Last week I wrote about some of the salient features of Hong Kong’s development over the past 30 years and how they reveal several key common manifestations of the deep contradictions in Hong Kong: alternating episodes of inflation and deflation, the division of society into “haves” and “have-nots” due to rising property prices, an ageing population, a workforce with rising numbers of less skilled workers, slow productivity growth, and rising poverty and income inequality. Today I continue with these themes by reflecting on the tenth manifestation. This is “welfare arbitrage”, which has arisen from a combination of China’s opening and Hong Kong’s approach to subsidized services and which is straining the resources of the latter.

 

Welfare arbitrage

 

In contrast to many business activities, the supply of housing, education, health care, social services, and domestic transportation in Hong Kong has a large element of public subsidy. A substantial component is also directly provided by government. The rising demand for such services and the lack of productivity growth in some of these sectors means that most of them will over time absorb a growing share of Hong Kong’s resources. Continuing with the current funding mode will lead to a significant increase in government expenditure. And when government expenditure increases as a share of the economy, our growth rate is likely to suffer and our ability to manage external shocks will be compromised. This inherent contradiction is not fully appreciated by the public, who see huge government fiscal surpluses but are not aware of the hidden liabilities.

 

The growing proportion of unskilled new immigrants in our population is also increasing the demand for subsidized services and is exacerbating this inherent contradiction. Hong Kong’s open society and generous welfare benefits encourage cross border marriages. But while China’s opening has been a blessing for many local residents, the arrival of new immigrants has become a source of internal divisiveness because of the pressure they put on subsidized services.

 

Hong Kong’s welfare benefits appeal to Mainland immigrants, some of whom engage in cross border “welfare arbitrage”. One example of this is our prisons where there are inmates with tuberculosis who entered Hong Kong to purposely commit a crime and be incarcerated so as to gain access to free medical treatment for their disease. Our welfare benefits are a magnet for low skill and low productivity immigrants.

 

The problem is worsened by the one-way permit system that restricts Hong Kong to 150 new immigrants per day. As a consequence, most families have to be separated by the border for long periods of time. This measure may reduce the short run pressure on welfare services, but it only compounds the problem further down the road. When the families are eventually united, the new immigrants are often poorly prepared for life in Hong Kong and may become a bigger burden for society.

 

The heavily subsidized sectors have often been slow and reluctant to respond to the rising demands from new immigrants. They naturally resist growing their services without additional public subsidies, while the government struggles to respond with the usual limited resources. These are difficult issues where imaginative, coherent and bold breakthrough solutions are sorely needed, but are not easy to find. Hong Kong will continue to be subject to “welfare arbitrage” and attract unskilled immigrants as long as generous welfare benefits are being provided.

 

A humane long-term policy solution requires a fundamental rethinking of Hong Kong’s policies on subsidized services. It is neither desirable nor appropriate to address welfare arbitrage by solely relying on a cap and control approach that limits the daily inflow of new immigrants. What is needed is a more comprehensive population policy to attract skilled immigrants, invest in the education of residents, and decide who has access to which welfare benefits in Hong Kong. It is worth noting that the massive migration of China’s rural population into the cities over the past 30 years was politically feasible because the cities denied most welfare benefits to newcomers. The sooner we address these issues in Hong Kong, the better off the city will be in the longer run.

 

In reflecting on these ten themes it appears to me that the source of Hong Kong’s deep contradictions arise from the need to reintegrate with the Mainland after China’s opening. Hong Kong has to face “dual integration” – the product of having to adjust from being integrated with the global market economy to being integrated with both the Mainland and the global market economy. The “dual integration” has created deep contradictions in how Hong Kong.

 

Dual Integration: More Pros Than Cons

 

Reintegrating with China is both inevitable and the preferred choice. It is inevitable because Hong Kong has an open economy and society that cannot be isolated from external influences. Its institutions are primarily designed to embrace the external world and this orientation has become part of Hong Kong’s economic and social culture. It is the preferred choice because insulating Hong Kong from the outside world would force the city to accept a lower level of prosperity and miss many economic and social opportunities. Reaching out to the Chinese domestic market holds particular promise. The recently released Global Trends 2030 estimates that 160m or 12% of the Chinese population are middle class consumers. By 2030, the proportion may be 74%. Dual integration with the world and China has to be the best choice for Hong Kong. However, this brings both challenges and opportunities.

