Still the Consummate Middleman

Even as China’s links to the world multiply, Hong Kong remains a vital facilitator.

Ten years after China resumed sovereignty over Hong Kong, the city continues to occupy a unique position in southern Chinese trade. It is a position born of its colonial legacy as Hong Kong continues to be defined by its free-port “system” and its traditional role as an intermediary in world trade with China.

Background: Hong Kong and China

At midnight on July 1, 1997, Britain transferred sovereignty of Hong Kong to the People’s Republic of China. The ceremony took place on a red-velvet stage partitioned into two sides, and each was adorned with its respective national flag. The British prime minister and Hong Kong’s last governor sat together with Prince Charles, who read a farewell speech on behalf of the Queen. When the clock struck midnight, the British flag was lowered, China’s was raised, and the British representatives boarded a yacht bound for England while God Save the Queen lingered in the humid night.

On that night, Britain’s 99-year lease on the New Territories north of Hong Kong Island expired, and Britain withdrew from the 1842 Treaty of Nanjing. The treaty, which ended the Opium War, established Hong Kong Island as a British port.

The British had long wanted to have greater access to Chinese products and had chaffed at the restrictions placed on traders in Guangzhou. Hong Kong quickly became a base for trade with China. Compradors played an essential role. They were Chinese middlemen who were competent in the languages and practices of both sides and served as links between the Chinese market and the outside world. Compradors and other traders earned commissions on transactions they oversaw. Some firms became powerful. One such firm, Jardine, Matheson and Company, initially grew in large measure by trading opium in the eighteenth and nineteenth centuries, and subsequently branched off into many other operations. It currently has extensive holdings both in and beyond Hong Kong.

Hong Kong became a vital financial and manufacturing center, especially after the new People’s Republic limited trade and other contact with foreign countries. In fact, Hong Kong developed so rapidly it was dubbed one of the four “Asian Tiger” economies, along with Singapore, South Korea and Taiwan. The post-1978 economic reforms in neighboring Guangdong province in conjunction with Hong Kong’s wages and costs increasing and the value of its dollar rising during the 1980s enticed manufacturers to the mainland, and Hong Kong transitioned to a service economy. The World Bank states that by 2005, the service sector made up 91% of Hong Kong’s economy, and by 2006, per capita gross domestic product was over US$ 27,000 – ahead of Spain and New Zealand, but behind Singapore and Italy.

For the first three decades of its existence, the People’s Republic of China had a state-directed and increasingly state-controlled economy. Progress in some sectors such as heavy industry was clear, but growth and development occurred at a far slower rate than that of its neighbors. In 1978, Deng Xiaoping and his associates took the first steps to liberalize the economy. Growth was steady and impressive and has dramatically accelerated with China’s 2002 accession to the World Trade Organization. Despite more than a tenfold increase in the size of its GDP since 1978, by 2006 China’s GDP per capita of US $ 2,010 (as measured by the World Bank) still lagged far behind the “tigers” (though Hong Kong’s neighbor, Guangdong province is much richer than the nation as a whole). Industry still accounts for 47% of China’s economy, with services providing 41% of GDP. While China’s per capita GDP remains relatively low, the economy as a whole is enormous and is growing much faster than the larger American, European Union, and Japanese economies.

One Country, Two Systems

Despite the transfer of sovereignty to China, Hong Kong has maintained some autonomy through China’s “One Country, Two Systems” policy, which was outlined in the Sino-British Joint Declaration of 1984 and expanded in the Special Administrative Region’s Basic Law of 1990. According to the Declaration, the Hong Kong Special Administrative Region’s role is to retain its economic and social system and enjoy political autonomy–except for defense and foreign affairs–for 50 years following the 1997 handover. “The laws currently in force in Hong Kong will remain basically unchanged,” reads Part 3 of Article 3 in the Joint Declaration, which also guarantees Hong Kong the right to maintain its role as a free port and separate customs unit. The 1984 declaration also grants Hong Kong the freedom to not be taxed by China and to issue its own travel documents for entrance and exit.

Hong Kong possesses a laissez-faire economy and a society based on British laws. Strong property rights are Hong Kong’s main comparative advantage, argues Barry Naughton, a professor at the University of California at San Diego. “Hong Kong residents,” he has written, “profit from the existence in Hong Kong of a secure and transparent system of property rights, in close proximity to the vague and uncertain property rights regime in China.”

Hong Kong as Middleman

Hong Kong remains a vital conduit for China’s global trade. Sung Yun-wing of the Chinese University of Hong Kong has called this continuity the “Hong Kong Paradox.” According to Sung, after China began implementing liberalization policies, the volume of trade passing through Hong Kong actually increased, despite the increasing ability to invest directly into the mainland. Naughton, paraphrasing Sung, notes that between 1978 and 1993, the proportion of China’s trade passing through Hong Kong increased “steadily and dramatically” from 11% to 48%.

