JPRI Working Paper No. 52: December 1998
The Political Economy of Hong Kong Since Reversion to China
by Christopher Howe

Few watersheds in modern history have been as explicit and aroused as much interest as Hong Kong's reversion to China in July 1997. Before the event, British stewardship was variously praised, criticized and then subjected to violently contradictory messages during the final five-year governorship of Chris Patten.

But as the handover approached, Hong Kong had a per capita income of more than US$24,000, a high growth rate, declining inflation, low official unemployment, and an international economic status secure enough for it to act as host to the World Bank/IMF 1997 annual meeting. Before reversion, all attention was focussed on human rights and political issues. A golden economic future was generally taken for granted. By October, 1998, however, Hong Kong's wealth measured by equity and property prices had fallen by approximately half; the output of the economy had been in absolute decline for two quarters; unemployment was a serious cause for concern; and the currency problem was acute.

In my view, the optimistic economic perspective of a year ago was incorrect because of: (a) an over-dependence on the growth and public-revenue-creating effects of companies in the service and property sectors; (b) a framework of financial regulation inadequate to its tasks; (c) a currency system that is vulnerable and not fully understood; and (d) a failure to appreciate the economic and social consequences of the long-run degradation of Hong Kong's physical environment. On top of these long-term problems, both the British and Chinese sides acquiesced in an asset-inflation-based boom that stimulated activity during 1996-97. In short, the Hong Kong economy has been a problem waiting to be recognized.

My second reservation about the pre-reversion perspective is the tendency to think of political issues as something separable from economic issues. Hong Kong's capability for managing its economic and environmental future depends very much on the nature of its representational system and the effectiveness of its policy-making and bureaucratic arrangements. While I remain optimistic about Hong Kong's long term prospects, I think there is some way to go in reaching an adequate appreciation of its contemporary predicaments. The Hong Kong system at present falls short of what will be required to find and implement solutions to its problems.

The Economic Transition

Hong Kong's present economic situation is the result of three linked processes: 1) the Thai currency and ensuing Asian crisis that started last summer; 2) the downturn of the domestic transition boom ; and 3) longer term problems concealed during the transition years. I will discuss the last of these first and then turn to the handling of the other two.

Over the long run, Hong Kong has had one of the highest growth rates of any economy in the post-Second World War era. The key features in recent years, however, have been a deceleration in the overall growth rate, the relocation of industrial activity to China (and elsewhere) and the continued rise of the service and property sectors. Some key data that summarize these trends are shown in Tables 1 and 2.
Table 1 Growth Rates of Real GDP, % per annum, 1961-1998
1961-73 9 1992 6.3
1973-75 1.3 1993 6.1
1975-80 11.6 1994 5.4
1980-92 6.4 1995 3.9
1992-97 5.1 1996 5
19981 [-4] 1997 5.2
1998-20002 5 1998 [-4]

1Official Preliminary
2Official Forecast, February 1998

Table 2 Structure of GDP: % Shares (current prices) 1970-1996

Year Manufacturing Services Other
1970 30.9 60.1 9
1980 23.7 67.5 8.8
1990 17.6 74.5 8.9
1996 7.2 84.4 8.4

Perhaps the most illuminating series that explain the evolving character of the economy are those for trends in domestic exports and re-exports shown in Table 3. We see here that while re-exports were less than half of domestic exports in 1980, they are currently more than six times as large. There has been both an absolute decline in domestic exports since 1992 and a sharply declining rate of growth of re-exports. These data account for the rapid change in output structure and also for similar shifts in employment. Table 4 shows the shifts between manufacturing and other sectors between 1991 and 1997.
Table 3 Domestic Exports and Re-exports, Growth Rates and Absolute Amounts, 1980-1997
Rates of Growth per Annum Domestic Exports Re-exports
1980-85 13.8 28.5
1985-92 8.8 30.8
1992-97 -2.0 12.5
Totals, current prices, in billions of HK$
1980 68.1 30
1997 211.4 1244.5

Table 4 Changes in the Distribution of the Labor Force, 1991 and 1997 (thousands)
1991 (Sept.) 1997 (Sept.) Absolute Change % Change
Total Employment 2751 3122 +371 +13
of which:
Manufacturing 655 309 -346 -53
Building/construction 64 78 +14 +22
Finance and banking 289 416 +129 +44
Retail/trade services 657 806 +149 +23
Restaurants and hotels 224 221 -3 -1
Other services 453 498 +45 +10

There are two schools of thought about the pattern of development these data reflect. One is that extreme specialization is the expected outcome of Hong Kong's reversion to its role as a metropolitan service provider for China and the East Asian region as a whole. In this view, statistical changes distort the de-industrialization process since many firms now classified as service providers are in fact still deeply engaged in the manufacturing chain but have relocated the manufacturing element of their activity out of Hong Kong. Analyses of the evolution of Hong Kong's role in the world textile trade provide interesting support for this view, which also sees reunification with the mainland as an unqualified gain that lowers transaction costs for still further specialization within the broad China region. This "golden scenario" is supported by top officials, by bankers such as Sir William Purves (Hong Kong Bank) and Dr. David Li (Bank of East Asia). It has also been regularly espoused in The Times of London by the influential columnist William Rees-Mogg.

