In geographical terms, the peninsula and collection of islands in south eastern China which make up the territory of Hong Kong are a little over 400 square miles in size, but in economic terms, the former British colony, which in 1997 was handed back to greater China, packs a serious punch on the world stage and can claim to be the globe’s third largest financial centre after New York and London, and the ninth largest economy in the world.

How has this been achieved? Well, the story of Hong Kong’s economic success has its roots in Britain’s colonial past, and is not really the focus of this feature. However, factors such as Hong Kong’s low business and personal taxation burden, its laissez-faire business environment enshrined in a common law system based upon English principles and its unique position as a trading and investment gateway to China have certainly helped.

One Country, Two Systems

Politically, since July 1, 1997, Hong Kong has been a Special Administrative Region of the People's Republic of China and the constitution known as the ‘Basic Law’ is modelled on the constitution of the People's Republic. Under the slogan of ‘one country, two systems’ which was established before the handover, the Chinese Government agreed that Hong Kong's capitalist system would remain unchanged until the year 2047. This means it has been pretty much business as usual in terms of the day to day functioning of the Hong Kong’s economy, (although it has to be said that question marks remain over Beijing’s desire to promote democracy in the SAR).

Nevertheless, the decision by China not to interfere in the local economy means that little has changed since 1997 to upset Hong Kong’s financial services system (apart from external economic factors beyond its control). Tokyo aside, Hong Kong is Asia’s largest banking hub in terms of external transactions volume. At the end of 2010, there were 146 licensed banks, 21 restricted licence banks and 26 deposit-taking companies in business. These 193 authorised institutions operate a comprehensive network of 1,300 local branches. In addition, there were 67 local representative offices of overseas banks in Hong Kong.

Total employment in the sector in 2010 was nearly 100,000. Bank deposits grew 5.3% to HKD6,862bn (USD881bn) at end-2010, roughly evenly split between Hong Kong dollars and foreign currencies. Renminbi banking is restrained so far, but as much as RMB315bn (USD48bn) in renminbi deposits were held in Hong Kong banks at the end of 2010 - four times more than was held just a year earlier (see below).

Furthermore, Hong Kong is recognised as the leading fund management centre in Asia, with the industry defined by its international and offshore characteristics, and it has become a popular choice for hedge fund managers. Until 2006, hedge funds were frequently domiciled elsewhere, owing to the fact that they are subject to profit tax in Hong Kong. But under The Revenue (Profits Tax Exemption for Offshore Funds) Act 2006, offshore funds owned by non-resident entities (which can be individuals, partnerships, trustees of trust estates or corporations) administering a fund, are exempt from tax in respect of profits derived from dealings in securities, dealings in futures contracts and leveraged foreign exchange trading in Hong Kong carried out by specified persons such as corporations and authorized financial institutions licensed or registered under the SFO to carry out such transactions.

Hong Kong’s hedge fund industry continued to register growth in 2010, according to a survey report released on March 11 by the Securities and Futures Commission (SFC). The “Report of the Survey on Hedge Fund Activities of SFC-licensed Managers/Advisers” shows that assets under management or advisory supervision in Hong Kong increased 14% from the time of the last survey in March 2009 to USD63.2bn as at September 30, 2010. The number of hedge funds managed by SFC-licensed hedge fund managers in Hong Kong stood at 538 as at September 30, 2010, similar to that in 2009 and nearly five times the level in 2004, the earliest year covered in similar SFC surveys.

The CEPA agreements (Closer Economic Partnership Arrangement) with mainland China have already gone a long way towards opening access for Hong Kong financial institutions to the mainland, and the city’s financial services industry is beginning to play a key role in the growth of fund management and international banking on the mainland, with China opening up its banking and investment sector under WTO rules.

