Econ 4474

The Hong Kong Economy

Lecture Notes

Francis T. Lui

Department of EconomicsHong Kong University of Science and Technology

(Fall 2011)

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Chapter 1

A Very Brief History of the Hong Kong Economy

(1.1) Introduction: Why is the Pre-1841 Economy Relevant to Our Study?

Many economists believe that institutions and economic policies are major determinants of large differences in per capita income across countries. It is also known that the economic prosperity that Hong Kong has been enjoying owes a lot to its institutions that respect law and order, protect private property rights, and preserve freedom, and to policies that promote free trade of goods and flows of capital, maintain balanced budgets and restrain the growth of government. When and why did Hong Kong begin to adopt these institutions and policies?

A study by Acemoglu, Johnson and Robinson on several dozen colonies in history can shed light on the question.1 According to them, Europeans had adopted very different colonization policies and institutions. Those having adopted bad ones would lead their economies into poor income growth. In places where Europeans had to face adverse environments (indicated by high mortality rates for the colonists there), they would not settle, but would more likely pursue short-sighted exploitative policies. If we try to generalize this empirical finding, we can say that the colonists would have much greater incentives to build up a good system with long-term vision if they found the colony an attractive place to settle.

Was Hong Kong an attractive place from the perspective of the British government at the time of the First Opium War (1840-42)? Britain’s Foreign Minister at the time, Lord Henry Temple Palmerston apparently did not think so. In a famous statement written on 21 April, 1841, he described Hong Kong as “a barren island with hardly a house upon it.”2 After the signing of the Treaty of Chuenpi (穿鼻) on 20 January, 1841, when Hong Kong Island was ceded to Britain, Palmerston, who preferred a commercial treaty instead, was not happy. He scolded Captain Charles Elliott, British government’s Superintendant of Trade in China who wanted to acquire Hong Kong, “You have treated my instructions as if they were waste papers.” He then replaced Elliott by Henry 1 Acemoglu, Daron, Simon Johnson and James A. Robinson (2001), “The Colonial Origins of Comparative Development: An Empirical Investigation,” American Economic Review, vol. 91, number 5, p. 1639-1401.

2 See George Beer Endacott, A History of Hong Kong, Hong Kong: Oxford University Press, 2nd edition, 1973, p. 25.

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Pottinger, who signed the Treaty of Nanking with the Manchu government on August 29, 1842.3

Palmerston was succeeded by Lord George Hamilton Gordon Aberdeen in 1841. The latter was even more reluctant to take over Hong Kong. In the instructions he sent to Sir Henry Pottinger, Aberdeen stated, “A secure and well-regulated trade is all we desire; and you will constantly bear in mind that we seek for no exclusive advantages, and demand nothing we shall not willingly see enjoyed by the subjets of all other states.”4 The British government seemed to be concerned with several issues. First, during Victorian time in England, the importance of free trade was a dominant doctrine. As such, a trade treaty with China would be superior to concession of land by China. Second, it would be costly to build a government to run a new colony. Third, Hong Kong was not regarded as a very attractive place by the government in London. It preferred Zhou Shan (舟山) Islands at the East China Sea.

Those who actually visited Hong Kong knew better. Elliott recommended Lord Palmerston to take over Hong Kong. Pottinger, the first Governor of Hong Kong, was able to get both a trade treaty and Hong Kong, when he signed the Treaty of Nanking. He was also pleased with the progress of settlement by the British on the Hong Kong Island.

What would have Elliott and Pottinger seen when they were in Hong Kong? They would easily recognize the value of Hong Kong’s natural harbor, which was greatly needed for doing business with China. They surely would know that Palmerston’s characterization of Hong Kong as “a barren island with hardly a house upon it” was factually wrong. To them, Hong Kong had to be a place attractive enough so that Britain should have the long-term vision of building up a superior governance system and promoting free trade there. These, in turn, as history shows, have far-reaching consequences for Hong Kong.

(1.2) History Before the Opium War

The British colonists would not find Hong Kong a deserted island that nobody cared about. Various estimates of the population of the Hong Kong Island when the British first occupied Hong Kong ranged from around 5650 to 8000 people.5 At Stanley at the southern part of the Hong Kong Island, for 3 See Hong Kong Government, Hong Kong 2003, Chapter 21, p. 445.

4 See Endacott, op. cit, p. 69. 5 Zhang Xiao Hui (張曉輝), (A Modern Economic History of Hong Kong) 香港近代經濟史 (1840-1949), Guangzhou: Guangdong People’s Press, 2001, p. 14-15.

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example, it was reported that there were 180 houses or shops, and 350 ships or boats mainly used for fishing frequently docked there.6 A stone inscription at the Hou Wang Temple (侯王廟) in Kowloon City, dating back to 1822, contains the names of more than a hundred shops and companies that donated money to renovate the temple. This indicates that at that time, in nearby Kowloon, there was already a significant economy.

These did not just emerged overnight. In fact, Hong Kong had already gone through many stages of economic development and structural changes by the time that the British came. To the early history of Hong Kong we now turn.

Archaeological findings have shown that Hong Kong had been under the influences of Chinese culture as early as neolithic times 6000 years ago. A second influx of people, the ancient Yue (越) people, probably came to Hong Kong around 3500 years ago. They depended mainly on fishing and hunting, supplemented by farming.

Formal assimilation of Hong Kong into the Chinese Empire occurred in 214 BC, when the First Emperor of the Qin Dynasty issued a decree to establish three regional magistrates to govern the part of China “south of the mountains” (嶺南). Hong Kong was then under the jurisdiction of the Nanhai Prefecture(南海郡). In 1955, a Eastern Han tomb was excavated at Lei Cheng Uk Village (李鄭屋村) in Shamshuipo. There were brick inscriptions inside the tomb saying “Great Fortune to Panyu County” (Daji Panyu大吉番禺) and “Peace to Panyu County” (Panyu Dazhili番禺大治曆). These suggest that Hong Kong was part of the Panyu county. Moreover, it is often conjectured that the tomb either belonged to a Salt Offcer or his family in the Eastern Han Dynasty. At the time, a Salt Officer would occupy a position almost as senior as that of the governor of a prefecture (州牧 or 郡太守). The production of salt was regarded as an extremely important matter and a major source of monopoly income for the government. During the reign of the Emperor Wu of Han (漢武帝), the position of Salt Officer was instituted in Panyu. Hong Kong also became a major salt production field. Salt production remained an important economic activity for many years to come, until the Qing Dynasty. In fact, the number of people involved in salt business once had become so large that a riot of salt workers in Lantau Island led to an attack of Guangzhou in 1197. To protect salt fields, governments in various periods often had to send troops to station in Hong Kong.

6 Johnson, A. R., “Note on the Island of Hong Kong,” London Geographical Journal, vol. 14, reprinted in Hong Kong Almanac and Directory, 1840.

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However, because of the vast distance between Hong Kong and the political and economic centers of China, it was often regarded as a place where barbarians and outlaws lived. Legend has it said that ancestors of the “boat people” (dan jia蜑家) first landed and settled at Lantau Island, after their leader, Lu Xun (盧循) of Tian Shi Dao (天師道, a branch of the Daoist rebels during the Eastern Jin Dynasty) was defeated and driven away from eastern China by General Liu Yue (劉裕) in 403 AD.7 Despite its obscurity, Hong Kong did command some importance by virtue of its geographical position. The official history of the Tang Dynasty (新唐書) records that there were armies stationed in Tuen Mun (or Tun Men, 屯門), a place strategically located at the entrance of the Pearl River. The name Tuen Mun even occasionally appeared in Tang Dynasty poems. At the end of the Song Dynasty, the last two emperors, Zhao Xia 趙昰(1276-1278) and Zhao Bing 趙昺(1278-1279), actually came and stayed in Hong Kong (stationed at Guan Fu Chang官富場, or today’s To Kwa Wan area in Kowloon) from February 1277 to June 1278.

For centuries before the British colony was established in 1841, the main outputs of Hong Kong had been incense (from Aquilaria Sinensis, 土沉香, commonly known as the incense trees8), salt, and pearls. It also relied on fishing, farming and shipping. The name of Hong Kong (Fragance Harbor) probably derived from the incense it produced, which would be shipped to Aberdeen, via Tsimshatsui (also known as Xiang Tou 香頭), for exportation to Guangzhou. Salt production, as discussed above, was always important as a major source of government revenue. Salt production mainly used the method of boiling seawater in some ingeniously designed pans called the lao pen (牢盆), which were made of bamboo, wood, and ashes from oyster shells. Even as of today, one can see many of the remains of the kilns used for boiling seawater along the coastlines of various parts of Hong Kong. Pearl production was also an important economic activity. In fact, the area probably equivalent to today’s To Lo Harbor was one of the most important centers of pearl production in ancient China.

In 1661, the Qing government, in an attempt to fend off military attacks from General Zheng Cheng Gong’s (鄭成功) army in Taiwan, ordered people living in the coastal areas of southeast China to move inland for several miles. Those who did not obey would be punished by death. This policy, or the so-

7 A Tang Dynasty writer, Liu Xun (劉恂), in his Ling Biao Lu Yi (嶺表錄異), recorded this legend. The truth of this, however, is not well established. Before the British occupation, the dan jia still preserved many of the customs of the ancient Yue people, such as using dragon and snake as their totem, having bare feet yearlong, and living on boats. There is a possibility that the dan jia are descendants of the ancient Yue people and Lu Xun’s followers, who inter-married with each other. See Lu Shou Cai (盧受采) and Lu Dong Qing (盧冬青), A History of Hong Kong Economy (香港經濟史), Hong Kong: Joint Publishing Company, 2002, p. 41.

8 For details of this tree, see http://www.hktree.com/tree/Aquilaria%20sinensis.htm.

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called “Sea Prohibition” (海禁), was abandoned in 1684. By that time, the salt, pearl and incense industries were devastated and could not be recovered. So Hong Kong had to rely more on shipping, fishing and agriculture.

Despite the damage to the economy caused by the “Sea Prohibition” policy in early Qing Dynasty, it is clear that Hong Kong has had a long and dynamic economic history. People had been living here for thousands of years. There were important commodities being produced and traded. Over time, there had been economic structural change in the sense that the economy relied on different kinds of production. Well-known schools or academies were also established in various parts of Hong Kong. One would not claim that it was an advanced economy when the British colonists came. However, the remark that it was a barren island was factually incorrect.

(1.3) Economic Development in the Early Years of British Occupation

The British began governing Hong Kong in 1841. It laid down a system of governance that was remarkably similar to what we have today. Several businesses emerged. Import and export trade, shipping, banking and finance gradually took root. Several British banks, including the Chartered Mercantile Bank of India, London, and China (1845), Agra and United Service Bank (1858), and Standard Chartered Bank (1859) opened branch offices in Hong Kong. The Hong Kong and Shanghai Banking Corporation was established and had its headquarters in the colony in 1865 with an initial capital of HK$ 5 million. Several major companies, such as Jardine, Matheson and Co. (established in 1832 in Guangzhou) and Swire (established in 1832 in Liverpool), moved to Hong Kong. The Hong Kong and Whampoa Dock Company (established in 1863) was a major shipbuilding company in Asia. Almost immediately after settling in the colony, the British government in 1843 proclaimed Hong Kong a free port. Official economic policy since 1860 had been that of a free market economy. These were conducive to the development of shipping and international trade. We should also note that Hong Kong, led by Jardine, Matheson and Co., was the world’s biggest trading and smuggling operator for opium in the mid 19th century. Even though opium could be traded legally, British companies such as Jardine preferred smuggling because they could avoid paying taxes. Trading of coolies into other countries, particularly to the newly discovered goldmines in California and Australia, also became an important business. From 1851 to 1872, Hong Kong exported 320,349 coolies.

The population in Hong Kong kept on increasing. In May 1841, as said above, there were between 5,600 to 8,000 Chinese in Hong Kong. By 1861,

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total population was 119,321, and by 1911, it was 456,739. Although it might have been intended in the beginning that Hong Kong would be a place mainly for European settlers, the majority of the population had always been Chinese. In fact, the proportion of Chinese in the population was usually above 95 percent. Some of them developed themselves into indispensable middlemen between businessmen in China and foreigners who wanted to do business there. As more Chinese came to Hong Kong, some of them could build up businesses of their own. Some notable department stores, such as Wing On (1907) and Dah Sun (1912), were opened. The Bank of East Asia, also owned by Chinese capitalists, began business in 1919.

The middleman role that Hong Kong had been playing made it an important place where the East met the West. This applied not only to business, but also to many other aspects of Chinese society, such as education, culture and politics. In fact, it is fair to say that Hong Kong was instrumental in helping China to learn many aspects of modern institutions. For example, it is well known that Hong Kong was a safe haven for revolutionaries and dissidents, such as Dr. Sun Yat Sen, throughout China’s modern history. The first Chinese student to go to the United States was Yung Wing (容閎), who attended Yale in the mid-19th century. Because of the efforts of Yung Wing, the Qing government agreed to send 120 young children to the United States to study in the 1870s.9 The majority of them were from Guangdong Province and many of them were related to Hong Kong. When these students returned to China, a disprportionately large number of them became prominent leaders in the modern history of China. That Hong Kong is a melting pot of East and West is still very much true today.

(1.4) Emergence of Chinese Entrepreneurs

After 1949, many Chinese entrepreneurs fled to Hong Kong from the mainland. They brought with them important industrial expertise and entrepreneurial spirit. In addition to shipping and trade, Hong Kong was able to build up industries in textile, plastic products, garments, ceramics, metal products and electronic products. There is a common element among these industries: they are all labor-intensive. This is due to the fact that Hong Kong had a lot of low-skill cheap labor, who migrated from the mainland to Hong Kong. However, it does not mean that the composition of skills in the industries remained unchanged. Table 1.1 shows that textile, which employed more than one-quarter of the manufacturing workers, was the industrial backbone in the 1950s and 1960s. Number of workers producing garments and

9 See, for example, Qian Gang (钱鋼) and Hu Jing Cao (胡勁草), Chinese Educational Commission Students (大清留美幼童記), 2003, Hong Kong: Chung Hwa Book Company.

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shoes, which required more skills than textile, increased steadily from 2.8 percent of the manufacturing population in 1950 to 19.7 percent in 1965.

Table 1.1: Employment in Textile, Garments and Shoes as Percentages of Total Manufacturing Population

Year Textile Garments and Shoes1950 30.4% 2.8%1951 34.1% 2.9%1952 32.1% 2.7%1953 33.7% 3.4%1954 33.9% 4.1%1955 30.5% 5.6%1956 30.5% 7.1%1957 30.7% 8.5%1958 30.1% 12.9%1959 24.5% 21.0%1960 26.0% 24.4%1961 27.5% 20.4%1962 26.1% 19.2%1963 25.1% 19.8%1964 26.1% 20.4%1965 26.3% 19.7%

Source: Hong Kong Statistics, 1947-1967.

These changes must be viewed within the context that during this period, the colonial government in Hong Kong did not pursue any industrial policy to actively influence the direction of development. Indeed, as Milton Friedman points out in his book, Free to Choose, Hong Kong can be regarded as a model coming closest to that of a free economy. We can safely argue that the upgrading in the skill-contents of the manufactured goods is a result of responding to market forces rather than following government directives.

As the people in Hong Kong became richer and richer, they wanted to change from being tenants to houseowners. The demand for housing began to rise. The market responded quickly to the new circumstances. Major real estate development took place. In 1954, the late Henry Fok introduced the concept of “housing futures” (lou hua 楼花). This contributed significantly to the further development of the real estate market. Since the mid-1960s, real estate had occupied a prominent role in the local economy. Some Chinese industrialists began to venture into the market of real estate development. A few of them had

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enjoyed such large increases in profits that by the late 1970s or early 1980s they were rich enough to rival the financial strength of major British companies. This was symbolized by their unfriendly take-over of such gigantic firms as Hutchison, Whampoa, Wheelock and Kowloon Wharf in the 1980s. The very fact that a significant number of Chinese entrepreneurs of humble orgins could rise to world prominence in terms of wealth is a testimony of the high degree of social mobility in Hong Kong at that time.

