The way this world works - like it or not

South China Morning Post  |  Sep 30, 2002

By Sin-ming Shaw

IT IS OFFICIAL. Chief Executive Tung Chee-hwa and Financial Secretary Antony Leung Kam-chung have both said the government will do "something" to support the property market to reduce deflation in Hong Kong. Mr Tung even promised to push the market "up a bit".

If higher property prices mean a better Hong Kong, all the government has to do is announce that for the next 10 years it will sell no land by auction or by private treaty, build no subsidised flats, and reinstitute a height limit on buildings on the Kowloon peninsula. There can be no doubt prices will go up and property stocks will rebound sharply. The only uncertainty is by how much.

But then what? How long will these prices remain high? Will the economy recover? Hong Kong is in deflation for two principal reasons. First, the world is finding the mainland an increasingly profitable alternative.

In technical terms preferred by Morgan Stanley economist Andy Xie Guozhong, investors are arbitraging between Hong Kong and China, especially Guangdong.

If two areas are producing the same goods or services, the prices, over time, should be the same in both societies save for transaction costs (transport, exchange risks) or country risks (legal, political, social and the like). There are fewer and fewer such barriers separating Hong Kong and Guangdong, except in the financial business. Hong Kong has a convertible currency and a financial infrastructure that is part of global finance. China does not - at least not officially.

Much of anything else Hong Kong can do - logistics, tourism, even education - Guangdong, Shanghai or Beijing can do as well. In arbitrage, the end result is straightforward: prices (including wages) in these two separate economic domains will converge. This means Hong Kong prices have some way to fall.

The Hong Kong dollar is over-valued. As long as the nominal rate of 7.8 to the US dollar remains unchanged, then the real rate of exchange must adjust. The adjustment process is better known as deflation. The decline of the property market is just one manifestation of that process.

Pro-peg diehards argue real estate is a "non-traded" good and hence irrelevant to the over-valuation calculus. It is true the Robinson Road flat cannot be moved to Shenzhen or Shanghai, but the "services" that flat provides can be relocated. The most important service a flat provides, other than shelter, is proximity to gainful employment and future income prospects. If a flat in Shanghai costs a small fraction of one in Hong Kong, and if the occupant can do a similar job up north, then there is no point in keeping that person in Hong Kong. The immovable flat is, indeed, irrelevant to the argument about non-traded goods.

Hence the demand for Hong Kong real estate falls relative to its competition. Today it may be Shanghai, tomorrow it could be somewhere else. Human capital, like financial capital, is highly mobile. As the world moves away from a hardware-centred world to one dominated by software, or brain power, it is increasingly important to look at the content of services provided instead of focusing on real estate that seems non-traded but in fact has substitutions.

Contrary to popular perception, the fixed nominal rate of 7.8 has brought only superficial stability. Hong Kong's core growth has declined over the past 20 years to a low single digit while bringing huge swings in the property market. A flexible exchange rate would not have resulted in years of negative real rates of interest and would have choked off speculative capital inflow into the property market because the nominal exchange rate would have appreciated.

Now Hong Kong has an over-valued exchange rate that is fixed, and that demands deflation as a price for its nominal stability.

The second reason for declining property prices has to do with the nature of bubbles. Just about every bubble in the history of bubbles declined by at least 80 per cent from its peak. The most recent exhibit is PCCW. Its share price on Friday of HK$1.14 is down by more than 96 per cent from its high. That is not totally abnormal in historical context.

The ever-changing official SAR attitude about land prices reflects a fundamental misconception about what makes an economy grow, as well as the government's own role in that process. Growth means profits, reinvestments, jobs and the confidence that job prospects are secure. Sound growth comes from businesses making a profit by doing things on a recurrent basis, by reinvesting, creating jobs, but not by trading assets which are considered non-recurrent.

Boosting property prices by administrative measures can only have a short-term, one-off impact, without a lasting consequence on economic activities. Hong Kong should have learned by now the bitter lesson of asset inflation mis-labelled as growth. Growth in Hong Kong has to come from productivity. Productivity has to do with what you can create in goods or services at a competitive price. Globalisation means competitors who have a winning idea can eat your next lunch at a speed unimaginable only 10 years ago. For Hong Kong, there is a competitor an hour away and whose currency, the yuan, is grossly undervalued against the Hong Kong dollar, and hence, against the US dollar.

