“Hong Kong has all its eggs in one basket – and that is labeled ‘stocks and shares and property’.” So screamed one headline in Hong Kong’s South China Morning Post (the SCMP) in early 2010.

With the bottom of the credit crisis nowhere in sight, China’s export market has been severely dented, taking Hong Kong’s trading business along with it. Lack of available credit has forced many SMEs to look for greener, and cheaper, pastures on the mainland.

With the high cost of doing business in Hong Kong, international corporations have chosen to cut expensive HQs and staff and move them to more cost-effective localities.

The Pearl River Delta and their aggressive development plan has been a focus for many. Despite initial attempts at co-operation, Hong Kong and PRD are now head-on competitors.

Overall it is estimated that almost half of Hong Kong’s professional staff complement will have moved to mainland China before the end of next year.

One émigré put it emotionally: “For us, as a family, Hong Kong has never really offered a great work/life balance. The cost of property has been exorbitant and relative living standards quite low. Now, with much fewer earning opportunities here, the Pearl River Delta and Shanghai appear to be so much more attractive. Quality of life has become the discussion for most of my friends – I feel like I’m part of a massive new migration!”

The effect on property prices has been devastating and more than one third of prime office space is now standing empty. Up-market shopping malls have been turned into noisy trading hubs, looking more like the old Stanley market than 5th Avenue.

This was yesterday’s headline in the SCMP: “Will the last one to leave HK please turn off the lights?”

ANALYSIS >> SYNTHESIS: How this scenario came to be

This article from The Standard, China’s Business Newspaper, dated 8 May 1997 gives an interesting historical perspective and the possible intentions of the Chinese government. (Original article can be found at this link)

BEIJING WILL KEEP RIVAL CITIES LEVEL
by Hoong Yik-luen

There has been much talk about Shanghai one day superseding Hong Kong as the financial centre of China.

While it is hard to speculate how each of these cities will develop, we can attempt to assess their potential from the existing situation.

With the return of Hong Kong to China in July, the financial markets in the territory have been changing rapidly. The most noticeable is that the Hong Kong Stock Exchange is rapidly growing red.”

Apart from the increasing number of red-chip companies which dominate trading volume, many of the traditional blue chips have turned, or are in the process of turning, “red” as a result of their investments in China. This, coupled with the scheduled listing of another 40 new H-share companies, [means] Hong Kong is undoubtedly China’s “international financial centre”.

In addition, Hong Kong is the most widely used window by Chinese banks and companies to raise foreign debts. Few syndicated loans or project financing deals are done out of Shanghai.

The direct implication of the Hong Kong exchange turning “red” is depriving both the Shanghai and Shenzhen stock exchanges of opportunities to obtain good assets to list in the domestic exchanges.

Through assets acquisition and injections, many of the prized properties in China are absorbed into the Hong Kong exchange’s market capitalisation. Even Shanghai Industrial, the vehicle of the Shanghai Municipal Government, chose to list in Hong Kong.

Shanghai, on the other hand, is undoubtedly the centre of Chinese Government debt and yuan trading. As the reform of the monetary system continues on the mainland, the People’s Bank of China has located the carrying out of a number of policy tools in Shanghai. These include the “discount rate window” and the “swap centre”, which is the precursor to a unified pan-China reunion currency market.

While the market capitalisation of the A and B-share markets remains small compared to Hong Kong, the introduction of a remote off-site electronic trading system has given the Shanghai and Shenzhen exchanges a head start in tapping the local liquidity in China’s vast interior.

Apart from financial exchanges Shanghai has a number of physical exchanges such as the Metal Exchange, the National Coal Exchange, the Commodity Exchange and the like.

As a result, Shanghai is well-poised to develop as the “all-round” domestic financial centre of China.

As long as the current situation persists, where yuan is not freely convertible, Hong Kong is maintained as a separate entity, and Beijing has to prolong its prosperity to attract Taiwan back to the negotiation table, Hong Kong and Shanghai each serve their separate functions well and largely remain off-limit to each other’s turf.

However, with the recent granting of approval to conduct limited yuan business to the foreign banks based in the modernised Pudong area, Shanghai is cementing its longer term lead over the development of the most prized market the yuan business.

The counter argument is, of course that none of the major local banks (apart from the Bank of Communication which is based in Shanghai) are re-locating their operational headquarters from Beijing to Pudong. In fact, much of the discretion to deal in foreign currencies within the local commercial banks has been moved from Shanghai back to Beijing in the wake of a few abuses of authority.

Nevertheless Shanghai is definitely on its way to being a “financial centre” albeit a domestic one temporarily. In the longer term, being the convergence point of the conduct of China monetary and currency policies bodes well for the development of its capital market as a whole.

One could even speculate that its equity market may eventually emerge as the leading market in China for the structure of its participants. No equity market in the world is complete without the involvement of the local liquidity.

Similar to other financial centres, such as New York, London, Tokyo and Singapore, Shanghai would eventually be the congregation point of China’s equity market, debt market, money market, physical markets, as well as commodity and futures markets. Hong Kong, unfortunately, does not possess such development potential given its background.

Promising as Shanghai’s future may be, it currently lacks the physical and intellectual infrastructure needed to achieve its grandiose aspirations in the short term. Apart from the passage of time, which allows Shanghai to build up its infrastructure, only slippage on the part of Hong Kong, either due to political jitters or the bursting of asset bubbles, would accelerate Shanghai’s ascent.

In fact, the constant rising cost of doing business in Hong Kong could prove to be the most important “push factor” for businesses to actively look to relocate their China operation headquarters to Shanghai to take advantage of falling rentals and relatively lower labour costs.

What then is Hong Kong’s chance of preserving its pre-eminence over Shanghai as the financial centre to China in the long term?

The answer lies in Hong Kong’s relationship with a third party, neighbouring Shenzhen City. Shenzhen could help Hong Kong to partially fill in the gap on access to local Chinese equity and debt markets.

If Shenzhen manages to obtain permission for foreign banks to conduct limited yuan business just like Pudong, it may prove to be the best “asset injection candidate to Hong Kong” so far.

Apart from a barren strip of land between Fanling in Hong Kong and Luohu in Shenzhen Hong Kong and Shenzhen have basically merged physically. There is already tremendous alignment of interest that would cause them to put their resources together to form an alliance in fending off the competition from Shanghai.

Finally, the future of Hong Kong and Shanghai lies in the hand of Beijing. Policy initiatives make or break a city in China. Beijing would be reluctant to see one of these cities completely dominate and thereby affect the power balance in the long term.