THE BANKING SYSTEM OF HONG KONG: PERSPECTIVES ON CHANGES AND DEVELOPMENT
Yuen Yin Chan
Submitted in partial fulfillrnent of the requirements for the degree of Master of Development Economics
Dalhousie University Halifax, Nova Scotia September 1998
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TABLE OF CONTENTS ...... LIST OF TABLES ...... -.-..-...... ABSTRACT ...... -.. ABBREVIATIONS...... ACKNOWLEDGMENTS...... -...- - .--...... -...... -...... CHAPTER 1 IM'RODUCTION ...... -...... 2 BANKING AND ECONOMlC DEVELOPMENT...... Overview,,...... Functions of a Banking System...... Channeling Savings into Real Investment...... Providing the Means for Payment...... Providing a Variety of Stores of Wealth ...... Providing Entrepreneurial Talent...... Stabilizing the Economy ...... Role of Banking System in Econornic Development...... Relationship between Financial Development and Economic Growth ...... 2.4.1 Demand-following Finance ...... 2.4.2 Supply-leading Finance ...... 13
3 THE ROLE OF BANKING IN THE ECONOMY OF HONG KONG...... 16 3.1 The Development of the Banking Industry...... 16 3.2 Hong Kong as an International Financial Centre ...... 22 3.3 Significance of the Banking Industry to the Economy ...... 30
4 THE CENTRAL AND COMMERCIAL BANKING IN
HONG KONG ...... -...... 37 4.1 Hong Kong Monetary Authority ...... 37 4.2 Monetary Policy ...... 43 4.3 Commercial Banking ...... 48 4.3.1 Legal Framework...... 48 4.3.2 Status of Foreign Banks ...... 51 4.3.3 Major Banking Groups...... 54
5 BANKl-NG SYSTEM N PIIIAINLAND CHINA AND ITS RELATIONSHIP WITJ3 HONG KONG ...... 63 5.1 Ovewiew of Mainland China's Banking System ...... 63 5.1.1 Pre-reform System ...... 63 5.1.2 Current System...... 64 5.2 Mainland China - Hong Kong Banking Activities .... 83 5.2.1 Overview of China .Hong Kong Econornic Relations...... 83 5.2.2 Hong Kong's Banking Activities in Mainland China...... 84 5.2.3 Mainland China's Banking Activities in Hong Kong ...... 86
6 TRENDS AND ISSUES ...... -...... 92 6.1 Monetary System of Hong Kong after 1997 ...... 92 6.1.1 Two Monetary Systems...... 93 6.1.2 Two Monetary Authorhies...... 94 6.1.3 Two Currencies...... 95 6.3 Cornpetitions frorn Other Financial Centres...... 99
7 SWYAND CONCLUSION...... 1 14 Appendix 1 Selective Basic Law Provisions Related To Monetary . . Policies ...... ,.. ,...... 1 19 BIBLIOGRAPHY ...... 131 LIST OF TABLES
Table 3.1 : Ranking of Hong Kong as an International Financial Centre, 1995 ...... 23
Table 3.2: Authonzed. . Banking Institutions in Hong Kong: Domicile and Parentage ...... 24
Table 3 -3: Authonzed Banking Institutions in Hong Kong: Country/Region of Beneficial Ownership ...... 26
Table 3.4: Presence of World's Largest 500 Banks in Hong Kong ...... 27
Table 3.5: Extemal Liabilities and Clairns of Hong Kong's Banking System ...... 28
Table 3.6: Loans to Non-Bank Customers by Hong Kong's Banks ...... 39
Table 3.7: Geographical Breakdown of Net Extemal Clairns/Liabilities of Hong Kong's Authorized . . Banking Institutions ...... 3 1
Table 3.8: Total Loans for Use in Hong Kong by Economic Sector...... , ...... 32
Table 3.9: Employment in the Industry Sector: 'Financing, Insurance, Real Estate and Business Services' ...... 33
Table 3.10: Contribution to GDP by the Industry Sector: 'Financing, Insurance, Real Estate and Business Services' ...... 34
vii Table 4.1 : The Three-tier Banking System of Hong Kong...... 50
Table 4.2: Distribution of Assets, Deposits and Loans in Hong Kong's Banking System...... 58
Table 5.1: A Measurement of the Independence of the People's Bank of China...... 71
Table 5.2: The Banking Structure of Mainland China ...... 75
Table 5.3 : Loans and Deposits of Major Banking Institutions in Mainland China, 1994...... - -...... 76
Table 5.4: Bank Representative Offices in Mainland China, by Country of Origin, End 1994...... 78
Table 5.5: Contracted Extemal Loans to Mainland China, 1979-1993...... , ...... 86
Table 5.6: Member Banks of Bank of China Group in Hong Kong ...... 87
Table 6.1: Cornparison of Hong Kong and Japan: Selected Categories, 1995...... -...... 10 1
Table 6.2: Cornparison of Hong Kong and Tokyo as Offshore Banking Centres...... 102
Table 6.3: Cornpaison of Hong Kong and Singapore as International Financial Centres...... 105
Table 6.4: Cornparison of Hong Kong and Shanghai as Financial Centres ...... 1 1 1 ABSTRACT
The objective of this thesis is to analyze the development. structure and prospects of
Hong Kong's banking system. In pahcdar. it attempts to investigate the monetary relationship between Hong Kong and Mainland China Through the assessment of the development of banking systems in Hong Kong and to a lesser extent Mainland China this thesis shows how these two economies carried out reforms in response to the changes and challenges to their banking industries, notably, the establishment of the Hong Kong
Monetary Authority and the empowered authority of the People's Bank of China. This study illustrates that Hong Kong and Mainland China have already established a close banking relationship. Despite this intimate relationship. the monetary systems of Hong
Kong and Mainland China will remain entirely separate even after Hong Kong's return to
China in 1997. As a small open economy, Hong Kong mut continue to compete with other financial centres in the region, such as Singapore which stands out as an imminent cornpetitor of Hong Kong. This study concludes that the future development of the Hong
Kong banking industry will hinge on whether Hong Kong can maintain its openness to the international cornrnunity and exercise proper and prudent supervision over its financiai institutions. More importantly, the economic and political development of
Mainland China, if this continues on the right track. will Merboost the sustainable developrnent of Hong Kong's economy. ABBREVIATIONS
ABC Agricultural Bank of China ACUs Asian Currency Units BOC Bank of China BOCOM Bank of Communications CI Certificate of Indebtedness CITIC China International Trust and Investment Corporation DTCs Deposit-Taking Companies EFAC Exchange Fund Advisory Cornmittee Forex Foreign Exchange GDP Gross Domestic Product KKAB Hong Kong Association of Banks KKMA Hong Kong Monetq Authority HSBC Hongkong and Shanghai Banking Corporation ICBC Industrial and Commercial Bank of China LAF Liquidity Adj ustment Facility LBs Licensed Banks MFN Most Favoured Nation PBC People's Bank of China PRC People's Republic of China RLBs Restricted Licensed Banks RMB Renminbi PCBC People's Construction Bank of China RTGS Real Tirne Gross Settlement SAR Special Administrative Region SEZs Special Economic Zones UK United Kingdom US United States WTO World Trade Organization ACKNOWLEDGMENTS
1 would like to thank Professor IanMcAllister for giving me the opportunity to explore an interesting and important thesis area. 1 would also iike to thank my other two readers, Professor Talan Iscan and Professor Kuan Xu for reviewing and making suggestions of my thesis.
1 am grateful to al1 my professors and fnends inDalhousie who, fiorn time to time, render support to my studies. Finally, I am indebted to Ms-Monique
Comeau and other administrative staff in the Department of Economics for offering me great assistance over the course of my studies. CHAPTER 1 INTRODUCTION
Since the 1960s. Hong Kong has been recognized as a newly indusmalizing region which enjoys sustainable economic growth and a rapidly rising living standard.
Following the success of the light manufacturing industries in the 1970s. Hong
Kong has started to move in the direction of reforming and developing its banking industry. The economic reforrn of Mainland China since 1978 has fueled the economic re-structuring of Hong Kong. To capture the lower costs in labor and land. many Hong Kong manufacturing companies have established outward processing facilities in Mainland China. The share of the manufacturing industry in
Hong Kong's overall GDP declined from 3 1.7 per cent in 1980 to 16 per cent in
1995. while the share of private employment also decreased frorn 54.8 per cent in
1980 to 17.6 per cent in 1996. The service industry. particularly the financial sector has emerged as the main pillar of Hong Kong's economy. In 1980. the share of the service industry in Hong Kong's GDP was only 67.5 per cent. By 1995. it had increased to 83.8 per cent. The share in the private sector employment also jumped from 45.2 per cent to 82.4 per cent during the period 1980-1995. Parallel to the growing importance of the service industry in Hong Kong, the banking industry continues to grow and develop. By the end of 1996, there were
182 licensed banks in Hong Kong of which 166 were foreign banks. Hong Kong's role as a gateway to Mainland China has been Merstrengthened upon Hong
Kong's rem to China in 1997. More and more banking activities are being conducted between Hong Kong and Mainland China.
The purpose of this thesis is to examine the development, structure and prospects of the Hong Kong banking system. In particular. this study attempts to analyze the banking relationship between Hong Kong and Mainland China after 1997 and the future trends of Hong Kong's banking. Including this introduction. this thesis is composed of seven chapten. With an objective to finding out the contribution of banking to an economy. Chapter 2 is devoted to an examination of the relationship between banking and economic development. With this conceptual fiamework in place, Chapter 3 reviews the development experience of Hong Kong's banking industry and evaluates its role in Hong Kong's economy. Chapter 4 discusses in greater detail the legal and institutional fkamework of Kong Kong's banking system and monetary policy. Mainland China has become Hong Kong3 most important business partner. The development of its banking system is analyzed in
Chapter 5. Against these facts and background, Chapter 6 examines the major trends and issues that may have great impacts on the Hong Kong banking industry.
Chapter 7 ends the thesis with concluding rernarks about the development of Hong
Kong's banking system. CHAPTER 2 BANKING AND ECONOMIC DEVELOPMENT
2.1 Ovewiew
This thesis aims to analyze the perspectives and changes of Hong Kong's banking system. This initial Chapter is devoted to giving a review of literature about banking and economic development. The functions of a banking system are discussed first. A banking system can channel savings into real investment. provide the means of payment. offer a variety of stores of wealth. supply entrepreneunal talent and stabilize the economy.
This Chapter will also discuss the role of the banking system in economic development and the relationship between financial development and economic growth. Among its other attributes, a banking system provides an efficient way to mobilize and create fùnds that can finance capital formation, and allocate these
Cunds throughout competing sectors of a growing economy. Yet. there are controversies of the relationship between financial development and economic growth. The demand-following finance pattern suggests that the development of a financial system only arises in response to the growth of the real sector. On the other hand the supply-leading fmance pattern asserts that the creation of financial institutions provides a leading role for the real sector.
2.2 Functions of a Banking System
2.2. I Channeling Savîngs into Real Investment
The first and essential function of any banking system is to act as intermediary between savers and investors. The banking system serves as a reservoir for the accumulated liquid savings of the cornmunity. It allocates those hds among alternative investment opportunities of the economy (R. Cameron and Patrick.
1967). Bain ( 1992, 10- 1 1) Mersuggests that financial intermediaries including the banking system facilitate this function by performing a variety of jobs:
Mobiiizing smings: The banking system mobilizes savings by providing
benefits for saving, such as security and the generation of interest income. In
doing so. it encourages people to Save therefore increasing the level of savings
within the economy.
Encouruging investment: The banking system faci litates investment b y
offering funds at a lower price and on better terms than those a borrower could
negotiate if he had to seek funds directly from saven themselves.
Transforming maturiries: The banking system provides liquid liabilities to
meet the needs of savers, while at the sarne time transforming their funds into the longer term fuiancial instruments which are more helpful for borrowers. As
some depositors may withdraw their deposits, othen will simultaneously add to
theirs. It is therefore legitimate for banks to allocate at least a proportion of their
deposits for long-tem loans.
Reducing information and transaction costs: The banking system can reduce
information costs as banks help disseminate information and ensure that both
savers and borrowers remain well informed. Banks also reduce transaction costs
by bringing savers and borrowers together and preparing the legal
documentation which is required for different types of lending activities.
Levine (1997, 691-702) also shares similar views to Bain. He believes that the financial system serves one primary function. that is. it facilitates the allocation of resources in an economy. He breaks down this prirnary function merinto five basic hctions:
Mobiïizing savings: The financial system pools capital fkom savers so that it
can be used for investment purposes.
Facifitating risk management: The financial system can ease the trading,
hedging and pooling of risk. It is capable of transforming maturities and
reducing liquidity risks. Monitoring managers and ei;rerting corporate controf: The financial system
performs the role of monitoring fms or investment project owners on behaif of
individual savers whose savings are lent out to fiance these projects. This
~'delegated monitoring" arrangement economizes on aggregated monitoring
costs, because a borrower or a firm is monitored only by the bank. and not by
al1 the individual savers,
Fuciiitating the erchange of goods and services: The €mancial system fulfils
the function of acting as a medium of exchange by creating money which
facilitates the exchange of goods and services.
AIIocating resources: An individual saver would find it e.xtremely costly to
acquire the necessary information for investing his savings. The financial
system economizes on these information costs by utilizing its expertise and
information pool. Therefore, the financial system improves the resource
allocation of society.
Levine (1997. 691) further States that the above five hnctions can contribute to economic growth through two channels: capital accumulation and technological innovation. The financial system affects capital accumulation by influencing the savings rate, or by reallocating savings arnong different capital-producing technological innovations, by facilitating the invention of new production processes and goods. Therefore. by positively affecting the saving, investment and allocation decisions, the fmancial system cm promote economic growth.
2.2.2 Providhg the Means for Payment
The banking system provides the means for payment and money supply by issuing its own banknotes or by holding and û-ansferring the monetary deposits of the public. Banks create money which is a specialized device to reduce the transaction costs associated with the bartering process. As part of its role in providing a means of payment, the banking system is in a position to serve as the custodians of the stock of money. as well as to increase or decrease this stock. The power of banks cm have considerable effects on society at large (R. Cameron. 1972, 7).
2.2.3 Providing a VarieV of Stores of Wealth
The banking system also creates a wide variety of financial assets by which savers cm store and increase their wealth. These financial assets such as bonds. treasury bills and mutual hnds do not only provide savers with a variety of ways to store their savings. they also serve different needs of the savers (N. Carneron, 1992. 50). 2.2.4 Providing Entrepreneurial Talent
Another funftion of a banking system, though less explicit, is the provision of entrepreneurhl talent and guidance for the economy as a whole. Banks may supply initiative and advice? as well as fuiance, for the creation, transformation. and expansion of industrial and other ventures. This banking function has been very important in underdeveloped and developing economies (R.Cameron, L972,7).
2.2.5 Stabiiizing the Economy
The levels of money supply and interest rates have important effects on the levels of output. inflation, and unemployment. If the banking system of an economy allows the govemment to exert control over money supply or interest rates or both. the govemment can fine tune the economy through these monetary tools. In this respect. one indirect function of a banking system is that it allows the government to carry out stabilization policies for the economy (N. Cameron, 1992, 50).
2.3 Role of Banking System in Economic Development
A major role of any banking system in the development process is to provide an efficient way to mobilize and create funds that can finance capital formation. and to allocate these hds arnong competing sectos of a growing econorny. If the banking system does its job efficiently, development may be accelerated; but if it does not, development may be retarded.
