Rebooting Hong Kong as an International Financial Center

Champagne corks were popping all over Hong Kong following the September 23 announcement by the government that it was scrapping compulsory quarantine for inbound travelers. The restrictions, in effect for 915 days, had exacted a heavy toll on the economy and morale in the Chinese special administrative region (SAR), whose second largest industry before Covid-19 had been tourism. As the city’s retailers and restauranteurs, as well as its flagship airline Cathay Pacific, can start to look forward to a return to normality, however, questions over the future of Hong Kong’s largest industry – financial services – linger.

More than just a key pillar of its own economy, Hong Kong’s capital markets play a critical role in facilitating trade and investment between China and the rest of the world. But the SAR’s standing as an international financial center has in recent years suffered numerous blows, both self-inflicted and outside its control.

In some ways, it is remarkable how resilient Hong Kong’s financial markets have been. In the wake of widespread social unrest in 2019 and in the midst of a global pandemic, Hong Kong Exchanges and Clearing (HKEX), the city’s sole exchange operator, reported a record year for derivatives trading volumes and its second best-ever annual turnover in stocks in 2021. This is testament to Hong Kong’s unique advantages under the “one country, two systems” model governing the SAR since its return to Chinese sovereignty in 1997. Structural shifts in its internal and external environments, however, have created both significant challenges and huge new opportunities. If Hong Kong is to retain its status as a leading international financial center, then it must adapt to these changes and take proactive steps to prepare for the future.

What are the key changes in Hong Kong’s operating environment?

Hong Kong ascended the ranks of the world’s leading financial centers over the past three decades by serving as the principal venue for China’s offshore capital formation. Since the first listing of mainland Chinese H-shares in 1993, the city’s stock market capitalization has risen 18-fold from around US$250 billion to US$4.5 trillion, while average daily share turnover has surged more than 30-fold from under US$650 million to over US$21 billion in 2021.

The underlying drivers of this success were Hong Kong’s unique position as part of China but operating under an English common law system and internationally accepted regulatory standards, China’s massive capital import needs, and other factors such as the city’s sound financial infrastructure, strong pool of talent, and innovative spirit. While dramatic changes have taken place since the 1990s, in light of the rapidly evolving business, geopolitical and technological landscapes, further structural transformations will throw up new competitive and regulatory challenges.

First, China’s rapid economic development means that it now has different financial needs. The funding requirements of Chinese companies can comfortably be met from domestic sources, whereas a rapidly ageing demographic profile means that Chinese policymakers now face pressures to help their citizens achieve better diversification and returns on their retirement savings.

Today, the largest allocation of Chinese household wealth is to residential real estate, followed by cash deposits at banks – which amounted to some US$35 trillion in 2021. Given the small size of China’s domestic capital markets relative to its economy, some proportion of these Chinese savings will need to be invested in international markets if the country is to avoid dangerous domestic asset price bubbles.

HKEX Connect Hall: Connect programs facilitate access for international investors to Chinese securities markets and enable mainland investors to buy Hong Kong-listed securities (Credit: HKEX)

Bonds tend to make up the larger part of pensions savings. Hong Kong’s financial sector, however, is overwhelmingly skewed towards the listing and trading of equity securities; its bond markets remain small and its capabilities to serve fixed-income issuers and investors are limited. Even in equities, the SAR does not offer mainland investors much in terms of diversification opportunities, with mainland Chinese companies accounting for 78 percent of its stock market capitalization and 88 percent of trading turnover. Hong Kong’s failure to diversify its market has therefore left it ill equipped to cater to China’s retirement savings needs today.

In time, as the working age share of China’s population shrinks, government borrowing will likely rise to meet increasing social welfare spending needs. To support these increased borrowing requirements, international investors will demand similar levels of capital and liquidity efficiency from their holdings of Chinese Government Bonds (CGBs) as they enjoy with other major sovereign securities. Catering to these requirements will involve enhancing post-trade efficiencies and developing collateral management capabilities that Hong Kong does not yet possess.

Second, Hong Kong is now facing rising competition both from the mainland and internationally. Its relationship with mainland Chinese financial centers, particularly Shanghai and Shenzhen, is evolving from one of “co-opetition” to one of increasingly intense rivalry. Both centers harbor international ambitions and, while Hong Kong continues to have the advantages of an open capital account and international regulatory standards, the gaps have significantly narrowed in recent years. The launch in 2019 of Shanghai’s STAR market, with its more flexible listing requirements, was aimed directly at wresting mainland technology IPOs from Hong Kong. Meanwhile, the Chinese government’s focus on the goal of “common prosperity” could lead to further curtailment of offshore listings by Chinese companies as a means for mainland entrepreneurs to transfer their wealth overseas.