The alternative view is that relocation of manufacturing has been mainly a defensive strategy by firms unwilling or unable to invest in the long-term process of technological up-grading. A combination of Hong Kong businessmen's preference for short term, "pirate" strategies (and especially the attractions of property development on formerly industrial sites), the failure of the financial sector to develop venture capital markets and institutions willing to lend on industrial projects, and failures of government policy in education and industrial support are cited as reasons for this strategy. According to this school of thought, successful innovation requires the closest integration of R&D, manufacturing, and marketing, and hence the danger for Hong Kong is that if firms split the "service" from the manufacturing elements in the production chain too sharply, they will remain stuck in their present trajectory of low technology activities, only remaining competitive by locating in ever cheaper and more distant labor cost regions. Eventually, even the service sector of Hong Kong may become vulnerable to competition as Chinese mainland cities accumulate skills and as changing technology undermines Hong Kong's advantages based on its harbor and container infrastructure.

Another problem with the current pattern of development is its impact on employment and income distribution. Comprehensive data on income (or indeed wealth) distribution are not available . But the reality of extreme income differentiation is not in doubt. In Hong Kong in 1996-97, shop assistants in large stores earned as little as HK$3,000 (about US$380) per month, and HK$8,000-HK$10,000 was the normal range for many semi-skilled manual occupations such as truck and bus driving. Meanwhile in the public services and professional sectors, significant numbers were on salaries of HK$50,000–100,000 and upwards. In the business sector monthly incomes of HK$1 million were commonplace. Surveys report that some chief executives were earning three times that amount, as well as other benefits in shares and kind. These differentials are hardly touched by direct taxation.

Estimates are that 20 percent of Hong Kong's households are living on HK$4,000 per month, and according to the Hong Kong Social Security Society, two-thirds of the workforce have had real income cuts during the past five years and are still receiving less than HK$10,000 per month. Given the inflow of labor during this period and the unfavorable and changing structure of demand for lower skilled work, these trends are exactly what one would predict.

Employment trends are equally disturbing. Trade unionists have long disputed the 2–3 percent range of the official unemployment figures, suggesting that a more accurate figure might be as high as 8–10 percent (and still higher today). The drastic employment restructuring illustrated in Table 4 must have had a major impact on labor markets; and the smooth absorption of those displaced by industrial relocation is improbable, particularly in the absence of large scale re-training schemes. The problem is that in Hong Kong as elsewhere, official figures hinge on intrinsically elusive definitions of both "employment" and the active labor force. Given the absence of social welfare provisions in Hong Kong, combined with inflation and other factors, pressures to work are high and hence it is likely that the actual participation rate (proportion of the population of working age in or seeking work) is higher than the official rate of 61 percent (which is about ten points lower, for example, than Japan's). If this is so, then structural unemployment is higher than officially estimated. Furthermore, in recent years many recorded as entering the "service" sector are probably family members who have been absorbed in family firms in what is essentially an income sharing device, where their net contribution to the economy is close to zero.

The Problems of 1997-98

The rise and fall of Hong Kong asset prices during the transition are indicated in Tables 5 and 6. Table 5 shows key turning points in the Hang Seng Index. Property prices are rather more elusive, but in Table 6 I have summarized average transaction prices in well-known apartment blocks as reported in the weekly property supplement of the South China Morning Post. For commercial rents, which reflect commercial property prices, I have quotations in Table 7 for Exchange Square at the top of the range, and for the more down market Bank of China Tower. The data in Table 5 show the sharp run up to the reversion in July, 1997, rising to a peak in the weeks immediately afterwards. The upper end of the range in August/October of this year partly reflects the impact of Government's intervention to support the market. Currently developers are selling new blocks at prices below development costs, and while no one is quite prepared to go on record as saying that prices have bottomed at this point, it is recognized that a further fall would have implications for the banking system.
Table 5 Representative Values for the Hang Seng Index, 1995-98
Jan.1995 8,000
Jan.1996 10,000
Jan.1997 14,000
July 1997 16,500
Sept.1997 9,000
Aug./Oct. 1998 6,600-10,000

Table 6 Index of Transaction Prices for Flats in Various Locations, 1996-98 (May 1996=100)
Happy Valley Ap Lei Chau Quarry Bay Shatin (New Territories)
May 1996 100 100 100 100
June 1997 158 142 153 148
May 1998 100 101 106 134
August 1998 78 72 90 84
Official index of flat price increases, 1992-96, 15.6% per annum

Table 7 Office Rentals, 1996-98, HK$ per sq. foot, per month
Exchange Square Bank of China Tower
May 1996 90 59
June 1997 80 56
May 1998 80 50
August 1998 70 46

As property prices rose in 1996–97, so did the number of transactions. By 1996 competition to buy new flats was so intense that for one block the coupon giving the right to stand first in line to place a deposit was worth HK$1.5 million (even for 104th in line HK$.4 million was considered a reasonable price to pay). Current transactions are running at about 25 percent of the peak level and a significant number of purchasers are left with negative equity. In extreme cases, purchasers made commitments that could not be honored because mortgage lenders would not provide the required loans.