Patrick (1966, 177-178) suggests that there are three major ways in which the financial system can influence the capital stock for growth purposes:
Financial institutions can encourage a more efficient allocation of wealth by
changing its ownership and composition by acting as an intermediary arnong
various types of asset holders.
Financial institutions can encourage a more efficient allocation of new
investment from relatively less to relatively more productive uses by acting as
an intermediary between savers and investors.
Financial institutions can induce an increase in the rate of capital accumulation
by providing higher incentives to Save and invest.
Drake (1980, 3 1-32) explains the relationship between financial development and real economic growth in terms of division of labor as follows:
The use of money allows greater scope for the division of labor as money
eliminates the rigidity of barter trade, thus promoting commercial activities. The introduction of financial instruments allows specialization in savings and
investrnent. Financial institutions provide bridges between ultimate saven and
ultimate investon and creates opportunities for putting the money of the
cautious savers at the disposa1 of the enterprishg borrowen, thus raising the
total levei of investment and income.
DaCosta (1982. 17) States that the link between fmancial intermediation and growth is based on the fulfillment of two assurnptions. The first is that financial institutions are more efficient than others in the allocation of savings, since they have more information and a larger pool of skills due to their specialization and economies of scale. The second is that the credit worthiness criteria of the banks should also satisfj the growth-oriented needs of the developing economy.
R. Carneron (1972, 8) in his study on the role of banking system in the process of industrialization suggests that banks cm promote econornic growth in the following ways:
As intermediaries, banks vigorously seek out and attract reservoirs of idle fünds
which will be allocated to entrepreneurs for investrnent projects with a higher
rate of return. As creators and providers of the means of payment, banks transfer resources
directly from less productive to more productive uses.
As potential entrepreneurs. banks assist in the establishment of firms in new
industries by underwriting a substantial portion of the capital and assuming
entrepreneurid initiative.
2.4 Relationship between Financial Development and
Economic Growth
The previous discussion suggests that banking systems are not "neutral?' with respect to economic development. Many economists support the view that financial development generally fosters growth. However, the central issue of the controversy over the role of financial institutions in the area of economic development is whether the development of financial institutions precedes. and therefore plays an active role in economic development, or whether it passively adjusts to the growth of the real sector, or is a two-way interaction process.
In Patrick's analysis (1966, 174-177) of finance in developing economies, he delineates two opposing viewpoints about the relationship between financial and real development, narnely demand-following and supply-leading finance. 2.4.1 Demand-following Finance
Demand-following fuiance is the type of financial development that reacts passively to the growth of îhe real economy. As such, the creation of the fuiancial system acts in response to the demand for fuiancial services by investors and savers. Therefore, the evolutionary development of the financial system is a consequence of the ubiquitous. sweeping process of economic development
(Pamck, 1966, 174- 1 75).
2.4.2 Supply-leading Finance
This refers to the creation of financial institutions and the supply of their financial assets, liabilities, and related financial services in advance of demand for them.
There are two fùnctions of supply-leading finance: to transfer resources from traditional sectors to modem secton, and to promote and stimulate an entrepreneurial initiative in these modem sectors. Exarnples of supply-leading phenornena include the financial development expenences of Germany since 1830 and Japan since 1870. In this type of development. the banking institutions act as a leading sector, that is, they are created before the demand for their assets and liabilities arises (Pamck, 1966, 175- 176). The "chicken and egg' argument of the relationship between financial institutions and economic growth remains one of the continuing controversies in this field.
There have been cases where banks preceded real growth and others where they followed. In actual practice, there is more Iikely to be an interaction of supply- leading and demand- following phenomena. Patrick ( 1966, 174- 177) suggests in his studies that before sustained modem industrial growth begins. supply-leading hance may be able to induce a real, innovative type of investment. However. as the process of the real growth occurs, supply-leading finance gradually becomes less important and demand-following finance becomes dominant. This sequential process is also Iikely to occur within and among specific industries or sectors. One industry rnay initially be encouraged financially on a supply-leading basis. As soon as it develops. it will shifl its financing pattern to demand- following finance. while another industry remains in the supply-leading phase (Patrick, 1966).
In fact. neither the supply-leading nor the demand-following classification of finance can conclusively explain the direction of the causality between financial institutions and economic growth. The different interpretations of the relationship by econornists may be due to the fact that the two phenomena interact for each economy at any moment and over time. As an econorny develops, the classification of the relationship rnay indeed change. The hctions of the banking system in an economy have been reviewed in this
Chapter. This channels savings flows into real investment, provides a medium of exchange and operates the economy's payment mechanism. It provides convenient stores of wealth, and a range of different credit facilities for savers and borrowers.
It also provides entrepreneurial talent and may offer the governinent or central bank an opportunity to influence the economic stability of the economy. This
Chapter also analyzes the ways in which the banking system might promote economic growth, and studies the causal relationship between financial development and economic growth. Although a strong and efficient banking system is important to promote grow-th, there is no fixed causal relationship between financial development and economic growth. which might be determined by the time and stages of development of an economy. Nevertheless. it is undeniable that a sound financial system is helpful to the development of an economy . CHAPTER 3 THE ROLE OF BANKING IN THE ECONOMY OF HONG KONG
3.1 The Development of the Banking Industry
At the time of the British takeover of Hong Kong fiom China in the mid- 1840s. the banking business in Hong Kong was mainly handled by the trading houses such as
Jardine Matheson, Gibb Livingstone and Dent & Co. Many smaller trading companies were dissatisfied with the oligopoly enjoyed by their counterparts. The conditions were therefore ripe for the development of a banking industry in Hong
Kong. ïhe first locally-based bank was established in 1864 by several British investors - the Hongkong and Shanghai Banking Corporation (HSBC). Since that date. HSBC has emerged as the principal bank in Hong Kong, and handles about half of Hong Kong's total banking transactions. Before World War II. Hong
Kong's banking industry was basically unregulated, such that a fiee banking system was operated during the first 100 years.
In 1948. the first Banking Ordinance was passed to stipulate a legal framework for the registration, regulation and licensing of banks. The Pace of development of the banking industry in Hong Kong started to accelerate at this time. The political uncertainty in China forced many industrialists and workers to move to Hong Kong. Both the industrial base and population size increased dramatically. The demand for banking services became much stronger, and local banks prospered in response to the increasing business opportunities. By 1962, there were already 87 licensed banks operating in Hong Kong.
The rapid increase in the nurnber of licensed banks, coupled with the lax banking regulations. gave rise to problems. Facing keen competition, the srna11 local banks stmggled to attract more deposits by offering higher interest rates and opening more branches. They also extended loans to the investors of stock market and real estates without careful screening of the applications. The liquidity of some banks was negatively affected. Consequently, a bank run occurred on the Liu Chong
Hing Bank in 1961. In 1965, an even more serious bank run took place. Two small banks, Ming Tak Bank and Canton Trust and Commercial Bank collapsed. Hong
Kong depositors quickly lost confidence in banks. particularly the small local banks, and rushed to withdraw al1 of their deposits fkom these banks. The panic reached a climax when the most successful Local Chinese bank. Hang Seng Bank, was faced with a similar bank run even though it was fmancially sound. The cnsis
\vas resolved soon after HSBC acquired a major interest in Hang Seng Bank and provided adequate liquidity for the depositors' withdrawals. Since then, many smaller local banks have sought capital injections fiom foreign banks. In the 1970s, another trend appeared in Hong Kong's banking industry. Hong
Kong had become used to having one type of bank - the Licensed Bank (LB). In
1970, a couple of foreign merchant banks exploited a Ioophole existing in the
Banking Ordinance to establish small finance companies which only took short- term time deposit f?om the public. In view of the huge profits that could be derîved from this type of operation, many local finance companies emerged. To remove the loophole, the Deposit-Taking Companies Act was passed in 1976. This required the registration of al1 depository institutions and brought the govemment's supervision of the finance companies more in line with that of the
LBs. The registered finance cornpanies were called Deposit-Taking Companies
(DTCs), which were allowed to take deposits of any rnaturity but of an amount not less than HK$ 50.000 for each account. They had to have a minimum paid-up capital requirement of HK$ 2.5 million. Unlike the LBs, the DTCs were not subject to the interest rates laid down by the Hong Kong Association of Banks.
They. thus, were able to take away substantial deposits fkom the LBs. To protect their deposit base. many LBs also set up their own DTC subsidiaries. From
December 1978 to March 198 1, the share of DTC within the total deposit base increased from 15 to 33 per cent. As a result of pressure fiom the LBs, a three-tier banking system was established in 1981. Under this system, the DTCs were divided into "licensed" and
"registeredo', with the LBs situated at the apex of the system. The LBs could take deposits eom the public for any arnount and for any maturity term. The Licensed
DTCs could take time deposits for HK$ 500,000 or more without restriction on matunty. while the Registered DTCs could only take time deposits for not less than HK$ 50,000 with a matunty tetm not less than three months. The effect of this new system was that depositon having surplus cash of more than HK$ 50,000 but less than HK$ 500.000. who wished to place their deposits on cal1 or on a short-term bais had to switch them from the DTCs to the LBs (KPMG Peat
Marwick, 1994, 3). AAer the introduction of the new system, the DTCs suffered a substantial loss of their deposits to the LBs.
With an eroding deposit base. the DTCs struggled to survive by borrowing hnds from the inter-bank market and undertaking hi&-rkk lending to real estate and stock market speculators. A number of DTCs without parent LBs to support them became insolvent. In addition, some mismanaged LBs Ied to another banking crisis between 1982 and 1986. Three main reasons accounted for this crisis (ho. 1988): [mpnident management or even hud was committed by the directors or
managers of the LBs or DTCs.
There was a general economic recession. a political crisis. and a rapid faIl in
property prices and the Hong Kong dollar exchange rate.
The banking regulations at that time were too lax and inadequate to handle a
banking system that \vas expanding at such a rapid pace. Some of the
government officiais were also not well equipped to supervise the LBs and
DTCs.
During this crisis. several DTCs collapsed and the govemment had to take over three banks - Hang Lung Bank. Overseas Trust Bank and Hong Kong Industrial
Commercial Bank. The govemment also supplied funds to rescue other banks in financial difficulty including Ka Wah Bank, Union Bank. Wing On Bank and Hon
Nin Bank. After this crisis. the government managed to sel1 the acquired banks to investors fkom Mainland China and other countries.
Learning from this. the government took a strong initiative to review the banking legislation and supervision system in Hong Kong. By the end of 1989. the eovemment had introduced international standards on capital adequacy C requirements. Al1 LBs and DTCs were requued to make provisions against their risk-weighted exposures, and this brought Hong Kong in line with the standards laid down by the Bank of International Settlement on Capital Adequacy. Another change took place in 1990 when the three tier system was restructured. The
Licensed DTCs and Registered DTCs were replaced by the Restricted Licensed
Banks (RLBs) and Deposit-taking Companies (DTCs), respectively. This arrangement aimed at improving the status of the Licensed DTCs, in order to facilitate their business expansion, especially in international banking.
Another historical move for Hong Kong's banking system was the establishment of the Hong Kong Monetary Authority (HKMA) in 1993. The HKMA plays the role of a central bank in which prudential supervision of the commercial banks is one of its main objectives. Details of the HKMA are also discussed in this Chapter.
Even although Hong Kong had experienced two major banking crises. the banking industry in Hong Kong still developed rapidly. At the end of 1996. there were 182
LBs, 62 RLBs and 124 DTCs in the region. 3.2 Hong Kong as an International Financial Centre
Hong Kong has long been considered an important financial centre in Asia. Jones
( 1992) suggests that Hong Kong was only a subregional Fiancial centre during the period of 19 19-65?which mainly facilitated the bilateral trade between Hong Kong and another economy in the region. From 1966 onwards. Hong Kong has emerged as a regional financial centre which provides comprehensive financial services to the whole region. According to Jones, Hong Kong is not a global financial centre which provides a wide range of services to the whole world. Only London, New
York and Tokyo can be viewed as global financial centres.
Jao (1997) gives a much more detailed account of Hong Kong's status in the international financial arena. He suggests that Hong Kong is the second largest international banking centre in the world, in terms of the number of foreign banks and the fourth largest in terms of the banks' foreign assets. Hong Kong is also the worldk fourth largest loan syndication centre' and the fifth largest foreign exchange trading centre. A summary of the rankings of Hong Kong as an international financial centre is provided in Table 3.1. Table 3.1 Ranking of Hong Kong as an International Financial Centre, 1995
Categorïes Asio-Pacific Worid Ranking Ranking Banking: Number of foreign banks Banks' foreip assets Banks' foreign üabilities Cross-border interbank claims Cross-border interbank liabilities Cross-border credit to non-banks Syndicated loans and note-issuing facilities (NIFs) (1994)
Fora market: Net daily turnover
Derivatives market: Net daily forex contract turnover Net interest rate contract turnover Overall
Stock market: Market capitalization Value traded Number of listed domestic companies Source: Jao, ( 1997.54).
Instead of going through the performance of each financial market in Hong Kong. this chapter focuses on the region's performance in commercial banking. The participation of foreign banks is very active in Hong Kong. Table 3.2 gives the statistics of the foreign banking institutions in Hong Kong during 1992- 1996. Table 3.2 Authorized Banking Institutions in Hong Kong: Domicile and Parentage
1992 1993 1994 2995 1996 LICENSED BANKS (i) Incorporated in Hong Kong 30 32 32 31 3 1 (ii) Incorporated outside Hong Kong 134 140 148 154 151 Total 164 172 180 185 182
RJBTRICTED LICENSED BANKS (i) Subsidiaries of licensed banks incorporated: (a) in Hong Kong 3 3 -3 2 -7 (b) outside Hong Kong 13 16 15 16 15 (ii) Subsidiaries of branches of foreign 27 29 36 35 34 banks which are not licensed in HK (iii) Bank related 10 7 7 7 8 (iv) Others 3 3 3 3 3
DEPOSIT-TAKING COMPANIES (i) Subsidiaries of licensed banks incorporated: (a) in Hong Kong 6)outside Hong Kong (ii) Subsidiaries of foreign banks which are not licensed in Hong Kong 37 34 33 33 32 (iii) Bank related 12 11 11 9 7 (iv) Others 19 15 15 15 14 Total 147 142 137 132 124 ALL AUTHORIZED INSTITUTIONS 367 371 380 380 368
LOCAL REPRESENTATIVE OFFICES Source: HKMA Annual Report. 1996. Generally, the number of LBs has risen by around 10 per cent in the past 4 years.
There was a slight increase in the number of RLBs firom 56 to 62. However, the
DTCs dropped by nearly 16 per cent. This indicates that the DTCs have already lost their attractiveness due to the legal restrictions placed on the type of business in which they cm engage.
Foreign institutions corne from a wide range of countries. Table 3.3 gives a snapshot of the distribution of the authorized institutions. As economic superpowers, the USA and Sapan take the lead. Due to its geographical and cultural proximity. Mainland China also has a lot of banks in Hong Kong.
The extent of internationalization of Hong Kong's banking industry can be reflected by the number of international banks operating in Hong Kong. It is a logical assumption that the international banks should be larger in size. As shown in Table 3.4, Hong Kong indeed enjoys a strong presence of world's largest banks.
