Henry C K Liu

Part 1: Compradore no more

Part II: Pegged down

This article appeared in AToL on July 3, 2002

After the demise of political imperialism in the world, capitalism manages to gain another new lease on life through the transformation of the newly set-up socialist planned economies into capitalist market economies via the expansion of world trade. Some political economists view unbalanced and unregulated world trade as a new form of economic imperialism, benign in appearance, rationalized under the laws of neo-classical economics that hold sacred the principle of marginal utility to maximize return on capital and the operational dynamics of free markets that favor the strong and perpetually condemn the weak.

These precepts, far from universal truth, were merely US national opinion, giving the US an inherently unfair advantage against the capital-starved and ill-equipped Third World. The international division of labor as currently constituted in globalization has been driven by wage competition between countries with a race-to-the-bottom effect. Countries also compete to reduce taxes, welfare benefits, environmental protection and trade regulations in the name of efficiency in a global market economy.

Technology, lowering the cost of communication and managing complexity, now allows central control of highly decentralized operations worldwide. Trade and foreign investment have pre-empted economic development and aid as the main paths for undeveloped nations to modernize and to prosper. Yet globalization of trade and finance has its critics in both developed and developing countries, but for different reasons.

In theory, free international movement of capital through integrated financial markets in a global economy allows efficient allocation of funds toward investments of highest productivity. But truly free markets do not exist in the real world and, even if they do, they operate under narrowly single-dimensional rules and historical biases, all of which aim toward maximizing return on capital without due regard for local social, political or environmental consequences or individual national aspirations. Moreover, global financial market pressures tend to supplant the traditional roles local political leaders and government institutions play in formulating macroeconomic policies that safeguard individual national interests.

Despite all the noise the United States makes about the benefits of world trade, US exports of US$564.7 billion (FOB, or free on board) constitutes only 7.6 percent of its gross domestic product of $7.6 trillion (1996) and US imports of $771 billion (CIF, or cargo, insurance and freight) constitutes 10.1 percent of GDP. Export to all of Asia amounts to only 2.4 percent of its GDP, of which Japan constitutes 1 percent. The US claims 12 percent of total world trade, Germany 9 percent. Japan 6.25 percent, China 4.1 percent and Hong Kong 2.5 percent. Thus, the US can sustain a strong bargaining position in setting the terms of trade on a take-it-or-leave-it basis. In contrast, Hong Kong's exports of $197.2 billion constitute 121 percent of its GDP of $163.6 billion (1996), and Hong Kong's imports of $217 billion constitute 130 percent of its GDP. It is obvious that a rupture in world trade would impact Hong Kong differently than the US. While Hong Kong has no viable alternative to total dependence on trade, it should bear in mind that it is now part of China, and that Hong Kong's national interest is part and parcel of that of China, where the issue of trade policy in relation to national independence has not been definitively resolved.

Excessive reliance on world trade may not be in a country's best national interest, simply because national governments are forced to surrender their power to manage their economy to world market forces, or international trade institutions and agreements. It is an argument put forward not only by the developing nations, but also by isolationists in the United States, with sufficient public support to deprive several US presidents of "fast track" authority to settle international trade disputes.

When capital is mobile, governments are able to enjoy the benefits of fixed-exchange-rate stability only if they are willing to forgo the empowerment of managing their economies through the setting of domestic interest rates and the supply and liquidity of money, the potent tools of monetary policy. This means that when global capital flows into a country, local interest rates will fall, sometimes to negative rates, distorting the orderly development of the affected economy. For example, beginning in the mid-1980s, Hong Kong's linked-exchange-rate mechanism created persistent negative local interest rates, causing abnormal investment flows into the property sector, resulting in unrealistic and unsustainable asset and price inflation that became a major problem in the subsequent downturn in 1998.

Conversely, when investors begin to pull out of a country or sell its currency, local interest rates will have to rise to counter the flow in order to maintain the exchange-rate peg. This invariably distorts and weakens the banking system and the financial markets, eventually causing bank failures and corporate bankruptcies. This happened to Hong Kong in October 1997, with disastrous long-term consequences that are yet to unfold fully. Hong Kong will be plagued by excessively high real interest rates until the linked-exchange-rate mechanism is abandoned or until the US dollar falls. There will be no sustainable long-term economic recovery for Hong Kong until the Hong Kong Monetary Authority (HKMA) regains its power to set monetary policies, and not allow the US Federal Reserve to dictate monetary policy for Hong Kong.

