Yongjun Peter Ni and Hao Jiang of White & Case consider Shanghai’s future as an offshore financial centre and ask whether it will be in a position to compete directly with Hong Kong.
Offshore finance generally refers to the provision of financial services by banks and other financial institutions to non-residents. Typical offshore financial services include banking, fund management, insurance, trust business, tax planning, and business structuring. Given the needs of non-residents, offshore finance could really take a variety of forms, in either inward or outward direction. There is no geographic limitation on conducting offshore finance.
Shanghai has been quite late in coming to offer offshore financial services. Two Chinese domestic banks, Bank of Communications and Shanghai Pudong Development Bank (SPD Bank) only started to be engaged in offshore finance in Shanghai in June 2002 after receiving the approval of the then regulator, the People’s Bank of China. While Shanghai’s progress has been impressive, it can hardly be characterised as a success. Since Shanghai is keen on building up a world class financial centre, offshore finance is again high on the agenda of the policy makers as a part of the overall strategy.
Globalisation has been a key driving force behind the rapid proliferation of offshore financial centres (OFCs). Any financial centre could be engaged in offshore finance activities and thus be considered an OFC. Under this broad definition, OFCs would include all the major financial centres and tax havens in the world. To distinguish between OFCs, the International Monetary Fund (IMF) specified certain criteria, including: (i) whether a jurisdiction has relatively large numbers of financial institutions engaged primarily in business with non-residents, and (ii) whether a jurisdiction has a financial system with external assets and liabilities out of proportion to domestic financial intermediation designed to finance domestic economy. If at least one of these criteria is met, such a jurisdiction is considered an OFC. The IMF even came up with a list of official OFCs.
Based on the IMF’s criteria, OFCs could be classified into three categories, including: (i) the major global financial centres, such as New York, London and Tokyo, (ii) the major regional financial centres, such as Hong Kong, Singapore and Luxembourg, and (iii) tax havens, such as Bermuda and the Cayman Islands. The major global financial centres all have considerable full-service financial activities, onshore and offshore. The major regional financial centres serve as regional financial hubs with well-developed financial markets and infrastructure. Tax havens tend to have small-size real economies and aim to attract foreign capital inflows through a race-to-the-bottom strategy and limited specialist services. Despite those differences, OFCs share some common features, such as capital freedom from foreign exchange control, low or zero taxation, moderate or light financial regulatory framework, independent and functional legal system, bank secrecy protection and so on.
Shanghai has never been on the IMF list of official OFCs. Despite its prominent economic status in China, Shanghai has only made limited inroads into the offshore finance arena thus far. In June 2002, Bank of Communications and SPD Bank started to offer offshore banking services to non-resident customers in Shanghai. By 2008, Shanghai’s offshore banking services had total assets of US$2 billion, deposit amounts of US$1.8 billion, outstanding loan amounts of US$850 million, and operating profits of US$25 million. Those numbers presented by Shanghai were simply a drop in the offshore finance ocean.
To use SPD Bank as an example. It was one of the first two banks to receive go-ahead to kick off offshore banking services in Shanghai back in June 2002. Within six months, SPD Bank had opened 96 offshore banking accounts for non-residents. In 2005, SPD Bank, along with two other Chinese domestic banks, was allowed to conduct offshore guarantee services. By 2008, SPD Bank had 6,773 offshore banking accounts for non-residents, largely consisting of small to medium-size non-resident customers. Despite its good efforts, however, SPD Bank is still struggling in this area and is representative of Shanghai in this regard. Understandably, Shanghai is largely limited to providing offshore banking services for the time being.
Shanghai clearly has the ambition to become an international financial centre with significant offshore financial undertakings. So what will be Shanghai’s development model with respect to offshore finance?
The IMF has provided three different categories which define an OFC. It is extremely unlikely that Shanghai will go down the route of a typical tax haven such as Bermuda. Thus, it appears that Shanghai’s real objective is to become either a major global financial centre or a major regional financial centre. Perhaps the two close rivals of Shanghai within these categories are Tokyo and Hong Kong. Since China has overtaken Japan as the second largest economy in the world, there could be some motivation to compare Shanghai to Tokyo with respect to offshore finance. In reality, however, it is Shanghai has set itself to compete against Hong Kong, especially in Greater China area.
