Hong Kong Reign as China's Wall Street Has Never Been So Fragile

In Hong Kong, a city that lives for business, 2016 is shaping up as a year to forget.

In the first quarter, the city’s gross domestic product shrank by the most since 2011. In February, property sales hit a 25-year low. That same month, HSBC voted to stay in London instead of relocating its headquarters to the former British colony. In March, Hong Kong fell behind Singapore in Z/Yen Group’s semiannual ranking of financial centers. Then in April, Dalian Wanda Commercial Properties, one of the world’s biggest real estate developers, told the 125-year-old Hong Kong stock exchange to suspend trading in its shares. The company plans to relist elsewhere, according to a document sent to prospective backers—and that somewhere else poses an existential crisis for capitalism’s Asian citadel.

Wanda’s action was especially significant because of the identity of its controlling shareholder. Wang Jianlin, 61, Asia’s second-richest person, is worth $33 billion, according to the Bloomberg Billionaires Index. The move by the ex-People’s Liberation Army officer—perhaps best known internationally as the owner of AMC Entertainment and a part-owner of soccer club Atlético Madrid—is a shot across the bow of the bankers, traders, and tycoons who turned Hong Kong into one of the world’s great financial centers. Wang’s decision was the first step toward delisting the $29 billion company on Hong Kong Exchanges & Clearing (HKEx) and listing on an exchange on the mainland—most likely on Shanghai’s, the largest. “The news took everyone by surprise,” says Raymond Cheng, Hong Kong-based analyst at CIMB Securities.

It was inevitable that, as the supercharged Chinese economy cooled, Hong Kong—long China’s Wall Street—would take a hit. But Hong Kongers are confronting a deeper shift in understanding their place in China, in Asia, and in the world. The very slowdown on the mainland that’s put the brakes on Hong Kong has at the same time spurred an acceleration in Beijing’s efforts to lure foreign investment by opening up its financial system.

Because of these big-picture changes, the Hong Kong and Shanghai exchanges are, however gradually, trading places. Keen to establish the mainland city as an international center of finance, China’s government has made it easier than ever to invest directly in mainland markets without going through Hong Kong.

That’s one reason why MSCI, whose indexes are used as benchmarks for tracking more than $10 trillion of investor assets, is moving closer to adding mainland shares to its emerging-markets gauges. It’s a decision that is inescapable. A nod from MSCI, which could come as soon as Tuesday, would spark an estimated $16 billion of inflows into China and signify the most high-profile endorsement yet of the country’s transition to a more market-based economy. “The distinction between Hong Kong and the mainland stock market will eventually cease to exist,” says Niklas Hageback, a Hong Kong-based money manager who helps oversee about $175 million at Valkyria Kapital, which focuses on stocks in the Asia-Pacific region.

Hong Kong is a survivor. A former fishing port molded by Anglo-Saxon capitalists and hard-working refugees from the mainland, it grew into one of the most business-friendly economies in the world, surmounting challenges along the way. Despite widespread fears when Britain passed the city back to China in 1997, Hong Kong for the most part runs its own affairs, and its recent boom was partly due to Chinese largess: initial public offerings, tourism, and preferential access to Chinese markets. The former colony is in its 19th of 50 years as a Special Administrative Region—it’s part of China, but it has its own government and, notably, a legal system rooted in English common law.

Hong Kong’s future could well depend on how quickly China relaxes the tight controls over its own economy and fully integrates into global financial markets. Optimists say the city’s decades-long head start in building a credible legal and market infrastructure will protect its status for years. Others argue that Hong Kong’s gateway-to-China strategy is obsolete and the city must reinvent itself. “The question people in Hong Kong should now be asking themselves is: How do we become the Chicago to Shanghai’s New York?” says Mark Austen, chief executive officer of the Asia Securities Industry & Financial Markets Association (ASIFMA) in Hong Kong.

Many of the city’s traditional strengths are already overshadowed by forces on the mainland. Chinese companies have issued the equivalent of $1.1 trillion in local bonds this year, vs. just $8.4 billion in so-called dim sum debt in Hong Kong. The market capitalization of Hong Kong-listed stocks, which through mid-2014 consistently exceeded that of stocks on the mainland, now trails them: $3.9 trillion as compared with $6 trillion.

The value of average daily shares trading in the city has been about $8.8 billion this year, against a combined $80 billion in Shanghai and Shenzhen, China’s two main financial centers. Companies announced plans to raise less than $460 million via IPOs in Hong Kong through April, the slowest pace since 2001. The declines have taken their toll on HKEx, whose market value has slumped 32 percent over the past year to $30 billion. Equity valuations in China are more than three times higher on average than in Hong Kong. That’s part of the reason Wang wants to relist Wanda’s property unit on the mainland.

Although the numbers seem stacked against Hong Kong, its defenders point out that 1,401 overseas companies had their regional headquarters in the city last year, up from 1,340 in 2011, according to the Census and Statistics Department. A survey of 100 companies inside and outside of Hong Kong with a capitalization of more than $1 billion showed that half believed the city was the “preferred or ideal” location for their regional financial management needs, according to East & Partners, a business-banking market research and analysis firm.

