The diagnosis that Hong Kong has deep contradictions that need to be addressed was first put forward by Premier Wen Jiabao when he met with SAR Chief Executive Tsang Yam-kuen in Beijing in 2005. But what are these contradictions? Premier Wen did not provide much insight, but he did elaborate in a press conference in 2010 on prescribed solutions for Hong Kong’s “deep contradictions”. He identified five points:

 

 “First, how to play the existing advantages and continue to maintain and develop Hong Kong’s financial center, shipping center and trade center position. Second, how to develop competitive industries that are appropriate for Hong Kong, especially in the services sector. Third, how to make use of Hong Kong’s proximity to the Mainland and further strengthen linkages with the Pearl River Delta. The Mainland’s huge domestic market and its rapid economic development present a huge potential opportunity for Hong Kong. Fourth, the people of Hong Kong should accommodate differences, act inclusively, build consensus, develop solidarity, and maintain Hong Kong’s prosperity and stability. Hong Kong will not only have great economic development opportunities, but will also progressively develop democratic politics, in accordance with the provisions of the Basic Law. Fifth, focus on improving people’s livelihood and the development of education.”

 

Still, the question of contradictions hangs in the air. These five elaborations are in actuality prescribed solutions for Hong Kong’s deep contradictions. They are things to do. The deep contradictions themselves are not explicitly identified, but left implicit. In my essays this week and next, I attempt to construct a conceptual framework of these deep contradictions based on a broad analysis of their manifestations using specific examples. And regard these examples as a beginning, as I will by no means exhaust the possible contradictions that can be studied.

 

Rising poverty, growing income inequality, inflation, unemployment, high property prices and rentals, and so on are the outcomes of underlying forces that are changing in our society. Are these outcomes themselves the contradictions? To the man in the street and the casual observer, it may appear that this is the case. But another approach is to consider whether they are the manifestations of underlying contradictions that have arisen due to changes in society.

 

Distinguishing between outcomes and underlying factors is important because treating the outcomes alone may not resolve problems.  At best it provides temporary relief and at worst it aggravates the underlying contradictions. It is therefore better to analyze these underlying factors if we are to identify solutions that resolve both the contradictions and their manifestations.

 

We can better understand  Hong Kong’s deep contradictions by examining: (1) the development requirements of a city economy and its vulnerabilities to external shocks, (2) the structure and institutions of the domestic economy and its responsiveness to external shocks and capacity to sustain growth and maintain stability, (3) political accountability and whether it is effective in legitimizing policies and policy changes; and (4) the advantages and disadvantages of being a British Crown colony and a Special Administrative Region of China.

 

Growth in a Globalized World

 

First, a city economy can have a high level of economic development only if it produces goods and services that can be exported beyond its borders. The city market is too small for the division of labor and specialization required to support a high standard of living. An outward looking entrepreneurial orientation is a necessity. It is also important to ensure the infrastructure is in place to facilitate participation in economic engagement with the outside world.

 

This means investing in airports, ports, telecommunications, and “softer” needs such as the ability to communicate with others (in Hong Kong that means abilities in both English and Chinese). Another often neglected element of the soft infrastructure is the lowering of regulatory barriers, for example, tax treaties, accounting practices, movement of people across borders, health and safety standards, foreign exchange and capital controls, and a million other regulations, many of which are specific to a particular industry or profession. As a general rule reducing barriers to entry facilitates connectivity with the rest of the world. This is an on-going evolutionary process as regulation patterns around the world are continuously changing.

 

Second, to sustain a rising standard of living and continuous economic growth, the productivity of the city’s population must increase. This requires investment in its own human capital. Investing in education by developing educational institutions, inviting foreign educational institutions to set up branches, or supporting citizens to study abroad has to be a conscious policy.

 

The US was a relatively poor country over much of the 19th century, but in the latter part of that century and throughout the 20th century, it overtook the UK and other major European countries in per-capita GDP. Throughout that period the US also developed a considerable lead over Europe in the schooling attainment of its labor force, especially at the higher education level. The lead remained significant through most of the 20th century; although in the last couple of decades it has narrowed. The higher educational attainments in the US were perhaps the major reason why the country overtook Europe and became the economic superpower of the 20th century.

