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Home , Donald Tsang, Environment of Hong Kong, Hamish Macleod, History of capitalism, History of Hong Kong

- LECTURE –

Hong Kong and the Context of Laissez-Faire: Myths and Truths about a ' Paradise'

By Catherine Schenk History of Series

2 June 2016

* * * Kong has developed a reputation for open markets, opportunity and free from its founding in 1842, when the British took the ‘barren’ island to function as the headquarters to open up the trade between China and the rest of the world and escape the constraints of trading through Canton and Macao. is persistently ranked as the world’s most economically free market by the Fraser institute (1970-2015) and by the Heritage Foundation (1995-2015). It thus forms a kind of bench mark for free market capitalism and seems at first sight to conform to the idea of laissez faire, or leaving and markets to do what they do best without interference. Moreover, Hong Kong is an important case study to understand the components of effective regulatory reform. While many states struggled with banking regulation in the new era of integrating market in the 1970s, Hong Kong carved its own path to establish a regional and then global international , in the absence of a (the Hong Kong Monetary Authority was formed in 1993).

Milton Friedman particularly lauded Hong Kong as a preserve for free markets even when its imperial master, , was at its most interventionist, promoting nationalised industry, strong labour unions and a large and generous welfare system. 1 Among Friedman’s final publications (a month before his death in November 2006) was a contribution to the Wall Street Journal where he described Hong Kong as ‘a shining symbol of economic freedom’.2 In 1998, Friedman specifically attributed the relatively poor economic growth of Britain compared to Hong Kong to ‘ in Britain, free enterprise and free

1 M. Friedman, ‘Asian values: right…’, National Review, 31 December 1997. M. Friedman, ‘Hong Kong Wrong’, Wall Street Journal, 6 October 2006. 2 Friedman, ‘Hong Kong Wrong’.

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markets in Hong Kong.’3 In 1960 Hong Kong’s per capita income was less than a third that of the UK, but by the time of the handover of sovereignty to China in 1967 per capita income in Hong Kong was more than 10% higher than in the UK.

The characterisation of unfettered markets is certainly true for international capital flows and the foreign exchange market, which operated more freely than almost any other centre in the world in the 1950s.4 But how well does this characterisation conform to more detailed historical evidence? Certainly, Hong Kong’s post-war economic development was remarkable and demonstrates a wealth of , resilience and appetite for trade. Despite Britain’s imposition of protectionist tariffs on Hong Kong’s exports of textiles in the 1960s, entrepreneurs in Hong Kong were able to nimbly shift production to new areas and deploy new models such as sub-contracting for large US and European distributors to follow markets. Looking at Hong Kong’s history more closely reveals a more complex system, vulnerable to bargaining between big business and the state.

A stylised version of Hong Kong’s post-war economic success is that the colony thrived originally on the principles of as an entrepot for Chinese trade with the west. After the Communist revolution on the mainland in 1949, China’s trade was disrupted throwing Hong Kong into a new and challenging environment. Partly through the influx of manufacturers and labour from across the border, labour intensive industry was quickly established in the colony to replace the traditional entrepot role. The persistence of free markets then supported the rapid of Hong Kong during the 1960s and 1970s through export-led growth. Low tax rates, freedom from controls on investment, open-ness to trade and led to a resilient and vibrant economy that flourished in an environment of cheap labour, predominantly English language, the strong British legal tradition and advantageous geographical position. The growth of labour-intensive production of textiles, toys and other light manufactures led to rising incomes per capita. When local wages began to rise after the 1960s, exports began to lose their competitiveness, but Deng Xiao Ping’s launch of China’s Open Door Policy at the end of 1978 provided the outlet for Hong Kong firms to shift their production to the low cost Special Economic Zones on the

3 M. Friedman, ‘The Hong Kong Experiment’. 4 C.R. Schenk, Hong Kong as an International Financial Centre: emergence and development 1945-65, : Routledge, 2001.

