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How Hong Kong will benefit from China’s rapidly changing economy

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                                                                  Economics – Hong Kong / China
                                                                                 December 2012

    A very special relationship
    How Hong Kong will benefit from China’s rapidly changing

                      The city’s economic future is becoming ever more closely entwined with China

                              Hong Kong has all the tools required to meet Beijing’s growing needs

                                           This is creating opportunities for many areas of business

                                                                                    By Donna Kwok

Disclosures and Disclaimer This report must be read with the disclosures and analyst
 certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it
   Economics – Hong Kong / China                                                                                abc
   December 2012


The economic relationship between Hong Kong and mainland China has advanced so much – and taken
on so many new dimensions – that it’s time to take another look at the way we assess the city’s future.
Hong Kong has long flourished as a gateway to China. What is changing is that the goods, services and
currencies that move through this gateway in both directions have become more diverse, mobile and
sophisticated. At the same time, the city is providing a controlled environment in which Beijing can test
and fine-tune its plans to liberalise its own financial system, including the offshore RMB market and the
opening of the capital account.

All this will create a range of business opportunities, especially in finance, tourism/retail, trade and
property. We estimate:

 By 2015, half of Hong Kong’s economy will be attributable to mainland China, up from a third today. By
  2020 as much as 70% of Hong Kong’s GDP will come from the city’s links with the mainland.

 For every mainland Chinese who visits Singapore or New York today, there are 20 or more who go to
  Hong Kong. We expect them to spend USD55bn in Hong Kong in 2015, equivalent to a third of its GDP.

 China’s swelling domestic demand for imported consumer goods and services will drive Hong
  Kong’s trade, half of which will likely be settled in RMB in three years.

No other city knows China like Hong Kong, which has location, history, speed and adaptability on its side. If
this Special Administrative Region of China can keep adjusting to the changes in the mainland’s increasingly
complex economy, it will retain its role as an indispensable go-between. This report looks at the areas where
Hong Kong can deepen and widen existing channels and open new ones to further develop this extraordinary
relationship as China moves rapidly towards becoming the world’s largest economy.


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    Economics – Hong Kong / China                                                                     abc
    December 2012


A very special relationship                               3     Servicing China                                 24
Deep roots                                                3     From exports to imports                         24

Three China trends which are changing the relationship    4     Services are the future                         25

Hong Kong is also evolving                                5     Time to adapt                                   26

Big numbers, big frictions?                               7     Tailor-made                                     26

Key numbers                                               8     A helping policy hand                           27

Marking Hong Kong’s card                                  9
                                                                Of bricks, mortar and bubbles                   28
                                                                Why mainland property buyers are here to stay   28
A financial incubator                                    10
Testing ground                                           10     How to control bubbles                          30

First-mover advantage                                    10     As safe as houses                               31

What’s next?                                             14
                                                                Disclosure appendix                             35
And don’t forget the power of the middle class           15
                                                                Disclaimer                                      36
The tourist dollar                                       18
The destination of choice                                18

Ticket to growth                                         18

More expected                                            19

Big spenders                                             20

Come rain or shine                                       20

Three years from now                                     21

From value to volume                                     22

Mainland import tax would not cut off mainland
visitor inflows                                          23

                                            Front cover design by Izumi Devalier


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   Economics – Hong Kong / China                                                                           abc
   December 2012

A very special relationship
 Hong Kong’s economic links with China are becoming ever closer
 As a gateway, the city has location, history, speed and adaptability on its side
 It is now also an incubator for the internationalisation of the RMB and the
   liberalisation of China’s capital account

Deep roots                                            Why Hong Kong?
Today, Hong Kong’s connections with the mainland      Location, history, speed and adaptability have
run much deeper than just trade, retail sales and     always been Hong Kong’s strong suits.
property. Overlapping infrastructure networks and     Geographically, the city sits in the middle of the
the exchange of human capital run alongside joint-    Pearl River Delta, which, excluding Hong Kong
development blueprints for the Pearl River Delta      and Macau, has accounted for a tenth of China’s
region and exchange rate reforms. Year by year, the   total GDP since 1993. Hong Kong is also right at
city’s economy is becoming ever more intertwined      the heart of Asia’s financial world and recently
with the mainland.                                    overtook the US at the top of the World Economic
                                                      Forum’s Financial Development Report (2011),
This close dance started more than 30 years ago.      which ranks countries by their financial stability
Although China started to open up in 1978, the        and business environment.
first two decades of economic integration with
Hong Kong were dominated by the production of         The rule of law is another cornerstone of Hong
tennis shoes, electronics and other cheap             Kong’s success, as is Beijing’s understanding of
manufactured goods. The signing of the Closer         the city’s financial markets and open,
Economic Partnership Arrangement (CEPA) in            international business mindset. For China’s
2003 took this integration a crucial step further,    regulators this makes it the best-controlled
opening a channel for the more active exchange of     environment in which to test and fine-tune
people, skills and services. Hong Kong quickly        liberalisation plans before introducing them on a
became a gateway for a lot more than just trade.      wider scale.

The same year saw the launch of personal RMB          For foreign investors buying into listed mainland
business services. Indeed, for the last two decades   entities, Hong Kong remains the most efficient
this city of 7.1 million has been home to a number    market in which to assess the fair value and risk
of important pilot schemes that have helped to        of investing in China. We expect this to hold true
drive financial liberalisation in China.              for many years, at least until China’s financial
                                                      landscape is largely liberalised and clear of most
                                                      current market distortions.


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    Economics – Hong Kong / China                                                                                                    abc
    December 2012

Although a number of mainland companies today                                We also believe Hong Kong is better placed than
trade in more than one international exchange,                               either Shanghai or Singapore when it comes to
over 85% of their offshore trading volumes still                             playing the China card. While Shanghai is making
takes place in Hong Kong (based on estimates                                 progress toward becoming a global financial centre,
from our Greater China equity strategists1).                                 it may take some years for it to build the same level
Indeed, the bulk of Hong Kong’s equity market                                of experience, pool of globally competitive talent
capitalisation today consists of mainland                                    and depth of market infrastructure that Hong Kong
companies or companies with considerable                                     already possesses. Singapore, meanwhile, lacks the
business exposure to China.                                                  geographical proximity, cultural links and policy
                                                                             access to China that Hong Kong enjoys.
Hong Kong has more than three decades of
experience of working with the mainland market,                              Three China trends which are
and also the closest cultural and linguistic alignment                       changing the relationship
with China of any Asian nation. Compared to
                                                                             1. Shifting demographics and a fast-
mainland cities, it has a significantly greater depth
                                                                             changing labour market
of expertise and experience in bridging the East-
                                                                             China’s demographic dividend is starting to run
West financial and diplomatic divide.
                                                                             out. According to projections by the United Nations
Finally, Hong Kong has a proven track record of                              Population Division, China’s workforce will start
resilience. Many doubted that the 1997 handover                              contracting from around 2017. Not only that, but by
from the British would go smoothly and thought                               2025 the proportion of people aged 65 years and
Hong Kong’s significance to China’s economic                                 over in China will jump from 10% to 16%.
development would diminish in the years that
                                                                             This has long-term implications for China’s growth
followed. But the change of sovereignty
                                                                             and consumption patterns. As the dependency ratio
proceeded without incident even though it
                                                                             rises, the IMF forecasts that age-related spending
coincided with the Asian Financial Crisis, which
                                                                             will rise by 4.1 % of GDP in China in the next 18
saw property prices nosedive.
                                                                             years (see Ageing Asia: The challenges of a
Since 1997 the city has prospered as a Special                               demographic shift, 16 October 2012).
Administrative Region (SAR) of China through an
                                                                             From a growth perspective, China should be able
arrangement known as “one country, two systems”
                                                                             to offset the impact of this ageing trend by
under which Beijing guarantees Hong Kong a high
                                                                             accelerating the process of urbanisation and
degree of autonomy over its own affairs, except for
                                                                             shifting jobless and underemployed workers to
defence and foreign policy, for 50 years.
                                                                             urban areas where they are most needed.
Hong Kong has also bounced back from the
                                                                             There is still considerable room for labour
Severe Acute Respiratory Syndrome (SARS)
                                                                             productivity to improve. It is often forgotten that
epidemic of 2002-03 and the recent global
                                                                             80% of the country’s remarkable growth between
financial crisis, averaging an annual growth rate
                                                                             1978 and 2004 was driven by rising productivity
of 6-7% throughout this period barring 2009,
                                                                             rather than expansion of its labour force (see
when it contracted by 2.5%.
                                                                             China Inside Out: Slowdown more cyclical than
                                                                             structural, 28 August 2012).
1 They estimate that 65% of total daily turnover in mainland listed equity
takes place onshore in the Shanghai and Shenzhen stock exchanges.


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    Economics – Hong Kong / China                                                                                                  abc
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China’s dwindling demographic dividend and the                             2. Financial reforms
accelerated pace of urbanisation have four                                 If China’s economic and social stability is to be
implications for the Hong Kong SAR:                                        maintained critical imbalances must be addressed.
 As urbanisation progresses, China’s demand for                           They include the: 1) widening wealth gap; 2)
  workplace innovation to enhance efficiency and                           disproportionate allocation of bank loans to state-
  improve urban living standards will grow. The                            backed entities instead of small and medium-sized
  average worker’s propensity to consume should                            enterprises (SMEs, which also provide the bulk of
  also increase as more people move from rural                             jobs and GDP growth); 3) absence of sustainable
  areas into the cities.                                                   long-term financing tools for infrastructure
                                                                           projects; 4) lack of a social welfare safety net.
 Positive wage growth in China is here to stay,
  which will strengthen the purchasing power of                            This means financial reforms must be
  the average mainland worker for years to                                 accelerated. As we argued earlier, there are clear
  come, along with their ability to travel. Total                          signs that the incoming new leadership will make
  additions to the workforce may be smaller, but                           speeding up reform top of their policy agenda (see
  workers’ share of new wealth creation should                             China’s Big Bang: New leaders ready to
  be higher. This, on balance, should strengthen                           revolutionize the financial system, November 2012).
  the purchasing power of households, including                            We expect China’s interest rates to be liberalised,
  those supporting non-working dependent                                   the onshore bond market to double in size, and the
  children and elderly family members.                                     RMB to be made fully convertible by 2017.

 Mainland demand for healthcare and other old                             China’s progress towards these goals will inevitably
  age-related services and products will rise.                             create significant near and long-term growth
                                                                           opportunities for Hong Kong.
 Only 30% of China’s working population has
  pension coverage (compared to an average of                              3. From trade to finance
  92% in Western Europe)2. With a minimal                                  China’s ability to connect its trade to the rest of
  social welfare safety net, China’s state and                             the world has been instrumental in driving the
  private pension systems will need to be                                  country’s economic development. Hong Kong, the
  dramatically expanded and upgraded in the                                gateway to the Pearl River Delta trading hub, has
  coming years.                                                            long played a major role in this process.

In all four of these areas the Hong Kong business                          Now, as China starts to develop its financial sector,
community arguably possesses some of the world’s                           Hong Kong is again acting as a bridge. It is an
leading expertise, and should benefit accordingly.                         increasingly attractive destination for mainland
This is provided that it does the necessary                                investors, provides a controlled environment for
homework to understand the intricacies of each                             testing pilot RMB currency/financial liberalisation
opportunity and tailors its services to fit different                      schemes and is also helping China’s companies
areas of China’s demand.                                                   expand overseas.