On the international front, the proliferation of algorithmic trading strategies has made major liquidity providers more market and asset-class agnostic. More and more investors are focusing on markets where they can achieve the best overall returns, net of costs. Here, Hong Kong has been poorly served by the monopolies controlling its core market infrastructure, which have had little pressure or incentive to invest in upgrading and enhancing the efficiency of their platforms. As a result, even disregarding the city’s stamp duty on share trading, investors in Hong Kong face steep fees and costs compared with other major markets.

Third, developments over the past several years have undoubtedly tarnished Hong Kong’s international standing. The underlying factors that precipitated the 2019 protests are complex and stretch back many decades, but the sight of violent unrest on the city’s streets broadcast across international news media badly damaged its reputation for offering a safe and stable living and working environment. While Beijing’s enactment in 2020 of the National Security Law (NSL) helped restore order to the SAR, it has also raised concerns among the international community that Hong Kong’s civil liberties are being curtailed. In response, the US sanctioned Hong Kong officials, and a number of countries relaxed immigration policies for people wanting to leave the city, particularly those facing possible legal prosecution.

Brain drain: In August, it was reported that 1.6 percent of Hong Kong's population had emigrated over the past 12 months (Credit: HUI YT / Shutterstock.com)

In August, the South China Morning Post reported that more than 113,000 Hong Kong residents, or 1.6 percent of the population, had emigrated over the past 12 months in what is seen as the most severe brain drain since the years in the run-up to China’s resumption of sovereignty. Undoubtedly, this included many expatriates who had grown weary of harsh Covid-related travel restrictions, but most of those departing were native Hong Kongers. Confronted with Hong Kong’s sky-high property prices and highly unequal access to education and other opportunities, middle class professionals had been seeking better lives elsewhere for their families long before 2019. Lower eligibility criteria to enter countries including Australia, Britain, Canada and the US since 2020 have simply opened the door for many more to emigrate. Unless it can be stemmed, this loss of talent will pose serious long-term challenges to Hong Kong’s competitiveness.

Meanwhile, social instability and the continued failure to address the underlying problems have undermined confidence among mainland Chinese constituencies. As China continues to race ahead in key areas of technology and infrastructure, Hong Kong’s privileged status could well be further called into question.

Fourth, increasingly strained relations between China and the US and the weaponization of the global financial system pose particularly complex challenges for Hong Kong. In the short term, while US restrictions on investment in certain Chinese sectors and the threat of de-listing facing US-listed Chinese companies may lead to an increase in secondary listings in Hong Kong, if widening geo-economic warfare begins to curtail cross-border capital flows, it will pose a significant blow to city’s financial services sector.

China’s continued dependence on the US dollar and Western control over key global financial infrastructure present major challenges in expanding Chinese outbound portfolio investment. International investment programs such as the Belt and Road Initiative (BRI), designed partly to help improve returns on China’s US$3.2 trillion in foreign exchange reserves, rely on foreign direct investment by Chinese state-owned enterprises. This has given rise to concerns over Chinese government influence in recipient countries, exacerbating geopolitical tensions. Without security against Western sanctions, however, Chinese policymakers are unwilling to relax restrictions further on portfolio investment in overseas securities markets.

Nevertheless, the unprecedented financial sanctions imposed on Russia in response to its military aggression in Ukraine could lead to major shifts in policy. To date, Chinese policymakers have taken a cautious and gradual approach towards internationalizing their currency, wary of shouldering the burdens the US faces due to the dollar’s global utility role. The freezing of Russia’s foreign exchange reserves has highlighted the risk of China’s continued reliance on the dollar and could prompt accelerated steps to internationalize the renminbi.

Other countries are also reconsidering their choice of currencies for trade settlements and reserve holdings. Saudi Arabia’s move to begin accepting renminbi to settle oil exports to China means that, based on current export levels and oil prices, the Saudi treasury alone could have as much as US$75-100 billion in renminbi-denominated reinvestment requirements a year going forward. Reports that companies from India and other countries trading with Russia have begun settling trade in renminbi also suggest that the offshore yuan pool could grow substantially in the coming years. This represents an enormous opportunity for Hong Kong, but there will be fierce competition from other international financial centers to satisfy the growing demand for offshore renminbi-denominated investment products.