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mainland. The subsequent rise of the international financial centre, logistics and tourism sustained the economy through the difficult decades of the 1990s and 2000s. On the eve of the hand-over of sovereignty to China in 1996, the colony’s per capita income had soared to 10% higher than that of the UK. But this stylised view of Hong Kong’s success is open to question when viewed in greater detail. The sections that follow will challenge the assumption that economic relations with China were suspended from 1950-1978, that markets were free and that the state did not intervene in the economy.

Evidence of Hong Kong’s economic success

Figure 1 shows the dramatic rise in per capita gross domestic product from 1961 to 2013. The consistent and accelerating growth from the 1980s to the 1997 Asian Financial Crisis is particularly striking although nominal output per person then fell from

Figure 2 shows how output changed in each year from 1961 to 2014 in constant dollars, which shows that the only years in which output fell in real terms was in the 1997 Asian Financial Crisis and the 2008 Global Financial Crisis. This emphasizes the vulnerability of Hong Kong to global factors, partly because of the

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open-ness of its economy. What is also striking is the higher average rates of growth during the years 1962 to 1989 (8.4% per annum) compared with the period from 1990-2014 (3.9% per annum). Hong Kong joined other so-called East Asian economic miracles much praised for their rapid development.5 A few years of slower growth in the mid-1960s were associated with local political disturbances. This was followed by another brief slow-down at the time of the first OPEC oil crisis and again a decade later during the negotiations for the transfer of Hong Kong to Chinese rule in the early 1980s. In the early 2000s, the SARS health crisis interrupted tourism and business travel to Hong Kong which adversely affected economic activity. Nevertheless, Hong Kong grew quickly relative to most of its neighbours and certainly much faster than Britain during the 1960s and 1970s.

Year-on-year % change in GDP (2013 dollars) 20

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1975 2001 1961 1963 1965 1967 1969 1971 1973 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2003 2005 2007 2009 2011

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Figure 3 shows the dramatic transformation of the economy that was achieved by integration with the mainland economy. What is particularly striking is the absolute decline in the of manufacturing output from the end of the 1980s as production was shifted across the border to and other coastal centres. Hong Kong has continued to be by far the largest source of foreign direct investment into China. The decline in manufacturing in Hong Kong was more than matched by an upward surge in the value of production in the service sector, particularly financial and commercial services. That this restructuring was achieved without faltering rates of growth or employment is a testament to the resilience and vitality of Hong Kong’s economy, and the importance of economic integration with the mainland two decades before the handover of political sovereignty.

5 See for example, World Bank, The East Asian Miracle: economic growth and public policy, , 1993. The others included South Korea, and Singapore.

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Hong Kong GDP HK$ million 1980-2007

500000

450000 Wholesale, retail and import and export , 400000 restaurants and hotels 350000 Transport, storage and communications 300000 250000 Financing, insurance, real 200000 estate and business services 150000 Manufacturing 100000 50000 0

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

Figure 4 confirms the increasing role of in Hong Kong’s trade. Before the open door policy, only about 10 per cent of Hong Kong’s trade was with the mainland, but by 2008 this had increased to close to 50 per cent. Almost all of the increase in the intensity of the trade relationship has been through imports and re-exports, most of which is related to the export processing industries located on the east coast of mainland China. China’s international trade and investment are thus closely related and Hong Kong’s trade is increasingly dependent on the vibrant mainland economy.

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Hong Kong’s financial centre is also increasingly dependent on the mainland.

Figure 5 shows the of China-related in Hong Kong’s market capitalisation since the early 1990s. Hong Kong Capitalization (% Total) 60%

40%

20%

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2004 2013 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2005 2006 2007 2008 2009 2010 2011 2012 2014 2015* H shares % of market Red chips % of market

By the time of the Global Financial Crisis, Chinese companies represented over half of Hong Kong’s stock market capitalisation and although this share has subsided, it is still significant at over 40 per cent. Thus far, the evidence supports the traditional story of Hong Kong’s rapid economic growth as a free first through trade then manufacturing and the importance of integration with the mainland starting in the 1980s. The following sections look more closely at the evolution of cross border relations and then at the extent of free market capitalism.