                                                                           Hong Kong is also evolving
                                                                           It’s not only China that is in transition. Since the
______________________________________                                     1980s Hong Kong’s trade flows have undergone a
2 Source: ILO. For further discussion, see Fred Neumann and Julia Wang’s
Ageing Asia: The challenges of a demographic shift, 16 October 2012.       dramatic change. First, there was the move from


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    Economics – Hong Kong / China                                                                                     abc
    December 2012

basic to advanced merchandise manufacturing.                    China’s RMB trade settlement scheme was
This was followed by the relocation of                           launched in Hong Kong in 2009; the city
manufacturing facilities from the SAR to Pearl                   dominates RMB trade settlement volumes.
River delta towns across the border. Next came the
                                                                The first offshore RMB product platform was
move away from tangible to non-tangible exports
                                                                 created in the SAR in 2010.
– 22% of Hong Kong’s exports now consist of
services, up from 16% in 1997.                                  The first RMB Qualified Foreign Institutional
                                                                 Investor (R-QFII) quotas were allocated to
Today, almost a third of services related to
                                                                 clients of Hong Kong-based mainland
shipments managed by Hong Kong traders do not
                                                                 brokerages in 2012.
even pass through SAR customs3; 45% of this
offshore trade service relates to China. Traders               Next on this list is likely to be Hong Kong’s launch
either buy goods outside Hong Kong for export                  of the first offshore RMB metals contract. The
elsewhere, or they arrange purchases/sales on                  groundwork was laid when the Hong Kong Stock
behalf of buyers/sellers based outside Hong Kong               Exchange (HKEx) acquired the London Metals
without taking ownership of the goods involved.                Exchange (LME) earlier this year.

The rise of the RMB is another important factor.               This broadens Hong Kong’s role from that of a
Three years ago Hong Kong was used as the main                 pure equity and financing-centre to one that will
testing ground for trade transactions using the                eventually support global commodity financial
RMB. The programme has subsequently been                       offerings. It also opens up a new training ground
expanded globally and today accounts for around                where mainland traders can learn much-needed
10% of China’s merchandise trade and well over a               global commodity pricing and risk hedging skills.
third of Hong Kong’s. It’s the latest example of
                                                               As China’s currency moves down the road
how China continues to make extensive use of the
                                                               towards full convertibility, the use of the RMB as
SAR as a financial incubator:
                                                               a global trade settlement currency should reach
 The first mainland companies listed in Hong                  critical mass by 2015. By this time we estimate
  Kong in 1993 (the start of the H-share market);              that a third of China’s total merchandise trade will
  major mainland banks listed in 2005-06.                      be settled in RMB. This process will go hand-in-
                                                               hand with the gradual globalisation of China’s
 It was the first offshore centre to develop
                                                               financial markets.
  personal RMB services (2004). Hong Kong
  still has the world’s most efficient and secure
  offshore RMB settlement platform and
  payment system.

 The first offshore RMB bond (commonly
  known as dim sum bonds) was issued in the
  SAR in 2007.



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    Economics – Hong Kong / China                                                                                                                                      abc
    December 2012

  Chart 1. Monthly average RMB trade settlement volumes in                                        residential property do not take longer
  Hong Kong have continued to rise despite the slowdown in
  global trade flows since 2Q12                                                                   than expected.
 800 RMB bn
                              669     684       693      669
                                                                                             To an extent, reputational risk is already an issue.
 600                                                                                         For example, a robust set of credit metrics4 (which
                                                                                             has been repeatedly tested over the years) suggests
 400           321
                                                                                             that the Hong Kong sovereign should have the
                                                                   214          239
                                       185           190                                     highest possible credit rating. However, it doesn’t.
 200                     134
            57                                                                               Our sovereign credit analyst thinks this is largely
   0                                                                                         because the SAR’s rating is being capped by the
            2H10          1H11          2H11         1Q12          2Q12          3Q12
                  Monthly average value: RMB trades settled in HK
                                                                                             economy’s growing ties with China (see Asia’s
                  Outstanding CNH liquidity in HK (period end)*                              Bond Markets – The View, November 2012).
  Source: CEIC, HKMA, HSBC. . * RMB liquidity includes RMB deposits; RMB certificates of
  deposit; and EMTN and CNH bonds issued by local banks with maturity of one year or less.   Having said that, we do not expect the city’s strict
                                                                                             bank credit risk management system (one of the
Big numbers, big frictions?                                                                  most reputed in the world) to be relaxed any time
There will, of course, be risks and challenges as                                            soon, especially with loose global liquidity
this story unfolds, including:                                                               conditions set to persist through 2015 (see FOMC
                                                                                             Impact: New chapter for Fed policy,
 China’s strong economic growth might be                                                    12 December 2012).
  unexpectedly derailed.
                                                                                             But this is a good example of how growing ties with
 Hong Kong could become too complacent                                                      the mainland can work both ways. While some see
  about its global competitive standing.                                                     Hong Kong’s unique policy access to and closer
 The number of mainland visitors could become                                               integration with China as an opportunity, others
  too great and exert excessive strain on                                                    may see it as a risk. Greater access means greater
  resources (e.g., hospitals and schools).                                                   exposure, but that comes with the territory if Hong
                                                                                             Kong is to gain a better understanding of how best
 The SAR faces reputational risk as a result of                                             to respond to a rapidly changing mainland market.
  closer integration with China (e.g., ease of
  doing business).                                                                           In the long run, we believe greater policy access
                                                                                             to China will remain more of an opportunity than
To avoid this, Hong Kong will have to:                                                       risk for Hong Kong, provided the SAR
 Ensure a high quality and quantity of                                                      government works actively, and pre-emptively,
  innovation in key service sectors.                                                         with mainland authorities to ease cross-border
                                                                                             barriers at the correct pace (e.g., the recent
 Adapt regulatory and tax frameworks to                                                     postponement of Shenzhen’s plan to allow non-
  maintain a first-mover advantage and keep                                                  permanent residents to apply for multi-entry
  ahead of regional competitors.                                                             permits to Hong Kong under the Individual
 Invest to maintain a very competitive skilled                                              Visitor Scheme).
 Make pre-emptive investments to prevent                                                    4 Hong Kong’s net external credit position was 282.5% of GDP at end-
                                                                                             2011compared to a median net creditor position of 21.2% of GDP for
  resource shortages. For example, making                                                    AAA countries over the past year, according to Fitch data. Moreover, it
                                                                                             has been running a current account surplus since 1998.
  certain that measures to increase the supply of


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    Economics – Hong Kong / China                                                                             abc
    December 2012

For China, it’s also an opportunity to absorb           Key numbers
international best practices already instilled in the
                                                        For Hong Kong to make the most of these
SAR’s economic fibre. Beijing is not seeking to
                                                        opportunities, it will have to tailor more of its
export its macro imbalances (e.g., in its banking
                                                        services for mainland consumers and businesses.
system) to Hong Kong. It is seeking to import the
                                                        As its economy becomes ever more closely
SAR’s globally competitive standards into its
                                                        entwined with China, we forecast huge increases
own system.
                                                        in tourist visits, RMB business, trade services and
We think the greatest challenge for Hong Kong           logistics. The key statistics are summarised in the
during this journey will be to maintain the quality     table on page 7, while the rest of this report
of economic growth and ensure that social friction      focuses on four areas where we see the richest
is kept to a minimum. The benefits of this evolving     potential – finance, tourism and retail, trade and
relationship with China must be distributed to a        asset markets (property).
broader cross-section of society than many believe
is happening at the moment.

This will require policy support to address any
unexpected or unintended side effects of deepening
economic integration, as well as other existing
challenges such as dealing with a widening wealth
gap and an aging population. The Hong Kong public
has already expressed concern about rising pressure
on hospitals and schools and the impact rising retail
rents is having on small businesses.

This report tries to quantify how Hong Kong SAR
can optimise the benefits of this unique
relationship as China moves closer towards full
currency convertibility and capital
account liberalisation.

The end point of this journey may arrive once the
mainland establishes the same level of experience,
pool of globally competitive talent and depth of
market infrastructure that Hong Kong currently
possesses, but that appears to be some years away.
What comes after that will require a separate
discussion as it may be a very different journey.


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     Economics – Hong Kong / China                                                                                 abc
     December 2012

Marking Hong Kong’s card
Why the SAR will continue to prosper from its relationship with the mainland

1)    By 2015, half of Hong Kong’s economy will be attributable to mainland China, up from a third today. By
      2020 as much as 70% of Hong Kong’s GDP will come from the city’s links with China.5

2)    Around 10% of deposits in Hong Kong’s banking system are now denominated in RMB. By the end of
      2015, we think this will rise to 30%.6

3)    Ten of the world’s top 20 global IPOs last year were in Hong Kong; half of the issuers were domiciled in

4)    For every mainland Chinese who visits Singapore or New York, 20 or more go to Hong Kong. We expect
      them to spend USD55bn in the SAR in 2015.8

5)    Six out of every 10 visitors to Hong Kong today are from China. By 2015, this should be eight.9

6)    In 2011 shopping by mainland visitors amounted to a quarter of total retail purchases in Hong Kong and
      was equivalent to 5% of the city's GDP.10

7)    Globally, Hong Kong ranks tenth in international tourism receipts. In per capita terms, it ranks second.11

8)    By 2015, mainland travellers will be making over 134m trips overseas, which would mean 50m mainland
      visitors heading to Hong Kong.12

9)    If spending by sectors dealing with tourists is included, we estimate that mainland visitors will be
      spending the equivalent of 34% of the city’s GDP in three years’ time.13

10) Merchandise trade settled in RMB has grown from around 2% of China’s total trade in mid-2010 to about
    10% today. Of that, Hong Kong handles about 90%, up from 60% in mid-2010 and 80% in mid-2011.14

11) Half of Hong Kong’s total merchandise trade will be settled in RMB by 2015.15

12) By 2020, it’s likely that China will account for around three quarters of both Hong Kong’s goods and
    services exports.16

13) Mainland buyers account for around 30% of the luxury property market and 10-20% of the mass
    residential market.17

5 Source: HSBC estimates.
6 Source: HSBC estimates.
7 Source: Dealogic, Thompson Financial, Ernest & Young “Global IPO trends 2012”.
8 Source: HSBC estimates.
9 Source: HSBC estimates.
10 Source: CEIC.
11 Source: UNWTO (as of June 2012), IMF, WB, HSBC estimates.
12 Source: HSBC estimates.
13 Source: HSBC estimates.
14 Source: HSBC estimates.
15 Source: HSBC estimates.
16 Source: HSBC estimates.
17 Source: Centaline.


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     Economics – Hong Kong / China                                                                                                                                                                abc
     December 2012

A financial incubator
 Hong Kong provides a controlled environment as Beijing
     encourages its companies, investors and currency to expand
 Independent regulatory and legal frameworks are key assets…
 …but the SAR’s global competitive edge is the greatest asset that
     must be preserved

Testing ground                                                              the free cross-border transfer of funds in and out of
                                                                            China for capital account items.
Hong Kong has many attributes that make it the
perfect place to launch, test and fine-tune China’s                          Chart 2. Competitive advantage: Hong Kong as top
                                                                             destination for new company registrations
financial reforms. Aside from location, it also offers
                                                                                          No. of new companies (12mma)
independent regulatory and legal systems, but it is                           9,000
the city’s global standing in financial markets which
really seals the deal. The SAR is variously
described as the world’s freest economy18; most                               3,000

developed financial system and capital market19;                                  0
second easiest place in which to conduct business20;
and third top financial centre21.