Chapter 2

Structural Changes, Labor Market and Unemployment

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(2.1) Structural Changes

An economy is said to be going through “structural changes” or “sectoral shifts” if many of its workers change jobs and move across industries. Throughout Hong Kong’s history, structural changes are the rule rather than the exception. These have far-reaching consequences on the development of Hong Kong, on the labor market, and on productivity changes. We shall first examine the structural changes that Hong Kong has gone through. Then we shall see how these and other factors affect the unemployment rate in Hong Kong.

Since 1978, the most important impetus of the economic structural changes in Hong Kong must be China’s Open Door Policy. Many local entrepreneurs decided to invest in the Pearl River Delta and other areas in China. The abundant cheap labor available enabled many small and medium-sized enterprises to gradually grow into multi-national corporations. Hong Kong businessmen have helped to build the Pearl River Delta into the “Factory of the World.”

Competition from China has exerted enormous pressure on labor-intensive manufacturing in Hong Kong. Figure 2.2 below shows that the number of employed people in manufacturing declined from more than 900,000 in 1980 to less than 150,000 at the end of 2008. In the same period, employment in the service sector has significantly gone up. Employment in “Wholesale, retail and import/export trades, restaurants and hotels” has gone up by more than 100 percent (Figure 2.5), “Community, social and personal services” by almost 200 percent (Figure 2.8), and “Financing, insurance, real estate and business services” by more than 300 percent (see Figure 2.7). Structural changes of such order of magnitude is an indication of how nimble the Hong Kong economy has been.

Figures 2.1 to 2.8 show how employments in various sectors change

from 1980:Q3 to 2008:Q4. Detailed data that generate these diagrams are available from the Government or from me upon request.

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Starting from March 2009, the Government has changed the Standard Industrial Classification system. As a result, new data series are not compatible with the old ones. Table 2.1 below shows the new classification with employment data for March 2011.

Table 2.1: Employment in various Sectors (March 2011)

Employment Percentage

Mining & Quarrying 66 0.003%

Manufacturing 115,135 4.455%

Electricity, Gas and Waste Management 10,904 0.422%

Construction Sites 58,807 2.275%

Import/Export Trade & Wholesale 564,955 21.858%

Retail 251,348 9.725%

Transportation, Storage, Postal & Courier Services 162,053 6.270%

Accommodation & Food Services 262,972 10.174%

Information and Communications 89,301 3.455%

Financing & Insurance 198,643 7.685%

Real Estate 116,784 4.518%

Professional & Business Services 317,445 12.282%

Social & Personal Services 436,239 16.878%

All Industries Covered in the Survey 2,584,652 100.00%

The composition of the GDP provides us with another way to look at the changes in the Hong Kong economy. Table 2.2 shows that manufacturing output as a share of GDP has declined from almost one-quarter of the GDP in 1980 to about 1.8 percent in 2009. It is clear that Hong Kong can no longer be regarded as an industrial city, a status it once enjoyed before. On the other hand, the service sectors did expand. Wholesale, retail, and import/export trades, financing and insurance, business services, and community, social and personal services have all experienced faster growth than the GDP. Hong Kong can more accurately be characterized as a service economy. The relative importance of the real estate sector, however, has declined in recent years.

To what direction will the structural changes lead is one of the most important questions facing businessmen and policy-makers in Hong Kong. However, the claim that this question can be answered is problematic in itself. Such an attempt presupposes that some “experts” or government bureaucrats know better than the market, and may lead to unwarranted industrial policies.

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Table 2.2: Outputs in Several Sectors as Percentages of GDP

Source: Census & Statistics Dept., “GDP by Economic Activities.”

(2.2) Unemployment Situation in Hong Kong

Unemployment is not something we can ignore. Besides the economic costs, its social impact could be far-reaching. In the U.S., for example, it has been found that a one-percentage point increase in the unemployment rate maintained for 6 years is associated with 21,570 deaths, 4,000 mental hospital admissions and 3,300 prison admissions.

In Hong Kong, as can be seen from Figure 2.9, unemployment rate fluctuated at a level around 2 percent from the mid-1980s to mid-1990s. However, from the late 1990s to the first half of the 2000s, it was much higher. It reached a peak of 8.6 percent during the period from May to July 2003. This high level may in part be due to the “SARS effect” of that period. When the economy began to pick up again since July 2003, unemployment rate also fell as a result. It declined to the level of 3.2 percent by July 2008. However, the global financial crisis of 2008 to 2009 took its toll again. Unemployment rate rose to 5.5 percent in August 2009 before it began to come down again. In July 2011, it had declined to 3.4 percent. What are the major factors determining unemployment rate in Hong Kong? This is an important issue because, as we shall see later, much of the increase in poverty among the poor is due to unemployment.

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(2.3) Sectoral Shifts and Unemployment

Suppose there are random fluctuations of product demand within individual markets. These induce fluctuations of labor demand and lead to wage differentials between markets, which encourage workers to move from low-wage to high-wage markets. These cause structural shifts in the labor market. Structural shifts would have no impact on unemployment if workers could find jobs in other sectors instantaneously. However, they would have an impact if it took time for laid-off workers to be re-employed.

Since employment statistics indicate that structural shifts have been a prominent feature in Hong Kong (see Figures 2.1 to 2.8), we should try to understand them better. A useful way to measure the extent of structural changes is to construct the so-called Lilien index, , which is defined by the following formula:

(1) ,

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where xit is sector i’s employment at time t, ln xit is the employment growth rate in sector i, Xt is the total employment in the 8 sectors, and ln Xt is growth rate of the total employment. If the growth rates of employment in different sectors varied a lot, then t would be larger.

The Lilien Index can be interpreted as the (weighted) standard deviation of the growth rates of employment in the different sectors. If employment in each sector remained constant, the index would be zero. If the growth rates varied a lot, the index would be large and this would signal significant movement of workers across sectors. Using the same employment data presented in section 2.1, we can calculate the Lilien Index for every period. Figure 2.10 shows the index from 1980-Q3 to 2008-Q4.

Just by looking at Figures 2.9 and 2.10, it is not clear that there is a definite relationship between sectoral shifts and unemployment. Macroeconomic theory tells us that actual unemployment rate would fluctuate around the natural unemployment rate. The latter is an equilibrium, whose value is affected by an array of institutional factors, such as sectoral shifts and labor legislations. Random shocks to the economy, particularly money shocks, would cause the unemployment rate to deviate from the natural rate. Following Kwan, Lian and Lui (1995), we hypothesize here that the natural unemployment rate is dependent on current and lagged values of the Lilien Index, which measures structural changes. We will find out how well this

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hypothesis fits the data. Thus, the natural rate is assumed to obey the following equation:

(2) ,

where L is a large integer. (We need a large integer for L because of possible long-lasting lingering effect of structural shifts.)

The problem of having a large L is that there may not be enough data for estimating the ’s precisely. This may cause the estimated coefficients to be quite erratic. A well-known technique to resolve the problem is to impose some “smoothness constraints” on the coefficients. This is done by using the polynomial distributed lag approach, in which the lagged coefficients are constrained to lie on a polynomial, with the amount of smoothness controlled by the degree of the polynomial. With quarterly data we find that L = 20 and a quadratic polynomial give the most satisfactory result. Let

(3) for k = 0,1, 2,…..20,

where the ’s are parameters. Substitute (3) into (2), we get the more operational equation

(4) , where

The S’s can be constructed by assuming that L =20.

Since the natural unemployment rate, Ut*, is not directly observable, we

can only use data for the actual unemployment rate, Ut. This requires us to take into account effects of the money shocks. This can be represented by the following relationship:

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Actual unemployment rate = natural unemployment rate + effects of money shocks + random error term.

We now turn to the discussion of money shocks.

(2.4) The Phillips Curve & Unanticipated Money Shocks

It is well known that the Phillips Curve is a central model in macroeconomics. Some believe that there is a negative relationship between the inflation rate and unemployment rate. Modern empirical and theoretical research shows that this relationship is likely to be temporary. Only unanticipated shocks in the money supply, which cause unexpected changes in the inflation rate, will lead to the “money illusion” phenomenon, and affect the unemployment rate.

Money shocks can be estimated by the following method. Let

(5) ,

where ΔMt - j is the growth rate of M3 at time t - j, the ’s are parameters that have to be estimated, and t is a random error. In the case of HK, we find that j = 5 would give us reasonable results. We can estimate the ’s above and calculate the expected value of ΔMt . Then t = ΔMt - E(ΔMt) is regarded as the shock to the growth rate of M3 at t. The residual, t , estimated in this way, is represented by ΔMRt . We posit that the unemployment rate, Ut , is a function of ΔMRt and ΔMRt-1 . (ΔMRt measures the unexpected shock to the growth rate of M3.)

(6)

The first 4 terms on the right-hand side of the equation represent the natural unemployment rate Ut*, the 5th and the 6th terms represent the money shocks, and the last term is a random error.

(2.5) How Important are Structural Changes & Other Factors?

Equation (6) forms the basis for estimating how structural changes and unanticipated money shocks affect the unemployment rate. In practice, there

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are other factors that may also play a role. Kwan, Lian and Lui (1995) includes two more variables into equation (6) before estimating it. They are labor supply and imported labor.

(a)Labor Supply.

If labor supply goes up and wage rate does not go down, unemployment will increase. However, if wage rate is flexible enough, labor supply has no effect on unemployment. In the case of Hong Kong, many people are paid annual bonuses or additional months of salary. These are more easily adjusted than salary. So unless the increase in labor supply is huge, this factor may not affect unemployment significantly.

(b) Imported Labor

Imported labor creates two opposite effects. First, it takes away jobs from local workers. Second, it helps to make some enterprises remain viable in HK and thus prevents job losses. Which effect is larger is essentially an empirical question.

(Remarks: Since unemployment is a labor market phenomenon, changes in labor legislation would possibly affect it. In particular, legislation that increases the cost of hiring some particular group of people may adversely affect their job opportunities. In the 1980s and 1990s, some bills had been passed to improve the severance and long service payments for some selected groups of employees. Journalists and labor unionists had reported that some employers took action to lay off workers who might potentially benefit from the new bills. Because of the general lack of data, it is difficult to estimate the magnitude of these unintended consequences.)

Results

Kwan, Lian and Lui (1995) has performed an econometric test to measure the relative importance of the different effects discussed above. It has found that from 1982:2 to 1995:1, about 60 percent of the changes in unemployment can be explained by structural shifts, 10 percent by money shocks, 2.5 percent by increases in labor supply. Imported labor has a positive effect on employment, but the effect is insignificant and negligible. Subsequently, Lai (2000) updated the study to include the data up to 1999. His results are not significantly different from the Kwan, Lian and Lui (1995) study, although the explanatory power of structural changes have weakened.

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It must be emphasized that the importance of structural changes as an explanatory variable for unemployment has diminished since the Asian Financial Crisis. During the Crisis, credit crunch seemed to be the main cause of unemployment, which rose from the average of 2 to 3 percent all the way to 6.3 percent in late 1999. After the economy had recovered from the Crisis, unemployment rate fell steadily to the level of 4.4 percent in late 2001. However, it started to climb up again and reached a temporary peak of 8.6 percent in early summer 2003, immediately after the SARS outbreak. Although the SARS effect has quickly disappeared, and unemployment rate has declined due to robust economic growth, it is not clear whether Hong Kong can ever go back to the 2-percent level. It is plausible that there have been significant upward shifts in the natural unemployment rate, which cannot be fully accounted by the structural change story. (Question: Why not?) (Discussion: Macau Effect?)

(2.6) The Phillips Curve Again

The framework in Kwan, Lian and Lui (1995) can be used to estimate the natural unemployment rate in every period. However, the usefulness of this approach is based on the assumption that structural changes are the main determinants of the natural rate. In view of the fact that the Lilien Index has diminished in recent years and the fact that unemployment rate climbed up significantly before the SARS period of 2003, one may suspect that the natural rate estimated in this way is biased downwards. We may therefore consider other alternatives in estimating the natural rate.

As pointed out in Section 2.4, the Phillips Curve is at the centre of the economic theory of unemployment. Unemployment rate is often found to be

negatively related to inflation rate. Figure 2.11 plots inflation rate, πt, against

unemployment rate, Ut, for the sample period from Oct. 1981 to July 2011. It is easily seen that there appears to be a negative relationship between the two variables. In fact, the results of regression (1) in Table 2.2 shows that we

indeed get a significant and negative relationship between πt and Ut. However, it is well known that the Phillips Curve is unstable in the sense that they may shift over time when people’s expectations about inflation change. In other words, the data in Figure 2.11 may represent points along different Phillips Curves that shift over time. (This has been verified by the Chow Test using the data for different sub-periods of the whole sample.) Shifting of the simple Phillips Curve can also be seen from the comparison between Figure 2.12 (pre-

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Asian Financial Crisis) and Figure 2.13 (post-Asian Financial Crisis), or comparison between the regression results of regressions (2) and (3) in Table 2.2.

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Table 2.2: Estimated Results for Simple Phillips Curves

Sample Period Dependent Variable

Constant Unemployment

Ut

R2

(1) Full Sample: 10/1981 to 7/2011

πt12.635**(35.45)

- 2.1284**(- 25.1)

0.639

(2) Pre-Asian Crisis: 10/1981 to 9/1997

πt9.0612**(17.63)

- 0.2978(- 1.55)

0.013

(3) Post-Asian Crisis:10/1997 to 7/2011

πt8.852**(14.72)

- 1.623**(- 14.74)

0.57

Notes: * indicates one-tail significance at the 5% level; ** indicates 1%. Values in parentheses are t-values.

The way to remedy it is to construct the expectational Phillips Curve, which is based on the hypothesis that only surprises in the inflation rate can

23

have an effect on the unemployment. This is represented by the following equation:

(7) πt - πte = α - βUt + εt ,

where πte is the expected inflation rate and εt is a random error term with

expected value equal to zero..

The left-hand side of equation (7) represents the difference between actual inflation and expected inflation, i.e., the part of inflation that is not anticipated. This, according to the theory, should have a negative effect on

unemployment. The values of πte can be estimated by regressing πt against its

lagged values. We have found that by including only πt-1 in the regression

using the whole sample data, 97.45% of the variations of πt can be explained. Thus,

πte = a + b πt-1,

where a and b are estimated coefficients from the regression. The expectational

Phillips Curve is constructed by plotting πt - πte against Ut. The curve for the

whole sample period is presented in Figure 2.14. This is also represented by results in regression (4) of Table 2.3.

Table 2.3: Estimated Results for Expectational Phillips Curves

Sample Period Dependent Variable

Constant Unemployment

Ut

R2

(4) Full Sample: 10/1981 to 7/2011

πt - πte 0.2214**

(2.43)- 0.0593**

(- 2.75)0.0221

(5) Pre-Asian Crisis: 11/1981 to 9/1997

πt - πte 0.3526*

(2.56)- 0.1424*(- 2.77)

0.0389

(6) Post-Asian Crisis:10/1997 to 7/2011

πt - πte 0.3817

(1.55)- 0.07228(- 1.61)

0.0155

The expectational Phillips Curves for the Pre- and Post-Asian Financial Crisis are plotted in Figure 2.15 and Figure 2.16, respectively. They are also represented by the results in regressions (5) and (6) in Table 2.3 above.

24

25

Since both the simple and expectational Phillips Curve have shifted during the full sample period (in the sense that both the constant term and the coefficient for unemployment have changed), we can divide the sample period into two parts: the one before the Asian Financial Crisis and the one after it.

Equation (7) can now be used to estimate the natural unemployment rate U*. If actual inflation rate exactly equals expected inflation rate, then there is no surprise in the expectation. Unemployment rate will then converge to the natural rate U*. Thus, by setting the left-hand side of equation (7) to zero, the natural rate can then be estimated by setting U* = α/β:

For the full sample period (regression (4)):

U* = 0.2214/0.0593 = 3.73 (percent).

Before the Asian Financial Crisis (regression (5)):

U* = 0.3526/0.1424 = 2.48 (percent).

After the Asian Financial Crisis (regression (6)):

U* = 0.3817/0.07228 = 5.28 (percent).

26

Thus, we see that the natural unemployment rate is estimated to have increased from 2.48 percent to 5.28 percent after the Asian Financial Crisis.

