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- LECTURE –

Hong Kong and the Context of Laissez-Faire:

Myths and Truths about a 'Free Market Paradise'

By Catherine Schenk

History of Capitalism Series

2 June 2016

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Hong Kong has developed a reputation for open markets, opportunity and free trade 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. Hong Kong 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 business

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 capital market in the 1970s, Hong Kong carved its own

path to establish a regional and then global international financial centre, in the absence of a central bank

(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, Great Britain, 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 ‘socialism 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 entrepreneurship,

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 free trade 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 industrialisation 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 competition 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, London: 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.

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 value of manufacturing

output from the end of the 1980s as production was shifted across the border to Shenzhen 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, Oxford University Press, 1993. The others included South Korea, Taiwan and Singapore.

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Figure 4 confirms the increasing role of mainland China 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 share of China-related companies in Hong Kong’s stock market capitalisation since the

early 1990s.

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

market economy 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 money. 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., Institutions, 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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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 profit 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 Milton Friedman. 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 Hamish Macleod, then by Chief

Executive Donald Tsang 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, South China Morning Post, 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 management 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 environment of Hong Kong 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 Hong Kong island (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 New Territories 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 company 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 woke 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 Economic History 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 Bank of England 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 financial system 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 history of Hong Kong as a benchmark of free markets

suggests there may be considerable benefits from closer historical treatment of capitalism(s) through

archival research.