Of the top 20 banks in the world, 19 had set up operations in Hong Kong by 1996. Table 3.3 Authorized Banking Institutions in HK: Country/Re@on of Beneficial Owoership Licensed Banks
ASIA & PACIFIC Hong Kong Australia China India Indonesia Japan Malaysia New Zeaiand Pakistan Philippines Singapore South Korea Thailand Taiwan Vietnam Su b-total 106 110 110 EUROPE Austria BeIgium Denmark France Gerrnany haly Netherlands Nonvay Republic of Ireland Spain Sweden Sw i tzer land United Kinrrdom- 7 7 Sub-total 52 51 50 NORTH AMERICA Canada 666 United States 14 16 14 Sub-total 20 22 20 South Africa - - - Bermuda - - - Others 22&7 GRAND TOTAL 180 185 182 - - Source: HKMA Annual Report 1996. Table 3.4 Presence of World's Largest 500 Banks in Hong Kong
World Ranking
Total 310 31 1 329 337 334
Source: HKMA Annual Report, 1996.
Hong Kong3 banking system is highly extemal-oriented. Table 3.5 provides information about the extemal liabilities and claims of Hong Kong's banking system. It shows that extemal liabilities accounted for 62 per cent of the total liabilities during 199 1- 1995. During the same period, the extemal claims were on average 67 per cent of the total daims (Jao. 1997,48). Tabte 3.5 External Liabilities and Claims of Hong Kong's Banking System (HK$ million)
Liabilities to banks outside CIaims on banks outside Hong Kong Hong Kong
As at end of HKS FC HK$ FC 1991 125,421 3,234,165 45,127 2,403,373 (2.2%) (57.5%) (0.8%) (42.8%)
Liabilities to non-bank CIaims on non-bank customers outside Hong customers outside Hong Kong Kong As at end of HKS FC HKS FC 1991 15,989 2 18,420 15,356 1,15 1,522 (0.3%) (3.9%) (0.3%) (25.8%)
(0.4%) (6%) (0.3 %) (29.6%) Source: Jao (1996,47). Note: FC = foreign currency Based on its extemal orientation, Hong Kong is also a syndication loan centre.
Table 3.6 shows the loans to non-bank customers from Hong Kong's banking system fiom 1992 to 1996. Loans made to non-bank customers outside Hong Kong accounted for an average of 55.8 per cent of the total loans during this period.
These loans nonnally are arranged in the form of a syndicated type by the international banks, in order to finance large-scale projects in the Asia-Pacific region.
Table 3.6 Loans to Non-Bank Customers by Hong Kong's Banks
Inside Hong Kong 999 1,179 1,389 1,554 1,80 1 (40.4%) (4 1.3%) (42.5%) (4 1.6%) (46.0%)
Outside Hong Kong 1,421 1,626 1,819 2,129 2,052 (57.5%) (56.9%) (55.7%) (56.9%) (52.0%)
0thers
Total 2,470 2,857 3,265 3,739 3,9 13 (100%) (100%) (100%) (100%) (100%) Source: HKMA Annual Report 1996.
In parallel to the growth of syndicated loans, foreign exchange dealing rose by 50 per cent, fkom US$60 billion in 1992 to US$90 billion in 1995. This ranks as the world's fifth-largest and Asia's second-largest market. Hong Kong's favorable time-zone location, fkeedom of capital, excellent communications and infkastmcture~ and the presence of numerous large multinational fuiancial institutions have contributed greatly to the growth of the foreign exchange market.
3.3 Significance of the Banking Industry to the Economy
As an international banking centre and a major financial centre. Hong Kong performs several fùnctions which, in turn, generate benefits for the economy.
Table 3.7 gives the total net claim position of the Hong Kong banking system with other countries and regions in 1995 and 1996. In this table. the positive net claim means Hong Kong as a net creditor to other countries, while a negative net claim means Hong Kong as a net debtor to other countries.
Hong Kong has long been a net creditor to the rest of the world. In 1996. Hong
Kong had a total net claim of HK$ 222 billion with the rest of the world. In general. Hong Kong obtained its largest net claim Eom the Asia-Pacific region. with a total of HK$ 70 billion in 1996. Japan took the lion's share of HK$ 354 billion. Hong Kong owed a lot to western Europe, with a total of HK$ 337 billion net liabilities in 1996. In a global economy, Hong Kong helps allocate funds from western Europe to the Asia-Pacific area. Ta bie 3.7 Geographical Breakdown of Net External CIaims/Liabüities of Hong Kong's Authorized Banking Institutions (HK% büiion)
RegionICountry Total Net Ciaims Total Net Claims (Lia bili ties) (Liabilities) ASIA & PACIFIC 647 701 Japan 345 354 South Korea 99 130 Thailand 107 117 China 63 60 Australia 47 51 New Zealand 33 20 Indonesia 20 17 Taiwan 26 9 India 8 7 Malaysia 5 5 Philippines (11) 2 Vanuatu (25) 1 Macau (19) (20) Singapore (51) (52) NORTH AMERICA 98 36 Canada 37 21 United States 61 15 WESTERN EUROPE (356) (357) Italg 14 11 Norway 2 2 Finland 1 Sweden Denmark Austria Switzerlmd Belgium Luxembourg Gemany France Netherlands United Kingdorn Others Source: HKMA Annual Report 1996. The banking industry in Hong Kong plays another important function by financing local economic development. Table 3.8 provides information of the total loans for use in Hong Kong, divided by economic sector, fiom 1992 to 1996. It shows that in the past four years, the total loans for use in Hong Kong has increased by 53% fkom HIC$ 1.179 billion to HIC$ 1.80 1 billion. In absolute terms. the loans to each economic sector Uicreased. although their shares of the total loans in each sector remained quite stable.
Table 3.8 Total Loans for Use in Hong Kong by Economic Sector
(HK$ billion) 1993 Secfor Hong Kong's visible trade
Manufacturing
Transport and transport equipment
Building, construction and property development. and investment
Wholesale and retail trade
Financial concerns (other than authorized institutions)
Individuals to purchase residential property
0th purposes
Others Total (a) 1179 100 L L (a) Includes rradefinancing foam but ercludes loans tojinance trade not rouching Hong Kong Source: HKMA Annual Report 1996. The banking industry in Hong Kong also generates various benefits for the local economy. Table 3.9 presents information about employment in the industry sector of -'financing, insurance, real estate. and business services" in selected years. This sector covers more than the banking industry. It is advisable to use this broadly defined financial sector since the banking industry is closely related to other industries in Hong Kong such as insurance and real estate.
Table 3.9 Employmeot in the Industry Sector: "Financing, Iosurance, Real Estate, and Business Services"
Employment 65,980 1 16,000 180,851 276,621 378,244 As % of total 3.5 5.0 6.9 10.0 12.0 Iabor force Source: Hong Kong Census and Statistics Department.
Table 3.9 shows that the employment in this sector rose by 5.7 times between 1975 and 1995. The financial sector is a growing industry in Hong Kong which has replaced its former mainstay manufacturing industry. Due to die economic reforrn that has taken place in Mainland China, most of the manufacturing facilities in
Hong Kong have already been shifted to the Mainland to benefit nom the lower costs in labor and land. In addition, the rapid economic development in the Mainland has created strong demand for foreign funding. Hong Kong has becorne a major loan centre which is used to transfer foreign fhds to fuiance projects in the Mainland. As a result, the demand for banking experts has continued to grow over the past hKO decades.
The financial sector has a relatively higher value-added compared with other industries. Table 3.10 shows the contribution to GDP by the broadly defined financial sector. The contribution of the financial sector to Hong Kongk economy increased by more than eight times during 1980-94. The share in the economy improved from 23 to 26 per cent. There were downfalls in the percentages in 1985 and 1990 as the property market and the banking industry were negatively affected by perceived uncertainty over the future of Hong Kong. When this pessimism cleared. it picked up again in the early 1990s.
Table 3.10 Contribution to GDP by the Industry Sector: "Financing, Insurance, Real Estate, and Business Services"
Year Amount (HKS million) % of GDP
1980 30,938 23.0 1985 30,739 16.0 1990 1 13,127 20.2 1994 248,750 26.1 1996 276,04 1 24.9 Source: Census and Statistics Department. Hong Kong's evolution to an international banking centre and a major fmancial centre also contributes to its economic growth through other --chah effects.?' Jao
( 1997,79) suggests the followings:
"In the presence of a large number of domestic and international competing
banks, entrepreneurs can more easily obtain credit. and at better terms than
would othenvise be the case.
Virtually any entrepreneur with a sound and viable project can obtain the
necessary financing, which may be denominated in Hong Kong dollars or any
other major currency.
The intemationally active banks, with their worldwide nehvork and superior
techniques. can easily tap the Euro-currency market or the Asian-dollar market
to fund any project in Hong Kong, especially those which are so huge as to be
beyond the capability of local banks."
Hong Kong certainly has to bear the costs of being a major financial centre. The regulatory costs required to exercise prudent supervision over the financial institutions and maintain the efficiency and faimess of the financial markets are substantial. The HKMA's operating expenses in 1993 were HK$ 248 million. In 1997. these increased to HK$ 745 million. The number of staff also rose fkom 469 to 5 16 between 1995- 1997. There are also other supervisory agencies that rnonitor each of the major financial markets, such as the Securities and Futures
Commission which oversees the stock market and the Ofice of the Comrnissioner of Insurance which oversees the insurance industry.
Other costs include the expenses that are necessary to prevent money laundering activities. "Cosmopolitan Hong Kong is recognized as supporting a variety of local and international illegal activities that require financing and produce cash flows that require laundering and placement (Hinkelman, 1994.209)." Costs are incuned to combat potential money laundering activities. Jao (1997) estimates that the staff costs of the law enforcement agencies that deal with money laundering activities were about HK$20 million in 1995. CHAPTER 4 THE CENTRAL AND COMMERCIAL BANKING IN HONG KONG
4.1 Hong Kong Monetary Authority
Before 1993, there was no central bank in Hong Kong. The central bank functions were per60nned by bvo govemment agencies and the leading commercial banks especially the Hong Kong and Shanghai Banking Corporation (HSBC). The legal tender notes were initially issued by two commercial banks: HSBC and the
Standard Chartered Bank. The Bank of China was ganted the right to issue Hong
Kong notes in 1995. HSBC was also the principal banker to the government and the management bank of the bankers' clearing house. The monetary policy was largely formulated by the Monetary Affairs Branch of the Hong Kong
Governrnent, which was also mandated to manage the Exchange Fund - Hong
Kong's foreign reserve. The Exchange Fund was also supposed to play the role of lender of 1st resort. but in practice, HSBC played the de facto role. The prudent supervision of the depository financial institutions was exercised by the Office of the Commissioner for Banking (Jao, 1988, 155). Therefore. no single institutional body had a mandate to take charge of Hong Kong's overall monetary affairs. 38 The Hong Kong Monetary Authority (HKMA) was established in 1993 by merging the Office of the Exchange Fund with the Office of the Commissioner for
Banking. The HKMA is the central bank in Hong Kong in al1 but narne. The primary objective of the HKMA is to maintain currency stability. This objective is specified in the Exchange Fund Ordinance 1992 which gave birth to the HKMA.
The fùnctions of the HKMA are as follows (HKMA Annual Report 1993):
To maintain currency stability within the framework of the linked exchange rate
systern,' through sound management of the Exchange Fund, rnonetary policy
operations and other means deemed appropriate;
To ensure the safety and stability of the banking system through the regulation
of banking business and the business of taking deposits, and the supervision of
authorized institutions;
To promote the eficiency, integrity and development of the financial system,
particularly payrnent and settlement arrangements.
Unlike other central banks, the HKMA does not perfom the following functions:
Note Issue
It is a long term practice that Hong Kong's legal tender notes are issued by the commercial banks. Currently, there are three note-issuing banks - HSBC, the
' Hong Kong's Iinked exchange rate system is basically a currency board system under which bank notes art: issued and redeemed against the US dollar at a fvced rate. 39 Standard Chartered Bank and the Bank of China. The note issue arrangement will be discussed in greater detail in the forthcoming section.
Banker to the Government
The HKMA does not act as a banker to the govemment. The government uses the services of the commercial banks to handle its bank account transactions. The
HKMA is accountable to the Financial Secretary, who is advised by the Exchange
Fund Advisory Cornmittee (EFAC) of which the Financial Secretary is the
Chairman. The members of the EFAC include the Chief Executive Officers of the major banks, senior partners of the public accounting finns, and university professors.
Before the retum of sovereignty, a11 of them were appointed by the Govemor (now they are appointed by the Chief Executive of the Hong Kong Special
Administrative Region). They set guidelines under which the HKMA may invest the assets of the Exchange Fund and advise the Financial Secretary on the annual budget of the HKMA (HKMA Annual Report, 1993).
The HKMA is headed by a Chief Executive who is appointed by and is responsible to the Financial Secretary. There are five divisions of the HKMA, namely Monetary Policy and Markets, Reserves Management, Banking Policy, Banking
Supervision and Extemal Division. The HKMA is considered "an integral part of the Government. but is able to employ staff on terrns different fkom those of the civil service in order to attract personnel of the ri@ expertise and expenence"
(HKMAAnnual Report, 1993). The Chief Executive and other staff members of the HKMA remain as public officers.
Unlike the central banks in many developed countries, central bank independence is not an issue for discussion in the banking cornrnunity in Hong Kong. To a large extent the HKMA has not been very independent at the outset. The institutional arrangement of the HKMA came fiom the merging of nvo government agencies.
The former heads of these govemment agencies have become the heads of the
HKMA. For instance, the Commissioner for the Office of the Exchange Fund was appointed as Chief Executive of the HKMA while the Commissioner of Banking became the Deputy Chief Executive. Most of the current senior management of the
HKMA are former senior oficials of the governrnent. In addition, the HKMA is accountable to the Financial Secretary who appoints the Chief Executive of the
HKMA and chairs the EFAC. In fact, Section 5A of the Exchange Fund
(Amendment) Ordinance 1992 specifies that the HKMA is established to assist the
Financial Secretary in the performance of his functions under the Exchange Fund Ordinance. Therefore, there is a high degree of policy integration between the government and the HKMA.All-in-dl. the HKMA can be viewed as an executive arm of the government to formulate and irnplement monetary policy under the instruction of the Financial Secretary.
There are a number of reasons why central bank independence is not popular in
Hong Kong. First, the main purpose of centra1 bank independence is to shield the central bank tiom fmancing any of the government's inflationary policies. Since
World War II. the Hong Kong government has pursued a conservative fiscal policy. There have been only three fiscal years during which the govemment ran up a budget deficit since 1966. During these years, it retained a huge surplus, and the government debts were insignificant. The Hong Kong Govenunent has often been criticized for by the grassroots groups as a "miser'? which refises to implement a better social security safety net, however, it has succeeded admirably
in accumulating wealth for Hong Kong. By the end of 1996. the accumulated fiscal surplus stood at HK$ 170 billion. With this abundant fiscal surplus, the HKMA is under no pressure to finance the govemment's budget.
Second, and as a related issue, central bank independence is mainly intended to fight inflation. However, fighting inflation is not the principal objective of the HKMA. Its main duty, as stipulated in the Ordïnance, is to maintain currency stability. The Hong Kong dollar has ken pegged to the US dollar at the rate of
HK$ 7.8 = US$ 1.0 since 1983. The HKMA is endeavoring to defend this exchange rate by using the Exchange Fund.
