Hong Kong’s Economic Growth: Laissez Faire or Entrepôt Trade?

Milton Friedman laments the passing of John Cowperthwaite’s policy of “positive noninterventionism”. John Cowperthwaite’s passing earlier this year was noted in this tribute:

Sir John Cowperthwaite, who died on January 21 aged 90, was Financial Secretary of Hong Kong throughout the 1960s; his extreme laissez-faire economic policies created conditions for very rapid growth, laying the foundations of the colony’s prosperity as an international business centre. Cowperthwaite was a classical free-trader in the tradition which stretched from Adam Smith to John Stuart Mill and Gladstone, rather than a modern monetarist. He was also a seasoned colonial administrator, with a strong streak of common sense. But his achievement in Hong Kong was hailed by Milton Friedman and other free-market economists as a shining example of the potency of laissez-faire when carried through to its logical conclusions in almost every aspect of government. The Right-wing American commentator PJ O’Rourke called Cowperthwaite “a master of simplicities”. Cowperthwaite himself called his approach “positive non-intervention”. Personal taxes were kept at a maximum of 15 per cent; government borrowing was wholly unacceptable; there were no tariffs or subsidies. Red tape was so reduced that a new company could be registered with a one-page form. Cowperthwaite believed that government should concern itself with only minimal intervention on behalf of the most needy, and should not interfere in business.

Free trade and low taxes as the engine of growth for Hong Kong has certainly been a theme of Dr. Friedman:

Take the fifty-year experiment in economic policy provided by Hong Kong between the end of World War II and this past July, when Hong Kong reverted to China … Nonetheless, there are some statistics, and in 1960, the earliest date for which I have been able to get them, the average per capita income in Hong Kong was 28 percent of that in Great Britain; by 1996, it had risen to 137 percent of that in Britain. In short, from 1960 to 1996, Hong Kong’s per capita income rose from about one-quarter of Britain’s to more than a third larger than Britain’s … I believe that the only plausible explanation for the different rates of growth is socialism in Britain, free enterprise and free markets in Hong Kong. Has anybody got a better explanation? I’d be grateful for any suggestions.

With such a kind invitation – how could one resist? Hong Kong is often referred to as an entrepôt economy with the term entrepôt referring to trading centers that generate significant profits. Sure, Hong Kong believed in free trade but my point is that it was able to thrive in large part because of certain restrictions to free trade between nations such as China and the U.S. While Hong Kong had been a trading center even before the British established it as a crown colony, its livelihood as an entrepôt was diminished by the UN embargo against trade with China as a result of the Korean War. Hong Kong in response moved to establish its own industries. Hong Kong’s role as entrepôt, however, revived over time and was discussed by Robert C. Feenstra and Gordon H. Hanson in Intermediaries in Entrepôt Trade: Hong Kong Re-Exports of Chinese Goods:

In this paper, we examine Hong Kong’s role in intermediating trade between China and the rest of the world. Hong Kong distributes a large fraction of China’s exports. Net of customs, insurance, and freight charges, re-exports of Chinese goods are much more expensive when they leave Hong Kong than when they enter. Hong Kong markups on re-exports of Chinese goods are higher for differentiated products, products with higher variance in export prices, products sent to China for further processing, and products shipped to countries which have less trade with China. These results are consistent with quality-sorting models of intermediation and with the outsourcing of production tasks from Hong Kong to China. Additional results suggest that Hong Kong traders price discriminate across destination markets and use transfer pricing to shift income from high-tax countries to Hong Kong.

The authors noted that the ratio of total trade to GDP for Hong Kong in 1998 was 259% and that the average markup on Hong Kong re-exports of Chinese goods was 24%. In other words, a significant portion of Hong Kong’s GDP comes from entrepôt trade. The authors often various explanation for these very high markup on trade:

One compelling hypothesis is that Hong Kong traders have an informational advantage in trade between China and the rest of the world … In their role as middlemen, traders may earn informational rents, which could account for the markups they charge … Many firms that import goods from China forre-export engage in outward processing. Before importing goods from China, they may purchase raw materials on the world market, process these materials in Hong Kong or elsewhere, and export the unfinished goods to China for yet further processing … Quality sorting and outward processing are often complementary activities and we attempt to control for this in our empirical work. We also control for other behavior which may influence re-export activity, including transfer pricing, circumventing trade barriers, and hubbing in international shipping … higher for products subject to Multi-Fiber Arrangement (MFA) quotas; and higher for products shipped to countries with higher corporate tax rates. These last two results suggest that firms may use re-exporting to transfer income from abroad to the low-tax jurisdiction of Hong Kong.

The role of the Multi-Fiber Arrangement was discussed years ago by Kala Krishna and Ling Hui Tang in a paper entitled Rent-sharing in the multi-fibre arrangement : evidence from U.S. – Hong Kong trade in apparel. The authors described an active market in selling valuable quota rights. Like Feenstra and Hanson wonder if the rents from these quotas might be exaggerated by creative transfer pricing, we have also suggested similar motivations. Raymond Fisman, Peter Moustakerski, and Shang-Jin Wei in Offshoring Tariff Evasion: Evidence from Hong Kong as Entrepôt Trader take the argument further by arguing that one of the reason why Hong Kong is a source for so much trade is the ability to evade tariffs. While the end of the Multi-Fiber Arrangement and other movements towards free trade may be good news for the world economy, such movements would tend to reduce Hong Kong’s advantages as entrepôt traders.