Phin Godfrey and Clarence Huang
Hong Kong’s history as a British colony for 156 years until 1997 and international trade hub have given it a cosmopolitan culture that bridges between between East and West. The city's finance industry, which generates over 20% of its GDP (Census and Statistics Department, 2020), enables firms from across the world to do business in the Asia-Pacific region - earning Hong Kong the status of International Financial Centre (IFC). Hong Kong's path to becoming an IFC is as unique as everything else about the city. However, following China's passing of a repressive natural security law in Summer 2020 in response to protests in the city, its civil liberties are in peril and the future of the financial services are at risk. In this article, we will chart Hong Kong's development into an IFC, and explore how the national security law could affect its finance industry.
History of Financial Services in Hong Kong
The early history of financial services in Hong Kong is closely linked to its status as a trade entrepôt following its colonisation (Chiu and Lui, 2008). Initially, non-specialist "agency houses" were able to meet the demand for financial services, but specialist banks were attracted to the city as trade and commerce grew. At first, these were British banks based in India, but European banks followed them soon afterwards. By 1866, 11 banks had established offices in the colony. The colony's growth also led to the founding of local banks - including the Hong Kong and Shanghai Banking Corporation in 1865.
Hong Kong's financial sector saw further growth over the first half of the 20th century at the expense of mainland China (Schenk, 2002). Shanghai had been the dominant financial centre in East Asia, but the political chaos and civil war in mainland China caused banks to relocate to Hong Kong's more stable environment in the 1930s and 1940s. Moreover, the official overvaluation of the Chinese currency between 1947 and 1949 created demand for forex in Hong Kong from arbitrage opportunities and Chinese exporters looking to benefit from the more favourable exchange rate when converting revenues.
The decades following World War II were a crucial period in Hong Kong’s rise as an IFC. Its free foreign exchange market giving it a unique selling point in the post-war Bretton Woods international monetary regime characterised by fixed exchange rates and limited currency convertibility (Schenk, 2002). As a British colony, Hong Kong's currency was pegged to the sterling and was a member of the "Sterling Area" - a group of mainly British commonwealth countries that pegged their currencies to the sterling and had looser exchange control between each other. However, only “authorised banks” (foreign and larger local banks) were allowed to operate on the official market, and official trade was only permitted for a restrictive set of “essential” imports like cereals and rice.
These strict restrictions created excess demand for forex for "non-essential" purposes, as well as excess supply from non-authorised banks that had been excluded from the official forex market. A secondary forex market developed to facilitate the trades which regulations prevented the official market from doing. Ignoring exchange controls was illegal, so the British government could have cracked down on the practice but was reluctant to for fear that doing so would derail Hong Kong’s status as a trade hub and by extension its political stability. As it became clearer and clearer that the free exchange market would not be regulated, trading volumes grew and grew. Eventually, even trading by authorised banks on the secondary market was turned a blind eye to.
The free exchange market had ample supply of US Dollars (US$) from gold dealers, remittances from Chinese emigrants, and merchants trading with the US. A reliable supply of sterling came from Sterling Area residents looking to convert to US$, particularly those wanting to convert sterling denominated securities to US$ ones. The liquidity that this created meant that Hong Kong had the unique position in the Bretton Woods monetary regime of easy conversion between sterling and US$, generating huge volumes of forex.
By the time the international monetary regime that gave Hong Kong its comparative advantage collapsed in the 1970s, Hong Kong had consolidated its position by developing other advantages (Chiu and Lui, 2008). The post-war boom in financial services created supply of skilled labour and strong institutions necessary for the financial sector to continue thriving. The stable Hong Kong dollar also meant multinational firms had minimal exposure to foreign exchange risk. Hong Kong was therefore an ideal headquarters for multinational financial firms to coordinate investment to the growing economies across the Asia-Pacific region, and in this role became the IFC that it is today.
The National Security Law and the Future
However, Hong Kong's championed independence came under fire when Beijing announced a national security law. Hong Kong's political climate has long opposed the existence of security legislation, so prior to it being passed in China's capital, away from the reach of Hong Kong's powers, there had never been a law governing such affairs. The law notably criminalises secession, subversion of central authority, terrorism, and collusion with foreign forces.
Critics from political figures to business leaders are concerned that, in tandem with the changing nature of the China-Hong Kong relationship, this law means the end of an independent Hong Kong.
Historically, Hong Kong has not just been financially independent, with its own stable currency and stock exchange, but also legally independent. Hong Kong's legal system is modelled after the British courts: independent from all other branches, operating under a common law system, and perceived to abide by the rule of law. Such perceptions are conducive to creating a financial hub. When expanding into China, non-Chinese corporate entities dealing with Chinese corporate entities must consider governing law clauses and arbitration agreements. These provisions are designed to find a neutral zone that will allow foreign entities to enforce contracts against enterprises tied to China's central government, which are often immune to legal consequences due to political connections.
However, as Hong Kong’s court system slowly moves closer to China’s, businesses are slowly losing confidence in the Hong Kong judiciary to provide a level of commercial certainty and fairness. Following the national security law, the UK's top ministers and judges have debated whether to withdraw expatriated judges from Hong Kong courts to prevent them from facing inappropriate pressure and legitimising a potentially compromised legal system through their ongoing presence (Croft et al., 2020). Accordingly, corporate clients have increasingly shied away from Hong Kong as the neutral entry point into China, with many law firms reporting that many Asia-Pacific financial clients have began seeking out arbitration services in Singapore (Kinder and Lewis, 2021). Compounding this is the expansion of Xi Jinping's anti-corruption platform into Hong Kong, which includes a policy that places tighter restrictions on mainland officials' financial dealings in the autonomous region. The reaches of such bureaucratic authority are seen as undermining regional economic autonomy, and could be perceived as a risk to non-Chinese corporate entities that, should they enter into dealings with well-connected mainland officials and businesses, those commercial relationships will be at constant risk of politically-motivated scrutiny and interference by Beijing.
Even so, Hong Kong remains strong due to businesses' reluctance to remove financial operations from the region. Hong Kong is the only city in China that even approaches the status of "financial hub", with its independent central bank and free capital movement attracting foreign businesses accustomed to these institutions in their headquartered countries. For many corporate entities, Hong Kong is the port of entry into the Chinese market, and currently holds US$9.7trn of cross-border debt. Combined with US$440bn worth of foreign reserves held in Hong Kong and the still-budding statuses of other potential financial hubs, financial operations looking to the Chinese market will find Hong Kong to be their best bet in the near future.
Census and Statistics Department (2020) Table 189: Value added of the four main industries as a percentage of GDP | Census and Statistics Department. Available at: https://www.censtatd.gov.hk/hkstat/sub/sp80_tc.jsp?tableID=189&ID=0&productType=8 (Accessed: 21 February 2021).
Chiu, S. W. and Lui, T.-L. (2009) Hong Kong: Becoming a Chinese Global City. London ; New York: Routledge (Asia’s great cities).
Schenk, C. R. (2002) ‘Banks and the emergence of Hong Kong as an international financial center’, Journal of International Financial Markets, Institutions and Money, 12(4–5), pp. 321–340. doi: 10.1016/S1042-4431(02)00017-3.