Vol 1 No 3 Autumn Issue

Page 1

Best Practice A Public Policy Journal for Hong Kong

Moving Hong Kong Forward Minimum wage – good intentions, bad results Competition Law – why Hong Kong is different Hong Kong Mortgage Corporation – past its use-by date The wider motivations behind pressures on Hong Kong

Autumn 2009 Vol.1 No.3

Inside Best Practice Vol. 1 N0. 3 Autumn 2009

25 Reflections on Global

3 4

From the Editor Contributors Minimum Wage – Good Intentions, Bad Results

Lion Rock writers unveil the problems with Minimum Wage and illustrate the economic reality – fewer job opportunities to exist for Hong Kong’s most vulnerable.

12 Competition Law – Why

28 Changing the Rules of the Game

Andrew P. Morriss dispels the bad reputation that onshore governments have given offshore financial centres and warns that in efforts to resist competition, onshores risk further damaging their economies.

Policy Recommended for the Crisis

35 Should Mortgages be

Hong Kong is Different

Hans Mahncke uncovers the roots of Hong Kong’s competition problems and explains why they will not be remedied by a cross-sector competition law.

17 Hong Kong Mortgage

Larry E. Ribstein exposes the wider motivations behind current international pressure to alter Hong Kong’s tax law.

Global Perspective Policy Analysis

Moving Hong Kong Forward


Legal Centers

Corporation – Past its Use-By Date

Bill Stacey argues that as the market has changed, the original policy rational of the Hong Kong Mortgage Corporation has disappeared. Editor: Nicole Idanna Alpert Editorial Assistant: Nicholle Brokke Design & Production: Firstline Limited Cover Artist: Bay Leung Best Practice is published quarterly by The Lion Rock Institute to encourage discussion of policy and current issues. Topics and authors are selected to represent a multitude of different views, and those opinions expressed within Best Practice do not necessarily reflect the views of The Lion Rock Institute. The Lion Rock Institute welcomes reproduction of written material from Best Practice, but editor’s permission must first be sought.


Arnold King argues that mortgage securitization should be allowed to die in order to keep taxpayers from inheriting more risk.

Around The World

41 Hong Kong Remains

No. 1

Wallace Chan expands on Hong Kong’s highest level of economic freedom in Economic Freedom of the World: 2009 Annual Report.

Editorial Office: Room 1207 Kai Tak Commercial Building 317-319 Des Voeux Road Central, Hong Kong Editorial Tel: +852 3586 8102 Subscription Service: +852 3586 8101 Fax: +852 3015 2186 Advertising inquires: Best.Practice@LionRockInstitute.org Production by: Firstline Limited www.FirstlineDesign.net Best Practice Advisory Board James A. Dorn, Alec Van Gelder, Philip Stevens, Tom Palmer, Reuven Brenner, Gary Shiu, Richard Wong, Francis Lui, Shih Wing Ching, Donald J. Boudreaux

42 Free Trade Agreements –

Do They Really Free Trade?

Dr. Khalil Ahmad on semantics aren’t FTAs only challenge – there’s a ways to go before trade is truly free.

Leader’s Bookshelf

44 State of the Nation

Eamonn Butler is interviewed on his most recent book, The Rotten State of Britain.

46 More Dangerous in

Death than in Life

Pierre Gave reviews Prisoner of the State: The Secret Journal of Premier Zhao Ziyang.

Odds and Ends

48 “Careful Design” in Policy Making

If policy engineered with careful design actually worked, we’d be in an utopia.

50 Guangzhou Express Rail Link

The Runaway Train that is the XRL.

52 Onshore vs. Offshore

Onshores not willing or able to compete – just like in any game – start playing dirty.

Article Submissions: All articles submitted to Best Practice must be exclusive unless permission has been sought. Articles should range between 600 and 4,000 words but may differ if editor’s approval has been sought. Please send all articles with a cover letter giving a brief summary of the articles along with the author’s fax number, day and evening telephone number, mailing address, email address and short bio. Please send articles by email to Nicole.Alpert@LionRockInstitute.org Certain images within Best Practice are published under Creative Commons licenses. We endeavor to comply fully with the terms of such licenses to ensure attribution of the author of the relevant image. For more information or details about the authors of particular images, please view our website, www.lionrockinstitute.org, or inquire.

Autumn 2009


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From the Editor Moving Hong Kong Forward


hile there is a sense that the financial crisis is loosening its grip, economists predict the next crisis is around the corner, glaring red in government budgets. In recessions, dirigiste practices are fashionable. In this environment, governments either resist progress with policies that increase debt and entitlements, inflate regulatory bubbles, and support protectionism – or – they follow best practice to apply smart regulations, undo crony capitalism, remove barriers to create opportunities and ensure proper safety nets are in place. Not surprisingly, most governments’ policy follows the former, breeding uncertainty. Hong Kong is now considering major changes following international trends, while larger issues like land reform linger. Hong Kong is still largely competitive, a great place to live and do business, but what direction is it headed in with the introduction of labour and competition policies, expansion of the tax law, new transportation projects, etc. What policies will move Hong Kong forward? In this issue of Best Practice: Moving Hong Kong Forward, authors analyse if the policy changes will do just that. Our cover story is dedicated to the recent debate surrounding Minimum Wage. After dissecting the bill and its potential impacts on Hong Kong, the authors of “Minimum Wage – Good Intentions, Bad Results” contend that after implementation, Hong Kong’s least competitive workers would be worse off. Hans Mahncke appeals to readers that an across-the-board competition law would not serve Hong Kong’s competition issues in “Competition Law – Why Hong Kong is Different.” After his examination, he maintains that only a reform of the land system and natural monopolies can fix Hong Kong’s competition problems. Bill Stacey adds a twist to this discussion with his detailed assessment of the Hong Kong Mortgage Corporation in “HKMC – Past its Use-By Date.” After breaking down its policy rationale, financial performance and outside-its-mandate activities,

he illustrates that the government and the HKMC itself realizes that its need has expired. Stacey reminds us that government involvement in mortgage markets has proved disastrous, leaving the HKMC, for all that it was and is today, far from desirable. In “Reflections on Global Legal Centers,” Larry Ribstein, who took part in a panel in Hong Kong this past summer on jurisdictional competition, weighs in on the current tussle between onshore and offshore governments. Ribstein’s analysis aids readers in understanding why Hong Kong recently introduced a bill to fund and add another sector to the Inland Revenue Department in order to avoid being on the OECD naughty list and comply with sharing tax information. Andy Morriss, in Best Practice’s Global Perspective Policy Analysis, “Changing the Rules of the Game,” unveils the measures onshore governments are taking to limit offshore financial centres’ ability to compete in the global financial market, and how they are doing so at their own peril. Arnold Kling’s “Should Mortgages be Securitized” warns that in order to revive mortgage securitization, taxpayers must absorb large risks. Around the World takes a look at Hong Kong’s economic freedom and free trade agreements while Leader’s Bookshelf reviews the influential book The Rotten State of Britain, and the highly controversial Prisoner of the State: The Secret Journal of Premier Zhao Ziyang. Moving Hong Kong forward doesn’t have to be like pulling teeth – but it takes the kind of determination and follow through that Zhao Ziyang had to record his memoirs, and the editors to release it to the public. Let us move Hong Kong forward, with best practice, in the right direction.

Nicole Idanna Alpert

Let us know what you are thinking. Letters can be sent to best.practice @lionrockinstitute.org

Autumn 2009




Hans Mahncke

Bill Stacey

Larry E. Ribstein

Andrew P. Morriss

Arnold Kling

Hans Mahncke, LL.B. (Hons.), LL.M., is an Assistant Professor at the School of Law at City University of Hong Kong. His research interests include international economic and WTO law, and common law history and method. He also teaches and publishes in these areas. Hans currently serves as a contributing editor to Halsbury’s Laws of Hong Kong and is a member of the editorial board of the Hong Kong Lawyer.

Bill Stacey is the Chairman of Hong Hong’s leading free market think tank, The Lion Rock Institute. He is also on the Board of Advisors of the Mannkal Economic Education Foundation. Professionally, Bill has been an executive with leading financial institutions in Asia and globally. He is currently a partner in boutique equity house, Aviate Global.

Larry E. Ribstein is the Mildred Van Voorhis Jones Chair in Law at University of Illinois, UrbanaChampaign. Professor Ribstein is the author of many books, including the forthcoming The Rise of the Uncorporation (2009). From 1998-2001 he was coeditor of the Supreme Court Economic Review. His blog site focusing on business law is located at www.ideoblog. org and his webpage is located at www.ribstein.org.

Andrew P. Morriss is H. Ross & Helen Workman Professor of Law and Business and Professor at the Institute for Government and Public Affairs at the University of Illinois, Urbana-Champaign. He is a Research Fellow of the NYU Center for Labor and Employment Law and is the author or coauthor of more than fifty book chapters and scholarly articles. Professor Morriss recently released the book, Regulation by Litigation (with Bruce Yandle and Andrew Dorchak).

Arnold Kling is an economist and member of the Financial Markets Working Group of the Mercatus Center at George Mason University. In the 1980s and 1990s he was an economist with the Federal Reserve Board and then with Freddie Mac. He blogs at econlog.econlib.org.

Wallace Chan

Dr. Khalil Ahmad

Dr. Eamonn Butler

Pierre Gave

Michael A. Ying la’O

Wallace Chan works with Canada’s largest and most prestigious free market think tank, The Fraser Institute, as their Coordinator, Chinese Affairs. He received his Bachelor of Commerce at the University of BC in 1994, a Bachelor of Education at the University of BC in 1998, and a Master of Economics at the University of Hong Kong in 2006. He has been published widely in Hong Kong and Canadian Chinese language publications.

Dr. Khalil Ahmad founded and heads the Alternate Solutions Institute, the first free market think tank of Pakistan. He holds a Ph.D. in Philosophy from University of the Punjab, and until 2006 taught courses on Philosophy and Education. He frequently contributes articles on current issues to various local and foreign newspapers. Alternate Solutions Institute is located at www.asinstitute.org.

Dr. Eamonn Butler is Director of the Adam Smith Institute, a market economics think tank based in London, and is a leading figure in the development of public policy in the United Kingdom. He’s written numerous academic and non-academic books including the latest, The Rotten State of Britain. He is Vice President of the Mont Pelerin Society, an international academy of free market economists and political theorists, and lectures and writes internationally on policy issues.

Pierre Gave joined GaveKal in 2001 and is today their Head of Global Research, coordinating the entire research process and contributing to the writing of the firm’s Five Corners, Ad Hocs, and Quarterly Strategy Chart Books. Pierre also meets regularly with GaveKal Research clients and speaks at GaveKal’s investment conferences, and Seminars. Pierre launched his career in 1998 as a financial analyst at a venture capital firm in Stockholm, where he specialized on company valuations.

Michael Ying worked as the General Manager of an online English language education company for the past three years. In 2004, he received his undergraduate degree in Political Science (minors in Legal Studies, and Philosophy) from Macalester College (St. Paul, MN). He now works with The Lion Rock Institute and continues to assist in the operations of the language education company.

Best Practice

moving hong kong forward

Zhao Hua Xi Shi

A worker cleans up in front of the harbour. There are fears that implementing the minimum wage will cause a large number of low wage jobs to be lost.

Minimum Wage – Good Intentions, Bad Results Lion Rock writers unveil the problems with Minimum Wage and illustrate the economic reality – fewer job opportunities to exist for Hong Kong’s most vulnerable


ong Kong is now debating whether minimum wage should be implemented in our city. Though media-worthy, as Hong Kong is one of the last developed economies without a minimum wage now considering implementing one, most attention has been on the dismal experience in the United States. The U.S. increase in their minimum wage came at the same time its jobless rates and youth

unemployment rates were at all time highs in most recent decades. This makes it all the more difficult for people to find work and get on the first rung of the career ladder. Despite the economic turmoil in Hong Kong’s past, the flexibility for workers to climb the ladder has never been encumbered. But, a minimum wage makes it certain – while it’s a very useful policy tool for the privileged, it’s devastating for the least competitive workers. In

this sense, the minimum wage is a useless tool to help them. The plans to introduce a minimum wage law in Hong Kong as outlined in the Minimum Wage Bill introduced 26 June 2009 will cause adverse effects on the Hong Kong public. Below, The Lion Rock Institute expands on its views on this policy. The key points can be summarized as follows: 1. The Minimum Wage Bill is immoral, will be extremely Autumn 2009


Ines Yeh

moving hong kong forward

Domestic helpers gather to spend their only day off together. The bill excludes domestic helpers because increasing their salary with the minimum wage will have detrimental socioeconomic effects on the public.

detrimental to women returning to the labour force, to young graduates, especially those that are not trained in tertiary institutions, new migrants, the elderly and finally, our city’s most vulnerable. 2. The Minimum Wage Bill is based on flawed economic theory and affects Hong Kong adversely in macro and microeconomic terms. 3. The Minimum Wage Bill, as currently proposed, suffers from a variety of logic flaws.

