When Shanghai announced in July last year that it will build a free trade zone (FTZ) that would replicate the Hong Kong system of freedom and international practice, it created jitters in Hong Kong, given that the Special Administrative Region (SAR) had been suffering from economic development fatigue with declining labour productivity and falling marginal returns on investment.
The recent political turmoil in the SAR regarding selection of the chief executive is adding uncertainty to the territory. Under normal circumstances, this would have added a significant risk premium to Hong Kong, bringing asset prices down and bond yields up. But surprisingly, Hong Kong stock and property prices have continued to rise, albeit at slower rates, land auctions have continued to receive enthusiastic bidding, and interest rates have remained at rock-bottom levels.
If you think all this is due to investors’ confidence in Hong Kong’s international competitiveness and bright future, think again.
The good old days of complacency for Hong Kong are over, though many people in Hong Kong still seem to be in denial. Shanghai’s announcement of its FTZ, and the whole exercise of opening up China to the world, has created anxiety in Hong Kong for good reasons. Despite its wealth and capabilities, Hong Kong is increasingly haunted by doubt over its future and whether it can remain a bridge between China and the world.
It is worrying that Hong Kong’s competitiveness is declining. The city is facing growth fatigue, with declining productivity growth and falling investment returns in its key economic sectors. Total productivity and the finance sector’s labor productivity growth have fallen from more than 6 percent and 12 percent a year, respectively, in the mid-2000s to less than 1 percent and 3 percent, respectively.
Productivity growth in the logistics and trade sectors has been stagnant since 2000. The marginal returns on investment in the economy (as approximated by the ratio of the change in GDP to the change in investment) have experienced a secular decline since the late 1980s. These are serious structural woes that should worry Hong Kong when Shanghai’s FTZ, and eventually the whole Chinese system, attempts to replicate its economic functions.
Hong Kong has to sort itself out to rejuvenate its economic structure. I will leave this topic to the policy experts. From a macro perspective, all may not be lost yet. Hong Kong does not have to compete with Shanghai head-on, and be marginalized, in the medium term. China is big enough to host two financial centers with different functions. Hong Kong has already developed as a global financial hub, acting as a bridge for foreign capital flowing into China. Its prime offshore RMB center status will remain, even if other centers emerge.
Meanwhile, Shanghai has developed as a domestic financial center, acting as a bridge for domestic capital allocation and expansion overseas. It has a lot to learn about international finance, but has the edge of being closer to the government and being more knowledgeable about China.
This “division of labor” between two financial centers is clear in Beijing’s development agenda for the medium term. The development of Hong Kong’s offshore RMB business can be seen as Beijing’s strategy to complement Shanghai’s financial development by learning from the Hong Kong “laboratory”.
So the “Shanghai/China threat” is not imminent. It is unrealistic to expect full capital account convertibility in China soon because it will have to make much more significant structural reforms to achieve that. But this may prove to be a tall order because of the clash between the macro reform drive and the micro distortion that erodes the macro incentive. The risk of capital flight also restricts the pace of China’s capital account opening process.
Hong Kong can continue to offer China high value-added services in trade and finance. But as Shanghai’s FTZ takes off, that role will begin to erode. The erosion of human capital and productivity relative to that of the mainland will take longer. But that, too, is a matter of time. This means that Hong Kong’s traditional role as a broker between China and the world is fading.
The structural decline in Hong Kong’s productivity growth and marginal returns on investment are wake-up calls for the city to upgrade and re-invent its economic strengths, in cooperation with the mainland. By deeper integration with the Pearl River Delta, it could still play a leading role in driving the expansion of the regional economy.
Hong Kong cannot deny Shanghai’s emergence because the latter has a crucial role to play in China’s transition from investment-led growth to a consumption-driven one. This new growth model requires the facilitation of sophisticated financial services, which both Hong Kong and Shanghai can provide.
If Hong King remains complacent, it will not be able to escape the eventuality of being marginalized by the rising influence of China. So what is preventing Hong Kong’s risk premium from going up under these worsening fundamentals and political uncertainty?
The answer is: the Hong Kong dollar peg. Try taking it away, my bet is that Hong Kong’s risk premium will go through the roof, crushing the local economy and asset market. Who said the Hong Kong dollar peg has served its time and should be scrapped?
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