Many of the economic and social changes Hong Kong faces today are the consequences ofChina’s opening and integration into the world economy. In an earlier article I pointed out that this is the origin ofHong Kong’s deep contradictions. And this manifests itself in many different ways inHong Kong.

 

At a press conference in 2010, Premier Wen laid out five issues that Hong Kong needed to address, three of which related directly to Hong Kong’s position at the frontline ofChina’s opening and the interface of the country’s ongoing integration into the world economy. Hong Kong in effect has a challenge of dual integration – reintegrating with the Mainland and sustainingHong Kong’s integration with the world economy.

 

HK as Panama Canal

 

The other two issues cited by Wen related to internal stresses that would inevitably arise in the process of dual integration: the need forHong Kongto make public policy decisions in politics more inclusive and to regard issues related to people’s livelihood and education as solutions.

 

In a profound senseHong Kong’s deep contradictions are a specific example of a broader phenomenon; and it brings both opportunities and challenges. The most significant global economic development of the past 30 years has been the momentous rise ofChina,India, the former Soviet Union and East European countries, Latin America andAfrica. Economies that were previously not connected to the global market economy became its fastest growing members. By mid-century the new emerging economies will overtake the old developed economies in terms of total economic output. The sheer scale of this development means everyone will have to adjust and adapt to this new order. The China-Hong Kong nexus is simply an advance and concentrated version of this unfolding story. But it means the economic and social consequences forHong Kongwill be greatly magnified.

 

Hong Kong’s situation can be usefully compared to thePanama Canal. The surface water levels on both sides of the Panama Isthmus – theAtlanticand Pacific sides – are different. ThePanama Canalconnects the two oceans and is designed with three sets of locks to let ships pass, but not the ocean waters. Without the system of locks,Panamawould be submerged as the waters of the two oceans rushed toward each other and connected.

 

Hong Kong, like the Panama Isthmus, has two sides –Chinaand the world economy.Hong Kongconnects the two economies, but it does so by having in place its own system of locks to prevent water flowing freely between the two oceans. If this free flow were to happen, we would have to ask whether the system of locks was fit for purpose and whether it should be reconfigured. Indeed, there are several dangers ahead forHong Kong.

 

System of Locks to be Reconstituted at Appropriate Time

 

First is the problem of water level equalization. The Panama Canal was never intended to equalize the surface water levels of the two oceans, but asChinacontinues to integrate into the world economy, the two “oceans” sitting on either side ofHong Kongwill begin to equalize. The completion of this integration will be a momentous event for the world, but it will also meanHong Kong’s system of locks becomes superfluous and will have to be eventually dismantled.

 

Hong Kongmust appreciate what its future holds and prepare for this. It has to make plans towards raising its ground surface level in order to avoid being submerged. For example, its residents must prepare by gaining the necessary human and non-human capital wealth needed to survive in such an economic future. The city must also re-design its system of locks with a view to flexibility and their eventual disappearance. The system of locks in the Panama Canal is fixed and not designed with such a purpose, but this will not do forHong Kongin a rapidly changing world.

 

Second, canal locks let ships pass but do not allow water to flow freely. But what exists inHong Kongis a system that sometimes allows the water to flow instead of the ships to pass. This paradoxical situation arises because the system does not completely fit the purpose of connectingChinato the world economy. For example,Hong Kong’s free market economy is ideal for this task, but its welfare state system is not. The challenge forHong Kongis to reconfigure its system of locks so that it will wither away or be easily dismantled when it has outlived its usefulness.

 

Third, the Mainland economy has its own system of locks that makes it appear to be a “honeycomb economy” (蜂窩經濟), where many markets have barriers to entry that are not always transparent.Hong Kong’s role is to help open these markets and thus help open or change the locks on the Mainland, but also to avoid being submerged when the Mainland markets fully open up. The world today is learning to live with a rising tide of emerging nations, especiallyChina.Hong Kongis in the unenviable position of being at the frontline and thus being the first to have to deal with the effects.

 

Lessons from the Multi Fiber Agreement

 

In a coming series of articles I hope to illustrate how these challenges manifest themselves in many different situations. Today I shall discuss the Multi-Fiber Agreement (MFA), which governed the international trade in textiles and clothing during the period 1974 to 2004. I believe there are many important lessons we can learn from this historical episode.