That under-valuation is the principal reason for its phenomenal export growth. The export growth in hard goods has translated into re-export margins, read profits, for Hong Kong manufacturers and investors who have wisely poured their overvalued Hong Kong money into undervalued yuan assets. For the past two decades or so, Hong Kong has been living off the returns on investments in China. The Hong Kong government can try once again to fiddle with its land policy to support the market. Unfortunately this government will not be able to change the deflationary forces demanded by a fixed nominal exchange rate that is overvalued. The best thing it can do is to institute a clear, transparent, rules-based, land supply policy, the way the US Federal Reserve Bank prints money.

It should announce a quantitative target and then live within the allowable margins of error. That target could be 50 hectares, zero or 200 hectares a year. But announce it and then get out of the real-estate business totally. There are no free lunches. If you want a stable nominal exchange rate, you can have it. The price of that is that prices of the entire economy will fluctuate up and down as they have done in Hong Kong.

The more overvalued it is, the more domestic prices need to fall. Further, the more efficient China becomes, the more its nominal exchange rate, now fixed, becomes undervalued, which will prolong Hong Kong's deflation.

While the economics strongly favours a much lower Hong Kong dollar, the institutional prerequisites do not exist to support a change.

Hong Kong has a credibility problem in its economic management and it lacks a properly staffed potential central bank - both necessary for a successful regime change.

Property prices in Hong Kong are down 60-65 per cent from their peak. If an 80-85 per cent decline is what defines a bubble bursting, then another 30-40 per cent decline from today's level should not be considered extraordinary. You may not like it, but that's the way the world works.

The government can stop that decline by a zero-growth land policy. The price of that policy would be to drive Hong Kong further down the path taken by Japan. There are no free lunches in this world.

The government leaders should be honest with its citizens about the dilemma and not promise more than they can deliver.

Sin-ming Shaw is a visiting fellow at St Antony's College, Oxford University

Don't cry for the SAR . . . at least not yet

South China Morning Post  |  Sep 11, 2002

By Sin-ming Shaw

Byline: While it may not be on the brink of financial meltdown, Sin-ming Shaw writes that there are parallels between Argentina and Hong Kong

IS HONG KONG the "next Argentina"? Don't dismiss the comparison so readily.

The perception of Argentina is that it is a laid-back Latin country, mismanaged by leaders better at tango or drug-trafficking than public governance.

Before the peso collapsed last year, the country supposedly was heavily in debt, had a weak banking system and a public sector that was a bottomless pit. Further, the yawning gap between the rich and the poor was a social disaster waiting to happen. And it did.

According to conventional wisdom, Hong Kong cannot possibly become another Argentina. The SAR has a workaholic labour force, a strong banking system, abundant reserves and a public sector surely smaller than any of the Latin countries. It has no foreign debt to service. The people, imbued with Confucian values, respect authority and shun disorder.

Look closer. Argentina and Hong Kong have both relied on currency boards to regulate their exchange rates. The Argentine peso was fixed at one to the US dollar for nearly a decade, the Hong Kong dollar for nearly two decades at 7.8 to the greenback.

In 1998, the International Monetary Fund (IMF) praised Argentina for its prudent financial management and its currency board. In May of this year, the IMF gave Hong Kong a clean bill of heath, upholding the linked exchange rate system as ideal for the territory.

In 1998, the World Bank gave Argentina and Hong Kong the same score of 21 in terms of how well banks were regulated among a list of 11 potential problem countries. Indonesia, the worst, scored a 51. Singapore, the best, got a rating of 16. In terms of capital adequacy, Argentina and Singapore were rated 1, Hong Kong got a 3. Smaller numbers indicated a higher performance in the rating.

The public sector in Argentina in 2000 consumed about 24 per cent of gross domestic product (GDP), roughly the same as Hong Kong today. The SAR budget deficit is running at 5.5 per cent of GDP, against only 2.5 per cent for Argentina in 1997-98, and 3.6 per cent in 2000. Public-sector employment here is about 10 per cent of the labour force, against 12.5 per cent in Argentina.