Last but not least. to make a central bank independent is a means to protect that central bank from political forces which are concemed only with the short term benefits of their constiniencies. This argument is not applicable to Hong Kong.
Although enjoying a good deal of fieedom, Hong Kong does not possess a genuine western-style democratic system. It was a British colony before July 1997. but the government structure has remained more or less the same after July 1997. The
Chief Executive of the Hong Kong Special Administrative Region was elected by four hundred people who were appointed by Beijing. The major government officials, who are responsible for policy formulation, are largely civil servants. The power of the legislature is limited, and there is no majority party which cm claim dominance in the legislature. In light of this political environment, the govemment does not necessarily concede to the demands of any political forces. The govemment including the HKMA has a high degree of freedorn to develop and execute the monetary policy that it considers appropriate. 4.2 Monetary Poiicy
The monetary history of Hong Kong tends to suggest that Hong Kong prefers to control the value of currency instead of its supply. Until 1935, the Hong Kong dollar was allied to a silver standard. Due to the increasing value of silver. the
Hong Kong dollar was pegged to the British pound sterling under a currency board system in 1935. The note-issuing banks had to pay the Exchange Fund in sterling at a fixed rate in retum for a Certificate of Indebtedness (CI) corn the governrnent.
This peg was changed to the US dollar in 1972, and the note-issuing banks were not required to pay US dollars in exchange for a CI. instead. they credited the account of Exchange Fund with the amount of Hong Kong dollars they had issued.
In 1974, the fixed exchange rate system was replaced by a floating one as the continuous weakening US dollar created too much strain on maintaining the HK -
US dollar parity. At that tirne. Hong Kong was very close to a Free banking scenario. There was no formal institution to regulate the supply of Hong Kong dollar. nor the exchange rate. The exchange value and the quantity of Hons Kong dollars available were left to the market mechanism. However. this experience kvas not a happy one. In 1983. the Chinese and British govermnents started to discuss the friture status of
Hong Kong. News spread widely that no agreement could be reached by either govemment due to their opposing standpoints. Losing confidence in the future of
Hong Kong, the value of the Hong Kong dollar dropped from around HK$ 6 =
US$ 1 to HK$ 9.6 = US$ 1 at its lowest peak in September 1983. The linked exchange rate system was thus reintroduced in October 1993.
The new system is again a currency board system under which the note-issuing banks have to pay the Exchange Fund in US dollars at a fixed exchange rate of
HK6 7.8 to US$ 1 for the bank notes they have issued in exchange for the CIs.
Under this mechanism. an increase in HK$ 7.8 in circulation is matched by a US dollar payment to the Exchange Fund. and a decrease in HK$ 7.8 in circulation is matched by a US dollar payment fiom the Exchange Fund.
The linked exchange rate system is, by and large. working under the arbitrage mechanism in which the HKMA does not necessarily interfere to maintain the linked rate. Arbitrage occurs when the market rate is over HK$ 7.8, and banks then find it profitable to buy US dollars with Hong Kong banknotes from the HKMA at the official rate of HK$ 7.8 and resell them on the open market. If the market rate is below HK$ 7.8, banks will buy US dollars in the open market and sel1 them to the HKMA. These arbitrage activities can thus force the market rate to move close to the official rate.
The HKMA sometimes has to intervene in the market in order to protect the linked exchang rate fiom speculation. For instance. when the inflow of foreign capital tends to push up significantly the Hong Kong dollar. the HKMA may intercede by selling Hong Kong dollars in the money market, and the vice versa.
To ensure that the principal objective of maintaining exchange rate stability is effectively delivered, the govenunent has found it necessary to have some tools in place with which it cm act against possible negative impacts on the linked exchange rate system. In 1988, the -'New Accounting Arrangement'' was introduced to strengthen the government's control over the level of interbank liquidity and thus interbank interest rates. Under the old practice, the clearing bank
(HSBC) could manipulate the net clearing balance to influence inter-bank liquidity and thus interest rates. The new arrangement requests HSBC to hold an account with the Exchange Fund which bears no interest. If the net clearing balance of other banks at HSBC exceeds the value of the HSBC account at the Exchange
Fund. penalties will be levied on HSBC (Luk 1995, 34). The "New Accounting
Arrangement'? was however replaced by the Real Time Gross Senlement system in 1995 under which al1 licensed banks settle directly with other licensed banks and
HSBC ceased to be the clearing bank.
To strengthen its capability in open market operations, the govemment issued debt secunties in 1990. The Exchange Fund Bills and the Exchange Fund Notes were
issued in 1990 and 1993 respectively, and these served as the short-term and
longer-term debt securities. Unlike govemment debts Ui other countries, the Hong
Kong govemment debts are used for monetary management rather than budget purposes. They are used as an instrument to affect market liquidity and interest rates.
In 1992, the Liquidity Adjustment Facility (LAF) was introduced. The LAF is the
Hong Kong version of a discount window. By setting the --offer and bid" rates, the
LAF allotvs banks to borrow or deposit funds with the Exchange Fund. It enables banks to make late adjustments to their liquidity position. Since the offer and bid rates of the LAF stand for the ceiling and floor of the ovemight interbank interest rate, the HKMA can influence interbank interest rates directly by changing the
LAF rates (HKMA Annual Report, 1996,27). The Hong Kong Govemment does not intend to change the linked exchange rate system despite the change of sovereignty. From the experiences of the early 1980s. the government has learnt that as a small open economy without capital control.
Hong Kong is vulnerable to unanticipated changes in the monetary policies of the major powers which cause volatile fluctuations in interest and exchange rates. and thus have a destabilizing effect on the Hong Kong economy. The "ope~ess"of
Hong Kong's economy suggests that stability in the exchange rate is beneficial to
Hong Kong's overall economic development.
By gaining control of the exchange rate, Hong Kong loses its autonomy over money supply and interest rate. Hong Kong's economic adjustment now falls on the changes of interest rate and money supply. When there is an outflow of capital due to the balance of payments deficit, a contraction of money supply and a higher interest rate will occur. The extemal equilibrium will be restored when the higher interest rate attracts an inflow of funds to offset the original outflow of capital. discourages domestic demand and imports, and improves export competitiveness.
By the sarne token. a balance of payment surplus will increase money supply and lower the interest rate. Al1 things being equal, an increase in money supply and a lower interest rate will lead to a higher rate of inflation. This will cause an outflow of capital, encourage imports and erode export competitiveness, and ultimately restore extemal equilibrium.
The linked exchange rate system certainiy has its downside. It severely lirnits the policy options of the HKMA. The monetary policy of Hong Kong mut shadow that of the US which makes it dificult to control inflation. The HKMA cannot use the interest rate as a tool to fight inflation as interest rate changes may make the exchange rate deviate significantly fiom the officia1 yardstick. Any significant exchange rate differential from US$ 1 = HK$ 7.8 will be matched by an interest rate differential. For instance, when the US interest rate fell to a historical low in
1992-93, Hong Kong had negative interest rates for more than three years
(Economist Intelligence Unit, 1996. 12).
4.3 Commercial Banking
4.3.1 Legal Framework
The HKMA is expected to exercise prudent supervision of the banking system. It must "ensure the safety and stability of the banking system through the replation of banking business and the business of taking deposits, and the supervision of authorized institutions (HKMA Annual Report, 1993)." Accordingly, the HKMA is the licensing authority for the authorization, supervision and revocation of al1 types of banks. The authorization criteria seek to ensure that only fit and proper institutions are enaisted with public deposits. It also performs continuous supervision of the banks through on-site examinations and off-site reviews. In supervising banks. the HKMA follows international practices as recomrnended by the Basle Cornmittee on Banking Supervision, such as. the capital adequacy fiamework, and minimum standards for the supervision of international banking groups. The "CAMEL" rating system (Capital, Asset quality. Management.
Earnings and Liquidity) is adopted to help identi@ those institutions which are deficient in financial condition, compliance with laws and regulations and overall operating soundness (HKMA Annual Report. 1996).
Under current remlations.Cr Hong Kong maintains a three-tier system of banks. namely, licensed banks. restricted licensed banks and deposit-taking companies.
These banks operate in Hong Kong as either locally incorporated companies or branches of foreign banks.
I. Licensed Banks (LBs): Only this type of bank may operate current and saving
accounts. and accept deposits of any size and maturity. By the end of 1996.
there were 182 LBs operating in Hong Kong; 16 of them were domestically
incorporated institutions, while the remaining 166 were foreign institutions. LBs must have minimum capital of HK$ 150 million. Local candidates must hold
public deposits of at least HK$ 1.75 billion.
II. Restricted Licensed Banks (RLBs): These are primarily engaged in merchant
banking and capital market activities. They may take call. notice or time
deposits of any maturity and in amounts of HK$5OO,OOO or above. By the end
of 1996. 62 RLBs were operating in Hong Kong. Domestically incorporated
RLBs must have minimum capital of HK$ 100 million. They must also meet
standards of acceptability of ownership, quality of management and adequacy of
supervision. as determined by the HKMA. Foreign institutions wishing to
register as RLBs must meet the same requirement.
Table 4.1 The Three-tier Banking System of Hong Kong
Licensed Banks RLBs D TCs Local Foreign Minimum capital HK$ 150 HK$ 150 HK$ 100 HK$Z million million million million Deposit base HK$ 1.75 not required not not required billion required Total assets HK$2.5 US$I4 not not required billion million required Deposit mirrimum none none HK$500 HK$ 100 thousand thousand Maturiîy restrictions none 3 months on deposits Ejrperience 10 years as a negotiable negotiable negotiable DTC Interest allo wed HKAB rates HKAB rates Liquid 25% 35% Capital adequacy- - 8% 8% 8% 8% Source: HKMA Annuai Report 1996. 1II.Deposit-Taking Companies @TCs): These are mainly owned by or othenvise
associated with banks and engage in a range of specialized activities, including
consumer finance, trade finance or securities business. These companies are
restricted to taking deposits of HK$ 100,000 or above with an original term to
maturity of at least three months. By the end of 1996, there were a total of 124
DTCs. The minimum capital requirement for DTC is HK$ 25 million. At least
50 per cent of the equity must be owned by a licensed financial institution.
Al1 of the authorized institutions have to satisfi the minimum Iiquidity ratio of 25 per cent and capital adequacy ratio of 8 per cent. A summary of the regulations on the authonzed institutions is given in Table 4.1.
4.3.2 Starus of Foreign Banks
Hong Kong offers no major barriers to foreign banks. Foreign banks receive the same treatment as their local counterparts in which they are also classified under the three-tier system. Against this background, 8 1 of the world's 100 largest banks are represented in Hong Kong in 1996. Foreign banks in Hong Kong held more than a half of total deposits in 1996. The Bank of China Group (it is considered a foreign bank) accounted for the largest share (23 per cent of total deposits), followed by the Japanese banks (14.6 per cent), European banks (1 1.3 per cent) and US banks (5.7 per cent). Foreign banks are also the major suppliers of loans and advances to custorners in Hong Kong. The Japanese banks accounted for around 55.6 per cent of total loans and advances, followed by European banks
(10.5 per cent), and the Bank of China Group (9 per cent) in 1996.
The only real restriction on the foreign banks that does not apply to the domestic banks is the "one-office bank'? policy. Foreign banks licensed before 1978 are fkee to open as many branches as they wish throughout the territory. However. the later registrants are now limited to a single oflice. The government's intention is to reduce cornpetition in retail banking. A foreign bank which desires to develop retail banking can do so by acquiring an existing bank which was established before 1978. Many foreign banks have acquired substantial interests in the local banks for this reason.
Foreign banks seeking to operate as authorized institutions can apply as either separate, incorporated. wholly-owned subsidiaries or as branches of the parent entity. Subsidiaries must bring in adequate capital to meet Hong Kong's requirements. Branches can count the parent bank's capital towards the satisfaction of the minimum capital requirernent and need only have adequate working capital in Hong Kong. In addition, foreign banks must be licensed at a comparable level in
their home countries, and home regulatory standards must meet those established
by the Basle Cornmittee on Banking Supervision. It is also expected that some
forms of reciprocal authorïzation must be made available for Hong Kong-based
banks to operate in the foreign banks' home jurisdiction (Hinkelman, 1994,203).
In general, Hong Kong provides a very open environment for foreign bah. In
most cases, the banking regulations and requirements of Hong Kong are less
stringent than those which the foreign banks are accustomed to in their home jurisdictions. The rules are applied evenly and do not discnminate betrveen local
and international institutions. A foreign bank can enter the Hong Kong market as
long as it has adequate capital. Therefore, there is no entry problem in Hong
Kong's banking industry.
In addition, Hong Kong does not impose any control on foreign exchange. and the
government does not require the disclosure of any information on cross-border
reminances of any size. The following are examples showing the fieedom of
foreign exchange Bows (The Economist Intelligence Unit, 1996, 14): There is no limitation on direct investment or on the amount of equity a foreign
company may take in a local company.
There is no restriction on foreign investment in the Hong Kong stock market,
and foreign investors can invest directly in the stock and bond market.
Residents and non-residents borrowing fkom abroad face no restrictions, and
approval for transaction is not required.
No restrictions are imposed on capital repatriation.
There are no limitations or restrictions on the remittance of interest and
principal on foreign loans.
There are no restrictions on foreign currency held locally by residents or non-
residents or held abroad by non-residents.
4.3.3 Major Banking Croups
The Hong Kong banking sector basically has the following features (Ho. 199 1.6):
It is highly intemationalized.
The deposit market is relatively segmented and heavily dominated by the
licensed banks.
The domestic market is quite oligopolistic, heavily dominated by several
banking groups such as HSBC and the Bank of China Group. In a society which is predominantly Chinese, there are however relatively few
purely local Chinese-owned banks.
In Hong Kong commercial banks can be divided into the following six major groups :
The Hong Kong and Shanghai Banking Corporation
The BankofChinaGroup
Local banks
Japanese banks
US banks
European banks
Hong Kong and Shanghai Banking Corporation (HSBC)
HSBC was founded in 1864 by a group of British and foreign businessrnen in
Hong Kong. Of al1 the British overseas banks. it is the only one that initially set up a headquarters building in Hong Kong. The fàmiliarity of its management with the local market enabled it to outperform other foreign cornpetitors and it built up a special relationship with the Hong Kong Govemment as well as loyalty frorn the local business community. By the turn of this century, HSBC had become the dominant bank in Hong Kong. In the 1950s, HSBC has started its global expansion. In 1965, it acquired Hang Seng Bank, the largest local Chinese bank at that time. In the 1980s, it acquired the Marine Midland Bank in the USA and the
Bank of British Columbia in Canada and renarned this the Hongkong Bank of
Canada. The major acquisition was achieved in 1993 by obtaining the controlling stake of Britain's Midland Bank which made HSBC as one of the top ten commercial banks in the world. Today, HSBC is a global financial conglomerate that comprises a wide array of financial institutions.
HSBC is however not only a commercial bank. Before the establishment of the
HKMA in 1993. it enjoyed a quasi-central bank status by virtue of its special relationship with the Hong Kong Government. Currently. it is still the principal note-issuing bank, and regularly accounts for the production of 80 per cent of legal tender notes. and is the principal banker to the govemment. The dominant status of
HSBC is commonly regarded by the local Chinese banks as the result of the Hong
Kong Government's patronage. It is predicted that the pnvileges now enjoyed by
HSBC will diminish due to Hong Kong's retum to China.