27

Chapter 3

Human Resources and Education

(3.1) Demographic Characteristics

According to the 2006 by-census, Hong Kong’s estimated resident population in mid-2006 was 6,864,346. Compared to 1961, when there were 3.168 million people, the population size in Hong Kong has more than doubled. This also represents a growth rate of about 1.8 percent per year.

Table 3.1: Hong Kong’s Resident Population by Age Group and Sex in Mid-2006

Age GroupSex

Both Sexes 

 Male  Female Percentage 0 - 4 110,433 102,172 212,605 3.10% 5 - 9 161,536 151,679 313,215 4.56% 10 - 14 212,582 201,273 413,855 6.03% 15 - 19 223,369 215,868 439,237 6.40% 20 - 24 224,834 244,934 469,768 6.84% 25 - 29 223,704 278,583 502,287 7.32% 30 - 34 239,021 310,818 549,839 8.01% 35 - 39 247,397 329,963 577,360 8.41% 40 - 44 305,447 366,048 671,495 9.78% 45 - 49 323,497 336,158 659,655 9.61% 50 - 54 264,753 269,380 534,133 7.78% 55 - 59 214,652 207,650 422,302 6.15% 60 - 64 128,319 117,480 245,799 3.58% 65 - 69 124,833 115,989 240,822 3.51% 70 - 74 112,372 116,681 229,053 3.34% 75 - 79 82,650 96,123 178,773 2.60% 80 - 84 44,756 68,030 112,786 1.64% 85+ 28,801 62,561 91,362 1.33%All age groups 3,272,956 3,591,390 6,864,346 100.00%

Source: Census and Statistics Dept, “Hong Kong Resident Population by Quinquennial Age Group, Sex and Broad Area, 2006”http://www.bycensus2006.gov.hk/data/data3/statistical_tables/index.htm

28

Every five years, the Census and Statistics Department of the Hong Kong SAR Government conducts a census or by-census. Since the sample size is much larger and more questions are asked, the results are more definitive and extensive than those from ordinary surveys. The census of 2001 shows that Hong Kong had a population of 6,708,389 in that year. This represents an average annual growth rate of 0.9 percent from the census in 1996 to that in 2001. Since 2001, population growth has further slowed down to an average annual rate of 0.4 percent. Thus, in recent years, population growth has significantly decreased, despite the more than 50,000 new immigrants coming from China every year. The reason is clearly due to the rapid decline in total fertility rate during the last three or four decades. Currently, the total fertility rate is around 1, which is the lowest in the world (if we ignore some very small economies such as Andorra or Macau). Not surprisingly, Table 3.1 indicates that children are declining in numbers. Moreover, the bulk of the population is in the age cohort between 25 to 54 years of age. A few decades from now, these people will reach retirement age. By that time, the children of today will be young adults, but they will not be many of them. This is an important issue that will be discussed in Chapter 5 when we deal with retirement protection systems.

Table 3.2 also shows that in 2006, for every 1000 females, there are only 911 males. While this imbalance between males and females is significant, the details for the different age groups show more surprises that need to be explained. From age 0 to 19, and from 55 to 69, there are more males than females. Even though the differences are not very big, it is unlikely that they can be explained by imbalance in birth rates between males and females. The more plausible explanation must be due to migration.

It is well known that many Hong Kong men go to the mainland to look for spouses. China’s policy permits their families to apply for migration to Hong Kong. We postulate that they want to get their offsprings, especially if these are boys, to go to Hong Kong as soon as they can, possibly before they reach the age of 5. Thus, we see that in the age group of 0 to 4, there are 8 percent more boys than girls. From age 5 to 19, the male-to-female ratio slowly declines. This is because many daughters begin to join their families in Hong Kong. This explanation is supported by the data in Table 3.3. In that Table, we report the differences between the number of people in age group T in 2006 and the number of people in age group T – 5 in 2001, for different T’s. As can be seen, for the age groups of 5 to 19 in 2006, there are bigger increases in females than in males, which clearly indicate net inflow of people.

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Table 3.2: Number of Males per 1000 Females in Different Age Groups (Mid-2006)

 0 - 4 1081  5 - 9 1065 10 – 14 1056 15 – 19 1035 20 – 24 918 25 – 29 803 30 – 34 769 35 – 39 750 40 – 44 834 45 – 49 962 50 – 54 983 55 – 59 1034 60 – 64 1092 65 – 69 1076 70 – 74 963 75 – 79 860 80 – 84 658 85+ 460All age groups 911

Source: Derived from Table 3.1

As for the 55 to 69 age group, we can trace their origin to the inflow of illegal immigrants in the 1960s and 1970s. At that time, illegal immigrants from the mainland who could reach the city area in Hong Kong would be permitted to apply for legal residency status. This attracted disproportionately more venturesome young males than females to overcome many barriers, possibly life-threatening, to come to Hong Kong.

A perplexing phenomenon is the enormous imbalance between males and females in the 20 to 44 age group. For example, the astounding 1000-to-750 female-to-male ratio for the 35 to 39 age group has caused a lot of concerns in society, especially among women who feel that they may have difficulties in looking for spouses. What causes such large discrepancy between females and males? Again Table 3.3 can provide an explanation.

Table 3.3: Number of People in Age Group T in 2006 Minus Number of

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People in Age Group T – 5 in 2001

 Age Group T Males Females 5 - 9 15,977 18,159 10 – 14 6,422 9,287 15 – 19 731 6,314 20 – 24 -6,495 25,944 25 – 29 -1,606 33,767 30 – 34 -2,687 26,654 35 – 39 -10,387 5,090 40 – 44 -9,927 -2,960 45 – 49 -11,584 -4,866 50 – 54 -2,237 4,736 55 – 59 -8,249 1,768 60 – 64 -5,898 3,452 65 – 69 -10,276 -2,699 70 – 74 -15,571 -4,387 75 – 79 -18,998 -11,472 80 – 84 -18,250 -11,700

Sources: 2006 age-group data are from Table 3.1. 2001 age-group data are from http://www.censtatd.gov.hk/major_projects/2001_population_census/main_tables/index.jsp

In Table 3.3, we see that there are significant reductions in the number of males in the age groups of 20 to 24 and 35 to 49. The former is likely due to students going abroad to study, while the latter is because of males going to the mainland to work. Quantitatively, the more important reason for the imbalance must be the big increase in the female population for the age group 20 to 39. This is likely due to two factors, namely, the employment of female domestic helpers from foreign countries, and the migration of young wives from the Mainland to Hong Kong. Since they are already married, they do not seem to be competing directly with Hong Kong women of similar ages in the marriage market. In the older age cohorts, there are sigificant reductions in both males and females. The obvious reason is deaths due to old age.

Table 3.4 provides information on the nationalities of the Hong Kong population. The people of Hong Kong are predominantly of Chinese origin. The second largest ethnic group is the Filipinoes. They, together with the Indonesians and Thais, come to Hong Kong mainly to work as domestic helpers. They rarely possess permanent immigration status. In terms of its ethnic composition, Hong Kong can hardly be regarded as a truly international immigration city. However, it is well known that a significant portion of its population are migrants from the Chinese mainland.

Table 3.4: Nationality of the Population in Hong Kong, 2006

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Nationality 2006Number %

Chinese       Place of domicile - Hong Kong 6 374 211 92.9 Place of domicile - other than Hong Kong 86 062 1.3Filipino   115 349 1.7Indonesian   110 576 1.6British   24 990 0.4Indian   17 782 0.3Pakistani, Bangladeshi and Sri-Lankan   12 181 0.2Thai   16 151 0.2Nepalese   15 845 0.2Japanese   13 887 0.2American   13 608 0.2Canadian   11 976 0.2Others   51 728 0.8Total   6 864 346 100.0

Source: Census and Statistics Dept., “Population by Nationality, 2006,” http://www.bycensus2006.gov.hk/data/data3/statistical_tables/index.htm

(3.2) The Emergence of Childless Families

As can be seen from Table 3.5, Hong Kong’s total fertility rate (TFR) is among the lowest in the world. This was not always the case, as Table 3.6 readily shows that in earlier years, TFR was much higher. The declining TFR is part of the demographic transition process, which has taken place in most developed economies in the world. (Question: What is the demographic transition?) However, demographic transition alone cannot explain why TFR in Hong Kong is so much lower than essentially every economy in the world now. Referring to Table 3.5 again, East Asian economies, including Hong Kong, are characterized by very low TFR’s. This is really a puzzle because these economies are influenced by Confucian ethics, which believes that failing to have descendants is the greatest disrespect for one’s parents. Fully resolving this puzzle is beyond the scope of this Chapter. However, it should be recognized that the low TFR could have far-reaching long-term consequences on the economy. (Discussion: What are the implications on saving rate, medical care, retirement protection, economic growth education etc. ?)

Table 3.5: Total Fertility Rates in a Sample of Economies

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1965 2008Asia-Pacific RimAustralia 3.0 1.76China 6.4 1.77Hong Kong 4.5 0.98Japan 2.0 1.22South Korea 4.9 1.29Taiwan 1.13Thailand 6.3 1.64Singapore 4.7 1.08Developed EconomiesEuropean Union 2.7* 1.5United States 2.9 2.1World 5.1 2.58

*The 1965 TFR figure of 2.7 is for OECD countries.Sources: Data for 2008 are from Central Intelligence Agency (2008). Data for 1965 are from World Bank (1992).

Table 3.6: Total Fertility Rate in Hong Kong

1965 1970 1981 1991 1996 2001 20064.5 3.3 1.95 1.30 1.20 0.93 0.98

Sources: 1965 and 1970 figures are from World Bank (1992, 1993). 1981 to 2006 figures are derived from the age-specific fertility rates reported in Table 2.6 of Census and Statistics Department (2007).

When TFR is well below two, we expect that some families may choose to have no children at all. Table 3.7 shows that in 2006, almost 32% of the women in Hong Kong aged between 41 to 45 did not have any children! We can also see that this proportion of childless women has been increasing rapidly over time. This phenomenon is one of the major driving forces of the low TFR in Hong Kong.

Why did so many women choose to remain childless? This must in part be due to the fact that raising and educating children have become very expensive in Hong Kong. Part of the cost may be due to the fact that it is hard to get into top universities. An estimate indicates that the subsidy needed to induce a parent to raise one more child than what she had originally planned to would on average be around 4 or 5 million HK dollars. (Discussion: What are the implications of childless families?)

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Table 3.7: Proportion of women at different age groups who do not have any children

Age Group

Year

20-40 41-45

1996 58.22% 20.90%

2001 63.83% 25.31%

2006 69.75% 31.81%

Sources: Figures for 2001 and 2006 are derived from the 5%-samples of the 2001 and 2006 Hong Kong Census micro data. Figures for 1996 are derived from the 1%-sample of the 1996 Hong Kong Census micro data.

(3.3) Educational and Professional Attainments of the Population

Table 3.8: Hong Kong Resident Population Aged 15 and Above by Sex and Educational Attainment 2006

Source: Census and Statistics Dept., http://www.bycensus2006.gov.hk/data/data3/statistical_tables/index.htm

Around 5.92 million people in Hong Kong belong to the “adult” population, i.e., they are older than or equal to 15 years of age. According to data from United Nations’ Human Development Reports 2006, adult literacy

34

rate in 2001 is estimated to be 93.5% (males 97.1% and females 90.5%). Table 3.8 provides us with more information on educational attainment. As can be seen, the highest level of educational attainment for almost 423,000 people is no schooling or kindergarten. Moreover, as many as 1.084 million have only attended some primary schooling and 1.125 million have received some lower secondary schooling. Thus, at least around 44.5 percent of Hong Kong’s adult population cannot be regarded as “adequately” educated. This is a major problem for Hong Kong if it wants to develop itself into a significant knowledge-based economy. Another concern is that the educational level of this group of people is not very different from the low-skill workers in China. Since the wage rate in China for unskilled workers is much lower, there is a high degree of competitive pressure on the the less educated workers in Hong Kong.

To build up a knowledge-based economy, there must be enough people with high levels of educational attainment. The total number of people who have some (but not necessarily completed) tertiary education is around 1.36 million in 2006. This is equivalent to 23 percent of the adult population. If we only look at those who have taken degree courses, the proportion is only 15.4 percent. Although these represent significant increases from 2001 to 2006, they are still rather low by the standard of the more developed economies. For the sake of comparison, let us look at Table 3.9, which shows the data on educational attainment for those equal to or older than 25 in the United States in 2003. As can be seen, 52.6 percent have completed some tertiary education. We will make use of this figure again in Section 3.4 below. We should also note that the United States is not the country with the highest level of educational attainment. The median number of years of schooling in the US is 15, whereas in some other developed countries, the corresponding figure is 16.

Table 3.9: Educational Attainment in the United States for Those Aged 25 and Above, 2003 (in Percent of Population --- Highest Level)

Not a High School

Graduate

High School

Graduate

Some College, But No Degree

Associate’s Degree

Bachelor’s Degree

Advanced Degree

15.4 32.0 17.2 8.2 17.9 9.3

Source: Statistical Abstract of the United States, 2004-2005, Table 214, http://www.census.gov/prod/www/statistical-abstract-04.html

35

Table 3.8 also demonstrates that a significant portion of the more educated people are in the age group of 20 to 44. This is partly due to the expansion of tertiary education in the 1990s. This means that the problem of low educational attainment will probably be alleviated in the future when more young people have gone through tertiary institutions.

Another way to look at the future is to find out the proportion of people receiving higher education at the appropriate age cohort. Table 3.10 indicates that 37.3 percent of those aged between 19 and 24 attend schools. This big increase from the 26.4 percent of 2001 is due mainly to the expansion of sub-degree programs. On top of this, we should add that probably 7 or 8 percent of the people at the appropriate age cohort go overseas for their studies.

However, as will be argued in Section 3.4, there is still a long way to go if Hong Kong wants to improve the quality of its labor force to a level comparable to those in well developed economies. Further investment in education and importation of talents will be necessary. This is even more important because more than 50,000 new immigrants come to Hong Kong from China every year, and most of them have educational levels lower than the average in Hong Kong.

Table 3.10: School Attendance Rates 2006

Age Group

School attendance rates

SexBoth Sexes

Male Female

 < 3 (2)

7.4 7.6 7.5  3 - 5 (2)

89.9 88.3 89.1  6 - 11 99.9 99.9 99.9  12 - 16 98.7 99.1 98.9  17 - 18 81.1 84.6 82.8  19 - 24 38.4 36.3 37.3  25+ 0.5 0.4 0.4 All age groups 21.2 18.5 19.8

Source: Census and Statistics Dept., http://www.bycensus2006.gov.hk/data/data3/statistical_tables/index.htm

Another perspective for assessing the situation of human capital in Hong Kong is to look at the number of people belonging to different occupations. The data are in Table 3.8. Compared to 1996, the proportion of managers and

36

administrators has gone down from 12.1 percent to 10.8 percent in 2006. There is a slight increase in the proportion of professionals and a more significant increase in associate professionals. If we want to know the number of people who can loosely be classified as “professionals,” then referring to Table 3.11, we can add up rows 1, 2, and arguably, row 3 as well. In 2006, about 1.11 million people belong to this category. These people form the core of the better educated and the middle class in Hong Kong. Since this is 33 percent of the working population, the proportion appears to be low when compared to economies of similar levels of economic development.

Table 3.11: Working Population by Occupation, 1996, 2001 and 2006

Source: Census and Statistics Dept., http://www.bycensus2006.gov.hk/data/data3/statistical_tables/index.htm

(3.4) Estimating the Rates of Returns to Investment in Education

Is it a good idea to spend more resources on education? This question can be answered by estimating the rates of returns to investments in different levels of education. We shall discuss the methodological framework for doing so. Using this method or some variants of it, and by employing household data from the various censuses in Hong Kong, one can provide regorous answers to the question above.

The seminal works in estimating the rates of returns to human capital are due to Jacob Mincer, whose book, “Schooling, Experience, and Earnings”`(1974), provides a useful discussion of the basic approach. The “earnings function” that he proposes is the most often estimated equation in economics. A simple form of this equation is as follows:

37

(3.1) ln yi = β0 + β1 Si + β2 Si 2

+ β3 Ei + β4 Ei 2 + εi ,

where Si represents the number of years of schooling and Ei the number of

years of working experience for individual i, yi is i’s income, εi is a random error term with mean equal to zero, and the β’s are parameters to be estimated. This equation has a number of desirable properties.

