“Understanding the Misunderstandings”
China’s Financial Markets IV Luncheon Keynote Address

Chairman Vincent Cheng
The Hongkong and Shanghai Banking Corporation Limited

New York, September 28, 2005

Good afternoon Ladies and Gentlemen. It is a pleasure to be in New York to talk about China. That said, I am aware that in recent months there has been considerable commentary here in the United States about China and its economic re-emergence.

There have been special interest groups saying China is "subsidizing its currency on an unprecedented scale" and at the expense of American jobs. There have been politicians suggesting that China has "a stranglehold on a broad range of industries." China is, they say, "putting up significant barriers to foreign investment and market access." There have also been articles talking about a "Chinese assault" on corporate America.

In short, the perception - at least of some - appears to be that China is a country engaged in unfair trade practices. A country that is manipulating its currency to increase exports. A country that can and has been blamed for everything from deflation to inflation to trade deficits to increased unemployment to higher oil prices.

The reality is that much of the negative sentiment about China is based on misunderstandings.

Today, I want to take the time to discuss five of these misunderstandings that are related to the business sector. I trust that you will understand that as a banker, I am going to leave Sino-US political issues to those who are infinitely more qualified and definitely more inclined to discuss such!

That said, the first misunderstanding I want to talk about is actually political in nature. In part, because it seems to often originate with politicians. And in part, because it is based on general trade frictions rather than specific economic facts. The misunderstanding I am referring to relates to the value of the yuan. In particular, to the relationship between the value of the yuan and the size of the US trade deficit.

Prior to China's decision to link the yuan to a basket of currencies, there was much talk about China deliberately undervaluing its currency in order to give its own exporters a competitive advantage. Almost daily, it seemed, there were calls for China to revalue the yuan.

Such calls came despite history-minded commentators pointing out that American trade deficits have existed since the mid-1970s. That such deficits are actually a reflection of "long-term trends in the development of global trade and the structure of the US economy" rather than the value of the yuan.

Such calls came despite economists warning that a substantial yuan revaluation would "cut foreign direct investment, cut China's growth rate, delay convertibility, increase bad loans, increase unemployment, cause deflation distress in rural areas, destabilize Southeast Asia, reward speculators, set in motion more revaluation pressures, and undermine China's compliance with WTO rules."

Such calls came despite learned individuals like Alan Greenspan declaring there was no evidence to suggest that an increase in the yuan would translate into any increase in American manufacturing activity and jobs. That while a significant change in the value of the Chinese currency might cause some manufacturers to move their operations - they would move to other low-cost markets. And not back to the United States. In short, this country's overall trade deficit would not change.

Simple math confirms that this country's trade imbalance is not being caused by some unseen currency manipulation in Beijing. Rather, that the trade deficit is largely due to American companies going to China. American companies going to China to produce their products in a lower-cost environment and then shipping these products back home. Indeed, close to 60 per cent of Chinese exports to the United States originate from companies in China that are, in whole or in part, foreign-owned. Including many which are American. And although it is difficult to determine a precise number, some estimate that foreign manufacturers have set up as many as 300,000 factories in China.

Simple logic therefore suggests the solution to improve the trade balance would be for the United States to sell more services to China. Rather than for China to undertake a significant revaluation that would not actually solve the issue. A significant revaluation that would also have the aforementioned negative effects on the Chinese economy.

I should perhaps pause to acknowledge that yes, the value of the yuan is not determined - at the moment - by fundamentals alone. Clearly China's currency policy is based on gradual change with an emphasis on maintaining monetary and economic stability. Equally clear, is the fact that China is moving towards a point in time when the yuan will be exchanged freely for foreign currencies. However, this is not going to happen quickly. Nor should it, in the interests of both the Chinese and global economy.

As for China's large trade flows, they are in reality a reflection of the rise in global production sharing. A reflection of China's participation in the assembly, processing and other labour-intensive stages of the production chain. China is, in effect, selling its low-cost labour services to the global market by assembling and processing exports. Assembling and processing largely imported components into products which when exported translate into a gross exaggeration of China's export value.

Consider, for example, a Japanese company that makes computer notebooks at a factory in China. They might import Intel chips from the United States. They may source LCD screens from Korea. They may also bring in a number of other components from other companies in Japan. Just for reference purposes, let's say the finished notebook has a total value of US$1,000. Some 80 per cent of this value is actually represented by imported parts and components. Hence the exaggeration I was referring to.