Pegging a currency's exchange rate to another currency does not automatically make an economy more stable. If domestic economic policies are inconsistent with the chosen exchange rate, a fixed rate can itself lead to instability. Small economies with less sophisticated financial markets face greater risk from opening to international capital. Sudden capital flight can create economic havoc, as in the European currencies crises of 1992-93, in Mexico in 1994 and in Thailand in July 1997. In the last quarter of 1997, institutional panic caused an abrupt drop of private capital flow, in excess of $100 billion, to the five most affected countries: South Korea, Indonesia, Thailand, Malaysia and the Philippines. South Korea alone saw its capital flow drop by $50 billion as compared with 1996.

And contagion effects can hit countries in an economic region and eventually the entire global system. As the economies of the lending nations contract, banks will withdraw urgently needed funds from other healthy economies where liquid markets still operate, thus forcing the healthy economies to collapse. This happened to the Hong Kong market in October 1997. It will happen again and again before recovery is in sight. The impact of Japanese banks retrieving capital from other countries, including the United States, is very direct. Japan has been in a prolonged phase of serious deflation. The dollar will continue to fall unless US interest rates rise, which in turn will cause the US economy to contract more, which will push down the dollar further.

To ensure a smooth transition, the Hong Kong Special Administrative Region (SAR) government has continued the policy of ensuring currency stability through linking the Hong Kong dollar to the US dollar at an exchange rate of 7.8:1 within a narrow range. The policy was adopted in 1983 by the previous British colonial government to encourage stability and investor confidence in the politically contentious run-up to Hong Kong's reversion to Chinese sovereignty. As part of the high degree of autonomy granted to the Hong Kong SAR government on all issues except foreign policy and national defense, Chinese officials have since declared their support for this monetary policy. Under the leadership of the chief executive and the policy responsibility of the financial secretary, authority for maintaining the exchange value of the Hong Kong dollar, as well as the stability and integrity of the financial and monetary systems, rests solely with the HKMA, not augmented by any multiple-exchange-rates structure or any foreign-exchange control.

Under the linked exchange rate, the global exchange value of the Hong Kong dollar is influenced predominantly by the movement of the US dollar against other currencies. Thus the price competitiveness of Hong Kong exports and services is affected in large part by the value of the US dollar in relation to third-country currencies. For the 14 years prior to 1997, the policy of linking the exchange rate to the US dollar served a British Hong Kong by insulating it from politically induced monetary instability in the latter part of the Cold War, albeit not without economic costs to the local economy. The linked exchange rate requires that Hong Kong interest rates generally track US interest rates. Hong Kong's high inflation meant that savers in Hong Kong faced negative real interest rates, forcing them to invest in real estate. Yet the benefits of stability, coupled with a high-growth Chinese economy and the boom economies of the Asia-Pacific region, had justified the economic costs for Hong Kong in the decade before 1997.

The economic fundamentals facing Hong Kong now are structurally different. It is now clear that the SAR can no longer afford the economic costs associated with an artificially high (or low) currency linkage, in view of the unfolding restructuring of all other economies in the region, and the benign political climate in Hong Kong resulting from China's non-intervention policies. The argument that de-linking the currencies will cause institutional investments to flee Hong Kong is increasingly inoperative. The fleeing, in the form of massive selloffs in the stock market, is now caused by inoperative interest rates necessitated by the artificial currency linkage. Hong Kong as a whole can surely weather the unavoidable pains of this complex regional economic restructuring which, while precipitated by speculators, have been caused by economic disparities created through years of government policies in the region. The adverse impacts, while not permanent, will not be short-lived, although Hong Kong, because of its special relationship to China, may be among the first economies in the region to recover if its leadership has the foresight to adopt the right policies. Even then, the resultant contraction may take years to work through. Hong Kong's considerable foreign-exchange reserves may be more beneficially utilized on programs that build long-term competitiveness than on defending an obsolete monetary policy that lowers competitiveness. Macro-management of the economy requires a macro-perspective, beyond being fixated on an artificial exchange rate.