First, the estimated equation can tell us how earnings are related to education and experience, which are the two most important ways for accumulating human capital. This would also shed light on income distribution, economic growth and policies on dealing with poverty. We can also use the results to estimate the rates of returns of investment at different levels of education, provided that we also have the cost data for the investments. (Discussion: Why do we need to distinguish between the social and private rates of returns?)

Second, the equation allows us to interpret the results conveniently.

Differentiating the equation with respect to Si , we can get

(3.2) d ln yi / dSi = β1 + 2 β2 Si .

The lefthand side of (3.2) can be interpreted as the growth rate in earnings per unit increase in schooling, when other things are held equal. (Recall the relationship that d ln X = dX/X.) Thus, a person who has one more year of

schooling can expect that his income can go up by a percentage of 100(β1 +

2β2Si). Note that this percentage increase depends on Si itself. This is important because the returns to schooling may be different at different levels of education. For example, we generally expect that one more year of university education raises income by a different percentage than that by one more year of primary school. We can do a similar interpretation for the effect of one more year of working experience, which can be summarized by the following.

(3.3) d ln yi / dEi = β3 + 2 β4 Ei .

38

Third, β0 has an interesting interpretation. When both Si and Ei are equal

to zero, then ln yi = β0 . Thus, equation (3.1) can tell us the expected income of a person who has absolutely no human capital but has to rely solely on raw labor.

Fourth, we can conveniently include more variables on the righthand side of equation (3.1) to study their effects on income. For example, we may want to find out whether there are any differences in incomes between males and females, long-time residents and new immigrants, and so forth, for the same level of human capital. In fact, if we have inadvertantly omitted some relevant variables, the estimated coefficients could be subject to specification biases. (The estimated coefficients would still be unbiased if the omitted variables are not correlated with those included.) Therefore, as a matter of routine, we should consider carefully what other variables should be added to equation (3.1).

Since we have got the raw data from the censuses (the one-percent or the five-percent samples are available), we can apply the above methodology to obtain interesting results. By doing this for the different censuses, we can gain better understanding of the changes in income over time. (This could generate good research topics for the term papers.)

(3.5) Some Considerations for Education and Immigration Policies

Hong Kong’s per capita GDP in 2006 was roughly US$27,600 using official exchange rate, or close to US$36,000 using purchasing power parity (PPP). This makes it one of the developed economies of the world. However, if we compare the educational attainment of Hong Kong with those in other well- developed places, then as has been noted in Section (3.3), Hong Kong is far below the average. (Discussion: Why can Hong Kong attain the rather high level of per capita GDP despite its low level of educational attainment?) We should try to understand what would be needed for Hong Kong’s future economic development.

Using an estimated value of β0 , I have calculated that the average monthly salary for raw labor (totally unskilled workers) is HK$3,750 for the year 2001. (Women get lower salaries than men.) Suppose all the workers in Hong Kong (3.44 million people) had absolutely no human capital, then their total wages, based on the above estimate, would be HK$155 billion. Census data for 2001 indicate that in that year, total wages ≈ HK$665 billion. This

39

means that human capital has contributed HK$510 billion to the GDP. In that year, GDP ≈ HK$1270 billion. So the contribution from physical capital should be roughly HK$605 billion. (This is a rather unusual feature of the Hong Kong economy, since in many developed economies, total wage income is about 70 percent of the GDP, whereas that in Hong Kong it is about 52 percent.) If we further assume that both physical capital and human capital had a rate of return of 5 percent per year, then the value of human capital stock in Hong Kong would be about HK$10,200 billion, and that for physical capital would be HK$12,100 billion.10

Assume that the aggregate production in Hong Kong is Cobb-Douglas:

(3.4) Y = ALα H

γ K

(1-α-γ) ,

where Y is the GDP, A, α, and γ are parameters, L is labor, H is human capital stock, and K is physical capital stock. If there is technological improvement, A will go up. From general properties of the Cobb-Douglas production function, we know the following:

(3.5) L (∂Y/∂L) = L (MPL) = αY.

(3.6) H(∂Y/∂H) = H (MPH) = γY.

(3.7) K(∂Y/∂K) = K (MPK) = (1 - α - γ)Y.

These equations indicate that α can conveniently be interpreted as the share of the GDP produced by raw labor, γ is the share produced by human capital, and (1-α–γ) is the share produced by physical capital. (Question: Why?) From the data above, we can estimate that

α ≈ 155/1270 ≈ 0.12,

γ ≈ 510/1270 ≈ 0.4,

and (1 - α – γ) ≈ 605/1270 ≈ 0.48.

Thus, equation (3.4) can be restated as

10 A study commissioned by the United Nations has estimated the wealth owned by the people in Hong Kong is around US$202,000 per capita, which is ranked as the highest in the world. This estimate is roughly equivalent to HK$11,000 billion of wealth for the whole economy, which is lower than, but close to my estimate in the text.

40

(3.4’) Y = AL0.12

H0.4

K0.48

This can be regarded as the estimated production function based on the census data of 2001, which can be further exploited to generate more results about the Hong Kong economy.

An interesting question we want to ask is the following. Per capita GDP of the United States in 2001 is roughly 1.47 times that of Hong Kong in the same year (US$35,397 versus US$24,000). Suppose that there were no changes in technology, physical capital stock and labor. How much would human capital stock in Hong Kong have to increase so that its per capita GDP would be the same as that of the United States? Let the newly required human capital stock be θH. Then the question above is equivalent to the following. If we want the Y (or Y/L) in equation (3.4’) to go up by 47%, then how large should θ be? Equation (3.4’) is now

1.47Y = AL0.12

(θH)0.4

K0.48

Since θ0.4

= 1.47, we must have θ ≈ 2.62. In other words, given Hong Kong’s productivity level (A), capital stock (K) and labor (L), its per capita GDP in 2001 would have been the same as that of the United States if its human capital stock in that year were 2.62 times of what it actually had. Hong Kong indeed needs more human capital if it wants to attain a per capita GDP at the level of that of the United States.

In practice, the growth of income is not driven only by growth in the human capital stock. Another useful property of the Cobb-Douglas production function in equation (3.4) is that it can be restated as

(3.8) ΔY/Y = (ΔA/A) + α (ΔL/L) + γ (ΔH/H) + (1- α - γ) (ΔK/K),

where ΔY, ΔA, ΔL, ΔH, and ΔK refer to the change in Y, A, L, H, and K, respectively. If we substitute the values of the estimated parameters into the equation, then it becomes

(3.8’) ΔY/Y = (ΔA/A) + 0.12(ΔL/L) + 0.4(ΔH/H) + 0.48(ΔK/K).

Hong Kong’s gross domestic saving rate, defined as (GDP – private consumption – government consumption)/GDP, is generally above 30 percent. This is already a high ratio by international standard. A larger saving rate will also lower consumption in the short run. Economic growth driven by higher

41

savings is costly to consumption. Increase in the population may contribute to GDP growth, but it hurts per capita GDP growth. Productivity growth (ΔA/A) is not free lunch either. It often requires growth in human capital stock as well. Growth in human capital stock is certainly also costly. It requires investment in education, better opportunities for people to acquire on-the-job training, and importation of talents. The large discrepancy in human capital between Hong Kong and many developed economies hints to us that manpower policy, possibly encompassing more aggressive education and immigration policies, is an important factor affecting the future development of the economy.

Chapter 4

Government Spending and Revenue

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(4.1) Size of the Government

The size of the government is an important factor affecting the prosperity of an economy. In the literature, government size is often defined as the ratio of government spending to GDP. If a government is too small, there may not be enough resources to protect property rights, safeguard the law and so forth. The long-term economic growth rate would then be negatively affected. On the other hand, a big government means that resources are concentrated in the hands of politicians or government bureaucrats who have little incentive to manage other people’s money efficiently. As we shall see in Chapter 7, this could also lower the long-term economic growth rate. Barro (1990) shows that theoretically there is an optimal size of the government, which maximizes the growth rate of the economy. However, empirically, one observes that, when other factors are held constant, there is a negative relationship between the long-run economic growth rate and government size. The implication of this result is that most governments in the world seem to have exceeded their respective optimal sizes.

Since Hong Kong does not have to pay for national defense and pay-as-you-go social security, which often constitute the two most important components of government spending in many countries, we should expect the size of its government to be relatively small. Indeed, if we look at government consumption as a share of GDP, it is just 8.44 percent in 2010, a value which is rather low by world standard. However, a better measure for government size in the context of Hong Kong is public expenditures as a share of GDP, which is substantially higher. “Public” and “government” expenditures are different because some of the public services in Hong Kong are not directly provided by the government, but by subvention organizations supported by the government. The most important example is the Housing Authority, which supplies almost half of the housing in Hong Kong. The Authority gets land from the government. In the past, it derived funding by using part of the free land to build and sell apartments. Public expenditures include consumption and investment by the government, and consumption and investment by subvention organizations. Table 4.1 and Figure 4.1 present actual and projected data on public expenditures/GDP from 1984 to 2013.

Table 4.1: Changing Size of the Government: Public Expenditures as Percentage of GDP

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Year 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993PE/GDP 15.5 16 15.2 14 14.2 15.5 16.3 15.6 15.3 16.7

Year 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003PE/GDP 15.8 17.1 17.2 17.2 20.6 21.3 20.3 21.7 20.6 22.0

Year 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013PE/GDP 19.9 17.7 16.4 15.9 19.9 19.0 18.8 21.0 19.5 18.8

Sources: Budget Speeches of the Financial Secretary, Hong Kong Government, various years. (Those in yellow are estimated or projected figures.)

As can be seen from Table 4.1, there had been substantial increase in the size of the Hong Kong government from the mid-1980s to 2003. In 1987, public expenditures/GDP was 14 percent, but in 2003, it was 22 percent. This represents a 57 percent increase in the size of the government. Since 2003, the government has made major efforts to control expenditures. Partly because GDP has gone up significantly, public expenditures as a share of GDP has declined to 15.9 percent in 2007, and was expected to stablize at that level for several years. However, the unprecedented budget surplus for the 2007/08 fiscal year had induced the government to spend more money. Moreover, the

44

slightly counter-cyclical policy subsequent to the financial crisis continued to maintain the level at the 19-to-20-percent range. Has government size moved closer to or farther away from the optimal level? The limited information available would not permit us to arrive at a definite answer. However, the slower average GDP growth rate from the 1990s to 2003 does not lend support to the claim that increasing the government size would help the economy.

An easier task is to find out the reasons behind the rise in government size in Hong Kong. Official statistics classify public expenditures into ten policy categories. Table 4.2 presents the shares of total public expenditures (including recurrent and non-recurrent expenditures) for each category for fiscal years 1991-92, 1997-98, 2007-08, 2008-09, 2009-10. It also shows the absolute amounts of the expenditures in 2009-10.

Table 4.2: Total Public Expeditures by Policy Functions

Sources: Budget Speeches of the Financial Secretary, Hong Kong Government, various years.

In Table 4.2, the figures for 2008-09 and 2009-10 should not be treated as representative of the average situation. This is because the big fiscal surplus of 2007-08, estimated to be $123.6 billion, had induced some unusual increases in non-recurrent expenditures. For the fiscal years 2009-11, the budget was very much affected by the global financial crisis. Thus, it is more useful to rely on the 2007-08 figures for our analysis. This table shows that the biggest component of public expenditures is education. (But this is only equal to 3.55% of GDP in 2010, which is far below the world’s average.) However, this is not the category that has the fastest increases. In fact, even though the share of total expenditures spent on education has increased in recent years, much of it goes to non-tertiary education. Figure 4.2 provides a better way to highlight the policy areas that have the fastest increases. There are four categories that have

45

shown positive growth in their shares from 1991 to 2007. They are education, health, welfare, environment and food. The other categories either have declining or stagnant shares during the same period. Out of the four increasing categories, welfare by far has the highest rate of growth. (Education and health arguably also consist of welfare components.) Thus, it makes sense for us to focus our attention on welfare.

Figure 4.2: Shares of Public Expenditures by Policy Functions

0.0

5.0

10.0

15.0

20.0

25.0

Education Support Health Welfare Housing Security Infrastructure Economic Environment& Food

Community &ExternalAffairs

1991-92 (%) 1997-98 (%) 2003-04 (%) 2007-08 (%)

Nominal expenditure under the welfare category in the fiscal year of 2007 is 5.57 times that of 1991. If we deflate it by the the Consumer Price Index A, which measures prices based on the consumption basket of low-income people, then in real terms, it is 3.81 times. This is by all standards a very large increase. Why was there such a rapid increase?

One possible explanation is that the number of old people has gone up significantly, forcing the government to spend more on welfare. The number of people aged at 65 or above in 2006 is 871,400, while that in 1991 is 482,040. This increase of 80.8 percent is substantial, but far from being able to explain the much larger rise in welfare expenditures. In fact, the population growth rate of people aged at 65 or above from 1991 to 2007 is 3.77 percent per year, while that between 1961 and 1991 is at the significantly higher rate of 5.48 percent

46

per year. From 1961 to 1991, we do not see the same large increase in welfare. Aging of the population may be able to explain part of the rise in welfare, but cannot provide a complete answer. We need to explore more explanations, which will be discussed in Chapter 7.

(4.2) Government Revenue and Surplus/Deficit

After the handover in 1997, Hong Kong was troubled for several years by the budget deficit of the government. Article 107 of the Basic Law, which is Hong Kong’s mini-constitution, states, “The Hong Kong Special Administrative Region shall follow the principle of keeping expenditure within the limits of revenues in drawing up its budget, and strive to achieve a fiscal balance, avoid deficits and keep the budget commensurate with the growth rate of its gross domestic product.” Therefore, continuing deficits would be against the Basic Law. From Figure 4.1, it can be seen that during the 1998-2003 period, the level of public expenditures as a share of GDP was significantly higher than other periods. If revenues could not go up as fast, then deficits would occur.

Table 4.3: Government Revenue and Expenditure 1998-2010 (in billions of HK$)

Year Total Revenue Total Expenditure

Surplus/Deficit

1998-1999 198.7 221.9 - 23.21999-2000 232.3 222.3 10.02000-2001 218.3 226.1 - 7.82001-2002 176.1 239.4 - 63.32002-2003 178.7 240.4 - 61.72003-2004 208.5 248.6 - 40.12004-2005 264.4 243.0 21.42005-2006 245.1 231.1 14.02006-2007 282.4 227.3 58.62007-2008 360.8 237.2 123.62008-2009 336.1 334.6 1.52009-2010 324.1 310.3 13.82010-2011 374.8 323.8 51.0Surplus 84

Sources: Expenditure figures are from Budget Speech of the Financial Secretary, HKSAR Government, various years. Surplus and deficit

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figures are from Information Pack for the Budget Speech of the Financial Secretary, November 2009, Hong Kong SAR Government, and from the 2011-12 Budget Speech.

Table 4.3 shows the revenue and expenditure figures of the government. During the 12-year period from 1998 to 2010, there were 5 years of deficits and 8 years of surpluses. On the expenditure side, the figures seem to be relatively stable for the years before 2008. Revenue, on the other hand, had suffered from significant reductions in the two fiscal years of 2001-02 and 2002-03. The huge deficits created had raised serious public concerns. In 2003-04, even though revenue had increased, the inability of the government to limit expenditure has resulted in another year of big deficit. Since the 2007-08 fiscal year, revenues have gone up to a higher platform, despite the onset of the financial crisis. This may largely be due to the expansion of the financial market in Hong Kong, which can generate revenues from stamp duties. Actual and official forecast values for government surplus and deficits are also presented in Figure 4.3.

Figure 4.3: Government Financial Position

 

 

Source: Information Pack for the Budget Speech of the Financial Secretary, 31/3/2011, Hong Kong SAR Government.