That share has declined, though the total trade volume has increased. An International Monetary Fund report by Thomas Rumbaugh and Nicolas Blancher noted that in 2002, Hong Kong handled about 22% of China’s trade. A significant but declining share of China’s foreign direct investment, however, goes to Hong Kong. Here too the relative share is declining, but the absolute amount is increasing. This is documented in an August 2007 paper by Randall Morck from the University of Alberta, Bernard Yeung   from NYU and Minyuan Zhao from the University of Michigan, which draws on information from China’s Ministry of Commerce and China Statistics Bureau. Chinese FDI into Hong Kong has steadily increased, reaching US $1.15 billion in 2003, $2.63 billion in 2004, and $3.42 billion in 2005. Hong Kong’s share of China’s outward FDI was 40% in 2002 and 28% in 2005.  The attractiveness of the tax-haven Cayman Islands is responsible for the sudden drop in Hong Kong’s relative position—in 2005 the Cayman Islands received an astounding US $5.16 billion in FDI from China. It’s clear that the trade and financial roles Hong Kong fulfills for China remain large. As  Professors Morck, Yeung and Zhao write, “Indeed, we are not even sure if the published data adequately capture the funds flowing from China into Hong Kong.”

In August of 2007, the Chinese authorities articulated a plan that would likely accelerate the flow of funds from China to Hong Kong. Known as the “thorough train to Hong Kong,” the arrangement would allow mainlanders to invest directly into equities on the Hong Kong markets. Joseph Yam, chief executive of the Hong Kong Monetary Authority, argued in a Viewpoint article that even though Hong Kong would surely benefit from the injection of cash, the “bigger picture” is “to help address the issues arising from the large and persistent balance of payments surpluses” in the mainland. Securities and banking officials in China, however, raised concerns that the risk to unsophisticated investors and the macro-economic implications of sudden deregulation into the world financial system are too great. As a consequence, Chinese Premier Wen Jiabao announced in late November that the program would be delayed, where the program’s current status rests. By October 24, 2007, Hong Kong’s Hang Seng Index had soared nearly 30% in anticipation of mainland money; during midday on January 18, 2008. It has since fallen back dramatically.

Hong Kong remains a key part of the global supply chain. Typically, Hong Kong firms set up suppliers of Chinese manufactured goods with foreign buyers, and arrange for the purchase and shipment of goods to foreign markets. Middleman transactions may be supplier-driven or buyer-driven, and the distinction typically depends upon the industry in question. James Wang and Daniel Olivier of Hong Kong University point out in their 2007 article “Chinese Port-Cities in Global Supply Chains” that consumer-goods industries like those of toys or televisions characterize buyer-driven global supply chains, and industries like those of machinery and electronic parts that produce semi-finished goods dominate supplier-driven chains.

Sung notes that from 1989 to 1995, outsourcing in China involving Hong Kong increased significantly. Re-exports—goods that are imported into Hong Kong and then exported a second time—increased nearly fourfold during that period (5,757 to 22,456 million US$ in 1989-95), and re-exports from China to the outside more than doubled (28,497 to 63,658 million US$ in 1991-5). Victor F. Sit of the University of Hong Kong has noted that from 1997-8, out-processing represented 84% of China’s GDP growth.

The out-processing trend has continued. The Economist concluded in November 2007 that “China is where…goods are made, not where much of the value is added.” That is, goods are often assembled or components are manufactured in Guangdong province, but the design and marketing of a product is typically done in Hong Kong or elsewhere in the world. The modern-day middleman in Hong Kong is far more than the trader of the past. Nowadays a Hong Kong intermediary performs complex functions that add high-value to the goods in production. For example, Hong Kong firms combine their knowledge of source and destination markets, connections with thousands of Asian factories, sophisticated logistics capabilities and expertise in managing subcontractors to provide an overall service to a foreign buyer.

The Hong Kong-based Li & Fung Group is one such modern-day middleman. The firm, founded in 1906, is a “turn-key supplier” in global supply chains, a term for firms that efficiently organize supply chains to meet the need of a foreign buyer. Brothers Victor and William Fung, who both have Harvard graduate degrees, oversee a network of over 8,300 suppliers and more than 70 sourcing offices in more than 40 countries and territories. According to their 2007 book Competing in a Flat World, the network employs more than two million people, of which the Li and Fung firm directly employs about 10,000. Despite the fact it does not own factories, raw material sources, or warehouses, Li & Fung is the world’s largest sourcing company, helping to produce and distribute more than two billion consumer goods each year for retailers such as Toys “R” Us.

Hong Kong, China

Chinese officials argue the Hong Kong Special Administrative Region status empowers Hong Kong, not restrict it. Hong Kong SAR officials, for example, may use the title “Hong Kong, China” to enter into agreements of cultural or economic nature with other states or international organizations. Hong Kong remains the consummate middleman in the global economy—the second largest destination for FDI in Asia, according to the United Nation’s World Investment Report 2007. Together, Hong Kong and China received more than half of FDI flows into the region the previous year. Victor Fung anticipated this early in the post-handover period, saying in a speech at an American Chamber of Commerce Summit, “Hong Kong has always had more sources of advantage than immediately meet the eye. And while this may make it difficult for many outside observers to accurately gauge the strength of the economy, this is in itself another source of strength. Because such a spread of advantages makes Hong Kong’s economy more resilient than most others in the region—or indeed, in the world.”

Christopher Alesevich is a senior studying International Relations at the University of Southern California.