China is finally ready for real currency reform
By Allison Jackson From The Financialist
The future of Hong Kong hangs in the balance.
Just about an hour’s drive northwest of Hong Kong, in a corner of the bustling Chinese city of Shenzen, there’s a roughly 6-square-mile piece of muddy reclaimed land known as Qianhai that has morphed over the last three years into a busy construction site. The thrum of activity comes as Chinese officials are working to turn the district into a laboratory for long-awaited financial reforms. Qianhai is slated to be built-out and fully operational in 2020, with the hope that it then becomes a thriving financial services center. Such is the excitement about Qianhai that people are already calling it a “mini-Hong Kong” or “Manhattan of the Pearl River Delta.” But the rise of a Hong Kong 2.0 right next door to the original isn’t necessarily an existential threat, Credit Suisse says. In fact, if all goes according to plan, it’s probably positive for Hong Kong.
Special economic zones like Qianhai are nothing new in China – in fact, there are so many that they shouldn’t really be called special anymore. They began popping up in the early 1980s when China threw open its doors to the West, ending decades of economic and political isolation. Most zones offer companies preferential policies such as tax breaks and lower tariffs to boost exports and attract foreign investment. But this one will be different. After Chinese officials renewed their commitment to market-based reforms at the Communist Party gathering that ended Nov. 12, there is reason to believe Qianhai may actually prove very special indeed.
Qianhai has a much larger purpose than previous economic zones: Credit Suisse says its success could be a major turning point in China’s increasingly urgent push to liberalize its economy and create a fully convertible currency. Under Beijing’s watchful eye, the existing channels for cross-border currency flows between Hong Kong and the mainland would widen. Banks based in Qianhai and Hong Kong would be allowed to set their own interest rates for renminbi-denominated loans to companies registered in Qianhai. In fact, 15 Hong Kong banks have already been authorized to lend to companies in the zone. Chinese companies in Qianhai will also be able to directly issue renminbi bonds in Hong Kong, known as dim sum bonds. Qianhai is set to welcome foreign-funded private equity firms, too. And yes, the typical goodies on offer in special economic zones will be available here, too – businesses will receive corporate and income tax breaks as well as other incentives to open offices there. The end result, authorities hope, will be greater flows of renminbi – though still in the form of offshore CNH – into and out of China.
Of course, building Qianhai on Hong Kong’s doorstep has raised questions about the city’s future as an international financial center. Following the British handover to Chinese authorities in 1997, Hong Kong was granted a large degree of control over its economic, political, financial and legal systems, even as it ceded foreign affairs and defense policy to Beijing. That made it a perfect setting for foreign companies that wanted to access Chinese markets while maintaining their head offices in a capitalist economy with a strong rule of law and a Westernized business culture. Hong Kong’s unique status as both a Chinese territory with special privileges as well as a modern city with plenty of clout in international markets has also helped Chinese companies expand offshore.
In one of the most significant experiments of the past decade, Hong Kong was designated an offshore renminbi trading center in 2003. The reform, seen as a significant step towards making the mainland’s currency fully convertible, confirmed Hong Kong’s importance in the eyes of China’s political leaders and international investors alike. But if Qianhai offers companies seeking access to the Chinese market a base on the mainland with many of Hong Kong’s advantages, plus lower wages, cheaper rents and competitive tax rates, the thinking goes, could it potentially be the first step in Hong Kong losing its own special status?
In short: no. On the contrary, Credit Suisse analyst Christiaan Tuntono thinks the rise of Qianhai could actually benefit Hong Kong. First, having a direct channel for currency flows and cross-border investment options will create more opportunities to put to work the more than RMB700 billion ($115 billion) in deposits sitting in Hong Kong’s offshore market. Second, the size of Hong Kong’s renminbi bond market – already the largest in the world, with RMB294 billion ($48 billion) issued since 2007 – should grow as Qianhai-based companies are allowed to issue dim sum bonds directly, allowing them to take advantage of Hong Kong’s lower borrowing costs, while also offering new investment alternatives to city investors.
Tuntono also believes an asset management industry catering to mainland corporations and individuals could develop in Qianhai, and Hong Kong’s sophisticated financial institutions and investors would likely play a lead role in its development. Finally, a robust Qianhai financial sector would create more jobs for portfolio managers, traders, brokers and analysts from both regions. “We think Qianhai represents another opportunity for Hong Kong, as the process of renminbi internationalization requires its close cooperation,” Tuntono wrote in a note released earlier this year entitled “Hong Kong: Is Qianhai a Threat or an Opportunity?” “Instead of fearing whether Qianhai shall replace Hong Kong in the future, we think investors should think how Hong Kong shall rise with Qianhai in forming an even greater financial and services hub in East Asia in the years to come.”
Qianhai does have competition. The Shanghai Free Trade Zone, which will also experiment with currency-related reforms, opened in late September, and there are already reports that some companies that had planned to invest in Qianhai are reassessing their options. Still, by mid-September, about 1,700 firms with registered capital of RMB200 billion ($33 billion) had signed up to open an office in the zone. Approximately 70 percent of them are involved in the financial services industry.
Given Beijing’s penchant for gradualism and tight regulation, it remains to be seen just how fast China’s stated currency, interest rate and capital account reforms will occur. Given the experience of many emerging markets of late, there is a legitimate worry that loosening currency controls on the capital account will leave China more vulnerable to sudden, potentially destabilizing inflows and outflows of investment capital than it would like to be. Officials have promised that the renminbi will be fully convertible, but many observers still think that’s highly unlikely in the near-term.
Turning back to what it all means for Hong Kong, even if the renminbi were to become a fully convertible currency and Qianhai grew into a thriving financial services hub, most analysts believe that both foreign companies entering the Chinese market and Chinese companies expanding offshore will still want the reassurance of Hong Kong’s strong legal framework, transparent markets and financial know-how. “Financial centers become international hubs only when investors perceive they provide a level playing field,” says Mark Williams of London-based research house Capital Economics. “This requires transparency, an independent legal system, and a willingness to adopt international norms. None of this is in place today in China.”
All that said, if China’s financial and legal systems do eventually mature enough to satisfy foreign businesses and investors – and that’s still a very big if — Hong Kong will certainly have to step up its game to stay competitive. “Hong Kong should not be complacent…about its existing advantages over China,” Tuntono writes. “The government, industries and general public in Hong Kong will all have to strive hard for greater advancement than they have achieved in the past so that the city can maintain a leading edge over the mainland.” But what other choice do they have?
PHOTO: Hong Kong
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