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The deficits from 2000 to 2004 significantly reduced the fiscal reserves of the government. Historically, the Hong Kong government had been able to accumulate substantial reserves because it had surpluses in most fiscal years. In 1997-98, fiscal reserves were sufficient to finance 28 months of government spendings. The deficits mentioned above had reduced the reserves to such an extent that in 2003-04, the government only had enough funds to finance 14 months of its expenditures. The dramatic change apparently had induced a sense of crisis in the government and society in general during the deficit years. More stringent spending controls began to appear, which resulted in several years of expenditure reductions. However, it was the increase in revenues, especially during the 2007-08 year, that was able to buid up the fiscal reserves again. In this year, the reserves accumulated were expected to be able to finance 25 months of spendings. Subsequently, the government expanded its expenditures again during the financial crisis.

From the point of view of financial prudence, it was clearly important for the government to deal with the deficit problem when the latter reached a level as high as 5 percent of the GDP. Deficit of this order of magnitude is regarded to be very high by any international standard. Had Hong Kong not been endowed with the large reserves in the beginning, real crisis could hae occurred. The government seemed to believe that the problem was due to the occurrence of “structural deficit.” This term was coined to convey the situation that revenue might persistently be lower than expenditure because an important source of income for the government, namely, proceeds from land sales, had diminished in importance. (QUESTION: Why can’t Hong Kong rely on deficit-financing?) Since fiscal surpluses had emerged again in the 2004-05 fiscal year, the term “structural deficit” has been used much less often. Moreover, it is not even clear that income from land sales will necessarily go down to very low levels in the future. However, even if it will, income from the investments of government reserves, though sometimes negative, or stamp duties may possibly make up for the decline in land sales. To understand this, we should note that the Hong Kong Monetary Authority is charged with the responsibility of managing the reserves of Hong Kong, of which fiscal reserves constitute only a portion. The total amount of the reserves had reached the level of HK$2.49 trillion in July 2011. Legally speaking, the Financial Secretary of the Hong Kong government has the authority to use all of these reserves, with the exception of those for backing up the monetary base, which amounted to HK$1.265 trillion. In other words, as of July 2011, the Financial Secretary has control over an amount equal to HK$1.225 trillion (Government fiscal reserves = 0.602 trillion, equity = 0.623 trillion). According to current practice, returns from investing the fiscal reserves are regarded as part of the fiscal revenue, but returns from other components of the reserves are not. But if this artificial

49

accounting practice were abandoned, the government would have an important new source of income that could make up for the possible losses in land sale. Lastly, if Hong Kong’s stock market can keep on expanding, as it did before the current financial crisis, stamp duties will become an even more important source of revenue.

To deal with its deficit, the government had relied on a number of measures. In addition to cutting spending and reducing the number of civil servants, it also raised some taxes. The government had also considered the possibility of imposing a sales tax (officially known as the “goods and services tax”) in Hong Kong, but because of mounting opposition in society, it dropped the proposal in late 2006. In July 2004, it issued HK$ 20 billion worth of government bonds. It is not clear whether the issuance of bonds will help Hong Kong to address its budget deficits. The Ricardian Equivalence reminds us that money borrowed now plus the interests have to be paid back in the future. The net income effect of issuing bonds on society could be zero.

Table 4.4: Composition of Government Revenues 2010-11 (Estimated)

Profits Tax 26.9%Salaries Tax 13.6%Stamp Duties 10.3%Other Operating Revenue 24.9%Land Premium 11.7%Investment Income 10.4%Other Capital Revenue 2.2%

Source: Information Pack for the Budget Speech of the Financial Secretary, November 2010, Hong Kong SAR Government.

Another outstanding problem of government revenue is that the tax base is generally regarded as narrow. Table 4.4 shows the composition of the official estimated revenues for 2009-10. Profits and salaries taxes together constitute a large faction of total revenue. But from Table 4.5, we can see that in 2006-07, 67.4% of the profits tax come from the top 1000 companies (1.4% of the total number of companies). This problem is also prominent in salaries tax. In Figure 4.4, it can be inferred that in 2008-09, 2.82% of the working population paid for 64.7% of the entire salaries tax, while less than 5.7% of the working population paid for 80.1%. Out of the 3.55 million people in this population, only 1.3 million (36.6%) were paying. The fact that so many people do not have to pay salaries tax may have political implications. Economic theory of

50

moral hazard tells us that those who do not have to pay may favor further expansion in government spending since the resulting financial burden would only be borne by others.

Table 4.5: Distribution of Profits Taxpayers

2006-07 (Actual revenue)

Assessable profits No. of corporations % of total profits tax yield

>$50M 1000 (1.4%) 67.4%

>$30M to $50M 600 (0.8%) 5.4%

>$20M to $30M 700 (1.0%) 4.3%

>$10M to $20M 2000 (2.7%) 6.6%

>$7.5M to $10M 1200 (1.6%) 2.5%

>$5M to $7.5M 2100 (2.8%) 3.0%

>$3M to $5M 3500 (4.7%) 3.2%

>$2M to $3M 3500 (4.7%) 2.0%

>$1M to $2M 7500 (10.1%) 2.5%

$1 to $1M 52100 (70.2%) 3.1%

Figure 4.4: Distribution of Salaries Taxpayers 2008-09

Source for Table 4.5 and Figure 4.4: Information Pack for the Budget Speech of the Financial Secretary, November 2008, Hong Kong SAR Government.

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The moral hazard problem caused by the narrow tax base may be partly mitigated by broadening the latter. If a major new tax, such as the sales tax, (officially called the goods and services tax), were introduced, the proceeds could be substantial enough to eliminate possible budget deficits in the short run. However, since the government would then have a new source of revenue, lobby groups in society might find it convenient to pressure the government to spend even more. Eventually, budget deficit might emerge again.

The government may deal with this criticism by making the sales tax “revenue-neutral,” in the sense that the rates for other taxes can be reduced so as to compensate for the new burden due to the sales tax. Can such a policy work? Introducing a major new tax like that of the sales tax is politically difficult. However, gradually increasing the rates of some taxes is much easier. Even though the sales tax may indeed be “revenue-neutral” in the beginning, there is no guarantee that the rates of other taxes will not be raised back to the old levels later. Whether this would happen or not depends on how powerful the lobby groups are politically. In Chapter 7, we shall deal with income distribution and the phenomenon of rent-seeking, which seems to have become more important in Hong Kong in recent years.

Chapter 5

Demographic Trends & Retirement Protection

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Hong Kong is a place where its residents’ life expectancy is among the highest in the world, while the total fertility rate is the lowest. These phenomena are relatively new. As such, the proportion of people aged 65 and above in 2006 was only 12.42% of the population. However, the proportion for those between 20 and 64 is 67.5%. (See Table 3.1 in Chapter 3.) Since the “support ratio” defined by the ratio of these two numbers is as high as 5.43, the immediate pressure of retirement support is not big. However, Table 3.1 also indicates that the proportion of chidren or young people is rather low. These facts imply that 15 or 20 years from now, the support ratio will decline sharply because today’s middle-aged people, who are in large number, will retire, but the increase in young adults will not be significant. Policies related to retirement protection must take these demographic trends into account.

We shall discuss various issues related to the theory and practice of old-age support in the world, especially those that Hong Kong has to face. The following is only an outline of my discussion.

(A) A Short History of the Debate: 1966; 1975; 1987; July 10, 1991; November 1991; 1992; November 1993; December 15, 1993; September 1, 1994; January 1995; March 8, 1995; July 27; 1995; April 1, 1998; December 2000.

(B) The Pay-as-You-Go (PAYG) System:Political attractiveness; rate of return; stability and sustainability; fairness; effects on savings, growth and fertility; risks. (Tables 2.1 and 2.2 of “Retiremen Book”).

(C) Central Provident Fund:What is it? Effects on savings; rate of return (Table 3.2); Singapore’s CPF (Tables 3.3 and 3.4).

(D) Chilean System: AFP—Privately Managed Pension Fund; Table 4.1; Phasing out the PAYG system; administrative costs (Table 4.3).

(E) Hong Kong’s Plan:

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Population structure (Tables 5.1 and 5.2); why PAYG is not good for HK; MPF benefits (Table 5.3); Comprehensive Social Security Assistance (CSSA) --- Table 5.5; Moral Hazard and Competition.

Chapter 6

54

Productivity Changes and Industrial Policy

(6.1) Introduction

We have seen in Chapter 3 that GDP growth can be driven by growth in human capital stock, physical capital stock, labor input, and productivity. In this Chapter, we shall focus on the last factor. We shall trace how this has changed over time in Hong Kong and discuss the reasons behind. The discussion is important for analyzing various developmental strategies, including whether there should be an industrial policy.

(6.2) A Tale of Two Cities: Comparing Developmental Experiences of Hong Kong and Singapore

The comparison between Singapore and Hong Kong is of great interest to development economists. On the one hand, the two economies share a lot of similarities. On the other hand, Singapore has adopted an industrial policy, in the sense that the government actively intervenes the direction of development of the economy, while Hong Kong, for quite a long time, has relied more on the free market by following the so-called “positive non-interventionism.” (In recent years, the Hong Kong SAR Government prefers to label its policy as “big market, small government.”) The similarities and differences provide us with a natural experiment on evaluating the effectiveness of proactive government policy.

Hong Kong and Singapore share broad similarities in institutions and economic structures. Both were British colonies serving as trade ports with little manufacturing before the War. Hong Kong had trade with China and other parts of the world. Singapore was the trading bridge between Malaysia, Indonesia and the rest of the world. Later on, both developed an export-dependent domestic manufacturing sector, and had passed through a similar set of industries. In the 1980s, both gradually moved into banking and financial services. GDP per capita was quite close in 1960 and also quite close now. Their governments have been fairly efficient and pro-business. Immigrant Chinese constitute a large part of the population in both places. Both are small cities with little natural resources.

55

There are also significant differences between the two. Hong Kong has been relying on free trade. Singapore has pursued the policy of forced saving and actively solicited foreign investment. Hong Kong’s investment-to-GDP ratio had been relatively stable at around more than 20 percent. Singapore’s ratio went up from 9 percent in 1960 to about 40 percent in the mid 1980s. The Singapore government also tries to target industries to drive its development. In short, Hong Kong, at least before the handover, followed a minimalist policy, but Singapore persistently adopts a maximalist policy.

How successful have the two economies been? In the case of Singapore, foreign investors are heavily subsidized through preferential loans, leasing land and buildings at reduced cost, shouldering labor training costs and assuming large equity positions. But by the early 1980s, the real return on Singapore’s massive capital stock was about 10 percent, while US corporations in Singapore could earn over 30 percent per annum. This means that domestically owned capital stock had a rate of return substantially below that of foreign capital. The real rate of return in HK was about 20 percent or more.

A more useful way of looking at their performances is to compare their total factor productivity (TFP). Conceptually, TFP is said to have improved, if all inputs remain constant, but output goes up. In the context of the Cobb-Douglas production function in equation (3.4), the parameter, A, measures the TFP. Equation (3.8) also shows how the growth rate of GDP is related to the growth rates of TFP and other input variables. The results in the Cobb-Douglas production function can be carried over to a more general context. For a production function that has constant returns to scale, the growth rate of output is related to the growth rates of TFP and the input factors in the following way.

(6.1) ΔY/Y = (ΔA/A) + sL (ΔL/L) + sH(ΔH/H) + sK (ΔK/K),

where si is the share of output contributed by input factor i. In this context, TFP growth is represented by ΔA/A. It may seem that TFP growth is like a free good, as it assumes that output can grow even if all inputs remain constant. In practice, TFP may change because of a number of reasons. For example, some more efficient institutions for resource allocation may have been adopted, or people may have become more efficient because of the experiences they have accumulated in their jobs, or there is a scientific or technological breakthrough. However, if all factors affecting output are properly accounted for, then there may be no more room for changes in TFP. This is why some economists regard A as a measure of ignorance, i.e., any changes that we have not taken into account are subsumed under the category of TFP. Nevertheless, it remains an often used measure for productivity changes.

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In a seminal study by Alwyn Young (1992) using growth accounting method based on a formula similar to equation (6.1), outcomes of the developmental experiences in Hong Kong and Singapore are carefully compared. Table 6.1 summarizes his main findings for the sample period from the 1960s to the mid-1980s. It is clear that during the sample period, Hong Kong’s TFP growth has always significantly contributed to GDP growth. For example, from 1961 to 1966, TFP growth contributes to 39 percent of the growth in GDP, while labor growth contributes 14 percent and capital 47 percent. The situation of Singapore is completely different. During the periods 1970 to 1975 and 1980 to 1985, TFP actually declines, causing a reduction in the growth of the GDP. From 1975 to 1980, it only contributes to 5 percent of the GDP growth. The main driving force of output growth in Singapore is capital accumulation. For example, in 1975 to 1980, TFP growth explains 105 percent of GDP growth.

The great dependence of Singaporean output growth on physical capital accumulation is problematic both in the short run and long run. Higher rate of capital accumulation means more savings and less consumption. To support growth there, Singaporeans can only consume a small share of its output. In the long run, because of diminishing returns, the marginal contribution from capital will go down as capital stock has become bigger and bigger. In the limit, the marginal product of capital could converge to zero. Young therefore concludes that the days of high growth rate in Singapore are numbered. Even though the Singaporean government has been actively involved in pushing its industries to move up along the technological ladder, its TFP has stagnated. The Singaporean experience is therefore regarded as an example of the failure of proactive government industrail policy. Hong Kong, on the other hand, allowed free market forces to guide its industries on what to produce, and TFP growth was faster during the sample period used by Young. (Question: How do market forces work in this regard?) (Discussion: Industrial policy in Taiwan.)

Table 6.1: Share of Contribution to GDP Growth by Labor, Capital and TFP Growth

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Share of Contribution of

Labor Growth Capital Growth TFP Growth_____________________________________________________________

Hong Kong

61-66 0.14 0.47 0.3966-71 0.25 0.42 0.3371-76 0.16 0.29 0.5476-81 0.42 0.40 0.1881-86 0.21 0.54 0.25

Singapore

66-70 0.14 0.64 0.2370-75 0.31 1.05 -0.3675-80 0.32 0.63 0.0580-85 0.42 0.78 -0.20

Source: Adapted from Young (1992).

(6.3) Hong Kong’s TFP Stagnancy in Recent Years

In more recent years, i.e., beyond the sample period used by Young (1992), various studies have indicated that Hong Kong’s TFP growth has declined or stagnated. Table 6.2 presents results of TFP growth from 1981 to 2000. The results are obtained based on the method of growth accounting as exemplified in equation (6.1), but human capital is not taken as a separate variable in this study. It can be seen that TFP, represented by g in the table, declines by 0.22 percent per year from 1991 to 2000. Much of the decline can be attributed to the period of 1996 to 2000.

Table 6.2: Hong Kong’s Productivity Accounting: 1981-2000

58

(Percentage Annual Growth Rates)

Contribution to sL sK sL*L sK*K

1981-19851986-19901991-19951996-2000

1991-2000

5.258.044.973.15

4.06

8.717.508.456.18

7.31

2.611.111.172.40

1.78

55.4653.9153.0556.64

54.85

44.5446.0946.9543.36

45.15

-0.07 3.98 0.38-0.89

-0.22

1.450.600.621.36

0.98

3.883.463.972.68

3.30

Note: Adapted from Li (2000). The sum of the last three columns should equal to the first column. Any differences are due to the rounding up of decimal figures. means (∆Y/∆t)/Y, which is the growth rate of Y per unit of time. This definition also applies to

and .

What are the causes of the TFP stagnancy? Table 6.3 provides some information about sectoral differences. It reveals that TFP growth rates for tradable goods or services do not show significant decline. On the other hand, in the non-tradable services sector, there has always been negative TFP growth. Since competitive pressure from the international market tends to be the keenest, the results in Table 6.3 is an indication that competition is important for maintaining positive TFP growth rates in Hong Kong.

Table 6.3: TFP Growth in Tradable Goods, Tradable and Non-tradable Services

Tradable Goods TFP growth rate1983-1990 6.11991-2000 4.2

Tradable Services1983-1990 0.21991-2000 1.1

Non-Tradable Services1983-1990 -1.41991-2000 -0.3

Further analysis shows that annual TFP growth in manufacturing for 1983-1990 is estimated to be 5.5%, while that for 1991-2000 is 5.6%. These

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rather high TFP growth rates were probably also due to international competition, which significantly reduced the labor force and increased efficiency in manufacturing. Companies or workers that were not competitive enough would be driven out of the market. Those that remained would tend to be more efficient. On the other hand, the sector consisting of finance, insurance, real estate & business services exhibits a decline of –0.9% in 1983-1990, and –0.3% in 1991-2000. These could be due to the inflow of workers and capital into this sector. The rather rapid expansion of these service sectors implies that the large number of new workers, who do not necessarily possess the approppriate skills, may dilute the general productivity.