Information about HSBC's proportional share of the total assets. deposits and loans in Hong Kong's banking system is not available. It is, however. expected that it takes a lion's share of the "other'' column as shown in Table 4.2. The Bank of China Group (BOC)
The BOC has a long presence in Hong Kong. Before the Chinese economic refonn. its activities were quite limited. Since 1978. the BOC has become more outward looking and aggressive in its business policies and strategies. Under the leadership of the People's Bank of China. the BOC specializes in international trade and finance. Apart f?om traditional services such as deposit-taking, lending and renminbi (China's currency) remittances. it is now expanding actively into new areas such as syndicated loans, securities trading and brokerage. foreign currency deposit. credit card, persona1 and customer loans. With its Mainland
China capital background. the BOC enjoys a strong comparative advantage in
China-related businesses.
The BOC is currently the second largest banking group in Hong Kong in tems of branch network. Table 4.2 shows BOC's position in the banking industry of Hong
Kong. Its share of total customers' deposits improved Eom 22.7 per cent to 23.1 pcr cent during 1992-96. Its total assets in Hong Kong and total loans to customers also rose fiom 9.2 per cent to 11 per cent and 7.9 per cent to 9.1 per cent. respectively in the same period. BOC's role in Hong Kong will be further discussed in Chapter 5. Table 4.2 Distribution of Assets, Deposits and Loans in Hong Kong's Banking System (HK$billion)
1992 Assets % Deposits % Loans % China 530 9-2 34 1 22.7 195 7.9 Japan 3,150 55.0 179 11.9 1.531 63.0 US 303 5.3 118 7.9 101 4.1 Europe 679 11.8 202 13.4 220 8.9 Others 1,070 18.7 663 44.1 424 17.1 Total 5,732 1 O0 1,503 100 2,471 1 O0
1996 Assets % Deposiis % Loans % China 870 11.0 563 23.1 354 9.1 Japan 3,516 44.5 355 14.6 2,177 55.6 US 422 5.3 138 5.7 165 4.2 Europe 1,166 14.7 374 11.3 410 10.5 Others 1 -93 3 24.5 1.103 45.3 807 20.6 Total 7,907 100 2.433 100 3.913 1 O0 Source: HKMA Annual Report 1996.
Local Banks
This category is used to describe a large number of commercial banks and their subsidiaries owned and managed by ethnic Chinese in Hong Kong. Although their presence can be traced back to the late nineteenth century, none of these banks has been developed into a major bank due to their lack of capital and expertise. Moreover. the poor management of some of these banks caused two banking crises in Hong Kong during the mid 1960s and mid 1980s. A couple of local banks becarne bankrupt and eventually were taken over by HSBC, the BOC and the govemment. The remaining independent local banks are now mainly engaged in retail and onshore business with special emphasis on serving individuals and small to medium sized local companies.
European Banks
The European banks consist of banks from a large number of countries. In general. the principal banks from the UK. France. and Belgium arrived earlier than their
German. Swiss and Italian counterparts. Among members of this group. the
Standard Chartered Bank has the longest history in Hong Kong and can be traced back to 1859. It is one of the three note-issuing banks in Hong Kong and has the third Iargest branch network.
Some other banks of this group have also had quite a long presence in Hong Kong.
They include Banque Indosuez, Belgian Bank. and Algemene Bank Nederland.
Since most of the European banks came to Hong Kong after 1978, they are subject to the one-office rule. Except for the Standard Chartered Bank, their retail banking activities are therefore rather weak. They focus their businesses on the areas of wholesale banking foreign exchange and merchant banking. As shown in Table
4.2? the loans and assets of the European banks increased from 1 1.8 per cent to
14.7 per cent and 8.9 per cent to 10.5 per cent. respectively during 1992-96, but the customer deposits dropped fkom 13-4 per cent to 1 1.3 per cent. This indicates that the deposit bases of the European banks have been eroded by other banking groups. in particular the Japanese.
US Banks
In 1996, there were 14 US licensed banks, 11 restricted licensed banks and 7 deposit-taking companies in Hong Kong. Among thern. only the Citibank and
Chase Bank are more active in retail banking. Normally. they are prominent in syndicated loans. made finance and foreign exchange. They specifically target high-net-worth individuals. The Chase Bank has successfully launched a Visa
Card business in Hong Kong which was separately listed in the Hong Kong stock market.
The US merchant banks are the major players in Hong Kong's investment banking business. They assist local companies in merger and acquisition. and equity and bond issues. They also expand their project finance activity into the infrastructure development in the region. For instance, Morgan Stanley has advised the Hong Kong Government on the financing of its new airport while Goldman Sachs' JP
Morgan. and Solomon Brothers have ail recently expanded their operations in
Hong Kong to prepare for their future development in China (The Economist
Intelligence Unit. 1996. 2 1).
As shown in Table 4.2, the loans and assets of the US banks were almost unchanged f?om 1992 to 1996 while the deposits dropped from 7.9 per cent to 5.7 per cent. The static and somewhat declining business of the US banks reffects the intensified cornpetition from other banking groups. It also indicates that the US banks tend to engage more in the non-traditional banking services such as investment banking business.
Japanese Banks
The Japanese banks are the largest national group in Hong Kong in terms of total assets. In 1996. there were 46 Japanese licensed banks. along with 11 restricted
Iicensed banks and 35 deposit-taking companies in Hong Kong. As with the US and European banks. they are not active in retail banking. In the 1960s and early
1970s, the main businesses of the Japanese banks were the booking and fùnding of loans. During the late 1970s and early 1980s, syndicated loans took a large proportion of their businesses due to strong demand for capital fiom the countries in this region. In the late 1980s. the Japanese banks expanded to the investrnent banking business. in particular securities undenvriting and treasury activities. In the 1990s. they are developing their focus on the market in Mainland China.
Table 4.2 indicates that both assets and loans of the Japanese banks declined kom
55 per cent to 44.5 per cent and 62 per cent to 55.6 per cent respectively dunng
1992-96. The deposits however increased nom 11.9 per cent ro 14.6 per cent in the sarne period. This increase in deposits may be the result of the expansion of the nurnber of Japanese banks in Hong Kong in the early 1990s. The decline in assets and loans may be due to the economic downtum in Japan over the past few years. tn 1996, Japanese banks still accounted for 55.6 per cent of total loans in Hong
Kong. However. this does not mean that the Japanese banks have dominated the loan market as they only use Hong Kong as an offshore booking centre to benefit from a tax advantage provided by the less stringent replations here. For the domestic loan market. other banking groups, particularly HSBC. should be the largest players. CHAPTER 5 BANKING SYSTEM IN MAINLAND CHINA AND ITS RELATIONSHIP WITH HONG KONG
5.1 Overview of Mainland China's Banking System
5.1.1 Pre-reforni System
Before 1978. the Chinese banking system was a monobank one. Almost al1 of
China's banking system was consolidated into a single institution - the Peoplek
Bank of China (PBC). Even although it was called a "bank?'. the PBC hnctioned as a department administered by the Ministry of Finance. There was no delineation between central and commercial banking functions. The PBC had a monopoly on the issuance of money. control of money supply. transaction clearing savings collections fiom individuals and enterprises, lending to commercial enterprises and representing the State Treasury (Jin. 1993. 140 and Reynold 1982. 26).
Virtually al1 banking transactions were handled by the PBC and its specialized banks such as the Agrïcultural Bank of China (ABC), the Bank of China (BOC) and the People's Construction Bank of China (PCBC). During this penod, alrnost no other national and comprehensive banking and financial ins tinition existed. The banking system was thus considered primarily a govemment agency. which was mandated to carry out monetary policies and to monitor state enterprises under the auspices of the government. The PBC had three main roles. The fmt was to effect the transfer of govemrnent budgetary allocations to the bank accounts of the state enterprises. Actually these transfers were gants rather than loans. Second. the
PBC made short term working capital available to the state enterprises according to the credit quota as designated by the government planning cornmittee. The PBC basically had no principles and criteria for lending except via the directions of the govemment. Third, the PBC performed the distinctive function of supervising and ensuring the proper implementation of China's National Developrnent Plans. Since
PBC's lending to the enterprises was directed by the govemrnent's budgetary allotments, the PBC was obliged to scnitinize the performance and activities of the enterprises as to the extent of their fuifilIrnent of the National Development Plan goals. The PBC's credit officers at provincial and district levels were required to ensure that financial requests of the enterprises conformed with the National
Development Plan. sometimes through the inspection of accounts and operations
(Reynold. 19 82,28).
5.1.2 Curreni System
In response to the economic reform of other sectors of the economy afier 1978, a comprehensive reform of the banking system was camed out through a senes of incremental steps. The broad objectives of the reform included the following (Lees and Liaw. 1996,39):
Strengthening the central bank with the responsibility of formuiating and
imp lementing monetary agencies;
Setting up unified and cornpetitive financial markets with strong, prudent
regulation and supervision:
Reforming the banking system so that existing state-owned banks operate on a
purely commercial basis;
Shifiing policy-based lending fiom commercial banks to newly created policy
banks,
Central Banking in 1984. the PBC was separated fiom the Ministry of Finance and designated the central bank of China. Since then, it has been responsible directly to the State
Council. To boost its central bank identity, the commercial banking fùnctions of the PBC were transfened to other specialized banks.
In 1995, the Central Bank Law was passed to assert the independence and responsibilities of the PBC. The Law confirmed PBC's legitimate control over the money supply and the fmancial system after decades of struggle arnong different government departments.
The fiinctions of the PBC as set out in Article 4 of the Law are as follows:
to formulate and implement monetary policies in accordance with the law:
to issue renminbi (RMB) and control its circulation;
to approve. supervise and administer financial institutions in accordance with
regulations;
to promulgate ordinances and niles conceming financial administration and
business;
to hold, administer and manage the state foreign exchange reserve and bullion
reserve;
to act as fiscal agent for the State:
to maintain the normal operation of payment, clearing and settlement system;
to be responsible for statistics, investigation analysis and forecasting for the
financial industry;
to engage in relevant international financial activities in the capacity of the
central bank of China. The Law also provides a range of monetary policy instruments for the PBC
(Article 22) which includes the following:
to require financial institutions to place a deposit reserve fimd at a required
ratio:
to fix the base interest rates;
to provide rediscount business for financial institutions with current accounts in
the PBC;
to provide loans for commercial banks:
to buy and sel1 state banks and other government bonds and foreign exchange in
the open market operation.
The PBC is also barred From financing the fiscal budget as laid down in Article 28-
29 of the Law:
The PBC may not provide the State with overdraft facilities and may not
directly subscribe to and underwrite State bonds and other bonds;
The PBC may not provide loans to local governments or govemmental
departments at any Ievel.
The PBC's policy is directed by a govemor and a number of deputy govemors.
The govemor is nominated by the Premier of the State Council, decided upon by the National People's Congress (the Parliament in Mainland China), and is appointed by the President of China. The deputy govemors are appointed and removed by the Premier of the State Council. Within the jurisdiction of the PBC. the govemor assumes overall responsibility for those who direct the work of the
PBC.
It is said that the independence of the PBC \vas strengthened after the promulgation of the Central Bank Law 1995. To test this statement. a simple index constnicted by Grilli, Masciandaro and Tabellini (199 1) is employed to measure the independence of the PBC. This index looks at 15 criteria covering a range of political and economic issues, and awards a mark of 1 if a criterion is satisfied. A high mark indicates a hi& degree of independence. and vice versa.
The criteria used to measure political independence are as follows:
1. The govemor is not appointed by the government.
2. The govemor is appointed for more than a five year tem.
3. Not al1 of the Board members are appointed by the govemment.
4. The Board is appointed for more than five years.
5. There is no mandatory participation of a government representative in the
Board. 6. There is no requirement for the govenunent to approve monetary policy
formulation.
7. There is a statutory requirement that the central bank pursues monetary stability,
at least as one of its goals.
8. There are legal provisions that strengthen the centrai bank's position in the
event of conflict with the govemment.
In the case of the PBC. the political independence level tends to be very low. It can only score for criterion 7. It cannot fulfil criteria 1 and 3 as the governor and other board members are appointed by the govemment. Neither cntena 2 and 4 are met as there is no provision on the duration of appointments in the Central Bank Law
1995. Criteria 5 and 6 cannot be fiilfilled as Article 12 of the Law States that --the
PBC shall establish a monetary policy cornittee whose fünctions. organization and working procedures shall be prescribed by the State Council and reported to the Standing Comrnittee of the Naiional People's Congress for the record."
Therefore. the monetary policy actually rests on the authority of the State Council rather than the PBC. The provision as suggested in Criterion 8 is also not included in the Law. The PBC only manages to score one mark in respect of political independence. There are seven criteria to measure economic independence in the index suggested by Grilli. Masciandaro and Tabellini ( 199 1):
1. The government does not have an automatic credit facility with the central bank.
2. When the govemment borrows frorn the central bank. it borrows at a market
interest rate.
3. Any borrowing fkorn the central bank is meant to be temporary.
4. Any borrowing fiom the central bank is subject to an upper limit.
5. The central bank does not participate in the primary market for govemment
debt.
6. The discount rate is set by the central bank.
7. Banking supervision is entnisted to the central bank alone.
In this regard, the PBC is able to fulfil cntena 1 to 5. Article 28 of the Central
Bank Law 1995 bars the PBC from lending to the government. subscribing and underwriting state bonds. Cnterion 6 is met by Article 27 of the Law which States that the '-PBC may ...determine the arnounts, duration. rate of interest and forms of loan to commercial banks." The whole Chapter V of the Law is devoted to the
PBC's supervision on financial institutions, Criterion 7 is thus fulfilled. Checking the score sheet (Table j.l), the PBC obtains a high mark in respect of economic independence, but a very low mark as regards political independence. Such an arrangement may be the result of central govemment's policy that. on the one hand, gives PBC more authority to perform its central banking function. and on the other hand. desires it to remain in ultimate control of China's monetary policy.
Table 5.1 A Measurement of the Independence of the People's Bank of China
hddcrr'ieria (1) (2) (3) (4) (5) (6) (7) (8) Total Politicai O O O O O O 1 O 1 Economic 1 1 1 1 1 1 1 NIA 7
Even though the PBC falls short of political independence, its authority as a central bank in China has been greatly enhanced by the Central Bank Law 1995.
Specialized and Policy Banks
In 1994, the PBC was designated as the central bank of China which would no longer be directly involved with commercial and retail banking business. Four specialized state banks were appointed to take up these activities.
Agricultural Bank of China (ABC): This provides banking services to the
rural enterprises and industries. It has the responsibility to channel the govenunent fùnds to the nual sector and to supervise the rurai credit CO-
operat ives.
The People's Construction Bank of China (PCBC): Its principal duty is to
manage budgetary allotrnents and fuiance construction investment.
The Industrial and Commercial Bank of China (ICBC): This was created in
1984 to take over the commercial banking operations of the PBC. It is currently
the largest commercial bank in China. Apart f?om providing commercial
banking services to the urban enterprises and individuals, it is the major supplier
of loans to the stated owned enterprises. It is also the clearinghouse for
transactions arnong the state enterprises.
Bank of China (BOC): This specializes in foreign exchange and foreign trade
activities. It is also responsible for making overseas securities transactions.
issuing bonds in the international markets, and establishing relations with
foreign banks. As discussed in the previous chapter, the BOC's Hong Kong
network is one of the major banking groups in Hong Kong.
The size of these four specialized banks is huge by international standards.