The immorality of the Minimum Wage Bill and potential damage to Hong Kong There are many social problems associated with the implementation of a minimum wage. But the most prominent social issue is how minimum wages have, in the past, led the most deprived members of society (the young, minorities, least educated) straight into unemployment. With a minimum 6

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wage in Hong Kong, the poorest and least educated people – the most vulnerable of our society – will typically be priced out of the labour market. They will no longer be able to get onto the first rung of the work ladder. A minimum wage thus creates a “welfare” class, those that are priced out of the market, unemployed. This despondent class typically creates the “welfare state.” In the long run, this leads to a higher crime rate and greater substance abuse. A Moral Evil – Sacrificing A Few for the Many It is not moral for the least fortunate to subsidize the better off. Ablebodied members of the public will be priced out of the market. The goal of minimum wage is to help the most vulnerable, whereas, in actuality, job opportunities will be lost and some of these workers will become or remain unemployed. It is not the Government’s prerogative to remove

individuals’ right to work. Yet, that is what minimum wage entails. The history of minimum wage is well known as a tool to discriminate. In New Zealand, the minimum wage was first used to discriminate against women. In South Africa, it was an apartheid measure to keep Black South Africans out of the work force. In both cases, the imposition of minimum wage meant that lowskilled workers whose productivity did not match the mandated wage level were effectively barred from participating in the work force. It is no surprise that these discriminatory policies are still being adopted. Hong Kong now seeks to discriminate with its own Minimum Wage Bill towards live-in foreign domestic helpers and interns. In his 2008 policy address, the Chief Executive declared that the voluntary scheme had failed, insisting that a statutory minimum wage was necessary to ensure “social justice.” The Chief Executive stated that the minimum wage would be applied to all members of society,1 and yet here the Bill discriminates against some. Discrimination in “Asia’s World City” Excluding domestic helpers is legally not justifiable in the Bill, but their exclusion is stated undoubtedly from the brief of the bill under the heading of “Possible significant and far-reaching socio-economic ramifications.”2 As the title suggests, the brief spells out that an increase in domestic helpers’ wages would lead to “distress” amongst Hong Kongers as far fewer families would be able to employ helpers. The ramifications of this policy, even without their exclusions, are far reaching. Of course, the exclusions themselves betray the

moving hong kong forward

bill as they show its hypocrisy. What applies to domestic helpers applies to other industry positions like security guards and cleaners too. If the government makes hiring more expensive, less people will be hired. Thus, the real reason for differentiating between domestic helpers and other lowwage workers is that low-wage workers in general are considered more dispensable than domestic helpers. What the Minimum Wage Bill does is discriminate against one group of people while rendering many others unemployable. Such discrimination and impediments to participating in the work force must not be tolerated in “Asia’s World City.” Hong Kong should not put forward bad policy in the name of politics.

Flawed economics Minimum wage laws do not make sense because the economic proposals do not back the suppositions. If the economics behind minimum wage laws are flawed, then the Minimum Wage Bill is flawed. Lacking Economic Justification Minimum wage legislation, by its very nature, benefits some at the expense of the least experienced, least productive, and poorest workers. Based on extensive research, we arrive at the conclusion that minimum wage is not an effective means of reducing poverty or helping low income families; it exacerbates existing problems and causes future harms. The minimum wage narrative began in earnest with the adoption of a voluntary wage protection scheme in 2006. If it was found in the overall review that the Wage

Protection Movement (WPM) failed to yield satisfactory results, the Government would introduce into Legislative Council legislation for a minimum wage for the two specified occupations, namely cleaners and security guards. Two years later, the Chief Executive, without providing reasons or publishing the relevant data, declared that the voluntary scheme had failed. Indeed those claims remain unsubstantiated. Further, rather than focus his efforts on the two specified occupations as previously declared, the government moved towards an across-the-board Minimum Wage Bill, albeit one that excludes domestic helpers. The only public source available on the overall review of the WPM consists of 5 pages with only one paragraph, 1/3 page length, devoted to the review itself, compared with 12 pages in the mid-term review. The only public document available for review as of this article is LC Paper No. CB(2)290/08-09(04), “Overall review of the Wage Protection Movement for cleaning workers and security guards, and progress report on preparatory work for introducing a bill on a statutory minimum wage.” In fact, the LC Paper No. CB(2)2012/07-08(04), “Wage Protection Movement for Cleaning Workers and Security Guards: Assessment Criteria for Overall Review in October 2008,” reached a “consensus on the continued adoption of six quantitative indicators of the mid-term review

in the overall review, and generally agreed on the categorisation of the quantitative indicators into core assessment criteria and reference indicators” set out in paragraphs 10 to 21. Yet, both the data requested and received from the Labour Department and the overall review do not sufficiently study these required indicators. The statement then, that the WPM has failed, cannot be justified. Nor should a policy based on flawed economics, like minimum wage, be implemented because another policy has failed. Less encouraging, the minimum wage economic consequences have not been fully acknowledged by the government. The conclusion that minimum wage will aid lowerincome workers is seriously flawed. The decision to implement minimum wage following the Wage Protection Movement is a flawed policy and cannot be justified. Increase in Poverty and Unemployment Like the relationship between the price of goods and demand, once labour is set at a higher price, less of it is demanded. When government mandates higher prices of labour, fewer people will be hired. Thus, the employment opportunities for less-skilled workers are reduced, especially those opportunities which are most directly affected by the minimum wage. This in turn will increase poverty and less-skilled,


he Chief Executive stated that the minimum wage would be applied to all members of society, and yet here the Bill discriminates against some. Autumn 2009


moving hong kong forward

Long-Term, Adverse Effects on the Hong Kong Economy Implementing the minimum wage


Shereen M

lower-income workers’ earnings. Put another way, if a worker’s productivity is below the minimum wage level, that worker will not be employed. It is the least skilled workers that will face greater probability of unemployment compared to those low- but still higher-skilled workers with greater productivity. For instance, assuming an employer can only afford to hire one cleaner under a minimum wage regime, the employer will seek the highest skills for that position and the competition for that position will increase. The minimum wage will force workers to enter an employer’s market (in which supply increases and demand drops) so that the employer now has more people to choose from to fill less jobs. Under minimum wage, competition increases because of fewer employment opportunities and the number of people unemployed looking for jobs will increase. Faced with this increased competition, it is primarily the poor and uneducated that bear the brunt of the minimum wage. In short, the minimum wage is a subsidy to relatively affluent workers at the expense of poorer and less educated workers. The result will price out certain groups from the labour force and create undue discrimination. Indeed, the minimum wage law will harm the very people it intends to help.

Without job opportunities, how can families fill their rice bowls?

will have long-term, adverse effects on wages, prices, inflation, profits and the youth. The minimum wage law will reduce the quantity demanded of workers, and may therefore, manifest itself through a reduction in the number of hours worked by individuals, or through a reduction in the number of jobs. This inefficiency in business caused by higher costs and therefore smaller profits will be targeted by changing other factors, such as a reduction in other employees’ wages, price increases for goods and services and automation. Businesses will try to compensate for the decrease in profit by simply raising the prices of the goods being sold thus causing inflation and increasing the costs of goods and services produced. Inevitably, as prices for a business increase,

n short, the minimum wage is a subsidy to relatively affluent workers at the expense of poorer and less educated workers. 8

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a firm will pass on the costs to its consumers. For those minimum wage workers and the unemployed, these higher costs will be most difficult to afford. While Hong Kong may not experience the same problems as other jurisdictions with businesses moving or closing under a newly implemented minimum wage, there will be some cases in which businesses will outsource jobs to other countries, causing greater unemployment. Exposure to minimum wage at young ages may lead to longerrun effects. Among the possible adverse longer-run effects are decreased labour market experience and accumulation of tenure, and diminished training and skill acquisition. Hong Kong’s youth may be drawn to minimum wage jobs rather than finish their schooling, which will have very negative effects for Hong Kong’s future. This will decrease overall human capital by encouraging people to enter the job market instead of pursuing further education.

moving hong kong forward

Hong Kong Dollar Peg and Monetary Policy The linked exchange rate system has large impacts for Hong Kong’s macroeconomic monetary and fiscal policies. Hong Kong’s interest rate cannot diverge from the pegged U.S. dollar interest rate by a significant margin and therefore, Hong Kong surrenders its independent monetary policy. In fiscal policy, the Hong Kong government must maintain huge reserves to keep confidence in the linked exchange rate system, and therefore must keep a balanced budget. Due to the constraints on both its monetary and fiscal policies,

Hong Kong must keep a very flexible economic system. Therefore, adjustment in an economic downturn, where Hong Kong may not employ monetary policy, must happen through price mechanisms. Therefore, price flexibility is key for Hong Kong’s domestic economy. The Minimum Wage Bill, which effectively restricts the flexibility of labour prices, would render the only method to stabilise Hong Kong’s economy ineffective. Once in place, it will be next to impossible to decrease the minimum wage level or repeal the law altogether. In an economic downturn, there is a great need for price adjustment. If the Government should continue with the pegged rate, and at the same time restrict wages, adjusting prices will be difficult and necessary market corrections will not be made. Therefore, the minimum wage is bound to undermine the link rate stability. In an economic downturn, without the currently available

mechanism to adjust price flexibility, it is the lower classes that will suffer the greatest. Exclusions The very exclusions in the Minimum Wage Bill spell out the problems with all minimum wage laws – they cause unemployment. For instance, the Minimum Wage Bill dedicates at least 5 pages to exclusions of live-in domestic helpers. The reason for this exclusion is because of “Possible significant and far-reaching socio-economic ramifications.” An increase in domestic helpers’ wages under minimum wage would lead to “distress” amongst Hong Kongers as far fewer families would be able to employ helpers. However, what economically applies to domestic helpers applies to security guards and cleaners also. When the government makes hiring more expensive, less people are hired. The same fears the government has with domestic helpers, indicated in this exclusion, apply to other industries as well. Roger Walch

Unintended Consequences In the midst of the financial crisis, the minimum wage in the U.S. was raised to its highest level since 1983. The U.S. Congress may not have intended for such a hike to be implemented at the most dangerous of all times but the consequences have been dire. For instance, youth unemployment has reached 25 percent and the jobless rate currently is at 9.8 percent as of this article. The U.S. experience with a hike in minimum wage during the financial crisis highlights problems caused by central planning that is the instigation of unintended consequences. However constructed the minimum wage procedures are, data will lag behind, and the government mechanisms will not be able to adjust to the changes. Regardless of efforts to assert qualifications and best technology, no prediction will match that of the market and planned mechanisms will always be incorrect at the expense of the public. The failure to coordinate the system, which under central planning is inevitable, has a catastrophic impact on the economy and people’s livelihoods.

If these job opportunities are removed from the market, priced too high, what jobs are lowwage workers left with? The government and unions have advised they can get on welfare. This is not a solution.