For China’s currency and capital to exit its borders,                                          HK                         SK                          SG                         TW
there must be offshore destinations. And that’s
                                                                             Source: CEIC, HSBC
where Hong Kong comes in. Opportunities here lie
on two fronts, internationalisation of the RMB and
                                                                            First-mover advantage
serving China’s emerging middle class.
The internationalisation of the RMB and
                                                                            The offshore RMB story started in 2007 when
liberalisation of the capital account top the new
                                                                            personal RMB banking services were first offered
Chinese leadership’s financial reform priorities. The
                                                                            in Hong Kong. But it wasn’t until Beijing
first equates to the lifting of restrictions on the
                                                                            endorsed the RMB as an official cross-border
international use, transfer and exchange of the
                                                                            trade settlement currency that the
currency. The second to the lifting of restrictions on
______________________________________                                      internationalisation process truly took off (see The
18 Heritage Foundation’s Economic Freedom Index 2012
19 World Economic Forum Index’s Financial Development Index 2012            rise of the redback: A guide to renminbi
20 World Bank Index 2013 (published October 2012)
21 Qatar Financial Centre Authority’s Global Financial Centres Index 2012
                                                                            internationalisation, November 2010).


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   Economics – Hong Kong / China                                                                                                                                                   abc
   December 2012

 Chart 3. RMB internationalisation: A three-stage process

           Trading                                    Investment                                                               Reserve
           Currency                                     Currency                                                               Currency

 • Kicked off in June 2009                   • Hong Kong’s offshore RMB                                    • More symbolic than material
                                               products platform CNH FX market
 • Potential lies in emerging,                                                                             • Minimum criteria: full RMB
                                               was launched July 2010
   not developed markets                                                                                     convertibility (by 2017)
                                             • Other side of the coin to trade
 • Around 10% of China’s trade                                                                             • Initial progress: some foreign
   already settled in the RMB, up                                                                            central banks have made
   from 2% in 3Q10                           • RMB product variety significantly                             small RMB bond purchases
                                               expanded to include dim sum
 • Critical mass expected by                                                                               • To be a true global reserve
                                               bonds, investment funds, equity
   2015, when 1/3 of China’s trade                                                                           currency, RMB must be
                                               products, exchange traded-funds,
   (USD 2trn) should be settled in                                                                           accepted across world:
                                               and currency derivatives
   the RMB                                                                                                   1) for investment, financing,
                                             • RMB investment outflows just as                               and payment purposes
 • Initially driven more by
                                               important as inflows for the                                  2) as a reserve, intervention
   import than export demand
                                               onshore-offshore circulation of                               and anchor currency
   but imbalance has lessened
                                               China’s currency

 Source: CEIC, HSBC

The global rise of China’s currency is best                       RMB liquidity22 is critical for nurturing transaction
understood in three stages – its rise as a global trade           turnover in a young CNH market (the offshore RMB
settlement currency, followed by its acceptance as a              is generally known as the CNH). The bigger the pool
leading investment currency and then its emergence                of CNH liquidity the more viable the market
as a reserve currency (see Offshore RMB: What’s                   becomes for institutional investors (see A new look
next? Four trends to watch, February 2011). The                   at CNH liquidity: Just turned two and growing up
first two stages go hand-in-hand as neither can reach             fast, August 2012).
critical mass without the other (see chart above).
                                                                    Chart 4. Hong Kong’s RMB liquidity growth has slowed but
                                                                    the level remains over six times higher than mid-2010
Merchandise trade settled in RMB has grown                          800
                                                                              RMB bn
from around 2% of China’s total trade in mid-                       700
2010 to around 10% today. Of that, Hong Kong                        600
handles about 90%, up from 60% in mid-2010 and
80% in mid-2011. With RMB trade settlement
being a major source of RMB deposit growth,                         200
Hong Kong’s pool of offshore RMB deposits is                        100
by far the largest in the world.                                       0





Liquidity and transactions                                                 Offshore RMB CDs*                                     Hong Kong: RMB demand deposits
                                                                           Hong Kong: RMB time deposits
As of end October, RMB bank deposits in Hong                        Source: Bloomberg, CEIC, HSBC. * RMB liquidity includes RMB deposits; RMB certificates of
Kong stood at RMB555bn, more than six times                         deposits; and EMTN and CNH bonds issued by local banks with maturity of 1-year or less.

the level in mid-2010. This has enabled the city’s
financial institutions and the Hong Kong
Monetary Authority (HKMA) to establish a                          ______________________________________
                                                                  22 Proliferation of short term higher yielding RMB assets as Hong Kong’s
thriving offshore RMB market.                                     CNH market matured since 2010 has led to an expansion of our definition of
                                                                  RMB liquidity, to include: RMB deposits; RMB certificates of deposits; and
                                                                  EMTN and CNH bonds issued by local banks with maturity of 1-year or less.


             FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
     Economics – Hong Kong / China                                                                                                                        abc
     December 2012

  Chart 5. Uptake of cross-border RMB trade settlement took                         6. We expect Hong Kong’s offshore RMB liquidity to top
  off with the launch of the offshore RMB products platform in                      RMB2.6trn by end 2015
  Hong Kong
 800        RMB bn                                                           700    3,000      RMB bn                                               35%
                                                                RMB bn                                           Offshore RMB lquidity
                                                                             600    2,500                      growth weighed down by               30%
 600                                                                         500                              sluggish global trade flows           25%
                                                                                    2,000                     and tight onshore liquidity
                                                                             400                                  conditions in China               20%
 400                                                                                1,500
                                                                             300                                                                    15%
                                                                             200    1,000
 200                                                                                                                                                10%
                                                                             100      500                                                           5%
     0                                                                       0           0                                                          0%
         12-093-10 6-10 9-1012-103-11 6-11 9-1112-113-12 6-12 9-12                             2009 2010 2011 2012f 2013f 2014f 2015f
             RMB settlement: Merchandise trade (Lhs)                                              RMB CDs and deposits (Lhs)
             RMB settlement: Service Trade and Other Current Account (Lhs)                        RMB deposits as % of total deposits in HK (Rhs)
             RMB deposits in Hong Kong (Rhs)
  Source: CEIC, HSBC. NB: RMB trade settlement data for merchandise versus          Source: HKMA, CEIC, HSBC estimates
  services and current account items only available from 2011 onwards.

The healthy development of CNH business looks                                      As China’s growth momentum strengthens and
set to continue in the SAR. At over RMB680bn,                                      monetary conditions return to their long-term trend,
total RMB liquidity remains at sufficient levels to                                we expect CNH liquidity growth to strengthen again.
accommodate healthy CNH transaction turnover in                                    We also expect the pool of offshore RMB liquidity
Hong Kong (see chart 4). And despite stalling                                      in Hong Kong to top RMB 2.6trn by the end of
global and regional trade, offshore RMB trade                                      2015. By then, we expect the RMB to account for
settlement is still growing strong (see chart 5).                                  about 30% of Hong Kong’s total deposits by the end
                                                                                   of 2015, up from today’s 9% (see chart 6).
RMB deposit growth has slowed over the past year,
in part because of slower mainland growth and                                      As offshore use of the RMB picks up pace our
tighter onshore liquidity conditions in China. But                                 credit strategist expects gross issuance of dim sum
other structural, not cyclical, factors also                                       bonds to total RMB280-360bn in 2013, up from
contributed to this slowdown, including:                                           RMB263 year-to-date in 2012 (see Offshore RMB
                                                                                   bonds: Dim Sum Tracker: A very good year,
 The moderation of RMB appreciation
                                                                                   13 December).
  expectations since late 2011. This has helped
  to rectify the severe imbalance between RMB
  outflows and inflows (slanted heavily towards                                     Chart 7. CNH 2013 issuance forecast: RMB280-360bn

  outflows from China throughout 2010-11).

 The expansion and/or opening up of new
  channels for RMB inflows back to China
  (e.g., RMB QFII), plus the streamlining of
  these channels by regulators (e.g., RMB FDI).

 The reallocation of RMB funds away from
  deposit accounts towards higher yielding
  CNH investment products, especially bonds
  and certificates of deposits.
                                                                                    Source: Bloomberg, HSBC
We take this gradual structural shift as a good sign,
as it indicates the market is maturing.


              FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
                                   Economics – Hong Kong / China                                                                                                                                       abc
                                   December 2012

 Chart 8. Hong Kong’s first-mover advantage in RMB trade                                                   Chart 10. … has translated into a first-mover advantage in
 settlement…                                                                                               processing offshore RMB transactions
800 RMB trade settlement, RMB bn                                                                                 % Share of offshore RMB global payments, via SWIFT
                                                                                                                 (by value )
                                       (% denotes proportion of trade
                                       settled in Hong Kong)                                                  Taiwan          0.5

                                                                                           90%             Singapore             3.9
                                                                    90%                                             UK           4.0
                                                                                                                China             5.1
                            0                                                                             Hong Kong                                                                             79.6
                                               3Q10                 3Q11                  3Q12
                                      Settled via Rest of World       Settled via Hong Kong                               0       10      20      30      40      50       60      70      80
           Source: CEIC, HSCB                                                                              Source: SWIFT (Society for Worldwide Interbank Financial Telecommunications), HSCB.
                                                                                                           Swift data is collated from 10,118 financial institutions in 210 countries (August 2012).

The birth of the CNH product platform offered                                                             Hong Kong’s CNH business. Frequent dialogue
Hong Kong’s financial and trade service providers a                                                       with the Bank of China (HK), which is the city’s
rare opportunity to develop brand new services and                                                        RMB clearing bank, and institutions such as HKEx
products from scratch. Even better, this platform                                                         and local banks has ensured that regulation has been
depends less on a global economic recovery than                                                           clear and coherent in a fast-moving environment.
product innovations. By opening up attractive
                                                                                                          Hong Kong’s CNH market structure is held up by
avenues for offshore RMB capital, offshore traders
                                                                                                          three core pillars: 1) a strong regulatory framework;
have become a lot more willing to use the RMB for
                                                                                                          2) a RMB real time gross settlement (RTGS) system
trade settlement, reinforcing Hong Kong’s position
                                                                                                          offered by the HKMA and Hong Kong Interbank
as the global centre of CNH liquidity.
                                                                                                          Clearing Ltd (HKICL), which allows almost 200
Product infrastructure                                                                                    Hong Kong and overseas participants to clear their
Products need a strong market framework to create                                                         cross-border RMB transactions; and 3) a RMB
confidence among buyers and sellers, which is                                                             clearing bank model that provides a bridge for
where the SAR’s now tried and tested CNH                                                                  transactions between China’s central bank, the
regulatory and transactional infrastructure comes in.                                                     People’s Bank of China (PBoC), and banks that
                                                                                                          participate in Hong Kong’s CNH market, and
           Chart 9. Hong Kong’s RMB clearing bank model
                                                                                                          clearly differentiates between sovereign and
Individual or corporate accounts

                                   banks/                                                                 commercial counterparty risk (see chart 9).

                                   Other                              Hong Kong        People’s Bank
                                                                                                          This market structure reinforces Hong Kong’s
                                                  HK RMB RTGS
                                                                     clearing bank    of China (CNAPS
                                                 Participant bank
                                                                       (BOC HK)           system*)        dominance in both the global market for RMB
                                                                                                          trade settlement flows (90%, see chart 8) and
                                   banks/                                                                 offshore RMB transactions within SWIFT’s
                                                                                                          international institutional payment orders network
           Source: SWIFT, HSBC. * China National Advanced Payment System can be seen as an “in-
           country RMB clearing system, which currently processes cross-border payments but with          (80%, see chart 10).
           limitations (e.g. local language requirements). Beijing plans to develop a new International
           Payment System referred as China International Payment System (CIPS) by 2014.
                                                                                                          The period between mid-2010 and the end of 2011
In the space of two years, the HKMA has created an                                                        was one of rapid growth for Hong Kong’s CNH
excellent financial regulatory infrastructure for                                                         market that included a number of growing pains and


                                         FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
     Economics – Hong Kong / China                                                                                                                  abc
     December 2012

regulatory fine-tuning23. In contrast, 2012 has been                         Table 1 summarises developments over the last
more stable and a number of moves have been taken                            year. Those with the greatest CNH business
to loosen regulations, including:                                            potential for Hong Kong are highlighted in bold.