Low Taxation

A great deal of Hong Kong’s economic success is undoubtedly attributable to its policy of low taxation. A big advantage is that tax is levied on a territorial basis, meaning that taxes are only charged on income arising from or derived in Hong Kong itself. Furthermore Hong Kong does not levy capital gains taxes, withholding taxes, annual net worth taxes or sales tax, although temporary budgetary constraints forced the government to actively consider the latter some years ago. Despite the government's efforts to convince taxpayers of the merits of a sales tax, the proposal was deeply unpopular with Hong Kong's public, however, and is no longer on the agenda.

The main tax encountered by business entities in Hong Kong is profit tax which is charged at a standard rate of 16.5% (15% for unincorporated businesses).

Property tax is also relatively low, and charged at 15% of the annual assessed rental income of the property. Corporations can set it off against profits tax. Hong Kong does buck the world trend somewhat by retaining stamp duty on the transfer of shares and market securities (charged at 0.2%) although it is the intention of the government to eventually phase out stamp duty altogether. Stamp duty on property transactions rises on a graduated scale to a maximum of 4.25%. A Special Stamp Duty (SSD) on residential properties was introduced in November 2010 to curb speculation as 'hot money' flowed into Hong Kong's real estate market (see below). This is charged at rates of up to 15% depending on length of ownership.

Personal income taxes are also low by world standards and constitute a major draw for foreign residents. Income tax, known in the SAR as ‘salaries tax,’ is based on the previous year's income. It is charged at either 15% of assessable income after deductions, or at progressive rates to 17% (March, 2011), whichever is lower. The territorial nature of Hong Kong’s tax system means that there is much scope to reduce taxation on various forms of income derived from foreign jurisdictions.

Prudent management of Hong Kong's fiscal finances in recent years allowed Financial Secretary John Tsang to sprinkle the cash around in the 2011/12 budget, announced in February 2011. As a result, every Hong Kong permanent resident aged 18 or over will get a cash grant of HKD6,000 (USD770), and there will be reductions of 75% in salaries tax and tax under personal assessment, capped at HKD6,000. The tax reduction mirrors a similar policy adopted in Tsang’s 2010/11 Budget. These measures replace the original proposal in the budget which had suggested injecting HKD6,000 into retirement accounts - a move that Tsang was forced to rescind following strong protests from some Legislative Council members, who argued that most taxpayers would not feel the benefit of this for many years.

Hong Kong until 2006 levied an estate tax, charged at a maximum of 15% on estates valued over USD1,350,000 (HKD10.5 million); but it was abolished in that year.

Residence

Hong Kong owes much of its success to international input, and its colonial past means that British influences abound. English can still be heard as the territory’s official language alongside Chinese. However, the overwhelming majority of Hong Kong’s densely packed 7.09 million (December 2010 estimate) population are of ethnic Chinese origin, with the major non-Chinese elements coming from the British Commonwealth, the US, Japan and Portugal.

All foreign nationals attempting to gain entry into Hong Kong must obtain a visa. The one exception to this rule is for British citizens, who may remain in the territory for up to six months before having to acquire a visa. However, the visa rules in Hong Kong are complex, and have become especially so since 1997. As a general rule those seeking to reside or work in Hong Kong who do not already have the right of abode or ownership of land in the territory need a visa. Whilst it may also be possible to arrive in Hong Kong on a tourist visa and obtain employment, it is becoming increasingly difficult for employers to obtain residential visas via this method, and it is therefore not the recommended path.

Employers will find the transfer of specialised staff or management posts within a firm is usually a straightforward business in Hong Kong, although the SAR government’s policy on importing labour makes recruiting specialised staff more difficult, and procedures are in place to ensure that local workers have ample opportunity to fill a vacancy ahead of foreign candidates.