 

The success of reintegration depends on many factors: the initial economic gap between Hong Kong and the Mainland, the size of China’s economy, the speed of China’s growth and opening, the responsiveness of Hong Kong’s many different institutions to change, and the capacity of Hong Kong’s leadership to guide and steer change and dual integration.

 

While there will be economic gains to be had, not every group or sector in society will benefit equally. Some will make enormous gains and some may even be harmed, but insofar as the total benefits outweigh total losses it will still be preferred. The inequality that arises means it would be wise to adopt remedial measures that compensate those who are harmed, so as to avoid deep internal divisions and active opposition to change and to dual integration. Even better would be to put in place forward looking policies that can anticipate such pains and ease or forestall them ahead of time.

 

In 1979 the economic gap between Hong Kong and the Mainland was substantial. Hong Kong’s development path had tied its economy to the world. Its product, labor, capital and money markets were fully integrated with the global economy through its free port, unfettered capital flows, highly mobile population, and the linked exchange rate regime. And its prices, wages, and interest rates were all basically aligned with the world market.

 

Asset Prices and Financial Crises

 

The only significant exceptions were land prices, property prices and rentals, where the availability of a key resource – land – was (and continues to be) largely determined by government policies and legal-administrative rules. Government ownership of land and its regulation of supply have led to multiple distortions arising from planning rules, building codes, rent controls, and the public provision of housing. The regulatory distortion of land resources has been one of the two key elements that have critically shaped the path of Hong Kong’s reintegration with China. The other is Hong Kong’s adherence to an open economy, including the linked exchange rate system.

 

Hong Kong’s management of this dual integration has been the most difficult challenge. The explosive result of this deep contradiction of regulation and openness has been the transmission of external macroeconomic and financial shocks through the linked exchange rate system to property prices, the effects of which have been amplified by stubborn planning and building regulations, land supply restrictions, environmental protection and conservation measures, and public housing programs that freeze large amounts of land resources. Fortunately this situation also creates an unprecedented opportunity to improve matters. It is the opportunity to create new institutional platforms to facilitate reintegration with the Mainland and to support China’s integration into the world economy.

 

Economic reintegration with the Mainland is necessarily challenging because from 1949 to 1979 China’s economy was essentially closed. Thirty years of isolation meant that China’s prices, wages, interest rates and rentals, if they existed at all, had to be very different from those in the world market and therefore in Hong Kong. Reintegration in practice means that large gaps in demand and supply emerge as the market opens up, exposing imbalances in both business and non-business activities.

 

The Mainland mothers who want to give birth in Hong Kong are a prominent example of these imbalances. Reintegration needs to be gradual and managed to avoid disruptive shocks that can be economically, socially and politically divisive. Managing demand and supply imbalances through new institutional platforms is equivalent to imposing a form of non-market order.

 

Given the enormous size of China’s economy, adjustment in Hong Kong means primarily accommodating China’s market demands and supporting her continued integration into the world economy. This requires an unending process of institutional innovation to manage and regulate market imbalances in all spheres of life. This is a new experience and challenge for Hong Kong.

 

In the very long run full integration requires Hong Kong prices to eventually converge to Chinese prices; of course, when China has successfully aligned its economy with the world economy these will be world prices. This is the law of one price. The faster China opens and grows, the greater the need for Hong Kong to respond swiftly and appropriately to met the demands of reintegration. The pace of development in China in the past 30 years has indeed been phenomenally rapid and unprecedented in human history. Hong Kong’s challenge is therefore also unprecedented in human history.

 

Hong Kong is not unfamiliar with working with managed or regulated markets. For many decades it had to work with the US Commerce Department on textile and garment quotas using the institutional platform created by the Multi-Fiber Agreement. There used to be a running joke that the Trade Department’s only important job was to work on matters related to this single Agreement. This is obviously an exaggeration, but it reveals the enormous transactions cost of building and working with such platforms in order to operate in managed or regulated markets. By all accounts Hong Kong navigated the Multi-Fiber Agreement with distinction and performed better than any other textile and garment exporting economy in the world. Hong Kong should revisit this episode of its trade history and study the creative institutional response it adopted in the face of this adversity.

 

In the past, selling to the world often meant marketing to clients overseas. This is the familiar work of the Hong Kong Trade Development Council (HKTDC). Today entering China’s market requires in addition the creation of new institutional platforms for each sector and profession, which entails considerable public effort and administrative cost. Given the diversity of Hong Kong’s business and non-profit sectors and its many professions, there is an explosive need for many more platform building initiatives. CEPA is such a platform that has to be made more effective and functional.

