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Hong Kong’s New Activism

Authorities wants deeper economic links with China to benefit from the mainland’s growth.

As a bastion of capitalism, Hong Kong has few peers. For decades the government has adopted a laissez-faire stance toward the economy. The city-state’s workers and entrepreneurs, many of them refugees from the harsh early years of China’s Communist regime, are legendary for their work ethic and business acumen; they have remade the small territory’s landscape into one of the most vibrant cities on the planet and built a vast network of manufacturing and trading companies at home and on the mainland. The freewheeling business tradition has earned Hong Kong a perennial first place in the Cato Institute’s ranking of economic freedom.

And so it’s a measure of today’s economic crisis, which some consider a crisis of capitalism itself, that Hong Kong is taking unprecedented steps to try to bolster an economy that has fallen into one of the deepest recessions in Asia. Over the past nine months, the authorities have adopted two stimulus packages of tax cuts, spending measures and loan guarantees worth more than HK$168 billion ($21.6 billion). The government has also guaranteed all bank deposits in a bid to shore up confidence in local institutions. And officials make clear that they are ready to consider additional action, if needed, to prevent further deterioration of the economy.

"This crisis is potentially more severe than anything we’ve experienced before," Financial Secretary John Tsang tells Institutional Investor in a recent interview in the Central Government Offices, in the city’s Mid-Levels district. "The worst is yet to come."

In addition to adopting pump-priming measures, the authorities are looking for ways to deepen economic links with China to benefit from the mainland’s continued growth. Hong Kong officials are also moving to tighten financial regulation, in an attempt to restore investor confidence in the markets.

The global downturn has ravaged Asia’s other export-dependent economies, with Japan, South Korea and Taiwan reporting record drops in shipments in January. But Hong Kong arguably has been hit even harder. Exports plunged by 21.8 percent in January from a year earlier — the biggest decline in 50 years — as the global crisis slashed demand for Chinese products shipped through the city.

The turmoil has prompted global banks to cut employment in the city’s big financial center and foreign investors to repatriate funds to pay for losses back home. Commercial and residential real estate prices have plunged about 20 percent in the past year, according to analysts at Credit Suisse, and may have another 20 percent to fall in 2009.

The government forecasts that the $318 billion economy will contract by between 2 and 3 percent this year, compared with growth of 3.6 percent in 2008. Economists at Goldman Sachs (Asia) predict output will decline by at least 3 percent. The recession, which began in the second quarter of 2008, is the first since the economy shrank by 3 percent after the outbreak of severe acute respiratory syndrome, or SARS, in 2003 and could rival the 5.3 percent drop that took place in 1998 during the Asian financial crisis.

"Even during the severe acute respiratory crisis, we were able to export, but during this occasion the export market is faltering," Tsang says. "This creates an incredible damage to not only the trade sector but also logistics, consumption. This is deep and devastating. The major concern is, we don’t know how long it will last or how deep it will go."

Last July, in a bid to halt the decline, Tsang and Hong Kong Chief Executive Donald Tsang (no relation) introduced a HK$60 billion fiscal stimulus package, equivalent to 2.4 percent of GDP, to build half a dozen new roads and bridges and increase social welfare spending. In February, John Tsang announced HK$8.3 billion worth of tax cuts in his budget for the fiscal year beginning April 1, including a 50 percent reduction in income taxes for people earning less than HK$194,000 a year.

In addition to those measures, in October the government moved to restore confidence in the banking sector after a brief run by depositors at the Bank of East Asia, the No. 3 local lender by assets, by extending guarantees to all HK$6 trillion in deposits at Hong Kong banks. And in December officials announced the creation of a HK$100 billion fund to stimulate enterprise lending by guaranteeing up to 70 percent of all new loans. The move followed a report by the Federation of Hong Kong Industries that one quarter of the 70,000 Hong Kong manufacturers operating in China had shut down, and nearly all had laid off workers, because of plummeting sales.

The government hopes the measures will create 120,000 new jobs, equivalent to 3.4 percent of the workforce of 3.5 million, in the coming 12 months. That would be welcome in a city where the unemployment rate rose to 4.6 percent in March, compared with 3.2 percent in March 2007.

"Hong Kong is moving in the right direction, but it could have done a little more in terms of boosting the consumption side of things, especially in offering bigger tax cuts," says Michael Buchanan, chief economist at Goldman Sachs (Asia) in Hong Kong.

Beyond the fiscal measures, the crisis is pushing the authorities to recognize that the biggest stimulus is sitting right across the border. China’s economy is far from immune to the global slump, but even so, the country is expected to grow by 6.5 percent this year, according to the World Bank. That explains why Hong Kong officials are pressing Beijing to expand the city-state’s Closer Economic Partnership Arrangement with China, a free-trade pact signed in 2003 that abolished duties on exports to China of 1,407 categories of goods and has allowed Hong Kong–based entities to compete more freely on the mainland in 40 service sectors, including banking, insurance, securities brokerage and legal advisory.