Euromoney's 1994 study on the ranking of Asian banks (Japan excluded) in terms of shareholders' equity, assets, and profits indicated that the ICBC was the largest bank in Asia, followed by the BOC (Euromoney, December, 1994). Even aithough the state specialized banks have been endeavoring to operate under commercial prhciples, they have however suffered fkom the following constraints
(Goldie-Scott. 1997,22):
They are lacking experience in commercial lending.
Until 1994. they were forced to make policy loans at reduced interest rates to
the state enterprises regardless of the credit status of the borrowers.
They are often under political pressure to make loans to certain "favored"
enterprises.
A large arnount of bad debt occurred due to the poor repayment record of the
inefficient state enterprises.
With the objective of transforming the debt-burdened specialized banks into efficient financial entities. the Chinese govemment has released the specialized banks fiom the "policy loan'? by creating three new O-policybanks" (Lees and
Liaw. 1996.40):
State Deveiopment Bank is responsible for providing low interest rates to
finance major infrastructure projects. China Irnport and Export Bank provides long-term credit for the import and
export of goods.
Agricultural Development Bank of China is obliged to fuiance the state
procurement of agricultural products and agticultural development.
Commercial Banks
In addition to the specialized and policy banks. a number of commercial banks have been established or re-established during the reform period. The Bank of
Communications (BOCOM) was founded in 1908, but was closed down in 1958. It was re-opened in 1986 as a joint-stock bank owned by the govemrnent and state enterprises. It handles a wide range of financial services and is the largest commercial bank (excluding specialized banks) in China. Table 5.2 The Baoking Structure of Mainland China
Central bank People's Bank of China
Poiicy banks State Development Bank of China Agricultural Development Bank of China Export-Import Bank of China
State speciaiized banks Industrial & Commercial Bank of China Bank of China People's Constmction Bank of China Agricultural Bank of China
Nation wiiie commercial banks Bank of Communications CITIC Industrial Bank China Everbright Bank Hua Xia Bank
Other commercial banks Guangdong Development Bank Shenzhen Development Bank Pudong Development Bank Shenzhen Merchants Bank Fujian Industrial Bank China Investment Bank Yantai Housing Savings Bank Bengbu Housing Savings Bank
ource: Scott (1 997.24).
Another large nationwide commercial bank is the CITIC Industrial Bank, formed fkom the banking department of China International Trust and Investment Corporation (CITIC). The CITIC Indusmal Bank is an external-oriented bank with a focus on foreign exchange transactions. extending credits for international trade and correspondent banking services. Being a member of CITIC, it is also engaged in other business activities such as production. technology transfer. import and export trade and services. There are also other national and regional commercial banks in China. The banking structure of China is given in Table 5.2.
Compared with the state banks. the market share of commercial banks is rather small. Table 5.3 provides the figures on the loans and deposits of major banking institutions in 1994.
Table 5.3 Loans and Deposits of Major Banking Institutions in Mainland China, 1994 (RMB 100 million)
Toral Deposit Total Loans State Banks 29331 .O 32,U 1.2 Other Banks 827.5 613.7 Source: Scott. (1 997,26).
In 1995. the Commercial Bank Law was promulgated. The objective of this Law is to "protect the Iegitimate rights and interests of commercial banks, depositors and other clients, standardize the behavior of commercial banks, improve the quality of funds, and strengthen supervision and commercial banking (Article 1 )." From the viewpoint of commercial banks. the Law provides a legal support framework for them to carry out fuiancial activities under sound commercial principles. Article 4 States that '-a commercial bank operates independently, takes up responsibility for al1 nsks it may encounter and for its own profits and losses it may bear, and exercises self-regdatory mechanism on the management p~ciple of economic efficiency, safety and liquidity. A commercial bank shall conduct its business in accordance with the law, fiee Eom interference by any department or individual." This Law therefore gants al1 commercial banks including specialized banks operational independence.
Foreign Bank
The Chinese banking industry is highly protective which is why foreign banks encounter a lot of entry barriers. In the 1980s. foreign banks were only allowed to have a branch or representative office in thirteen coastal cities in the Special
Economic Zones. Ten imer cities were added in 1994. Foreign banks are also restricted to opening one branch per permitted city and are only allowed to handle foreign currency business with foreign enterprises or joint-venture companies. Despite these dificulties, more and more foreign banks are operating in China. By the end of 1994. there were 250 foreign banks in China with 99 full branches. The total assets of foreign €inancial institutions in China increased from US$ 8.1 billion in 1993 to US$ 14 billion by the end of March 1995 (Goldie-Scott. 1997, 67).
Table 5.4 gives the information of the country of origin of those foreign banks in
China.
Table 5.4 Bank Representative Offices in Mainland China, by Country of Origin, 1994
Japan 68 USA 24 CI' 16 Hong Kong 19 France 18 Germony 14 Neth erlands 9 Itaiy 11 Canada 6 South Korea 8 Others 57 Tot& 250 Source: Scott (1997,68).
The rapid growth of foreign trade and number of foreign bank branches has made the old laws inadequate. In light of this, the govemment promulgated new rules and procedures in 1994 which are called -'Regulations on the Administration of the
Foreign Financial Institution in the People's Republic of China.'' Under the Regulations, a foreign bank falls into one of the following categones
(Article 2):
Subsidiary banks incorporated by foreign capital in China (these are called
foreign banks):
Branches of foreign banks (these are called foreign bank branches):
Banks incorporated jointly by foreign and Chinese capital (these are called
joint-equity banks);
Finance companies incorporated by foreign capital (these are called foreign
finance companies):
Finance companies incorporated jointly by foreign and Chinese capital (these
are called joint equity finance companies).
The foreign bank has to fulfil the following conditions in order to operate branch in China (Articles 5-7):
Having rnaintained a representative office in China for two years or longer;
Total assets not below US$20 billion:
Minimum registered capital of RMB 300 million yuan;
Paid-up capital of at least 50 per cent of the registered capital. Foreign banks and foreign bank branches and joint-equity banks are allowed to conduct the following business (Article 17):
Foreign currency deposit taking
Foreign currency lending
Foreign currency bill-discounting
Approved foreign exchange investments
Foreign exchange remittance
Foreign exchange guarantee
Import and export settlement
Foreign currency dealing and brokerage
Exchange of foreign currencies and bills denominated in foreign currency
Foreign currency credit card payment
Custody and safe-deposit box service
Credit verification and consultancy
Approved business activities in domestic currency and other foreign currencies
business.
The foreign finance companies and joint-equity finance companies are allowed to conduct the following business activities (Article 18): Foreign currency deposit of US$ 100,000 in minimum for each deposit with a
maturity of three months or longer
Foreign currency lending
Foreign currency bill discounting
Approved foreign exchange investments
Foreign exchange guarantee
Foreign currency dealing and brokerage
Credit verîfication and consultancy
Foreign exchange trust business
Approved business activities in domestic currency and other foreign currencies
business.
Among these foreign banks. HSBC is considered the most success£Ùl. As with other Hong Kong-based banks, HSBC is viewed by the Chinese govemment as a foreign bank in Mainland China. This status has remained unchanged since the retum of Hong Kong to Mainland China. This issue will be discussed in the forth coming section. HSBC had a large network in Mainland China before the establishment of the People's Republic of China (PRC). After 1980, it started to open again branches in the SEZs, Beijing, Shanghai and Tianjin and employs more than 400 staff in China. Goldie-Scott (1997, 72) estimates that HSCB's Shanghai branch is the most profitable foreign bank branch in China. By February 1994, one year &er the opening of this branch, the foreign currency deposits amounted to
US$ 2.25 million and the outstanding loans were US$ 6 million. The fmt year's import/export seulement business was US$ 183 million. HSBC can achieve a better result in China mainly because it has a strong cornpetitive edge in providing services relating to the trade and investment between Hong Kong and Mainland
China.
China endeavos to attract more foreign banking operations through its development of Shanghai as a financial centre. In 1930. Shanghai was a major financial centre in Asia. The government desires to restore this status. In 1989. it announced its intention to develop the Pudong New Development Zone in
Shanghai. It is estimated that the Pudong project will require an infkastructural investment of about US$ 30 billion (Lees and Liaw? 1996. 32). The govemment also allowed foreign banks to establish branches in Shanghai in 199 1. In 1996. it became the first place to allow foreign banks to handle RMB businesses so permitting them to gain access to the domestic market of China. 5.2 Mainland China - Hong Kong Banking Activities
5-2.1 Overview of China - Hong Kong Economic Relations
Hong Kong maintained very close social and economic ties with Mainland China
even under the British rule. The economic interaction between both parties
intensified after Mainland China's "open doof' policy in 1978. From 1979 to
1995. the total trade between Hong Kong and China increased si.uty times from
HK$ 16.5 billion to HK$ 987 billion. In 1993, China became Hong Kong's largest
trading partner. The bilateral investments have been rising as well. By the end of
1994. Mainland China's investrnent in Hong Kong amounted to US$ 42.5 billion.
while Hong Kong's investrnent in the Mainland was worth US$ 68 billion (Jao.
1997.67).
The increasing trade and investment relationship created a greater demand for
banking and financial services. As discussed in the previous chapter, Mainland
China has fifieen licensed banks, two restrkted licensed banks and fifieen deposit- taking companies in Hong Kong. The BOC was granted the right to issue banknotes in Hong Kong. By the end of 1995, the BOC held about 28.2 per cent of
Hong Kong dollar deposits (Jao, 1997, 68). 5.2.2 Hong Kong's Banking Activities in Mainland China
The rapid development of the Mainland's economy created a great demand for capital financing. As discussed in the previous section, China is just initiating its reform in commercial banking. The commercial banking system in China is still far from being able to perform the role of efficiently allocating surplus hdsand supporting economic development. The Hong Kong banking institutions contribute greatly to supplementing the inadequacies of the banking system of China in a number of ways.
First. the economies of Hong Kong and South China are highly integrated. Many
Hong Kong manufacturers have shified their operations to South China. Most of these manufacturing companies are small companies which depend heavily on bank Ioans. For eficiency reasons, these companies borrow from the banks in
Hong Kong rather than those in Mainland China. Since there are established relationship between these Hong Kong companies and the Hong Kong banks. the information costs of loan screening and monitoring are reduced. In addition. the
Hong Kong banks often request these companies to put up their Hong Kong assets as collateral. Under such practices, Hong Kong's commercial banks actively finance various production activities in the Mainland (Luk, 1995, 50). Second, Hong Kong is a major supplier of foreign loans to the Mainland. Table 5.5
gives the figures of the contracted extemal loans made to Mainland China fiom
1979 to 1993. The demand for total foreign loans increased in this period while
Hong Kong's share rather fluctuated with a peak of 10 per cent in 1989. Due to the
absence of information, it is not possible to separate the arnount of commercial
loans nom the loans relating to foreign aid purposes. It is expected that foreign aid
has been very substantial over the past years. For commercial loans only. Hong
Kong's share should be even higher (Luk, 1995.53).
Although Hong Kong carries out intensive banking activities in the Mainland. there is no integration of the two banking systems. Hong Kong's banks in
Mainland China are regarded as foreign banks while the Chinese banks in Hong
Kong are also considered foreign banks. The separate banking systems that existed before 1997 will remain in place. Chapter 5 will elaborate more on the monetary relations behveen Hong Kong and the Mainland. Table 5.5 Contracted Extemal Loans to Mainland China, 19794993 (US$ million)
Total Foreign Loans Hong Kong's share as Ie~der
(average) 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 11,306 1,045 (9.2) Source: A lrnanac of China 's Foreign Economic Relations and Tmde. various issues: Luk (1 995. 54).
5.2.3 Mainland China's Banking Activiiies in Hong Kong
Located in Southem China, Hong Kong has become used to having a close banking relationship with the Mainland. In 19 1 7. the BOC 's Hong Kong Branch was established. Since that time, the BOC has become the flagship of Mainland
China's banking operations in Hong Kong.
The BOC actually consists of thirteen banks ffom Hong Kong and one bank fiom
Macau, of which nine are China-incorporated, four are Hong Kong-incorporated and one is Macau-incorporated (See Table 5.6). The entire BOC is under the supervision and leadership of the PBC. while the BOC in Hong Kong reports to the BOC Beijing headquarters. Therefore, the BOC in Hong Kong (and Macau) is actually an overseas branch of the BOC. In order to achieve better CO-ordination arnong its sister banks. the BOC in Hong Kong is under the supervision of the
BOC - Hong Kong and Macau Regional Office.
Table 5.6 Member Banks of Bank of China Group in Hong Kong
Bank of China Bank of Communications Nangyang Commercial Bank Kwangtun Provincial Bank Sin Hua Bank Kincheng Banking Corporation Po Sang Bank Hua Chiao Commercial Bank National Commercial Bank China State Bank Chiyu Bank China South Sea Bank Yien Yieh Commercial Bank
The main fùnctions of the Regional Office are as follows (Wan, 199 1.66):
To CO-ordinatethe business between sister banks so as to avoid unnecessary
competition between them; To oversee and evaluate the performance of the sister banks;
To establish banking policies within the Group and detemine the guidelines for
loan approval;
To CO-ordinateand operate the group-wide cornputer system;
To provide training for Hong Kong staff as well as those from Mainland China:
To collect and analyze local and international economic information.
Although the Regional Office is at the apex of the BOC. the sisten banks still enjoy a great deal of independence in policy making and managing daily operations.
At a higher level. the Regional Office has to follow the Beijing headquarters'
c.guidelines in setting its banking policies. particularly those relating to political belief, marcoeconomic policies. major banking policy and large amount loans. For exarnple, the sister banks in Hong Kong will seek approval From the Hong Kong and Macau Regional Omce for loans of a certain amount. The Regional Oftice will in tum ask for permission from the Beijing headquarters if the loan amount exceeds its authorized limit. For the approved loans. the sister banks will be responsible for the lending as well as the collection of fünds (Wan, 199 1. 72). The sister banks of the BOC initially were infomally assigned specific business areas. For instance, the Bank of Communications was predominantly engaged in the foreign exchange and money market. The Po Sang Bank was well known for its precious metal trading business and the Savings and Commercial Bank \vas actively involved in industrial loans. However, due to the rapid expansion of the
Group. the overlapping of business has been inevitable. In the late 1980s. the BOC rrplaced the Standard Chartered Bank as the second largest banking group in Hong
Kong in terms of branch network.
The BOC focuses on the more traditional retail banking businesses such as deposits, loans. trade finance, foreign exchange. deposit boxes and automatic-teller machine services. It has a monopoly in the area of RMB reminances. it is currently moving to higher-end services such as merchant banking covering syndicated loans, brokerage and fund management services.
The role of the BOC in Hong Kong is not confmed to that of a profit-making commercial bank. It has also social and political responsibilities. One of the intemal slogans of the BOC is that "Being deeply rooted in Hong Kong and supported by the rnotherland. we are capable of facing overseas challenge (Wan.
1991, 70):' The BOC has two specific missions. First, it acts as a stabilizing force in Hong Kong. As discussed in Chapter 2. there have been two major banking crises in Hong Kong. HSBC performed the lender of 1st resort fùnction to rescue the problem banks. Since the return of Hong Kong to China, the BOC appears to be more active in taking up this obligation. In 1987. together with HSBC, the BOC extended standby credit facilities to Ka Wah Bank. a local bank suffering fiom massive deposit withdrawals. in the same yeq it provided HK$ 100 million in stand-by credit for the Hong Kong Comrnodity Futures Exchange to prevent the market fiom Mercollapse. The BOC Group also stood fim to support the Hong
Kong Government's decision to peg the Hong Kong dollar to the US dollar at a fixed rate of HK$ 7.8 = US$ 1 in order to prevent the declining value of the former.
