HONG KONG—Tim Freshwater, Asia vice chairman of Goldman Sachs Group Inc., gazes across the Hong Kong skyline from his 68th-floor window toward a rectangular building that houses the barracks of China’s People’s Liberation Army (PLA).

“Remember all that fuss about the PLA marching in?” says Freshwater, 62, recalling the dawn scenes on July 1, 1997, when 4,000 Chinese troops rolled across the border hours after Britain handed sovereignty back to Beijing, ending 156 years of colonial rule. “There was all sorts of drama about what might happen to the war memorial.”

Ten years later, Britain’s memorial to the war dead remains undisturbed. The PLA’s soldiers are mostly confined to barracks, surrounded by a growing army of bankers, fund managers, lawyers and accountants. The newcomers pay as much as $17.50 a square foot a month—rivaling London and New York—to lease the glass-and-steel offices that now tower over the beige, 28-story symbol of Chinese military power.

When mainland Chinese leaders flew down from Beijing to celebrate the hand­over anniversary over the weekend, they found a teeming enclave on the Pearl River delta with even stronger capitalist characteristics than it did in its colonial days.

Hong Kong is now home to the world’s sixth-biggest stock market (up from eighth in 1997), and last year it overtook New York to become the biggest market after London for initial public offerings (IPOs).

Its island-studded harbor, overlooked by the gravity-defying apartment blocks that cling to the slopes of Victoria Peak, was last year the world’s second-busiest container port.

In January, Hong Kong was named the world’s freest economy for the 13th year by the Heritage Foundation, a Washington-based advocacy group, which cited its low taxes, openness to investment and lack of tariffs. “Our main target is to turn Hong Kong into a New York or London of the East Asia time zone,” says Donald Tsang, Hong Kong’s Beijing-sanctioned chief executive.

Not all of the changes since the handover have been for the better. The city today is swathed in pollution, with air quality so poor that the government advised people with asthma or cardiovascular disease to stay indoors on 41 days last year.

The city is facing increased competition from Shanghai and other locations such as Singapore. Hong Kong’s leaders are struggling to deliver on promised democratic reforms, while the gap between rich and poor is growing.

“We have a split economy,” says Marc Faber, 61, who oversees $300 million at Marc Faber Ltd. in Hong Kong and has managed money in the city for 34 years. “The super-rich, the money shufflers and lawyers, are doing exceedingly well. However, the lower and middle classes are doing just so-so. Hong Kong today is extremely dependent on the financial sector, and it could suffer rather badly in a downturn.”

One country, two systems

Under the arrangement known as “one country, two systems,” the city in 1997 became a special administrative region of China, with Beijing guaranteeing it autonomy over its own affairs, except over defense and foreign policy, for 50 years.

China’s communist leaders pledged not to tamper with Hong Kong’s way of life and its laissez-faire economy. It would retain its own currency—the Hong Kong dollar, which is pegged to the US dollar—and its British common law system, administered by judges in horsehair wigs.

Beijing also agreed to let Hong Kong keep other forms of economic and legal independence, including separate membership in the World Trade Organization.

Unconvinced, 545,000 people—one-twelfth of Hong Kong’s population—mostly refugees or the children of refugees from communism, emigrated between 1984 and 1997.

The oldest British-owned company, Jardine Matheson Holdings Ltd., moved its headquarters to Bermuda and its stock listing to Singapore. Fortune magazine ran a cover story titled “The Death of Hong Kong.” Milton Friedman, the late US Nobel Prize-winning economist, predicted that within two years of the handover, Beijing would impose capital controls and do away with the Hong Kong dollar.

Instead, China stuck to the deal, says Chris Pratt, chairman of Swire Pacific Ltd., a British-owned company that opened its first office in Hong Kong 137 years ago. Swire controls Cathay Pacific Airways Ltd., which in 1997 did not fly to the mainland.

Today, Cathay has 400 flights a week to the mainland—more than any foreign-owned carrier—most through its Dragonair subsidiary. Cathay bought the 82.2 percent of Dragonair it didn’t already own last year for $1.1 billion and doubled its stake in Air China Ltd., the mainland carrier, to 17.5 percent.

“We took the view China meant what it said about Hong Kong,” says Pratt.