"We believe we can recover from this crisis stronger, and this is because we are part of China," says John Tsang. "Mainland China is the spark of hope in the international arena as an engine of growth. It is aiming to grow at 8 percent in 2009. That would generate a lot of business opportunities for Hong Kong."

China’s leaders show every sign of being receptive. At the end of the annual National People’s Congress in Beijing last month, Premier Wen Jiabao pledged that his government would agree in coming months to expand the economic partnership arrangement to give Hong Kong companies greater access to the Chinese market for goods and services, and would speed up construction of bridges and roads connecting Hong Kong to Guangdong province and the Pearl River Delta manufacturing hub.

Wen also committed Beijing to strengthening Hong Kong’s role as an international financial center by allowing companies there to accept yuan for settling trade transactions with businesses in Southeast Asia. Currently, traders are limited to converting no more than 20,000 yuan ($2,920) a day in Hong Kong, a pittance compared with the estimated $200 billion a year in trade between Hong Kong and Guangdong province. China’s State Council is expected to approve a substantial increase in that ceiling later this year.

"This move will make Hong Kong the largest offshore yuan trading center and will strengthen Hong Kong tremendously," says Richard Roque, chairman emeritus of the Hong Kong Venture Capital and Private Equity Association.

In January, China announced that it had signed a 200 billion yuan swap agreement with Hong Kong to strengthen the city’s ability to cope with the global financial crisis. The facility is not expected to be used any time soon — with HK$542 billion in fiscal reserves generated by years of budget surpluses and HK$1 trillion in foreign exchange reserves, Hong Kong isn’t short of resources. But the swap does underline the commitment of authorities in Beijing and Hong Kong to closer economic and political cooperation.

The success of China’s own stimulus package — Beijing has committed to spending 4 trillion yuan to spur growth — will be as important for Hong Kong as any bilateral measures, says Goldman Sachs’ Buchanan. The fiscal package should help the Chinese economy grow by 6 percent this year and 8 percent in 2010, he forecasts. "How well China manages its way out of this crisis will benefit Hong Kong more than any other economy," he notes.

In addition to fiscal and trade measures, Hong Kong is taking steps to bolster confidence in the city’s financial markets.

Confidence took a hit last fall from the collapse of Lehman Brothers Holdings. The U.S. investment bank had sold HK$15.7 billion worth of structured, credit-linked derivative products known as guaranteed minibonds to more than 43,000 Hong Kong investors, portraying the instruments as low-risk. But those products became worthless overnight when Lehman filed for bankruptcy.

In the wake of that debacle, the Securities and Futures Commission launched an industrywide review to ensure that brokerages don’t mislead clients and that sales agents are clear about investment risks. In January the Hong Kong regulatory agency reprimanded local brokerage Sun Hung Kai Investment Services, which subsequently announced that it would voluntarily repurchase HK$85 million worth of Lehman minibonds from investors.

"We are reminding the industry that they must keep strict adherence to a code of conduct, that there be due diligence of products, and customer assessments, to make sure the product they are selling is suitable to the customer," Martin Wheatley, chief executive of the SFC, tells II .

Regulatory officials have come in for some criticism during the crisis. In particular, critics have cited a partial climbdown by the Hong Kong Stock Exchange in February on a key transparency measure. The exchange had proposed to bar corporate directors from trading their company’s stock for as long as four months before an earnings announcement, up from one month currently. The proposal was a response to widespread objections to alleged insider trading. But after complaints from more than 200 local companies, the exchange announced that it would extend the prohibition to a maximum of two months.

Investors also complained in March after the exchange canceled an end-of-day share auction in the wake of a 24 percent drop in HSBC Holdings’ stock price. Such auctions were introduced in May 2008 and provide a ten-minute window for investors to trade after the market’s normal 4:00 p.m. close.

"Hong Kong regulators shouldn’t flip-flop on policies just because of criticism," says the venture capital association’s Roque.

The SFC’s Wheatley defends both actions by Hong Kong Exchanges and Clearing, the exchange operator. "With any change there is controversy," he says, "but the HKEx has come up with a compromise."

Wheatley says Hong Kong regulators have done their best to maintain free and open markets. He points to the decision not to impose a ban on short-selling, a practice that most major markets curbed or outlawed in the past year, in the midst of the global equity market meltdown. Todd Kennedy, a Sydney-based portfolio manager at State Street Global Advisors, says his firm appreciates the regulator’s restraint. "I think it is a sign of maturity of the financial markets in Hong Kong," he says.

Officials believe the regulatory moves are laying the groundwork for Hong Kong to expand its financial services industry as the regional economy recovers. Expressing the optimism that is Hong Kong’s hallmark, Financial Secretary Tsang says, "The crisis gives us an opportunity to strengthen our financial services sector, enhance our product mix and expand our reach into even more emerging economies."