Autumn 2009


Kenn Chan

moving hong kong forward

the costs more easily than the former. This policy amounts to the government creating an unfair competitive environment for smaller business, as larger businesses will be able to absorb the costs of minimum wage with greater ability. Indeed, minimum wages may also lead to It appears as if the government is running out of good excuses to exclude domestic helpers – if most minimum demands for higher wages wage recipients would stay in public housing, the from non-minimum wage helpers’ housing issue cited as a reason to exclude domestic helpers is not viable. staff, and therefore push up prices of goods. With prices A De Facto Tax on Minimum Wage of goods on the rise, minimum wage Businesses recipients face hardship to afford The minimum wage policy which the more expensive goods. Chief Executive has said promotes “social justice” indeed does not. Logic flaws Minimum wages infringe upon the Legally, the bill as currently proposed liberty of both sides of a business suffers from a variety of defects and relationship, which is coercive logic flaws. The bill excludes domestic towards individual freedoms of helpers, interns, and people with employers and employees; actual disabilities. benefits most likely go to outsiders who face reduced competition Domestic Helpers from smaller firms hobbled by the There seems to be a contradiction minimum wage law. It is industries between Article 3 of the bill and the that employ minimum wage workers, justifications for excluding domestic such as cleaners or security guards, helpers from its ambit. which must face greater costs. This The legislative brief states that, practice represents the government in the case of domestic helpers, it placing a de facto tax on employers “would be impossible to ascertain of minimum wage workers, the actual hours worked.” It also discriminating towards certain states that “(t)he distinctive working businesses for political goals. pattern, i.e. round-the-clock presence Rather than a concerted effort and provision of service-on-demand by the government and the public to help the city’s most vulnerable workers, minimum wages are funded through a de facto tax on employers in sectors that employ the less fortunate. Minimum wage will hamper firms’ ability to reduce wage costs during downturns. The law will also harm small businesses rather than large businesses as the latter can distribute


expected of live-in domestic workers, will give rise to insurmountable practical difficulties in bringing them under the SMW.” However, Article 3(1)(a) states that hours worked by an employee cover “any time during which the employee is in attendance at a place of employment, irrespective of whether he or she is provided with work or training at that time.” There seems to be a contradiction between the demands for minimum wage as laid out by the Chief Executive in his 2008 policy address and the actual Bill. Specifically, the Chief Executive required that “if the Government introduces a statutory minimum wage, employees in all trades and industries should be covered at the same time.” Clearly, this statement is incompatible with the bill’s exclusion of domestic helpers. Article 6(3) of the bill is economically non-sensical. It states that the “Ordinance does not apply to a person who is employed as a domestic worker in, or in connection with, a household and who dwells in that household free of charge.”3 The drafters seem to have overlooked the fact that the dwellings used by domestic helpers are not free of charge but rather create an opportunity cost for employers. This cost could be quantified and expressed as a part of a domestic helper’s overall wage package.

ather than a concerted effort by the government and the public to help the city’s most vulnerable workers, minimum wages are funded through a de facto tax on employers in sectors that employ the less fortunate.


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moving hong kong forward

Similarly, the legislative brief used the terms “free food,” “free medical treatment,” and “free passage.” These items are not actually free. Employers have to pay for these benefits and they can be quantified as part of the overall pay-package. In fact, they amount to perks or employment benefits. Further, one aspect which does not seem to have been considered at all is that most, if not all, possible minimum wage recipients live in heavily subsidised public housing. Why, if the housing issue is deemed to exclude domestic helpers, is it being overlooked with respect to low-wage workers who profit from subsidised housing?

John McNab

Student Interns The legislation defines a student intern very narrowly, as “a student undergoing a period of work arranged or endorsed by an education institution specified in Schedule 1 in connection with an accredited programme being provided by the institution to the student for which the work is a compulsory or elective component of the requirements for the award of the academic qualification to which the programme leads.” The relevant education institutions are also narrowly defined and include only education institutions in Hong Kong. This provision will create major

In Chicago, IL, 1914, unemployed men queue up for a meal. Removing job opportunities removes people’s right to work.


nless students take part in an approved internship programme organised by one of the listed Hong Kong education institutions, they will not be eligible for exemption from minimum wage and thus, find it very difficult to secure internship places. problems for students who wish to undertake internships on a voluntary basis. Unless students take part in an approved internship programme organised by one of the listed Hong Kong education institutions, they will not be eligible for exemption from minimum wage and thus, find it very difficult to secure internship places. Basic Law The proposed legislation has a far-reaching impact on the business community in that it interferes with free market principles which have up to now been applied in determining wage levels. As such, the proposed legislation seems to fall foul of Article 5 of the Basic Law, which guarantees that the socialist system and policies shall not be practiced in Hong Kong.

Avoiding disharmony in Hong Kong Working towards providing Hong Kong with the best policies for its people is of great interest to The Lion Rock Institute, but we must move forward in a way that avoids creating more harm than good. There are other options in policy which can do what minimum wage purports to with the negative consequences of minimum wage mitigated. Under the minimum wage law there will be rent seekers that will benefit the most – a few to prosper at the expense of the

poor. It is not fair to take away job opportunities for those people in need, only to prop up the more educated on the career ladder. Furthermore, this policy will create disharmony in Hong Kong which will undermine the great tradition of melting minorities into our fabric. Stability and harmony is the nation’s number one priority, and this bill threatens those objectives. We must pursue policies that are best practices for Hong Kong as a whole.

Conclusion The Minimum Wage Bill will harm Hong Kong’s most vulnerable, and therefore Hong Kong should no longer consider this policy. Hong Kong is very capable of making good policy choices and solving Hong Kong’s problems with Hong Kong solutions. Let us move forward in a positive way. Lion Rock writers contributing to this piece are from Lion Rock’s Associate Scholars and Research Associates. 1. Hong Kong Government, Chief Executive Policy Address 2008-09: Embracing New Challenges (Hong Kong Government: 2008), P. 64. 2. Hong Kong Government, Legislative Council Brief: Minimum Wage Bill LD SMW 1-55/1/4(C) (Hong Kong Government: 2009), 5-6 No. 15(c). 3. Hong Kong Government, Minimum Wage Bill (Hong Kong Government: 2009), C. 623 (2c).

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Competition Law – Why Hong Kong is Different Hans Mahncke uncovers the roots of Hong Kong’s competition problems and explains why they will not be remedied by a cross-sector competition law Joe Gratz

but also, more broadly, why standard competition law models are not suitable for Hong Kong.

A new direction

An interesting feature of competition law is that it is usually enforced administratively through a special agency, rather than judicially through the courts.


year and a half has passed since the Hong Kong government put forward its proposals for a cross-sector competition law regime. Although draft legislation was to be tabled in the Legislative Council during the 2008/9 legislative session, the government decided to put the plan on hold. According to a spokesman for the Commerce and Economic Development Bureau, the delay is due to “technical, legal and policy issues.” Meanwhile, Donald Tsang, the Chief Executive, who had earlier promised to enact competition


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legislation during the 2008/9 legislative session, now states that “people’s main concerns are the economy and livelihood issues.” While the government’s explanations for the bill’s delayed introduction are not particularly tangible, the policy debate which led up to the postponement offers good clues as to the material reasons for the delay. This article aims to look at those reasons by reviewing the case against the government’s competition law proposals. By doing so, the present study will explain not only why, specifically, the government’s legislative proposals are ineffectual

The competition law narrative in Hong Kong has a long history. The Consumer Council first called for the introduction of competition legislation in 1996. In 1998 the government issued a statement on competition policy stating that “competition is best nurtured and sustained by allowing the free play of market forces and keeping intervention to the minimum.” Throughout Tung Chee-hwa’s tenure as Chief Executive the government maintained this approach. The first sign of a change in attitude became visible in 2005 when the current Chief Executive used his first policy address to state that the government would “promote fair competition and adopt appropriate measures according to the circumstances.” By the time of his 2007 policy address, aptly entitled “A New Direction for Hong Kong,” Donald Tsang had decided to introduce competition legislation.

Competition law basics Before exploring the situation in Hong Kong and delving into the detail of the government’s plans for competition legislation,

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Competition law and Hong Kong Moving to the specific situation of Hong Kong, there are some peculiarities which may affect the applicability of competition law. First, Hong Kong has developed into its current levels without having employed an across-the-board competition law regime. Instead, it has adopted sectoral regimes in the areas of telecoms and broadcasting. These will be revisited below. Second, unlike all other countries and customs territories in the world (save for Macau), Hong Kong is a free port. This means that no customs duties are levied on imports or transhipments. In theory this should ensure that market power concentration is not possible as new players can freely enter the market. However, this only applies to trade in goods. As far as other sectors are concerned, most notably natural monopolies, trade in services, and the property market, the situation may not be as straightforward. Third, the Hong Kong government had, until recently, observed a policy of “positive noninterventionism” which was built on the belief that the economy tends to do better without government interference. The policy was adopted in 1971, modelled from the Financial Secretary John Cowperthwaite, but ostensibly abandoned in 2006 by the current Chief Executive, whose preference is a model he has coined “big market, small government.”

Competition deficits There are those who feel that Hong Kong has fared well without a

eyond these basic commonalities, national competition laws are largely idiosyncratic.

John C. Abell

it is instructive to first consider competition law from a broader perspective. Generally, competition law (or antitrust as it is called in the United States) seeks to address three types of market behaviour, namely monopolies, collusion amongst competitors, and mergers and acquisitions. The commonality amongst these three types of conduct is that they are indicative of potentially concentrated market power. Thus, the aim of regulating such conduct is to ensure that such concentration does not occur or that market power is not abused either by overcharging consumers or by denying other suppliers the opportunity to do business. Yet, beyond these basic commonalities, national competition laws are largely idiosyncratic. What is a monopoly? When is collusion detrimental to consumers and when is it beneficial? When should mergers be allowed? Different countries’ systems provide different answers to these questions. Indeed, the answers change over time, even within the same country, depending oftentimes on the individuals in charge. Thus, the vigour of European Union competition law enforcement has been closely tied to the respective commissioner in charge. Similarly, the extent of application of antitrust law in the United States tends to depend on which party controls the executive branch. Another feature of competition law is that it is usually enforced administratively through a special agency, rather than judicially through the courts.

Since competition law is enforced administratively, it is vitally important to have a democratically legitimated administration.

comprehensive competition law and that, therefore, the status quo should be maintained. Indeed, the government, as explained below, could also be counted in this group. However, the various individuals, organisations, and policy makers who have been calling for competition regulation in Hong Kong cannot be ignored. At the very least, irrespective of whether competition law is needed, there seems to be a strong perception within the community that there are competition deficits in Hong Kong. The most common grievances relate to concentrated market power in the energy, transport, property, construction, and supermarket retail sectors. Concerns have also been raised in the area of telecoms. However, as mentioned above and discussed below, there is already a competition regime in place for this sector. The areas complained about can roughly be grouped into two categories. First, energy, transport, and telecoms all fall within the area of natural monopolies. That is to say, these are sectors which inherently do not lend themselves to free market philosophy. For instance, it is neither feasible nor desirable to build multiple or duplicate rail networks, highways or electricity grids. Instead, Autumn 2009


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There is no balance between private and public housing.

the market is naturally limited to a low number of participants. Thus, to protect consumers and businesses, government regulation is desirable in order to ensure the best service at the lowest price. But while these sectors ought to be regulated and it can be argued that the Hong Kong government has not done particularly well in doing so, the existence of natural monopolies does not justify a cross-sector competition law. Second, this leaves the property, construction, and supermarket retail sectors. While it may not be immediately apparent, there is a commonality between these sectors: the land system in Hong Kong. While the nexus between the land system and the property sector is clear, supermarkets are also affected as the restrictive land system prices potential competitors and new entrants out of the market. Similarly, the close connection between property development and construction in many cases means that these sectors operate in symbiosis. Most importantly, these sectors are dominated by a few players who have used the land 14

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system as a platform for building their respective business empires.

The land system While it may be debated how far the current government has strayed from the “positive non-interventionism” policy, there is no mistaking the fact that the government has for decades interfered with the system of land distribution and allocation, often with catastrophic consequences for competition in Hong Kong. This interference manifests itself twofold. First, the government provides heavily subsidised public housing to 3.3 million people, roughly half of the population. Second, all land in Hong Kong is owned by the government which, from time to time, auctions off leases to certain plots of land. Both these factors represent massive interferences in the operation of the free market and can be said to be the true source of Hong Kong’s competition troubles. With regard to the public housing system, eligibility for tenancy is strictly means tested, whereby the income limit for a couple is set at HK$ 11,600. As a result of this

low threshold, rents paid by public housing tenants are very low, usually a fraction of those paid on the private market. While one may argue about the social desirability of Hong Kong’s public housing policy, the undeniable consequence of it is that the rental housing market is starkly divided between cheap and expensive housing with very little in between. Further – and perhaps even more serious – is the size of the public housing sector means that the size of the private market for property is kept artificially small. In turn this keeps private market prices high. This leads to the second issue, the role of the government in making land available for private development. Instead of having a predictable policy for auctioning land leases, the government chooses to supply land depending on prevailing prices, almost always with the aim of keeping prices high. For instance, when the economy finds itself in a downturn, auctions are put on hold. The situation can similarly be influenced by electing not to sell certain plots of land. One example is the massive old airport site in Kowloon City which, more than eleven years after the last plane took off, remains in disuse. A related problem is the land premium system whereby property owners can negotiate with the government to amend the covenants on land use. Re-classification can be used to increase land prices, for instance, by re-designating agricultural land for residential use. Land premium negotiations take place behind closed doors and afford the government wide discretion in decision making. One may ask why the government would be interested in maintaining high property prices. The reason is that a large portion of the government’s income is generated

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through property sales, land premiums, and stamp duty. Thus, undersupplying the market helps the government as much as it helps property developers. The operation of this system has had three effects. First, it has created an indirect tax on consumers and businesses, be it through higher rents or higher retail prices. Second, artificially high property prices stifle economic activity. Third, the land system has facilitated the rise of a few family-owned property conglomerates that control large swathes of the economy, ranging from electricity to transport to supermarket to telecoms. Li Ka-shing and his family are probably the best exponents of this situation, owning amongst others, Hong Kong Electric, the former Hong Kong Telecom (PCCW) and Hutchison Whampoa, with its port facilities and major supermarket retailer Park n’Shop. There are others too, such as the Kwok family who control Sun Hung Kai, which operates Kowloon Motor Bus (KMB), one of the world’s largest private bus companies, various construction and engineering enterprises, as well as Smartone, a leading telecoms firm. Another example is Lee Shau-kee who owns major property developer Henderson Land, Hong Kong and China Gas, Hong Kong Ferry, and a number of department stores.

