By Dr Simon Ogus, CEO of DSG Asia Limited
Despite Hong Kong’s well-documented troubles, at this juncture, the SAR remains indispensable to Beijing as a controlled funnel for financial flows both in and out of the Mainland. The SAR also remains overwhelmingly the principal gateway for both RMB trade settlement and offshore RMB deposit taking (90% and 80% of the 2019 totals respectively). And it also dominates bond and equity trading in and issuance for Mainland companies. Only Hong Kong combines an internationally top-notch financial and legal architecture with an un-replicable pool of talent with deep Chinese knowledge, connections and expertise.
Hong Kong will continue to play a pre-eminent role in Beijing’s RMB internationalization project. One can fairly expect the Yuan’s role as a transactional, trade finance and internationally investible currency to be carefully and steadily expanded, though not without the potential for periodic episodes of retrenchment. However, full currency convertibility seems far from imminent, if indeed it can ever be tolerated. The RMB may rise over time to become a secondary reserve currency on a par with say the Yen or the old Deutschmark, but as things stand currently, it is unlikely to grow into a principal reserve currency that replaces or even operates at a similar level to the US dollar. According to the 2019 BIS triennial survey on foreign exchange and derivatives turnover, the RMB remained a pygmy in the rankings of international trade (and investment) currencies involved in only 4% of transactions compared to the 88% share for the dollar.
Beijing should have some success over time in raising this share as increasing numbers of overseas merchants begin to accept and use Chinese digital payments platforms. Nevertheless, overseas adoption of Chinese payments systems only applies, at this stage, to current transactions which remain merely a tiny subset of total investment flows. The broader challenge for Beijing remains to create a large enough pool of investible RMB assets and hence sufficient trade and investment flows in its own currency to be able to insulate itself from the US-dominated financial system.
International investor purchases of onshore Chinese assets are, from a very low base, on the rise. Increased purchases in the sovereign bond markets have been seen thanks to the RMB’s inclusion in the SDR basket. Foreigners are also allocating greater amounts to the local Chinese bourses, almost all of which remains funneled through Hong Kong. Nevertheless, many remain leery about Mainland accountancy, legal and convertibility issues and continue to prefer to invest in offshore securities where they perceive their investment protections are somewhat more robust. At this stage, foreign investors hold less than 3% of Chinese onshore bonds and only 4% of onshore equities by market capitalization.
The PRC could, in theory, help kill two birds with one stone by encouraging its firms to issue far greater quantities of bonds and shares overseas denominated in RMB. Hong Kong would seem to be the logical place to start and the process could be turbocharged by switching the currency of new or even existing Chinese domestically focused business listings into RMB while simultaneously encouraging the deepening of local currency hedging markets.
Chinese offshore stock market listings already total around USD3 trillion equivalent to about 40% of the domestic markets’ capitalization. Prior to 2014 the HKEX was overwhelmingly dominant but because of its unwillingness to embrace dual-class share structures, which allow companies to issue shares with different voting rights, Chinese tech companies tended to gravitate towards the NYSE and NASDAQ. In April 2018, the HKEX relented and changed its rules to permit “innovative” companies to list with dual-class structures.
The timing seems to have been apposite if last year’s Alibaba listing is anything to go by. Although the company might have been prompted by the rule change to pursue its secondary listing, not to mention the chance for China-Hong Kong Stock Connect inclusion, the proposed US Equitable Act seems to be focusing minds. Were this Act to come into force, then the importance of Hong Kong’s stock exchange as a source for China listings will only increase further.
There are a number of ways that the SAR could lose its privileged perch of course. Great financial centers and city states have come and gone over the centuries and historians a century hence could be writing about Hong Kong’s descent into irrelevance. However, for this process to accelerate alarmingly, some or all of at least three things would need to happen.
First, and most optimistically, the Mainland could move rapidly towards developing a fully functional rule of law, transparent and free financial markets and fully open capital accounts. This does not appear to be imminent.
Second, and more destructively, Mainland practices could be increasingly allowed to seep into the local commercial legal system. Were the courts start to be perceived to be ruling in a systematically biased manner in favor of Mainland entities, Hong Kong’s unique attractions could be rapidly eroded. To date, there is little evidence that this has occurred, but it is an issue that bears close monitoring. The final threat comes from an ungovernable Hong Kong that provokes a harsher, direct intervention from Beijing. It ultimately remains incumbent on the SAR’s leadership to promote policies that can assuage local unhappiness in order to head off such a tragic scenario.
Dr Simon Ogus is the CEO of DSG Asia Limited, a macroeconomic and political analysis consultancy, and a member of the Board of Governors of AmCham Hong Kong.