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Integration with China before 1978

It is important to recognise that the economic relations between Hong Kong and the People’s Republic of China were crucial to Hong Kong’s development not only well before the 1997 political handover, but also during the early decades of Hong Kong’s post-war economic development. This economic integration persisted despite the political isolation of China from the 1950s to the 1970s. The embargoes on trade with China imposed by the US in 1949 and then by the United Nations in 1951 did not end Hong Kong’s dependence on trade with the mainland. During the 1950s recorded (re)-exports to China certainly tailed off (although there was considerable smuggling), but imports from the mainland were still 15-25% of Hong Kong’s total imports. Even more important was the nature of these imports; Chinese food, including vegetables and pork were staples in the diet of the low wage industrial workers of Hong Kong. About 80% of Hong Kong’s food was imported and about half of this came from mainland China. The ability to source cheap food was an important factor depressing the cost of living and therefore the cost of labour during the period of labour intensive industrialisation that drove Hong Kong’ s economic miracle. 6 The second main link between Hong Kong and China before 1978 was financial. During the 1960s twelve PRC-registered or controlled banks operated in Hong Kong, ranging from the powerful Bank of China to the small Po Sang Bank, which mainly traded in gold. Together this group held 14 per cent of deposits in Hong Kong in the mid-1960s.7 Moreover, after the American authorities blocked the use of US dollars in 1950, the Chinese state relied on sterling and other currencies to purchase essential imports. China’s trade surpluses with Hong Kong generated much needed foreign exchange that could be converted in the free exchange markets in Hong Kong. Figure 6 shows the monthly sales of sterling to the Bank of China, which equate to between £350-£600 million per month in today’s . This essential flow of foreign exchange covered about one quarter to one third of China’s total import bill at the time.8

6 C.R. Schenk, ‘Economic relations between Hong Kong and China 1945-51’, in Lee Pui-tak ed., Colonial Hong Kong and Modern China, Hong Kong University Press, 2005, pp 199-218. 7 C.R. Schenk, ‘The re-emergence of Hong Kong as an International Financial Centre 1960-1978: contested internationalisation’ in L. Quennouëlle-Corre and Y Cassis eds., , Markets and Capital Flows: Why are Financial centres attractive?, Oxford University Press, 2011, pp. 229-253. See also, L. Goodstadt, Profits, Politics and Panics; Hong Kong’s banks and the making of a miracle economy 1935-1985, Hong Kong University Press, 2007, pp. 115-128. 8 C.R. Schenk, ‘Banking and exchange rate relations between Hong Kong and mainland China in historical perspective: 1965-75’ in C.R. Schenk ed., Hong Kong SAR’s Monetary and Exchange Rate Challenges; historical perspectives, 2009, pp. 45-72.

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Sterling Sold to China Against HK$ (£ million)

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The ability to run a trade surplus and to use this surplus to import food and capital goods from third countries was an important boost to China’s development planning during the decades before the Open Door Policy. Trade and financial relations between Hong Kong and China were thus of significant mutual benefit despite the relative isolation of the People’s Republic of China during these decades, well before the Open Door Policy linked China more strongly to western markets from 1978.

Laissez-Faire and Positive Non-Interventionism

As noted in the introduction, Hong Kong’s exceptional reputation for free markets makes it an important bench mark to understand the nature of capitalism. But the way that the relations between the state and the market have evolved in Hong Kong is quite nuanced and contested. Certainly in the early post-war years the state, and in particular the Financial Secretary J.J. Cowperthwaite, was strongly averse to interfering in markets even to the extent that pressure from London to regulate markets or even to collect financial statistics was resisted.9 In the 1970s the Financial Secretary, Sir Philip Haddon-Cave, coined the phrase ‘Positive Non-Interventionism’ and this awkward form of words has come to dominate perceptions of Hong Kong’s successful post-war economic development. 10 The phrase was meant to express the deliberate (positive) effort by the state not to intervene in the allocation of productive resources. This

9 L. Goodstadt, Uneasy Partners: the conflict between public interest and private in Hong Kong, Hong Kong University Press, 2005, pp. 118-20. 10 P. Haddon-Cave, ‘The making of some aspects of public policy in Hong Kong’ in D. Lethbridge ed., The Business Environment in Hong Kong, Oxford University Press, 1980.

