What’s unusual about Hong Kong’s decision to peg its currency to the US dollar in 1983 is that this was a political decision, rather than an economic one.  So Hong Kong’s subsequent development is both economically and politically influenced.

Background

In 1839 and again in 1856, Great Britain invaded China to force Beijing not to ban the trade in opium,  which Britain supplied from India and which was a key factor in its economic health.

At the end of the First Opium War, Britain also compelled China to give up Hong Kong Island; at the end of the Second Opium War, China was forced to give up Kowloon, a narrow strip of the mainland directly opposite Hong Kong Island, as well.  In 1898, Britain obtained a 99-year lease on the New Territories, a tract about 10x the size of Hong Kong Island, consisting of land surrounding Kowloon and a number of adjacent islands, including Lantau Island (where today’s Hong Kong airport and Disneyland stand).  These three areas comprised the Crown Colony of Hong Kong.

The Handover

In 1979, the British government approached Beijing about extending the lease on the New Territories.  Deng Xiaoping’s reply was that not only the New Territories but also the rest of the colony must be returned to China. China made this position public in 1982.  Britain agreed to China’s demands in 1984.  Handover was set for July 1, 1997.  For at least the following fifty years, China promised that Hong Kong would be run autonomously under its existing political system.

What to do?

Put yourself in the place of an ethnic Chinese citizen of Hong Kong in 1982.  Your family may well have fled the mainland in the late Forties, losing most of its wealth in the process.  You would have had a front row seat to witness the Cultural Revolution.   You would know that there was no love lost between China and Britain, not least because of the opium trade and the burning of the Old Summer Palace in Beijing.  And here you are, wearing western clothes, speaking English on the job, likely working for a British company–maybe even for one of the conglomerates that the old opium trading companies had become.

At first blush, your position doesn’t look so good.  Who knows what living conditions will be like after the Handover?  Will your wealth be confiscated?  More than that, your daily working life could easily be construed as one continuous effort to undermine socialism, and therefore a serious political crime, requiring some sort of hard labor “rehabilitation.”.

So you have to prepare for the worst.  You have to get another passport (Parliament will ultimately reject appeals to give UK citizenship to Hong Kong residents, saying that they would find the British Isles too cold).  And you have to get your money out of Hong Kong.

The passport can wait.  But for the money, an issue of timing comes in.    On the one hand, you can probably continue to make a substantial return on any money you have invested in Hong Kong,  On the other, at some point–likely long in advance of 1997–the currency could begin to decline, in anticipation of the start of Chinese rule.  Once it starts, the drop could be very fast and very sharp. Rebounds would be unlikely.   So, you think, you have to have your money out before the currency collapses.  Probably the best solution is to get at least some funds out right away.

Here’s where the peg comes in

In October 1983, Hong Kong decided to switch its currency from a free float to a fixed link with the US dollar at a rate of HK$7.8 to US$1.

This is a political decision, to prevent widespread flight of capital–to assure citizens that they will be able to remove funds from Hong Kong up until the date of the transfer without any loss in value.

As an economic decision, it doesn’t look so great.  To keep the currencies in line, Hong Kong will have to mimic the interest rate policy of the US, a much slower-growing country.  So money policy in Hong Kong will always be too loose, an invitation for chronic inflation to step in.  Since Hong Kong has very low tax rates and no bond market, it has very little ability to enact fiscal policies that would counteract the continual monetary stimulus it has opted for.

economic effects

The initiation of the link stemmed the outflow of capital from Hong Kong.

Hong Kong had experienced a huge bout of inflation, averaging about 11% a year, from 1978-1984.  The link can’t be blamed for that, since the currency was freely floating.  But after a three-year lull, inflation shot back up to about 9%, where it stayed from 1988-1995. We can certainly say the link had a role in this.  (Chinese policy on HK government land sales and on infrastructure development pre-Handover also had an influence, but this post is complicated enough the way it is.)

Very high inflation has the effect of intensifying the pace of economic change.   In Hong Kong’s case, by the early Eighties manufacturers had already begun to shift operations from Kowloon into the New Territories, and to move from garments and textiles to assembly of electronic components.  The link forced another step change in development.

Special Economic Zones (SEZ):  a third way for development

At the same time, China had embarked on its own economic development plan by opening itself to foreign direct investment.  Foreign manufacturing operations were allowed to be set up on the mainland through joint ventures set up in a series of Special Economic Zones.  The first, established in 1980, was in Shenzhen, just to the north of the New Territories.

Normally, participants in labor-intensive industries located in high-inflation countries have two choices:  either relocate to lower labor-cost areas, or increase the capital intensity of their businesses.  In Hong Kong, though, the SEZs presented a third way:  keep the corporate headquarters and some of the manufacturing in Hong Kong, but relocate the most labor-intensive parts to Shenzhen.

Keeping China employed

One of China’s biggest political problems is how to find jobs for new graduates,  plus workers laid off from grossly overmanned state-owned enterprises, plus rural workers leaving agriculture for a better life in the cities.  So one would have a near-endless supply of low-cost workers available for the SEZs (in fact, the “real” borders were those between the SEZs and the rest of China, designed to keep work seekers out).  And a manufacturer might imagine one day expanding and setting up operations deeper in China than just the SEZs.

Of course, there’s a also a political issue to consider.  The longer you stay, the more assets you have in China and the more deeply you’re entwined in commerce there, the harder it will be to liquidate those assets and leave if need be.  Also, it’s one thing if you’re ethnic Chinese; it may be another if you’re a descendant of the British “oppressors,” and/or work for one of the old opium traders.

How Hong Kong chose

Decisions among the trading conglomerates varied widely.  Jardine Matheson, the “Noble House” in the James Clavell novel, made itself the poster boy for everything evil about the UK, at least in the minds of the Chinese leadership, by immediately reincorporating in Bermuda.  Cheung Kong, the flagship of the Li Ka-shing empire, retained its high standing by getting involved in Chinese infrastructure projects, while also diversifying into oil sands in Canada, mobile phones in Europe and ports all over the world.  Swire Pacific has embraced China, but from where I sit, its British heritage has meant smaller opportunities for Chinese expansion.  Smaller, Chinese-owned businesses expanded increasingly wholeheartedly into the mainland.

At some point, maybe early in the Nineties, Hong Kong began to realize that the day China decided to take back the colony was actually the luckiest day of their lives.  Those who had expanded into the mainland were making huge amounts of money and were being perceived as essential to the future growth of China.  Suddenly, company managements began to emphasize their Chinese heritage, replace their tweeds with more neutral business suits and intensify their Mandarin lessons.

Changes in Hong Kong

Hong Kong itself has changed dramatically  over the twenty-five or so years of the link.  Through the Seventies, it was primarily a manufacturing economy, based on textiles.  Inflation, the link and the opening of the SEZs transformed it into a banking, trade finance, international trade and real estate economy, with progressively less manufacturing.

Since the Handover, a new generation of Chinese leaders has preferred to emphasize Shanghai over Hong Kong as the shining star of China.  Nevertheless, Hong Kong remains the financial hub of China.  Tt has expanded its services role, and now houses the international headquarters of many mainland corporations.  It has also come to be for China what the Riviera is for Europe, although its high costs make it, I think, still primarily a destination for mainland visitors.  Because of the China connection, however, it has not developed the more capital-intensive heavy industry of Japan, Korea or other Asian developing nations.