Boom and busts

Hong Kong’s history has been marked by boom-and-bust cycles. London started calling the shots in 1841, when it seized Hong Kong island, whose name means “fragrant harbor” in Chinese, after a war sparked by Britain’s illicit trade in opium. In 1860, China ceded the tip of the adjacent Kowloon peninsula as well.

Then in 1898, Britain more than doubled the size of Hong Kong’s territory by acquiring another chunk of mainland, known as the New Territories, on a 99-year lease.

British companies that set up there were known as hongs, or trading companies, and the men in charge were taipans, which means great managers in Cantonese. Four of the hongs grew into global companies.

In addition to Swire, they are: HSBC Holdings Plc., founded in Hong Kong in 1865, and now the world’s fourth-biggest bank by market value; Hutchison Whampoa Ltd., now owned by billionaire Li Ka-shing, and the world’s biggest port operator; and Jardine Matheson, once known as the Princely Hong and controlled by the Keswick family, descendants of William Jardine, which operates the Mandarin Oriental hotel chain.

By the end of the 1970s, the question of renewing the leases on properties that expired after 1997 forced Britain to start talking to China about Hong Kong’s future. In 1984, Prime Minister Margaret Thatcher and paramount leader Deng Xiaoping signed a joint declaration guaranteeing the one-country, two-systems solution until 2047.

Fears for the future were heightened in 1989 when Chinese troops cracked down on democracy activists in Tiananmen Square. In Hong Kong, the stock market plunged 37 percent in three weeks, and a million people took to the streets in protest, according to the Hong Kong government.

Others headed for the airport. China’s economic growth slumped to 4.1 percent from the 11.5 percent it had averaged over the previous seven years.

In 1991 the mainland economy resumed its rapid growth. By the mid-’90s, returnees outnumbered those leaving the territory, now with the security of foreign passports. At the time of the handover, the Hang Seng Index had risen eightfold to 15,196 in as many years since Tiananmen, and property prices had hit records.

Just one day later—on July 2, 1997—the Thai baht collapsed, sparking a regional financial crisis. Hong Kong’s stock market plummeted 60 percent in a year.

In 2003 a mysterious pneumonia-like disease, Severe Acute Respiratory Syndrome, or Sars, swept across the border, killing 299. Shops, hotels, restaurants, subway lines, airplanes and even the normally packed Edwardian-era trams that still trundle between bank towers downtown lost business overnight.

Those who did venture out hid behind white and blue surgical face masks. “Sars was in a sense worse than the Japanese occupation,” says Ronald Arculli, 69, chairman of Hong Kong Exchanges & Clearing Ltd., who has childhood memories of the war years. “This time, the enemy was faceless.”

China’s advance

Caught in a deflationary spiral that lasted until 2005, homeowners found their properties lost two-thirds of their value. Such a home-price plunge would be unthinkable in the West, says Peter Churchouse, a former Morgan Stanley property analyst who’s now director of Hong Kong-based property consultant Lim Advisors Ltd. “If you had a decline like that in America or Europe, there would be blood on the streets,” he says.

China came to Hong Kong’s aid, signing a trade agreement that allowed Hong Kong companies freer access to Chinese markets. It eased travel restrictions on mainlanders visiting the territory, saving the Sars-ravaged tourism industry.

“That was a huge boost that turned the economy around,” says Amar Gill, 43, an analyst at CLSA Asia-Pacific Markets. The official China Daily agreed. “The central government gave Hong Kong a big gift,” it said of the free-trade deal.

China also allowed more of its giant state-owned enterprises to sell shares on the Hong Kong market, which helped boost stocks to a record 21,070 on May 7.

Chinese companies now make up half the market capitalization of the Hong Kong exchange, up from 10 percent a decade ago. Eight of the 15 largest stocks in the Hang Seng Index are Chinese companies.

Hong Kong’s economy has grown 7.6-percent annually for the past three years, and gross domestic product per capita on a purchasing power parity basis will be $37,385 this year—higher than the $31,585 of its former colonial ruler.

Property prices for offices in the central business district and luxury apartments and houses on the slopes of the peak are also back to 1997 levels, according to Lim Advisors.