The 2008 proposals Given the situation described above, the pivotal question which arose from the government’s release of its 2008 competition law proposals was whether the same government that maintains and profits from a distorted land system would introduce a competition regime that had the effect of undermining

that land system. Not surprisingly, as betrayed by the details of the government’s feeble competition law proposals, the government’s mindset was more occupied with maintaining the land system than with fixing Hong Kong’s competition deficit. Thus, the government’s overall goal seems to have been to cursorily appease those who have called for competition law while preserving the status quo. Although a detailed discussion of the government’s 2008 proposals seems futile at a time when they are being reconsidered, the proposals do yield some information on what may be changed if and when the government releases its new proposals. The four most glaring defects in the 2008 proposals were the lack of adequate penalties, the exclusion of mergers and acquisitions, administrative enforcement and the fact that the government was attempting to exempt itself from the effect of the legislation. While it cannot be expected – for the reasons mentioned above in relation to the land system – that the government will remedy all defects, there will inevitably be some changes. Penalties First, with respect to adequate penalties, the 2008 proposals had

set a limit of HK$ 10 million as a penalty for breaching competition provisions. Alternatively, a penalty amounting to up to 10% of turnover was to be levied in some circumstances. Compared to other jurisdictions these are small amounts and there have been no indications that the government intends to alter these thresholds. Mergers and Acquisitions Similarly on the second issue, the fact that an area as important as mergers and acquisitions was left out of the original proposals must have been carefully considered at the time and, therefore, it is not expected that this item will be amended. Even if relevant provisions are introduced, the example of the Telecommunications Ordinance (discussed below) suggests that they will not be effective. Administrative Enforcement Third, there are, however, indications that the issue of administrative enforcement may be revisited. This is a problematic aspect to competition law in most jurisdictions, but would be especially so in Hong Kong where there is a lack of democracy and, therefore, lack of legitimacy of the executive. Comments made by Secretary for Commerce and


he pivotal question which arose from the government’s release of its 2008 competition law proposals was whether the same government that maintains and profits from a distorted land system would introduce a competition regime that had the effect of undermining that land system. Autumn 2009


Billy Alexander

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We should change our traditional approach – if the government did not intervene in the distribution and pricing of land, there probably would not be as many competition problems.

Economic Development Rita Lau Ng Wai-lan in March 2009, as well as by other government sources reported in the local media, suggest that the government may try to transfer competition law enforcement from an administrative body to the courts. Although this would overcome some of the difficulties created by Hong Kong’s democratic deficit, it would still pose serious questions with respect to the courts’ capacity to handle competition law related cases. One of the reasons competition law cases in other countries are often handled by specialised administrative bodies is that they are said to have the expertise necessary to deal with complex economic questions. It would also pose the risk of courts being asked to act as policy makers. The conclusion one might draw is that without a democratically legitimised executive, competition law is unfeasible. Government Exempt from Legislation Fourth, there are indications that the government is willing to back away from its earlier desire to exempt itself from being covered by any competition law. However, the extent of this retreat is likely to be 16

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limited, perhaps covering a number of selected statutory bodies. Thus, it is not expected that the modifications the government might introduce to its competition law proposals will change the fact that the law will remain ineffective. Indeed, the competition regime already in place for the telecoms sector is a good indicator of what can be expected. Since 1999 the Telecommunications Authority has been charged with enforcing rules on anti-competitive conduct, abuse of dominance and mergers and acquisitions in the telecoms sector. It is also charged with investigating misleading and deceptive conduct. However, these last two types of conduct fall outside the scope of what is usually regarded as competition law and also outside the scope of the 2008 proposals for a general competition law. A look at the competition law related cases investigated by the Authority reveals a disturbing picture. Out of a total of 39 cases of suspected abuse of dominance or anti-competitive conduct which were examined by the Authority, only one case led to issuance of a warning. In all 38 remaining cases, the complaint was said not to have been established. Indeed, given this trend it is not surprising that there has been a very sharp drop in cases being brought. In fact, 23 of the 39 cases in total were brought in 1999, the year the Authority started its work. Similarly, there have been eight investigations relating to


mergers and acquisitions, whereby the Authority saw no problems in any of the eight cases.

Conclusion Thus, while Hong Kong has competition problems, they are not of the sort which can be remedied by the introduction of a cross-sector competition law. Instead, the roots of the problems lie with poorly regulated natural monopolies and with the land system. Unless and until these issues are addressed, there is no point in adopting an across-the-board competition law. In particular, unless the land system is fixed, both in respect of revamping the market segmentation created by public housing, as well as reducing land prices by overhauling the current system of allocating and designating land, nothing will change. If the government did not constantly intervene in the distribution and pricing of land, there would probably be no need for it to intervene elsewhere. But just as the government has shown itself unwilling to properly regulate natural monopolies, it will in all likelihood not change the way the land system operates. And thus, Hong Kong’s competition ills will remain, with or without a competition law regime. Hans Mahncke is a Lion Rock Associate Scholar and an Assistant Professor at the School of Law at City University of Hong Kong.

he conclusion one might draw is that without a democratically legitimised executive, competition law is unfeasible.

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Hong Kong Mortgage Corporation – Past its Use-By Date Bill Stacey argues that as the market has changed the original policy rational of the Hong Kong Mortgage Corporation has disappeared Daniel Y. Go

1997 Annual Report was to: 1. Purchase portfolios of mortgages or other loans secured by residential properties situated in Hong Kong from Hong Kong “authorized institutions,” 2. To raise financing for purchase of mortgages through the issuance of debt securities in the capital markets, and 3. To securitize mortgage portfolios.

A failure of the HKMC and the government would be to allow the institution to linger beyond its use-by date – continuously violating its mandate.


he Hong Kong Mortgage Corporation (HKMC) has reached its use-by date. It has sought to survive through a strategy of diversification that takes on higher risk with public funds. The organization now does little more than exploit credit and regulatory arbitrage opportunities. The government should dramatically reform HKMC by either listing the company or selling its stake to private institutions.

Rationale for HKMC Hong Kong Mortgage Corporation (HKMC) was established in 1997. The original rationale stated in the

At founding the idea was to provide an outlet for banks to manage total mortgage exposures and the Hong Kong Monetary Authority (HKMA) was particularly interesting in building Hong Kong fixed income markets. The original rationale was weak. Hong Kong had not developed deep fixed income markets because the strong fiscal position of the government, relatively conservative gearing of corporations, as well as easy access to Eurodollar markets saw limited supply of term credit. Investor demand was also weaker when in a linked exchange rate regime USD securities provided many investment alternatives. The idea that a mortgage market might emerge internationally along the lines of the U.S. model was fashionable at the time. Freddie Mac and Fannie Mae were great proponents of their model, which was advocated across Asia. However, where securitization did grow internationally it was mainly in markets where banks were more heavily wholesale funded. The Hong Kong banking system HKD loan-deposit ratio is currently just 71% and has declined since HKMC was established for reasons largely independent of the HKMC. The HKMC has strayed far from its original rationale. Mortgage Insurance is now an important line of business (from 1999). In October 2006 the Board of HKMC approved a diversification strategy. Non mortgage assets Autumn 2009


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are growing (from 2006) and since late 2007, HKMC has expanded the strategy by growing Asia mortgages assets, with 24% of loan exposure now outside Hong Kong. This diversification has not been driven by opportunity and market demand, but by a drive for institutional survival as the original business rationale disappeared. It is not a harsh assessment. The HKMC in its 2008 annual report states that: “The Board accepted the assessment [by a consultant] that without substantial asset acquisition by the Corporation, there would be little room for the corporation to remain a viable entity.� For a private business, changing corporate strategy with changing markets is a necessity. There is always the sanction that a shrinking business or unsuccessful diversification will see closure of the business, merger or other restructuring. However for a public institution using public funds, divergence from the original purpose needs a strong policy justification. Given the actual role and performance of HKMC, it is not at all clear that it any longer serves its original policy purpose.

smaller regional banks with funding and liquidity. Closer to Hong Kong, it can play a role as an alternative to the major deposit taking banks in Hong Kong providing liquidity to the money market which funds the balance sheets of smaller banks. Despite initial promise during the period from 200103 when banks themselves faced pressures, HKMC has for the past five years been a declining business. Irrespective of mortgage credit growth, which in Hong Kong has been subdued compared to many markets globally, HKMC has been losing market share and its portfolios contracting. HKMC mortgage loans

Performance of HKMC – less than it seems HKMC operates three main lines of business: 1. a domestic mortgage business, 2. domestic mortgage insurance, and 3. international mortgage and mortgage insurance. Non mortgage assets are small. Hong Kong Mortgages The core business of HKMC is the purchase of mortgage loans from Hong Kong banks and funding these purchases either through securitization or HKMC debt facilities. HKMC does not originate or service mortgages. Its customers are the banks and debt markets. This basic role is very similar to Freddie Mac and Fannie Mae (Government Sponsored Enterprises or GSEs) in the United States, although both of those institutions ultimately diversified considerably from their original function. A key difference between Hong Kong and U.S. markets is that typical Hong Kong mortgages are variable rate, compared to the fixed rates that are common in the U.S. Therefore, HKMC does not have the interest rate risk intermediation function of the GSEs. It also operates on much less leverage and as a much smaller player in the market. The role of the HKMC is more akin to the historic role of competing money centre banks in the U.S. providing 18

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This is mainly because the mortgage market in Hong Kong has changed. Deregulation of interest rates and the entrance of new competitors, as well as the more recent impact on the market of China banks, have significantly reduced net interest margins in the mortgage market from the levels seen in the 1990s. Subdued corporate lending growth as capital markets intermediate more credit has reduced balance sheet growth for banks and made mortgages more attractive. Lower capital requirements and favourable treatment under Basle 2 further encourage banks in Hong Kong to focus on retention and growth of their mortgage portfolios. Market share of mortgages and mortgage growth

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As a result of these changes, the market share of mortgages held by HKMC has declined from a peak of 9.3% to 4.6% today. Further, the average life of a mortgage varies with interest rates and expected incomes, but around six years is relatively low by international standards and is a declining trend. Hong Kong consumers have, since the experience of negative equity in 1999-2004, had a cautious appetite for leverage. This portfolio shrinkage creates challenges for funding programmes and the demand for HKMC paper in the market. It makes it difficult to sustain securitization vehicles. It is evident from this data that whilst the HKMC might have a desired function, its core business rationale does not look sustainable. As a result, the focus of the HKMC has shifted from a purported business rationale towards a policy role “providing liquidity” to the Hong Kong banking sector and helping them manage their balance sheets. Even that rationale would have looked flimsy if not for the financial crisis. Yet even here the role of HKMC was slight. A single local bank had a small “run” driven by rumor rather than actual balance sheet stress. Amongst measures taken to ensure liquidity for that bank, a substantial portfolio of mortgages was sold to HKMC. This measure was not essential to the bank concerned. Other established liquidity measures would have been sufficient for the bank to work through the short-term challenge. Indeed, other banks may well have been willing to acquire the portfolio or other assets. The bank has since intimated that it might have preferred not to have sold those mortgages. In retrospect, the minor and arguably unnecessary role of HKMC during an extreme crisis of the financial system underlines that the institution has reached its use-by date. We examine below the financial performance of this part of the business.

Hong Kong Mortgage Insurance HKMC is also the major provider of mortgage insurance in Hong Kong. It began the business in 1999. Mortgage insurance provides lenders guarantees that in the event of mortgage default they will not suffer losses or that those losses will be capped. Typically mortgage margins are fine and insurance is only used for higher risk mortgages. In the case of Hong Kong, the HKMA imposes stringent constraints on mortgage origination. Amongst other limits, banks are not allowed to offer mortgages with a loan to valuation ratio (LVR) over 80% unless those mortgages have mortgage insurance. In other markets, an LVR up to 90% might commonly be underwritten without mortgage insurance and LVR limits are usually bank practice rather than regulatory rules. As a result, penetration of mortgage insurance is growing quickly and now stands at 16% and 84% of approvals are for secondary market transactions. These rules have underpinned rapid growth in HKMC mortgage insurance premium. This growth has been further boosted by policy changes designed to support the market during the financial crisis. HKMC sharply expanded its mandate, offering mortgage insurance for mortgages with an LVR of above just 60%. Previous extensions offered premium discounts for lower risk loans and extended insurance to cover non-owner occupied property.