 

Positive Non-intervention And Dual Integration

 

Government management of market imbalances has mushroomed with China’s opening. These imbalances appear in all spheres of economic and social activities and they place new demands on the work of government. The faster China opens and grows, the greater the demands on government. The bureaucracy today therefore appears to be a slow bungling laggard. Big business at times is able to forge ahead without the support of government platforms and this has become a complaint from other businesses that lack such capacity. 

 

Designing institutional platforms requires innovation of the highest order and a lot of capacity building. The platforms have to be orderly, transparent, predictable and open to all participants. They function like pseudo markets to create order when there is excess demand or excess supply. Their job is to allocate resources when prices cease to clear markets or when markets cannot function properly. As China continues to open and grow there will be a need for the institutional platforms to evolve and adapt to new supply and demand conditions. Institutional innovation has to be an on-going process until markets can function properly again, that is, when prices can once again equilibrate supply and demand. At that stage the greatest challenge will be the capacity to retire institutional platforms that have outlived their usefulness.

 

Does this situation exist today? Is positive non-interventionism now out of date as many have claimed? Quite the contrary, it is more relevant than ever. Hong Kong’s dual integration means it continues to face the difficult challenge of reintegrating with China without creating disruptive shocks in the face of enormous imbalances in demand and supply. This is a situation where the market has ceased to work and society is faced with the consequences. So more than ever, Hong Kong needs to build and operate new institutional platforms whose task is to resolve the resource allocation problem outside the market place. This is a situation when government intervention is appropriate and therefore “positive”.

 

The next question is how to design such platforms and operate them. Here the market principles of rule based orderliness, transparency, predictability, and open access become important and relevant. What should be avoided are ad hoc policy interventions that come across as exercises in crisis management. It is desirable to ensure that the new modes of engagement not only service provider participation but also consumer participation.

 

The cardinal role of government in building and operating such institutional platforms is to ensure open and equal access for all, on both the supply and demand sides. Government performs the role of the referee rather than the advocate or the selector of winners. This is desirable for three reasons. First, a neutral referee means the government will be an honest broker and its role will command authority and respect by all participants. Second, as an honest broker the government will be the only credible authority to retire an institutional platform once it has outlived its usefulness. This ensures that these platforms do not become a source of future inefficiency used to protect vested interests. Third, such platforms are built specifically for Hong Kong to engage the Mainland, but it would be even more beneficial it they can be open to all participants so that the platforms can also help China to engage with the world.

 

The Closing of Industrial Restructuring

 

In the first 15 years of China’s opening the reintegration process was relatively painless and primarily positive for Hong Kong. During this period the primary movement was of capital and management expertise into the Mainland. As an international economic city with enormous entrepreneurial talent, it was easy for Hong Kong and its small and medium businesses to perform this role. There was little need for government involvement in the process. This was the only period when reintegration did not require the creation of institutional platforms for engagement.

 

In the subsequent 15 years the reintegration pains grew visibly over time. First, there was conscious political apprehension about economic and social reintegration after the restoration of sovereignty over Hong Kong from Britain to China. Second, Hong Kong became busy managing external shocks originating from the global economy. Third, the nature of reintegration began changing as the arrival of new immigrants in Hong Kong and the southward movement of labor came to replace the northward movement of capital. As the economic benefits from relocating manufacturing across the border petered out, the failure to build new institutional platforms for engaging economic and social activities led to an impasse and slow progress in almost all areas. Only the high profile financial sector made some headway.

 

The need for new institutional platforms to engage with China is not the only challenge. Those who are leading Hong Kong must devise a coherent and comprehensive strategy at the conceptual level to articulate in detail the goals and responsibilities of the Hong Kong SAR Government in managing and operating such platforms. Politicians, who are involved in the thick of battle, responding to client requests and struggling anxiously to keep their constituents, are poorly suited to finding the appropriate solutions. Mr. C H Tung recognized the importance of mapping the way forward for Hong Kong during his tenure as Chief Executive, but his groundwork does not appear to have been sustained. Focusing our thoughts on the way forward is the most important task for Hong Kong.

 

 

References

 

European Union, Institute for Security Studies, Global Trends 2030 – Citizens in an Interconnected and Polycentric World, ESPAS Report, 27 April 2012.

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