As a specialized bank in international finance and trade, the BOC has the duty to make use of foreign hnds to finance the economic development of China. It not only provides Ioans on its own behalf for the Mainland's development, but also acts as a bridge between China. the overseas Chinese and other investors. The
BOC is in a favorable position to provide the necessary information and connections for those cornpanies which are interested in developing trading and investing relations with China. On many occasions, the BOC has taken the initiative to team up with overseas investors to launch projects in China. For example, it formed a joint venture with Hong Kong's Hopewell Holding Co. in the
Shaojia Coai Fired Power Plant with a total investment exceeding HU 4 billion, and arranged syndicated loans with other financial institutions for the Shanxi Coal
Exploration and Guangdong Province Highway Network (Wan. 199 1.74).
Since the retum of Hong Kong to China the BOCk status in Hong Kong has increased. It became the third note-issuing bank in Hong Kong in 1993. It also assumed the Chairrnanship of the Hong Kong Association of Banks in 1996. a role which was traditionally reserved for HSBC or the Standard Chartered Bank. It is expected that the BOC will become much more active and influential in Hong
Kong. CHAPTER 6 TRENDS AND ISSUES
6.1 Monetary System of Hong Kong after 1997
Although Hong Kong and Mainland China are economically highly integrated. their monetary systems were separate before 1997 and will remain so. For a long period. Hong Kong's monetary system has been highly independent, and was not even regulated by the Bank of England. the central bank of the UK. The independence of Hong Kong's monetary system afler 1997 is guaranteed by the
Sino-British Joint Declaration and the Basic Law. The Declaration stipulated that the policy of 'One Country, Two Systems?' (a capitalist system for Hong Kong and a socialist systern for Mainland China) will be practiced for fi* years after Hong
Kong's return to China in 1997. Hong Kong has becorne a Special Administrative
Region (SAR) which enjoys a high degree of autonomy. The Basic Law (Hong
Kong's constitution afier July 1997). which Merelaborates upon the principles of the Joint Declaration, was promulgated in 1990. The articles related to Hong
Kong's monetary system are given in Appendix 1. Under the Basic Law, the monetary relationship between Mainland China and
Hong Kong after July 1997 can be descnbed by 'rhree twos"- two monetary systems. two monetary authorities and two currencies.
6.1. I Two Monetury Systems
There are shq differences between the monetary systems of Hong Kong and
Mainland China. Compared with Mainland China's system, Hong Kong's monetary system operates more in line with international practices. The Chinese government adopts a pragmatic view that the two monetary systems are independent of each other, which means that -'one system does not have precedence over the other. and one system is not superior or inferior to the other.
Furthemore. the assets and liabilities of the two monetary systems are to be considered foreign assets and liabilities. Mainland China's banks operating in the rnonetary system of Hong Kong are to be treated as if they are foreign banks. and similarly for Hong Kong incorporated banks operating in China. In participating in the financial markets in Hong Kong, Chinese enterprises expect to be and will be treated as equally as any other market participants from either Hong Kong or elsewhere. They will not seek and will not be given special privileges.''~
' joseph Yam, Chief Executive, Hong Kong Monetary Authority, "Monetary Relationship behveen Mainland China and Hong Kong after 1997", Speech to British Chamber of Commerce, 18 September 1996. Many Hong Kong-based companies repeatedly press the Hong Kong Government to ask for privileges fiom the Chinese authority, so that they cm have a cornpetitive edge over other foreign companies when entering the Chinese market.
The Hong Kong Government however has refiained fkom making such demands simply because the concept of a "fkee lunch" does not exist in bilateral economic relations. Once privileges had been received, Hong Kong would then be expected to provide reciprocal treatment to the Mainland's enterprises. Such special treatment would destroy Hong Kong as a centre of fiee trade and investment. Since no preferential treatment is given to or received fiom the other monetary system, the independence of Hong Kong's monetary system remains well protected.
6.1.2 Two Monetary Authorities
Since the monetary systems of Hong Kong and Mainland China are "mutually independent". it is quite natural that the two monetary authorhies are mutually independent as well. The Hong Kong Monetary Authority will be accountable solely to the Hong Kong Government while the PBC will not take the place of the
HKMA. and will not set up any ofice in Hong ~ong''3
The HKMA continues its prudent supervision of the banking systems based on the internationally accepted regulatory standards in Hong Kong while the PBC exercises its supervisor-fiction on the banks in the Mainland. As such, -'Chinese banks are subject to the same licensing criteria and the supervision of the KKMA. as any other foreign banks entering and operating in Hong Kong. Sirnilarly. Hong
Kong incorporated banks are subject to the same licensing criteria and the supervision of the PBC as any other foreign banks entering and operating in
~hina."4
6.1.3 Two Currertcies
The Basic Law states clearly that the Hong Kong dollar will continue to exist after
1997. "The Hong Kong dollar and the RMB will circulate as legal tender in Hong
Kong and the Mainland respectively. The Hong Kong dollar will be treated as foreign currency in the Mainland. Likewise, the RMB will be treated as foreign currency in Hong on^.?''
There is skepticism about the future of the Hong Kong dollar as. on the economic wound, there are doubts about the value of maintaining two currencies in one Ci country. Since the economy of Hong Kong is highly integrated with that of
Mainland China, a single currency can remove the uncertainty of exchange rate
Chen Yuan, Depury Governor. People's Bank of China, "Monetary Relations between China and Hong Kong", Speech at the Bank of England Seminar, London, 10 September 1996. 'Joseph Yam. Chen Yuan. fluctuation beîsveen the two currencies. Furthexmore, it cm facilitate capital mobility between Hong Kong and the Mainland.
However, pressure to abolish the Hong Kong dollar is not great at the current time for several reasons. First. there is constitutional protection for the continuity of the
Hong Kong dollar for the next fifty years. Second, the RMB is still not hlly convertible. so that there is liale market demand for RMB in Hong Kong. Third. monetary stability is the principal mission of the HKMA. As an small open economy. the Hong Kong dollar's link with the US dollar is viewed as essential to maintaining a stable value for Hong Kong's currency. Fourth, the share of the money supply of the Hong Kong dollar is as large as 40 per cent of China's. It would have a great impact on the monetary policy of China if the RMB were to replace the Hong Kong dollar.
Nevertheless. the RMB has the potential to substitute for the Hong Kong dollar if the demand for RMB in Hong Kong becomes greater than that for the Hong Kong dollar. Two events could aigger such a demand. First, if the RMB were to become fully convertible. Second, if Hong Kong were to become more and more integrated with and dependent on the Chinese economy. The relations behveen Hong Kong and the Mainland are certainly not confmed to monetary aspects. Hong Kong, to a certain extent has already been integrated into the Chinese economy. Mainland China is currently the largest market for Hong
Kong's total exports and the major source of Hong Kong's imports, accounting for
36 per cent of total imports. Hong Kong plays an important role in re-export trade related to Mainland China. In 1995.92 per cent of Hong Kong's total re-exports to the world either originally came fiom or were destined for Mainland China. Hong
Kong is used by the Mainland to conduct its trade with the rest of the world. in particular the USA. Europe, Japan and Taiwan (Fung. 1997. 14- 17).
In terms of cumulative investment. Hong Kong is the largest foreign investor in the
Mainland. accounting for more than 60 per cent of its total foreign investment.
Mainland China is also a major foreign investor in Hong Kong. In 1995 alone. its investment in Hong Kong reached US$23 billion (Fung. 1997.86).
The close relationship between Hong Kong and the Mainland undoubtedly generates tremendous opportunities for Hong Kong's economic development. but at the same time. Hong Kong has to share the risks associated with Mainland
China's extemal relationships. For decades, Hong Kong did not have any major trade disputes with its trading partners due to its open economy. Its World Trade Organization (WTO) membership cm. to a certain extent? avoid a unilateral trade action from its main trading partner. Unlike Hong Kong, Mainland China's trading relations with other countries. in particular the USA, have been rather uneasy.
Apart fiom the economic issues such as trade surpluses and unfair trade practices. the USA and Mainland China continue to argue over human right issues and the
Taiwan quandary . W ithout WTO mem bership, Mainland China is more w lnerable to unilateral action on the part of the USA.
The Basic Law has granted Hong Kong constitutional grounds to adopt a different position in case a made war occun between Mainland China and other countries. In practice. Hong Kong will however still be severely hampered due to its hi& integration into the Chinese econorny. Currently, Hong Kong suffers uncertainties each year when the decision of the USA to renew China's Most-Favored Nation
(MFN) status is being ascertained. According to an estimate made by the Hong
Kong Govemment in 1994, if Mainland China had lost its MFN status in that year.
Hong Kong's re-export business would have been reduced by 33 per cent to 36 per cent. Hong Kong's national income would have lost between US$ 2.2 to US$ 3.4 billion. There is to be no "fiee lunch" for Hong Kong as it enjoys the booming Chinese market. It has to bear the potential downside risks. The rapid growth of China's output and trade will more than likely attract more international economic dispute.
Due to China's diffenng political philosophy fiom the West, it is expected that this tension will continue. It is unfortunate for Hong Kong that the causes and effects of such tension are beyond its control. However, what it can do is to maintain a flexible economic structure to reduce any hmcaused by extemal shocks.
6.2 Cornpetition from Other Financial Centres
Another challenge facing Hong Kong is the competition fkom other financial centres. Being a small open economy. Hong Kong's survival is very much subject to its international competitiveness. Foreign capital will move away from Hong
Kong if Hong Kong ceases to provide satisfactory retums on investment. lao
( 1997) and Enright. Scott and Dodwell ( 1997) suggest that there are a nurnber of existing and emerging financial centres which have already competed or are going to compete with Hong Kong. They include Tokyo, Singapore, Taipei. Manila and
Shanghai. However. of al1 of these centres, only Tokyo and Singapore have the capacity to exert strong pressure on Hong Kong while some pressure is being felt from Shanghai. As the capital city of an economic superpower, Tokyo is currently an international financiai centre with a status similar to that of New York and London. Table 6.1 gives a cornparison of Japan and Hong Kong in the selected categories of business.
Due to the absence of data, Table 6.1 uses the whole Japan rather than Tokyo for this cornparison. This proxy is reliable as most financial activities in Japan take place in Tokyo. This table shows that Hong Kong outperformed Japan in two categories only - the number of foreign banks and cross-border credit to non- banks. Japan is far ahead of Hong Kong in al1 other categories especially in derivatives trading and stock market. The results are easy to understand as Japan has a sheer size of domestic econorny which is second only to the USA. However. this does not mean that Tokyo enjoys a mynad of comparative advantages. Japan has frequently been criticized by the USA and European countries of being highly protective of its domestic market. Foreign financial institutions find it diffcult to overcome the entry barriers. As a measure of financial liberalization, Japan set up an offshore banking centre in Tokyo in 1986. However, the regulations are still much more restrictive than those of Hong Kong (see Table 6.3). Therefore,
Tokyo3 offshore banking centre has been unable to take away business fiom Hong
Kong. Table 6.1 Cornparison of Hong Kong and Japan : Selected Categories, 1995
Hong Kong Japan
Banking: Number of foreip banks 357 153 (Tokyo) Bank's foreign assets USS705bn US$ 1,177bn Bank's foreign iia bilities USS 614bn US$772bn Cross-border interbank claims US$38lbn US$911bn Cross-border interbank liabilities US$614bn US$749bn Cross-border credit to non-banks US$324bn US$266bn
Forex Markets: Net daiiy turnover
Derivaiives Market: Net daily forex-contract turnover USS 56bn US$112bn Net interest rate contract turnover USS18bn US$377bn
Stock Market: Market capitalization USS 303,705m USS 3,667,292m Value traded US% 106,888111 US$1,231,552m Number of listed domestic companies 518 2,263 Source: Jao ( 1997. chapter 4). Table 6.2 Cornparison of Hong Kong and Tokyo as Offshore Banking Centres
- - -
Variabies Hong Kong Tokyo
Nature of offshore banking- Integrated with Segregated from domestic banking domestic banking
Reseive requirernent None Exempt
Interest rate regdation Exempt Exempt
Withholding inferest tor None Exempt
Access tu funds by raidents Free Prohibited
Deposit insurance scheme None Exempt
Foreign =change control None
Taration on offshore loan Only if earned without Subject to interest and in corne the intermediation of an corporate tax, local overseas establishment tar, and stamp duty
Income tuon international None Subject to han syndication corporate tar, local tar, and stamp duty
Dividend distribution out of Free Free offshore-- -profits - Source: lao (1988,Chapter 7).
Hong Kong and Tokyo also serve different custorners. Those who invest in Tokyo are attracted by its vast domestic market. Their presence in Japan does not involve handling offshore banking, but onshore banking. The financial institutions investing in Hong Kong mainly have their sights set on the huge market of
Mainland China. Loans and ficial services cm be provided to Chinese customers through their Hong Kong branches. Tokyo can never take arvay this role from Hong Kong. In view of this, Tokyo is unlikely to become a major competitor of Hong Kong.
Hong Kong and Singapore share many similarities. Both are former British colonies, Gree ports and small open economies. Without nahua1 resources. both economies rely heavily on the development of tertiary industry. Singapore appears to be the immediate cornpetitor of Hong Kong in the international financial businesses. Unlike the laissez-faire economic policy employed by Hong Kong,
Singapore has been more active in strengthening its status as a major financial centre in the Asia-Pacific. In 1968, Singapore set up Asian Currency Units (ACUs) for the transaction of cross-border and cross-currency banking business under better regdatory and tax conditions. Singapore had also established its central bank. the Monetary Authority of Singapore. to regulate its banking and rnonetary affairs long before the establishment of its counterpart in Hong Kong. Generally.
Singapore has a better record of pmdent supervision of the commercial banks in terms of banking crises. In Table 6.3, Jao (1997) surnrnarizes the comparative figures of Hong Kong and Singapore. As it shows, Hong Kong has a much larger national income (almost double) than that of Singapore. But Singapore has a better track record of achievements in promoting economic growth and controlling inflation. As discussed in the previous chapter, the HKMA is unable to employ interest rates to reduce inflation since its primary objective is to maintain the stability of Hong Kong dollar. Hong Kong's interest rate movement has to be in step with that of the USA. One major difference between these two cities is their primary markets. Hong Kong relies heavily on the Chinese economy while
Singapore provides services mainly to Malaysia, Indonesia and other Southeast
Asian counmes. Due to the booming Chinese economy. Singapore has already taken the initiative to provide financial services to the Mainland.
Table 6.3 also shows that Hong Kong is more attractive to the commercial banks.
Hong Kong outperformed Singapore in almost al1 major banking activities, and the equity, gold and insurance markets. Obviously. Singapore's potential is constrained by the size of its domestic econorny. Without sufficient domestic market. the growth of the equity market is severely limited. Hong Kong's equity market becarne much more active when the Mainland Chinese companies received approval to be Iisted in Hong Kong. By the same token, the population of
Singapore was only around 2.5 million while Hong Kong had a total of 6.5 million in 1996. The insurance business, in particul% the life insurance market is much bigger in Hong Kong.