There are a number of private sector mortgage insurance providers internationally. Given the strong underwriting track record in Hong Kong despite stressed markets, it could be an attractive niche market for some of these underwriters. These attractions of the business for private providers are underlined by the financial performance of this business for HKMC. The expense ratio for an insurer is a measure of efficiency that compares costs to net premium written. This ratio has continued to decline and is currently 8%, an extremely low number by industry standards.

espite initial promise during the period from 2001-03 when banks themselves faced pressures, HKMC has for the past five years been a declining business.

Gross premium growth

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The claims performance has also been extremely strong, consistent with the good credit quality experience in Hong Kong. At the peak of the negative equity experience, claims were just 6% of net premium. Note that the high claims ratio in 2008 reflects a growth in “claims incurred but not reported” simply reflecting very prudent provision for economic changes and the rapid portfolio growth rather than any actual losses. This results in a combined ratio on an underlying basis of under 10%, where insurers are typically happy with any number under 100%. The appetite of private sector insurers for Hong Kong mortgage risk is illustrated by the high use of reinsurance by HKMC in the early stages of its mortgage insurance programme. Retention ratios under 50% are low and reinsurers were clearly happy to take on the risks. HKMC has been increasing retention, sharply increasing the profit contribution from insurance, albeit increasing risk exposures. HKMC insurance combined ratio

The insurance business is a growing contributor to the HKMC bottom line, now delivering 13% of pre-tax profits. However the underlying contribution without the high reserves taken in 2008 is probably much higher and will be reflected in a rapid profit growth going forward. Insurance % of total profit


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Two criticisms can be made of the HKMC mortgage business. The first is that it is largely the result of “regulatory arbitrage.” The business comes into existence and has its current scale mainly because of the stringent HKMA prudential requirements on mortgages. Secondly, the HKMC has displaced potential private providers in the business. They might reasonably argue that the Hong Kong market is small and would not be adequately provided with mortgage insurance if not for their role. However, the appetite of reinsurers for HKMC risk suggests this is not the case. Further, the extremely high profitability of the business since inception suggests that there should be more competition. Unfortunately although there are no formal restrictions on new entrants, the close relationship between the HKMC and the banking regulator likely makes the private sector reluctant to compete. International Mortgages The international business includes mortgage portfolios from Korea, a joint venture in Malaysia, and a new venture in Shenzhen China. The international operations contribute 24% of assets, but just 12% of profits for HKMC. The business started in December 2007 with the purchase of HK$ 5.5bn of mortgage-backed securities from Korea. The Korea purchase looks like little more than an investment strategy adding assets to the balance sheet with HKMC adding no value in origination. The joint venture in Malaysia with Cagamas, the Malaysian mortgage corporation, targets mortgage guarantee business particularly in Islamic markets, though not limited to Malaysia in its scope. There is extensive over-building in parts of Malaysia and it is one of the riskier mortgage markets in Asia. The China venture is established with an associated company of the Peoples Bank of China and will also offer mortgage guarantees. The international business diversification has moved beyond the core businesses operated in Hong Kong. The guarantee business is not the same as mortgage insurance and arguably carries higher underwriting and operational risks. The guarantee business typically lacks the close cooperation with originators and the ability to manage underwriting criteria that is found in mortgage insurance. Loan guarantee businesses operated by domestic insurers in China had a very patchy track record, albeit that they did not target the mortgage market. China already has an extensive network of private loan guarantee providers and it is not at all clear what gap in the market is targeted by the HKMC and its partner.

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These ventures may all prove to be well thought out and successful. However, they seem driven more by the necessity to diversify than by strong market opportunities. That both are also with government related partners in countries without the same discipline about governance and returns that are present in Hong Kong is also a concern. These operations are new and there is little disclosure about the strategic case for them and financial targets. There is no question but that the international businesses are higher risk ventures than the existing business of HKMC. Credit arbitrage is an old game. A highly rated company can easily raise cheap funds and report higher earnings by investing that money in higher risk assets. However, that strategy does not add value, unless those higher risk assets are being mispriced in the market or the acquirer can manage those assets better. The international strategy to date looks simply like an exercise in credit arbitrage. Asset mix HKMC

conservatively invested. However, the contribution of the investment portfolio is growing over time to 28% of interest income. HKMC looks like it has delivered very stable net interest margins, managing interest rate volatility well. Historically, higher short-term interest rates were negative for margins, increasing funding costs before loan repricing. However, with a greater reliance on investment securities for interest income, it looks like low investment yields have recently depressed margins and offset the funding cost changes. HKMC does not have the advantages that a bank might have of a stable source of low cost retail deposits. It has longer duration liabilities and is not in the business of “borrowing short and lending long.� With lower risk assets than a bank, HKMC delivers and should deliver consistently lower margins than large mortgage oriented banks. HKMC NIM compared to Hang Seng Bank

Profit mix HKMC

Financial Performance of HKMC The Hong Kong Government, the company, and HKMA tout a strong financial performance as vindication of the HKMC operations and strategy. The view seems to be that if the HKMC can support itself financially and also perform a valuable back up public policy role, then it might as well continue. Revenues and margins Looking at that overall financial performance in more detail, 85% of revenues for HKMC are Net Interest Income, although with the growth of the insurance business the reliance on interest income has declined over time. Interest income is generated from interest generated on loan portfolios and investment securities. The investment securities portfolio largely represents the return generated on placement of HKMC capital and is

However, HKMC should have significant advantages over banks in delivering a return to shareholders. As an investor rather than an originator, it can run much leaner cost structures. As a mortgage specialist it should be safely able to operate with higher gearing than a commercial bank. More importantly, as an arm of the HKMA and the Hong Kong government, HKMC has a much lower cost of funds than a bank.


hat both are also with government related partners in countries without the same discipline about governance and returns that are present in Hong Kong is also a concern. Autumn 2009


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The chart below compares the average cost of liabilities for HKMC to the yield to maturity on HSBC wholesale debt. It points to a funding cost advantage in term debt over even the strongest private sector players of 100-200bp. This sovereign support is a key competitive edge of HKMC over banks or any potential commercial rival. The structure of the Hong Kong market, with a focus on variable rate mortgages, benchmarked at prime rates or HIBOR somewhat neuters this as a competitive advantage in mortgage acquisition. However, the lower cost of funds from the government relationship does enhance HKMC returns and influences the economic incentives as HKMC looks at expansion opportunities.

Efficiency HKMC runs a lean cost structure reflecting its low growth, wholesale or intermediary business model and a focus on productivity. However, staff costs (65% of total costs) have started to grow much more quickly with the implantation of the diversification strategy. Staff costs in 2008 were 31% higher than in 2006, whilst revenues were down 6.8% in the same period. Staff costs growth

HKMC comparable cost of funds

Most of the non interest income at HKMC is generated by the insurance business. However, under new Hong Kong accounting standards, more of the investment activities are reflected in non interest income via gains on disposal, dividends, and fair value adjustments. In 2008 securities valuations and foreign exchange differences were a large, though likely non recurring drain, on income. However, the higher emphasis on international business and greater reliance on securities income than loans is likely to lead to more volatile revenues.


he lower cost of funds from the government relationship does enhance HKMC returns and influences the economic incentives as HKMC look at expansion opportunities.


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Asset quality Reflecting the market, HKMC has delivered extremely good loan asset quality. In the weakest property market of a generation in 2003, delinquencies peaked at 60bp of loans. Loan loss provisions peaked at 43bp of loans and in the 3 years afterwards, there were two years of write back reflecting provisioning conservatism. HKMC mortgage delinquencies

Gearing is conservative HKMC has traditionally run conservative gearing, with simple equity to assets ratio of 11.5% in 2006-07. In 2008 this dipped to 8.8% with a combination of asset growth and the impact of market shifts on reserves. 1H09 has seen the capital ratio rise up at 9.6% because of fair value gains and retained earnings. By way of example, despite HKMC likely having a lower risk

moving hong kong forward


taff costs in 2008 were 31% higher than in 2006, whilst revenues were down 6.8% in the same period.

profile, Hang Seng bank has an equity to assets ratio of 6.8% and Bank of China (Hong Kong) of 8.4%. Conservative gearing contrasts HKMC with mortgage companies that had high losses and caused systemic problems in other parts of the world. However, it also suggests a lazy balance sheet struggling to deploy the financial resources at hand. Guidelines for HKMC issued by the Financial Secretary limit the equity to assets ratio to 5%. Returns probably understated, but flattered by low funding costs Over its life, HKMC has delivered an average Return on Equity (ROE) of 11.5% and Return on Assets (ROA) of 1.3%. The underlying performance is probably better, shown by the 15.6% annualized ROE achieved in the first half of 2009. It also looks like HKMC are consistently conservative in reserving for loan loss, insurance liabilities, and seems to take reserves for “contingencies” that I estimate suppress ROE by 60bp. Combined with the conservative gearing, the “rents” being extracted from mortgage holders by HKMC are obscured by these layers of caution. HKMC returns

Returns are very sensitive to the cost of liabilities. The benefit from the government supported lower cost of funds enhances ROE by as much as 5%. Considering the offsetting impacts of a low cost of funds and reporting conservatism, the normalised return on equity for a business like HKMC would be in the 1012% range; a mediocre return in a mature business with no domestic growth. HKMC funding cost normalised returns

Disclosure Slips On the whole, HKMC should be commended for reasonable monthly disclosure that meets investor and rating agency needs. However, as the business has expanded, regular monthly disclosure has slipped. Through its 10 years of operations, the following disclosure changes have been made: • For insurance, the actual insured amounts were dropped • The key insurance approval data was dropped • Charge off rates are no longer published • Detail of LVR for insured loans has been dropped • Volumes of Korea and international mortgages are no longer disclosed monthly • There was a recent switch back from disclosing insurance applications received to approved Some new disclosure has been added on debt programmes in particular. However, it seems that the data no longer disclosed is more likely to be controversial and seems to be data that would be most helpful in understanding the pattern of portfolio risks being taken. A private firm can cite commercial confidentiality as a constraint on disclosure. Public institutions should not be in businesses that cannot be fully disclosed.

That said, compared to a company operating without the sovereign backing that supports its low cost of funds, HKMC enjoys an advantage. As a rough estimate, the funding cost advantage averages something like 60bp.

How HKMC distorts the market The origins of the HKMC can be appreciated and arguably, management has done a reasonable job Autumn 2009


moving hong kong forward

Policy for reform At the core of HKMC is an incentive problem. Management are public officials with an incentive to keep the institution running and grow its scale, but have weaker incentives to deliver strong financial performance. They can perform better by using bureaucratic skills to expand their brief and policy role than by winning business in more competitive markets. This can be seen in conservative financial statements and a strategy of diversification that seems more like diplomacy and networking than leveraging strong business advantages. It is not harsh to observe that HKMC exists only to exploit credit arbitrage and regulatory arbitrage. 24

Best Practice

Louise Docker

executing the original policy vision. However, the market has changed and the HKMC no longer plays a role that justifies the investment of public funds and support of the public finances strong credit rating. The existence of the HKMC distorts the domestic mortgage market. First, in the domestic mortgage market, its shrinking portfolio is only viable because of the low cost of funds. The role in a “crisis” does not seem essential. There is a risk that HKMC activities crowd out new entrants in securitization markets that do not have the advantage of funding costs at sovereign benchmarks. Without any portfolio growth, the HKMC cannot play its desired role deepening the fixed income market. Second, the insurance business is reliant on regulatory arbitrage. Owned by HKMA, the HKMC is reliant on the parent’s stringent mortgage prudential rules for delivery of volume to its business. This provides a disincentive for reform of those prudential rules. Those rules are one reason why mortgage products in Hong Kong do not have the flexibility and features that can be accessed in other mature mortgage markets. This means that banks have fewer options in terms of non price competition to differentiate themselves and contributes to very aggressive pricing in the mortgage market. The HKMA themselves have recently warned against aggressive mortgage pricing. On top of this, the partial data available seems to suggest that HKMC are generating excessive returns from mortgage insurance and may be overcharging consumers. Third, the diversification strategy seems reliant on the low cost of funds and under leveraged balance sheet for a rationale. There is little evidence that the investments are driven by a strong business rationale. They look more to be a tool to ensure survival of the institution.

