Hong Kong: China’s, and the World’s Offshore Problem

May 4th, 2011

In Treasure Islands I briefly mention Sir John Cowperthwaite, Hong Kong’s Financial Sectetary from 1961-1971, who had such stridently anti-government views that he banned the publication of official statistics because they would, he said, attract too much attention from civil servants. Such is the anti-government, anti-society worldview that I have so often encountered offshore.

I also quote Jack Blum, a top US criminal investigator, who described Hong Kong as an “anything-goes, no-regulation world . . corporations doing business in China set up Hong Kong companies with secret shareholdings . . today Hong Kong is where most of the corruption in China is accomplished.” In this light, it is frightening to note the latest bank to be given a banking licence in Hong Kong: the appalling LGT Bank of Liechtenstein.

Now Golem XIV, a widely-read UK economics blog, has a fascinating series of posts looking at Hong Kong’s role in China’s economy and political system. Let’s start with this post from a couple of weeks ago, and one of several interesting comments:

Last week we had the amazing spectacle of Wen Jiabao, the Chinese Premier, “asking” local governments to take responsibility to keep housing affordable and saying,

The central government’s aim to control the property market is “clear” and the determination is “firm,…

Since when did Communist supreme leaders “ask”? And when did they feel it necessary to make their determination “clear” and “firm”?

It is a post asking the question “who runs China?” Essentially, what he is saying, albeit a little tentatively, is that while the central bank has been trying to rein in lending, the regional governments, banks and developers have been largely ignoring the Central bank’s restrictions. Here’s the nub of it:

“Today I think we are seeing a major shift in power relations within China, a quiet revolution, in which the power to control China’s lending and debt is shifting away from Central government. What I think we are seeing is the opening of a financial backdoor to China. One that lies outside of Central Bank and Central Government control.

And that financial back door is Hong Kong.

If I am correct then this will create massive changes within China – nothing short of the crowning of a new financial elite to contest control with the old political elite of Beijing – and for the rest of us it will create a new source of sub prime securities, this time made in China.”

In short, his argument is this. One of the great troughs of money for Chinese regional elites – party cadres, officials, bankers, developers and business people – is land sales. They all want the river of money from land to keep flowing, and that means continued access to loans from banks. But the government is trying to curb lending. So:

on one side the regions have land to sell and developers who want to buy and develop it. What they both need is loans to finance the enterprise. The central government is doing its best to limit funding from those it has the power to regulate – Chinese banks and the few Western financial institutions that operate inside China.

On the other side we have a Western Banking system which needs to find two things: a place or venture which will provide them with a higher return on their money than they can get at home, and a securitization system, essential to how the banks operate, which is in dire need of something to securitize.

Between the two is Hong Kong.

Golem points to a document from the Hong Kong Monetary Authority from 2006, before the global financial crisis hit, salivating at the possibilities, including securitisation / CDOs, Total Return Swaps, Credit Linked Notes, CDS swaptions, and more. Then a very nice paragraph:

Why put up with all the interference from Central authorities inside China, when you can operate ‘outside’ of mainland Chinese regulations in Hong Kong? Hong Kong has always been the Asian portal in to the off-shore world of unregulated capital. When they took over, the Chinese did nothing to change that aspect of Hong Kong. Why shouldn’t China have its own off-shore conduit?  It’s like being a nuclear power – it gives a nation membership of a very exclusive club.

Britain would most certainly agree! Treasure Islands, looking carefully at the evidence, finds that essentially, around the mid-1950s, Britain exchanged one form of empire with another: its formal empire of colonies around the world, for a new financial empire, with London remaining as the “governor of the imperial engine.”

Then Golem points out the problem for China.

“But the offshore world is a franchise. Countries can have an outlet/inlet but that doesn’t mean they control it.  Hong Kong does not work primarily for China or the Chinese. Just as London does not work primarily for Britain or the British. Hong Kong works for the extra-territorial, supra-national interests of global capital, just like London, Jersey, The Cayman Islands and The Virgin Islands.  And there is the rub.

I couldn’t agree more. Fantastic, blistering stuff. He continues:

What is now, I believe, maturing fast in Hong Kong is a fully fledged off-shore, off-balance sheet portal into the world of shadow banking and unregulated, borderless finance.”

In a more recent post, Golem XIV (the author is David Malone, author of The Debt Generation) delves into a little history.

In the hand over of Hong Kong to China I feel quite sure the Hong Kong Monetary Authority and the global bankers would have told the Chinese government that preserving Hong Kong’s off-shore, arm’s length, ‘light touch regulation’ status and reputation would give China privileged access to Western Capital.

What I suspect they did not make quite as clear, is that it would, in time and once all the proper facilities were in place, give Western Capital, particularly its off-shore, off-balance sheet, shadowy part, the ability to access China via its own private backdoor.  Nor that once that happened there would be little the Chinese central government could do to stop or even regulate it. I believe we are at that point.

Leaving aside the question of whether or not China is at such a point, this is highly reminiscent of the U.S. authorities’ tolerance of U.S. banks diving into the offshore, unregulated Euromarkets – seeing it as a way to let the banks play their games elsewhere, without the U.S. having to degrade its own domestic regulations. The offshore escape route, in the long term, rebounded on spectacularly on the U.S.: among other things, it became the platform for Wall Street to conquer U.S. politics. (My last post illustrates one aspect of this nicely.)

The U.S. authorities had another reason to tolerate this business: it helped the U.S. keep the dollar as a reserve currency (a reason underlying its deficits today.) China, it seems, has similar ambitions. As the FT reports a few days ago, on the first ever Renminbi-denominated shares to be traded outside China:

“the listing has been hailed as an important milestone in China’s attempt to turn the renminbi – also known as the yuan – into a more global currency.

Hong Kong as an offshore market for the (otherwise tightly controlled) Chinese currency is a central part of that strategy. This is a very new business: it really just took off last year — see page 6 of this report to see how recently the corporate side of this has taken off.

It is, as an HSBC official puts it, “a financial revolution of truly epic proportions.”

All of this will change the structure of power in China “the crowning of a new financial elite” – in ways that will most probably not be a good thing for ordinary Chinese (though the current leadership is bad enough, as my own friends in China attest.)

And it will change the world too – also, most likely, not in a good way. Not at all.

Written by Nicholas Shaxson

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