Two early birthday gifts landed in Hong Kong’s lap ahead of the 20th anniversary of its establishment as a special administrative region (SAR): a bond trading link and a credit rating downgrade. Together they illustrate the prosperous yet potentially hazardous links that bind the two together and the delicate balancing act facing Hong Kong.
China officially blessed the trading link, dubbed Bond Connect, with Hong Kong on May 16, enhancing the Chinese SAR’s position as a hub for global investors seeking access to the mainland’s fast-growing markets.
Then eight days later, Moody’s cut Hong Kong’s credit rating by one notch and forecast a negative outlook, citing the increasing systemic risk from China — which it also downgraded.
Despite capital controls between the two, China and Hong Kong’s financial infrastructure have become progressively more interdependent since Britain ceded control over its colony on July 1, 1997. The anniversary is being marked by the arrival of Chinese President Xi Jinping in Hong Kong on Thursday.
Hong Kong has benefited from a surge in trade with its parent state and neighbour, boosted by pacts such as the 2003 Closer Economic Partnership Arrangement (Cepa), and that has extended to financial services. The share of Hong Kong’s financial service exports to China has risen by about 75% since 2009 and accounted for 6.3% of its overall financial service exports in 2015.
Mainland Chinese customers bought more than 35% of Hong Kong-based insurers' new premiums last year, and listings by mainland Chinese ‘red chip’ companies have turned Hong Kong into one of the world's top venues for initial public offerings.
Over the last two decades, the market capitalisation of companies listed in Hong Kong has grown by 790% to stand at HK$29 trillion as of May 31. The bourse has been the top IPO venue globally, in terms of total funds raised, in five of the past eight years — and it owes that all to mainland China.
In the five years ending 2016, new equity offerings sourced from the mainland made up 60% of the bourse's total number of IPOs and 91% of the IPO funds raised. By May this year, Chinese companies accounted for 64% of Hong Kong's market capitalisation, compared with 50.3% in 2006.
Still, feeling increasingly threatened by the rise of Shanghai and Shenzhen as onshore financial hubs, Hong Kong has of late been rushing to deepen integration still further. As a result, it has launched several mutual market access schemes: the Shanghai-Hong Kong Stock Connect in 2014; the Shenzhen-Hong Kong Stock Connect in 2016; as well as Bond Connect, which is due to open before the end of 2017.
While these financial ties will mean more liquid markets and growth in good times, they also create channels for financial contagion from China – in particular volatility created by China’s ongoing efforts to cut back on debt. As such, Hong Kong could turn increasingly susceptible to swift portfolio outflows if investor sentiment towards Chinese companies suddenly turn negative.
Mounting bad loans in mainland China are also putting pressure on the balance sheets of Hong Kong banks, with mainland-related lending climbing 3.5% to HK$3.6 trillion in the six months to end-2016, creating another potential source of negative contagion.
So watch out for when President Xi Jinping seeks greater fiscal discipline and intensifies his clampdown on China’s shadow banking system, once he has orchestrated his power reshuffle at the 19th National Congress of the Communist Party this autumn, because the extra pain indebted Chinese companies will feel will likely feed through to Hong Kong too.
Vive la difference
Hong Kong needs to be clearly pro-market, not supportive of crony capitalism, in order to protect itself as much as possible from the worst aspects of being married to China by bolstering global investor confidence in the integrity of its financial institutions.
The diversification of Hong Kong’s tycoons away from the SAR is no bad thing as they have in some ways stultified its economic and financial development while enriching themselves. However, Hong Kong should be careful not to let a new breed of elite from mainland China fill this power vacuum.
China’s new economy entrepreneurs, such as Alibaba founder Jack Ma who agreed to buy the South China Morning Post newspaper in 2015, are lobbying to change the financial infrastructure in ways that would undermine investors’ interests. Ma has publicly called on Hong Kong to "innovate", which many commentators have interpreted as allowing dual-class shares that would allow founders to control listed companies with only a minority of the shares. While Singapore and London may be considering allowing dual class structures, Hong Kong should not engage in a race to the bottom.
The exchange also needs to guard against the excessive use of cornerstone investors in many of the Chinese IPOs that come to market — large investors brought on board before the launch of an IPO who are typically locked in for six months.
The growing use of cornerstones is tying up liquidity in the stock exchange. That increases the chances of a rush for the exits turning into a stampede, say, if China’s deleveraging process began to spook investors.
Research by FinanceAsia also suggests that Chinese companies that have relied on Chinese cornerstone investors to get their IPOs away have performed poorly compared with those with cornerstone support from global institutions such as BlackRock or Fidelity.
Under the “One country, two systems" framework, it is clear that Hong Kong has benefited from the rapid growth in trade with China, yet has retained a degree of independence. One continuing symbol of Hong Kong's detachment is its peg to the US dollar.
FinanceAsia, which was 20 years old just last year, has watched China’s rise and continued to advocate for Hong Kong to maintain its differences. In finance this means maintaining its superior investor protection, legal framework, and corporate governance.
Another credit rating agency, Standard & Poor’s, cited this distinction when rating Hong Kong’s credit higher than China’s. But the closer the financial systems converge, the more closely the two credit ratings will converge.
Hong Kong has a delicate balancing act to perform and it should take heed of Moody’s warning shot as it embraces China.