Real estate

Until 2008, people looking to buy property in Hong Kong found that real estate prices had begun to recover after a long slump which began amid the Asian financial crisis of 1997/1998. Prices were up approximately 30% in 2006 and 2007, and were around 40% above their historic lows reached in 2003. However, prices remained depressed and were, on average, about 50% below 1997 levels. We are talking relatively here, because property in this densely populated territory remains comparatively expensive by international standards. Indeed, according to a survey by ECA International, the human resources consultants, Hong Kong is the third-most expensive place in the world to rent a two-bedroom apartment, partly due to the sheer lack of space in the territory. "Additionally, low interest rates, high liquidity in the market and a shortage of supply have contributed to pushing rents up," observed Lee Quane, Regional Director, ECA Asia.

Hong Kong’s residential prices were 90% up in the five years to January 2008. The market went into reverse again in 2008, of course, with falls of up to 25% in most categories of property. Transaction levels fell, and bank lending dried up, at least for non-HK residents without local income. But strong demand from mainland China in 2009 resulted in an overall increase of 20% in property values in that year and prices rose 65% in the two years to March 2011, reaching a 13-year peak.

Gross rental yields for residential properties are running at about 2% for luxury units and 3% for smaller units in early 2011. Apartments cost between HKD3,000 (USD385) and 8,000 (USD1,025) per square foot depending on location; but larger apartments in fashionable neighbourhoods would cost a lot more than that.

In its 2010/2011 budget, the government introduced measures to cool the market, including an increase in stamp duty on properties valued at over HKD20m (USD2.6m) from 3.75% to 4.25%; and buyers are no longer allowed to defer payment of stamp duty on such transactions.

Following a significant inflow of 'hot money,' leading to substantial increases in asset prices in Hong Kong, Financial Secretary Tsang announced new anti-property speculation measures in November 2010. Among them was the Special Stamp Duty (SSD) on residential properties, which is to be charged on top of the current ad valorem property transaction stamp duty. Any residential property acquired on or after November 20, 2010, either by an individual or a company, listed or unlisted, and regardless of where it is incorporated, and resold within 24 months will be subject to the proposed SSD.

The SSD is payable jointly and severally by both the buyer and the seller in the resale transaction, and is calculated based on the consideration for the resale transaction at regressive rates for different holding periods. It is charged at 15% if the property is held for six months or less; 10% if the property is held for more than six months but for 12 months or less; and 5% if the property is held for more than 12 months but for 24 months or less.

It was also proposed to disallow deferred payment of stamp duty, including SSD, for residential property transactions of all values, while, to deter non-compliance, the existing statutory sanctions were to be extended to cover the SSD. Any person who fails to pay the SSD by the deadline for payment is liable to penalties up to 10 times the amount of the SSD payable.

Not long after Tsang's announcement, Secretary for Transport and Housing, Eva Cheng, told the Legislative Council that additional measures will be introduced to cool the property market if the stamp duty and other curbs on speculative buying are not successful. In fact the SSD had not yet become law as of March, 2011, since constitutional issues have been raised in Legco and debate continues.

Closer Economic Partnership

As mentioned, Hong Kong’s unique relationship to China allows it to serve as a convenient base for international manufacturers and investors with plans to tap into the Chinese market place. Beijing and Hong Kong have sought to oil the wheels of the trading machinery that exists between the two jurisdictions by agreeing to the Closer Economic Partnership Arrangement (CEPA), which came into effect on 1st January 2004, and has been extended several times since, most recently in 2008. Speaking at the time, Chief Executive Donald Tsang said CEPA had brought encouraging economic benefits to both the Mainland and Hong Kong. During the first three years since its implementation in 2003, CEPA had created 36,000 new jobs for Hong Kong and brought additional capital investment of HKD5.1bn. It also attracted investment from the Mainland and overseas. At the end of 2007, more than 900 Mainland enterprises had been granted approval to invest in Hong Kong, with investment amounting to more than USD5.5bn, and at the end of August 2008, more than HKD14.5bn worth of goods had entered the Mainland market making use of the zero-tariff preferential treatment under CEPA, of which 65% was exported to Guangdong. As for trade in services, more than 2,000 Certificates of Hong Kong Service Suppliers had been issued.

