Chris Devonshire-Ellis: China’s Financial Center, Shanghai or Hong Kong?

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Op/Ed Commentary: Chris Devonshire-Ellis

Jul. 26 – One of Shanghai’s vice mayors, Tu Guangshao, stated last week that it would be preferable for Shanghai to be China’s main financial center, and should be promoted over Hong Kong to capture global attention on China’s markets. While Shanghai Communist Party chief Yu Zhengsheng has conceded that Shanghai would not catch up with Hong Kong until 2020, the polarization of both cities as China’s main financial center is an issue that still has a long way to go before being resolved.

Tu was the co-author of an influential report citing that Shanghai and not Hong Kong should be China’s premier international financial center in the longer term, and recommended measures to make Shanghai a top international financial center by 2020, a policy adopted by the State Council in 2009.

“In the long run, it is impossible for China to have two international financial centers,” said the report, which was issued by the Brookings-Tsinghua Center for Public Policy, the Beijing branch of the U.S.-based Brookings Institution. “China will finally have only one financial center and that is Shanghai.”

Several senior mainland officials co-authored the report, including People’s Bank of China governor Zhou Xiaochuan and Yi Gang, director of the State Administration of Foreign Exchange and deputy governor of the central bank.  John Thornton, chairman of the Brookings Institution and a former Goldman Sachs Asia chief also contributed to the report, which recommended making the yuan fully convertible within a decade, a prerequisite that will enable Shanghai to be an offshore yuan center.

Not all authors were in agreement. Tu mentioned that in the eyes of the foreign observers, “Hong Kong is not like Shanghai, for it is only a regional market. Overall, in foreigners’ eyes, Hong Kong is only part of China. Anyone having long-term strategic vision would say China’s financial center will be in Shanghai. It represents how the world looks at China.”

So which city should be the top dog for China?

The comparisons at times can be off-kilter, and Shanghai’s politicians are long noted for their aggressiveness in making statements concerning Hong Kong. I recall previous vice mayors stating that by the time of the Beijing Olympics, Shanghai would already have overtaken Hong Kong as a financial center, however this has not happened. What then, are the differences between the two cities and what needs to be done to truly make Shanghai an international financial center to rival or even overtake its southern counterpart?

Shanghai as a financial center
It is important to recognize that Shanghai today is not an international financial center, although the city certainly likes to promote the fact that it is. There are a number of restrictions that apply to Shanghai that do not apply currently to the markets and status of Hong Kong. These include:

  1. The RMB Yuan as an internationally tradable currency: Until China changes the current policy over the yuan and permits it to be a freely tradable currency, Shanghai cannot be an international financial center. The Hong Kong dollar is a tradable currency on the global currency markets. Consequently, currency trading is endemic in Hong Kong, and licensed money changers can be found on the streets. Mainland China maintains currency controls and until this is eased Shanghai will remain a yuan-denominated market only suitable for domestic China trade.
  2. Mainland China stock markets are not open to foreign investors: Although the indexes in Shanghai are quoted internationally as a benchmark, in reality they are no such thing. Foreign investors are not permitted to purchase Mainland China stocks on the Shanghai or Shenzhen bourses, and in any event, the proportion of stock held by the government remains unfeasibly high to evade concerns over market fixing or vested interests. There is, in short, no direct link between the Shanghai market and any impact on stocks held in international jurisdictions. Quite why the Shanghai index continues to be regarded as influential when compared to internationally tradable markets in Hong Kong, Singapore and Tokyo continues to bemuse me.

A reform program is to be put into place to permit foreign companies to list, but this is rather different from allowing access to mainland stocks by foreign institutional investors. The China government has a great need to get out of stocks it holds in its listed state-owned enterprises, and it needs to release the majority of these into public holdings. The problem is that in doing so, the massive amount of shares that would come onto the domestic market would seriously deflate prices. China is caught between managing stocks in companies it owns in a market it remains the regulator of, and the alternative is being out of stocks and appointing an independent regulator. Neither of these two scenarios is under state consideration at the present.

Hong Kong’s rule of law
Hong Kong still maintains a British-derived legal system, and has had a stock market since 1891. The market, Asia’s second largest after Tokyo, has developed and retains a sound legal and regulatory system used to the dealings, disputes, claims and liabilities of international finance. Although Hong Kong does have a regulatory conflict between its commercial and regulatory position, generally speaking the market is well managed and possesses global credibility. Market manipulators, insider dealers and fraudsters are routinely jailed when caught, and the city retains an independent commission against corruption to monitor and look into such activities.

Mainland China is not in a position to provide that for Shanghai unless a massive evolution in the regulatory conflicts between state and commerce is undertaken. The past behavior also of some of China’s own investment funds, including government-backed ones such as GITIC, and the constant play between China and Hong Kong over asset holdings and evasion of liabilities dictate that neither are many of mainland China’s financial and political hierarchy able to fully appreciate the concepts of transparency and financial responsibility.

China needs to implement an independent financial and regulatory body separated from the government; to ensure that financial trades and dealings are transparent, and to ensure that insider dealing and fraud are routinely punished by prison – no matter who they are. Hong Kong’s legal and regulatory system is in place, works, and is familiar to those who use it. For Shanghai to succeed, that complete infrastructure needs to be put into place from scratch. It is not in place at the present.

In terms of the Brookings-Tsinghua report, its Highlanderesque statement that “there can only be one” also seems odd. Why does there only have to be one? Last time I was in the United States, both Chicago and New York seemed to be doing OK in terms of having worked out their respective positions viz-a-viz competition and collaboration, and in any event Hong Kong and Shanghai, rather like Chicago and New York are totally different animals. The real issue today is that Shanghai serves, and will continue to develop to serve, the raising of capital in yuan denominations for business expansion on the Chinese mainland. The soon to be announced reforms that will permit foreign businesses to list in Shanghai are therefore to be welcomed. It’s a far more preferable route than having to bring in investment capital from the overseas parent as is currently the case. Hong Kong meanwhile remains a sensible choice for regional and Mainland Chinese firms to raise foreign currency for business expansion plans in Asia. The system is far from broke, and there isn’t any real need to change it.

The real concerns about Shanghai and its taking over from Hong Kong remain much the same: a Mainland China government far too involved with commerce, heavily invested in its own listed companies, and practicing the self regulation of its own market. Add to that concern over China audit capabilities, transactional transparency, rule of law and a basic understanding of what a free market really is, and Shanghai remains not 10 years behind, but decades.

Chris Devonshire-Ellis is the principal of Dezan Shira & Associates, a foreign direct investment practice he founded 18 years ago. The firm provides corporate establishment, due diligence, and business advice, in addition to tax, accounting and audit assistance. The practice maintains ten offices in China, five in India, and two in Vietnam. Contact:

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