A logical implication of this interpretation is that the more frequent were structural changes, the lower would be the growth rate of TFP. This is because human capital acquired through learning by doing in previous jobs would be obsolete for the new ones. However, structural changes have been taking place in Hong Kong for many decades. So why could we still observe significant TFP growth during the sample period of Young (1992)? One plausible answer to this question is to that the education requirements for the workers in the past were different from what Hong Kong needs now. Workers who left the manufacturing sector to become, say, taxi drivers, might find the adjustment relatively easy because both jobs required roughly the same level of education. However, they would find it much more difficult to move to other sectors that were technologically more advanced. Their education background, which was insufficient, could reduce the efficiency of their learning process in the new jobs.

Chapter 7

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Income Distribution and the Political Economy

(7.1) Income Distribution

It has often been claimed that income distribution in Hong Kong has become more unequal, in the sense that the rich have become richer and the poor poorer. To evaluate this claim and the conditions under which this is true, we need to know how income inequality is measured. A common method popularly used in Hong Kong and elsewhere is to measure the so-called “Gini’s coefficient.” Figure 7.1 helps to explain the meaning of the Gini.

Figure 7.1: The Lorenz Curve and Gini’s Coefficient

% of total income earned by the corresponding proportion of people A 100%

Lorenz M Curve

b

450

N B 0 a 100% % of the population

Gini’s coefficient is computed from the Lorenz Curve, which tells us what the proportion of total income earned by any given percentage of the population is. For example, in Figure 7.1, b% of society’s total income is earned by a% of the population.

Gini’s coefficient = Area of M / (Area of M + Area of N).

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If income distribution is absolutely equal, then the Lorenz Curve will be a straight line joining OA. (Why?) In this case, M = 0. Therefore, Gini’s coefficient = 0.

If income distribution is absolutely unequal, the Lorenz Curve will be a horizontal line starting from point 0, and it becomes a vertical line at B. The last person earns 100% of the income. Gini’s coefficient = 1 in this case. (N = 0. M/(M + N) = 1. )

Thus, the Gini ranges from 0 to 1. It is often said that the higher it is, the more unequal is income distribution. The crude measure of the Gini for household income in Hong Kong for 2006 is 0.533, which is often cited as evidence that HK’s income distribution is quite unequal.

This position is misleading because of two reasons. First, consider the following example. Suppose that in the beginning, everybody in the economy is equally poor. Then the Gini is 0. Now assume that one of them has become rich, but all others remain poor. The Gini will go up. (Why?) If two people have become rich, then the Gini will further go up, and so on. It will be at the highest at around the point where half are rich and half are poor. Beyond this point, if more and more people have become rich, the Gini will fall again. When everybody is rich, the Gini will be zero once more.

When some poor people have become rich, does it mean that income distribution is more unequal? There is no obvious answer, even though the Gini does go up.

Second, the crude measure of the Gini does not incorporate differences in tax rates and subsidies in kind, and changes in household sizes over time. It is well known that only a small proportion of the people in Hong Kong pay salary taxes or profit taxes. About half of the citizens in Hong Kong, who are of low income, live in public housing. Subsidies in the form of health care, education and welfare are provided disproportionately to low-income. Moreover, average size of households has declined from 3.3 persons in 1996 to 3.0 in 2006, in such a way that low-income households tend to have fewer household members. In principle, a better estimate of the Gini should take these issues into account.

Table 7.1: Different Measures of the Gini for Household Income

1996 2006Gini based on pre-tax, pre-benefit household income 0.518 0.533

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Gini based on post-tax household income 0.508 0.521Gini based on post-tax, post-benefit household income

0.466 0.475

Gini based on post-tax, post-benefit per capita income 0.429 0.427

Source: Census and Statistics Dept, HKSAR Dept, Thematic Report: Household Income Distribution in Hong Kong, June 18, 2007.

Table 7.1 compares different measures of the Gini for household income before and making various appropriate adjustments. The crude meaure has indeed gone up from 0.518 in 1996 to 0.533 in 2006. However, after making adjustments for taxes and subsidies in kind, the Gini has substantially declined. But the Gini in 2006 measured in this way is nevertheless higher than that of 1996. After adjusting for the decline in household size, the Gini in 2006 is actually lower than that in 1996. Thus, the increase in Gini often claimed in the popular press is really due to the systematic change in household size rather than to greater income disparity.

Some people have raised an argument pertaining to the widening of income dispersion in recent years. From 1997 to 2009, official statistics indicate that real GDP has increased by 44.2%. (See Table 7.2.) However, median household income has slightly gone down during this period. This could mean that the lower half of the population had not got any increase in income, despite that real GDP had gone up.

Table 7.2: Changes in Household Income

Year GDP in 2007 dollars

(millions)

Nominal GDP

(millions)

Number of Households

Nominal GDP per

Household

Household Size

1997 1,113,826 1,365,024 1,892,600 721,243 3.32009 1,606,155 1,622,322 2,319,200 699,518 2.9

Change 44.2% 18.85% 22.54% - 3.01% -12.12%

This argument turns out to be fallacious. Much of the increase in real GDP is due to the significant decline in the GDP deflator (17% reduction in this period). However, Composite CPI has only declined by 3.3% during the same period. (Question: Which price index is more relevant in measuring people’s welfare?) More importantly, the number of household has gone up by 22.54%. As Table 7.2 indicates, nominal GDP per household has actually gone down. It is no surprise that median nominal household income has also decreased. This fact should not be interpreted as a widening of income distribution.

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Since the 4th quarter of 2009, Hong Kong’s economy has been recovering from the Financial Tsunami. Nominal GDP growth in 2010 was 7.5%. This would have alleviated the problem of slow growth modestly.

(7.2) Social Mobility

There are two important concepts of equality: equality in outcomes and equality in opportunities. Gini coefficient is a measurement of equality in outcomes, but not equality in opportunities. The proper criterion on the latter is whether there is sufficient social mobility. In the process of economic growth, it is rare that everybody’s income moves up by roughly the same proportion simultaneously. Usually some people become rich faster than others. When a sizable group of people are rich, their consumption and increased productivity will help to drive the economy forward, thereby raising the income levels of those who are still poor, provided that there are no major obstacles blocking social mobility.

Table 7.3: Employed Population by Monthly Total Personal Income (1991 and 1996)

Monthly Employment 1991 1996 Change Earnings (in 1996 $)

< 1,999 133,262 66,310 2,000 – 3,999 179,567 97,167** - 356,318 4,000 – 5,999 347,627* 309,9996,000 – 7,999 638,566 469,228

8,000 – 9,999 407,439 469,17010,000 – 14,999 429,886 670,90115,000 – 19,999 232,197 306,829 + 521,50820,000 – 24,999 65,477 174,72425,000 – 29,999 47,187 82,070

30,000 – 39,999 60,502 104,21040,000 – 59,999 46,547 76,63460,000 – 79,999 23,355 33,474 + 103,40580,000 – 99,999 8,827 14,478> 100,000 19,664 33,504

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Total 2,640,103* 2,908,698** + 268,595

Notes: *75,000 foreign domestic helpers have been deducted.

**135,000 foreign domestic helpers have been deducted.

The Hong Kong government conducts a census or by-census once every 5 years. Table 7.3 is a comparison of income distributions for the years 1991 and 1996. From the Table, it is clear that from 1991 to 1996, the number of low-income people (those receiving less than HK$ 8000 per month) decreased, but the number of people belonging to higher income groups increased. Rich people became richer, but poor people did not become poorer. Moreover, it is evident from the figures presented that some low-income people in 1991 had moved up the income ladder.

The above results were for a period when the economy was growing. What would happen if the economy were not doing very well or unstable? Table 7.4 presents the number of people in each income group in 1996 and 2006. During this period, the economy had gone through turbulent times. In both Tables 7.3 and 7.4, foreign domestic helpers are excluded from the data because their actual compensations, which include food and lodging, are not reflected in their salaries.

Table 7.4: Percentage of Employed Population & Monthly Total Personal Income (1996 and 2006)

Monthly Employment 1996 2006 Change Earnings (in 1996 $) (Adjusted for MPF income)

< 1,999 2.28% 1.89% - 0.39%2,000 – 3,999 3.34% 3.30% - 0.04%4,000 – 5,999 10.66% 8.16% - 2.50%6,000 – 7,999 16.13% 12.02% - 4.11%8,000 – 9,999 16.13% 12.43% - 3.70%10000 – 14999 23.07% 21.85% - 1.22%15000 or above 28.39% 40.35% + 11.96%

Source: Data derived from the 1996 and 2006 census, Census and Statistics Dept, Hong Kong SAR Government (Foreign Domestic Helpers

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have been excluded). Notes: 5% of MPF contribution from employers has been added to total employment income of workers for 2006. Consumer prices in 2006 are 4% lower than those in 1996.

We can see from Table 7.4 that the percentages of people in lower income groups have continued to decrease from 1996 to 2006. However, the speed of decline seems to have slowed down. In making the computations, we have adjusted for the 4% decline in the comsumer price index from 1996 to 2006. Moreover, since 2000, employers are required by law to contribute 5% of wage incomes to the accounts of the employees. This has to be taken into consideration.

Table 7.4 indicates that the claim that poverty has become much more serious than before is not supported by data from the Census. Moreover, we should not forget that during the 10 years between 1996 and 2006, there were about 500,000 new immigrants coming from China. Most of them belonged to the low income group. In 2001, the median household income of these people was $6,100 per month, which was much lower than $18,000, the median income of the households in Hong Kong at that time.

In short, upward social mobility in Hong Kong was still significant during the 1996-2006 period, despite the instability in the economy at that time. But it was not as substantial as in the period of 1991-1996, when economic growth was robust.

(7.4) Rent-Seeking and the Political Economy

When government interferes heavily with the economy, rent-seeking activities are likely to occur. This can be understood by a simple example of government interference, namely, an output quota. In Figure 7.2, Q* is the quota imposed by the government. The firms are willing to sell at the price of P*. However, they know that they can charge P’ instead. There is an extra profit equal to (P’ – P*)Q*. Thus, for those who can get a larger percentage of the quota, they can get a bigger share of the area of P*P’AB. This area may be interpreted as the “rent” of owning the quota.

Since the quota is valuable, people will spend resources to compete for it. The theory of rent-seeking tells us that people will spend up to a value equal to the area of P*P’AB in order to compete for the rent generated by the quota.

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A significant portion of these resources could be “wasted” in the process because competition for the rent is privately optimal but socially unproductive.

Figure 7.2: Rent-Seeking

P S

P’ A

P* B

D O Q* Q

We can hypothesize that the more are the resources controlled by the government, the greater will be incentive to engage in rent-seeking activities. (Why?) In 1987, public expenditure as a share of GDP in Hong Kong was 14%. In the fiscal year of 2003-04, public expenditures amount to HK$ 272 billion, which was around 22% of the GDP. This represents a 57% increase in the size of the government over a period of 16 years.

Why does the size of the government go up? When the government responds to pressure from interest groups by rewarding their rent-seeking activities, there will be stronger incentives for the latter to invest more in such activities. This will also induce other groups that did not do so to engage in rent-seeking too. When many people do the same thing, political pressure on greater government spending will be even stronger. The rapidly increasing size of the government could in part be due to this vicious cycle. The government actually does not have strong incentive to resist the pressure because the money to be used is public money. Even though the budget deficit will impose some constraint, the end result may still be an expansionary government. The government can “solve” the problem by raising more taxes (such as sales tax) and issuing government bonds. Perhaps the real restraint on the government will eventually be public opinions, especially those by the taxpayers. However, even this is not for sure because, as we have seen in Table 4.5 and Figure 4.4 in Chapter 4, the proportion of taxpayers in the population is rather low.

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Chapter 8

Hong Kong’s Currency Board and the

Asian Financial Crisis

(8.1) What are Currency Boards (CBs)?

The monetary system in Hong Kong is that of a currency board, which, as a special form of monetary institution, was first introduced in the British colony of Mauritius in 1849. Since then, more than 70 CBs had been established in British colonies and other places. The most recent ones are in Argentina (1991), Estonia (1992), Lithuania (1994), Bulgaria (1997), and Bosnia and Herzegovina (1997). Argentina, however, had in effect abandoned the system when it announced in December 2001 that it would use two exchange rates at the same time. As such, Hong Kong is the only financial center in the world that has a CB.

Hong Kong first adopted the currency board in 1935. There were two interruptions: one during World War II (1941-1945) and another from 1974 to 1983. CB is popularly known in Hong Kong as the Linked Exchange Rate.

CBs can take many different forms, but there are two main characteristics. First, the board has the obligation to exchange on demand local currency for some major international currency, or the “reserve currency,” and vice versa, at a fixed exchange rate stipulated in the legislation. Second, local currency is issued based on at least 100 percent reserve of securities denominated mainly in the reserve currency.

(8.2) A Brief Monetary History of Hong Kong (1934-1983)

Before 1934: Hong Kong followed China in using the “silver standard,” i.e., the value of the Hong Kong dollar was denominated at a fixed exchange rate with silver.

1934: The United States bought silver at a high price in the international market. This led to a large outflow of silver out of Hong Kong and China. Both governments decided to abandon the silver standard.

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Dec. 1935: Hong Kong enacted the Currency Ordinance, which was later renamed as the Exchange Fund Ordinance. The government purchased all the privately held silver coins. The note-issuing banks, which were private, had to deposit their silver reserves with the newly created Exchange Fund and received Certificates of Indebtedness (CI) in return. The Exchange Fund sold the silver in London for sterling. From then on, if an authorized bank wanted to purchase more CIs, it would have to pay sterling at the fixed exchange rate of HKD 16 = 1 pound. The authorized banks are allowed to issue currency only if they have bought the corresponding amount of CIs.

1941-45: The system was interrupted by the Japanese occupation of Hong Kong.

Nov. 1967: Devaluation of the sterling forced the Hong Kong dollar to depreciate relative to other currencies. The government decided to restore the strength of the currency by changing the exchange rate to HKD 14.55 = 1 pound.

Jul. 1972 to Feb. 1973: Further devaluation of the sterling led to the abolition of the old peg. The HKD was pegged to the USD with a + 2.25% intervention band around a central rate.

Nov. 1974 to 16 Oct. 1983: Hong Kong followed a free-float regime. Banks still had to purchase CIs before they could issue money.

1978: The government transferred the accumulated fiscal surpluses to the Exchange Fund, which since then has been managing the fiscal reserves for the government.

17 Oct. 1983: The Hong Kong dollar has since been pegged to the US dollar at the official rate of HKD 7.8 = USD 1. (Question: Why 7.8?)

(8.3) Is the Currency Board Immune of Currency Crisis?

As has been mentioned, there is 100% reserve for cash under the CB regime. Since September 1998, the newly proposed “technical” measures require that the monetary base (cash plus exchange fund bills and notes) be backed up by foreign reserves. Does this mean that currency crisis cannot occur? Let us look at some monetary statistics of Hong Kong:

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Table 8.1: Foreign Reserves and Money Supply

1/2008 1/2009 8/2011

Foreign Reserves1,247,267 (38.3% of HKD M3)

1,417,361(43.4% of HKD M3)

2,180,638(55.6% of HKD M3)

Monetary Base

CurrencyAggregate BalanceExchange Fund Bills & Notes

338,366

187,045 4,655 146,666

541,516

203,491157,450180,575

1,055,049

248,878 148,632657,539

M3 (HKD) 3,254,167 3,265,577 3,920,532

M3 (Foreign Currency)

2,796,644 2,978,334 3,884,887

Total M3 6,050,811 6,243,901 7,805,420

Notes: Values are in millions of HKD. The reserves managed by the HKMA include the above, plus those denominated in HK dollars. Monetary base is sum of currency, aggregate balance and exchange fund bills and notes.

