Hong Kong betwixt and between

By Howard Chao and Neil Campbell, O'Melveny & Myers

Published March 10, 2009 at 2:15 PM

With the full force of the financial crisis now breaking around the world, ironically these unique attributes are why Hong Kong is hurting. Like other financial centers, Hong Kong's financial services sector has suffered -- the Hong Kong Stock Market index has been decimated (down 53% since the start of last year) and international financial institutions have laid off probably thousands of bankers in Hong Kong since the last quarter of 2008. There have been very few initial public offerings on Hong Kong's formerly vibrant stock market since last summer.

The collapse of Lehman Brothers Holdings Inc. has triggered the "mini-bonds" affair, with many retail investors complaining they should not have been sold close to $2.5 billion of complex structured investment products (including $1.78 billion worth of mini-bonds, or credit linked notes) now gone sour, and the government has the vexing political problem of how to handle the frequent public demonstrations by retail investors calling for accountability from individual banks that sold the mini-bonds and the government.

No local Hong Kong financial institution has suffered significant impairments to capital, but a number of international banks with significant Hong Kong businesses have recently come under greater scrutiny and pressure from their home market investors. Global banking groups such as HSBC Holdings plc and Standard Chartered plc, with dominant positions in the Hong Kong banking sector, have both announced large rights issues to bolster their capital positions. Notably though, neither has asked for emergency government funding, unlike some of the other major international banks.

Many international banks have pulled back their lending activities in Hong Kong, leaving some local companies scrambling for funding. It is questionable whether Hong Kong's local banks can fill this credit gap. This may be the inflection point where the huge mainland Chinese banks increase their market share in Hong Kong, and perhaps elsewhere too.

In the trading sector, container throughput slumped a staggering 23.2% in January 2009 compared with a year ago and is expected to worsen in the coming months. Property and retail, Hong Kong's two other key sectors, are riding a serious downdraft with property prices in the exclusive Peak area dropping 41.4% in the last quarter of 2008 compared with the prior quarter and the number of home loans under water quadrupling in this last quarter, raising the prospect of a significant increase in personal bankruptcies.

The overall retail sector has held up reasonably well, but luxury sales have declined and consumers are starting to pull back.

Local government officials are also under heavy pressure. In response to the crisis, Financial Secretary John Tsang has proposed a stimulus package as part of the government's budget for the coming fiscal year. This includes a spending plan of $5 billion for infrastructure development and a $205 million program to create 62,000 jobs and internships for new graduates. Many critics panned the budget as disappointingly conservative -- many felt that given the strength of the Hong Kong government's balance sheet (projected to have $62 billion in fiscal reserves in its fiscal year ending March 2009) a more robust plan was called for. But one cannot help wonder how much difference the small Hong Kong government can make in the face of the mounting storm.

It is in difficult times like these, ever since her return to Mainland rule in 1997, that Hong Kong looks to China as a source of support and comfort. China looms large above Hong Kong's political and economic landscape. Almost all large Hong Kong companies now rely heavily on China for business, and the Hong Kong government consults with Beijing on all important decisions. The extraordinary growth of China has been a boon to Hong Kong, and it is hoped that China will be able to weather the crisis better than most, thereby sheltering Hong Kong too.

Further, China intends to look after Hong Kong, announcing in December various measures to bolster Hong Kong's economy. Most important are: a commitment to maintain Hong Kong's status as a regional financial hub, including a $29.3 billion currency swap pact to stabilize Hong Kong's currency and ease a cash shortage in Hong Kong; supporting the listing of mainland companies in Hong Kong; allowing qualified companies to settle trade obligations in Hong Kong in RMB; commencing construction of a bridge linking Hong Kong, Zhuhai (China) and Macau; and further opening up China's service sectors to Hong Kong companies.

At the same time, Hong Kong must deal with the rise of Shanghai. While no parent likes to admit it favors one child over another, it seems pretty clear that China hopes Shanghai will eventually assume the lead role as China's financial capital, with Hong Kong as the offshore financial center. The Chinese government now requires all state owned enterprises that plan to list to do so first in China before they can list in Hong Kong.

With the crisis, the shortage of international capital has accelerated the trend for Chinese companies to look increasingly for domestic sources of capital funding, and more business will gravitate toward China's domestic capital markets. Helping this trend is that the Shanghai A Shares Index is up about 13.2% this year, among the best performing markets in the world for the period. China has also announced the establishment soon of the new Growth Enterprise Board of the Shenzhen Stock Exchange, which will make it easier for smaller Chinese enterprises to list domestically in China.

Of course, the dearth of IPOs has not helped Hong Kong. Once the markets come back, it will be interesting to see whether Hong Kong will be able to continue to attract the massive Chinese IPOs that it did the past few years, or whether the trend will be to stay onshore. It is noteworthy, however, that all of the major international securities firms have or are trying to set up joint venture domestic securities firms to cover the burgeoning domestic capital markets of China.

It will also be interesting to see how in Hong Kong, the land of laissez-faire, policymakers react to the global trend toward consolidated prudential oversight of the financial services sector and greater state involvement in the economy. Of course, the crisis did not originate in Hong Kong and, other than the mini-bonds case, there are no general complaints about the regulatory system in Hong Kong. Martin Wheatley, head of Hong Kong's Securities and Futures Commission, summed it up: "What has gone wrong in Hong Kong did not start here -- it is the affect of failures in the U.S. ... Hong Kong's system has broadly worked well. We have not had an institutional systemic failure, which I think is important for Hong Kong because many other markets do. We do have a problem of retail selling, and we need to put that right. However, whether we need to throw out the entire regulatory structure and re-develop it in light of the failure that we have had is a very big question, and one which requires careful and balanced consideration."

Nevertheless, the reality is that with the West moving toward tighter regulatory controls to avoid systemic risk and China having always been tightly regulated, Hong Kong ironically is now the odd man out. Hong Kong will feel the international pressure for all financial regulatory systems in the global network to become harmonized. One model being considered, as in the U.S., is the creation of a central regulatory agency to be responsible for systemic risk and prudential oversight, to supplement existing sector-specific regulatory agencies. But at least Hong Kong has been able so far to avoid the need for emergency state ownership of private financial institutions and other companies, which is more than can be said now for most of the capitalist world.

So there sits Hong Kong, betwixt and between state-capitalist mother China and the collapsed financial markets of the West. Hong Kong, a part of China, may be the last bastion of pure capitalism in a world where China and the rest are converging to a more government-dominated economic model. It seems unlikely that Hong Kong can remain an island.

Howard Chao heads the Asia practice of O'Melveny & Myers LLP and Neil Campbell is a partner in the Hong Kong office specializing in finance. Edward Bong provided research assistance in preparing this article.