Debt? In Argentina, domestic debt was 41 per cent of GDP in 1998, well below the 60 per cent ceiling imposed by the Maastricht Treaty on countries of the European Union. Total foreign debt was 51 per cent of GDP in 2000, better than several European Union countries. The IMF was clearly not worried in 1998. Malaysia's external debt was over 60 per cent. Hong Kong has no public debt, but external private debt is 220 per cent of GDP.

Anne Krueger, deputy managing director of the IMF, speaking with 20/20 hindsight in July this year, observed that there were essentially two factors that broke Argentina -  an overvalued peso, now above 3.6 to the US dollar, and an increasingly weak fiscal policy. That being so, then Hong Kong should be on red alert for it also faces these two problems.

Recent figures confirm SAR deficits are between $60 to $70 billion a year. At this rate, official reserves will evaporate in five years. If the deficit continues at this level for another year, it will convince financial markets that a currency crisis is a matter of when, not if.

Raising taxes to balance the budget now or later in a deflating economy would further depress demand and stifle growth. There is only one way out. The government must drastically cut its deficits.

The SAR pays 70 per cent of its budget in salaries. The over-paid civil service has agreed only to a two per cent cut after 30,000 officials took to the streets. The chief executive, lacking a mandate from universal suffrage, seems swayed easily by street politics.

Ministers can get $4 million a year. Some at such institutions as the Hong Kong Monetary Authority (HKMA) make more than $8 million. Shouldn't the wages of these public servants be cut more than the rank and file? Besides, the top 3.7 per cent of the civil service - fewer than 4,000 officers - receives 21 per cent of all salary outlays. The top 13.5 per cent get 52 per cent of outlays. The bottom 67 per cent receives a mere 8.2 per cent of the total.

An across-the-board cut is neither fair nor effective. The public pays local academics, part of the public sector, a 40 per cent premium over the top US payer, Harvard University. Are we that good?

Backed by huge reserves, the Hong Kong dollar is supposedly impregnable. However, it is, by most estimates, roughly 40 per cent overvalued against the US dollar and twice that against the yuan, prolonging deflation.

The 7.8 peg against the US dollar will stay only as long as holders of Hong Kong dollars remain confident the rate will not change. If enough lose conviction and wish to convert to other currencies, they will drive interest rates to a level that no society could tolerate without unrest. In Argentina, the end game began when its citizens lost confidence in the currency.

Would floating the currency now be a viable option, even if the chief executive were to go back on his commitment to the 7.8 peg for five more years? No. Hong Kong lacks a proper central bank. Without it, a float could be disastrous.

The HKMA is not a central bank but a bank regulator with central bank ambitions. No senior staff have the appropriate education or the experience to conduct monetary policy.

The late Merton Miller, Nobel laureate in economics, said at a Legislative Council hearing in November 1998: "Joseph Yam [head of the HKMA] and I have somewhat different educational and professional backgrounds, and sometimes it turns out when we are discussing matters, he's talking about one thing and I'm talking about something else, even though the words are sometimes essentially the same."

The HKMA must be re-staffed before a float can even be contemplated.

The gap between the rich and the poor in Hong Kong is widening.

The Gini coefficient, a measure of income distribution, for Hong Kong stands at 0.53. In 1996 it was 0.476. The benchmark ratio of one means that one person gets all the income, the rest nothing. A zero means even distribution. Argentina's Gini coefficient was 0.49 in 1999, the same as the Philippines. China is at 0.42.

Hong Kong is under social stress. Polls show low and declining respect for top government leaders and for all political parties.

A month ago more than 500 triad members flaunted their presence in a prime tourist district in broad daylight.

Several months ago, the police chief openly challenged action by the head of the Independent Commission Against Corruption against a senior police officer. The row raged for more than a week, even after the chief executive reportedly had ordered the policeman to pipe down.

Hong Kong is not quite Argentina yet, but there are disturbing signs. Let's hope the world will not have to cry for Hong Kong one day.

Sin-ming Shaw, former chief international economist of The Capital Group and head of its office in Hong Kong, is a visiting scholar at St. Antony's College, Oxford University

Taxpayers' cash not for venturing, Mr Minister

South China Morning Post  |  Jul 12, 2002

By Sin-ming Shaw

ONLY TWO WEEKS into their job, some of the policy signals the cabinet has sent out are alarming.

The new Secretary for Commerce, Industry and Technology, Henry Tang Ying-yen, is considering investing public money in small and medium-sized enterprises to boost the economy.