What fuelled these extraordinary movements? First, in the case of property, these movements were an exaggeration of a fairly regular Hong Kong cycle. In the normal case, developers seek to buy land at government auction as near the bottom as possible and then to sell developed properties as near to the top as they can. The timing of the cycle is structured by the five year grace period allowed by the government for developers to undertake construction. For developers who time their transactions well, mark-ups over development costs are reported to be as high as 70 percent.

During 1996–97, additional factors fuelled both the property cycle and the share market. In the case of shares, domestic and international sentiment improved as uncertainties surrounding the transition were removed, dissipating the negative "Hong Kong" discount. These uncertainties included confirmation of the top leadership positions in the civil service and judiciary and the arrangements for the Provisional Legislature. The share market also reflected the strength of Wall Street and relatively low interest rates in 1996. These factors also helped property, which was further exceptionally supported by a large inflow of funds from both overseas and mainland Chinese. In the latter case, even quite small local government entities were reported to be on flat-buying sprees, aided by loose foreign exchange controls. These trends were so strong that some large luxury blocks became almost entirely investor rather than occupier owned.

The post-transition decline was prompted by changing sentiment and the defense of the Hong Kong dollar in the wake of the Asian crisis, and by the arrival of an "Asian" interest rate premium reflecting market valuation of Asian risks generally. In addition, the government announced a target of 85,000 residential units per annum to be built by public and private sectors and promised to support this target by appropriate land policies. Demand for property was further undermined by weaknesses in the real economy, particularly those originating in the tourism and retail sectors.

Interest rate factors are particularly crucial in Hong Kong. This is because developers without land banks can only participate in the business through auction purchases that are highly leveraged with bank loans. Purchasers, too, require large, bank-provided mortgages. According to research by Goldman Sachs, it is common for households to commit up to 70 percent or more of their income to repay the US$450,000 mortgage needed for a small flat costing US$650,000. On standard variable rate terms, therefore, the "Asian" premium alone could potentially put an intolerable strain on households. Finally, falling inflation in Hong Kong had ended several years of negative real interest rates before the final boom in 1997, and this structural weakness in property demand was a negative factor waiting to reassert itself as the boom subsided.

The most recent performance of the economy is shown in Table 8. The rise and fall of asset prices has been one factor in the deceleration and decline in the economy's growth rate. The decrease in tourists and the new Hong Kong airport's problems are additional factors. The role of the relative appreciation of the Hong Kong dollar in Asia is not yet clear. Surprisingly, businessmen in Hong Kong have found that their loss of price competitiveness vis-à-vis Southeast Asia has not yet been felt as strongly as might be expected because general dislocation and the credit crunch in competitor economies have made it difficult for them to respond to demand at any price. Hong Kong is expensive but still functioning. However, this advantage can only be temporary. In the longer run Hong Kong has to reduce costs either through exchange-rate adjustment or through the process of real wage and other cost reductions. It made such an adjustment (that is, reduced real wages through market forces) in 1973-74, in response to the oil shock, but the process is likely to be much more difficult and socially explosive under present circumstances.

Table 8 Recent Indicators of Performance, 1997-98
1997 3rd Quarter 1997 4th Quarter 1998 1st Quarter 1998 2nd Quarter
GDP +6.0% +2.7% -2.8% -5.5%
Unemployment rate (offical) 2.2% 2.5% 3.5% 4.0%-5.0%

The Environment

The environmental problems of Hong Kong have become acute in recent years. The clear blue skies of winter and the warm, swimmable seas of summer are now both rarities. The government has a variety of programs for monitoring, controlling and remedying problems and the current annual spending on the environment is about HK$8 billion. Nonetheless, the existing situation is probably the most discreditable legacy left by the former colonial administration. Time and again strong words were spoken and legislation enacted, but the political will to make these effective and override the business community was never present. The colonial system depended too much on business support, and prominent lawyers could be hired in defense of flagrant breaches of the law. The severe implications of this failure both for public health and the economy were never adequately grasped.

During 1996-98 several environmental disasters and developments have at last brought these issues to the forefront. In the case of air pollution, monitoring is relatively recent, but since 1995 alone, 10 major alerts have been issued requiring children, old people and anyone susceptible to respiratory problems to remain indoors. The levels of suspended particles in the air (especially PM10) are dangerously high in the dry season. The government uses a synthetic measure of six pollutants, and recent readings at street level have revealed pollution levels there up to 170 percent worse than those taken from the 17-20 meter high monitoring points normally used to establish the danger points. An estimated 2,000 people die prematurely each year due to these problems and the incidence of child asthma, emphysema and related complaints is rising. These problems are often worst in the New Territories; in Tuen Mun, for example, it was estimated that air pollution would double between 1996 and the year 2000.