 

The MFA was a multilateral pact signed in 1974 as a short-term protectionist measure. It imposed quotas on the yarn, fabric and clothing that developing countries could export to advanced countries. The agreement, which comprises a series of bilaterally negotiated quota restrictions between individual importing and exporting developing countries, was originally meant to last five years. However, it was renewed five times.

 

Under the quota restrictions, the exporting country is allowed to supply a certain volume of textile and clothing products up to a specified ceiling, and it is up to the exporting country to allocate the quota allowance among its domestic producers. These quotas were valuable rights, like other rights that theHong Kongpublic is familiar with, for example, taxi licenses, right of abode, bus franchises, electricity franchises, and so on.

 

The quota restrictions were known as “voluntary export restraints (VERs)”. Of course there was nothing voluntary about these restrictions since they were imposed by the advanced importing countries, but the “voluntary” label meant the governments of importing countries were precluded from auctioning off the quotas to the highest bidder. The importing country therefore received the value inherent in the quotas; these are quota rents.

 

The impact of the MFA was quite simple. By limiting imports, theUSand the EU raised their domestic prices of clothing. Domestic production rose, and domestic consumption fell. Outside of these two markets, however, the effects were more complex. Exporting countries benefitted from the higher prices of textiles and clothing that resulted from quota restrictions. In a world of free trade, the developing countries did not have quota rents to collect, but under the MFA they had to limit their total volume of exports and suffer a loss in the total value of output they produced. It has been estimated that the value of lost output exceeded the quota rent collected in theUSby nine times and in the EU by seven times.

 

A World Bank and International Monetary Fund study in 2003 also estimated the MFA system cost the developing world 27 million jobs and US$40 billion a year in lost exports. At the same time, protection by theUSgovernment of its textile and clothing industries was calculated to cost the American public US$13 billion per year.

 

Redrawing the Global Geographic Landscape of the Garment Industry

 

The MFA had some expected and unexpected consequences. One consequence was producers began to diversify production into goods that were not subject to quota restrictions. Given that the MFA quotas were based on volume rather than value, product upgrading was a means of raising the income earned on a consignment of goods. By increasing the quality and hence the value of goods, producers could gain without increasing the quantity of goods exported.

 

The export restraints imposed on one set of countries created opportunities for others, driving geographical changes in the world’s clothing supply. Limits on exports byJapanand Hong Kong increased export opportunities forTaiwanandSouth Korea. Restraints then imposed onTaiwanandSouth Koreaincreased opportunities forThailandandIndonesia. In this way, the MFA spread to more developing countries and investment in textile and clothing production also spread. Entrepreneurs from developing countries who were limited by the MFA shifted capital and expertise to countries that otherwise lacked the ability to export significant amounts of clothing. Hong Kong entrepreneurs were important global investors who took advantage of opportunities that arose outsideHong Kong.

 

The pursuit of profits under the MFA introduced inefficiencies in textile and clothing production. On the exporters’ side, firms in many developing countries were structured to acquire quotas and maximize the profits from these quotas rather than to compete in the marketplace based on labor costs. Overseas subcontracting was pursued by many firms in order to seek out other geographic locations that were not subject to the bilateral agreements. However, as soon as suppliers in these new locations became successful exporters, MFA quotas were imposed.

 

On the importers’ side, many US and EU importers pursued the excess profits inherent in a quota system by squeezing exporters, who often had to rely on the importers to distribute their textile and clothing products through wholesale and retail operations. Many exporters were non-brand name operations and were dependent on importers who owned the brand names. Estimates showed that the importers often captured a significant share of the quota rents from the exporting countries.

 

Paradoxically, one of the most significant results of the MFA was the setting-up of large scale textile and clothing industries in developing countries that previously took no part in world trade and hence were not constrained by the MFA quota. These were often subsidiaries of firms from advanced countries. Large industries now exist in such places asBangladesh,Cambodia,Pakistan,Mauritius,Egypt, Sub-Saharan Africa,Sri Lankaand so forth, that are heavily dependent on the goodwill of the developed nations to which they export and which favor them.

 

HK Quotas Fully Utilized Without Wastage

 

An unexpected development of the MFA quotas inHong Kongwas that they began to indirectly protect the local industry after its competitive advantage in labor costs began to disappeared. This was because the quota allotment was frozen in time. Bilateral quotas hence arbitrarily divided up markets and prevented trade flows from efficiently allocating production and efficiently distributing goods among consumers in different countries.