Fifth, even absent geopolitical tensions, the financial services industry has been evolving rapidly. In the wake of the 2008 global financial crisis, financial regulators have imposed significantly greater regulatory requirements on banks and other financial intermediaries. This was undoubtedly necessary, given that inadequate capital and liquidity buffers had contributed to the crisis. The new rules, however, have led to a reconfiguration of business models, where risks have migrated to other nodes in the financial system and fresh ones have emerged.

For example, the exit by investment banks from proprietary trading means that market liquidity today depends more heavily on less well capitalized market-making firms. This has made financial markets more susceptible to shocks arising from rapid liquidity withdrawal. Meanwhile, the drive towards central clearing, while helping to increase market transparency, has concentrated risks in clearing houses.

Celebrating a new listing: Hong Kong’s financial sector is skewed towards the listing and trading of equities; its bond markets remain small and its capabilities to serve fixed-income issuers and investors are limited (Credit: HKEX)

In the asset management sector, rapid growth in passive index-tracking funds has put pressure on fees, which in turn is driving a greater focus on costs. Cost pressures, along with the European Union’s Markets in Financial Instruments Directive II (MiFID II), have forced an unbundling of services traditionally provided by brokers and investment banks, with a host of new providers stepping in.

All financial centers must strike a balance between providing a flexible environment, in which new business models can develop, and appropriate regulatory oversight. Hong Kong, however, also faces a struggle to gain greater influence in the formulation of global financial standards.

Sixth, exponential advances in technology are accelerating the process of creative destruction. Among the most revolutionary technologies in financial markets today is blockchain. Looking beyond the speculative frenzy in cryptocurrencies, blockchain’s capabilities promise to bring about substantial cost and other efficiencies in trade processing and settlement. But new technological capabilities are changing the financial ecosystem in other ways.

The success of the large-scale experiment in working from home during the Covid-19 pandemic is likely to accelerate trends in the outsourcing of higher-end services and will require financial centers to accommodate remote business models in their regulatory and infrastructure set-ups.

Hong Kong, like other major markets, has experienced huge growth in high frequency trading (HFT) volumes, which rely heavily on algorithmic models. As the May 2010 US flash crash bore witness, malfunctioning algorithms can cause extreme market volatility. Notwithstanding the enormous impact of HFT activity, regulators remain several steps behind market developments.

Technology is not only altering the structure of markets at the institutional level. Today, low-cost online brokers offer retail investors analytical tools that were only available to the most sophisticated institutions just a decade ago. Mobile applications have also made trading more accessible. Consequently, more retail investors are participating in more complex products such as derivatives. This presents dilemmas about the extent to which regulations should restrict access to certain investment products, and the risk that doing so will only drive them to competing financial centers, where protections may be fewer.

Given the scale of these structural changes in its operating environment, Hong Kong needs to craft a comprehensive strategy to meet the evolving needs of its various constituencies and to grasp emerging new opportunities.

How should Hong Kong respond?

Hong Kong has had some success in diversifying its financial services offerings over the past decade. Notable achievements have included the Stock and Bond Connect programs, which have facilitated access for international investors seeking to invest in the Chinese onshore securities markets and enabled individual mainland investors to invest directly in securities listed in Hong Kong for the first time. In addition, the 2018 Listing Reforms significantly increased the attractiveness of its market for mainland technology and biotech company listings. These initiatives, however, mostly focus on more of the same – the listing and trading of shares in mainland Chinese companies.

A strategy for long-term success must concentrate on those opportunities where Hong Kong has, or can develop, sustainable competitive advantages and incorporate key capability building. Opportunities meeting these criteria include:

• Serving Chinese savers’ international investment and diversification needs

  This would involve two parallel initiatives. First, Hong Kong must seek to attract more share and bond issuance by international issuers. Second, it should seek to support mainland Chinese portfolio investment in international markets beyond Hong Kong.
  
  The key enablers of Chinese outbound investment beyond Hong Kong would be: (i) a secure safekeeping infrastructure to protect mainland investors from foreign sanctions, and (ii) a high degree of transparency for Chinese regulators over their investors’ transactions and holdings in international securities, since, unlike their US counterparts, they do not have the ability impose Foreign Account Tax Compliance Act (FATCA) requirements on the rest of the world.
  