 January 2012: allowing local banks to use                                  Table 1. RMB internationalisation: last 12 months
  RMB assets in statutory liquidity ratio                                    Date                   Event
  calculations, subject to certain conditions24.                             October 2011   A standardisation of the RMB remittance process
                                                                                            for funds raised offshore as FDI back into China
 May 2012: allowing local banks to determine                                December 2011 Launch of a new RMB QFII (RQFII) programme
                                                                                            for mainland brokerages based in Hong Kong
  their own RMB net open position (NOP) limit                                January 2012   Establishment of an offshore RMB interbank
                                                                                            benchmark rate in Hong Kong with rate
  in consultation with the HKMA, rather than                                                contributions from local CNH participant banks;
  imposing a standard NOP on the                                                            critical for developing credible and well founded
                                                                                            interest rate fixings to support CNH lending and
  whole market25.                                                                           product innovations.
                                                                             February 2012 Introduction of physical exchange-traded
 June 2012: introducing a RMB liquidity                                                    funds (ETFs) linked to China’s A-share
                                                                                            markets in Hong Kong, giving investors
  facility to help local banks deal with short-                                             access to China’s securities markets via the
                                                                                            R-QFII programme
  term liquidity tightness (triggered by                                     February 2012 First issuance of an offshore RMB bond by a
  unexpected external capital market                                                        Chinese non-financial corporate in Hong Kong
                                                                             April 2012     A doubling of the daily trading band for the
  developments).                                                                            onshore USD/CNY spot exchange rate to 1%
                                                                                            above or below the PBoC’s reference rate
 June 2012: extending the Hong Kong RMB                                     April 2012     QFII quota expanded from USD30bn to
                                                                                            USD80bn, giving foreign investors access to
  RTGS’ operating hours to 11.30pm local time                                               China’s onshore markets. R-QFII quota also
                                                                                            increased from USD20bn to USD70bn
  from 6.30pm to accommodate demand from
                                                                             April 2012     PBoC announced plans to develop an independent
  Europe and North and South America.                                                       international payment system (China International
                                                                                            Payment System, or CIPS) to process cross-border
What’s next?                                                                 May 2012
                                                                                            RMB clearance by 2014.
                                                                                            The NDRC, an important economic planning
                                                                                            body, launches of an offshore RMB bond
To retain their first-mover advantage, Hong Kong                                            issuance framework for onshore non-financial
institutions must stay at the forefront of CNH
                                                                             May 2012       Official approval for 10 China corporates in
innovation. As the RMB approaches full                                                      Guangdong take out direct offshore RMB loans
                                                                             June 2012      China’s interest rates liberalisation process moves
convertibility (see China’s Big Bang: New leaders                                           forward, with onshore banks allowed to deviate for
ready to revolutionise financial system, November                                           the first time from the benchmark deposit rate by
2012), opportunities will be created around the:                             July 2012      The State Council approves the development
                                                                                            of Qianhai in Shenzhen as a pilot zone for
1) deepening and liberation of China’s onshore                                              more innovative cross-border RMB business
capital markets; 2) relaxing of restrictions on                                             with Hong Kong
                                                                             August 2012    China and Taiwan sign a memorandum of
China’s exchange rate; and 3) loosening of                                                  understanding on cross-Strait currency clearing; each
                                                                                            designates a bank to provide local currency
restrictions on cross-border capital flows.                                                 clearing/settlement services
                                                                             September 2012 Creation of a deliverable RMB futures exchange
                                                                                            in Hong Kong
                                                                             October 2012   The Bank of Taiwan is given official preliminary
______________________________________                                                      approval as the TWD clearing bank in China.
23 For instance: 1) overcoming the issue of counterparty risk for Hong       October 2012   Launch of RMB-denominated ETFs in China
Kong’s RMB participant banks in dealing with the clearing bank (Bank of                     tracking Hong Kong stocks, allowing mainland
China Hong Kong), due to the latter’s dual status as a commercial bank, by                  investors the first (albeit indirect) channel to
creating a judiciary account arrangement; 2) the temporary suspension of a                  trade in Hong Kong equity and better diversify
RMB conversion facility window in December 2010, which the clearing bank                    their portfolios.
used to offer for RMB trade settlement transaction.
24 This encouraged banks to hold more RMB-linked assets such as bonds        Source: HSBC, various onshore and offshore media sources
and short-term loans.
25 This enabled banks to better manage their FX risk, allowing greater
opportunities for CNH liquidity to grow.


           FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
    Economics – Hong Kong / China                                                                                                                                    abc
    December 2012

And don’t forget the power of                                                             USD8.2trn from USD1.7trn during this period. A
the middle class                                                                          recent report by Capgemini and RBC Wealth
                                                                                          Management counted over 560,000 high net worth
The second area of financial opportunity for Hong
                                                                                          individuals (HNWI)29 in China today, with
Kong lies in serving the growing needs of China’s
                                                                                          USD1m or more at their disposal for investing.
emerging middle class. This group is accumulating
                                                                                          Mainland millionaires are Asia-ex-Japan’s largest
wealth fast. At 333m and rising, they are hungry
                                                                                          group of HNWIs by this measure, with 25% of the
for opportunities to diversify their wealth
                                                                                          region’s HNWI wealth (USD2.7trn in 2011).
internationally. They want to be ready to respond to
the anticipated easing of restrictions on outbound                                         Chart 12. China accounts for 40% of Asia-Pacific ex Japan’s
                                                                                           high net worth individuals
private investment, in order to boost the rates of                                         1,500     Person (000)
return on their savings.

Backed by a long-term annual GDP growth rate of                                            1,000
at least 7-8%26 and government policy27 biased
towards faster income growth, China’s disposable
income growth is likely to accelerate for many
                                                                                                                                      41%         39%         40%
years. This, in turn, should propel China’s longer-                                                      37%            40%
term ambitions to have an economy that is driven                                                0
                                                                                                        2007           2008          2009         2010        2011
by domestic demand.                                                                             China               South Korea         India            Singapore
                                                                                                Taiwan              Hong Kong           Others

  Chart 11. Though far behind other developed economies,                                   Source: Capgemini Lorenz Curve Analysis (2012), HSBC
  China’s middle class is catching up fast

350     Person, mn                                                          %        30   Another recent report from the Industrial Bank
300                                                                                  25   Private Banking and Hurun Report30 puts China’s
                                                                                     20   number of HNWIs (earning over RMB6m or just
                                                                                     15   over USD0.9m) even higher. In a sample of 29
                                                                                          Chinese cities, they identified almost 2.8m people
                                                                                          with assets of over RMB6m31, the majority of
 50                                                                                  5
                                                                                          whom are concentrated in Eastern China.
   0                                                                                 0
         2005       2006      2007      2008      2009       2010      2011               As China continues to lower its capital account
                Urban middle class (Lhs)                % of population (Rhs)
                                                                                          barriers, demand for asset management services will
  Source: CEIC, HSBC. NB: Middle class defined as households with an annual income
  between RMB 60,000 to $500,000 (NBS definition, 2005).                                  increase significantly. This means new business
                                                                                          opportunities for foreign bank services and wealth
Besides the middle class, the number of millionaire                                       management providers, operating not only inside
households in China is also expected to more than                                         but also outside of China.
double from 1.2m in 2011 to 2.5m by 202028, with
                                                                                          While investors tend to see Singapore as the best
the total wealth held by this group rising to
                                                                                          place to access Southeast Asian investment
26 See China Inside Out: Slowdown more cyclical than structural, August                   opportunities, Hong Kong is typically seen as the
27 Current 12th Five-Year Plan calls for urban disposable income and rural                best centre to tap investment openings in China.
average net income to grow by 7% per annum in 2011-2015. Chinese                          ______________________________________
Communist Party's 18th Congress set target of doubling China’s per capita                 29 “2012 Asia-Pacific Wealth Report”, September 2012.
income by 2020.                                                                           30 "The Chinese Luxury Consumer White Paper, March 2012".
28 “The next decade in global wealth among millionaire households” May                    31 29% of whom had assets worth RMB 6-10m, 45% with RMB 10-15m,
2011, Deloitte Center for Financial Services.                                             15% with RMB 50-100m and 11% with assets worth over 100m.


              FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
     Economics – Hong Kong / China                                                                                                                                 abc
     December 2012

More importantly, onshore mainland HNWIs also                                       world’s top equity IPO launch pad over 2009-
prefer to use Hong Kong as a springboard for                                        11. Last year, the SAR raised USD36bn of
investing overseas, for both cultural and business                                  IPO capital compared to New York’s
reasons32. The challenge for Hong Kong is to nurture                                USD31bn. Hong Kong has been ranked
and retain this “preference”.                                                       among the top five IPO centres since 200138.

We think Hong Kong is better positioned than other                              Chart 13. Hong Kong: Market of choice for mainland assets*

cities to be China’s major offshore wealth                                                North
management centre, for five reasons:                                                    Europe and
1     As the top listing destination for Chinese                                         regions
      companies, it is the preferred offshore
      investment market for mainland investors
      seeking exposure to their “home-grown                                                                                                       Hong Kong
                                                                                      Rest of                                                       60%
      corporate champions” in a free-market                                         Asia Pacific
      setting. Ten of the world’s top 20 global IPOs
      last year took place in Hong Kong, with half
      the issuers domiciled in China33.. As of the                              Source: SFC Fund Management Activities Survey 2011 (July 2012), HSBC. * Mainland
                                                                                assets managed in Hong Kong in 2011.
      end of 2011, almost half of the 1,326
      companies listed on HKEx were linked to                               3       Hong Kong is good at investing “other people’s
      China; 13% were H-shares, 8% red chip                                         money”. The city’s attraction to mainland
      stocks, and 28% non-H-share mainland                                          investors is enhanced by its experience in
      private enterprises34.                                                        servicing regional and global investors. Some
2     Hong Kong is one of the most active fund                                      60-70% of the city’s fund management
      raising hubs in the world, with exceptionally                                 business last year was managed on behalf of
      deep capital markets. For example, it is: one of                              non-local investors. Of this, mainland assets
      the top fund management centres in Asia with                                  accounted for USD8bn, around 60% of which
      a combined fund management business of                                        was invested in Hong Kong.
      USD1.16trn at the end of 2011, compared to                            4       The SAR’s unique economic and policy links
      Singapore’s USD1.03trn35; the leading hub for                                 to China enhance cross-border financial
      hedge funds investing in Asia36 ; the largest                                 regulation. As the CNH market has proved,
      hub for QFII and QDII managers37; and the                                     co-ordination between Hong Kong and
                                                                                    Beijing allows financial regulations to be
32 Capgemini and RCB Wealth Management (“2012 Asia-Pacific Wealth                   implemented efficiently and swiftly, priceless
Report”, September 2012)
33 Source: Dealogic, Thompson Financial, Ernest & Young “Global IPO                 in a fast-changing market environment.
trends 2012”.
34 Source: HKEx. Note: H-share companies are companies incorporated in
Mainland China and whose listings in Hong Kong are approved by the          5       Hong Kong is strong on the basics. As a
China Securities Regulatory Commission. Red chip companies in contrast
are enterprises incorporated outside China but are controlled by Mainland           mature and established financial centre, Hong
Government entities. Non H-share Mainland private enterprises are those
incorporated outside China but controlled by Mainland individuals.                  Kong has a deep pool of expertise, a simple,
35 Source: HKMA ("Fund Management Activities Survey 2011), July 2012
and MAS ("2011 Singapore Asset Management Industry Survey") June 2012.              transparent taxation system39, and a robust
36 By value of hedge fund assets hosted (USD 38.9b) and the number of
start-up hedge funds launched in 2011. Source: AsiaHedge.                   ______________________________________
37 As of the end of October 2012, there were 159, 21 and 105 approved       38 Source: Hong Kong Stock Exchange (HKEx).
investment funds accumulated under the QFII, RMB QFII and QDII schemes      39 For instance, no withholding tax on income distribution, VAT or capital
respectively. Source: CEIC.                                                 gains tax.


           FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
     Economics – Hong Kong / China                                                                                                           abc
     December 2012

  Chart 14. 71% of China’s overseas investment sits in Hong Kong       Chart 15. Two-thirds of China’s FDI came via Hong Kong in 2011
 % of total accumulated ODI (2011 annual invested value, USD bn)        70      % of total annual FDI (2011 annual utilized value, USD bn)
70       45                                                                           77
60             36
50                                                                      50
                                             2006        2011                                              2006    2011
40                                                                      40
30                                                                      30
20               11                                                     20
10                    8 3
                               3 3 2 1 0 1 1 3 1 0              1 1     10                   7      6        6
 0                                                                                                                    3       3        1









                                                                                 HK      Taiwan Japan     SG      USA      Korea    GER

  Source: CEIC, HSBC. V&C = Virgin and Cayman Islands.                 Source: CEIC, HSBC.

      and internationally competitive regulatory and                  The scheme is expected to be launched in a matter
      legal infrastructure. Decades of experience                     of months, although the amount involved is still
      have helped the city to minimise bureaucratic                   unclear. Foreign hedge funds may be given only
      red tape, making it attractive to investors and                 gradual access to the QDLP in order to give the
      companies seeking to raise funds.                               local equivalents time to develop sufficient know-
                                                                      how to compete on equal terms. That said, it is
To put the size of this opportunity in context,
                                                                      clear that Beijing is keen to tap into the extensive
China is already the world’s sixth largest exporter of
                                                                      global reach offered by foreign hedge funds.
capital (2011: USD75bn). And, despite the y-t-d
decline in FDI inflows, China became the world’s                      It is likely that the bulk of QDLP flows will be
top FDI destination in the first half of this year40                  routed through Hong Kong. Over 70% of China’s
(USD59bn, compared to USD61bn in 1H11, and                            outward direct investment sits in Hong Kong,
USD116bn for the whole of 2011).                                      which was also the source of two thirds of foreign
                                                                      direct investment entering China last year.
As barriers to investment outflows from China
continue to be eased, we expect mainland assets to
account for an increasingly significant portion of
Hong Kong’s fund management business. It’s a
golden opportunity for the SAR to bolster the
15% share of GDP and 6% of jobs that its
financial sector already provides.

Many significant initiatives are already under
way, including the proposed Qualified Domestic
Limited Partner (QDLP) scheme which will
eventually permit foreign hedge fund managers to
raise RMB capital from mainland investors and
then exchange these funds into foreign currency to
invest offshore on their behalf.
40 “Global Investment Trends Monitor No. 10” 23 October 2012,


             FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
     Economics – Hong Kong / China                                                                                           abc
     December 2012

The tourist dollar
 Hong Kong is the hottest offshore tourist destination for Chinese
 Tourism accounts for 15% of Hong Kong’s GDP and 13% of jobs
 28m visitors from China arrived in the SAR last year; we expect
     this to top 50m by 2015

The destination of choice                                            capital controls are loosened. With income growth
                                                                     and spending set to take off on the mainland, Hong
Mainland tourism is the hand that keeps on
                                                                     Kong should remain first in line for Chinese
giving. Hong Kong receives 26 times more
                                                                     overseas investment and spending for at least
mainland visitors than Singapore and 20 times
                                                                     another decade. Besides wealth management (as
more than the US. Ever since the introduction of
                                                                     already discussed), tourism, retail, food, and
the Individual Visitor Scheme (IVS) in 2003 it has
                                                                     accommodation services should benefit too.
been the destination of choice for outbound
mainland visitors looking to spend their money                       Ticket to growth
overseas – be it for shopping, property buying,
                                                                     Tourism makes a direct contribution of 7% to both
eating, or entertainment.
                                                                     Hong Kong’s economy and job market (2011). The
Many of these visitors are also likely to be looking                 World Travel & Tourism Council estimates that if
for new ways to invest their savings, especially as                  the indirect contribution is included (e.g., aircraft

 Chart 16. Resident departures projected to rise steeply in China (number of departures shown in chart)

 Source: CEIC, HSBC; NB: no data readily available for India


          FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
     Economics – Hong Kong / China                                                                                                                                                              abc
     December 2012

  Chart 17. Mainland tourists have always spent the bulk of their budget on shopping (2011 vs. 2003)

  80       %                                                                                        70
                                   US tourists                                                                                           Mainland tourists
  60                     53
           18                          16
  20                                                                                                               13
                                                                                   8                                                      9
  10                                                 4                                                                                                     2                        4
                                                                    0.5                                                                                             0.4
            Shop          Hotel         Meal          Entz              Tour       Misc              Shop             Hotel                Meal            Entz         T our       Misc
                            % of US v isitor spending                                                        % of Mainland v isitor spending
  * Black and red columns denote breakdow n in 2011, grey columns in 2003.

  Source: CEIC, HSBC. NB. Data refers to overnight visitors only.

purchases, hotel construction, or IT purchases made                                           Kong ranks tenth in international tourism receipts
by sectors dealing with tourists), then the total                                             (see table 2). If you calculate Hong Kong’s tourism
contribution to growth and jobs is even higher, at                                            receipts on a per capita basis, it is ranked second
15% and 13%, respectively.                                                                    (chart 18).

While tourism’s contribution to the SAR’s GDP is                                               Chart 18. On a per capita basis, Hong Kong’s ranks second
                                                                                               in the world
not as high as the finance industry (15%), it employs
                                                                                              Tourism recepits per citizen(USD)
similar numbers of people and more than the
                                                                                              4,000 >50,000
professional services sector, including legal,                                                3,500
accounting and engineering.                                                                   3,000
                                                                                              2,000               1,402
In Asia, Hong Kong’s travel and tourism sector                                                1,500                      1,299
accounts for the fourth-highest share of GDP, behind                                          1,000                            852 709
                                                                                                                                       573 474 373
                                                                                                500                                                                                     36
Macau, Thailand and Malaysia, and the second-
highest share of jobs (after Macau). Globally, Hong



                                                                                                                 Hong Kong





                                                                                               Source: UNWTO (as of June 2012), IMF, WB, HSBC
Table 2. International tourism receipts
                         _______ USD ________ currencies                           Million
                                                                                              More expected
                          Billion   Change % Change %                                Popu-
Rank                    2010 2011* 10/09 11*/10 10/09 11*/10                       lation**   Of the more than 70m mainland travellers who left
Total                     927 1,030         8.2       7.7           -          -              China in 2011, 40% headed for Hong Kong; most
1. US           103.5 116.3 9.9                      12.3     9.9        12.3         312     went shopping. The China Tourism Academy
2. Spain         52.5 59.9 -1.2                      14.0     3.9         8.6          46
3. France        46.6 53.8 -6.0                      15.6    -1.1        10.1          63     (CTA), a government think tank, expects almost
4. China^        45.8 48.5 15.5                       5.8    15.5         5.8       1,347     78m overseas trips to be made by mainland nationals
5. Italy         38.8 43.0 -3.6                      10.9     1.4         5.6          61
6. Germany       34.7 38.8 0.1                       12.0     5.3         6.7          82     this year. By the end of September, 25m had already
7. UK            32.4 35.9 7.5                       10.9     8.4         6.9          63
8. Australia     29.8 31.4 17.4                       5.5    -0.2        -6.2          22
                                                                                              been made to Hong Kong41.
9. Macao, China 27.8      .. 53.2                       ..   53.5           ..        0.6
10. HK, China    22.2 27.7 35.5                      24.7    35.6        25.0           7     ______________________________________
                                                                                              41 Compared to 28m for the whole of 2011 and 22m in 2010.
Source: UNWTO (as of June 2012), IMF, WB, HSBC. *provisional data. ** 2011 data except for
Macao, for which 2010 applies. ^ only USD, not local currency data has been used for China.


                FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
      Economics – Hong Kong / China                                                                                                                      abc
      December 2012

  Chart 19. Mainland visitors to Hong Kong have been the most                   Chart 20. Mainland visitors are one of the biggest spending
  resilient during the recent economic downturn                                 tourist groups in Hong Kong
 50       %yoy, 3mma                          %yoy, 3mma      50
                                                                                         USD, per capita                                        %
 40                                                                      40     1,200                                                               80
                                                                                1,000                                                               70
 30                                                                      30
                                                                                  800                                                               50
 20                                                                      20
                                                                                  600                                                               40
 10                                                                      10                                                                         30
  0                                                                      0                                                                          20
                                                                                  200                                                               10
-10                                                                      -10         0                                                              0
                                                                                            ME          CN      AUS        US        EU       SG
-20                                                                    -20
                                                                                                     Shopping expenditure (Lhs)
  Sep-07      Sep-08          Sep-09     Sep-10         Sep-11    Sep-12                             Other expenditure (Lhs)
          Mainland visitors            All other visitors        US visitors                         % total expenditure on retail spending (Rhs)

 Source: CEIC, HSBC                                                             Source: CEIC, HSBC

By 2015, we estimate that total departures could                               Travel Market, October 2012 and European Travel
almost double to 134m, which would mean 50m                                    Commission, Autumn 2012).
mainland visitors heading to Hong Kong (see
                                                                               For example, almost 60% of the average Chinese
Frederic Neumann and Tushar Arora’s Chart of the
                                                                               traveller’s budget is spent on shopping in Paris
Week: See you at the beach, August 2011).
                                                                               and Taiwan, but in Hong Kong this rises to over
Chinese holidaymakers accounted for 67% of total                               70% (see chart 20).
visitors to Hong Kong in 2011 (up from 29% in
                                                                               Hong Kong’s status as China’s offshore shopping
2000). The percentage of visitors from the US and
                                                                               destination is not new. As early as 2003, the
Europe has fallen from 19% in 2000 to just 7%.
                                                                               average Chinese visitor to the SAR was already
Despite China’s slowdown in recent quarters, an                                spending nearly 70% of their budget on shopping.
average of 3.9m mainland travellers visited Hong
                                                                               In 2011, Chinese visitors spent almost USD19bn in
Kong every month so far this year, up 16.3% over
                                                                               Hong Kong, equivalent to 7-8% of the city’s GDP;
the same period in 2011.
                                                                               of this USD13bn went on shopping. This was more
Big spenders                                                                   than three times the amount they spent on retail
                                                                               therapy in the city five years earlier, and 10 times
Tourists from China were the third highest spenders
                                                                               the amount a decade ago.
globally last year, splurging USD73bn, not far
behind the Germans (USD84bn) and the Americans                                 Come rain or shine
(USD79bn). However, their budgets increased the
                                                                               Mainland visitors are a resilient lot. They continue
most, jumping 32% y-o-y (source: World Tourism
                                                                               to travel during times of economic distress (chart
Organization UNWTO, May 2012). Bearing in mind
                                                                               19) and also spend more in absolute terms in Hong
that their per capita spending is still only 20% of
                                                                               Kong than visitors from other countries (chart 20).
how much the average Russian spends on holiday,
there is clearly more room for mainland                                        They are not yet the biggest individual spenders,
holidaymakers’ budgets to grow.                                                but they are getting there. For example, the average
                                                                               Middle Eastern visitor spends more (HKD8,450 or
About a third of their spending on travel goes on
                                                                               USD1,083) than the average mainland visitor
shopping, although the percentage varies according
                                                                               (HKD8,220 or USD1,054). But when the total
to the destination (source: Euromonitor and World
                                                                               number of visitors is taken into account – over 28m


             FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
    Economics – Hong Kong / China                                                                                                               abc
    December 2012

  Chart 21. Hong Kong’s retail sales and real GDP growth rates                 Chart 22. Hong Kong forecasts: GDP and retail sales (value)
  are closely aligned

   15    %yoy                                                %yoy      30       25     %yoy
   10                                                                           20
                                                                       15       15
                                                                       0          5
   -5                                                                  -5
  -10                                                                  -15       -5
    Mar-00          Mar-03        Mar-06         Mar-09          Mar-12                 2006         2007    2008   2009       2010      2011
             Real GDP (Lhs)                     Retail sales vol (Rhs)                              Real GDP        Retail sales (value)
             Retail sales value (Rhs)
  Source: CEIC, HSCB                                                           Source: CEIC, HSCB

from China and less than 200,000 from the Middle                              the SAR should expect to receive over 53m
East last year – it’s clear who offers the greater                            mainland travellers who could spend USD55bn.
support to Hong Kong’s economy.
                                                                              Based on the latest per capita budget breakdown for
Shopping by mainland visitors represented a quarter                           mainland visitors (2011), at least USD38bn of the
of retail purchases in Hong Kong in 2011,                                     projected USD55bn should flow to Hong Kong
equivalent to 5% of GDP. They flock to Hong Kong                              retailers. There’s plenty to go around and hotels
to avoid domestic import duties, VAT and                                      (USD7bn), food and beverage (USD5bn),
consumption taxes on staples and luxury brands.                               entertainment and cross-boundary passenger
Our consumer brands and retail team estimates that                            transport should all benefit too.
more than 50% of handbags and watches sold in
                                                                              If we are right about the USD55bn in mainland
Hong Kong are purchased by visitors from China42.
                                                                              tourist dollars by 2015, it would represent around
Three years from now                                                          15% of Hong Kong’s GDP. If you add on spending
                                                                              by sectors dealing with tourists, we estimate that
Some 70m international trips were made by
                                                                              mainland holidaymakers will be spending the
mainland residents last year. Based on our
                                                                              equivalent of 34% of the city’s GDP.
estimates, this will nearly double to 134m by 2015
and almost triple to 208m by 2020 (see chart 16).                             These projections have significant implications for
                                                                              growth because retail sales are an excellent proxy
Assuming that the average mainland traveller spends
                                                                              for Hong Kong’s real GDP growth (see chart 21)
USD1,054 per trip (last year’s figure43), we expect
                                                                              and tourism-related activities support 15-20% of
total annual global spending by Chinese overseas
                                                                              jobs in the economy.
travellers to grow from USD73bn last year to
USD139bn by 2015.                                                             We expect China’s consumption growth to
                                                                              strengthen through 2020. The resilience of income
By then, if around 40% of them head first to Hong
                                                                              and private spending growth that we have seen in
Kong – as they have done for the last decade – then
                                                                              China since 2010 should continue, underpinned by
                                                                              Beijing’s determination that growth should be driven
42 See Luxury red bull: A sequel - Chinese shoppers: more excitement, extra   by domestic consumers rather than investment.
headaches, September 2012.
43 World Tourism Organization estimates that China’s 2011 total
tourism expenditure amounted to USD72.6bn.


              FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
     Economics – Hong Kong / China                                                                                                            abc
     December 2012

As China’s outgoing president Hu Jintao stated at                  Chart 23. A rising proportion of mainland visitors to Hong
                                                                   Kong are opting not to stay the night
the opening of the Chinese Communist Party’s 18th
                                                                  24     ppl (mn)*                                           ppl (mn)*   24
Congress, the aim is to double the country’s per
                                                                  20                                                                     20
capita income by 2020. Doubling the current
nominal level of USD4,94044 (versus USD48,450 in                  16                                                                     16

the US) should not be a problem. Indeed, we expect                12                                                                     12
China’s real income per capita to rise almost seven-
                                                                   8                                                                     8
fold by 2050 (see Consumer in 2050: The rise of the
                                                                   4                                                  May 2012           4
EM middle class, October 2012).
                                                                   0                                                                     0
From value to volume                                                2007        2008         2009         2010        2011     2012
                                                                                       Mainland visitors: overnight
While we expect mainland travellers to support the                                     Mainland visitors: same-day
                                                                                       Mainland visitors: Individual Visitor Scheme
Hong Kong economy for many years to come, these
                                                                   Source: CEIC, HKMA, HSBC. *12-month rolling sum.
visitors are already to starting to change their habits.
For example, visits are becoming more frequent and                As chart 23 shows, growth in the number of same-
shorter and purchases are moving away from luxury                 day visitors is closely correlated to that of
goods to more routine items.                                      mainlanders entering the SAR via the Individual
In a recent report on Chinese shoppers, HSBC’s                    Visitor Scheme (IVS).
head of consumer brands and retail research, Erwan                Mainland travellers used to only be able to visit
Rambourg, said Hong Kong is slowly evolving into                  Hong Kong either on a business visa or in
a volume rather than value driven destination (see                organised tour groups. With the launch of the IVS
Luxury red bull: A sequel, September 2012). This                  in July 2003, they were allowed to travel to the
trend emerged in May 2011, when for the first time                SAR on an individual basis, triggering a huge
on an annualised basis Hong Kong received more                    surge in numbers. The scheme, originally
same-day than overnight visitors from China. We                   launched in 10 mainland cities, has been
think this trend is here to stay for reasons related to           expanded multiple times since 2003 and now
policy and a shortage of hotel accommodation.                     covers 49.

                                                                  Although a recent attempt to loosen visa
                                                                  procedures for non-residents in a further six
                                                                  Chinese cities close to Hong Kong has been
                                                                  delayed, we see further relaxation of travel policy
                                                                  as inevitable. This, in turn, should encourage
                                                                  increasingly numbers of mainland travellers to
                                                                  visit Hong Kong.

                                                                  At the same time, a shortage of hotel rooms is
                                                                  pushing up room prices and will likely lead to a
                                                                  long-term rise in same day rather than overnight
                                                                  travel. Hong Kong’s hotel occupancy rate of
______________________________________                            around 90% is amongst the highest in Asia, well
44 World Bank GNI per capita (Atlas method, current USD), 2011.   ahead of 50% in Bangkok, 80% in Taipei and
                                                                  below 80% in Seoul. With property prices at a


          FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
   Economics – Hong Kong / China                                                                            abc
   December 2012

record high and land in downtown locations scarce,     Mainland import tax would not
hotel capacity is unlikely to be expanded fast         cut off mainland visitor inflows
enough to accommodate the growing influx of
                                                       Lowering or eliminating certain types of
mainland visitors in the next few years.
                                                       consumption tax has been discussed for some time,
As travel restrictions are further relaxed and         but no significant changes have been made. While
transport costs fall, the income entry point for the   China’s ascension to the WTO saw tariffs on
average mainland traveller to Hong Kong should         imported luxury goods fall from 2005, they are
gradually come down. There are signs that this         still in low double-digits.
trend is already starting to change the spending
                                                       With Beijing’s renewed focus on boosting
habits of the average mainland visitor.
                                                       domestic demand, it’s likely some progress will be
Luxury goods such as watches and jewellery are         made in the coming years. But we don’t think this
still very popular with the wealthy, but lower-end     will significantly reduce Hong Kong’s appeal as a
goods such as baby milk powder and cosmetics           shopping centre for the following reasons:
tend to dominate the shopping lists of mass market
                                                       1   Price differences: Even if a tax cut of
shoppers as a wider variety of non-mainland
                                                           between 10% and 30% were proposed, Hong
branded goods is available. In recent months,
                                                           Kong would still be considerably cheaper. For
China’s economic slowdown probably made the
                                                           example, high-end cosmetics sold in China
big spenders more reluctant to open their wallets,
                                                           are 60-70% more expensive than in Hong
but the growing attraction of the shopping centres
                                                           Kong. If import taxes were reduced, as has
closer to the mainland border (e.g., Sheung Shui or
                                                           been proposed, shoppers would still have to
Shatin) suggest that a new retail landscape is
                                                           pay two other taxes – VAT of around 17%
emerging. Popping into Hong Kong to buy basic
                                                           and consumption tax of up to 30% for luxury
goods is likely to become the norm. The good news
                                                           fashion items.
is that higher transaction volumes of lower margin
products (e.g. supermarket sales) tend to generate     2   Better choice: The range of goods on sale is
more jobs than lower volumes of higher margin              far wider in Hong Kong than in China, where
luxury goods.                                              certain products (e.g., cosmetics) have to
                                                           undergo complicated registration processes.
Same-day travel makes a lot of sense. Most tourist
attractions (e.g., Disneyland and Ocean Park) take     3   Shopping experience: Even if luxury
only a day and the money saved on a hotel room             spending by mainland tourists were to decline,
means more money to spend elsewhere. We think              their total number would likely still rise
the increase in visitor inflows from China will in         substantially in the coming years because of
future be driven more by same-day (volume) than            the differentiated shopping experience in
overnight (value) visits.                                  Hong Kong.

Higher visitor inflows inevitably put more pressure    4   Possible price hikes: Lowering consumption
on Hong Kong’s capacity. This is already evident in        taxes in China is no guarantee that mainland
transport (e.g., MTR and taxis) and health (e.g.,          retailers would not simply increase prices.
hospitals) systems. This is a challenge that will          Foreign luxury brands would probably raise
require effective policy responses and continuous          their prices to maintain an exclusive image.
upgrading of urban infrastructure for years to come.


     FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
     Economics – Hong Kong / China                                                                                                    abc
     December 2012

Servicing China
 Hong Kong’s future as a trade hub lies in services, not goods
 This change will be driven by China’s growing appetite for imports
 The SAR’s logistics service industry is set to grow by double-digits
     through 2017

From exports to imports                                          assembly products at 27% and ordinary end use
                                                                 products 58%.
Some 20% of Hong Kong’s GDP and 15% of its
jobs are products of the import and export business.             This means that irrespective of when the global
If related logistics and professional business services          trade cycle recovers to pre-2007 levels, China’s
are included, the numbers become even higher.                    swelling domestic demand should keep the SAR’s
                                                                 trade logistics service providers busy for years to
Hong Kong’s position as a prime Asian trading hub
                                                                 come. It also means that Hong Kong’s logistics
has always relied on China’s status as a net exporter
                                                                 service industry is likely to continue to expand for
of goods to the West. But this is changing and we
                                                                 at least another 5-10 years.
expect it will increasingly be driven by China’s
transition to becoming a net importer, which could               The big difference is that as China’s per capita
happen in the next 10 years.                                     income rises and financial reforms pick up pace,
                                                                 mainland customers will want more than trade-
Fifteen years ago, imports for “processing and
                                                                 related services. They will require an increasing
assembly” accounted for 52% of China’s imports,
                                                                 array of other services to go with a growing range
and ordinary “end use” products for 27%. By last
                                                                 of imported goods. The experience of other
year, this ratio had reversed, with processing and

 Chart 24. China’s imports are no longer only for assembly        Chart 25. Strong correlation between the US’ per capita
 processing                                                       income growth and its services consumption share of GDP