 

The Multi Fiber Arrangement was a major departure from the basic GATT rules and particularly the principle of non-discrimination. In 1994, as part of the World Trade Organization (WTO) Uruguay Round of multilateral trade negotiations, it was decided to phase out the MFA by January 1st, 2005, as part of the Agreement on Textiles and Clothing. The new agreement was successfully implemented under the aegis of the WTO.

 

Amongst economists, the MFA is largely regarded as an example of chicanery by the advanced world, which seriously harmed developing countries. It constrained expansion in those developing countries that had quotas and encouraged dubious bilateral political trade-offs between the governments of advanced and developing nations, which meant favored nations got preferential treatment.

 

Domestically, the MFA encouraged corruption as exporters competed for scarce quotas held by their governments. Many of these governments held onto the quotas jealously and distributed them to firms in an opaque manner. Since the quotas expired after a year, this resulted in many quotas never being utilized. In some cases quota utilization rates were as low as 20%. Firms that received purchase orders often failed to secure quotas from their governments in time, which increased waste and costs and reduced production and innovation.

 

Hong Kongbenefitted enormously from the decisions of a succession of Financial Secretaries to allocate the quotas to firms in strict proportion to their export performance in the previous year, as soon as the quotas were finalized in the MFA negotiations. In addition, firms were allowed to freely transfer their quotas to others at market determined prices without interference of any sort from the government. The net result was that all the quotas were fully utilized every year. Industry efficiency was guaranteed.

 

The advantage of such a system was manifold. First, it was totally transparent and fair. Second, it ensured efficiency in the utilization of the quotas. Third, government corruption was effectively prevented as the value of the quotas was completely privatized at the outset.Hong Kong’s textile and clothing industry could therefore develop in the best possible circumstances permitted under the MFA. Fourth, the local textile and clothing industry was hence well prepared and positioned to expand into developing countries either before they were quota restricted or to take advantage of their under utilized quotas.

 

This approach ofHong Kong’s could not have been possible in the absence of a fundamental appreciation of the political soundness and economic benefits of positive non-interventionism. It was a market approach to a situation in the absence of a free market, and it permitted Hong Kong to adopt an institutional platform for engaging both advanced and developing economies with the most effective and efficient institutional arrangement. It afforded quota flexibility and allocative efficiency, encouraged innovation and productivity enhancement, was politically fair and transparent, and was corruption free.

 

Cost-Effectiveness Makes the Choice

 

I recall hearing a number of newer clothing manufacturers complain to me in the 1980s about their market disadvantage because they did not have a track record to secure MFA quotas and were therefore being squeezed by older companies with quotas. I explained to them that a transparent freely transferable system was the best possible arrangement under the circumstances.

 

A system of open bidding with subsequent unfettered transfers would have achieved a similar result except for one aspect – the government would have collected the quota rents. I think this is an inferior arrangement for two reasons. First, government would then be tempted to maximize the value of these quotas for itself and begin to manipulate the timing of these quota auctions and even set ridiculous reservation prices. This would make the system less efficient and more wasteful. Second, if local industry were unable to capture the quota rents then its ability to secure long term overseas importers would be compromised as it would not have quota rents to share with them. A world with the MFA could never be prefect.

 

Hong Konggained a reputation overseas as a reliable manufacturer and exporter. The captains of industry and government worked closely together on a common agreed goal to maximize the advantages forHong Kongin negotiations with the advanced economies and take a market oriented approach to economic matters. Another result of this relationship was that for many years, leading textile and clothing manufacturers were important advisors to the government on a wide range of public policy issues affectingHong Kong’s economic development.

 

Hong Kong’s enormous reputation as a free market economy still gives her more punch than her weight. By all accounts it navigated the Multi-Fiber Agreement with distinction and performed better than any other textile and garment exporting economy in the world.Hong Konghad initiated and adopted a creative institutional response in the face of an economic challenge.

 

Economic reintegration withChinaand supporting her integration into the world economy requires similar creative institutional responses. These are costly administrative arrangements, but we need them in order to engage effectively withChina. Every sector could do with such arrangement to help it move forward, but there is a limit, economically, to how many arrangements the government can effectively take up. The administration will have to be selective and should choose based on cost benefit considerations rather than political ones.

 

 

Hong Kongand Mainland Economic Integration Series No. 1

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