Moreover, the SAR government has a socio-political responsibility to ensure that its crisis-management measures distribute the economic pains fairly among all segments of the population. A case can be made that an obstinate currency linkage benefits mostly those with low-interest US dollar debts, namely, Hong Kong's large corporations and developers, at the expense of the local population, which borrows in high-interest Hong Kong dollars.

Press reports until most recently have persistently reported that China is opposed to de-linking the Hong Kong dollar from the US dollar. The underlying logic attributed to the alleged Chinese position is that decision makers in Beijing are apprehensive of possible resultant instabilities from de-linking and the adverse economic impact on Hong Kong's and China's economies, which are closely linked. Regardless of the reliability of these reports, the validity of such apprehension can be challenged by sound analysis.

Hong Kong prides itself on being a free-market economy. Yet with regard to its currency, Hong Kong strangely clings to an obsolete exchange rate that has become markedly unresponsive to market forces. A free-floating Hong Kong dollar will have a number of positive effects on the Hong Kong economy with minimum disturbance in the local price structure. It will improve the price competitiveness of Hong Kong goods and services in world markets, lower the cost of doing business in Hong Kong and attract new international capital to Hong Kong because of its enhanced local purchasing power. A free-floating currency will reduce interest rates on local currency loans, thereby stimulating the stagnant local economy. It will moderate the real inflation rate in Hong Kong in global terms without requiring drastic reductions in local prices.

It will revive the depressed Hong Kong tourist industry without subjecting it to destabilizing price cuts. It will encourage localized savings by eliminating the surrealistic phenomenon of negative real interest rates. It will encourage localized corporate and personal expenditures through the increased cost of foreign goods and services. The hefty Hong Kong foreign-exchange reserves will also increase in local-currency terms while suffering no decline in real value.

To be sure, despite all the benefits, there are transient detriments in de-linking the Hong Kong dollar. Existing US-dollar-denominated debt would experience an increase in the cost of debt service and amortization. But Hong Kong has no public debt, except infrastructure debt held by quasi-public authorities. Indebtedness from infrastructure improvements is serviced by user fees that can be increased in local-currency terms without fatal pain to the public and without altering Hong Kong's price competitiveness in world markets, since this debt has been structured on a fixed exchange rate tied to the US dollar. Hong Kong's foreign-exchange surplus will moderate temporarily, but if the Hong Kong dollar reflects its true market value, there will not be any compelling need for a large foreign-exchange reserve to support a monetary policy that ignores market forces. Property values will drop in real terms but an asset-value deflation through exchange-rate fluctuations is less damaging than a direct decline in local prices. In any event, most analysts agree, including those in government, that Hong Kong property values are over-inflated.

The confidence factor is a red-herring. International confidence will increase in a Hong Kong flexible enough to deal intelligently with new realities rather than being incapacitated by blind adherence to obsolete policies.

Private debts are worrisome. There does not appear to be a painless way out. Some 40 percent (more than US$50 billion) of the outstanding bank debt is issued to companies purchasing or developing property. Much of this debt ($7 billion, the highest in Asia except for Japan) is in the form of convertible bonds that do not appear on the borrower companies' balance sheets. Convertible bonds require the debtor to repay the investor if the shares of the issuing company fall below a pre-fixed level while they give the investor the right to convert the debt into company shares if the price increases to a level the investor finds attractive.

Persistently high local interest rates will force these companies into financial difficulties if not eventual bankruptcy. Banks and the property sector account for half of Hong Kong's stock-market capitalization. Still, the prospect for a soft landing may be better with a currency de-linking than a drastic collapse in local prices, because with currency de-linking, the economy receives compensatory stimulation through lower interest rates and lower costs, which in turn may provide borrowers with sufficient cash flow to service foreign currency debt at higher exchange rates.

Hong Kong's prosperity came from the opportunistic response to Cold War peculiarities. It profited from the US embargo on China during the Korean War and the Vietnam War. With the opening of China since 1978, Hong Kong has benefited from the China market.