In January 1998, Hong Kong was hit by the chicken flu virus. Eighteen people became seriously ill, of whom six died. This led to the total slaughter of the chicken stock--a horrifying and economically damaging event. Subsequent analyses showed that far from being an isolated accident, 20 percent of the chicken population carried the virus at the time of the outbreak.

Finally there is the sea, a source of continuing environmental anxiety. The government has been active in clean ups of the harbor and in monitoring and standard-setting in the coastal environment generally. But in April 1998, Hong Kong was affected by a "Red Tide" of marine algae from the north that killed most of the fish stock and left one to two thousand tons of dead fish floating in the sea. So confused was the handling of this disaster that the public was not even told whether the dead fish could be eaten or how long the clean-up process would take. In the same month the Guan Hang, a small vessel carrying ammonium chloride, sank in the sea off Tuen Mun causing the precautionary closing of some of the last of Hong Kong's "safe" beaches. Of the 400,000-500,000 vessels that pass through Hong Kong waters, a high proportion are similar craft, often carrying waste products of unknown type and origin, and many are scarcely able to float in the choppy waters of the inner harbor area.

The problem is that none of these incidents was a one-of-a-kind, unforeseeable disaster. On the contrary, they were manifestations of cumulative trends now intrinsically difficult to control, threatening the health and quality of life of the Hong Kong people. The economic price is also likely to be high, particularly in relation to tourism. The chicken flu was disastrous for the 1998 New Year tourist season (normally a peak period for Japanese and other visitors) and it ruined an attempt by Cathay Pacific to revive its fortunes with special offers during this period.

Tourism is estimated to be Hong Kong's second largest industry, accounting for around 8 percent of output and a higher share of employment. It is already severely affected by holding the currency peg at its current level of HK$7.8=US$1. Unlike Macao, Hong Kong has also undermined its intrinsic attractiveness by tearing down many colonial buildings. A reputation for environmental disasters and the rising trend in cases of food poisoning and cholera will only add to the difficulty in keeping up with competitors in the Asian market.

Financial Regulation

The final challenge of the transition period was financial regulation. Prior to the mid-1980s financial regulation of any kind was rare in Hong Kong. This was true of the stock exchanges, brokerage houses, banks and deposit-taking institutions of all kinds, until a series of incidents led to major changes. Most spectacular was the collapse of George Tan's Carrian Group. Tan was an illegal immigrant who, starting from a few minor deals in the 1970s, built up a property conglomerate that eventually employed 33,000 people. Tan established a string of off-the-peg companies (with such names as "Smart Money" and "Eager Earnings") to borrow large and ultimately unrecoverable sums. To the end, which came in October 1983, Tan was highly regarded by blue-chip banks and investment advisers in Hong Kong and London. The legal case against him lasted thirteen years and was only closed in 1996, at immense cost to the Hong Kong taxpayers.

In the downturn of the early 1980s, a number of smaller banks also got into trouble, usually from combinations of incompetence and fraud. Between June 1985 and March 1986, the government was obliged to take no less than four such banks into some form of public custody. As a result, a major program of financial regulation was initiated. This was partly to avoid recurrences and partly, by then, to provide a system capable of withstanding shocks in the reversion process and insulation from the kinds of commercial malpractice rampant across the border. Unfortunately this process has not been followed up with the vigor required. In April 1998, after publication of an extensive review of the financial and currency markets, the Financial Secretary said that "fine tuning" was all that was needed to improve them (South China Morning Post, April 24, 1998). But the downturn of 1997-98 revealed new problems in both regulation and the working of the peg. Three brokerages have gone into default, as has Peregrine Investment Holdings, one of Hong Kong's most prestigious investment houses. The turning point for Peregrine was the discovery of its US$200–$300 million exposure to an Indonesian Taxi Company called "Steady Safe," a name unfortunately reminiscent of George Tan's fund raisers. The total deficit for Peregrine was reported to be in excess of US$2 billion.

Although triggered by the Asian downturn, early warnings of these problems were available. Peregrine itself had recently been nominated by the Hong Kong Securities and Futures Commission as one of two companies to represent the territory in a survey of futures market practices undertaken by the Bank of International Settlements. The BIS subsequently reported that both companies fell "far short of key guidelines" and were only making satisfactory disclosures under 2 of 85 possible headings (South China Morning Post, November 10, 1996). Further, in May, 1998, the chairman of the Securities and Futures Commission, Anthony Neoh, described the Hong Kong Stock Exchange as "a private club" that was failing "to adequately supervise its broker members." Commenting on the Exchange's refusal to establish a compensation fund, he compared it unfavorably with the much publicized Maria's Cakeshop that, while going bankrupt, still went to great lengths to honor its free cookie tokens.