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attitude was in marked contrast to the ‘governed market’ approach that prevailed in other East Asian newly industrialising economies in the 1970s such as South Korea, Singapore and Taiwan, where the state had a strong influence over the direction of economic development.11 It also diverged strongly from the British Labour government’s approach in the UK in the 1970s, as noted by . But Haddon- Cave drew a distinction at the time between laissez-faire and non-interventionism, noting that there was a positive role for government to overcome market failure, i.e. when the public good was not best served by unfettered market forces. One of the clearest private expressions of positive non-interventionism is in a letter from Haddon-Cave to the famous entrepreneur and businessman Li Ka-Shing in 1981, months before Haddon-Cave demitted his post as Financial Secretary to become Chief Secretary. After thanking Li for an entertaining evening at his home, Haddon-Cave expresses the difficulty of sticking to his commitment to free competition. ‘the way in which so many in the market place, in these scratchy times, damn us if we even suggest something and simultaneously damn us if we do nothing is beginning to get me down! I am determined, for as long as I am here, to keep the economy, and all the markets within it, free and that means free from unnecessary and clumsy Government intervention, free from fiscal discrimination, free from the stifling effects of excessive taxation and an over-large public sector and free from all other influences which inhibit competitive forces.’12

Haddon-Cave’s successors embraced his philosophy although the death of positive non-interventionism has been announced several times, as early as 1992 by Financial Secretary , then by Chief Executive in September 2006 and again in August 2015 by his successor Leung Chun-ying. 13 Nevertheless, the slogan has survived despite a turn to ‘big market-small government’ in the mid-2000s. But how non-interventionist was the Hong Kong government during the period of high speed growth? And how influential were Haddon-Cave’s adversaries ‘in the market place’?

Indirect State Subsidies

11 R. Wade, Governing the Market: Economic Theory and the Role of Government in East Asian Industrialization, Princeton, 1990. 12 Letter from Haddon-Cave to Li Ka-shing, 11 March 1981. Italics underlined in the original. HSBC AP, Financial Secretary, 1983-86. HKO 196/088 Carton II. 13 Macleod quoted in S. Staley, Planning Rules and Urban Economic Performance: the case of Hong Kong, Chinese University Press, 1994. p. 37. Tsang, , 13 September 2006. Chief Executive Leung Chun-Ying quoted in South China Morning Post, 15 August 2015. A.B.L. Cheung, ‘Repositioning the state and the public sector reform agenda; the case of Hong Kong’, in M. Ramesh, E. Araral Jr and X. Wu eds,. Reasserting the Public in Public Services: new public reforms, Routledge, 2010, pp. 79-101.

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A first important qualification to Haddon-Cave’s own assessment is to note that the state played an important role in promoting the economic and business in ways that went far beyond allowing market forces to operate freely. First, the state controls the scarcest resource in the economy: land.14 Through leasing, zoning and other allocations of land the state had considerable influence over the nature and distribution of economic activity across the colony during the period of high speed growth in the 1960s and 1970s. Secondly, the state is very active in subsidising the cost of living in Hong Kong (and therefore the cost of labour). From 2005-2015 housing absorbed only about 6% of government spending, which does not sound like so much, but in 2015, 30% of the population was able to take advantage of subsidised public housing, which represents either significant income foregone or government competition with the market. During this period rents in public housing were less than one

quarter of the cost of smaller private flats in (only 14% in 2015).15 Access to cheap accommodation keeps down the cost of living and therefore the cost of labour for industry and services. In this sense, the state has been indirectly subsidising the labour intensive industries that were the foundation of Hong Kong’s successful industrialisation.