This time, Hong Kong isn’t heading for another bust, says billionaire Victor Fung, a former Harvard Business School professor who’s chairman of Li & Fung Ltd., a supplier of Chinese-made goods to retailers such as Wal-Mart Stores Inc.

“Looking back, we were going through a bubble in 1997,” Fung, 62, says. “Now we are on very solid ground. We are much more important as a financial center.”

Billionaires

Although mainland China has two stock markets of its own, in Shanghai and Shenzhen, Hong Kong remains the No. 1 source of capital for the world’s fastest-growing major economy.

Hong Kong IPOs raised $43 billion in 2006 compared with $10 billion in 1997. That total included $16 billion of the $22 billion raised last October by Industrial & Commercial Bank of China (ICBC) in the world’s biggest-ever share sale (the other $6 billion was raised in Shanghai).

In April, Hong Kong hosted the biggest initial public offering so far this year when Beijing-based China Citic Bank Corp. sold $5.95 billion of shares in a dual listing in Hong Kong and Shanghai. Country Garden Holdings Co., China’s most profitable developer, also sold $1.9 billion of shares in Hong Kong this year.

In terms of personal wealth, Hong Kong is home to the most US-dollar billionaires per capita, says Kathryn Shih, Hong Kong-based Asia-Pacific head of wealth management at UBS AG. That’s 29 in a population of seven million. One in every 50 residents is a millionaire, Merrill Lynch & Co. and Capgemini SA reported in a 2006 world wealth survey.

Total funds under management in Hong Kong are $579 billion, three times as much as in 2000, according to the Hong Kong Securities and Futures Commission.

To win a share of Hong Kong’s booming investment banking and wealth management markets, foreign banks have been boosting their presence. UBS, which last year topped the league tables for arranging Hong Kong and Chinese overseas share sales, according to Bloomberg data, has doubled its Hong Kong staff to 2,000 in the past three years, Shih says. UBS arranged $7.4 billion worth of Chinese share sales last year, including part of the $11.2-billion IPO of Bank of China Ltd., the country’s No. 2 lender.

“There’s no opportunity I have seen anywhere in the world that compares with what we have before us here today in Hong Kong,” says Steven Barg, UBS’s head of equity capital markets for Asia.

At Goldman Sachs, profits from Asia exceeded those from Europe since 2005, and last year more than doubled to $4.02 billion compared with $3.01 billion in Europe. Goldman now has 1,300 employees in Hong Kong, up from 800 in 2003.

“In the 10 years since the handover, Goldman Sachs in Asia has gone from being marginal to a genuine third leg of the global business,” Freshwater, the Asia vice chairman, says.

Goldman was the No. 2 underwriter of China IPOs last year, arranging $7 billion, including the Bank of China sale. The US bank has a paper profit of $8.75 billion on the $2.6-billion investment it made in ICBC last year before the share sale.

“No one would have dreamed the amounts of equity raised through listings here could have been done in that period of time,” says Freshwater, a Briton who has spent 30 of the past 40 years in Hong Kong and who, as president of the city’s law society in 1984, witnessed Thatcher and Deng sign the joint agreement.

Maintaining its edge

Chief Executive Tsang, who was reelected in March, says one of his priorities in his second five-year term is to make sure Hong Kong doesn’t lose its edge to Tokyo, Singapore or China’s domestic financial center, Shanghai.

Tsang, a policeman’s son who picked up a British knighthood before the handover, ticks off Hong Kong’s advantages for foreign investors: a well-regulated market, the British-based legal system, free media and minimal corruption.

Hong Kong ranks 15th cleanest—higher than the US, Japan and Germany—out of 163 countries in the 2006 corruption perception index compiled by Transparency International, a Berlin-based advocacy group. China is 70th.

“We are part of the Chinese nation, but we are a unique jewel,” Tsang says. “There are certain things that we represent that are lacking in the mainland.”

Casting a shadow over Tsang’s vision is mainland China’s commercial capital, Shanghai. Shanghai’s stock market trades in so-called A Shares that are reserved mostly for Chinese investors using yuan. Increasingly, Chinese companies listing in Hong Kong are getting a second listing for their shares in Shanghai.