In thinking about this problem one must bear in mind that Hong Kong has only relatively recently emerged from the world of Chinese money shops--a world where loans are made by informal word-of-mouth and where family and business money cannot be meaningfully distinguished. The modernization of this world is well underway, but the impression given by glass skyscrapers and glossy computerization is a misleading indicator of how near to completion the process really is.

The First Year of the New System

If one looks at the political response to these problems, it is clear that within the constraints of current arrangements both the Chief Executive, Tung Chee-hwa, and the Chief Secretary, Anson Chan, have emerged from the year with credit. The Chief Secretary has played a crucial role in post-colonial continuity. This has been buttressed not only by her experience and ability, but also by the stature she gained in declining Beijing's invitation to take a premature "loyalty oath" to the Provisional Legislature. Instead, Mrs. Chan remained true to the old order until it was appropriate to transfer her allegiance to the new. Meanwhile Mr. Tung, battered by a politician's worst enemy--the unexpected--and hampered by colonial legacies, has shown real strengths. Although quite inexperienced in any form of popular politics, he has represented Hong Kong effectively abroad and begun some important initiatives at home.

Performance by officials in the economic sphere has been more problematic. Response to the Asian crisis and its domestic economic repercussions has been slow, failed until quite late to take account of the speculators' double play on Hang Seng Index futures and the currency, and appears to have paid too little attention to the regulatory defects that are emerging. There have also been moments of extreme political insensitivity and a failure to begin to fully rethink old economic ideologies. In the budgets of 1996 and 1997, before the turnover, the Financial Secretary, Sir Donald Tsang, was confident and optimistic. In mid-1996, worried about the economy overheating, he said "I expect much more money flowing [in] than we might be able to handle," and he dismissed as "ridiculous" mainland (Zhou Nan's) anxieties about Hong Kong's social spending budget commitments (South China Morning Post, June 30, 1996).

In Hong Kong's first budget as a Special Administrative Region of China, issued February 1998, Tsang estimated growth at 3.5 percent for the year, with several years at 5 percent thereafter. Some analysts were immediately concerned, noting the downturn in tourism, the completion of the airport, and the poor trends in both exports and re-exports. In March of this year, Mr. Joseph Yam, Head of the Hong Kong Monetary Authority, gave gung-ho speeches to meetings of bankers and analysts in Tokyo and London at which he blamed asset deflation on previous "irrational exuberance" and said that markets were working well. He concluded: "that is why the Hong Kong economy is not expected to be seriously affected by the [Asian] turmoil." He affirmed the 3.5 percent target and further commented: "The over-employment situation may ease; but, however one sees it, I hope unemployment would not become a serious problem." As late as May 24, 1998, the Financial Secretary said it would be "premature and unnecessary" to revise his budget forecast. Four days later the government admitted there was a downturn, and the July data confirmed what was already all too visible to everyone else. The economy is shrinking, unemployment is a serious issue, and asset and currency markets continue to weaken.

On August 14, 1998, the Hong Kong Government entered the share market in an attempt to frustrate speculators making the double play with August futures, and on September 5, new measures were announced in an effort to control and make more transparent any speculative activity. Among hedge funds with interests in the Hong Kong market were those associated with George Soros, who was reported to have a US$20 billion investment against the currency. However, when it is was rumored that Soros might be in Hong Kong in late August, Mr. Yam's only comment was, "I don't think I would have time to meet him." These recent financial moves have proved extremely controversial in Hong Kong (not to mention elsewhere), with some members of the business community in strong support but others highly critical.

Can Hong Kong Cope with Its Future?

How do Hong Kong's capabilities match up to the tasks ahead? First, it is important to emphasize how difficult any transition of this kind is bound to be. No post colonial transition has been easy, even though this particular transition was planned far ahead and by parties of high sophistication. The intrinsic problems to be addressed in creating a form of government that is both effective and socially acceptable have simply not been appreciated, particularly by those not directly involved. Given the shocks of the past year, it is remarkable that the system has survived as well as it has. Nonetheless, we need to look hard at this experience to take a sensible view of the future.

Let me start by enumerating the crucial problems that lie ahead, together with their social and political implications, and then relate these to the machinery and ethos of government in contemporary Hong Kong. The principal problems for economic strategy are, first, to resolve policies for the peg and to define government's role in relation to share and property markets and, second, to work out thinking for the long-term shape of the economy.

The peg poses the immediate problem of how can real costs be brought down without devaluation. No magic productivity formulae are going to solve this, and with a fixed peg and declining inflation, the process is now underway in the only form possible: attempted and imposed direct wage cuts in the private sector. This has already been shown to be immensely unpopular and divisive, partly because public sector sacrifices have been relatively modest and inequalities were in many cases high to start with. On the other hand, to abandon the peg would have serious costs for the financial services sector and for the real incomes of those in the public sector. This is an old colonial dilemma. British civil servants kept India on the gold standard to preserve the value of their pensions, thereby denying Indian industry a chance to compete against Japan and the silver standard economies in the late nineteenth century. In Hong Kong today, the issue still pits the interests of the employed against the unemployed, the public against the private sectors, and the financial against the manufacturing and tourism sectors.