With every year’s shrinking need for the HKMC, it further expands its balance sheet and violates its mandate.

Given a moderately successful track record over 10 years under poor incentives and a degree of genuine expertise in mortgage and funding markets, it makes sense to look at options for reforming HKMC rather than abolition. Moving HKMC into the private sector through listing or sale of a stake to other financial institutions could put it on a commercial footing. This would provide management with an incentive to grow returns, but also look more critically at regional markets. Support for the credit rating from the government could be progressively phased out. For businesses to survive in dynamic markets they have to change. One of the great virtues of the capitalist system that Hong Kong’s Basic Law is committed to preserve is that institutions that no longer serve their owners or customers are closed and resources are reallocated to more productive uses. This is not failure for the system, it is a success. Hong Kong banks, HKMA, and the government have created an efficient mortgage market that no longer needs the HKMC – this should be counted as a success. Failure would be to allow the institution to linger beyond its use-by date. Government involvement in mortgage markets has proved disastrous in the United States and other markets. Hong Kong has avoided these problems so far, but the new diversification strategy takes HKMC into markets that have had a more difficult track record. Bill Stacey is the Chairman of The Lion Rock Institute and a partner in a boutique Hong Kong based securities company.

Trey Ratcliff

moving hong kong forward

Hong Kong is competitive not only as an attractive place to do business but, in its distinct way, also an attractive place to live.

Reflections on Global Legal Centers Larry E. Ribstein exposes the wider motivations behind current international pressure to alter Hong Kong’s tax law


rom sanctions to blacklists, there is international pressure to significantly depart from Hong Kong’s current practice and start collecting information in relation to the tax affairs of other jurisdictions. In May 2009 I traveled to Singapore and Hong Kong to get some background information on these leading examples of global legal

centers. It connects with my broader work on jurisdictional competition discussed in my recent book (with Erin O’Hara), The Law Market (Oxford University Press, 2009). Under the general theory articulated in this book, firms seek to escape from regulatory and tax burdens imposed by their home country by “unbundling” law to some extent from that territory. Unbundled law becomes like a

commodity traded in a market. “Offshore” jurisdictions are key global suppliers of this type of law. While interest groups in “onshore” jurisdictions seek to grab benefits from firms’ connections with their countries, interest groups in offshore jurisdictions reduce their tax and regulatory price in exchange for reaping benefits of firms’ moving some of their activities and legal work to their jurisdictions. Autumn 2009


moving hong kong forward

Although it might seem that this competition imposes the costs of deregulation to the firms’ home countries, in fact, onshore jurisdictions can respond simply by applying their own law to local firms. At the same time, onshores are constrained by the fact that firms can completely sever their local connections and withdraw fully – or “exit” – not only to offshore jurisdictions, but to other onshores that are willing to recognize offshore law and tax. This type of exit would leave behind in the onshore jurisdictions what O’Hara and I refer to in our book as “exit-affected” interest groups – those who gain economically from the escaping firms’ physical presence, including workers, lawyers and other professionals, and all those who depended on the local headquarters of a big firm. These interest groups can join with other anti-regulatory groups to oppose attempts to inefficiently tax and regulate firms. Consider what happened after the U.S. passed the Sarbanes-Oxley Act (SOX), when New York saw firms pull out and go to other markets, such as London. Although academics continue to debate exactly what happened and why, the fact of the pullout, and the reaction by former lead SOX supporter Senator Charles Schumer, among others, to seek to limit or delay SOX, are clear enough. Offshore jurisdictions cannot win


the competition just by negating onshore tax and regulation. To begin with, they have to offer reliable law in the sense of establishing a reputation that they will stick to their tax and regulatory bargains. Firms also seek sophistication, expertise, and predictability from the offshores’ adjudicators. And given that onshores have the last word in deciding whether to recognize offshore law, offshore jurisdictions must take account of how their laws affect onshore jurisdictions. To take a recently prominent example, onshores are worried offshores will compromise their whole ability to tax or regulate by offering Swiss-type privacy or, more generally, a safe haven for wrongdoing. An offshore may be able to generate a global consensus to enforce its regulation by demonstrating that it will not compromise important offshore regulatory and tax norms. It may be difficult for an onshore to defect from this consensus because firms can find plenty of other onshore homes. Now let’s consider where Singapore and Hong Kong fit in all this. These jurisdictions offer unique advantages. First, they both have fairly substantial reputations as reliable and sophisticated providers of reasonable tax and regulatory rules. Both have histories as strong regional offshores, Singapore attracting wealth from Malaysia,

recently prominent example, onshores are worried offshores will compromise their whole ability to tax or regulate by offering Swiss-type privacy or, more generally, a safe haven for wrongdoing.


Best Practice

Indonesia and India, and Hong Kong, of course, from China. Second, both have common law English-based legal systems. Even if one does not assume that this is generally a developmental advantage, it is a clear advantage for a global legal center because it combines flexibility and ability to evolve in a rapidly changing world with the stability brought by the established traditions of legal certainty and property rights embodied in the common law. Partly because of their similarities, Hong Kong and Singapore compete for increasingly global rather than regional legal business. On my visit, I didn’t get a strong sense of each jurisdiction’s competitive strategy. That may be partly due the fastmoving nature of the global legal environment and the uncertainty of the roles to be played by various types of offshores. Moreover, the main players in each jurisdiction lack the control over their legal system that Delaware lawyers, for example, exercise. Singapore has long been dominated by Lee Kwan Yew, and is still basically operating under his vision. Hong Kong has China to contend with, subject mainly to China’s self interest and the loose constraints of Hong Kong’s SAR status and the Basic Law. I gathered that Singapore has tended to regulate its financial institutions with a somewhat lighter hand than Hong Kong, though I’m still working on the specifics. Singapore evidently has been competing with Switzerland in offering privacy, though both have bowed recently to global demands for transparency. At the same time, Singapore may be more careful in deciding which financial institutions to admit to their zone of safety.

moving hong kong forward

In theory, at least, both jurisdictions might do more in offering innovative legal structures for firms, somewhat along the Delaware model. My most recent book, Rise of the Uncorporation (Oxford University Press, 2009), shows the role played by coherent business organization statutory standard firms. I see little U.S.-style experimentation elsewhere in the world, which suggests a market opportunity for global legal centers. Singapore recently adopted a limited liability partnership act, though it’s not clear precisely what types of firms the act is designed for. The global financial meltdown poses a challenge for global legal centers. As discussed in my article, Bubble Laws (40 Houst. L. Rev. 77, 2003), financial crashes become boom times for regulation – from the English Bubble Act, through the 1930s securities laws, SarbanesOxley, and now, what? This tendency is especially important in the context of global regulatory competition. Recall that onshores have an incentive to recognize offshore law to avoid costly exit by firms, including to other onshore jurisdictions. Offshores theoretically can be defeated by a strong regulatory cartel of onshores, perhaps effectuated through the Organisation for Economic Co-operation and Development (OECD) or other organizations with global reach. These organizations loosely serve the role of the federal government in the U.S. system. But without a strong constitution binding onshores, the cartel is difficult to maintain. The difficulty of maintaining a strong onshore cartel diminishes in a global financial crisis. The risk of a complete breakdown in the financial system, made salient and

perhaps exaggerated by the media, and the general tendency toward post-bubble regulation, can reinforce the cartel. This environment might let U.S. Congress and the Obama administration significantly increase financial regulation and reduce opportunities for tax and regulatory flight without worrying about a repeat of the post-SOX-type exit of cross-listing firms if the firms have nowhere better to go. However, this bubble mentality has a limited shelf life. Perhaps more importantly, offshores are responding, and even if they do nothing will look more attractive as the U.S. ratchets up the tax and regulation, including increased regulation of hedge funds. Significantly, Hong Kong and Singapore are not only attractive places to do business but, in their distinct ways, attractive places to live. Hong Kong taxes its residents at a much lower rate than high-income earners currently pay in the U.S., and the U.S. is planning to increase that differential. Hong Kong offers more of a go-go life style and nightlife than Singapore. Based on what I experienced, both places are easier to live in and offer some advantages over cities like New York, London, Chicago or Los Angeles. Among other things, they both have impressive mass transit systems which are clean and efficiently run. So where is this going? Onshores can get more aggressive in blocking the exits. The U.S. deals with the tax lure by taxing U.S. non-residents on their non-U.S. income. Onshores also can go the other way and lighten up on those who have the greatest ability to expatriate. We saw a bit of this with the post-SOX exemptions by the U.S. Securities and Exchange Commission for foreign firms. The danger with this

“price discrimination” strategy is that the less mobile will demand equal treatment. They won’t like being “discriminated” against just because they’re more stuck in (some would say more loyal to) their home country. This exit can lead to general deregulation. In general, the offshores are beginning to realize how to compete in a global environment. Onshores like the U.S. seem increasingly clueless. Does it really make sense to yield to short-sighted demands for financial regulation if this causes the U.S. to lose its edge as a global leader in finance? Does it make sense to cede access to one of the most exciting business environments in the world to other country’s citizens in order to grab a comparatively little more tax revenue? In short, Hong Kong and Singapore offer something relatively new, or at least a new stage in an evolutionary process: full-service global legal centers, which use law and legal systems to attract not only legal business and “brass plates,” but also firms themselves and their workers. Hong Kong and Singapore thus transcend other offshores like the Cayman Islands, though this type of “limited-service” offshore center also has an important role to play. Both places have shown that they can use their legal systems to attract considerable wealth. If the U.S. tries to deal with this competition by pinning its hopes on a global cartel or withdrawing into itself, it may end up increasingly on the margins of the global financial community. © Larry E. Ribstein Professor Larry E. Ribstein is the Mildred Van Voorhis Jones Chair in Law at University of Illinois.

Autumn 2009


global perspective policy analysis

Changing the Rules of the Game Andrew P. Morriss dispels the bad reputation that onshore governments have given offshore financial centres and warns that in efforts to resist competition, onshores risk further damaging their economies Ryan Morrison

Demonstrators react to onshore politicians blaming offshore financial centres for “contributing to the crisis” and calling for regulatory measures to limit offshores’ abilities to compete in the global financial market.


ecause goods, services, capital, and people can move across borders, states must compete for these resources. That competition limits the ability of states to move toward the interventionist end of the spectrum and so frustrates proponents of greater regulation of financial markets. Part of the competition for economic activity involves provision of law and competition among states that helps shape the law they provide. This competition takes place within 28

Best Practice

a framework of international law including treaties, customary public and private law, and conflict of law rules. Like any competitor with power to affect the rules of the game, however, states seek to alter this framework to provide themselves with advantages against their competitors. The global financial crisis provided a powerful group of states, including the United States, the United Kingdom, France and Germany, with an

opportunity to change the rules of international regulatory competition to disadvantage offshore financial centres in their competition with these onshore governments over financial services. Interest groups favouring additional regulation in these onshore jurisdictions have sought to use the financial crisis to seek changes in the rules of the game for international financial competition that reduce offshore financial centres’ (OFCs) comparative advantages.