All he needs to do is to call Premier Zhu Rongji and hear from China's top manager how much public money the country has wasted on businesses best left to risk-taking entrepreneurs.

Once a firm has public money involved, can the Hong Kong government allow it to go under if the investment does not pan out? How many demonstrations can Mr Tang ignore by laid-off workers if projects were allowed to go under?

Granted, not all government projects lose money. Those that do not are typically monopolies such as those for tobacco or alcohol. Not all public monopolies can make money, either; airlines are an example.

Small and medium-sized firms are by definition firms that have a lower barrier to entry - unless they have a unique intellectual property. If a company developed an operating system that could make Windows XP eat dust, it would certainly be a profitable project. If so, the company would have to fight off investors around the world trying to throw money at it.

Someone should give Mr Tang a quick tutorial on investments. The world is not short of money, only ideas. Bad ideas need government equity; good ones do not.

It is puzzling that the scion of a textile fortune, all made on private initiatives over two previous generations, wants to spend taxpayers' money playing venture capitalist. On second thoughts, maybe it is not so surprising.

Mr Tang has inherited money. But someone should remind him that it is taxpayers' money he wants to play with, not money from his family or friends.

Public investments have long had a disreputable record, and not just in China. The world is littered with money-losing public projects begun with the best of intentions.

The Europeans did not want commercial aviation dominated by Boeing. So they built the Airbus. The engineering is excellent. Even the Americans buy them. But Airbus still lives off taxpayer subsidies as it cannot turn a profit.

Once government assumes the role of investing money to make more, the supply of bad ideas usually is endless. Each of them can be counted on having at least one impeccable social objective such as providing employment.

As secretary of industry, commerce and technology, Mr Tang does have a useful role to play. If his contacts in Beijing are really as good as many presume, he should use them to help Hong Kong-owned firms in southern China get proper legal protection from corrupt official squeezers who have become a routine fact of life.

If he did just that and did it well, he would be a hero to Hong Kong's true wealth creators. Mr Tang should also organise more encounters between university engineering departments and local manufacturers to transfer know-how to the factory floor.

Hong Kong's true strengths are in medium-tech manufacturing. The prime exhibit is Johnson Electric. It is a world-class company with a near monopoly in supplying micro-motors to the best luxury vehicles in the world.

Johnson Electric is essentially a 19th century mechanical engineering firm updated with modern precision technology that has very little to do with "hi-tech". It became successful without any public handout. Nor has any successful Hong Kong commercial or industrial firm received any government subsidy.

Financial Secretary Antony Leung Kam-chung wants to raise taxes next year. He is worried about fiscal deficits that just refuse to go away. Since he cannot get the public servants to cut their wages voluntarily, he feels part of the solution is to increase taxes. But he is wrong to do so because he has not exhausted his options.

Rank-and-file civil servants are not going to take serious pay cuts lying down when senior public servants such as Hong Kong Monetary Authority chief executive Joseph Yam Chi-kwong, his deputies and those at other public service bodies make twice as much as Chief Executive Tung Chee-hwa.

If Mr Leung were to cut by at least 50 per cent the wages of the multi-millionaire public servants, then he could look the civil service in the eye.

Salaries at other subvented or semi-public institutions are equally appalling.

The combined salaries of the Hong Kong Stock Exchange and the Securities and Futures Commission last year were $841 million - about 10 per cent of the incomes received by every broker in the world trading through our stock exchange.

If the best ideas this cabinet can come up with consist of throwing public money at smaller enterprises or increasing taxes, then perhaps one cannot expect too much from Hong Kong's "first and best team".

Sin-ming Shaw is a writer and private investor

The Suicide of Hong Kong

Project Syndicate  |  Jul 1, 2002

By Sin-ming Shaw

China has been celebrating the five year anniversary of Hong Kong's return to the motherland from British rule. Firecrackers, dragon dancers, and President Jiang Zemin's visit marked the festivities. Now that China's rulers have returned to Beijing, it is time to take a more realistic look at what those five years have wrought.

Hong Kong's ruling elite delights in telling foreign visitors how wrong pessimistic predictions of the territory's have proven to be. Fortune, for example, once entitled a cover story "The Death of Hong Kong." That article forecast heavy-handed meddling by Beijing in local affairs, which would allegedly emasculate the vitality of Hong Kong's economy. The article was wrong, because Hong Kong's deepest wounds have not come from China's ruler, but are self-inflicted.