  The Connect programs already provide an established mechanism for transparency. Furthermore, over 70 percent of all international investors’ holdings of mainland A-shares are held through Stock Connect, and some 53 percent of foreign holdings in the Chinese domestic bond market are held through Bond Connect, making Hong Kong the largest safekeeping center for international investors’ holdings of domestic Chinese securities. The principal reason why overseas investors have chosen to entrust these holdings to Hong Kong is because they feel they enjoy greater legal and regulatory protections in the SAR versus investing directly in the onshore market. As part of China, Hong Kong can be trusted to provide similar protections to mainland investors when they invest overseas.
  
  

• Helping expand international demand for Chinese Government Bonds

  To increase international demand for CGBs, investors must be offered similar levels of efficiency in these holdings as they enjoy when investing in US Treasuries. CGBs are not yet widely accepted as collateral for short-term borrowing or to satisfy clearing margin requirements in international markets, and they lack an established infrastructure for their placement and acceptance as collateral. One challenge is that few international investors would be willing to rely on a pledge of collateral under mainland Chinese law. This could be resolved by using Hong Kong as the jurisdiction of pledge since its English common law system is acceptable to both Chinese and international institutions.
  
  At this point, readers might ask: Given the enormous savings of Chinese households, cannot Chinese government borrowing needs be satisfied from domestic sources? In short, no. The time when China’s government borrowing needs begin to rise sharply coincides with the time that Chinese savers going into retirement will be rapidly drawing down their savings. Further, on balance, it would be of greater benefit to China for Chinese savers to invest in higher-yielding assets globally, with foreign investors helping to fund China’s government borrowing needs. China’s demographically driven financial challenges cannot therefore be resolved without greater reliance on international markets.

Renminbi rush: The growing demand for offshore yuan-denominated investment products represents an enormous opportunity for Hong Kong, but there will be fierce competition from other international financial centers (Credit: humphery / Shutterstock.com)

• Supporting a more international role for the renminbi

  So far, Hong Kong’s claim to be a renminbi hub has largely rested on having the largest amount of offshore renminbi deposits. It has been slow to develop more of the yuan-denominated investment products that must be available offshore to encourage wider acceptance of the Chinese currency in international trade. Far more concerted efforts are required to build this ecosystem of renminbi products to meet growing demand.
  
  Hong Kong, however, must also anticipate that greater international usage of the renminbi in financial markets will involve products issued and traded in other financial centers. The success of London, Brussels and Luxembourg in cementing lynchpin roles in the Eurodollar system has relied on post-trade services, including clearing, cross-border settlements, securities safekeeping, and collateral management. Here, Hong Kong’s competitive advantage will derive from catering to international investment needs of mainland investors, but it must invest in developing world class post-trade systems and capabilities.
  
  

• Servicing the financial needs of the wider Asian time zone

  For far too long, Hong Kong has neglected the huge opportunities in Southeast Asia and beyond. Rapid growth in both GDP and wealth makes the Asian region one of the most exciting prospects in global markets. But the fragmented nature of the region’s capital markets, with multiple national exchanges, each with limited liquidity, has been an obstacle to attracting international investors and to retaining issuance activity by their local corporations. Nevertheless, intraregional rivalries and failure to develop a regional central securities depository (CSD) to support cross-border settlements have stymied past attempts to pool regional liquidity, such as the ill-fated ASEAN Trading Link.
  
  Competitive and geopolitical tensions mean that Hong Kong will face institutional and political resistance if it were to seek dominance as an IPO center for Southeast Asian issuers. Yet, helping to connect mainland Chinese and international investors in the Hong Kong market to other financial regional markets would be a win-win proposition.
  
  Another major challenge for Asian countries has been the limited acceptance of their sovereign securities as good collateral in international markets. At this point, it is unknown whether growing questions about the dollar system will result in a bipolar global currency regime, in which the renminbi becomes the clear alternative to the greenback, or if we will move to a more multipolar system. Hong Kong should prepare for each eventuality by supporting the expansion of Asian local currency markets through facilitating acceptance of regional sovereign securities as good collateral.
  
