New Opportunities likely to open up as finance centers take on complementary roles

China's State Council has formally launched a general framework governing the development of the China (Shanghai) Pilot Free Trade Zone. Using the term "China" as the prefix, signals how significant this initiative is to the nation's economic landscape in the future.

The plan is a bold step to lift China's economic reform to the next level as the central government appears to give Shanghai greater autonomy to run the designated site of 29 sq km. More importantly, the zone is planned to honor the free-market spirit. In three years, the zone's development may reach a stage compatible with other market economies: the Chinese currency may be fully convertible, interest rates market determined, and asset valuations guided by a mark-to-market principle.

This free trade zone initiative is ground-breaking. Even after three decades of reform and liberalization across different spectrums, the world's second-largest economy has continued to tightly control cross-border flow of funds. Domestically, interest rates, the prices for borrowing and lending, are still tariffed according to the central bank's benchmark. Now that a small piece of land near Lujiazui is zoned to follow the laissez-faire spirit, Shanghai may be equipped to serve global financial markets in a few years. Whether it will overtake Hong Kong becomes an inescapable question.

This is probably one of the most popular questions we, as economists, have encountered in our careers. In 1997, Frank Martin, president of the American Chamber of Commerce in Hong Kong, said: "(Shanghai) will be, I think, the most important city on the Chinese mainland, and to some extent the roles will be complementary." His 15-year old comparison appears to remain the dominant view today. "We (Hong Kong) have a transparent open legal system and Shanghai, of course, does not have that."

Over the years, the Hong Kong versus Shanghai debate has gone beyond the simplistic software-hardware comparisons to scrutinizing the market potential of the yuan business in the two financial hubs, which I think is the core differentiator of Hong Kong from any other Chinese city.

Should Hong Kong be worried about Shanghai's ascent if the latter allows free flows of capital? While ranking different cities in a league table may be entertaining, it is not a meaningful way to address the issue. In the end, blending a set of performance indicators (e.g. market capitalization) or subjective assessment of qualitative factors (e.g. legal infrastructure) is just an artificial, or superficial, construct. Economic advancement of different cities in the world is never a zero-sum game.

For instance, New York's rise on the back of the US' super political power after World War II has not undermined London's importance, though they work in the same open Anglo-Saxon financial platform. Though Wall Street is the largest equity market with total capitalization of $18.6 trillion last year, London remains the dominant foreign exchange giant with its 40.9 percent share of global turnover this year, the latest survey by the Bank for International Settlements says. If we are willing to abandon an either-or approach when it comes to the two giant cities, there is no reason for us to narrowly confine the paths of their respective advancement.

The reality is that the world is always moving on, and the future is often unpredictable. Hong Kong faced the same worry two decades ago when China's industrialization began to take off in Shenzhen and Guangdong with their low labor costs. Manufacturing's share of Hong Kong's GDP fell from 17.6 percent in 1990 to merely 1.6 percent in 2011. In exchange, Hong Kong moved up the value chain and transformed itself into a research and development, sourcing and distribution center. The rise of the Chinese mainland has also freed up labor and capital for Hong Kong to develop financial services. If history is a guide, we could actually foretell how Hong Kong will benefit from a successful execution of the fee trade zone, provided the same old entrepreneurial spirit lives on.

So it is more sensible to ask how Hong Kong will interact with the rise of Shanghai given development of the free trade zone. On this point, understanding China's national development strategy is of the utmost importance. While a cynic may suggest the approval of the Shanghai free trade zone signals Beijing's disappointment with Hong Kong's contribution to the mainland, this is clearly a false proposition. Over the next few years, China will experience rapid progression through urbanization and macroeconomic rebalancing. Hong Kong and Shanghai are likely to play an equally important yet complementary role when fitting into this national plan on at least three fronts.

First, the central government appears to be positioning both Hong Kong and Shanghai to upgrade China's service sector. The 12th Five-Year Plan (2011-15) clearly sets a target to raise the service sector's contribution to GDP by 4 percentage points to 47 percent by 2015. Hong Kong is obviously way ahead of the curve with the service sector representing 93 percent of the GDP.

The establishment of Qianhai in the form of Shenzhen-Hong Kong Modern Service Industries Cooperation Zone clearly suggests the service sector expansion. In addition, the overall plan for Shanghai clearly shows how serious the government is about boosting six service industries. It will offer a green field for Hong Kong's businesses to transfer their know-how and professional talent on the one hand, and expand its geographical reach on the other. Shanghai is a new market for Hong Kong's service industry, not a threat.

Second, each of the two financial hubs is endowed with unique features and will raise the economic profile of their respective locations, consistent with China's overall urbanization plan that will cover 20 city clusters. The Pearl River Delta and the Yangtze River Delta represent roughly 10 percent and 17 percent of China's GDP. Their scale of development is sufficiently large to be the critical mass to support a financial hub. Through the Closer Economic Partnership Arrangement, the greater Hong Kong economy can potentially increase its access to the mainland market, particularly in the Pearl River Delta region. Just as other mega cities extended their geographical coverage through subway expansion and cooperation with other municipalities, the Pearl River Delta is wide open for Hong Kong's advancement.

Third, Hong Kong and Shanghai will still serve different client segments and investor bases by virtue of their comparative advantages. Hong Kong is running its own monetary system with a stable exchange rate regime. Free flows of capital and information will continue to be Hong Kong's core advantage. At least in the foreseeable future, multinational firms and financial institutions will continue to find it in their interest to maintain the Asian headquarters in Hong Kong because of its global positioning. On the other hand, companies that wish to be physically closer to the Chinese domestic market may want to expand their base in Shanghai. Even though this division of roles will increasingly blur as Shanghai is catching up, such a development will in fact encourage Hong Kong to become more global instead of simply relying on the fortune of China as in the past decade. London is not a financial hub serving Britain but the entire Atlantic time zone, and Hong Kong has the potential to play a similar role.

For Hong Kong, the Shanghai free trade zone project deserves close attention, but with a correct mindset. Everyone wants to see a successful transformation of the Chinese economy. So long as Hong Kong stays open to new ideas, opportunities will knock. When Shanghai started to develop its stock exchanges more than a decade ago, no one sold off their Hong Kong equities. Likewise, there is no reason to short Hong Kong today because of the free trade zone.

The author is a senior economist with ANZ Banking Group. The views do not necessarily reflect those of China Daily.