The Mainland’s Trojan Horse

China has handed Hong Kong a golden chalice. But could the sweet-tasting contents contain a slow-acting poison?

The promise of the chalice – the opening of the Hong Kong stock market to mainland individual investors – helped push the Hang Seng index up almost 6% in a single day. It was gratefully received, coming as it did after days of sharp falls driven by the global credit crunch.

Much will depend on Beijing’s motives in making the announcement and on the follow-through. Will this remain a special favor which would give Hong Kong’s market a long-term boost, or is it merely a temporary situation in which the rules to be applied to Hong Kong will soon be applied more generally?

If this is another political gesture by China to show its goodwill and role in Hong Kong’s prosperity it should be looked at with suspicion. If it has been sought by the Hong Kong authorities simultaneously to boost the financial sector and show their patriotic commitment to the mainland, it should be viewed as a Trojan horse. Hong Kong prospers as an international financial center and as such must stand on its own feet, not seek special deals that undercut its status.

Already claims to being a separate territory in economic and trade terms were undermined when the Hong Kong government pushed China for the Closer Economic Partnership Arrangement (CEPA) giving the territory, in theory at least, favored treatment. This is the first preferential trade deal Hong Kong had been in since the collapse of the British Commonwealth preference system 40 years ago.

Prior to this week’s announcement, Hong Kong officials had been trying to persuade the mainland to encourage major state enterprises to list as H shares in Hong Kong rather than as A shares in Shanghai. It was another case of special pleading by bureaucrats anxious to deliver short-term benefits for Hong Kong but ignorant of the either the business issues or the long-term consequences.

Mainland authorities had every reason to prefer local listings to reduce excess liquidity rather than see state companies add to excess foreign exchange holdings by listing overseas. The companies themselves also may have favored the A share market because of its higher prices. Yet here was supposedly free-market Hong Kong trying to persuade Beijing to act against both market forces and China’s national interest.

Likewise the Hong Kong government’s efforts to persuade China to give it a head start in the yuan offshore deposit and bond trading business looks like a sign of weakness, not a reflection of a financial market able to stand on its own feet. As it is these markets are mere tokens, touted by the Hong Kong government but of minimal importance to date because the mainland is moving very cautiously and knows that in the longer term it cannot give serious advantages to Hong Kong in what will become an international trade. It could well be that the chalice for the stock market is similar – the timetable will be dragged out and actual investment fund flows will in practice be regulated by the need to pass them through the Bank of China.

The mainland’s second motive will have been to reduce the price differentials between H and A shares issued by the same company. It is assumed that mainland money would at first flow into the H shares of mainland companies now trading at big discounts to their A counterparts. That at least would end pie-in-the-sky talk from Hong Kong officials about creating an arbitrage mechanism between the two markets. Let money flow freely and the prices will get closer – but there are good reasons for differences to remain.

The biggest issue for Hong Kong however is if and when the decision to allow mainland individuals to invest in Hong Kong is extended to other markets. It seems unlikely that Hong Kong’s special position can be sustained in the face of the pressure on China for wider opening. Foreign companies anyway are not going to list in Hong Kong just on the off-chance that the special position will remain long enough to take advantage of mainland money.

The more Hong Kong relies on mainland listings and money the less effort it will make to get other business. It has been lulled into a false sense of importance by the incredibly lucrative listings of banks and other mainland giants over the past two years. Meanwhile it has barely bothered to go after foreign listings, at which London has excelled and Singapore made good progress.

Now the territory faces the prospect of a drought of new H shares as mainland companies list at home, while the gradual opening of mainland money and capital markets begins to erode Hong Kong’s special advantages for mainland companies and its role as an intermediary between the mainland and the rest of the world – in the same way that port and other developments in Shenzhen have eroded its trading hub role.

The chalice looks likely to bring some short term benefits but in the longer run it ensures integration with mainland markets and hence reduces Hong Kong to a secondary status compared with Shanghai. Meanwhile it will distract from the need for Hong Kong to focus on non-mainland financial markets. The territory’s new financial secretary visited Malaysia briefly recently and pronounced Hong Kong’s desire to become a center for Islamic finance in a tone that suggested he had just discovered the subject. Meanwhile local rules continue to discourage listings from countries other than a favored few.

In short, the chalice has given a big boost to Hong Kong listings of mainland stocks, some of which rose by double digits following the announcement. But the broader market may soon see this as of limited value. And those who concern themselves with Hong Kong’s future as an international financial center will have plenty to worry about.