Direct investment access to China threatens Hong Kong

For a tiny territory on the edge of a vast country, Hong Kong has played a disproportionately large role in China’s development. Over more than 150 years, most of which was spent as a British imperial entrepot, the mercantile port has acted as a conduit for the west into the Middle Kingdom — and a harbour for the exchange of goods, services and ideas.

But that status as the bridge into China is threatened. Local businesses can now raise funds in China itself, and foreign investors find it easier than before to invest directly in the mainland, albeit in a slower, riskier and more restrictive fashion than in much of the west. China’s free trade zones in Shanghai and Shenzhen present opportunities for foreign investment; the use of the renminbi as a trading currency is growing; and the recently implemented Shanghai-Hong Kong Stock Connect are all bolstering ties between China and the rest of the world, both directly and through Hong Kong.

These shifts raise questions about Hong Kong’s future role as a financial intermediary between China and the rest of the world, while rival cities in the region such as Singapore also pose a challenge.

But David Webb, a Hong Kong-based investor and governance activist, insists the territory still enjoys key advantages. “Part of what distinguishes Hong Kong from its competitors is that it is part of China,” he says. “It has a large contingent of lawyers fluent in Mandarin and who are familiar with mainland business practices.”

Any lessening of Hong Kong’s dominance would require China to improve its legal disclosure rules and accounting practices and expand its professional legal industry, experts say. “Hong Kong is a hub of experience — a critical mass of deal and product expertise, and diverse viewpoints and vital insight. You don’t get that unique mix in many other places,” says Hwang Hwa Sim, a capital markets partner in Hong Kong for law firm Linklaters. “Almost all of the knowledge sits with people. They understand what is possible. The legal profession needs to be aware of what makes Hong Kong unique.”

However, a sign that China is starting to rely less on Hong Kong as an intermediary was the South Korean government’s issuance last December of Rmb3bn ($460m) in “panda bonds” — renminbi-denominated debt sold by foreigners into China’s bond markets.

The deal created the first non-Chinese sovereign bonds issued in the renminbi in China’s onshore market — sneaking in ahead of a similarly sized issuance by the Canadian province of British Columbia.

Several law firms were involved. Bae, Kim & Lee, based in South Korea, advised the national government, as did King & Wood Mallesons; Allen & Overy worked on behalf of the issuers, HSBC and Bank of China (Hong Kong). A&O diplomatically refers to the “considerable differences in practice and procedure for bond offerings in the international and China interbank bond market”.

“There was no established precedent in this matter. This was a very adventurous task,” says Eui Jong Chung, BKL’s lead partner on the deal. “There were also troubles relating to timing issues. There were three languages involved — Chinese, Korean and communications in English — so getting the translations approved in time was challenging.” Mr Chung thinks the deal sets a precedent for South Korean banks.

Another sign of China’s lessening dependence on Hong Kong came with the formation of the China Europe International Exchange (Ceinex) — a Frankfurt-based exchange that trades several renminbi-denominated financial instruments. The exchange was set up by the Shanghai Stock Exchange, advised by King & Wood Mallesons; German exchange operator Deutsche Börse; and China Financial Futures Exchange, advised by Dacheng Law Offices.

The exchange’s opening last October — attended by Germany’s chancellor Angela Merkel and China’s premier Li Keqiang — was the latest move by Europe to court Beijing for its significant business. Dacheng calls Ceinex “a crucial overseas extension and supplement for China’s capital market” and says it will have “a significant influence” on China’s economy, capital markets and currency.

Christian Cornett, a partner at KWM, says the ambition behind Ceinex is that a range of financial products relating to Chinese markets should be tradable in the west. “The main challenge was it had not been done before [so we had] to find a common denominator where the converging interests could agree, where both interests are equally well promoted,” he says.

Norton Rose Fulbright in November 2014 advised Hong Kong-listed Renhe Commercial Holdings — the Chinese developer known for turning China’s disused underground bomb shelters into shopping malls — on its $436m rights issue. The deal was the first by an eligible Hong Kong Stock Exchange issuer since the launch of the Shanghai-Hong Kong Stock Connect. The Stock Connect is a cross-border trading programme that has given overseas funds free access to mainland-listed companies for the first time.

Previously, global investors needed approval to invest if they wanted to hold domestic shares. Stock Connect also gave many Chinese investors access to Hong Kong stocks for the first time. The local exchange of the southern Chinese city of Shenzhen was last year due to launch a trading link with Hong Kong, although this has been delayed.

As well as the rights issue, Norton Rose Fulbright advised Renhe on bank financing and tender offers that were combined into a triple-layered financing arrangement, which had not been done before, says Rachel Chan, senior counsel at the law firm. “Normally these parts could have been separate, but because of the innovative structure we were able to make it one,” she says.

Even though international investors gained direct access to China, Hong Kong’s capital markets remain an important financial conduit. Last December, Linklaters advised the underwriters for Baosteel Group’s $500m issuance of a China Construction Bank Corporation bond that was exchangeable into so-called H shares, which are listed on the Hong Kong stock exchange. There are more than 200 Chinese companies with such H shares, and the agreement has paved the way for future equity-linked deals.

The transaction achieved several firsts, including creating the first international bond changeable into H shares and the first equity-linked deal with underlying shares in a Chinese bank. “The deal itself was only possible because of a combination of technologies. It was basically introducing a new product to a new class of investors. It opened up a whole new market,” says Mr Sim.

Slaughter and May’s work with China Re’s insurance IPO was also notable for its inventiveness. “This was a groundbreaking transaction for us. It was also the first reinsurance group listed in Hong Kong, the first Chinese reinsurance company listed anywhere,” says John Moore, partner at Slaughter and May.

Despite the competitive threats from the mainland, Singapore and other emerging cities, Hong Kong still holds substantial legal advantages over its rivals. “Hong Kong seems to have developed a dynamic of its own in so many areas,” says Mr Moore.

“Hong Kong has an incredible amount of talent that is bilingual, and they have been brought up within the system. I have no doubt that Hong Kong will continue to play an important role in the future.”

Mr Webb, the governance activist, says: “Hong Kong does have appeal as a trustworthy legal jurisdiction, but do keep in mind that we have only 31 years until the promises of the Basic Law [the territory’s mini constitution], expire. By 2047, we may have a new highest court in the land — potentially in mainland China. That could undermine the confidence of long-term investors.”

Mr Sim of Linklaters adds: “[The Baosteel transaction] couldn’t have been done by a group outside of a vibrant hub such as Hong Kong. We knew what our investors were willing to accept, and also what was possible. Unless Hong Kong loses its ability to remain as a catalyst for ideas, it will stay a hub for deals.”

Letter in response to this article:

Basic Law gives good reason to assume continuity in Hong Kong / From Dr Tim Summers

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