Can Hong Kong adapt as China opens up?

The position of special administrative region to what may (or may not, if pessimistic predictions come to pass) be the greatest growth story of our lifetime has, thus far, treated Hong Kong rather well. The Pearl of the Orient’s ‘Gateway to China’ status has assured its continued growth and prosperity, even while debt concerns threaten to fragment the eurozone, and the US mounts an economic recovery that might charitably be described as faltering.

Today, of course, Hong Kong enjoys a position as one of the world’s pre-eminent financial centres, largely as a result of its role as offshore capital formation centre for mainland firms. Since 1993, when Tsingtao Brewery became the first Chinese incorporated firm to list an ‘H-Share’ in the region, its contemporaries have queued up to list on the Hong Kong Stock Exchange (HKEX) and gain access to Western investors keen for exposure to the Asian Dragon.  

Primary slowdown

But growth is slowing. The primary market, which has maintained Hong Kong’s development for more than a decade, is still robust, but it has become so large that even 2010’s record total fund raising of $110bn in initial public offerings (IPOs) and follow-on offerings amounted to just 4% of HKEX’s $2500bn underlying market cap of listed companies. And the stream of domestic listings may be drying up as Shanghai and Shenzhen’s exchanges become stronger. Recently, Hong Kong has even lost the position it held for two years running as the world’s number one IPO destination.

“[Primary market growth] doesn’t move the dial like it used to,” rues HKEX’s head of market development, Romnesh Lamba. “We really see growth coming from other areas now.”

Perhaps most immediate among these sources are international listings. Recent months and years have seen firms such as Prudential Insurance come to Hong Kong for a ‘listing by introduction’ for strategic or branding reasons, as well as others, such as Glencore or Prada, which have opted for primary or dual primary listings. The latter is a trend that is very much evident among natural resources firms, branded consumer goods (including luxury), and spin-offs of Chinese or Asian subsidiaries.

It is also one that looks set to continue, as more and more emerging market firms look eastwards, says Yes Bank’s co-founder and senior managing director, Aditya Sanghi. “There have been some very successful listings in Hong Kong of late among global firms, which have led to an increasing awareness among Indian companies of its potential as an alternative market to list internationally.”

However, relying solely on international listings for growth may not be sensible. Market conditions have not lent themselves to an IPO-heavy climate anywhere in the world, and not everyone is convinced that Hong Kong has the international clout to compete effectively with its peers. “Recently, Hong Kong has focused more on attracting companies outside of Asia to list,” says Tracey Pierce, director of equity primary markets with the London Stock Exchange. “What we’ve found at the current time is that there is very limited appetite there for equity stories without a substantial Chinese footprint, so those companies that are looking for a truly international exchange are still looking towards New York or London.”

Plans for growth

Whatever the shape of demand for international listings, one of HKEX’s key priorities is increasing turnover velocity – the ratio between an exchange’s electronic order book turnover of domestic shares and its market capitalisation – a reflection of how often cash equities are traded. Hong Kong’s 2010 average was 61% as opposed to NYSE Euronext’s 130% and Nasdaq OMX’s 340%, according to World Federation of Exchanges data, and figures for the US market would be even more striking if alternative venues such as Direct Edge and BATS were included. Meanwhile, despite less sophisticated markets, figures for Shenzhen and Shanghai are still 344% and 178%, respectively.

So how can HKEX catch up? A small contribution should be made by a growing pool of core investors, via start-up and relocating hedge funds, for example, although this is not likely to increase trading dramatically.

In Europe and the US, higher velocity is, for the most part, a result of super-fast equity trading strategies. But for Hong Kong, high-frequency trading (HFT), as seen in the US and European markets, is rather harder to achieve. Most importantly, Hong Kong’s government imposes stamp duty of 10 basis points (bps) on each side of a cash equities trade, which effectively kills HFT, because such strategies typically generate margins of less than 10bps. “[HFT operations] just don’t play, and I don’t think the government is going to get rid of stamp duty any time soon,” says Mr Lamba. Not that it would necessarily be a welcome development if it did, he adds. The main issue is technical, even though HKEX recently upgraded its trading infrastructure and improved average transaction time by many orders of magnitude, it still lags behind the latest in lightning-fast platforms.

However, exchange personnel are unlikely to be overly concerned at present, especially when, as Gabriel Butler, director of global execution services for Asia with Bank of America-Merrill Lynch, points out, there is still plenty of mileage from close links with its mainland neighbours. “There is no impetus for HKEX to embrace high-frequency trading until its gateway to China status dries up,” he says. “[It is] doing the smart thing for [itself] and the city of Hong Kong.”

Opening up

And it is here that Mr Lamba and HKEX envisage significant growth, thanks to the expectation that China will open up its capital controls, and gradually allow investors the freedom to buy securities elsewhere. Hong Kong, they hope, will be the first port of call.

China already allows for a qualified domestic institutional investor tranche to make overseas investment, although 2007’s much hyped ‘through train’ proposal of allowing retail investors direct access to Hong Kong-listed shares was never implemented. But that does not mean it will not happen eventually, even if the concept of losing millions of Chinese investors to Hong Kong at a single stroke never comes to pass. “This time around, I don’t think it is going to be as simple,” says Mr Lamba. “[But] we believe that they are going to increasingly let foreigners into China, and they will let Chinese investors come out of China.

HKEX has a privileged first-mover advantage here, but it must be sure not to squander its position. To that effect, the exchange is currently in a period of transition and planning. “What we’re doing right now, is investing in the future,” says Mr Lamba. “But we’re not necessarily going to see the results of that this, or next, year, because we’re taking a medium- to long-term view. We will always be the exchange that has the greatest access to China when it begins to open up. But if we don’t [capitalise on that], someone else will.”

Efforts are being made to make sure that it does include the exchange’s preparations for an offshore renminbi equity market, Mr Lamba adds. “We want the product to be renminbi. If it can be currency-neutral for Chinese investors, it’s going to be more attractive for them.”

Redundant gateway

But it seems unlikely that the liberalisation of China’s capital markets will stop there. Almost inevitably, at some point, overseas investors will no longer need to rely on Hong Kong to buy shares in Chinese firms. So what will happen to the gateway when the walls come tumbling down?

It may well find itself in a diminished position, says Larry Tabb, CEO and founder of research and advisory firm Tabb Group, but it is not, of course, an immediate problem. “If you wind up having a floating Chinese currency and a relaxation of capital controls, you could see Shenzhen and Shanghai growing at the expense of Hong Kong.”

It is a danger, Mr Lamba says, that HKEX is keenly aware of. So for now, while there is plenty of room for further growth in the exchange’s core equities classes, the realisation that it will not last forever has led to moves towards diversification, such as its first steps into futures and options markets. “While we feel there’s plenty of growth to come from equities, if we don’t start in other asset classes, that’s an opportunity cost, because China at some point could do it directly.”

HKEX seems determined to seize the opportunity, but as the financial world realigns itself on a more Asia-centric focus, losing out may not be inevitable, says Mr Tabb. “China is just so big that you can’t assume there’s only going to be one or two exchanges. There’s enough growth and demand and scale that there should be multiple markets with enough different models and product sets to keep everyone happy." For HKEX then, the coming years may not be easy, but the outlook is not necessarily bleak.