CEPA, in parallel with China's accession to the World Trade Organization, has set in motion a process of trade liberalisation in goods and services between the SAR and China and has cemented Hong Kong’s position as the conduit for investment into the mainland. Tariffs have been removed on a wide range of goods and services; it has also removed or reduced geographical, financial and ownership constraints on a variety of services sectors including professional services, communications and media, financial services and trade related services, legal services, construction, information technology, conventions and exhibitions, audiovisual, distribution, tourism, air transport, road transport, and individually owned stores. Importantly, these liberalizations apply to companies of any nationality provided the firm is incorporated in Hong Kong, has operated there for a minimum of three years, is liable to pay tax in the territory, and employs at least 50% of staff locally.

However, overseas firms without a presence in Hong Kong can still take advantage of the CEPA provisions by outsourcing to, or partnering with, a qualified Hong Kong-based manufacturer or service provider. Foreign manufacturers can achieve this by satisfying rules of origin requirements which essentially means that goods must be ‘substantially changed’ in Hong Kong to qualify. Overseas service providers meanwhile, can partner with or invest in a CEPA-qualified firm to gain greater access to the mainland market.

CEPA also includes a number of rules enabling mutual recognition of professional qualifications as part of the services rules in a number of sectors.

CEPA Supplement VII, agreed in May 2010 and effective from January 2011, provides for a further 35 market liberalization and trade and investment facilitation measures in 19 sectors. Supplement VII further relaxes the market access conditions in 14 service sectors, including: technical testing, analysis and product testing; specialty design; banking; securities; tourism; and air transport. Among them, "technical testing, analysis and product testing" and "specialty design" are new sectors, bringing the total number of liberalized service sectors under the CEPA from 42 to 44.

In January 2011, Invest Hong Kong announced that it had assisted 284 overseas and Mainland Chinese companies to set up or expand in Hong Kong in 2010, with these companies creating 3,056 jobs in their first year of operation or expansion. According to InvestHK, of the completed projects, the Chinese mainland continued to represent the largest single source of investment into Hong Kong with a total of 52 projects, with the rest of the top five comprising the US with 51 projects, the UK with 36, Japan with 19, and Australia with 16. The high prevalence of Chinese expansions and start-ups among the 284 completed projects seemed to suggest that the Closer Economic Partnership Arrangement (CEPA) between Hong Kong and the mainland, and the expanded liberalisation measures that have come as part of the Agreement, in areas such as education services, innovation and technology, and cultural and creative industries have played a significant part in the investment decisions of businesses looking to establish or expand.

Renminbi

More recently, CEPA has led to the easing of restrictions on the trading of the Chinese currency, the renminbi, in Hong Kong. Hong Kong importers are now allowed to settle direct import trades from the Mainland in renminbi, while financial institutions in the Mainland have begun to issue renminbi financial bonds in Hong Kong on a pilot basis.

While the renminbi is not yet fully convertible, the Chinese government has taken several steps to incrementally liberalize the currency in recent months and years. In March 2011, the State Administration of Foreign Exchange (SAFE) confirmed that it will look for a developing use of China's currency, the renminbi, in capital account transactions this year. While it will continue its close monitoring of capital account flows, it is now to be expected that convertibility of the renminbi for cross-border investment purposes will mirror the use of the renminbi for cross-border trade settlement, which is already much further developed. It was reported that it is also proposed to extend the trial of renminbi-denominated cross-border trade settlement to all cities in China by the end of this year. The central bank has said that such settlement reached a total of more than CHY506bn (USD77bn) in 2010. In addition, by the end of the year, more than 67,000 Chinese companies had joined the renminbi settlement programme.

Inevitably, much of the growth in offshore renminbi business is taking place in Hong Kong, and progress has been seen in various areas, including cross-border trade settlement, deposits, bond issuance and the introduction of financial products. Moreover, in February 2011, the Tsang announced in his budget presentation that further measures will be taken to foster growth in offshore renminbi trade.