Moving on. The second misunderstanding I want to address is the suggestion that China maintains a 'one-way street' for foreign investment.

During the recent Unocal saga, I recall a commentator here in New York saying he was "not opposed to Chinese companies buying American firms or participating in the markets." But, he went on to say, it is "hard to swallow because of China's lack of reciprocity when foreign companies seek to buy Chinese companies or enter Chinese markets."

I would submit to you that there is ample evidence to suggest otherwise. Ample evidence that China has been consistently and methodically opening up its economy to foreign investment for the last 25 years. Ample evidence to suggest many foreign companies - including many American firms - are doing quite well in China.

Consider the retail sector. Consider the American retailing powerhouse Wal-Mart. If it were treated as an individual economy, it would be China's eighth largest trading partner, ahead of countries like Russia, Australia and Canada. Consider Kentucky-based Yum! Brands. The parent company of KFC, Pizza Hut and Taco Bell opens up on average one new restaurant a day in China. Adding to the more than 1,500 restaurants it already has in the country.

Consider the insurance business in China. Foreign insurance companies now account for half of the insurance companies in the country according to the China Insurance Regulatory Commission. Indeed in the first four months of 2005, foreign firms captured 13 per cent of China's rapid-growing market for insurance, up from just over 2 per cent a year earlier.

Consider the cumulative total of American foreign direct investment in China: over US$48 billion as of the end of 2004. A rather large sum which means the United States remains the second-largest foreign investor in China after Hong Kong. Also, consider the significant number of American companies currently operating in China. Some 50,000 according to one senior Chinese official.

Consider the profits of some of these American companies. I recently read that GE's revenue from its China business is expected to reach US$5 billion this year. Likewise, nearly two-thirds of respondents to a recent US-China Business Council survey said their profitability in China meets or exceeds the profitability rates for their companies as a whole.

Finally, consider investments in the banking sector. Consider the billions of dollars that have been invested in Chinese domestic banks by foreign banks like Merrill Lynch and Bank of America, as well as Royal Bank of Scotland, Credit Suisse and others.

Now, it is true that no foreign bank can walk into China and buy a Chinese bank outright. And yes, there are restrictions on the total stake a foreign bank can own in a Chinese domestic bank. However, such restrictions may also be further eased by as early as the end of next year according to Liu Mingkang, Chairman of the China Banking Regulatory Commission.

It should also be noted that restrictions on foreign banks are far from unique to China. As the Chairman of a Bank with operations in numerous countries and territories in Asia, I can assure you that many other places have similar and in some cases even more stringent restrictions on foreign banks.

Please excuse me for not naming names. It probably wouldn't be in HSBC's best interests if I did. What I can tell you, however, is that we - along with other foreign banks - face various restrictions in various markets. From restrictions on geographic locations of branches to limitations on the number of expatriates we can employ. From not being allowed even one, single off-site automated teller machine to being granted or denied permission to expand at the sole discretion of a regulator rather than on the basis of any written legislation. From going decades without being allowed to open any new branches anywhere in a country to being taxed at significantly higher rates than domestic financial institutions. And all of the aforementioned are just in Asia!

What I can also tell you is that we also see such restrictions and regulations as a part of doing business. We have offices in 77 countries and territories around the world. This means we are guests in at least 76 - perhaps even all 77. What this also means is that as guests, we must respect the wishes of our respective hosts. In other words, how much and how quickly foreign banks are allowed to expand in any given market is entirely a matter for governments and regulators in that market.

The third misunderstanding I want to discuss relates to the intentions of Chinese companies in the United States.

Against a backdrop of both successful and unsuccessful bids by Chinese companies to acquire US corporate assets, there have been headlines declaring 'The Chinese are coming.'

All of which sounds - as others have pointed out - quite similar to the fretting of two decades ago. When there were concerns here in the United States that Japanese companies were coming. That the Japanese were buying up American companies and real estate. And that the Japanese were also manipulating their currency to up their exports.

In fact, it is both natural and quite desirable for Chinese companies to be interested in acquiring assets in America and elsewhere. Natural because as many companies in China continue to grow - just like American companies - they will also be seeking to diversify - just like American companies. Seeking to increase their distribution capabilities beyond their home market. In some cases, even seeking to become global brands, whether it be by building on their own name recognition or by acquiring an existing well-known name. It is also natural because large Chinese companies will simply be doing what every other big company is doing. Namely, looking around the world for the best growth opportunities. Looking to allocate capital to places where they see the most potential. Indeed, America should be flattered.