Hong Kong promotes itself as a world city. Yet nobody goes to Hong Kong to see the world. People go there as a stopover to see China. The warning of former chief secretary Anson Chan notwithstanding, Hong Kong is a Chinese city, although not all Chinese cities are alike.

As the economy of Hong Kong changes, new elites will emerge. The old compradores represented by Robert Ho Tung were replaced by a wave of Chinese national bourgeoisie after World War II, who brought to Hong Kong their know-how on labor-intensive manufacturing, such as textile and toys. Then the British, who owned all the land, engineered the property boom, creating a docile and collaborative group of property tycoons as the new compradores. During the Cold War, the US controlled the Hong Kong economy through its trade quotas.

The future of Hong Kong will belong to the new wave of Chinese enterprises from the mainland. Each wave on arrival was despised and discriminated against by the establishment. Hong Kong wasted five years with its fixation on being a world city on the doorstep of China, rather than being a Chinese city with a special window to the world. China has now surpassed Japan as the largest investor in Hong Kong. The number of mainland Chinese enterprises registered in Hong Kong has topped 2,500, with total assets valued at about US$40 billion. The Bank of China is now the second-largest banking group in Hong Kong after HSBC. Hong Kong's future depends on how it can serve the Chinese economy constructively, and not as a compradore serving foreign interest.

Hong Kong helping the Pearl River Delta? What a joke. Hong Kong needs to shed its air of superficial superiority and its schizophrenic attitude toward Guangdong province, its bigger brother. Exorbitant projects such as airports and tunnels that enriched monopolistic British firms have left Hong Kong with a bloated transportation system with critical bottlenecks that poorly connect to the Pearl River Delta.

Hong Kong cannot be the Switzerland of Asia. Switzerland is an independent nation and politically neutral historically. Hong Kong cannot be a New York. New York is part and parcel of the US economy. "One country, two systems" defines Hong Kong as external to the Chinese economy. Hong Kong cannot be a Shanghai because Shanghai is part and parcel of the Chinese economy. The Hong Kong government untiringly defends itself against criticism by pointing to external problems. Yet all problems facing Hong Kong, or any other country, are external problems. The government cannot afford to take the position that it is powerless to deal with external problems as they impact the territory.

Hong Kong faces a severe identity crisis. The economic downturn has exposed structural problems in the economic system. Often lauded as the bastion of freewheeling capitalism, the city has a surprisingly closed economy. A handful of powerful banks, holding companies and property developers control key markets, driving up prices for everyone else. Hong Kong will have to reinvent itself, weaning itself away from its disproportionate reliance on property.

Hong Kong has always been run by and for its commercial interests - first the British trading houses, or hongs, and lately the Hong Kong tycoons. The bottom line is that Hong Kong's economy is intimately tied up with the government. The most obvious example of that is the real-estate sector. The billionaires are rich because of property development, the proceeds of which have also filled the government's coffers. Although this keeps taxes down - less than half of the populace pays any salary tax at all and few pay the top rate of 15 percent - high rents form an oppressively high levy, which squeezes consumers and small and medium-sized businesses.

Even as property values dropped 60 percent since 1997, the high cost of real estate means Hong Kong firms have a tough time competing with regional neighbors, and increasingly that includes southern China. Hong Kong companies, large and small, have thus far found only one sure answer: move north. Smaller firms relocate lock, stock and barrel to Guangdong. Larger ones, such as Cathay Pacific and HSBC, have moved back-office activities to Shenzhen. The migration south from China into Hong Kong of the past 50 years is going into rapid reverse.

Finally, the unemployment problem cannot be solved by market forces. Hong Kong does not have unemployment insurance. Thus a 9 percent unemployment rate is much more serious in Hong Kong than in the United States. Hong Kong has the means and the need to institute a full-employment government policy; what it needs is political courage.

In US politics, the second and final term of a presidency is a time for bold programs, unless the administration is crippled by scandals. Hong Kong's chief executive, Tung Chee-hwa, will have a window of opportunity of three years before the lame-duck syndrome sets in. It is a sure bet that the global economy will not recover within the next three years, and quite possibly will fall into a financial abyss. Hong Kong cannot afford to wait for the US economy to recover or for a sudden growth in world trade. It must find a useful role in the building of China's domestic economy. There is no other option.