 

Third, another method for augmenting human capital is to import talent. New York City and London are magnets for talent from all over the US and UK, and also from foreign countries. Major economic cities are almost always located in large populous countries where they can easily attract national talent from the rest of the country. Small sparsely populated countries seldom have major economic cities.

 

Just as cities in a large country can benefit from the inflow of people from the rest of the country, they also need an influx of foreign talent to offset the detrimental effects of an aging population. Many countries are experiencing this problem due to the post-World War II baby boom effect, and the share of the working population is beginning to decline. This is bad for sustaining economic growth. Countries that are able to attract population inflows have the opportunity to offset the aging effect.

 

To attract foreign talent, it is necessary to have immigration and other policies that are cognizant of the long term benefits to economic growth. International economic cities can only emerge when their governments recognize the value of implementing a liberal immigration policy that attracts foreign talent. Investment is also needed in social and cultural amenities such as quality international schooling and other cultural and social facilities and activities. 

 

Singapore, a city state, has aggressively pursued a population policy to attract skilled foreign nationals as residents to counteract the ageing local population and achieve racial balance. Hong Kong has failed to develop an analogous population policy and it is apprehensive about the inflow of people from the Mainland. Those admitted are mainly allowed in for family reunion purposes and tend to be unskilled.

 

Fourth, every economy that connects with the global economy has to decide whether to float its currency or fix its value against that of some other currency. For almost its entire history Hong Kong has adopted a fixed exchange rate regime through its adherence to the currency board system. The advantage of such an arrangement is to facilitate a close economic integration with the world’s economies by removing uncertainty about the exchange rate or currency value. It also adheres to Hong Kong’s overall strategy of sustaining economic growth through an outward oriented development path.

 

A fixed exchange rate regime, however, requires Hong Kong to maintain tight discipline in the conduct of its fiscal and bank credit policies and means Hong Kong no longer has autonomy over its monetary policy. Monetary policy becomes purely passive and adapts to international capital flows in the balance of payments. The nominal interest rate cannot diverge from that of the US nominal interest rate.

 

The consequence of this policy is that Hong Kong has endured two prolonged episodes of inflationary pressure and one of deflationary pressure in the last 30 years, all instigated by external events. China’s opening at a time when US nominal interest rates were low helped fuel a period of high inflation in Hong Kong from the late 1980s to the mid-1990s. The Asian Financial Crisis precipitated a period of deflation that lasted until 2003 and ended only after US interest rates began to turn and the US Dollar began to soften. The Global Financial Tsunami of 2008 led to another era of low US nominal interest rates and a weak US Dollar therefore price inflation began to reappear in Hong Kong.

 

Responses to External Shocks

 

Fifth, these external developments and shocks have contributed enormously to rising and falling property prices in Hong Kong. This has put enormous stress on our banking system and explains why the Hong Kong Monetary Authority has periodically intervened to regulate bank credit policy, especially the loan to value ratios on mortgage loans, in order to manage the risks of failure in the banking system. One of the consequences of such regulation has been to make it more difficult for low and middle income families to purchase homes.

 

The long term consequences of the shocks and risk management solutions have led to a divided society of rich property owners and poor non-owners; between those who are “haves” and those who are “have-nots”. It makes “unity” and “stability” challenging to achieve, if not impossible. Our commitment to the linked exchange rate therefore requires us to manage more pro-actively the resulting economic, social and political risks.

 

Sixth, a critical element of risk management for long term macroeconomic stability under the linked exchange rate regime is fiscal prudency and conservative budget management by the government. Government spending involves very nearly permanent commitments that cannot be easily reduced, at least in the short run. Whenever a severe external economic shock occurs, it can be a source of comfort if there are fiscal reserves to maintain government spending without having to resort to deficit financing.

 

Prudency also means that whenever a positive economic shock is experienced that buoys the economy and government revenues, the government maintains discipline and resists the temptation to provide populist handouts to social groups, professional bodies, and business interests. Positive non-interventionism is both a policy and an economic ideology, and it gives respectability to the idea that it is usually better to let markets resolve problems over time rather than the government, unless there is convincing evidence to do otherwise.