The peg is also linked to the property market, although this is a problem that has been maturing for twenty years. High property prices in Hong Kong are no accident. They are the mechanism by which a regional metropolitan city asserts its specialization, forcing out lower productivity activities, including all but the highest technology manufacturing. The growth of the property development industry and rising government dependence on property-related revenues are natural consequences of this. In Hong Kong, this link has been reinforced by two unusual features of the territory: Crown, now Special Administrative Region, ownership of all freehold, and the large potential for land reclamation from the sea. These factors together are a license to print money.

Under the colonial system, market forces were softened by the provision of public housing and active land policies for industry. But these policies also have their problems, and the tension between narrow and broader concepts of economic efficiency and the conflict between these and social need is great. The challenge is to escape from the current crisis in a way that secures some balance between the demands of developers, government revenue and, in the private sector, of owners, near-owners, and those with no hope of ever owning a roof over their heads. (Those with no hope include the 10,000 people who live in cages, single people now waiting 13 years for public housing, and recent migrants.)

Finally, there is the issue of government intervention in the market for land and property. And, since the August 1998 decision to intervene to frustrate the double play, there is now also the new issue of government intervention in the stock market. August's intervention resulted in the government holding up to 15 percent of the value of the Hong Kong stock market, with what might be regarded as major positions in banking and property companies. These positions are technically large enough for it to seek control and justify a place on their boards. Such a situation is bound to create serious conflicts of interest when the government sets land, tax, and other policies.

In addition there is the problem of intervention in industry and technology policy. In the early 1980s, the Hong Kong government consciously rejected calls to guide firms in any way or to provide the financial and institutional infrastructure that would have been required to up-grade domestic industries. For a decade, the opportunities created by the accelerating reform movement in China provided an economic alternative to such processes. Now, however, the limitations of low-technology based regional specialization are becoming clearer, and Hong Kong is falling ever further behind Taiwan, Singapore, and other Asian economies in technological capabilities. Voices in favor of upgrading on the basis of government-guided research and development are again beginning to be heard. These include Dr. S. Y. Chung (an Executive Council member and a veteran of Hong Kong's higher education expansion); some Democratic and Liberal politicians; and in academia, Professor Charles Kao and local heads of universities. Interestingly, pro-Beijing figures are also critical of the colonial government's failure to support industry and appear to be gaining ground. The current government has committed itself to support the first Report of the Innovation and Technology Commission published in September 1998.

Can the Hong Kong system be expected to cope with these complex technical and politically charged issues? In my view, only with great difficulty. There are three aspects of government that need to be considered in this context. These are basic structure, ideology, and non-governmental intellectual resources.

Basic Government Structure

By basic structure, I refer to the roles of executive, legislature, and civil service. The core of the early postwar system was the governor, whose powers were largely exercised with the advice of the Executive Council (Exco), essentially a cabinet made up of the most senior government officials and a small group of important local citizens. Below Exco was the Legislative Council (Legco), on which served a somewhat more representative group of local members, both Chinese and expatriate. The key functions of Legco were to debate and pass the annual budget legislation in the spring and to hear and debate the governor's annual policy address in the autumn. Key Exco members also served on Legco, where they acted as intermediaries between the two bodies. The acceptability of this system rested on public acquiescence in Britain's role in Hong Kong and on the pragmatic balance of benefits and disadvantages experienced by the population as a whole. In the 1950s and 1960s, the benefits consisted mainly of public order and the legal framework needed to make a living.

The system was rocked by the Kowloon riots of 1966 and the Chinese Cultural Revolution, but in 1972 Hong Kong's key modern governor, Sir (later Lord) Murray MacLehose, appeared on the scene. MacLehose first broadened the representative character of Legco by appointing from a wider social band than had been usual. Then, in 1980, he initiated a democratization process through reform of local government. This was a subtle maneuver in which functional rather than any abstract considerations were emphasized. At the same time, using land sales and related revenues, MacLehose financed an expansion of housing, education, and other social welfare expenditures. The combination of political and economic improvement did much to reestablish local acceptability of the system. The long-term issue then became how far the direct democratic principle would be extended, particularly in Legco. Beijing ultimately rejected the Patten version of this process and the planned "Through Train" Legco was supplanted by a one-year arrangement for a Provisional Legislature, with an election under a new system (approved by Beijing) to be held in 1998. The key role in selecting the Chief Executive and the Provisional Legco and in setting up the post-1997 electoral system for Legco has been played by a Beijing-appointed selection committee.