Tight Controls on the Banking System

Even more striking than this positive support for markets, however, was the extent of controls on the banking system that restricted free competition. The financial sector is often a target for regulation even by most adherents of free markets because of the prevalence of market failure due to information asymmetry. Thus, depositors do not usually know the purpose to which their funds are put by banks (how liquid or risky the banks’ loan portfolios are) and therefore they cannot measure the risk of not getting back their deposits. Banks in turn do not have perfect knowledge of the likelihood of default by their customers. Private information is a key asset of banks so they have an incentive not to disclose commercially sensitive information to the public. This generates a need for rules to govern bank liquidity, insider-lending and minimum capital and a system of prudential supervision to ensure the rules are being

14 R. Nissim, Land Administration and Practice in Hong Kong, Third Edition, Hong Kong University Press, 2011. 15 Hong Kong Housing Authority, Housing in Figures, 2015. In the public rents were 42% of private rents in 2005, falling to 20% in 2015. The comparison is to private flats less than 70m2 . https://www.housingauthority.gov.hk/en/common/pdf/about-us/publications-and-statistics/HIF.pdf

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followed. Prudential bank regulation increases transparency and supports the operation of competitive markets.

At first, the Hong Kong government was very reluctant to regulate the banking system, preferring to allow banks to seek deposits and make loans without restriction or supervision. There was no central bank and currency notes were issued by HSBC, Chartered Bank and the Mercantile Bank under an effective currency board system operated through the government managed Exchange Fund.16 Bankers merely registered under the ordinance and were allowed to collect deposits from the public; by 1947 there were about 250 different banking institutions in the colony. The first banking regulation in 1948 required a nominal license fee to be paid but imposed no prudential controls on minimum capital, no reserve requirements or liquidity ratios, and little guidance on balance sheets. As commercial business in the colony slowed down after the restrictions on trade with China, banks began to compete for deposits by offering higher interest rates and engaging in more risky loans so that in 1961 Hong Kong suffered its first major banking crisis. This the authorities and the leading bankers to the dangers of contagious bank runs because of weakly capitalised or corrupt banks.

HSBC and Chartered Bank began to draft a new and tighter set of bank regulations that included prudential controls, and they organised a cartel to control interest rates offered on deposits to constrain competition.17 From 1964 a sub-committee of the Hong Kong Exchange Banks’ Association met periodically to set deposit rates that could be offered to their customers. HSBC and Chartered Bank would then adjust their best lending rate in concert to reflect any changes in deposit rates. Interest rate cartels were not unusual in the 1960s; similar arrangements existed in both the USA and the UK. However, most countries abandoned interest rate controls in the 1970s, while Hong Kong maintained their Interest Rate Rules in amended form until 2001. The new Banking Ordinance was debated and amended and finally came into force in 1964 just in time for a second, larger, banking crisis which required the government to bail out depositors and led HSBC to take over Hang Seng Bank.

16 Hong Kong is not, therefore, a case of ‘free banking’ in the sense of a competitive market in bank-issued notes. 17 C.R. Schenk, ‘Banking Crises and the Evolution of the Regulatory Framework in Hong Kong 1945-70’, Australian Review, 43(2), pp. 140-154, 2003. On the origins and operation of the Interest Rate Agreement see, Schenk Hong Kong, pp. 66-68.

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The diagnosis from this troubled period was that competition among banks was excessive and needed to be curbed to ensure stability. This view was strongly argued by the leading incumbent banks, but also supported by advisors and (somewhat reluctantly) by the Hong Kong state. This diagnosis had long lasting implications since the medicine prescribed was a set of anti-competitive measures that included not only the cartel on interest rates, but also a moratorium on new bank licences that lasted from 1965 until 1981 (with a brief hiatus for Barclay’s Bank) and then limits on the number of offices that new banks could operate until 2001. Foreign banks, in particular, were considered ‘parasitic’ by the Banking Commissioner even though this was the era in which Hong Kong emerged as an international financial centre.18 While the moratorium was aimed at increasing the stability of the banking system, it had the effect of decreasing the regulatory breadth of the government, and reducing incentives for mergers and acquisitions that might have improved governance. Widespread evidence of fraud immediately after the

moratorium ended showed that it was not a lasting cure for the governance problems of the Hong Kong banking system.19