The battle between Shanghai and Hong Kong is subtle yet fierce. In the long-term, few expect China to have more than one international financial centre with both strong onshore and offshore financial capabilities. The question is how Shanghai will gain an edge over Hong Kong over time. Despite the competition, Shanghai is different from Hong Kong in a number of ways. Unlike Hong Kong, Shanghai is not interested in becoming merely a major regional financial centre. Given the size of China’s economy, Shanghai has no other choice but to aim higher. In addition, Shanghai’s policy makers will probably never view offshore finance as comparable to onshore finance in its financial strategy. The development of Shanghai’s onshore finance is expected to drive the growth of its offshore finance, while Hong Kong has apparently gone in an opposite direction.
The objectives Shanghai has set could take years or even decades to materialise. In boosting its offshore financial capabilities, Shanghai has to clear out formidable barriers. First, the biggest barrier is arguably the onerous foreign exchange control regime. While the current account has free convertibility, China allows only restricted convertibility on the capital account. As long as the Chinese currency RMB is not freely tradable, it is difficult to see Shanghai’s future as an OFC having meaningful impact. The capital account restrictions essentially frustrate the capital movements needed for the offshore financial services. The tight grip China holds on the exchange rate indicates that China will not lift the capital account restrictions any time soon.
Second, the lack of access to domestic capital markets remains a significant barrier to non-residents. In particular, non-residents are generally prohibited from participating in China’s A-share stock markets but for few exceptions available to limited institutional investors. It is reported that the Chinese regulators are considering the listing of foreign companies in the A-share stock markets. Such baby steps would not be enough to make the Shanghai index an internationally recognised benchmark. Since Shanghai has virtually no direct link with foreign stock markets, non-residents do not seem to have convincing business or investment needs for an offshore financial account in Shanghai.
Third, the unfavourable regulatory and legal environment hampers the development of offshore finance in Shanghai. The central government has a firm control over the offshore finance policies and rules under its own agenda. It appears that the policy space for offshore finance is quite limited at the best. The Chinese regulators are generally not considered independent, transparent, clean, and capable. The Chinese legal regime is often scorned and avoided by non-residents out of distrust over the rule of law status. It is unclear when there will be a sound and effective regulatory and legal system in place to address the frauds, disputes, or liabilities incurred in offshore finance activities. Until then, the risk exposure for non-residents will be too great to be swallowed.
Although Shanghai has little or no power over the offshore finance policies and rules, it can certainly lobby the central government to widen the permissible use of offshore financial activities. As long as China is continuously opening up the financial market, Shanghai’s offshore finance status will certainly be strengthened. Supporting Shanghai’s offshore finance role is consistent with national and local interests. On the other hand, Shanghai should review its options to expand offshore financial services under current policies and rules. As a regional headquarter for many giant multinational companies, Shanghai is in a strong position to leverage its existing economic and financial clouds. The growing cross-border trade and investment through Shanghai will continue to demand the availability of offshore financial services in specialised areas.
Shanghai is currently undertaking well-planned steps to boost its offshore financial capabilities further. First, it specifically designated Yangshan Bonded Zone (Yangshan) as a hub for the offshore financial services after consolidating various local bonded zones. While Yangshan is not exclusively reserved for offshore finance, it will enable Shanghai to coordinate with various regulatory agencies for a unified and simplified regulatory environment. Second, Shanghai is in the process of developing strategies to expand the scope of its offshore financial services. The scope will certainly go beyond the traditional offshore banking area and expand to future transaction services, reinsurance, asset management and so on. There are some encouraging examples in the development.
In July 2010, the Shanghai Pudong District Government issued a notice to support financing lease business. The notice will provide some financial incentives for entities (including non-resident companies) engaged in financing leases with respect to aircraft or ships. The financial incentives include allowances to the entities as well as tax benefits to executives. Presumably, non-resident companies engaged in this business would need some offshore financial services from banks in Shanghai. In October 2010, the General Administration of Customs approved an application for bonded future settlement trial services in Yangshan with respect to imported copper and aluminum. The trial period is one year upon the approval. This will allow the Shanghai Customs to process imports more easily and tax-favourably. Such a trial is expected to broaden the offshore future transaction services in Shanghai.
Shanghai’s offshore finance potential is closely tied with China’s fortunes in the international financial market. Presented with both challenges and opportunities, Shanghai bears some resemblances to both Tokyo and Hong Kong. In the foreseeable future, however, Hong Kong will still be Shanghai’s biggest rival with respect to offshore finance. Shanghai’s OFC status will be ultimately determined by various factors, including the future of RMB, the openness of domestic stock markets, and China’s regulatory and legal environments. Despite some barriers, Shanghai is forging ahead with its ambitious strategies and is expected to bear decent fruits in the near future.
Yongjun Peter Ni and Hao Jiang, White & Case, Shanghai