The interest of Chinese companies in American assets is also desirable for the future. Desirable because - as others have argued - the United States needs to continue to attract foreign investment. Because such investment is critical to keeping current standards of living. And because such investment will be even more vital in helping to maintain equity prices after the baby-boomer generation has retired. In short, such investment is good for Americans in the face of this country's changing demographics.

The fourth misunderstanding on my list relates to foreign investment in China's financial sector. In particular, the suggestion that foreign Banks are rushing into China. The headlines which say banks like mine are vying "for China loans amid 'bottomless' pitfalls." The implication being that we, and others, are leaving our common business sense at home.

Clear I cannot speak for behavior of other banks. But I can speak for HSBC. And I can assure you we are not rushing into China. What we are doing is building a diversified foundation for our business for the future. In the last 4 years, for example, we have invested roughly US$5 billion in several select Chinese financial services entities and in the organic growth of our own operations in China.

Our investments include an 8 per cent stake in Bank of Shanghai. A bank which, as its name suggests, focuses its business in mainland China's richest city. We also have acquired 19.9 per cent stakes in both the country's second-biggest insurer, Ping An Insurance, and China's fifth largest domestic bank, the Bank of Communications.

Other foreign banks are taking other approaches in China. Some are making strategic investments in China's Big Four, choosing limited or no management say in return for access to large national networks. Others are joining consortiums to diversify risk and reduce their total exposure. And at least one is using the start-from-scratch approach, preferring a completely clean balance sheet over any sort of established physical presence. Time will tell, of course, which strategy - or strategies - will work the best.

All of which brings me to the fifth and final misunderstanding I want to address. The belief that China's banks are in "terrible trouble" to use the words of one American business magazine.

Clearly, China's domestic banks and Chinese banking regulators still face many challenges. Challenges such as ensuring a new generation of non-performing loans is avoided. Finding ways to encourage the more efficient use of incoming capital. Further developing the country's equity and bond markets. Building up more of a credit culture in its domestic banks. Improving risk management practices. All challenges which you have talked about this morning or are likely to discuss this afternoon.

What is also clear is the fact that China has already made considerable progress in cleaning up its financial sector. In enhancing its regulatory infrastructure. In improving corporate governance in the banking sector. When I go to mainland China today and talk to other bankers, they no longer want to discuss topics such as asset and liability management. Or to know more about the credit and risk practices of foreign banks. Rather, their top priority is corporate governance. How they can improve it and how they can implement it throughout their organisations.

HSBC's experiences with Bank of Communications also confirm just how much China's domestic banks have changed. Bank of Communications is measurably more transparent today. Its investor relations are also evolving as its management is becoming increasing familiar with the intricacies of being listed and of dealing with analysts, the media and regulators. Indeed their management has even changed. Their new vice president is HSBC's former CEO for China. And he is also not the only individual we have seconded to them. Other changes at the Bank include committees being set up to oversee risk management, audit and compliance. Committees at both the Board and senior management level. We are also seeing a strong desire to introduce more checks and balances.

I should perhaps pause to point out that a number of the evolutionary changes I am referring to started prior to HSBC's investing in Bank of Communications. Changes such as the setting up of corporate credit approval centres. Centralising the management of customer data. Introducing management by business line and by geographic region. In other words, there was enthusiasm for improving corporate governance before we came along. Today that enthusiasm remains, albeit with a little help from us I suppose.

In closing, let me make one final observation.

As China remerges economically, it is not surprising to see increased angst here in America and elsewhere about the impact it will have. About the role China will play. About how China can best integrate itself into the global economy. The surprise would be if there were no such anxieties. However, amidst the inherent frictions of an evolving trade relationship with the United States - and indeed with the world - there are certain facts to be mindful of.

First, the fact that the United States and China have already become economically intertwined. China clearly depends on American companies for further foreign investment as well as American consumer spending to remain robust. The United States, meanwhile, continues to benefit from China's investments in US bonds as well as access to a steady supply of lower-cost goods.

The second thing to remember is that China is going through a transformation that is unprecedented in terms of sheer scale and in terms of complexity. Increased pressure to prematurely open itself to the swings of a free-floating currency will only complicate the situation even further.

And third, the economic re-emergence of China is a reality. On this last point, I realise that I am likely speaking to the converted. After all, if you did not already understand this fact, you would not be at this conference on this day.