 

Seventh, over the years positive non-interventionism has been softened along the edges as government administration responds to greater representation in the Legislative Council. The role of government has been re-conceptualized as “maximum support, minimum intervention and fiscal prudence”, “a proactive market enabler”, “market leads, government facilitates”, and “small government, big market”. Nevertheless, the commitment to an essentially limited government role in the economy continues. This lends legitimacy to its other role of managing risk in a small open economy on a fixed exchange rate.

 

Fiscal prudence is a necessary risk management principle in a small open economy on a fixed exchange rate. Adherence to a policy of positive non-interventionism provides the rationale and legitimacy for government to perform its other policy role. This second role can be seen in the government’s level headed response to various interest groups and lobbyists, who want benefits and some armed with persuasive reasons.

 

The Hong Kong government’s bureaucracy is well constituted and well trained to refuse to be overwhelmed by such requests. No doubt some are beginning to question why they have to be put in the hot seat and take the blame all the time, and some may be softening their resolve to resist some of the more persuasive lobbyists. Nevertheless, positive non-interventionism is in general a good economic ideology and a critical one for an outwardly oriented city economy with a fixed exchange rate.

 

Another benefit of positive non-interventionism is that it provides a legitimate cover for an administration wary of intervening too aggressively in the affairs of private businesses and individuals when its own political legitimacy to govern may be challenged. This was the situation when Hong Kong was a British colony and exists even now as a Special Administrative Region. If today’s administration needs a new economic ideology, then it also needs to rethink how it can be made more legitimate through greater accountability. It also needs to rethink what this new economic ideology might be and how it will gain acceptance in a society that is divided and in a political system that is still in transition.

 

Eighth, the opening of China was a momentous event for Hong Kong. It precipitated a total transformation of our industrial structure. Manufacturing moved and expanded across the border, labor was redeployed into producer services to support that manufacturing base, and at the end of the process Hong Kong became a total service economy.

 

During the adjustment period wages rose rapidly as productivity increased across all sectors. The benefits of China’s opening therefore were broadly shared. Rising incomes and wealth fuelled the demand for all goods and services. Non-traded services that could not be imported experienced a rapid increase in prices and wages. Property prices also went up, especially for domestic premises which were, of course, also a form of non-traded service. All those who became property owners during the 1980s and the early 1990s became the new “haves” in society. 

 

Ninth, another effect of China’s opening was the arrival of large numbers of unskilled immigrants. Over a two-year period in 1978-80, some 300,000 unskilled migrants who came across the border to settle in Hong Kong. The pressures on social services and the labor market were overwhelming. Negotiations were initiated with the Mainland authorities to regulate the inflow and this ended Hong Kong’s reach base policy for Mainland arrivals.

 

A one-way permit scheme was introduced and administered by the Mainland authorities to allow 75 individuals to enter Hong Kong every day which, by 1995, rose to 150. About 1.3 million new immigrants have entered Hong Kong under this system to date, mostly spouses and children of Hong Kong residents who married across the border, bringing the total number of new immigrants who have entered Hong Kong since China’s opening to 1.6 million. On average the new adult immigrant is less educated then the Hong Kong population.

 

China’s opening created economic opportunities for the people of Hong Kong. But it also led to a massive influx of unskilled new immigrants, which has lowered the average stock of human capital in Hong Kong. Their incomes are low and have not grown as fast as the rest of the population, resulting in a less equal distribution of income as the lower tail is stuck in low productivity. Economic growth lags behind Singapore, which has successfully attracted large numbers of highly skilled immigrants from China. Hong Kong’s large body of new immigrants is familiar with the Mainland, but most are too unskilled to take advantage of the opportunities there.

 

Hong Kong has yet to develop a population policy to attract skilled immigrants on a much larger scale and with greater effectiveness. Several admissions schemes have been introduced but none are adequate for the task. The best scheme is the university admissions of overseas students, but the lack of student hostels has compromised its effectiveness.

 

 (to be continued next week)

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