The cross-border RMB trade settlement handled in Hong Kong reached RMB370bn (USD56.3bn) last year. And, as mentioned, at the end of 2010, total RMB deposits in Hong Kong exceeded RMB300bn, which has increased by four times when compared to some RMB60bn a year ago.

As part of Hong Kong’s attempts to consolidate its position as a platform to raise international capital and enhance the competitiveness of its asset management industry, Hong Kong’s RMB bond market will be further developed. As at end-January there were a total of 31 RMB bond issues with an issuance size of about RMB74.4bn. The range of issuers has expanded from Mainland financial institutions to multinational non-financial institutions. Hong Kong will continue to encourage overseas enterprises to issue RMB bonds in Hong Kong, solicit more Mainland enterprises to issue bonds in Hong Kong and seek the expansion of channels for enterprises to invest in the Mainland the RMB capital raised in Hong Kong. In addition, the government plans to optimize the RMB clearing platform to attract more enterprises to use Hong Kong’s RMB settlement services.

Recovery

Economically speaking, Hong Kong hasn’t had an altogether easy ride in recent years, and has had to deal with a long period of deflation and the widespread impact of 9/11 and the SARS epidemic in early 2003, which joined with cyclical factors to slow economic growth considerably.

However, the government is determined to avoid a repeat of the SARS crisis which virtually shut down the city for a number of weeks in 2003, in the process crippling the economy across all sectors and eventually claiming the lives of 300 people.

Realising that there is much at stake if another epidemic were to occur, Hong Kong in 2003 earmarked some HK$1.3 billion (US$200 million) to be spent on various public health projects whilst laws have been changed to strengthen and enforce hygiene standards and promote a more hygiene-conscious culture among the city’s population.

The SAR had a couple of good years in 2005/2006, with GDP growth estimated at 7.3%, followed by 6.8%. Since then the SAR has bumped along the bottom, with GDP actually falling 3% in 2009. There looks to have been a sharp rebound in 2010 however, and recent figures suggest that the SAR's economy grew by 7.1% in the first three quarters of the year.

As an entrepot and trading city, with only a small domestic manufacturing base, Hong Kong's performance has historically tended to reflect overall global trading conditions, which have scarcely been benign in the last three years. One success story at least in 2009 was the performance of the new issues market: Hong Kong hosted 73 IPOs in 2009 raising HKD240bn, four times more than in 2008, and topping the world's rankings. Generally though the stock market had a mediocre year: average daily turnover value on the Stock Exchange decreased about 14% to HKD62.3bn, and the average daily turnover of derivatives contracts and stock options contracts dropped marginally to 206,458 contracts and 15% to 191,676 contracts respectively.

But what a difference a year makes! 2010 saw a number of trading record broken on the Hong Kong exchange. Total equity funds raised reached HKD850.1bn by December 31, beating the previous annual record of HKD642.1bn set in 2009. Funds raised by Chinese mainland enterprises (IPO and post-IPO) reached HKD466bn by year's end, well above the previous record of HKD384.9bn set in 2006. The total number of shares traded in 2010 reached just under 35 trillion by the end of the year, surpassing 2008's record of 27.1 trillion. New records were also set in trading turnover for several instruments, including exchange-traded funds, futures and options, index futures and options, and stock options. The number of listed companies on the exchange rose by 8.65% to 1,244 during 2010, and market capitalisation was just under HKD30 trillion as at December 31, 2010, 17.86% higher than the end of 2009.

Whatever short-term travails it may have experienced, however, Hong Kong holds an enviable position as the conduit for global investment into China, and with its economy built firmly on a foundation of low taxation and decades of expertise as a financial services hub, it seems that prospects for the former British colony appear bright. The jurisdiction is likely to remain popular both as a place to do business, and a place where foreigners can take advantage of an attractive tax regime, for some time to come.