Table 6.3 Cornparison of Hong Kong and Singapore as International Financial Centres
Variable Memures Hong Kong Singapore 1. GDP (1995) US$143.7bn US$76.6bn
2. Per capita GDP (1995) USS23JlO US%25,530
3. Per capita forex reserve US$ 8,787 US%32,222
4. Annual real GDP growth (1990-95) 5.2% 8.3Y0
5. Annual CPI inflation (1990-95) 9.4% 2.7%
6. Economic freedom Better
7. Economic hinterland China Malaysia and Indonesia
8. Location Nearer to China, Nearer to Taiwan,Japan,&Korea Southeast Asia
9. Government support of financial Fmm laissez-faire to Always strong centre active support support as national policy
10.Costs of doing business Rents and housing prices are higher in Hong Kong, but other costs are approximately the same
11.Use and standard of English Somewhat ahead
12."National Treatment" record Better
13.Regulatory regime Both are now transparent and conform to international standards (Bank of International Settlement)
14.Ta.x regime Standard rate 15%, Corporation rate corporation rate ta%, offshore 16.5%, no tax on incorne 10% overseas income 15.No. of financial institutions (1995) 1,763
16.No. of foreign banks (1995) 357
17.Deposit banks' foreign assets USS705bn (1995)
18,Deposit banks' foreign liabilities US%614bn USS 436bn (1995)
19,Cross-border inter-bank daims USS381bn (1995)
2O.Cross-border inter-bank liabilities US%614bn USS 36Sbn (1995)
2 1.Cross-border credit to non-banks USS 324bn (1995)
22.Syndicated loans and NIFs (1995) US% 12bn
23.Net daily turnover of forex market USS90bn (1995)
24.Net daily turnover of derivatives (1995): forex US%56bn USS63bn interest rate USS18bn USS4Obn
25.Equity market (1995): market capitalization USS305bn USS 207bn value traded US$107bn USS65bn listed companies 542 297
26.Gold market (1995) Larger
27.Bond market (1994) US$l2bn US$ J5bn
28.Insurance (1993): no. of companies 229 140 total premium USS4.2bn US$23bn
29.Fund management (1994): no. of mutual funds and unit trusts 1,007 113 funds managed US%56.6bn USS65.4bn Source: Jao (1997, 105). However, Singapore performed better in the foreign exchange, derivatives and bond markets. This is mainly because of the Singaporean Governrnent's effort to promote these markets. For example, the ACU market helps promote the foreign exchange business. In addition, Hong Kong's bond market is only in its infancy due to the absence of substantial govemment bonds.
As a financial centre, Hong Kong is currently larger than Singapore. Cornpetition exists between these two cities although this is not head-to-head competition.
Hong Kong has a strong comparative advantage of China-related business while
Singapore acts as a stepping-stone to Southeast Asia for many muiti-national corporations. However. technological innovation has greatly reduced the location economies. Many of the offshore banking activities may be shifted fiom Hong
Kong to Singapore if Hong Kong cannot maintain or enhance its competitiveness.
Over the past two decades. Mainland China has been the major market for Hong
Kong's trade and investment, and has stimulated Hong Kong3 banking activities.
Hong Kong's retum to China symbolizes a closer relation between both parties.
Hong Kong however has to face growing competition tiom Shanghai, China's former and brefinancial centre. Shanghai was the major fmancial centre in China and the Far East during the period 19 19- 1939. In 1936. Shanghai was host to 1 15 banks of which more than one-third were foreign banks (Jao. 1997. 109). Its fmancial activities were interrupted during the Japanese invasion of China in the late 1930s and early
1940s. The subsequent Chinese civil war and the final victory of the Communist
Party led to the establishment of the PRC. Based on the Marxist econornic theory. banking and financial sectors were given no support. Shanghai no longer performed its function as a financial intermediary in China.
With the implementation of China3 "open door" policy. a series of banking industry reforms have been carried out (Chapter 4 has already discussed this issue in detail). In the late 1980s, the Chinese Government determined to promote the
"renaissance" of Shanghai and aimed to "develop Shanghai into a leading international industrial, financial and commercial centre by the year 2010 (Jao.
1997, 1 1O)."
The major initiative is the development of the Pudong New Development Zone. It is estimated that the investment in infiastructure and industries in the Pudong project will be around RMB $ 30 billion. The Shanghai Govemment finances the project rnainly through two initiatives: opening up the securities markets and
permitting the operation of foreign banking in Shanghai (Lees and Liaw, 1996,
32).
During the 1990s. Shanghai has developed rapidIy achieving the following major
accornplishments (Lees and Liaw, 1996.33):
China's first national interbank currency market was established in Shanghai.
The China Foreign Exchange Trading Centre was established and located in
Shanghai.
The Shanghai Securities Exchange was re-opened.
Selected foreign banks and brokers were allowed to establish offices in
Shanghai.
ïhe commodities exchange such as grain and metal futures markets were re-
opened.
Shanghai3 rapid progress has raised concern in Hong Kong that it will ultimately
take over Hong Kong's status. Table 6.4 gives a snapshot of the cornparison
between Shanghai and Hong Kong. This table demonstrates that Shanghai still Iags well behind Hong Kong in tems of major financial activities. There are no
imminent indications that Shanghai will pose a challenge to Hong Kong. Although the official target of the Chinese Govemment is to catch up on Hong Kong by the year 2010. Shanghai still has to overcome major obstacles before the plan cm corne to hition.
On top of the infrastructural and institutional development, an international or regional financial centre requires fkee flows of information. Under the existing political system in Mainland China. it is questionable if the banking institutions there will enjoy such fieedom. Besides, Hong Kong and Singapore are the favored places for investment partly due to their well-established legal systems. Both cities have an ample supply of lawyers and accountants working to international standards. Foreign investors enjoy property rights. and proper arbitration procedures are available if disputes arise. Since the legal system in Mainland
China is still developing, it may not yet provide sufficient mechanisms for the needs of a modem financial centre. Table 6.4 Cornparison of Hong Kong and Shanghai as Financial Centres
Selected Measures Year-end Shanghai Hong Kong Bank deposits 1994 US$26.9bn US% 248.9bn
Bank loans USS 23.6bn USS418Sbn
No. of financial institutions 162 1,669
Foreign banks and other financial 118 1,292 institutions
Equity Market: No. of listed companies 171 502 Market capitalization US% 5bn USS 2673bn Daily turnover US$0.22bn USS0.59bn
Bond market: Daily turnover USS0.76bn USS2.9bn
Forex market: Dai1y turnover USS 0206bn US$ 90bn
Inter-bank market: Daily turnover USS 0.076bn US% 15.2bn
Futures market: DaiIy turnover of commodities USS0.6bu - futures Daily turnover of financial - USS 0.85bn futures Source: Yao (1 997, 1 1 1).
Another major obstacle to Shanghai ?s "renaissance" is the inconvertibility of
RMB. Because RMB is not convertible, it is difficult for foreign firms to move their funds in and out. Although Mainland China intends to have RMB fülly convertible by the year 2000, this could prove an insurmountable task. If it adopts a floating exchange rate system after RMB's fiee convertibility, this will inevitably lead to fluctuations in the exchange rate. Coupled with speculative attacks, the exchange rate may become highly volatile. It is quite questionable if the Chinese leaders are ready to accept this scenario. For a floating rate system. the PBC has to develop effective control over the money supply. However. up to now, the PBC has not been well equipped with the necessary instruments. If it detemines to choose the fixed exchange rate system, it will require a substantial foreign reserve to back it up. No matter which currency it will be linked to, Mainland China will lose its autonomy on monetary policy, particularly the control over interest rates in order to maintain a stable currency value. Judging f?om their past performance. the
Chinese leaders may be reluctant to have their monetary policy rest in the hands of others.
In either case. free convertibility means free capital inflow and outflow which will cause uncertainty in the economy. The fiee movement of capital does not fit into a command economy, which plans well ahead any major economic activities.
Therefore, Mainland China has to develop a much more market-oriented economy before RMB is fully convertible. It is quite clear that Shanghai will be unable to cornpete with Hong Kong for international financial business in the near future. The developrnent of Shanghai's fmancial sectors will enable it to become China's national hancial centre, which is rnainly engaged in RMB business and domestic banking. If Hong Kong continues to maintain and enhance its international competitiveness, it will become
China's international financial centre and its major window for access to international financial services. In view of this, specialization will appear between
Hong Kong and Shanghai, in which case these two cities will become complernentary rather than cornpetitive. CHAPTER 7 SuMMARY AND CONCLUSION
This thesis has exarnined the development, structure and trends of the banking system in Hong Kong. Following the introduction in Chapter 1. Chapter 2 is devoted to a review of the available literature in respect of the hnctions of a banking system and the relationship between the banking system and econornic development. The theories of supply-leading and demand-following fiance have provided different viewpoints to explain the direction of the causality between financial institutions and economic developrnent. Despite this theoretical controversy, it is agreed that the intermediary services provided by the financial institutions contribute positively to the economic development of countries.
Chapter 3 has reviewed the development experience of Hong Kong's banking system and its role in Hong Kong's economy. The growth of Hong Kong's banking industry has not been painless. There have been IWO major crises Ieading to the insolvency of a number of banks and a re-organization of the banking system. Learning from these failures, Hong Kong has become a major financial centre in Asia and an international banking centre. Hong Kong's robust banking industry is characterized by the presence of 166 foreign banks in 1996. The status of the banking industry in the economy has been elevated due to the economic re- structuring of recent years. In a service-oriented economy like Hong Kong, the banking industry contributed around 26 per cent of the total GDP in 1996.
Chapter 4 analyzes Hong Kong's monetary policy and the functions of its central bank - HKMA. To cope with the rapid expansion of the banking uidustry and to manage the foreign reserve fund more equitably. the HKMA was established in
1993. Its principal mission is, however. different from that of many central banks in other countries. Instead of controlling money supply and interest rates. the
HKMA has a mandate to maintain cwency stability. The current monetary policy of Hong Kong is to peg the Hong Kong dollar to the US dollar at the fixed ratio of
1:7.8. The HKMA is required to intervene through market operations in case of a senous deviation from the official rate. The HKMA is also responsible for the prudent supervision of the commercial banks. Hong Kong currently employs a three-tier system under which the banking institutions are classified into licensed banks, restricted licensed banks and deposit-taking companies. There are six major banking goups in Hong Kong: HSBC, BOC. local banks, Japanese banks.
European banks and US banks. In retail banking business, HSBC and the BOC are most influential while foreign banks are engaged more in the up-market services. Since the rem of Hong Kong to China in July 1997. the development of the banking industry in Mainland China is likely to have an impact on Hong Kong.
Chapter 5 has reviewed and evaluated the banking system of the Mainland.
Various banking reforms are being implemented in the Mainland. although commercial banking activities are in their infancy. It will obviously take some time for the Mainland to develop modem central and commercial banking systems.
However. due to its huge domestic market. a lot of Hong Kong banks and other foreign banks have been active in entering the Chinese banking industry. HSBC is one of the most successful operators in the Chinese banking business. By the same token. Mainland China has expanded its banking business in Hong Kong through the BOC which is currently the second-largest banking group in Hong Kong.
Chapter 6 has analyzed the trends and the major issues that have impacted on the future development of Hong Kong's banking system. The monetary relationship between Hong Kong and Mainland China is important to Hong Kong's future because an independent monetary system is a pre-requisite for the continuity of
Hong Kong's rnonetary policy and banking system. Under the constitutional protection of the Basic Law and the guarantee of the Chinese leaders. Hong
Kong's monetary system will remain separate from that of the Mainland. Afer
1997. Hong Kong will continue to have its own currency, monetary system and monetary authority. If China keeps its promises, the monetary independence of
Hong Kong will remain unchanged.
As a small open economy, Hong Kong3 banking industry has to compete with othes. There are three other major existing or emerging financial centres in the
Asia-Pacific - Tokyo. Singapore and Shanghai. Tokyo has already established itself as an international financial centre with a much larger scale of banking transactions than that of Hong Kong. Instead of engaging in offshore banking activities. Tokyo concentrates far more on the onshore banking business serving the economic activities of its domestic market. Singapore is a potential competitor to Hong Kong in light of the similarities of both economies. With its larger economy, Hong Kong is currently ahead of Singapore in most bankinp activities.
Shanghai is only at its early stage of reform and is prirnady engaged in onshore banking activities. Hong Kong and Shanghai will likely be complementary to each other with Hong Kong acting as an international financial centre and Shanghai as a national financial centre.
The development of Hong Kong's banking system reflects a process of how a small open economy responds to the dynarnic world economy. The continuous growth of the banking industry cari be largely attributed to favorable goverment policies. which are conducive to the participation of foreign banks. As one of the most open banking systems in the world Hong Kong is able to host the highest number of foreign banks. Its f'ture development will hinge on two major factors.
First. Hong Kong has to maintain its openness to foreign countries and provide a level playing field to the banks of every country. Prudent supervision however has to be exercised to ensure the qudity of the banks. Second, the political and economic development in Mainland China undoubtedly will be the most critical determinant. Presently, Hong Kong and Mainland China enjoy a close economic relationship. Mainland China has achieved remarkable economic growth since its refom in 1978. If Mainland China keeps itself on the right track and continues to reform and Iiberalize its trade and investment regime. this will give constant momentum to the sustainable development of Hong Kong's economy. APPENDIX 1 SELECTIVE BASIC LAW PROVISIONS RELATED TO MONETARY POLICES
The Basic Law gives a high degree of autonomy to the Hong Kong Special
Administrative Region (SAR). Under the Law? a) The Government of the Hong Kong SAR shall provide an appropriate economic
and legal environment for the maintenance of the status of Hong Kong as an
international financial center (Article 109). b) The Government of the Hong Kong SAR shall. on its own, formulate monetary
and financial policies, safepard the fiee operation of fuiancial business and
financial markets, and regulate and supervise them in accordance with the law
(Article 1 10). c) The Hong Kong dollar. as the legal tender in the Hong Kong SAR shall.
continue to circulate. The authority to issue Hong Kong currency shall be vested
in the Govemment of Hong Kong. The issue of Hong Kong currency must be
backed by a 100 per cent reserve hnd. The system regarding the issue of Hong
Kong currency and the reserve fund shall be prescnbed by law. The
Government of the Hong Kong SAR may authonze designated banks to issue or
continue to issue Hong Kong currency under statutory authority. after satisming
itself that any issue of currency will be soundly based and that the arrangements for such issue are consistent with the object of maintaining the stability of the
currency (Article 1 1 1). d) No foreign exchange control policies shall be applied in the Hong Kong SAR.
The Hong Kong dollar shall be 6eely convertible. Markets for foreign
exchange. gold. securities, futures and the like shall continue. The Government
of the Hong Kong SAR shall safeguard the free Bow of capital within, into and
out of the Region (Article 1 12). e) The Exchange Fund of the Hong Kong SAR shall be managed and controlled by
the govemment of the Region, primarily for regulating the exchange value of
the Hong Kong dollar (Article 1 13). t) The Hong Kong SAR may on its own, using the narne --Hong Kong, China".
maintain and develop relations and conclude and implement agreements with
foreign States and regions and relevant international organizations in the
appropriate fields, including the economic, trade. financial and monetary,
shipping, communications, tourisrn, cultural and sports fields (Article 15 1).
Source: The Basic Law of the Hong Kong Special Administrative Region of the
People's Republic of China. 1990. BIBLIOGRAPHY
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