            USD bn, 3mma, sa                                     30,000     USD (current prices)                            %    48
  80                                                                                                                             43
  70                                                             20,000
  50                                                             15,000                                                          38
  40                                                             10,000                              China in 2020
  30                                                                                                                             33
  20                                                              5,000                  China in 2010
                                                                      0                                                          28
                                                                          1967         1977          1987      1997      2007
       96      98      00   02    04    06     08     10    12                          US Per capita income (Lhs)
               Ordinary imports        Processing imports                               US Services consumption % of GDP (Rhs)

 Source: CEIC, HSBC                                               Source: CEIC, U.S. Census Bureau, HSBC


             FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
      Economics – Hong Kong / China                                                                                                                                                   abc
      December 2012

 Chart 26. Hong Kong’s goods exports exposure is weighted disproportionately to China, but its services exports are more evenly spread
 between the US, China, and the rest of Asia

          % of total merchandise ex ports                                                                     % of total serv ices ex ports
 60                                                                                               30              27
 50                                                                                               25
 40                                                                                               20
 30                                                                                               15                                                    12
 20                                  14                                                           10                                                                   6          8
 10                                              7          4                                       5
                                                                       3          2
  0                                                                                                 0
             CN       US        Asia* W.EU^             JP Germany UK                                          CN         US          Asia*       W.EU^           JP         UK

       1995-1998           1999-2003            2004-2008             2009-2011                             1995-1998        1999-2003            2004-2008            2009-2010

 Source: CEIC, HSBC. * Asia excluding China and Japan. ^ Western Europe excluding the UK. NB: services export data not available for Asia and Western Europe before 1999.

developed economies like the US (chart 25)                                                      Services are the future
suggests that consumption of services will
                                                                                                Gross exports amount to 230% of Hong Kong’s
increase in line with rising income levels.
                                                                                                GDP (2011: 180% goods and 50% services), so any
China’s services consumption equates to around                                                  shock to global trade flows would hurt the
14-15% of GDP today. This compares to 33% in                                                    economy. However, it is often forgotten that over
the US in 1975, when US per capita income was at                                                three quarters of its merchandise shipments are not
a similar level (around USD5,000). We expect the                                                produced within the SAR. This means that net
share of services consumption in China’s GDP to                                                 exports as a share of GDP is arguably a better
rise alongside per capita income growth. Moreover,                                              measure of Hong Kong’s true exposure to trade.
compared to the US, the pace of increase will likely                                            And on this basis, it is clear the SAR has been
be steeper thanks to a lower starting base.                                                     gradually shifting away from goods towards
China accounts for over half of Hong Kong’s                                                     services since the late 1990s.
merchandise exports but only around a quarter of                                                The city has a net trade deficit for goods, equating
its services exports. By 2020, it’s likely that China                                           to 23% of GDP; for services, it has a net trade
will be responsible for around three quarters of                                                surplus of around 27% of GDP (2011). At the
both Hong Kong’s goods and services exports.                                                    same time, the contribution of net goods exports

 Chart 27. Hong Kong’s trade exposure shifting away from                                          Chart 28. Breakdown of Hong Kong’s services exports
 goods to services
 30          % of GDP                                                                                        % of total
 20                                                                                                                 25                33                 32                 30
                                                                                                    60              32                                                      27
  0                                                                                                                                   31                 31
                                                                                                                    22                                                      22
-10                                                                                                                                   22                 21
                                                                                                                    20                15                 16                 21
-20                                                                                                     0
-30                                                                                                            1995-1998         1999-2003          2004-2008          2009-2011
      3Q98    3Q00       3Q02      3Q04       3Q06      3Q08       3Q10       3Q12
                                                                                                             Trav el           FIB*             Transport               Trade
                  Net merchandise exports                  Net services exports

 Source: CEIC, HSBC                                                                               Source: CEIC, HSBC. *Financial, insurance and business services.


              FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
     Economics – Hong Kong / China                                                                                                   abc
     December 2012

to real GDP growth has turned increasingly               Table 3. Hong Kong ranks No 3 as a global container port (2011)
negative, in contrast to the 1980s when Hong                                                      _____ Million TEUs ______
Kong used to produce over 60% of goods that it           Rank Port, Country                      2010 volume       2011 volume
exported, compared to 2% today.                          1.       Shanghai, China                           29.1             31.7
                                                         2.       Singapore, Singapore                      28.4             29.9
Hong Kong’s strength in services exports                 3.       Hong Kong, China                          23.7             24.4
                                                         4.       Shenzhen, China                           22.5             22.6
currently lies in trade, accounting for 29% of total     5.       Busan, South Korea                        14.2             16.2
                                                         6.       Ningbo-Zhoushan, China                    13.1             14.7
services exports last year. Transportation is the        7.       Guangzhou, China                          12.6             14.3
second most important, making up 27% of all              8.       Qingdao, China                            12.1             13.0
                                                         9.       Jebel Ali, Dubai, UAE                     11.6             13.0
services sold to foreigners last year. Travel            10.      Rotterdam, Netherlands                    11.1             11.9
services came third (23%) followed by financial,         Source: World Shipping Council

insurance and business services, which make up
the remaining 21% today (see chart 28).                  As its port business matures, Hong Kong needs to
                                                         reduce its reliance on trade and target sectors where
Time to adapt                                            China lacks the skills, infrastructure and experience.
Hong Kong’s success as a services exporter still         This will involve developing services exports in
relies heavily on trade, but this is changing. The       areas such as education, business advisory, financial
international container port market has become           risk and compliance, IT infrastructure and
increasingly crowded and the SAR is no longer the        international legal and fiduciary expertise.
top provider of trade processing services to China.
Hong Kong lost its No 2 place in global port             Each year, around 15m rural labourers are expected
rankings to Shanghai in 2007, which has since            to flow into China’s urban areas46. At the same
overtaken Singapore to become No 1. Since then           time private enterprise should find it easier to grow
Hong Kong has faced increasingly fierce                  and the growing middle class will become richer
competition from rival mainland cities in southern       and more sophisticated. This means demand for
China, a region from which 70% of its container          Hong Kong’s expertise – everything from business
traffic comes.                                           logistics to wealth management to legal services, to
At ports like Shenzhen most container traffic            marketing and urban planning – is set to boom.
consists of direct shipments, but 60% of Hong            The key to tapping into China as a services export
Kong’s throughput is transhipments, which means          market is being able to adapt to the country’s
it is counted twice. According to the Hong Kong          customs, practices and consumer attitudes. Hong
Container Terminal Operators Association, if only        Kong service providers are already starting to take
direct shipments are counted, the SAR lost its No 3      advantage of these opportunities.
global ranking to Shenzhen several years ago45.
                                                         Education is a good example. Helped by the
                                                         government adjusting immigration policy to make
                                                         it easier for mainlanders who graduate in Hong
                                                         Kong to get jobs, education providers have been
                                                         busy marketing their services in China. Hong

                                                         46 Assuming China’s urbanization ratio reaches 70% within two decades, as
______________________________________                   per projections from the Development Research Center of the State Council
45 Source: South China Morning Post, 26 November 2012.   (Financial Research Institute).


          FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
    Economics – Hong Kong / China                                                                                                abc
    December 2012

Kong universities are integrated into the mainland                          Numerous supplementary agreements have been
admissions and have started to establish joint                              signed since, further liberalising cross-border
ventures with Chinese universities to offer Hong                            economic activity. The most recent development
Kong-accredited degrees inside mainland                                     was the September 2012 launch of the Qianhai
campuses47. As a result, over 90% of Hong                                   Shenzhen-Hong Kong Modern Service Industry Co-
Kong’s non-local student population today comes                             operation Zone. This is intended to strengthen
from China48.                                                               collaboration between Hong Kong, Shenzhen and
                                                                            the Pearl River Delta in helping high-end service
A helping policy hand
                                                                            industries to enter mainland markets, and increase
In 2003, China and Hong Kong signed their first                             the international use of the RMB.
free trade agreement, otherwise known as the
                                                                            Hong Kong is the only significant offshore market
Closer Economic Partnership Agreement (CEPA).
                                                                            with such favoured access to China’s onshore
This helped to lower or eliminate barriers to the
                                                                            markets. This makes all the more important for
free flow of goods, services, and both human and
                                                                            Hong Kong’s service providers to make the most
financial capital between the two sides.
                                                                            of this advantage. We are confident they will.
The agreement offered three things: 1) tariff free
treatment of a wide range of merchandise;
2) preferential treatment for Hong Kong service
providers entering China’s markets (including
mutual recognition of professional qualifications);
and 3) facilitation of trade and investment cross-
border initiatives.

47 For instance, a recent venture by the Hong Kong Baptist University and
Beijing Normal University offering a liberal arts bachelor’s degree in
English at a campus in Zhuhai.
48 For more discussion, see "Exporting higher education services: An
engine of growth for Hong Kong?" by Glenn Shive. Hong Kong
Journal, Spring 2010.


           FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
     Economics – Hong Kong / China                                                                                             abc
     December 2012

Of bricks, mortar and
 The influence of mainland buyers on Hong Kong’s real estate
     market is long term
 This is because of income growth, demographics and supply-
     demand imbalance
 Price stability in the housing market is important for home-owners
     as well as the SAR’s overall economic well-being

Why mainland property                                40% compared to the previous week49. Weekly
buyers are here to stay                              transaction volumes revived slightly in the two
                                                     weeks thereafter, before falling again to a near-
Mainland buyers have been exerting increasing
                                                     one year low level.
influence on Hong Kong’s residential property
market. They now account for 30% of the luxury       Meanwhile, a recent survey conducted by
market and 10-20% mass residential market            Midland Holdings showed that 62% of 229
(source: Centaline), leading to concerns that they   respondents from China plan to hold off property
are helping to create a property bubble.             purchases in Hong Kong for the next six months,
                                                     another 35% remain in “wait and see” mode, and
In October, the Hong Kong government
                                                     around 3% appear to have written off buying
responded by introducing a Buyer’s Stamp Duty
                                                     property in the SAR altogether.
(BSD) of 15% for all residential purchases by
non-Hong Kong permanent residents or                 We need to see more data over a longer period to
companies (see Hong Kong Real Estate: A step-up      assess the near to medium term outlook for the
in housing policies, 29 October). At the same        city’s property market. For example, a month after
time, it raised the rates and extended the period    the introduction of the SSD, secondary property
covered by the Special Stamp Duty (SSD)              transactions were still up. For the next 12 months
introduced in November 2010.                         they drifted down but prices stayed resilient and
                                                     then rose again throughout the following year.
The latest measures came into effect on 27
October but the data has been too volatile for any   Whatever happens in the next 12 months or so, we
clear trend to emerge. For example, in the first     think the influence of mainland buyers is here to
week, secondary flat sale transactions dropped by    ______________________________________
                                                     49 In a survey of 50 selected housing estates monitored by local estate
                                                     agency Ricacorp Properties.


       FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
   Economics – Hong Kong / China                                                                                                                   abc
   December 2012

 Chart 29. Hong Kong’s property supply is expected to fall short          Chart 30. Despite record high property price levels, Hong Kong’s
 of demand for at least another few years                                 banking system is structurally sounder than before
40,000                                                             8%    12     %                      Tightening of maximum            225
              units)                                     %                                                                         %
                                                                                                            loan to value ratio         200
35,000                                                             7%    10
                                                                                                                 for mortgages          175
30,000                                                             6%     8                                                             150
25,000                                                             5%                                                                   125
20,000                                                             4%
                                                                          4                                    Global Financial Crisis 75
15,000                                                             3%                                                                   50
10,000                                                             2%                                                                   25
 5,000                                                             1%     0                                                             0
                                                                         01-Mar-97 01-Mar-00 01-Mar-03 01-Mar-06 01-Mar-09 01-Mar-12
      0                                                            0%
          1990 1993 1996 1999 2002 2005 2008 2011                                       Residential mortgaga: delinquency ratio* (Lhs)
                                                                                        Doubtful, substandard or loss, as % of total loans (Lhs)
                  Supply                 Take-up      Vacancy                           Residential property pric e index (1999=100) (Rhs)

 Source: CEIC, HSBC property research estimates                          Source: CEIC, HSBC. * > than 3 months

stay for reasons of income growth, demographics                         Ultimately, more housing is needed to address the
and supply-demand imbalance (see chart 29).                             imbalance between supply and demand. This is
                                                                        something that the government has started to
In our view, mainland income levels will continue
                                                                        address but it will likely take another 3-4 years
to grow at double-digit rates for at least another
                                                                        before the new supply of housing has any impact.
decade, partly because of supportive government
measures and China’s changing labour market                             In the longer term, although Hong Kong’s
supply dynamics. As restrictions on mainlanders’                        population growth is expected to decline, the
ability to travel to and invest in Hong Kong are                        absolute size of the total population will still likely
further relaxed their investment in Hong Kong                           expand through 2040. This, along with the
property should increase.                                               additional demand from mainland migrants, should
                                                                        support the long-term property market outlook.
Regarding demographics, of the 270,000 plus
mainland mothers who have given birth in Hong                           Meanwhile, despite record high property prices, the
Kong since 2000, 50-60% are planning to send                            banking system shows no signs of strain. For
their children back to Hong Kong before the age                         example, the residential mortgage delinquency ratio
of 20 (source: Hong Kong Census and Statistics                          has been at a record low for the last two years,
Department). As more than 60% of the fathers of                         around 0.01%, compared to its previous peak of over
these children work as managers/administrators                          1.4% in 2001 (see chart 30).
and professionals, it is possible that the return of
                                                                        The vulnerability of owners to unexpected price
their Hong Kong born offspring will result in
                                                                        fluctuations has been reduced since the government
more (mass market) residential home purchases.
                                                                        tightened the mortgage loan-to-value ratio in 200950.
We think property prices will continue to be                            This has given home-owners a greater buffer against
supported by loose liquidity conditions and low                         the risk of negative equity, as they had to put down
mortgage rates, which will likely remain at least                       more equity up front, and enabled banks to better
through 2014 thanks to accommodative US Fed                             manage the credit risk associated with their
policies. Limited supply, at least until 2015,
should also help.
                                                                        50 From 70% to 50% for homes worth more than HKD10m, to 60% for
                                                                        homes worth HKD7-10mm and to 70% for homes worth less than HKD7m.


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     Economics – Hong Kong / China                                                                                                         abc
     December 2012

mortgage portfolios. Over half of all households in                                dominant drivers at play. Where asset prices are
Hong Kong are owner-occupiers51.                                                   concerned, multiple rounds of aggressive
                                                                                   monetary easing in the West, as well as in Japan,
Housing affordability (see chart 31) also remains
                                                                                   have increased liquidity in emerging Asian
close to, or more favourable than its long term trend,
                                                                                   markets. This has fanned asset prices, not only in
thanks to an ultra-low interest rate environment.
                                                                                   Hong Kong but across the rest of emerging Asia,
 Chart 31. Housing affordability remains close to or more                          including Taiwan, Singapore, China and Korea.
 favourable than the long-term average
120 %                                                  %                     120
                                                                                   For the last few years, frothy property markets
100                                                                                and rising inflation rates have been just as
                                                    less affordable
 80                                                                          70    prevalent in other parts of Asia, where there is
 60                                                                                greater exchange rate flexibility.
 40                                                                          20    For example, in Singapore, where a floating
 20                                                                                exchange rate system is in place, inflation
     0                                              -30                            averaged 4.7% during the first 10 months of this
     Oct-94 Oct-97 Oct-00 Oct-03 Oct-06 Oct-09 Oct-12                              year, above the 4.2% recorded in Hong Kong
                             Household Affordability Ratio (Private)
                             Household Affordability Ratio (Overall)               during the same period. Both economies saw
  Source: CEIC, HSBC. * dotted lines denote long-term historical averages.         private residential property prices grow at a
                                                                                   double digit pace throughout 2010 and 2011, both
How to control bubbles                                                             have imposed stamp duties on purchases by
The peg is not the issue                                                           foreigners in the last 12 months, but both are still
                                                                                   seeing property prices persist at record high
Unlike other central banks in the region that can
                                                                                   levels. As of the end of 3Q12, residential prices in
lower or raise interest rates to control inflation,
                                                                                   Singapore were 14.7% above their last peak in 2Q
the HKMA’s hands are tied by the SAR’s
                                                                                   1996, and in Hong Kong they were 11.8% above
currency board system (or linked exchange rate
                                                                                   their last peak in 2Q 1997.
system, LERS) which acts as a de facto peg of the
HKD to the USD.                                                                    Besides excessively loose global monetary
                                                                                   conditions, other drivers have stoked asset and
However, while exchange rate flexibility is often
                                                                                   consumer price inflation in Asia. In Hong Kong,
viewed as a defence against overheating, it’s not the
                                                                                   strong growth, higher wages and food prices have
only means of achieving macroeconomic balance.
                                                                                   fanned CPI inflation just as much as rising
Fiscal consolidation can also be used to temper
                                                                                   property rental costs. Demographics, land and
demand and curtail demand side inflationary
                                                                                   housing supply, and household income,
pressures. This also allows governments to stock up
                                                                                   meanwhile, have all contributed to the steady
on fiscal ammunition that can be used later to deal
                                                                                   increase in demand for property.
with any shocks (see A fiscal dilemma: Save it or
spend it?, 24 February 2012).                                                      Is the peg still relevant?
The argument that the peg is the top driver of                                     With the RMB accounting for almost a tenth of
asset and consumer price inflation in Hong Kong                                    bank deposits, some may wonder if the HKD peg to
is flawed, in so far as that there are other more                                  the USD is still relevant. We think it is. Of course,
______________________________________                                             it ties Hong Kong’s monetary policy to that of the
51 Source: HK Censtatd. 52% of domestic households were owner-
occupiers at the end of 3Q12, down from 53% at the end of 2011 and 2010.           US. But, as the International Monetary Fund stated


               FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
   Economics – Hong Kong / China                                                                                 abc
   December 2012

after its consultation in June 2012: “The Linked           housing unit supplies to the property market (as
Exchange Rate System is simple, credible,                  already initiated by the government). Third, it can
transparent, is widely understood, and merits              take measures to diversify Hong Kong’s food
continued support”.                                        sources and enhance productivity to alleviate
                                                           inflationary risks.
From a legal perspective, any review of the SAR’s
current monetary system would need a review of the         Finally, the Hong Kong economy can always
Basic Law (Articles 111 and 113), Hong Kong’s              depend on its tried and tested resilience in coping
mini-constitution, which assigns the HKD as legal          without monetary policy flexibility, as
tender and the government as guardian of the city’s        demonstrated over 1998-2004 when the SAR
exchange rate stability, at least through 2047 (after      endured almost six years of continuous deflation
which the Basic Law will no longer be in force).           after the Asian financial crisis. This structural
                                                           adjustment was all the more painful as the city was
From a practical perspective, there is simply no
                                                           struggling to revive growth in a tight liquidity
better alternative. For one, a basket comprising
                                                           environment for most of this period (thanks to US
currencies from Hong Kong’s biggest trading
                                                           Fed policies), alongside neighbours who were able
partners would not necessarily offer more
                                                           to devalue their currencies in support of trade.
monetary policy control, given the exceptionally
low level of global, not just US, interest rates. For      Ultimately, inflation can be considered as “pay-
another, the RMB is not yet fully convertible,             back” for healthy economic growth. To an extent,
making it an inappropriate candidate for legal             it provides some form of counter-balance to an
tender in a system that is not legally allowed to          economy in danger of going into overdrive.
establish capital controls. Article 112 of the Basic       Inflation is rarely an issue when growth and
law states: “No foreign exchange control policies          household demand is weak, for lack of demand-
shall be applied … (and that) The Government…              side price pressures.
shall safeguard the free flow of capital within, into
                                                           As safe as houses
and out of the Region”.
                                                           The stability of the housing market is important
We continue to expect the HKMA to maintain the
                                                           not only for home-owners, but also for Hong
integrity of its currency system. After all, if it ain’t
                                                           Kong’s overall economic well-being. That is
broke, why fix it? (see Asian FX Focus: HKD peg
                                                           because the sensitivity of consumer spending to
still fits, 31 October 2012).
                                                           asset prices is amongst the highest in Asia (see
Not without options                                        charts 32 and 33). If property prices in Hong
Any form of capital control would risk jeopardising        Kong had suffered a sharper dip during the 2008
the stability of Hong Kong’s financial services            downturn, private household spending would
sector, which is underpinned by the free movement          unlikely have been strong enough to enable Hong
of capital in and out of its banking system and drives     Kong’s subsequent rebound, and continued
one-quarter of its economy.                                growth since (see Hong Kong: Swinging back up:
                                                           GDP accelerates in 3Q12, November 2012).
That said, the SAR isn’t without options. First, it can
use a mix of macro-prudential and relative fiscal
prudence to temper aggregate demand (see Hong
Kong Real Estate: A step-up in housing policies, 29
October). Second, it could increase land or public


      FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
      Economics – Hong Kong / China                                                                                                                                                                                                  abc
      December 2012

 Chart 32. Impact on private consumption spending from a                                                     Chart 33. Impact on private consumption spending from a
 10% rise in Hong Kong’s residential property price index                                                    10% rise in Hong Kong’s equity index
  Percent impact on private consumption                                                                       Percent impact on private consumption
0.7 0.65 0.59                                                                                               0.7
0.6                 0.53                                                                             0.50   0.6               0.52
                            0.47 0.44
0.5                                                                                                         0.5                      0.41
0.4                                                             0.32                                        0.4
0.3                                                                         0.24 0.22                       0.3                                  0.25
0.2                                                                                                         0.2                                            0.14
                                                                                                                                                                0.08 0.05
0.1                                                                                                         0.1
  0                                                                                                         0.0
                                      Hong Kong*





                                                                                                                             Hong Kong*






 Source: HSBC                                                                                                Source: HSBC

It is still difficult for mainlanders to invest in
offshore equity assets but for those that do have
stock portfolios in Hong Kong, there is no reliable
data about exactly how they invest their money.
As with the property market, we think it is safe to
say that the anticipated rise in mainland migrants
and capital inflows into Hong Kong should
support the city’s equity market.


                  FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
Economics – Hong Kong / China                                                   abc
December 2012



  FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
     Economics – Hong Kong / China                                                   abc
     December 2012



       FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
    Economics – Hong Kong / China                                                                              abc
    December 2012

Disclosure appendix
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opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their
personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific
recommendation(s) or views contained in this research report: Donna Kwok

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1    This report is dated as at 14 December 2012.
2    All market data included in this report are dated as at close 13 December 2012, unless otherwise indicated in the report.
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      FIRST LAST 12/15/12 07:05:17 AM Hong Kong Highpower
     Economics – Hong Kong / China                                                                                                         abc
     December 2012

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Donna Kwok
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Donna Kwok is a Greater China Economist for HSBC Research, based in Hong Kong. Before joining HSBC in 2010, Donna worked as
an economist for the Hong Kong-China equities research arm of a global research provider. Prior to that, she was East Asia analyst at
Strategic Forecasting (US) and a strategy consultant at Deloitte Consulting (London). Donna holds a Master of Arts in International
Relations (Economics and China Studies) from Johns Hopkins University School of Advanced International Studies, and a Bachelor of
Arts (Hons) in Economics and Management from Oxford University.

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