FINANCIAL DEVELOPMENT IN HONG KONG AND CHINA: A HAYEKIAN PERSPECTIVE.

• Author: Chu, Kam Hon

This article draws on certain Hayekian ideas, such as the Hayekian knowledge problem and spontaneous order, to better understand financial development in Hong Kong and China. Ignorance or neglect of such ideas can lead to devastating consequences. A case in point is Hong Kong. If Hong Kong drifts from its grounding in the rule of law and individual freedom, under pressure from the Chinese mainland, its dynamic financial markets may suffer as investors lose trust in Hong Kong's institutions.

Hong Kong as an International Financial Center

Hong Kong's financing and insurance industries account for about 20 percent of GDP and more than 6 percent of the total labor force. (1) These figures do not include the closely related industries like law, accounting, and information technology, not to mention the vital and conducive role of a financial system to the functioning of an economy.

Hong Kong is an indispensable window through which China absorbs foreign investment and new technology. According to statistics released by the Ministry of Commerce of the People's Republic of China (2020a, 2020b), more than half of the actually utilized foreign investment during the last decade came from Hong Kong (Table 1). Over the years, foreign investment in China was on an upward trend until 2018, and the share of foreign investment coining from Hong Kong had also increased from just below 50 percent in 2009 to 65 percent in 2018, reflecting the increasing reliance of China on Hong Kong as a source of foreign investment. After 2018, China's foreign investment from Hong Kong and the rest of the world declined noticeably, at least in the first 10 months of 2019. Despite the apparent slowdown in foreign investment in China and the anti-extradition protests in Hong Kong in 2019, Hong Kong has remained the largest source of foreign investment for China and its investment share has become relatively more important at the same time.

In addition to foreign investment absorption, Hong Kong plays a pioneering role in the internationalization of the renminbi (RMB). Despite the lath of comprehensive statistics on the volume of offshore RMB transactions, Hong Kong is for sure one of the largest, if not the largest, global centers for offshore RMB businesses. According to the Triennial Central Bank Survey (BIS 2019), for instance, Hong Kong was the largest global offshore RMB foreign exchange market, with an average daily turnover of US$107.6 billion as of April 2019, considerably higher than the US$56.7 billion for London and the US$42.6 billion for Singapore.

For the rest of the world, the OECD countries in particular, I long Kong not only acts as a springboard for foreign firms' investment and expansion into the Chinese markets, but also benefits foreign countries given Hong Kong's special status under the "one country, two systems" principle of the Basic Law. For instance, the United States has persistently run a merchandise trade surplus with Hong Kong (US$11.7 billion in 2019), and American financial institutions earn lucrative profits through their investment banking activities and other financial services in Hong Kong. (2)

Even before the return of Hong Kong to Chinese sovereignty in 1997, all these stakeholders have had economic incentives to maintain and promote Hong Kong's status as an international financial center. In recent years, however, this situation has become more difficult to sustain because of political and ideological divergence and conflicts partly arising from China's promotion of national revival, more generally known as the "Chinese Dream," since 2013.

China's Drive to Create a Global Financial Center

There should be no doubt that China recognizes the importance of an international financial center in fulfilling the Chinese Dream: the nation needs money and finance to accomplish its series of grand projects like Made in China 2025, internationalization of the RMB, the Belt and Road Initiative, as well as development of the Guangdong-Hong Kong-Macau Greater Bay Area. Following economic reform in 1978, the Chinese leaders put forward several strategic economic plans to develop Shanghai, Shenzhen, and Qianhai into international financial centers. (3) Moreover, in December 2019, about six months after the outbreak of anti-extradition bill protests in Hong Kong, there was news, though officially unconfirmed, that President Xi Jinping endorsed the diversification of Macau into a global center for tourism and finance--probably as a contingency plan to replace Hong Kong if the social unrest in Hong Kong deteriorated. In June 2020, China's State Council released an ambitious master plan to transform Hainan into its largest free-trade port, including liberalization of the financial sector and free exchange of capital, by 2035 (Wong 2020).

However, things are easier said than done; none of these strategic plans have materialized. Undeniably, there are more stock markets and financial institutions than before, but all these Chinese cities are still far from being an international financial center comparable to Hong Kong. The Chinese government seemingly had the confidence that it could design and build up a financial center, or even financial centers, through economic planning. Yet nearly a century ago, in the socialist calculation debate, Mises and Hayek had already correctly pointed out that central economic planning was both erroneous and infeasible in theory and practice.

The Infeasibility of Central Planning

In a planned economy, the central planner will inevitably fail to coordinate production plans and allocate resources efficiently, because of at least two major problems. (4) First, in socialist or centrally planned economies, goods and services are transferred rather than exchanged via markets; hence, they are either unpriced or irrationally priced. Economic calculation is therefore infeasible in the absence of a market price system where relative prices play both a signaling and rationing function to promote efficient use of resources (Mises [1920] 1990).

Second, economic calculation cannot be made by simulation of markets under market socialism or central planning because of a knowledge problem (Hayek 1937, 1940, 1945). According to Hayek's pathbreaking insight, the knowledge relevant to rational economic calculation exists as dispersed bits of incomplete knowledge possessed by millions of separate individuals rather than in an integrated form given to the central planner. Moreover, individuals may have no or little incentive to convey their knowledge to the central planner. This incentive problem, together with the prohibitively high communication and search costs associated with the available dispersed knowledge at a given moment, implies that it is virtually impossible to make the most effective use of the available dispersed information for efficiently allocating society's scarce resources under central planning. This Hayeldan knowledge problem, as Kirzner (1984) argues, cannot become solvable by any planned search for the necessary information, because the planner has only limited knowledge and is likely unaware of his own ignorance. Nevertheless, the knowledge problem can be overcome by the alertness of private firms and entrepreneurs to profit opportunities through the competitive discovery process in a decentralized market economy (Hayek 1978a; Kirzner 1984).

Hayek followed the Austrian tradition of Carl Menger and held that money, like language and law, is one of the complex social institutions whose evolutionary outcomes are the result of human action, not deliberate design (see, e.g., Hayek 1960: chaps. 2 and 4; 1967a; 1973: chaps. 1-2; 1978b: 37-39; and 1988). Moreover, the evolutionary outcomes are inherently path dependent. This notion of society's spontaneous order is equally applicable to the development or evolution of monetary and banking systems. (5)

Hong Kong's Financial Development as a Spontaneous Order

Hong Kong's rise as an international financial center is an example of a spontaneous order that emerged given limited government and the rule of law. During the 1970s and 1980s, when Hong Kong went through an economic transformation from a manufacturing city into a financial center, the Hong Kong government did not have any economic plan to deliberately turn the city into an international financial center. Hong Kong had, however, certain favorable factors, like its geographical location, a meeting point of East and West, free trade, no exchange control, freedom of press, low tax rates, a credible legal system, a corruption-free government, and its doctrine of "positive non-interventionism." (6) At the same time, there were the trends of globalization and China's economic reform and opening up its door to the rest of the world. (7)

All these factors acted together, at the right place and at the right time, to help establish Hong Kong as a vibrant global financial center. International investors, entrepreneurs, and financial...