Since the first election in May 1998, we now have a Chief Executive appointed through a process that ensures a paramount say for Beijing; an Exco appointed by the Chief Executive; and one-third of Legco elected by direct popular vote, with the balance coming from functional constituencies and a Beijing-controlled selection committee. In relation to the policy issues discussed above, there are several problems with this structure. First is the excessive dominance of business-related appointees. This was always a danger under the colonial system. In the nineteenth century, London ensured that the merchant interest was kept under control, and although London's role clearly declined in modern times, it was always a backstop factor ensuring that some account be taken of wider social interests. (A good example of this backstop role was the Labor government's concern with trade union rights in Hong Kong in the 1970s.) Today, Beijing is in the backstop position. Before the reversion, Beijing was indeed quite active in playing this role, notably (through the Xinhua News Agency) in complaining about the social implications of rising property prices in the 1990s. But now any such intervention would be extremely controversial, since it would be seen as violating the principle of "Hong Kong people running Hong Kong." The Chief Executive is therefore on his own with a cabinet largely drawn from a narrow constituency.

The second problem is that the current system perpetuates the division between Legco and Exco initiated by Patten. (There is only one common member, and his role is regarded as controversial.) This makes the possibility of Legco/Exco clashes a real one, and although Legco now has less power than in pre-1997, it can still create serious trouble by refusing to pass legislation, including the budget.

What about the civil service? During the 1990s, the civil service has been subject to three new pressures. The first was localization--that is, replacing British officials with Hong Kong Chinese. In terms of the top positions and the heavy leadership responsibilities that go with them, localization only goes back to the mid-1990s. Moreover, since under the old system the second-line departments headed by local civil servants had key policies heavily constrained by policy direction and budget guidelines from above, all levels of the government have been finding their way in an unfamiliar world.

Second, the civil service has been subject to political pressures. This was a problem under Patten, who created some unease by seeking civil service support for his reforms. Beijing followed suit, attempting to legitimize the Provisional Legislature by asking for civil service "loyalty oaths" and conducting pre-handover "interviews" with top officials.

Another source of pressure has been changes flowing from the democratization of Legco. Although the government has never needed or sought a "government party" as such, introduction of directly elected members (even though they are in a minority) revolutionized the scale and depth of questioning and open criticism of government activity. This has been particularly important in relation to finance, but also for other departments of popular concern. Officials now have to respond to these demands. In the early stages some were visibly not up to the task and were hopelessly at sea on television, for example, when faced with well-briefed interviewers. Others, however, have warmed to the new world with enthusiasm and skill. This leads to a further question: what precisely is the role of a policy secretary in a major branch of government? In the past they were ministers in all but name but usually not public figures. Now, any policy secretary can, if his department is on the firing line, become a public figure. Are they in fact ministers? Or are they, on the Japanese pattern, permanent deputy ministers? And what are the role and status of the unofficial Executive Council members who make up the "cabinet?" Some of them clearly have specialized expertise and policy agendas they are pursuing in Exco and the public domain--agendas that overlap the domain of government departments.

Finally, there is the problem of the colonial legacy in certain key government positions. The top Hong Kong official in economic policy is very much defined by his job title: Financial Secretary. Under the colonial system this title and its implied focus were appropriate, as the priority of London was to ensure that the colonies were financially self-sufficient. The main job of the Financial Secretary and his department was thus to deal with budgetary and related financial matters. The new task, to think about government policy, is much wider and very different from that required by the colonial system.

Ideology

Structures are one thing, but to understand how they operate one must also look at the ideologies of the actors. Here I will touch on only two issues. First is the principle of "One Country, Two Systems."

Of the three parties to the Hong Kong negotiations, this slogan served London best. It enabled London to reassure the public and investors in the run-up to reversion by emphasizing the continuity of Hong Kong's way of life and the preservation of its system. The more binding the detail that was provided, the better people felt about it. For China, however, the principle presented a problem. First, Party members in China wanted to know why this concession was allowed to Hong Kong; and second, they could ask a simple question: if Hong Kong's "current social and economic systems . . . life style . . . rights and freedoms . . . etc." (as described in the Joint Declaration of 1984) were indeed the key to success, as Hong Kongers maintained, why could they not be speedily transferred to the mainland? This question must have been asked many times, since in 1996 President Jiang Zemin finally responded by denying that Hong Kong's inherited system and rights were the key to its success, ascribing it instead to China's open door policy and the Chinese people's efforts--both of course now available on the mainland. For Hong Kong itself, the formula is also a problem. While on the one hand Hong Kong wants the reassurance of continuity and non-interference by Beijing in domestic affairs, the fact is that Hong Kong's system and ways of life have been in continuous and rapid evolution since the 1960s, and any attempt to impose a fifty-year freeze is likely to be damaging to the thinking and changes needed to advance into the future.

The constraints on Hong Kong posed by old economic ideologies also comes into play. For example, when the government entered the stock market in August, Mr. Yam of the Monetary Authority entered a vigorous defense of the government's action. Most remarkable about at least one version of this, however, was Mr. Yam's concern to show that what had been done was in direct continuity with Hong Kong's model of laissez faire. Indeed, he argued that it fell within the definition of acceptable intervention laid down by a former Financial Secretary, Sir Philip Haddon-Cave.

