Shanghai free-trade zone plan offers new challenges to Hong Kong

Hong Kong's challenge is not China's economic rise, Shanghai's free-trade zone, or even the mainland's impending financial reforms. These are all new opportunities.

Instead, Hong Kong's future depends on adjustment to China's new stage of growth and the multipolar future.

The different paths of Hong Kong and Shanghai as rising global financial centres are largely explainable on the basis of historical colonialism and global economic integration. In the 1920s, Shanghai was still the major centre of international trade and finance in East Asia. The position of the "Pearl of the Orient" eroded only with the turmoil of the 1930s.

In contrast, Hong Kong has benefited from global integration since the post-war era. After the second world war and the civil war in China, most foreign firms moved their offices from Shanghai to Hong Kong, which also became the home of Shanghai's entrepreneurial elite.

As textile and manufacturing grew with low-cost labour and population growth, Hong Kong industrialised. The export-led growth model boosted living standards rapidly. Meanwhile, Shanghai was transformed into an industrial centre. It became the largest contributor of tax revenue to the central government, but at the cost of crippling its own infrastructure and capital development.

As Shanghai fell into a historical oblivion, Hong Kong thrived, even during the first decade of reforms and opening-up policies, because these began in Guangdong. In Shanghai, the development of Pudong was initiated only in 1992.

Nevertheless, even after 1997, Hong Kong enjoyed another extraordinary decade as the financial lifeline of the mainland, due to the level of economic development and relatively closed financial sector in China. However, a new era dawned in March 2009, when the State Council approved Shanghai's plans to forge itself into one of the world's leading financial, trade and shipping centres by 2020.

Internationally, these changes were largely discounted as "mere talk" until January this year, when the mayor of Shanghai Yang Xiong unveiled the city's plan to develop the mainland's first free-trade zone. This plan, in turn, has been accompanied by financial reforms.

For over half a decade, China's equity, bond and currency markets have expanded significantly. New reforms will allow commercial banks to grow their lending, to expand the fragmented bond market, to move gradually towards the securitisation of loan portfolios and to open doors to foreign investors and financial institutions.

China's new leadership needs growth for greater equity, and more sophisticated financial services for consumption-led growth. This is why Premier Li Keqiang fought opposition by industry regulators to open Shanghai's financial services sector to foreign investors.

In this transition, Shanghai will have the driving role as China's emerging global financial hub.

Despite its wealth and capabilities, Hong Kong is increasingly haunted by doubt over the future.

After the collapse of the Soviet Union, the Finns relied on a similar intermediary role in the 1990s, but it ended soon as foreign multinationals began to establish subsidiaries in Russia. Over time, economic development mitigates the need for regional intermediaries.

Already in 2010, the International Monetary Fund noted that Hong Kong's prospects are overshadowed by unprecedented monetary policy easing in the US and domestic recovery, in part driven by spillovers from the mainland. Both fuelled property prices, which could translate into financial risks.

Nor is Hong Kong any longer alone in its quest to capitalise on its status as an offshore renminbi centre. New rival cities look forward to 2015, when Beijing is expected to liberalise the capital account.

In the coming months, the liquidity masquerade will eclipse in the West. As the US Federal Reserve will begin to hike rates by mid-decade, Hong Kong's property markets must cope with a major correction. Currently, Hong Kong may be overheating, due to ultra-loose liquidity, but China's decelerating growth and slow global growth will keep GDP growth below trend.

Concurrently, Hong Kong's competitiveness is eroding. In May, it lost its status as the world's most competitive economy in the annual IMD survey. A month later, it plunged from China's second-most competitive region to its fifth in a major think-tank survey. While Hong Kong has world-class scores in various innovation rankings, the hi-tech sector has shrunk as part of export trade.

Instead of looking into the future (read: pushing new emerging industries), Hong Kong continues to rely on its traditional economic legs, such as finance, logistics and trade, tourism, and professional services. However, the latter evolved when China was still a low-income nation, but are now under rapid change.

A few years ago, Malaysia's strategic advantages began to erode with the rise of manufacturing exports from Guangdong, which contributed to the Malaysia 2020 initiative. Hong Kong cannot avoid similar forces. To sustain its high prices and costly living standards in the future, it needs to boost its high-end advantages.

Hong Kong can still offer broader and deeper services in trade and finance. But as Shanghai's free-trade zone will take off, that role will begin relative erosion in the next two to five years. The corrosion of human capital relative to that of the mainland will take longer, but that, too, is a matter of time.

Until recently, Hong Kong has thrived as the mainland's intermediary. But those days are fading. Now it is time for Hong Kong to upgrade and innovate its economic strengths, in co-operation with the mainland. By deeper integration into the Pearl River Delta, it could play a leading role in the expansive regional economy.

The idea that Shanghai is about to become a "mini-Hong Kong" is based on a rear-window outlook of future. In the future, Hong Kong is more likely to be seen as a "mini-Shanghai".

That is no reason to give in, but all the reason to start anew. That is no reason to fight the future, but to embrace it.

Once, Hong Kong had to learn to thrive without China. Tomorrow, it can excel with the mainland. You don't have to look back, if you can share in the future.

Dr Dan Steinbock is research director of international business at India China and America Institute (USA) and visiting fellow at Shanghai Institutes for International Studies (China) and the EU Centre (Singapore)