If anything is on Hong Kong’s side, it’s history. Whereas China is just opening up to the world, Hong Kong has been a global, outward-looking place since the British took charge in the mid-19th century. The former colony’s established legal system and tradition of laissez-faire governance help explain why Hong Kong for 22 straight years has sat atop the Heritage Foundation’s annual measure of business-friendly economies. China, by contrast, ranked 144th in this year’s survey. “Hong Kong is fully compatible with the international system,” says Kevin Lai, the Hong Kong-based chief economist for Asia (excluding Japan) at Daiwa Capital Markets, a Japanese brokerage. “It has taken 50 years to build these qualities. Even if China announces legal reforms today, it would take 20 years.”

The compatibility Lai cites is one reason why China in November 2014 chose Hong Kong to anchor what’s known as the Stock Connect, a cross-boundary investment channel linking the Hong Kong and Shanghai stock exchanges. The program allows traders from around the world to buy and sell Shanghai shares through their Hong Kong brokerage accounts. A second link—with China’s second-largest stock market, in Shenzhen—is expected to be implemented this year. While trading volumes and financial benefits haven’t been overwhelming, Stock Connect is an important symbol of China’s opening up to global trade.

Quite the opposite message emanated from China last year. When shares on the Shanghai Stock Exchange crashed, the authorities went to extreme lengths to prop up the market, allowing hundreds of companies to halt trading in their shares and banning major stockholders from selling. Several people, including executives at Citic Securities, China’s largest brokerage, were arrested. But China has started to roll back those harsh measures while also quietly pushing forward on some key changes to make mainland markets more appealing to foreign funds. In the interbank bond market, for example, financial firms and institutional investors now have quota-free access to more than 37.8 trillion yuan ($5.8 trillion) in securities.

MSCI called China’s recent changes “significant,” but it also noted that international investors still have concerns, including the risk of widespread trading halts during stock market downturns. Among 23 strategists surveyed by Bloomberg in May, 10 predicted MSCI will allow Chinese shares in its indexes, 5 forecast a rejection, and 8 said it was too close to call.

In the long term, China’s growing financial clout is the greatest threat to Hong Kong’s prominence. In the shorter term, the danger is that mainland authorities will chip away at the freedoms and legal protections that make the city so attractive to international investors.

Tensions between Hong Kongers and the rulers in Beijing have been a regular feature since the 1997 handover. Thousands of citizens flooded the streets of Hong Kong in the summer and fall of 2014 for 79 days of pro-democracy protests, demanding an end to what they said was China’s increased political interference. When Zhang Dejiang, the No. 3 figure in the Communist Party leadership, visited from Beijing in mid-May, Hong Kong deployed as many as 6,000 police officers every day of his trip to protect him and keep protesters at bay.

Last October the Securities and Futures Commission of Hong Kong put forward a plan to gain direct access to the identities of anyone conducting trades through the city, fueling concern that the data would be shared with mainland authorities. China is one of very few major markets where such monitoring activity occurs at the level of individual traders; the U.S. and most other jurisdictions only do so when there's evidence of wrongdoing. “The core values in Hong Kong are under more pressure than people had previously perceived,” says Steve Vickers, founder and CEO of Steve Vickers & Associates, a specialist risk mitigation, corporate intelligence, security, and consulting company in Hong Kong.

To maintain its importance as a financial center, Hong Kong should not only defend its traditional advantages—the rule of law, its deep pool of financial expertise—but also build itself into a hub for derivatives and asset management, says ASIFMA’s Austen. By refashioning itself as a bit of Chicago and a bit of Boston in the shadow of New York, he says, Hong Kong could complement rather than compete with the overpowering growth of equity and debt markets in China.

It’s a vision shared by HKEx CEO Charles Li. He argued in a blog post in April that the city has an opportunity to thrive as a place where investors come to hedge their China risk with contracts on everything from currencies to interest rates. HKEx’s revenue from equity and financial derivatives rose to HK$2.2 billion ($283 million) last year from HK$750 million in 2010. “We will be able to continue in our unique and irreplaceable role of facilitating China’s development while securing Hong Kong’s prosperity for another generation and beyond,” Li wrote.

Add it all up, and it’s clear that unless Hong Kong changes in the face of the mainland’s rise, it faces further erosion of its status. Having slipped behind Singapore as a hub, Hong Kong might find it difficult to bounce back, says Fraser Howie, co-author of Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise. “Five hundred years ago, Venice was the economic power in the Mediterranean,” Howie says. “Now it’s just a tourist attraction.”
 
Mamudi covers market structure in Hong Kong.

This story appears in the July/August issue of Bloomberg Markets. Subscribe now.

To contact the author of this story: Sam Mamudi in Hong Kong at smamudi@bloomberg.net.

To contact the editors responsible for this story: Stryker McGuire at smcguire12@bloomberg.net, Michael Patterson at mpatterson10@bloomberg.net.