Last year, 71 percent of the $62 billion of funds raised on Chinese stock markets was in Hong Kong, according to PricewaterhouseCoopers LLP. This year, 64 percent of an estimated $58 billion will be raised in Shanghai and Shenzhen as companies already listed in Hong Kong sell more shares domestically, the New York-based accounting firm says.

In the first quarter of 2007, Shanghai’s container port also overtook Hong Kong to become the world’s second-busiest after Singapore, according to mainland and Hong Kong statistics.

“If you are complacent, you risk being overtaken one day,” says Fred Ma, Tsang’s secretary for financial services.

The momentum may already be moving away from Hong Kong, says Simon Murray, Hong Kong-based founder and chairman of General Enterprise Management Services, a $750-million private equity fund.

“Hong Kong’s such a great stock market because foreigners can’t invest in A Shares,” says Murray, a former Asia chairman of Deutsche Bank AG and CEO of Hutchison Whampoa, Hong Kong’s biggest conglomerate.

Eventually, China will make its yuan convertible to the dollar and other currencies. “When that changes, we will all be up in Shanghai,” he says. “If you want to catch fish in China, you have to be up there. From Hong Kong, you need a very long rod.”

Murray, a marathon runner, says pollution could also drive investors away from Hong Kong. “To be a successful financial center, you need to be not just transparent in your systems but also in the air you breathe,” he says.

In the 1980s and ’90s, Hong Kong moved its manufacturing industry across the border to Guangdong province, where labor is cheaper. Now, the pollution from 60,000 Hong Kong-owned factories wafts back across the border, adding to the city’s homegrown haze.

In November, Merrill Lynch cut its ratings on three Hong Kong property developers over concerns that Hong Kong’s pollution problems could cause a brain drain. “The air quality in Hong Kong is now regularly so poor that the long-term competitiveness of this city-state is, in our minds, in some doubt,” former Hong Kong-based Merrill analyst Spencer White told clients in a note.

By comparison, rival Singapore has the best air quality of any major city in Asia, says ECA International, a London-based human resources consulting firm. Even Shanghai’s is less polluted, ECA says.

In October, Tsang’s government unveiled plans to enforce emission caps on power companies and give tax breaks for cleaner vehicles. He says he’s also talking to his counterparts in Guangdong. “We will certainly do all we can in Hong Kong, but that will not be half enough,” he says. “It will take hard work and continuous monitoring for the next five years.”

Promised democracy

As important as economic issues, Tsang says, is winning approval from both Hong Kongers and leaders in Beijing for a plan to introduce a democratic system of government. Although China is a one-party state, it has promised that the people of Hong Kong will one day be able to choose their own chief executive.

Currently, the 60-member legislature has just 30 directly elected members. The chief executive is elected by 800 people, mostly Beijing loyalists.

Tsang says his goal is to set a timetable for introducing universal suffrage for the territory before he leaves office in 2012. To get approval for the necessary reforms, Tsang—who won 649 votes after being challenged by a pro-democracy candidate, barrister Alan Leong—has to win approval from Beijing plus two-thirds of Hong Kong legislators.

Pro-democracy legislators, including Leong, want universal suffrage to happen in time for the next election. Beijing’s leaders are more cautious, Tsang says. “I will try and maneuver and find something that is acceptable at the end of the day,” he says.

Is Tsang confident he can deliver on his democracy pledge? “That’s not the right word, but I am determined,’’ he says.

Gutsy call

Tsang has shown resolve in the past, says Goldman Sachs’s Freshwater. In 1998, at the height of the financial crisis, the Hong Kong dollar came under attack from hedge funds that had profited from the collapse of the Thai, Indonesian and South Korean currencies.

Tsang, then financial secretary, fought back, spending $15 billion to buy up blue-chip Hong Kong stocks and shore up the market.

Tsang, who stands 5 feet 6 inches tall and wears a bow tie to work every day, says he didn’t inform Beijing until 30 minutes after he entered the market. “Someone in Beijing said I must have swallowed a tiger’s gall bladder,” says Tsang, referring to a Chinese expression for someone who shows unexpected strength.

“It was a very gutsy call,” Freshwater says. “Some people say it was a tougher decision than it would have been in 1996 because under a British governor, that decision would have been made by the Bank of England in London.”