global perspective policy analysis

Changing the rules Soon after the current financial crisis began, public officials in onshore economies began to blame offshore financial centres for contributing to the crisis and to call for regulatory measures to limit OFCs’ abilities to compete in the global financial market. New York City District Attorney Robert Morgenthau complained that “vast sums of money … lie outside the jurisdiction of U.S. regulators and other supervisory authorities.” U.K. Prime Minister Gordon Brown called on “the whole of the world to take action. That will mean action against regulatory and tax havens in parts of the world, which have escaped the regulatory attention they need.” French President Nicolas Sarkozy denounced “the excesses of financial capitalism, which has experienced serious abuses: concealment of risks, uncontrolled sophistication of financial instruments, gaps in regulation and persistence of tax havens capturing a part of global savings that would be more justly employed financing investment and growth.” It shouldn’t be a surprise that at the same time they are demanding “standards” and “level playing fields,” many countries are acting inconsistently with well-established international legal principles. In the United States, the Obama Administration endorsed the Stop Tax Haven Abuse Act, legislation proposed by Sen. Carl Levin aimed squarely at OFCs that did not cooperate with the U.S. Treasury in enforcing American tax laws. The Levin proposal requires that OFCs assist in stopping not only criminal tax evasion but also legal tax avoidance, ignoring well-established international law principles that

jurisdictions are not required to assist each other in collection of tax revenue. In a second departure from normal state-to-state conduct, Germany and other European governments have paid millions of Euros to a thief for account data stolen from a Liechtenstein bank and Germany created a new identity for the thief through a witness protection program. Despite Liechtenstein’s attempt to arrest the thief for violation of its banking laws, Germany’s government displayed a dramatic unwillingness to abide by the usual norms of comity toward a fellow member of the European single market. In a third major departure from established international legal principles, Britain invoked antiterrorism laws against a bank in NATO ally country Iceland to seize assets after the bank’s Internet subsidiary collapsed, putting the bank on the same terrorism list as al-Qaeda. All these measures are expressions of the desire of interest groups within large, developed economies to rewrite the rules to limit regulatory and tax competition by small jurisdictions. If successful, these efforts will damage the world economy by removing an important set of competitors from

the scene. The losers will include not just the residents of OFCs, but the residents of the developed economies, since OFCs play an important role in encouraging transaction cost and minimising regulatory and financial innovations. Competition helps everyone, because when one jurisdiction discovers a new efficiency-enhancing innovation, it can lure economic activities to it. Other jurisdictions then must adopt similar innovations if they are to compete effectively. The spread of the LLC in the United States following its initial adoption by Wyoming and the development of segregated portfolio companies by offshore jurisdictions with several domestic U.S. jurisdictions following the OFCs’ lead and adopting their own laws allowing versions of these entities, are examples. Of course, competition can’t prevent every bad outcome. Antigua’s relationship to Sir Allen Stanford and Stanford International Bank, which appears to have been little more than a sizeable Ponzi scheme, is a recent example. While the legal literature contains many claims of such competition producing a “race to the bottom,” including with respect to Delaware’s role in corporate governance, these claims are often contested. The challenge


ll these measures are expressions of the desire of interest groups within large, developed economies to rewrite the rules to limit regulatory and tax competition by small jurisdictions. If successful, these efforts will damage the world economy by removing an important set of competitors from the scene. Autumn 2009


global perspective policy analysis


Best Practice

Thomas Hawk

for onshore and offshore alike is to distinguish legitimate efforts to prevent fraud, money laundering and other criminal activity from efforts to weaken competitors under the guise of tackling such problems. There are a number of reasons to think regulatory competition is likely to be beneficial. In The Law Market, reviewed in Cayman Financial Review in April, Professors Erin O’Hara and Larry Ribstein offered a theory of regulatory competition based on domestic interest groups lobbying for laws that will attract outsiders to do business in a jurisdiction, with the additional business benefiting the domestic interest groups (e.g., the Delaware corporate bar benefits from the use of Delaware by outof-state corporations as the state of incorporation). In a forthcoming book I am editing for the American Enterprise Institute (AEI), Professor Jonathan Macey and Anna Dionne argue that competition between offshore and onshore jurisdictions produces efficiency-increasing competition to offer regulatory measures and innovations in both onshore and offshore jurisdictions as a result of competition to offer “optimal laxity.” In the same volume, Professor Rose-Marie Antoine shows that offshore jurisdictions are more innovative than onshore jurisdictions in developing governance mechanisms for trusts as a result of their competition for trust business, while I argue that OFCs have produced beneficial innovations in hedge fund and captive insurance law. However, as noted earlier, the financial crisis has prompted a wide range of policy proposals from onshore governments aimed at restricting the ability of OFCs

Offshores tread carefully.

to compete with the onshore governments. Implicit in these proposals is the argument that competition between OFCs and onshore governments reduces onshore jurisdictions’ ability to regulate in beneficial ways. Other critics of OFCs have argued that offshore jurisdictions promote fraud and theft, particularly in countries with poor governance and proposed regulatory measures limiting competition from OFCs. These proposals rest on claims that onshore governments’ regulatory efforts in financial services are undercut by competition from OFCs and that restricting competition from OFCs will enhance onshore regulatory efforts. Both of these statements are controversial, although the policymakers making these arguments have generally treated them as self-evident and not requiring an effort to provide proof.

Do OFCs undercut onshore regulation of financial services? The claim that onshore regulatory efforts are undercut by the regulatory competition provided by OFCs

can be divided into three parts. First, onshore regulators claim that offshore jurisdictions regulate too little. Second, onshore regulators argue that offshore confidentiality laws allow onshore taxpayers to illegally evade taxes they owe onshore governments. Third, onshore governments argue that the lower tax rates in offshore jurisdictions reduce onshore governments’ abilities to tax their citizens by enabling onshore taxpayers to structure transactions to reduce their taxes. Regulatory Laxity There are three reasons to believe OFCs are not competing through laxity. First, there is no agreed objective measure of regulatory stringency by which we can compare regulators in different jurisdictions. While onshore politicians sometimes suggest that OFCs are unregulated, regulators in major OFCs often have broader powers than onshore regulators and are less constrained by formal restrictions imposed by administrative law. Comparing regulatory frameworks thus requires both evaluating formal rules and powers and the actual practice of

global perspective policy analysis

regulation across jurisdictions. Leading OFCs like Bermuda, the Cayman Islands, the Channel Islands, Dubai and Singapore offer a combination of laws, regulations, regulators and regulatory culture that makes the effective degree of regulation at least equal to that in onshore jurisdiction, although sometimes with different goals. Second, offshore jurisdictions have large investments in their reputations, since any offshore jurisdiction that allowed significant fraudulent or criminal behaviour would quickly lose its ability to attract business and so deprive its population of the benefit of the offshore financial sector. These revenues are significant: the Cayman Islands derives approximately half of its government revenues from offshore financial industry fees and a significant portion of tourism is finance-industry-related as well. As a result, the major OFCs have invested heavily in their regulatory infrastructure. For example, the Cayman Islands Monetary Authority board consists of financial professionals drawn from both the islands and internationally and whose credentials compare favourably to those of regulators in the United States. The Cayman Islands Stock Exchange is an affiliate member of the International Organisation of Securities Commissions, a member of the Inter-market Surveillance Group and recognised by the U.K. Revenue and Customs Board, signalling that it meets international standards and allowing listed securities to be sold in major markets. Major OFCs are regularly reviewed by the International Monetary Fund, an organisation controlled by onshore governments, and generally received

favourable reviews when compared against best practices standards that onshore governments sometimes do not themselves meet. British OFCs are also reviewed by the British Treasury and most have received favourable reviews. Thus by most objective measures, the major OFCs, if not the less developed ones like Antigua, have been successful at providing adequate regulation, at times even exceeding the regulatory stringency of onshore governments. There is some indirect evidence to support this contention. The most dramatic frauds in recent years have occurred not in OFCs but in onshore jurisdictions: Enron, Parmalat, and Madoff are scandals with onshore roots. Third, even among regulators in major onshore financial centres, there are differences in how regulatory agencies are structured, the regulatory philosophy, and the regulations imposed on financial services firms. The United States and the United Kingdom take dramatically different approaches to financial services regulation in both the structure of their regulators and type of regulation. The competition between New York City and London over financial services business is at least as intense as the competition between those financial centres and OFCs. Thus, aside from jurisdictions that have no serious regulatory oversight or corruption problems, the largest OFCs provide what is best described as a different

form of regulation rather than an absence of regulation. This is not surprising; as Macey and Dionne note, jurisdictions compete in many regulatory dimensions and zero is rarely the desired level of regulation by financial services firms themselves. Since OFCs specialise in products for sophisticated investors, it is not surprising that OFCs regulate differently from onshore jurisdictions where regulatory concern is focused on retail products. Distinguishing difference from the absence of regulation seems to beyond many onshore politicians but is critical to understanding the role of OFCs. The differences between legitimate OFC and onshore regulators are differences in focus, philosophy, and approach, similar to the differences among onshore jurisdictions rather than driven by regulatory laxity. The regulatory competition is thus better described as a competition for the optimal level of regulation. Confidentiality Onshore governments love to attack OFCs for providing strong financial privacy laws. An attack on confidentiality is central to the proposed Stop Tax Haven Abuse Act in the United States, with the draft legislation including a series of presumptions to disadvantage those jurisdictions that fail to assist the United States in stopping tax avoidance as well as tax evasion. Does confidentiality undermine


he most dramatic frauds in recent years have occurred not in OFCs but in onshore jurisdictions: Enron, Parmalat, and Madoff are scandals with onshore roots. Autumn 2009


global perspective policy analysis

onshore efforts at regulation? Certainly the inability of onshore law enforcement or tax authorities to obtain comprehensive information on offshore financial activity means that money laundering and tax evasion are more likely to succeed than if onshore authorities had complete information. But success in law enforcement and tax collection are not the sole metrics by which policies must be evaluated. As Rose-Marie Antoine argues, however, “that confidentiality can sometimes be abused does not make confidentiality itself an abusive or illegitimate concept. Rather, we have accepted that in every financial endeavour and structure there will be weaknesses and what we need to do is to have checks and balances and avenues for redress.” Financial privacy is not something of interest only to OFCs or money launderers. Confidentiality in financial matters is a well-established principle in both civil and common law. For example, most common law OFCs trace their confidentiality laws to the landmark 1924 U.K. decision, Tournier v. National Provincial Bank and confidentiality in commercial matters is the basis for the protection of trade secrets, a position that the United States, among others, has frequently and vigorously asserted. Civil law jurisdictions have their own long history of respecting financial privacy. Differences over confidentiality between onshore jurisdictions and OFCs thus reflect differences in emphasis, not differences in kind. Further, financial confidentiality also protects opposition politicians from countries like Venezuela, Russia and Zimbabwe, where governments have attempted to undercut domestic opponents by 32

Best Practice


ivil law jurisdictions have their own long history of respecting financial privacy. Differences over confidentiality between onshore jurisdictions and OFCs thus reflect differences in emphasis, not differences in kind. attacking their financial resources. A significant problem with the attacks on confidentiality by the European Union and United States is that those attacks make it harder for jurisdictions to refuse requests for information from unsavoury regimes Confidentiality is thus not an issue on which onshore governments can legitimately claim that other interests must yield to their interests in enforcing their tax laws. Rather, it requires that jurisdictions negotiate accommodations to each others’ interests, with both OFCs and onshore jurisdictions treating each others’ interests as deserving of respect. At the moment, however, the onshore assault is yielding some results, with Switzerland tentatively agreeing to breaches of bank secrecy, which would have been previously unthinkable, as a result of the UBS scandal. And if the Stop Tax Haven Abuse Act becomes law in the United States in anything approximating its summer 2009 form, it will be virtually impossible for any jurisdiction to avoid a high degree of cooperation with the United States tax authorities to avoid the draconian presumptions the act will apply to non-cooperative jurisdictions. These changes are unlikely to have the effects their sponsors anticipate. Confidentiality was vital to the 1960s and 1970s business

models of OFCs seeking individual wealth management business but is irrelevant to the 1990s and later business models built on aircraft financing, captive insurance, asset securitization, and hedge fund domicile. Tax Competition Tax competition is often misleadingly described as a simple competition between high and low tax jurisdictions over rates applied to a single form of taxation. Rather, as Professor Craig Boise notes in the AEI volume mentioned earlier, different jurisdictions have different tax structures and those differences create opportunities for business structuring to reduce overall tax bills. For example, while the “zero tax” Cayman Islands has no income tax, it has what is effectively a hefty sales tax through import duties. Cayman also has significant property transfer taxes. As a result, Cayman’s tax structure is quite similar to that used by Texas, which also has no income tax and a predominately sales and property tax regime. Not surprisingly, given onshore jurisdictions’ hypocrisy on tax practices, Cayman, but not Texas, is considered to be engaged in “unfair tax competition” and is singled out for pressure over its tax structure. Differences in tax systems are

global perspective policy analysis

inevitable because their purposes differ and because of path-dependent choices about definitions and concepts. As a result, businesses have an incentive to structure themselves to minimise the total cost of doing business, including legal and accounting fees plus tax payments. Onshore governments can restrict such competition by erecting barriers that raise the cost of using OFC structures, but they do so at a cost to themselves. For example, Barbados has an extensive network of tax treaties that allow companies from high tax jurisdictions to reduce their tax burden on international operations below the domestic level. Opponents of tax competition typically portray this as a loss of tax revenue to the high tax domestic jurisdiction. It is equally possible to consider it as enabling the high tax

jurisdiction to price discriminate in its taxation between international and domestic activity, applying a higher rate to domestic income than would be possible otherwise. For example, Canadian natural resource companies, among the world’s leaders in their field, would find it difficult to compete internationally if they had to pay domestic Canadian tax rates on their non-Canadian operations. Moreover, there are a number of areas where taxation is irrelevant to OFCs’ business models. For example, the Cayman Islands is the domicile of the captive insurance companies of many U.S. non-profit health care providers, a group unconcerned with taxation of earnings. And many offshore captives opt to pay U.S. income taxes as if they were U.S. entities, again making tax issues

irrelevant to the decision to locate offshore. Similarly, many investors in offshore hedge funds are non-profit organisations, such as university endowments. For these investors, the tax exemption of an OFCbased hedge fund is not a means of avoiding U.S. income taxes. Finally, tax-related OFC structures often offer onshore jurisdictions considerable benefits. For example, the use of finance subsidiaries in the Netherlands Antilles in the 1970s and early 1980s saved U.S. corporate borrowers an estimated 2-3 percent interest because such subsidiaries allowed the U.S. parents to obtain financing in the cheaper Eurodollar market. Tax structuring undoubtedly plays a role in some aspects of modern OFC business models but it is less important than onshore governments appear to believe. Ryan Morrison

Reputations of offshore jurisdictions are hurt when accused of being tax havens.