Although foreign reserves are several times bigger than cash, they are not sufficient to back up HKD M3. Imagine that people panic and want to exchange their bank deposits for, say, USD. There won’t be enough foreign reserves. [HKD M3 is backed up by HKD-denominated assets held by the banks, e.g., real estate properties.] The situation is similar to that of a bank run. There is no guarantee that a currency crisis would not occur. (Discussion: Monetary base went up by 99.51% and Foreign Reserves went up by 40.17% in 2009. They then remain stable since Januar 2010. Why have these gone up so much in 2009? )

The received doctrine at the Hong Kong Monetary Authority before the Asian Financial Crisis, however, was that the CB was as solid as a rock, despite the fact that the foreign reserves could not fully cover M3. This is because there was an auto-piloting or automatic adjustment mechanism safeguarding the CB. According to this doctrine, currency crisis could not occur.

Suppose that some capital outflow is taking place, i.e., people are exchanging HKD for USD. The decline in HKD liquidity will push up the

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interest rate of the HKD. (Why?) The rise in interest rate will attract people to hold more HKD, which will strengthen in the foreign exchange market, i.e., it will appreciate.

If the above mechanism works, then it is indeed true that the CB is very safe. But suppose that for some reasons, people just lose confidence in the HKD. They believe that there is a high probability that the CB will collapse soon, possibly because the government might decide to abandon it. Then in order to induce them to hold HKD at the same exchange rate of 7.8, they have to be compensated by a higher interest rate, i.e., HIBOR > LIBOR. (HIBOR = Hong Kong dollar interbank offer rate. LIBOR = Interbank offer rate of USD in London.)

Exchange Rate (HK$/US$)

C

A G

D F 7.8

E

B

0 HIBOR – LIBOR

Figure 8.1: Relationship between Exchange Rate and Interest Rate Differential.

In Figure 8.1, AB depicts the relationship between the difference of HIBOR and LIBOR and the exchange rate when people were completely confident of the currency board. Indeed when HIBOR went up relative to LIBOR, the exchange rate of the HKD would strengthen. However, when there were loss in confidence, the interest rate differential would become a “risk premium.” The higher were the risk of holding HKD relative to holding USD, the bigger would be the interest rate differential. In Figure 8.1, AB would shift to CE if people lost confidence in the HKD. Higher interest rate does not always lead to a stronger HKD.

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Now assume that the Hong Kong Monetary Authority (HKMA) tries to artificially push up interest rate to defend the HKD, for it believes that this would attract money to flow into Hong Kong again. If interest rate goes up too much, it may backfire. A very high interest rate can send out at least two signals. First, the economy will possibly go into a deep recession (Why?), which will lead to more public criticisms of the CB system. Political pressure may force the government to abandon it. (Example: The case of the fixed exchange rate in Sweden in the early 1990s.) Second, the large interest rate differential may indicate the high risk of holding HKD. In some cases, people may decide to hold less HKD when they see that the interest rate is too high. This is depicted by EG of Figure 8.1. As we shall see, the HKMA’s misguided confidence in the automatic adjustment mechanism had led to major policy mistakes during the Asian Financial Crisis in 1997-1998.

(8.4) Rules versus Discretion

The CB system is a passive system based on a set of rules. The HKMA is not supposed to make any discretionary judgment in monetary policy. In fact, there is no room for monetary policy under a true CB. Suppose that the HKMA took an active role in “defending” the peg by deviating from the fixed rules. Then perhaps in the short run, the HKD might be stabilized. However, this would also erode the credibility of the CB. If the HKMA could ignore the rules once, it could abandon the CB itself later on if it so desired. (What would happen to the line AB if the HKMA followed discretion?)

The HKMA’s policy towards the currency board actually has changed over time. By paying attention to the use of discretion or fixed rules, we can postulate that the CB after 1983 has gone through three stages:

(1) Oct. 1983 – Apr. 1992: rule-bound regime.(2) Apr. 1992 – Sept. 1998: discretion regime.(3) Sept. 1998 – 2005 or beyond (?): rule-bound regime.

During the first phase, the government by and large followed the fixed rules of the CB passively and maintained stability of the “spot rate” in the foreign exchange market. However, in 1988, some new “Accounting Arrangements,” which made open market operations possible, were introduced. Exchange Fund Bills (what are these?) have been issued since March 1990. A liquidity adjustment facility (LAF) was opened in 1990 to provide liquidity to the banks. These tools made it possible for the HKMA to intervene Hong Kong’s money market.

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Active use of these tools began around April 1992. (See Figure 8.2.) The HKMA established a first line of defense of the spot rate at 7.75, rather than the 7.8-benchmark. (Why did the HKMA do that?) This created a problem. Whenever the spot rate went above 7.75, the market would fear that the HKMA might choose not to defend the peg. To restore confidence, the HKMA was forced to intervene at 7.75. The HKMA had become a slave of its own discretion. A more serious implication of the greater reliance of discretion is the erosion of the public’s trust that the HKMA would always keep the peg. Since it had deviated from the passive rules of the CB, then there was no guarantee that it would not abandon the peg altogether.

Figure 8.2: Spot exchange rate

Empirical Tests

Was the CB more credible during the rule-bound or discretion regime? This is a testable question. The test is briefly described as follows.

Let s(t) = logarithm of the spot exchange rate, c(t) = logarithm of the central parity, x(t) = deviation of the spot rate from the central parity.

Then s(t) = c(t) + x(t), i.e., x(t) = s(t) – c(t).

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HK$/US$ exchange rate83:11:1 - 99:4:21

7.70

7.75

7.80

7.85

7.90

1/84 1/85 1/86 1/87 1/88 1/89 1/90 1/91 1/92 1/93 1/94 1/95 1/96 1/97 1/98 1/99

HK

$ p

er

US

$

Suppose the CB is credible, i.e., people firmly believe that it will not be abandoned. Then auto-piloting will work. An increase in (HIBOR - LIBOR) => it is less likely for the currency to devalue => the x(t) in the next period will drop (exchange rate is measured in such a way that the higher is s(t) or x(t), the weaker is the currency) => x(t+) – x(t) goes down, where is some positive number,

On the other hand, if an increase in (HIBOR – LIBOR) results in the weakening of the local currency, i.e., x(t+) – x(t) goes up, then it must be true that auto-piloting is not working. In other words, the CB is not credible.

We can regress x(t+) – x(t) (after making some appropriate adjustments) on (HIBOR – LIBOR) and other relevant variables. The results show that the CB was credible during regime 1, but not credible in regime 2. (See Reading 11 for more details.) This shows that the reliance on discretion was hurting the credibility of the CB.

(8.5) The Real Time Gross Settlement (RTGS) System and What Happened during the Financial Crisis

To understand what happened during the financial crisis, we need to understand the RTGS.

On December 9, 1996, the HKMA introduced a new inter-bank payment system, the RTGS. The “aggregate balance” of the banking system, which is equal to the sum of the balances in the individual banks’ accounts opened at the HKMA, can be regarded as the lubricant for the inter-bank settlements. (How?) Because the RTGS was very efficient, the aggregate balance often stayed at a level as low as around HKD 2 billions.

Suppose that there is an outflow of capital, which amounts to, say, HKD 5 billions (bigger than the aggregate balance). The banks’ clients instruct the banks to sell this amount of HKD for, say, USD. If the latter cannot be purchased in the banking system, then the banks must buy it from the HKMA. They can do so only by using deposits in their clearing accounts. If a bank does not have enough money in its clearing balance for purchasing the USD, it must borrow from the clearing balances of other banks. Since the total outflow exceeds the aggregate balance, the banks simply cannot settle their committed transactions and interest rate may have to go up almost without limit. (N.B.: In principle, the note-issuing banks can also take the CI’s to the HKMA and exchange for USD. Alternatively, banks can also sell the exchange fund bills

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and notes they own to the HKMA in return for some HKD liquidity to be injected into their accounts opened at the HKMA. They may also borrow from the HKMA through the LAF.)

This scenario is essentially what happened on October 23, 1997, when the interest rate once reached 280%. In fact, the HKMA believed at the time that the interest rate hike was a necessary evil. (Remember auto-piloting?) The HKMA deliberately delayed the injection of liquidity back into the system so as to squeeze up the interest rate by even more. Banks were sent a memo from the HKMA on that day, warning them that they might have to pay very high penalty interest rate if they kept on using the LAF.

Thus, we can see that the interest rate in Hong Kong was very sensitive to the size of capital flows. The HKMA might choose to magnify interest rate volatility through such discretionary measures as changing the time of liquidity injection.

This approach did not work because of two reasons. First, auto-piloting would work only under the condition that there was enough confidence in the HKD, but this condition was lacking in HK during the Financial Crisis. Interest rate of the HKD remained significantly higher than the LIBOR for a long time. This signaled that the market did not trust the HKD. The perceived probability of devaluation was high.

Figure 8.3: HIBOR and LIBOR

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1-month HIBOR and LIBOR1997:1:1 - 1999:4:21

0

10

20

30

40

50

60

1/1

/97

2/1

/97

3/1

/97

4/1

/97

5/1

/97

6/1

/97

7/1

/97

8/1

/97

9/1

/97

10

/1/9

7

11/1

/97

12

/1/9

7

1/1

/98

2/1

/98

3/1

/98

4/1

/98

5/1

/98

6/1

/98

7/1

/98

8/1

/98

9/1

/98

10

/1/9

8

11/1

/98

12

/1/9

8

1/1

/99

2/1

/99

3/1

/99

4/1

/99

HIBOR

LIBOR

Second, the market players could anticipate accurately that the HKMA would squeeze up interest rate. They could then double play or triple play the market. They would first short the Hang Seng Index and/or the HKD in the forward market. Then they would short the spot HKD. Interest rate would go up. This would lead to the fall in the Hang Seng Index and the HKD forward. They would lose in the spot market, but the losses would be more than compensated by their profits in the other two markets. The higher was the interest rate, the bigger would be the profits.

(8.6) HK Dollar Put Options or Structured Notes

If auto-piloting did not work, what would? We see that the key issue is confidence in the HKD. If confidence could be restored, then auto-piloting would function again.

Seeing that confidence was crucial in defending the CB, several economists at UST proposed the issuance of HKD put options. This was also supported by the late Nobel laureate in economics, Merton Miller, who came to Hong Kong twice in 1998.

The main ideas of the HKD put options, or structured notes, are as follows.

(1) The HKMA issues some structured notes and sell these to the public. The price of the notes is determined by supply and demand in the market.

(2) Individuals or corporations holding the notes are guaranteed that a specified amount of HKD can be exchanged for USD at the rate of 7.8. The more notes they buy, the bigger is the amount guaranteed.

(3) The guarantee is for a limited period only, say, 3 or 6 months. At the expiration of the notes, the HKMA can issue new ones and sell these in the market.

(4) Within the guarantee period, if the HKMA devalues the HKD, it will lose money because it is legally liable for compensating holders of the structured notes the losses they incur because of the devaluation. (Non-holders of the notes are not guaranteed, except for cash.) If there is no devaluation, there is no need to compensate. The structured notes become valueless.

(5) It was suggested that probably the HKMA should issue notes sufficient to guarantee 50 to 60 billions of HKD.

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(Chrysler’s example. Problems of the put options.)

The main purpose of the structured notes is to mitigate the fear that the HKMA might choose to abandon the peg. It does not insure against the risks that adverse external conditions might force the abandonment of the CB. Central banks often claim that they will never devalue their currencies, but this is not credible. (Why?) If the HKMA has issued the notes, it will lose money if it devalues the CB. This provides incentives for the HKMA to maintain the CB. This is also an act of putting money where the mouth is. In economics, this is known as “costly signalling.” The purpose of the proposal is to move the AB curve to A’B’ or further to the left.

Exchange rate

A

A’

7.8 B’ B

HIBOR – LIBOR

Figure 8.4: Theoretical Effect of the HKD Put Options

(8.7) The Eight “Technical” Measures of the HKMA

The HKMA was not receptive to the above idea in the beginning, for it believed that auto-piloting was sufficient to end the attack. The government also believed that the crisis would end by Christmas 1997. Speculative attacks came again January 1998, June 1998, and August 1998. HK seemed to have become an ATM for the speculators. On Sept. 5, 1998, the HKMA announced 7 “technical” measures to defend the HKD. They are summarized as follows:

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(1) The HKMA provides a clear undertaking to all licensed banks in HK to convert HKD in their clearing accounts into USD at the fixed exchange rate of HKD 7.75 per USD.

(2) Banks can use the Exchange Fund Bills and Notes as collateral to borrow overnight HKD from the HKMA.The market was not too sure how serious the undertaking was. On Sunday, 13 September 1998, Mr. Joseph Yam, chief executive of the HKMA conveyed to a reporter of the Hong Kong Economic Journal the idea that it would be cleaner for the HKD to move from 7.75 back to 7.8. After the interview was published the next morning, within several hours, 9 billions of Hong Kong dollars flowed out. The HKMA had to announce another measure:

(3) The HKMA introduced a time element into the convertibility undertaking. It specified clearly that within the following 6 months, the convertibility undertaking would be at the rate of 7.75. Later on, it would move to 7.8 over a period of 500 working days.

(Question: Why are the 8 measures equivalent to the HKD put options? Why is it that without the 8th measure, the convertibility undertaking is not legally binding?)

The difference between the HIBOR and LIBOR immediately narrowed after the 8th measure had taken effect. More importantly, credibility of the CB improved again. In other words, auto-piloting worked. The CB moved to regime 3, or a rule-bound regime. (What rules?)

(8.8) Should Hong Kong Adopt the Currency Board?

One may classify different types of exchange rate regimes in many ways. Milton Friedman (2001) provides a useful classification. According to him, there are regimes that are (1) hard fixed (e.g., currency board, members of the Euro), (2) pegged by a national central bank (e.g., China), and (3) flexible (e.g., U.S., Japan, Euro currency union). He also believes that the peg by a national central bank is the worst. (Why?) CB is an example of a hard fixed exchange rate regime. Is it suitable for HK?

This is an extremely controversial policy question. A popular view is that the high inflation rate and high housing costs before the Asian Financial Crisis, which in turn led to the decline of Hong Kong’s competitiveness, were due to the CB. Another view is that the exchange rate rigidity associated with a CB makes it harder for an economy to adjust to changing economic conditions. Supporters of the CB also provide many arguments. For example, exchange

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rate stability makes investments in Hong Kong more predictable and therefore is conducive to fostering Hong Kong as an international financial center.

The criteria that we use to answer this question should both be based on sound economic theory and empirical verification. On the empirical part, we shall compare the performance of the economy during the CB period with that during the free-float period. We shall also see whether the rule-bound CB is better or worse than the discretionary CB. As for the theory part, we shall identify the necessary conditions for the CB to function effectively. We shall also investigate the question of whether the HKD was over-valued during the recent recession.

Performance of the Currency Board

Between 1983 and 1997, the volatilities of GDP and price appear to have decreased.

Standard deviation of output growth during Free Float years = 2.94.Standard deviation of output growth during CB years = 2.23.Standard deviation of inflation rate during Free Float years = 1.55.Standard deviation of inflation rate during CB years = 1.05.

Some people, including those at the HKMA, interpreted these results as evidence that the CB had effectively caused greater stability in output and price, which are something desirable. However, one can always make an argument against this conclusion. Perhaps the reduction in volatility is due to some other factors, e.g., changes in the economic environment, but not due to the CB per se. Thus, we may have two possible effects causing the exchange rate stability: the institutional effect due to the CB, and the environment effect. We use a method developed by Blanchard and Quah (1989) to isolate the two effects.

Sketch of the method:

Let x(t) = (y(t), p(t)), and e(t) = (e(d, t), e(s, t)).

Where y(t) is the change in the logarithm of output at time t, p(t) is change in the logarithm of the price level at time t, e(d, t) is demand shocks at time t, and e(s, t) is supply shocks at time t. Then

x(t) - = B1 e(t) + B2 e(t-1) + B3 e(t-2) + …….,

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where is mean of x(t).

The difficulty is how the supply shocks and demand shocks (what are these?) can be estimated. There is a technical way to do so. Here we just take it for granted that this can be done. The parameters, or the B’s, represent the institutional effect. The changes in e’s represent changes in the environment.

We can show that the values of the B’s have changed from the FF (free float) regime to the CB regime. So there is indeed an institutional effect. We can run “counter-factual” simulations in the following way.