Tsang hasn’t won all his battles. An attempt to introduce a goods and services tax was blocked in the legislature. In a city where the maximum income tax rate is 15 percent and the top corporate tax is 17.5 percent, Tsang says, Hong Kong still urgently needs to broaden its tax base.

Still, he says one thing he doesn’t have to worry about is the PLA. He says the Chinese soldiers are more disciplined than their British predecessors, who were famous for rowdy nights in the bar district of Wanchai.

“We have never had any incident—not even a speeding ticket,” Tsang says. “These people behave impeccably.”

Even with their bird’s-eye view into the PLA compound, Freshwater and his Goldman Sachs colleagues say they never see signs of military activity. If so, the barracks may be the only place in today’s Hong Kong where nothing much is happening.

***** 

THE LAST 10 YEARS

Following is a chronology of events after Hong Kong’s return to Chinese sovereignty on July 1, 1997.                                                                               

June 30-July 1, 2007: Hong Kong marks 10 years of Chinese rule. Chinese President Hu Jintao visits the city and Hong Kong’s government plans 460 events. 

April 26, 2007: Two pandas, a gift from China’s government for the 10th anniversary, arrive in Hong Kong. Their names, Ying Ying and Le Le, mean prosperity and happiness in Chinese.                                                          

March 25, 2007: Incumbent Donald Tsang is reelected as the city’s chief executive by an 800-member committee. He pledges a solution for the issue of universal suffrage, without giving details or a time frame.  

January 11, 2007:  China’s yuan exceeds the Hong Kong dollar in value for the first time in 13 years, underscoring the economic growth of China. 

December 28, 2006: Hong Kong’s benchmark Hang Seng Index breaks the 20,000 mark for the first time. 

November 8, 2006:  Margaret Chan Fung Chun, the former director of health during the Hong Kong Sars virus outbreak, becomes World Health Organization director-general.                                                 

October 26, 2006: China’s biggest bank, Industrial & Commercial Bank of China, raised $21.9 billion in the world’s biggest initial share sale and the first dual listing of shares in Hong Kong and Shanghai. 

December 13-18, 2005: The World Trade Organization holds a ministerial meeting in Hong Kong. The city’s police use tear gas to dispel antifree-trade protesters and arrest more than 900 people, mainly South Koreans.  

September 12, 2005: Hong Kong Disneyland, 57-percent owned by the government, opens. 

March 10, 2005: Chief executive Tung Chee Hwa quits for health reasons. He is succeeded by Chief Secretary Donald Tsang.    

September 5, 2003: Hong Kong’s government drops a national security law which it said was required under Article 23 of the Basic Law, which governs sedition, treason and theft of state secrets.    

July 1, 2003: About half a million people take to the streets to protest against the proposed national security law and the government’s handling of the economy. 

June 29, 2003: China and Hong Kong sign a Closer Economic Partnership Arrangement to help revive the city’s economy after Sars. The free-trade accord scraps duties on 273 types of Hong Kong exports and offers Hong Kong’s banks, brokers and insurers easier access to the mainland’s market. 

April 2, 2003: The World Health Organization warns against travel to Hong Kong because of Sars. Some 299 people died of the disease in the city, with the last patient recovering on January 18, 2004. 

August 7, 1998: The Hong Kong dollar is attacked by speculators trying to break the currency’s peg to the US dollar. The speculators fail and the peg stays. The Hang Seng Index slumps 12 percent in a week.                                                                          

July 6, 1998: Hong Kong International Airport opens. The $20-billion facility is roiled by initial difficulties that force the cancellation or delay of hundreds of flights. 

October 28, 1997: The Hang Seng Index drops 13 percent to 8,776, the biggest slide since 1989, amid the Asian financial crisis.    

July 1, 1997: Hong Kong is handed over to China from Britain, ending 155 years of colonial rule. Tung Chee-hwa, the first Chief Executive of the Special Administrative Region, runs the city under the “one country, two systems” formula. --Bloomberg

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HONG KONG—Tim Freshwater, Asia vice chairman of Goldman Sachs Group Inc., gazes across the Hong Kong skyline from his 68th-floor window toward a rectangular building that houses the barracks of China’s People’s Liberation Army (PLA).

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