Even the powers of supervision that were granted under the 1964 Banking Ordinance (and subsequent amendments) were circumscribed in practice. The office of the Banking Commissioner was under-funded and he repeatedly had to fight for resources to hire staff that would allow effective inspection of banks. His frustration was expressed clearly in a letter in 1969 to the Financial Secretary J.J. Cowperthwaite:

It is abundantly clear that there is a complete lack of comprehension or knowledge of the duties that my office performs; this is a point upon which I have spoken to you many times in the past and more recently concerning the status and authority of this office. I am asking for an interview with HE [His Excellency the Governor] upon this last point. The time has come, in my opinion, to establish whether the Colony’s banking authority is to have the independence and status which it deserves or not.

18 C.R. Schenk, ‘”Parasitic Invasions” or Sources of Good Governance: Constraining Foreign Competition in Hong Kong Banking 1965-81’, Business History, Vol. 51(2), March 2009, 157-179. 19 C.R. Schenk, ‘Banking Crises and the Evolution of the Regulatory Framework in Hong Kong 1945-70’, Australian Economic History Review, 43(2), pp. 140-154, 2003.

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No change arose out of this plea and his successors still found the office under-staffed fifteen years later.20 In the meantime hundreds of new financial institutions opened and operated outside the Banking Ordinance to avoid the interest rate cartel and prudential capital requirements imposed on banks. The moratorium on new bank licenses combined with the interest rate cartel created a large unsupervised financial sector that increased the fragility of the as a whole.

In the 1980s there was yet another series of banking failures and this time the costs were even greater.21 From 1983 to 1986 seven banks collapsed and a further 100 other deposit-taking companies went out of business. Of the seven banks, three were taken over directly by the government to be restructured and sold off and the rest were supported financially to facilitate private acquisition.22 The causes were linked

to poor supervision including over-exposure to volatile asset markets like property and equity, insider lending and outright fraud.

Conclusions

This lecture has emphasized the need to be careful about generalisations about policy environments based either on stylised facts or on constrained quantitative indicators such as government spending as a share of GDP or nominal tax rates. Looking closely at how state-market relations actually work in practice, including the obscure and sometimes shady relationships between individuals and institutions, can be revealing. We must also be careful to assess the trade-off between a light regulatory hand and the influence of special interests. Goodstadt, for example, has claimed that rather than promoting a competitive environment, non-interventionism left the Hong Kong public ripe to be exploited by ‘business cartels and other anticompetitive practices’.23 The anti-competitive controls on the banking system that protected incumbents introduced damaging distortions which contributed to financial instability in Hong Kong in the longer term. While it is challenging to accumulate detailed evidence of the interactions

20 Memo by Bank Commissioner Colin Martin, September 1980, Bank for International Settlements Archive, Offshore Centres Meeting of Supervisors BS/80/41e5. 21 This round of financial crisis was prompted in part by the government’s mismanagement of the monetary system as well as contagion between bank and non-bank financial institutions. J. Goodwood, Hong Kong’s Link to the US Dollar: origins and evolution, Hong Kong University Press, 2008. T. Latter, Hong Kong’s Money: the history, logic and operation of the currency peg, Hong Kong University Press, 2007. 22 R. Li, ‘Banking Problems: Hong Kong’s experience in the 1980s’, Bank for International Settlements. 23L. Goodstadt, Uneasy Partners; the conflict between public interest and private profit in Hong Kong, Hong Kong University Press, 2005, p. 5.

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between the state and the market, the economic as a benchmark of free markets suggests there may be considerable benefits from closer historical treatment of capitalism(s) through archival research.

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