Sir Philip was certainly one of the three seminal Financial Secretaries in Hong Kong's post war history, responsible for several important innovations in financial policy. As a former lecturer, Sir Philip was inclined to theorize, notably in his elaboration of various "ratios" designed to ensure Hong Kong's sound financial management. These were all of value in their day, but to justify Hong Kong's policy in the world of the late 1990s in terms of ideas a quarter of a century old is both extraordinary and somewhat alarming. It is hardly surprising that Hong Kong politicians in dialogue with the bureaucracy this summer over desperately serious issues described officials as "too old-fashioned and inflexible in their thinking" (South China Morning Post, June 16, 1998).

Fortunately, this reverence for old colonial ideas seems selective. In the early 1980s various schemes for industrial policy in a broad sense were put to the government, including a proposal to give the universities HK$40 million (US$5 million) over three years for research on technology and development. This proposal was turned down on the advice of the Financial Secretary, who remarked to me at the time that he was worried academics could spend any amount of money available on research. He also said that while the proposal might have had some merit, it "came in too expensive at $40 million." Last month the new Hong Kong government decided to establish a HK$5 billion dollar fund to support technology and research, and as far as I know not a word of dissent has been uttered by the financial establishment.

The Policy Community

One last obstacle to good policy-making in Hong Kong is the absence of a strong policy community outside of government but capable of providing research, critical thinking, and debate of use to it. Here Hong Kong has a peculiar problem in that it is a community so small that the government, private sector, and intellectual elites know each other well and have interests that interlock closely--particularly with the recent trend toward careers that start in the public and end in the private sector. The result is not only that the bureaucracy is tending to weaken in relation to its demands on the private sector, but also that there are few people with the ability and freedom to make up the kind of critical community of policy makers that is commonplace in most democracies.

Hong Kong is also deficient in well-funded think-tanks. This, again, reflects a weakness inherited from the British system in which public funding dominates in education and the governing elites are not really convinced that research into public policy is necessary or desirable. A good illustration of all this is Made By Hong Kong (1997). This report is an excellent job by a visiting group from MIT that had government support and some public funding. Nonetheless, this detailed research on an issue so central to Hong Kong's future rested on what was basically a private initiative, undertaken by researchers from thousands of miles away who were relatively unfamiliar with the region.

To address its economic policies Hong Kong needs a policy community, the civil service, the legislature, and the "cabinet" all playing well-defined roles and engaged in processes wherein the public feels both informed and represented. As it is, the tensions arising from current problems are already spilling into the streets, the courts, the press, and various platforms of the public arena, as vested interests and policy barons seek to preempt the arguments and impose their views.

All these arguments are reinforced by the environmental problem, which is a far more intractable issue than the peg and macroeconomic policy. In the long run, the exchange rate is a trivial matter compared to poisoning the public's supplies of air and water. Past failures in this field partly reflect excessive political dependence of the colonial government on the business elite. That situation has not changed, and only elected power can counter-balance vested interests. There is, however, a further dimension. Every one of the environmental incidents discussed earlier has links to the mainland. Air pollution is worsened by old trucks and drifting construction dust from the mainland. "Red Tides" and water pollution are caused by untreated sewage effluent and marine accidents. (In Shenzhen only 10 percent of household waste is treated and the situation is similar in cities further up the coast.) Many experts also believe that the chicken flu must have originated with the chicken stocks on the mainland. As the South China Morning Post summed it up two years ago, the mainland border is "The Frontier of Filth" (July 27, 1996). The mainland authorities are aware of the problems and are seeking to collaborate with Hong Kong to limit the damage. But effective action will require the Hong Kong government to face up to the mainland authorities as vigorously as they must face up to domestic vested interests. They will not be able to do this without the unambiguous support of the population, and for this reason alone government by opinion poll and phone-in program can only have a limited future in Hong Kong.

The colonial legacy of Hong Kong and the peculiar circumstances of its post-colonial transition have placed enormous emphasis on detailed continuity with the past--something that would have been regarded as absurd under other circumstances. In actual fact, a minimalist approach to government that arose quite naturally out of the colonial situation in the 1950s and 1960s was later overlaid by a sprinkling of fashionable laissez-faire thinking to which it had no organic connection. Therefore, both structures and habits of thought will need to be revised if Hong Kong is to achieve the economic and social potential that British framers of the Joint Declaration hoped for. The alternative future could be a dangerous synthesis of irresponsible market and state capitalism in Hong Kong and China, in the short run feeding on each other, but in the long run heading for a common downfall.

CHRISTOPHER HOWE is Professor of Economics of Asia at the University of London and a regular visitor to Hong Kong since 1965. His most recent books include Origins of Japanese Trade Supremacy: Development and Technology in Asia from 1540 to the Pacific War (Chicago, 1996) and (with Charles Feinstein) Chinese Technology Transfer in the 1990s (Edward Elgar, 1997).


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