Enter the dragon: Shanghai comeback challenges financial might of Hong Kong

On Shanghai's waterfront Bund, once the financial centre of Asia, the flagships of old wealth find it politically acceptable again to trade on former glories. The Peace Hotel, known as the Cathay Hotel when Noel Coward stayed and penned Private Lives, has turned its top floor into an international bankers' club, "a place specially used for social contact and communications between celebrities of financial circles". As its regulations announce, "sloppily dressed" people are not welcome.

In Shanghai, the (smartly dressed) international banker is again a creature to be welcomed. The city has set ambitious targets to reclaim some of the stature of its Thirties heyday. "We have worked out a three-phase action plan," said Wang Zhan, director of the government's Development Research Centre: to be China's national financial centre before 2000, Asia's regional financial hub by 2005, and a global financial centre in 2010.

Where, then, does that leave Hong Kong? Is the "dragon's head" of the Yangtze River, as Shanghai is officially described, set to eclipse Hong Kong after sovereignty reverts to China? "By 2010, I think Shanghai will be a city that stands out as a regional financial centre, on a par with Hong Kong if not ahead," said Douglas Red, general manager of the Shanghai branch of the merchant bank, ING.

By Chinese standards, modern Shanghai is a late starter. For decades, the city was used as a cash cow by the communist government and between 1949 and 1983 remitted 87 per cent of its revenues to Peking. After market reform was launched in 1978, Shanghai's relative economic status declined sharply as Peking instead promoted an export-oriented boom in southern China.

The turning point for Shanghai was 18 April 1990, when the central government launched the Pudong district, across the river from the Bund, as China's future financial centre.

The results, as Mr Red said, have been "startling". "In 1990, there was very little in the way of foreign investment and foreign presence in Shanghai. [Today] the foreign community is growing dramatically, the infrastructure has developed in a way which I would say is the envy of most metropolitan areas in China, and the growth seems set to continue," he said.

The physical transformation has been probably the fastest of any city on earth. Annual promised overseas investment in Shanghai has surpassed $10bn (pounds 6bn) a year for the past three years and in Pudong there aremore than 4,000 foreign-funded financial and manufacturing companies. There is enough office space to satisfy all foreseeable demand and rents have slumped. Even so, this year, another 3 million square feet will become available in Pudong alone, with 140 high-rise buildings under construction.

Hong Kong, while fearing competition, also has a vested interest in Shanghai's future. It is the biggest investor in Shanghai, and accounts for more than 40 per cent of foreign funds promised for Pudong. Business links are strong; many Hong Kong moguls, including the future chief executive Tung Chee-hwa, are displaced Shanghainese, whose families fled when the Communists took control in 1949.

The question is whether - and when - Shanghai's revival will start to undermine Hong Kong. The colony's greatest asset, its natural deep-water port, means that it handles nearly half of China's exports; it will take years of river-dredging before Shanghai is able to handle the next generation of container ships.

As a financial centre, even Chinese officials for the time being play down Shanghai's threat to Hong Kong. Li Qian, the spokeswoman at the Shanghai Stock Exchange, defines the future relationship as "co-operation and competition". The onus is on Shanghai to implement further reform. At the moment, the total value of companies quoted on the Hong Kong stock market is seven times the Shanghai market, and most of the shares in China are still "A" shares which can be purchased only by Chinese.

Similarly, there are already 44 foreign branches of international financial institutions in Shanghai. But it is only very recently, and after agreeing to put branches in Pudong, that a handful of foreign banks has been given permission to conduct limited local-currency business.

Many of Shanghai's barriers - including the prerequisite of a freely convertible currency - can be solved by central government edict, and probably will be over the next few years. But other requirements of a world financial centre are less tangible, such as a free press, a transparent regulatory and legal system, low corruption, and an ease of entry for foreign players. By all these counts, Hong Kong is in a different world to Shanghai. The question, after 1 July this year, when the British colony reverts to China, is whether these relative advantages will be eroded because of greater mainland influence in Hong Kong.

By Mr Wang's dates, the first phase of Shanghai's renaissance is on target. His second goal is more of a challenge; Hong Kong is the bridge for international finance into China and will remain so until foreign banks see Shanghai as a place to put their Greater China or East Asia regional headquarters.

Some time in the next century that is likely to happen. But there are those who think that Shanghai's renaissance does not have to be at Hong Kong's expense. At the Pudong New Area Administration Office, Fan Zonglin said: "China is very big, so two business centres is not too many."