  As HKEX develops more derivatives based on regional benchmarks, there are natural reasons for Hong Kong’s clearing houses to accept regional government bonds to meet their margin requirements. But by developing its collateral management capabilities, Hong Kong could also support placement and acceptance of these securities as collateral across the region. This would help lower borrowing costs for Asian governments and corporates, and reduce their foreign exchange risks.

Capturing the four opportunities outlined above will require Hong Kong to develop itself as an international depository and collateral management center. Offering safekeeping for the international securities of Chinese investors would address mainland policymakers’ need for transparency and protection against foreign sanctions. Facilitating the placement and acceptance of mainland Chinese securities of international investors that are already safekept in Hong Kong as collateral in international markets would provide international investors with far greater capital efficiency and liquidity from these holdings, thereby expanding demand for Chinese securities. Playing a central role in the safekeeping and cross-border settlement of renminbi securities would also give Hong Kong a slice of the action on the trading of yuan investment products in other markets, as the global renminbi ecosystem develops. Furthermore, by taking advantage of the scale of Chinese cross-border investment to serve the needs of other Asian countries, Hong Kong could unlock huge opportunities for China, its neighbors in the region, and itself.

Realizing this vision, however, will require developing closer relationships with other financial centers across Asia, reasserting its value to the US and other international constituencies, addressing the potential financial security concerns of other countries, enhancing the competitiveness of Hong Kong’s financial infrastructure, and developing and retaining top-tier talent.

Beyond the technical question of connecting its depository infrastructure with regional CSDs to facilitate cross-border settlement and collateral management, if Hong Kong is to play such a strategically important role for China and international capital markets, it must build sound foundations of trust and address the potential concerns of other countries. The city has long played a critical role in serving as a regional hub for US and international corporations doing business in China and across Asia. Notwithstanding the withdrawal of recognition of Hong Kong’s autonomy by the US during the administration of Donald Trump, Hong Kong’s leaders must strive to serve as a bridge between China and the West, helping to increase mutual understanding and resolve disagreements.

But building better relationships requires more than just catering to the commercial interests of other countries. Hong Kong must continue to provide an attractive environment for members of the international community to live and work in, with freedom of movement and expression, as well as rich and diverse cultural offerings, to supplement its robust judicial and regulatory systems.

There should be no illusion that, in the current geopolitically fraught environment, other countries will be willing to rely solely on Hong Kong’s legal and regulatory protections. After all, laws and regulations can be changed. No country today will be willing to support the emergence a financial ecosystem that might give China excessive leverage over them in the future. For Hong Kong to serve as an international depository center, the system must be underpinned by structural protections that guarantee security for all travelers on the global financial highways.

One way in which this could be achieved is through “designed vulnerabilities”, or mutual dependencies, that guarantee that no one country can weaponize the financial system against others without causing catastrophic harm to itself. This could be by splitting core functions within the system across multiple financial centers. For example, where Hong Kong serves as the center of collateral safekeeping and management, and other countries serve as the centers of collateral usage, the operation of the whole system would depend on a nexus between Hong Kong and one or more other jurisdictions. This would limit China’s ability to inflict unilateral sanctions on other countries without seriously damaging its own interests, and vice versa.

Substantial investment will be required to develop and upgrade Hong Kong’s financial infrastructure. The city’s post-trade systems serving the equities and fixed income markets were introduced in the 1990s and, compared with those of other major financial centers, are highly inefficient. But merely a large one-time investment in bringing those systems up to date is insufficient. To foster an environment of innovation that will sustain its long-term competitiveness, Hong Kong must introduce real competition among its financial market operators.

Developing and retaining the talent needed to support all of this will require investment and reforms across Hong Kong’s educational system to ensure that not only the children of affluent families but all young people are given access to world-class education and training.

One factor that has held back innovation in the SAR’s financial markets has been a regulatory philosophy centered on supervising the suitability of financial products and the selling processes of financial intermediaries, but which neglects looking at investors themselves. In an environment of free information and capital flows, rules around product availability that are too restrictive will simply drive investors to other financial centers. By investing in improving financial literacy from an early age and developing a better-informed investing public, Hong Kong could not only better protect its retail investors but also create a deeper professional talent pool for the future.

Finally, Hong Kong needs to rekindle a belief in itself. The city has seen many tough times over its history and experienced numerous existential crises, but it has always bounced back stronger than before. Achieving this ambitious vision to enhance Hong Kong further as a leading international financial center will require marshaling its people’s famed “Lion Rock Spirit” to get the necessary things done.