Hong Kong should scrap its stamp duty on share trading
The 10 basis-point rate may not sound like much but it is easily enough to discourage high-frequency traders from dealing in the city's market
To support its unsuccessful attempt to list in Hong Kong, Chinese internet retail giant Alibaba argued that the city's share of Asian stock market trading was in severe decline.
A high-profile initial public offering from a big technology company, insisted Alibaba executives, was just what the Hong Kong stock exchange needed to revitalise its flagging market.
It is true that trading activity in Hong Kong-listed shares is relatively limp by regional standards.
In the first nine months of this year, Hong Kong's average market velocity - the value of shares traded each month as a proportion of total market capitalisation - was just 44 per cent.
As the first chart shows, that's the lowest among East Asia's major stock markets. In contrast, Japan's market velocity is almost four times as great at a blistering 161 per cent.
But the reasons activity in Hong Kong is so limp have nothing to do with a shortage of attention-grabbing offerings.
Part of the explanation is the relatively high proportion of listed stock held by controlling shareholders. According to data from Bloomberg, the free float of the Hong Kong market is just 55 per cent, compared with 80 per cent for Japan.
But the tight grip of tycoons and mainland state enterprises on the local market is only partly to blame for Hong Kong's lacklustre trading volumes.
The main reason is the Hong Kong government's stamp duty on stock transactions.
Every time a share changes hands on the Hong Kong stock exchange, the buyer and seller each pay 0.1 per cent of its value in tax to the government.
That might not sound a lot, but 0.1 per cent - or 10 basis points - is easily enough to deter high-frequency traders from dealing in Hong Kong's market.
These are fund managers who use computer programs to trade large quantities of shares at lightning speeds in an attempt to profit from momentary small mis-pricings.
They are big players in Japan, significantly boosting local volumes, and lately they have moved into other regional markets including Australia. But with the margins they expect to make on their trades typically less than 10 basis points, Hong Kong's stamp duty is enough to shut them out of the market.
The government, regulators and stock exchange don't see that as a bad thing. They argue that the absence of high-frequency traders protects Hong Kong from sudden bouts of volatility like the "flash crash" of May 2010 in which the US stock market dropped 9 per cent in a matter of minutes before instantly bouncing back.
But that argument is disingenuous. Hong Kong already has circuit-breakers to prevent such abrupt sell-offs.
Meanwhile, ordinary investors suffer, both from reduced liquidity, and from the cost of stamp duty.
The stamp duty rate may be low, but it compounds over time. Assuming just one portfolio rebalancing a year, it can easily knock five percentage points or more off a pension plan's return over 30 years.
On top of that, the imposition of a stamp duty means share prices are lower than they otherwise would be. That means companies pay a higher cost of capital, which reduces their willingness to invest, damaging the overall economy.
To add insult to injury, the government doesn't even need the money. In the fiscal year that ended in March, the stamp duty on share deals raised just HK$20 billion, less than 5 per cent of the government's total revenue.
Given that in the same year the government ran a surplus of HK$65 billion, it could scrap the stamp duty on stocks without even noticing the difference.
The government could even profit. As the largest shareholder in Hong Kong Exchanges and Clearing, it would benefit from the increase in exchange earnings generated from the resulting rise in trading volumes.
It's what's called a no-brainer.