, among other things. The big state owned Chinese enterprises all list in Hong Kong, but a large number of smaller companies have opted for Singapore in the belief they will get more attention there; Singapore is also pushing hard as a listing centre for places like India and Vietnam.

One area that is symptomatic of this competition is the hedge fund industry. A year ago much of this industry seemed to be drifting to Singapore. Then, in the middle of last year, the Securities and Futures Commission launched a new set of guidelines to make it easier for funds to be registered and licensed. “From what I can gather, the hedge fund industry has taken note of that,” says Chen. He says the funds management industry generally has grown around 35% over the last two years, “and a lot of that growth comes from the hedge fund industry.”

Craddock agrees. “In Hong Kong there are several big hedge funds setting up right now. It’s still one of the natural places to set up.”

Singapore has also stolen a march in the development of real estate investment trusts (REITs). Hong Kong did launch several, but with the exception of LINK, the first and biggest (and backed by the state) they have all performed badly. “Somehow or other we’ve been a little slow off the mark,” says Arculli. “Hopefully going forward we’ll be able to improve whatever differences or shortcomings investor perception of the market might have.” Many feel that Hong Kong’s REITs have struggled because of investor suspicion about the level of financial engineering in many of the structures, and that this cool reception has instead caused issuers to stay away from REIT issues. However, the recent decision by Champion REIT to unwind some of its financial engineering may mark something of a new start for the sector.

“The sentiment has got so bad that it should do a lot better,” says Horrocks. “The reason REITs didn’t do so well is because people thought they were relying too much on financial gearing. But if the general inflationary environment continues here it’s a much better scenario for them.” That doesn’t, though, mean anyone else is going to be inclined to launch them. “That’s the key thing. But for investors in existing products, that’s not a bad thing. You might get scarcity value.”

The broader market has been battered this year, dropping 12.5% in the first two months. There may be worse to come. “I’m still pretty cautious,” says Look. “This is going to be a difficult year.” Others think the fall has made Hong Kong undervalued; Horrocks sees good prospects in banks and property companies.