Tung Chee Hwa, Hong Kong's leader, insists that the "one country, two systems" scheme devised by Deng Xiaoping works perfectly. The Financial Secretary, Anthony Leung, last year boasted that Hong Kong would become Asia's "Manhattan Plus." Chief Secretary Sir Donal Tsang calls negative assessments of the territory the product of second-rate minds.

But official bravura has little sympathy beyond this narrow circle. Among Hong Kong's public, there is a pervasive feeling that it has changed for the worse since 1997 -- not as a result of overweening interference from Beijing, but due to worrisome decisions made by local rulers.

Mr. Tung, the scion of a shipping empire, and his tycoon friends like to blame Britain's colonial government for leaving behind "time bombs" that make Hong Kong look bad. In 1998, for example, the government led a chorus blaming the British for the property price bubble that was punctured by Asia's financial crisis of 1997, causing the stock market to fall sharply. But the bubble was really manufactured by China's communist rulers over a decade earlier on the advice of local property magnates, who wanted to limit the amount of land British colonials were permitted to sell.

Local officials soon began to broaden their attack. In 1999, the government sought and received the Beijing government's direct intervention to overturn a decision by Hong Kong's Court of Final Appeals on an immigration issue because the verdict did not please the government. Humbled and humiliated, the Court has acted timidly since. Locals now call it the "Court of Semi-Final Appeals."

In 2000, one of Mr. Tung's political aides called on the president of the prestigious University of Hong Kong to express concern over a faculty member's opinion polls, which consistently recorded Mr. Tung's declining popularity. Soon after the meeting, senior university officials warned the pollster that further funding for his work might not be forthcoming.

Robert Kuok, the Malaysian owner of Hong Kong's major English language newspaper, the South China Morning Post , is one of Mr. Tung's friends and fiercely loyal to China's leaders. In 2001, the journalist Willy Lam, a respected China expert, was sacked from the paper after Mr Kuok publicly berated him for his views on China's rulers.

President Jiang and China's rulers have had very little, if anything, to do with any of these decisions. They were taken because Mr. Tung and his allies wish to demonstrate how in tune they are with official thinking on the mainland. But are they in tune?

The presumption that China wants Hong Kong to become more like the mainland is ludicrous. China has had entirely too much of the "one country." What it wants now is the "two systems." China's search for an alternative social and economic arrangement became urgent with the student revolt of 1989, the subsequent Tienanmien massacre, and the collapse of the Soviet Bloc. The Chinese communist party knew it had a legitimacy problem, and the driving idea behind Deng's ingenuous formula was to allow Hong Kong to show China a short cut to prosperity.

True, China's ruling elite remains a Leninist party prepared to crush all potential threats to its monopoly of power. Yet many officials working directly under the party leaders are earnestly scrutinizing western countries for institutional details that might shed light on what China can do for itself in the future. In other words, China is looking for a new system to replace the existing one.

Mr. Tung, whose moral precepts are informed by a doctrinaire interpretation of Confucian classics emphasizing obedience to one's superiors, seems oblivious to what China views as the fundamental challenge that it now faces. Instead, his behavior is reminiscent of a feudal district official whose main priority is to ensure that his superiors are treated with due reverence.

Nor is Mr. Tung alone. Much of Hong Kong's elite shares the same mindset, despite their training in Western business schools and their fortunes gained from property trading. Their priority is to nurture a cozy relationship with Chinese officialdom -- much of which can be easily bought. Whether Hong Kong remains an open, liberal society has never been a major issue for them.

One senior Chinese cadre doing graduate work at Harvard recently uttered in amazement that Hong Kong, with its leaders acquiescing dutifully in every inane utterance by China's rulers, struck him as more "leftist" than the mainland. Indeed, many Chinese officials privately laugh at Mr. Tung and his cronies sycophantic behavior and are increasingly confident that the mainland has nothing to learn from Hong Kong's example. What China regards as Hong Kong's comedy of deference is quickly becoming a tragedy of errors for Hong Kong's citizens.
Sin-ming Shaw is a leading investor in Hong Kong.
Copyright: Project Syndicate, July 2002