Impose the post-1983 values of the e’s on the pre-1983 parameters of the B’s See what would happen to x(t).

Results: If the CB were adopted, given the environment of the 1970s, output volatility would have declined from 2.94 (SD) to 2.46. This implies that 62.5 percent of the reduction in output volatility was due to the adoption of the CB, while the remaining 37.5 percent was due to a more tranquil environment. Similarly, 58 percent of the reduction in inflation volatility was due to the CB. (Similar results will appear if we impose the post-1983 values of the e’s on the pre-1983 parameters of the B’s.)

2.94 FF + pre-1983 environment

2.46 CB + pre-1983 environment

2.23 CB + post-1983 environment

Figure 8.5: Estimated standard deviations under different scenarios.

It can be shown that the economy under the CB regime in HK is more sensitive to demand shocks. However, because HK followed some stable fiscal policy, the magnitudes of the demand shocks were small. In other words, if in

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the future the Hong Kong government resorts to unstable fiscal policy, then the economy under CB may become more volatile.

In some further research by Kwan and Lui using the above method, it is shown that had HK adopted the discretionary CB regime (1992 to 1997) during the free-float period, volatility in output and price would have increased instead. To reduce volatility, we need the rule-bound CB.

(8.9) Was the Hong Kong Dollar Over-Valued or Under-Valued?

After the Asian Financial Crisis, it had often been argued that the HK dollar was seriously over-valued. Reliance on market adjustments of wages and prices would not work because the processes would be too slow. Therefore, at any point of time during the deflation period, wages and prices were higher than the market equilibria. The prolonged period of deflation was an indication of market failure, i.e., market forces failed to equate supply with demand. As late as the summer of 2003, many people believed that the HK dollar was over-valued by 30 percent or so.

An episode of capital inflow beginning in late September 2003 seriously challenged this view. By October 7 of that year, the exchage rate against the US dollar had appreciated to 7.711. It was only until April 2004 that it could go back to the 7.8-benchmark. Beginning in 2005, the HKMA officially allowed the eschange rate to fluctuate between a narrow band of 7.75 and 7.85. As can be seen from Figure 8.6, since 2004, there had been several major episodes of appreciation of the Hong Kong dollar, the first from October 2004 to January 2005, the second from May 2005 to December 2006, the third from August 2007 to October 2007, and the fourth from August 2008 to early 2009. These episodes make it difficult to argue that the Hong Kong dollar was seriously over-valued.

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Source: Hong Kong Monetary Authority

One could argue that the strength of the HK dollar relative to the US dollar was due only to the weakness of the US dollar. Perhaps in the past, the HK dollar against the currencies of its trading partners were indeed grossly over-valued, and that in more recent years this had been alleviated by the weak US dollar. Figure 8.7 does not support this view. The index of the (trade-weighted) nominal effective exchange rate of the HK dollar against its trading partners had weakened from 100.6 in January 2000 to 99.9 in September 2003. This is a decrease of only 0.7 percent, which is far smaller than necessary for justifying the argument of over-valuation. In other words, the evidence for the above period does not justify the assertion that the HK dollar was over-valued against the US dollar or the currencies of Hong Kong’s other trading partners. However, for the several years afterwards, the continuous weakening of the US dollar had indeed been forcing the effective exchange rate of the Hong Kong dollar, which is pegged to it, to depreciate significantly. In June 2008, the effective exchange rate had dropped to 85.2. Since then, because of continuous capital flow into the US due to instability in the global financial market, the US dollar, and hence the HK dollar, had appreciated against other currencies again.

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Source: Hong Kong Monetary Authority.

(8.10) Conditions for CB to Perform Better.

In Kwan and Lui (1999), it is shown that an economy under the CB is more responsive to shocks in fiscal policy, but less responsive to supply shocks. Since HK often has stable fiscal policy, the economy is less volatile under the CB. This implies that for the CB to perform well, it is necessary to make fiscal policy as stable as possible. Stability also pre-supposes that the government does not often run into fiscal deficits. Without this condition, foreign reserves could be depleted over time and credibility of the currency board could be undermined. (Argentina’s experience.)

Stability in fiscal policy is not the only condition needed. We have to remember that a CB ties an economy (country A) to an “anchor” country B. What happens in B will therefore necessarily affect A. Suppose, for example, that the economy in B is doing well. This will push up not only the interest rate of B, but also that of A. If business cycles in the two economies are synchronous, then there is no major problem. However, if A is in a recession, then the imposed high interest rate will deprive it of an important source of self-adjustment. The recession there may become more serious. This is the problem of “Optimum currency area” pointed out by Mundell in the 1960s.

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When there are other sources of flexibility, the above problem may not be too serious. Friedman (2000) has listed a number of conditions that we have to pay attention to.

(1) How extensive is trade between A and B? If it is extensive, it is more likely that business cycles of the two economies are synchronous. Transaction costs for trade between the two countries are likely to be lower when there is a fixed exchange rate linking the two place.

(2) How flexible are wages and prices in A? Suppose people believe that HK is too expensive because of the linked exchange rate. If internal wages and prices can adjust downwards easily, then the problem can disappear completely.

(3) How mobile are workers within A and between A and B? Mobility of labor is one form of adjustment. If workers in A are too expensive, those in B will be attracted to go there and therefore push down the wages in B.

(4) How mobile is capital within A and between A and B?

(5) How good are monetary policies in A and in B? If B is bad, but A is good, then forcing A to be linked to B will make it easier for the bad effects of B to be transmitted to A.

(6) What is the political relationship between A and B?

To summarize, we can say that CB makes a lot of sense for HK. However, HK has to adopt stable and prudent fiscal policy, commit to the fixed rules of the CB, and ensure that wages and prices are as flexible as possible. Realistically, these conditions are only partially satisfied in Hong Kong. This implies that the wages and prices in Hong Kong, as measured in, say, USD, are not as flexible as they should be. This would cause some inefficiency in resource allocation. (Why?) On the other hand, the alternative of using a free-float regime also has problems of its own. Given the small size of the Hong Kong economy and the huge amount of capital flow in this international financial center, the exchange rate in a free-float regime could be very unstable. Adjustment in wages and prices measured in USD (or any other foreign currencies) would be too fast and excessive. This also would cause misallocation of resources. (What do you think is the best exchange rate policy design for HK?)

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In the long run, when the RMB has become a credible and convertible international currency, it may not be a bad idea to link HKD to the RMB, rather than the USD, provided that the economies of HK and the Chinese mainland are synchronous. Whether and when this will happen may depend significantly on future changes in the international monetary system.

Hong Kong’s total exports to 5 Destinations as shares of total exports to all destinations

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Chapter 9

International Trade and Economic Relationship with

the Mainland

(9.1) International Trade

Having no natural resources, Hong Kong must rely on international trade in order to prosper or even to survive. It has done relatively well in this regard, as Table 9.1 shows. Although it has been a city with only 7 million people and less, the volume of its merchandize trade has always been ranked among the top 13 in the world.

Table 9.1: Ranking of Hong Kong’s Merchandize Trade in the World

Year 1985 1990 1995 2000 2005 2007 2008 2009 2010Rank 13 10 8 10 11 12 13 11 10

That Hong Kong is very much dependent on international trade can also be illustrated by Figure 9.1. We can see that the sum of total exports and imports has always far exceeded GDP. Since China began its open door policy, Hong Kong has become an even more important re-exports center. The increase in re-exports is coupled with a corresponding rise in imports. Trade volume as a percentage of GDP has risen steadily to more than 300 percent of GDP in recent years. The upward trends are reversed in 1997-99 and in 2009, but they are only temporary. They are likely due to the contractions of global trade due to the Asian Financial Crisis and the global financial tsunami.

Another aspect of international trade in Hong Kong is that merchandize trade deficit is the rule rather than the exception. From 1961 to 2010, there were only four years in which Hong Kong had experienced trade surpluses. This is an indication that Hong Kong has been a net exporter of services and/or it has been a net recipient of capital inflow. (Why?)

The changes in the composition of trade can be demonstrated by comparing the relative sizes of imports, domestic exports, and re-exports as shares of GDP in 1961, 1980 and 2010. The results are in Table 9.2.

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Table 9.2

Imports/GDP Domestic Exports/GDP Re-exports/GDP1961 0.801 0.394 0.1331980 0.779 0.475 0.2102010 1.925 0.040 1.694

It can be see from Table 9.2 that from 1961 to 1980, when China’s economic reform just began, there had been little changes in the relative sizes of imports, domestic exports and re-exports. However, since then, both imports and re-exports rose dramatically. Imports have gone up but the goods are not consumed in Hong Kong. They are re-exported to other countries. Another significant change is that domestic exports as a share of GDP has declined drastically from 0.475 in 1980 to 0.04 in 2010. Hong Kong is no longer an important industrial city.

(9.2) Economic Relationship with the Mainland

Hong Kong and Mainland China have long been benefiting each other economically. In 2010, 52.73% of Hong Kong’s exports went to the Mainland, while 61.5% of Hong Kong’s re-exports also came from the Mainland. Hong Kong has become an import-export logistic center for China.

Another indicator of Hong Kong’s contribution to the Chinese economy is the proportion of China’s foreign direct investment (FDI) that comes from Hong Kong. Hong Kong has always been the main source of FDI for China. Figure 9.3 shows that in the past, Hong Kong had contributed to more than half of China’s total FDI. The ratio has declined over time, but in recent years, it has risen again.

Recently, China has begun to invest overseas. Hong Kong again turns out to be the main destination of these investment. In fact, in 2009, China invested 56.5 billion US dollars outside of the mainland. However, 62.98% of this actually was invested in Hong Kong. So Hong Kong, being an important international financial center, has become both a source and a destination of investment for China.

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Although Hong Kong has played an instrumental role in China’s economic development, one should recognize that the relative importance of Hong Kong must have diminished over time. China now has constructed some major container terminals. That means, China has greatly increased its capacity to engage in international trade itself. Capital is now much more abundant in China than in the past. So the FDI from Hong Kong or elsewhere is much less important for China’s development. In 1990, Hong Kong’s GDP, measured by official exchange rate between the two places, was 25% of that of the Mainland. In 2010, this ratio has declined to around 3.78%. If we use purchasing power parity to do the comparison, it is likely to be less than 2%. In all likelihood, the ratio will continue to decline, since China’s economy grows faster than that of Hong Kong. It would be interesting to find out whether Hong Kong would be able to develop some core businesses that China finds indispensable. (Discussion: What could these businesses be?)

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Chapter 10

Residential Housing Market

(10.1) The High Price for Housing before 1998

Hong Kong’s residential quarters have several types. In 2010, privately owned residential units constitute about 56 percent, public rental flats provided by the Housing Authority around 28.8 percent, and subsidized sale flats belonging to the Home Ownership Scheme (also by the Housing Authority) 15.1 percent of the total number of quarters.

An outstanding feature of Hong Kong’s private residential market is the high price, even though it has adjusted downwards significantly after 1997. Take the price in November 1996 as an example. The average price for recorded transaction was HKD 4534 per square foot. A family buying a small flat of 380 square feet would have to pay 0.5 million HKD as the down payment. Each month it would have to pay HKD 12,000 for a total of 20 years. In 1996, the median household income was HKD 17,500. So more than 70 percent of the household income would have to be paid for the mortgage. Housing price in 1996 was not at its highest. The peak actually occurred in the 3rd quarter of 1997, as is shown in Figure 10.1. Even today, since housing price has come back to the 1997 level, housing cost is still a great burden on many families, despite the low interest rate.

Why has high price been a dominant characteristic of Hong Kong’s private residential market? There are several popular explanations, but not all of them valid.

(1) The speculators effect. Many people, including the government, often blame the high price on the speculators. There are of course people who buy and sell in the housing market for quick profits. These people often make a lot of efforts to collect, and process, information about the market so that they can make better decisions. But in this sense, their transaction activities in the market may just indicate that they are messengers of market forces. If they believe that housing price is going to increase, they will buy. This gives valuable information to developers

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who can adjust their construction plans accordingly. We also have to remember that they also sell. Thus, we cannot say that they only exert upward pressure on housing price.

Misunderstanding the role played by the speculators could lead to undesirable outcomes. In 1994, the government introduced two measures targeted at the speculators: (a) developers could not sell flats unless construction was completed or due for completion within the next 9 months; (b) buyers could not resell the flats until they had been completed or delivered. These measures had created uncertainty for the developers. (Why?) Housing price dropped and production also dropped. So two years later, supply of new housing declined by almost one third. This was one of the most important reasons driving the high housing price in 1996 and 1997. (Discussion: The Chinese government last year enforced a value-added tax on land ownership. The policy was aimed at stabilizing housing prices by inducing developers not to hoard their land lots. Would this work?)

Speculators also had found a way to defeat the policy. Instead of selling the housing “futures,” they used companies to buy and hold the flats and then sold the companies. One may expect that true speculators would prefer this method. In 1996, only 1.87 percent of the market transactions involved companies. So the proportion of speculators was

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unlikely to be high and their impact on the market would be limited. In more recent years, no significant speculators effect can be identified.

(2) Developers’ market power. Hong Kong has some of the world’s largest real estate developers. It is true that a few of them have significant shares in the market for newly constructed residential units. For example, Sun Hung Kai often supplies up to 25 percent of new units. One may then wonder whether they exert monopoly power in setting prices. However, we should not forget that these new units have to compete with those supplied in the secondary market. When the housig market in Hong Kong was booming in the`1990s, the number of transactions in the secondary market was often 6 or 7 times that of the transactions in the primary market. Thus, we cannot say that the developers always possess significant market power.

(3) Optimism of the Future. If people expect that the housing price will go up further in the future, some will be willing to buy apartments despite the high price. The expectation must be driven by past performance of the housing market and by the economy as a whole. Before 1997 these two factors seemed to work well for the housing market.

(10.2) The Big Decline after 1997

After the 3rd quarter of 1997, housing price began to decline. By August 2003, it had reached a bottom that was almost 1/3 of the peak price. What are the reasons for the decline?

Empirical analysis will readily show that changes in the GDP were significant cause for the decline. The decrease in GDP during the Asian Financial Crisis had powerful effects on the property market. Moreover, once the price began to go down, people could no longer anticipate that it would always go up in the future. A very important element supporting the housing price, i.e., the investment motive, disappeared. The only reason left for buying a house was for living space. The drop in demand created a viscious cycle, causing the price to go down further.

A popular explanation for the reduction in housing price is the government’s plan of supplying enough land so that 85,000 units would go into the market every year. This policy was very much welcome by the public and by the developers when it was announced in 1997, but later on, it was a major

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target of public complaints. In fact, according to the government plan, roughly 50,000 units would be supplied by the government in the form of publicly provided rental and sale units, and less than 35,000 units would be built in the private sector. From the 1980s to mid-1990s, the average annual production of private flats was about 30,000 and housing price increased at a rapid rate. If the 85,000-quota were the only reason for the price reduction, it would be hard to understand why a change from 30,000 to less than 35,000 per year would make such a big difference. In June 2000, the Chief Executive of the Hong Kong government abruptly announced in an interview that there had not been such a policy for a while. Yet, housing price continued to go down for another three years. The importance of the 85000-units explanation is dubious.

From 1998 to 2002, the government had used various minor plans to restore market confidence, but none of them worked well. Housing price continued to decline, as is evidenced in Figure 10.1. The rapid decline caused a serious problem for the Hong Kong economy. Since house-owners typically would have to borrow more than 70 percent for mortgage, their equity would be wiped out if housing price had gone down by more than 30 percent. This created a new group of people nicked name as the “negative equity” class. Their emergence was a major source of political pressure in Hong Kong during the period.

On November 13, 2002, the Secretary for Housing announced a series of new policies attempting to push up prices again. Before this time, the government had already changed the usual method of land auctions into something called “Application List.” The idea is that the government would supply land for sale only if some real estate companies had expressed an interest to buy certain plots of land. The package announced by the Housing Secretary included suspending the Application List until the end of 2003. Before that time, there would not be any supply of land, either in the form of land auctions or through compiling an Application List. It was hoped that the construction or completion of flats would decrease drastically so that housing price would be pushed up. Figure 10.2 shows the actual number of units completed from 1997 onwards.

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