March 20, 2014

Hong Kong's Stock Exchange at a Crossroad

Hong Kong Exchanges and Clearing Ltd. is on the cusp of transformation — and pivotal to the internationalization of China.

Sharon Kahn

It is the world’s seventh largest stock exchange and the marketplace where foreigners first bought Chinese equities. But don’t expect Hong Kong Exchanges and Clearing Ltd. to rest on those laurels. HKEx, as it is known, is fast moving into fixed income, currencies, derivatives and commodities.

As China increasingly looks outward, CEO Charles Li is positioning the exchange not only as a gateway to invest in China but as a vehicle that Chinese companies and investors can ride to invest in the rest of the world.

“The past 20-plus years have seen an inflow of capital that has transformed China,” he explained earlier this month at the 15th Sir Gordon Wu Distinguished Speaker Forum, sponsored by The Jerome A. Chazen Institute of International Business. “The next five years will involve a shift from accumulation of money to export of capital. Hong Kong has tremendous opportunities to help China spend money.”

Commodity Powerhouse

HKEx made an emphatic statement in 2012 when it bought the London Metal Exchange, the world’s largest marketplace for trading metals and derivatives contracts on metals. Its $2.16 billion offer amounted to more than 150 times earnings compared with the 66 times earnings bid from the Chicago Mercantile Exchange. But Li saw the purchase as laying the groundwork for the exchange's 2013–2015 Strategic Plan.

Noting that China accounted for about 40 percent of the global demand for metals but just 20 percent of the LME’s trades, Li said China has let the rest of the world set prices. A Hong Kong—owned commodity exchange presents huge trading opportunities both to HKEx and China Inc., said Li. The exchange is currently lobbying Beijing to change the law to let HKEx develop physical warehouses in China, which would make commodities delivery easier for local buyers — and more profitable for the exchange.

The gold market offers a separate opportunity. In addition to being a traditional investment within China, gold represents a way for the government to spend its cash beyond investing in US Treasuries and dollars. HKEx stands to host to a potentially viral trading opportunity. “It doesn’t really matter if the market is up or down,&rdqu; said Li. “As long as people trade, we make money.”

Li hinted that metals may be just the beginning of HKEx commodities trading. The exchange’s 2013–2015 strategic plan includes an intention to “leverage the acquisition of the LME to build an extensive commodities platform.” Li told the New York crowd: “We still need to offer a place where international producers of agriculture and other commodities can find buyers in China.”

HKEx is also building the groundwork for trading of China’s currency. In November it launched OTC Clear, an over-the-counter derivatives clearing service with an emphasis on trades involving the renminbi. Demand is currently nascent, as the RMB is largely an internal currency, but the move builds both derivatives and currency capabilities within the exchange.

The Future of Securities

Calling stock trading “largely a local industry,” Li described HKEx as a home for domestic and foreign companies to showcase their equities and debt offerings to Chinese investors, as well as a marketplace for Chinese issuers to tap international capital. To date, 33 international companies have issued stock in Hong Kong, including the luggage maker Samsonite and the fashion company Prada. The latest was Fast Retailing, a Japanese-headquartered owner of fashion brands. Bond offerings come from such multinationals as McDonald's and Caterpillar, which used the renminbi they raised to expand in China; sovereign issuers such as the Canadian province of British Columbia have also accessed the RMB bond market.

To boost its equity business, the HKEx is strengthening reporting requirements and beefing up technology. Noting that compliance with Sarbanes-Oxley standards has caused some Chinese companies to delist in America, Li said, “No way will they see the light of day in Hong Kong.&rdqu;

Walking the Political Tightrope

But Li hinted that HKEx may hand off some of its equity prowess to China’s mainland exchanges as it concentrates on it its newer businesses. “Hong Kong&rsqu;os success within China is based on the trust that we will always be on the edge, breaking into the next thing,” said Li.

Both Mainland stock exchanges have grown substantially; the Shanghai Stock Exchange is now larger than HKEx. And competition may often seem like cooperation. In 2012, for example, HKEx, the Shanghai Stock Exchange, and the Shenzhen Stock Exchange established China Exchanges Services Co. Ltd. as a joint venture to develop new derivatives products that give investors exposure to companies listed in both Hong Kong and China.

Beneath Li’s remarks was the “one country, two systems’ doctrine that lets Hong Kong retain its own capitalist economic and political system — as long as it doesn't run afoul of Beijing. “As soon as we’ve accomplished our task, our job is to let China Inc. take over and move onto a new challenge,” Li said. “To create trust, we need to take off the table that Hong Kong is more than a partner that can help China when it’s ready.”

By Li’s account, China is ready.

(I’ll put this in a bio sidebar.) Li, 52, is a kind of Renaissance man with his own far-ranging curriculum vitae. He came to HKEx in 2009, after serving as chairman of JP Morgan Chase China and president of Merrill Lynch China. Li also was a practicing lawyer (having received his JD degree from Columbia University School of Law in 1991), a journalist (working for the China Daily after receiving a masters degree in journalism from the University of Alabama) and an offshore oil worker in the North China Sea prior to receiving a bachelor of arts degree in English literature from Xiamen University. Such broad-based credentials have helped Li envision an exchange that extends far beyond equities, all the while harnessing China's power--both its autocratic control and its impressive growth.

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