International investors have been scared by recent volatility on the Hong Kong stock market. When almost half of the value of Goldin Group and Hanergy Thin Film Power was wiped in two days last month, to say that the public was concerned would be an understatement. Only a few days earlier, the Hong Kong Securities and Futures Commission (SFC) made a rare public announcement it was investigating the affairs of Hanergy, whose shares had just surged and then suffered a spectacular crash, and whose chairman had denied to the media that such an investigation was being considered. People remembered that not long before that, SFC Chief Executive Ashley Alder had defended the commission's watchdog role following the two listed units of the Goldin losing 40 percent of their value in a single day. "Increased turnover and volatility does not necessarily imply there is a rise in market manipulation or misconduct," said Alder.

In spite of Alder's confident statement, Hong Kong does have a history of market manipulation. A recent study by the University of Wollongong documented numerous cases of intervention in Hong Kong's market in recent years. These were all prosecuted by the SFC, but not before the manipulators managed to boost share prices. A research team led by Dionigi Gerace, in a paper published in the Australasian Accounting, Business and Finance Journal, concluded, "The results show that markets are not capable of efficiently responding to manipulation. Rational information-seeking investors who normally keep markets efficient may be the unfortunate victims of market manipulation. The results, therefore, provide an empirical justification as to why manipulation must continue to be prohibited by law and robustly and effectively prosecuted."

The prosecution of offenders is the responsibility of the SFC. The purpose of the SFC is "to ensure orderly securities and futures market operations, to protect investors and help promote Hong Kong as an international financial center and a key financial market in China." In the past it has been generally successful in this task. However, Hong Kong's market is growing rapidly and operations are becoming increasingly complex, with new financial instruments being developed and the growth of regional and international links. The SFC is hiring dozens of new staff and signalled that it will become more proactive in investigating and prosecuting. This is a response in part to public concern about whether the commission can continue to maintain standards. Commentators have noted that it is being pulled in two directions by the political imperative to encourage the growth of the market in Hong Kong and the mainland while still maintaining order as the watchdog of the market.

Watching mainland's phenomenal economic growth, people around the world had long wished to invest but found institutional barriers to participation. They were encouraged when President Xi Jinping spoke about the importance of internationalizing the market and bringing in new sources of funding. Hong Kong is well placed to capture this interest, particularly since November 2014 when the Shanghai-Hong Kong Stock Connect scheme gave local investors access to the mainland market. Hundreds of mainland stocks with a total value of many billion dollars became available to local and international investors, and most believed that they could rely on the Hong Kong's market regulation.

Many hoped that the market link with Hong Kong would bring some order into the chaotic mainland market that after years of under-performing had rocketed to dizzying heights in the last 12 months. Observers who applauded the mainland's government crackdown on corruption in the marketplace and action to correct lax credit lending expected that local financial regulators, trained in an international market environment, would scrutinize listed companies.

Recent events have led international investors looking to China to increasingly query the validity of Hong Kong's market regulations. Andrew Schmulow of the University of Melbourne, in a paper published earlier this year, compares the regulatory success of Hong Kong with other international systems. He notes that institutional regulation of financial markets, through bodies such as the Monetary Authority and the SFC, is not always reliable. "The solution to successful prudential regulation, and regulatory enforcement is a function of regulator culture, inter-agency co-ordination, and regulatory philosophy." That is, political culture and leadership play a critical role.

The author is a visiting professor at the School of Languages and Cultures, University of Sydney. She was previously a senior officer in the Australian Department of Foreign Affairs and Trade. Her last posting was as consul general in Hong Kong and Macao.

(HK Edition 06/05/2015 page11)