Autumn 2009


global perspective policy analysis


t most, OFCs offer some American businesses a chance to lower their tax rates in the same fashion as the complexities of the Internal Revenue Code do for others.

Efforts to limit tax competition are likely to be at least partially counterproductive, since obstructing use of OFCs will deny the benefits of OFC structures to onshore jurisdictions’ economies. To the extent that tax competition from OFCs limits the upper level of tax rates an onshore jurisdiction can charge, an onshore jurisdiction wishing to charge more must simply find other margins on which to compete. New York and France are able to levy high taxes on entities operating within their boundaries despite tax competition from Texas and Ireland because they offer amenities and advantages not available in the latter two. New York and France may not be able to accomplish all of their tax policy objectives, but their tax policies can hardly be said to have been frustrated by tax competition from lower tax jurisdictions.

Will limiting competition by OFCs enhance onshore regulation? No, OFCs like Bermuda, the Cayman Islands, the Channel Islands, Hong Kong and Singapore play a constructive role in international finance for three reasons. First, they offer onshore jurisdictions important advantages. OFCs provide a means of price discrimination. Some economic activities sensitive to transactions costs, including tax rates, relocate to OFCs. But 34

Best Practice

the profits from the OFC-located segment ultimately will be re-invested or spent in onshore jurisdictions, creating more economic activity onshore, because investment opportunities within OFCs are too small to absorb the capital created by the offshore sector. As the example of Canadian natural resource companies shows, allowing businesses to opt out of domestic tax regimes for their international businesses can have important benefits for both shareholders and businesses. As the non-profit health care captive example shows, OFCs offer more ways to cut transactions costs than low taxes. Second, the constraints imposed on well-run onshore economies by OFCs are relatively small and affect large economies like the United States and European Union only on the margin. For example, even assuming the worst case scenario, nominal U.S. corporate tax rates remain among the world’s highest. At most, OFCs offer some American businesses a chance to lower their tax rates in the same fashion as the complexities of the Internal Revenue Code do for others. Confidentiality provisions are largely irrelevant to most business structures and virtually all OFCs already have tax information exchange agreements that permit transfer of information where there is specific evidence of criminal activity. Even the impact of legal

innovations offshore is attenuated by the additional transactions costs of operating in multiple jurisdictions. It seems hard to credit onshore politicians’ claims that there is a significant pool of unregulated and under-taxed funds to be recaptured by new international financial regulations. OFCs are likely to have a larger impact on smaller economies, where the ability to opt out of a corrupt or inefficient legal system is important to creating viable non-state sectors. Third, setting the “rules of the game” for international finance is properly the subject of multilateral negotiations among all affected jurisdictions. The domestic interests of any one sector, whether concerned with tax collections or securities regulation, cannot be the only concern. In their efforts to resist competition from OFCs, the United States and European Union risk damaging an international financial system that has served the world economy well since World War II. Rather than changing the rules, onshore jurisdictions should strive to compete more effectively on the merits. Andrew Morriss is H. Ross & Helen Workman Professor of Law and Business and Professor at the Institute for Government and Public Affairs at the University of Illinois, UrbanaChampaign. A longer version of this article including footnotes will appear in Nexus, Chapman University’s journal of law and policy, as part of a symposium on “Law, Markets and the Role of the State.” This article was first published in the Cayman Financial Review, Fourth Quarter 2010, Issue 17.

policy recommended for the crisis

Should Mortgages be Securitized? Arnold King argues that mortgage securitization should be allowed to die in order to keep taxpayers from inheriting more risk Alan Turkus

The Humpty-Dumpty of mortgage securitization.


ike Humpty-Dumpty, mortgage securitization has taken a big fall. There is a widespread presumption that government policy, if not all the king’s horses and all the king’s men, should be aimed at putting securitization together again. The purpose of this essay is to question that presumption. The first section of this paper will describe how securitization worked at Freddie Mac in the late 1980s, when I worked there. This will allow me to introduce and explain the concepts of interest rate risk and credit risk in mortgage finance. The second section of this paper will describe developments in the mortgage industry from the mid1980s through the 1990s, when Freddie Mac and Fannie Mae took on more interest rate risk. The third section

looks at what evolved over the past ten years, when the process for allocating and managing credit risk changed, with “private-label” securitization and the growth of subprime mortgages. The fourth section of this paper describes various options for reviving mortgage securitization. The final section steps back and looks at interest rate risk and credit risk from a public policy standpoint. Government policy influences the allocation of credit risk and interest rate risk in capital markets. What are the social costs and benefits of various allocations? I suggest that policymakers might consider reverting to the housing finance system that preceded the emergence of securitization, in which depository institutions were responsible for managing both credit risk and interest rate risk for mortgages. Autumn 2009


policy recommended for the crisis

If the profits of the securities business would be fully privatized, and the credit risk would be fully socialized, the systematic risk would be borne by the taxpayers again.

Freddie Mac around 1989 I joined Freddie Mac as an economist in December 1986. About eighteen months later, I was promoted to Director of Pricing/Cost Analysis, under the Vice-President for Financial Research. My job was to oversee the models used to manage interest rate risk and credit risk. At the time, my primary focus was credit risk. Freddie Mac bundled loans into securities, and then it sold the securities. If a mortgage loan defaulted, Freddie Mac would pay the entire unpaid balance on that loan to the security holder and then try to recover as much as it could from foreclosure proceedings on the property. Thus, Freddie Mac insulated security holders from the credit risk. This was known as the guarantee business, because Freddie Mac would guarantee that investors in its mortgage securities would not have to worry about individual mortgage defaults. A change in market interest rates could affect the value of the cash flows due to the investor in a mortgage. Because Freddie Mac packed nearly all of the mortgages it guaranteed into pass-through securities, Freddie Mac in the late 1980s had very little interest rate risk. The interest rate risk was borne by the investors who bought Freddie Mac securities and relied on the cash flows that were passed through. Note that at that time there was a difference between Freddie Mac and Fannie Mae. Fannie Mae had traditionally financed most of its mortgage purchases with its own debt, rather than with pass-through securities. Thus, Fannie Mae had taken on interest rate risk. Interest rate risk arises because the typical mortgage in 36

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the United States is a thirty-year fixed-rate mortgage with a prepayment option. This means that the firm receiving the cash flows of the mortgage (call this the mortgage holder) faces a difficult problem in matching funding with the cash flows from the mortgage. Suppose that the interest rate on the mortgage is 8%, and suppose that the mortgage holder finances its position by issuing a five-year bond at 7%. If interest rates remain unchanged, then after five years the holder can issue another five-year bond at 7%. If this environment persists for thirty years, then the holder clearly makes a profit. However, suppose that after two years, market interest rates drop by two percentage points. The borrower takes advantage of this to obtain a new mortgage at 6%, using the proceeds from this refinance to pay off the original mortgage. The holder is still stuck with having to pay interest on the five-year bond for three more years at 7%. However, the holder cannot find investments that yield more than 6 percent, so the holder takes a loss. This is known as prepayment risk, or the cost of the prepayment option. On the other hand, suppose that after two years market interest rates rise by two percentage points and that this rise is permanent. Now, the mortgage borrower will try to retain the loan as long as possible, while the mortgage holder’s financing will run out after five years. At the end of the fifth year, the holder is going to have to obtain new funding, which will cost 9%, so that the holder is going to be suffering a loss. This might be called duration risk, because the cash flows from the mortgage have a longer duration (the last payment will not be received until thirty years from the date of origination) than the holder’s liability (a five-year bond in our example). When I joined Freddie Mac, its major competitors had recently been stung by duration risk. In the late 1960s and early 1970s, mortgage interest rates were around 6%. By the early 1980s, market interest rates had more than doubled. Fannie Mae, which at that time relied on medium-term debt to finance its mortgage holdings, was losing $1 million a day in 1982. More importantly the savings and loan industry, which financed its mortgage holdings with short-term deposits, was bankrupt. Thus, by the early 1980s, the approach of funding mortgages with short-term deposits was discredited. Securitization, which allowed the interest rate risk to be transferred to institutions such as pension funds and insurance companies, seemed to be a superior financing method.

policy recommended for the crisis

The big challenge with securitization was managing credit risk. This required pricing policies, capital policies, and risk management policies. For pricing, we wanted to price mortgages according to risk. We specified a probability distribution for house prices, and we assumed that losses from mortgage defaults would take place when individual house prices fell below the outstanding mortgage balance. Because of this, the guarantee fee charged on a loan that was for 80% of the purchase price would be higher than the fee charged on a loan that was for 60% of the purchase price. Our capital policy was tied to something that we called “the Moody’s scenario,” since it was suggested to us by that credit rating agency, based on what happened in the Great Depression. Under this scenario, the average house price would fall by 10% per year for four years, and then remain flat thereafter. Although this was the average price path under the Moody’s scenario, we simulated a distribution of house prices, in which some fell by more and some fell by less. We then measured the total losses under this scenario, and we assumed that we would need enough capital to cover those losses. The cost of this capital was then priced into the guarantee fee. This capital charge did even more to penalize the relatively high-risk loans, such as loans backed by rental properties or loans with a high loan to value ratio. Pricing for risk is fine, assuming that the loan origination process is standardized. However, because loan origination was not under the control of Freddie Mac, we faced principal-agent problems. The incentive of the originators was to aim for volume, regardless of quality. To appreciate the challenge that we faced, consider that we might encounter a shady mortgage originator, whose intent is to create fraudulent mortgages and then abscond with the origination fees – or even the entire proceeds of the loan. Freddie Mac might revoke the eligibility of the shady operator, only to find that the operator moves to another location and does business under a different name. To manage this principal-agent problem, Freddie Mac had a number of devices (and Fannie Mae had very similar measures): • a qualification system for sellers. To sell loans to Freddie Mac, you had to prove that your staff had experience and you had to show sufficient capital that you could buy back loans that had been improperly originated. • a seller-servicer guide. This spelled out exactly the

procedures and rules that we wanted originators to follow when approving or rejecting loan applications. • contractual obligations. Sellers were providing contractual representations and warranties to us that they were following our guide. • quality control. We inspected the loan files of a sample of loans from each originator. Loans that were found to violate the “reps and warrants” were put back to the seller to be repurchased. All of these risk management processes were costly, and all were imperfect. The principal-agent problems in securitization were difficult, and we were constantly tinkering with our systems to try to improve them.

Freddie Mac and Fannie Mae achieve domination In the mid-1980s, inflation and interest rates began trending down. This made it profitable to finance mortgages with medium-term debt. Indeed, the downward movements in interest rates served to highlight prepayment risk. Mortgage holders had difficulty protecting themselves against sharp declines in interest rates, which caused borrowers to refinance while the holders were still paying interest on medium-term debt. Fannie Mae found a solution to the prepayment problem by issuing callable debt. For example, it might issue a ten-year bond that it could extinguish at par after five years, if interest rates had fallen. This effectively transferred prepayment risk from Fannie Mae to its debt investors, in return for which Fannie paid a slightly higher interest rate. The innovation of callable debt ultimately produced a dramatic change in the mortgage market. It undermined the Freddie Mac model of issuing pass-through securities. Investors were more comfortable with the relative simplicity and transparency of callable debt. In the 1990s, Freddie Mac jointed Fannie Mae as a “portfolio lender,” meaning that it held its own mortgage securities and funded them with callable debt. Funding mortgages with callable debt was so efficient


hen I joined Freddie Mac, its major competitors had recently been stung by duration risk. Autumn 2009


policy recommended for the crisis

If Freddie Mac, Fannie Mae, and AIG all are unable to proceed without government backing, then there is no way that securitization can come back without the government acting as a guarantor of last resort.

that by 2003 Freddie Mac and Fannie Mae together held half of the mortgage debt outstanding in the United States. This dominant position was undermined by other innovations, discussed below.

Securitization goes private-label The benefits of securitization come from the fact that investors do not have to go to the trouble and expense of examining the underlying mortgages. Investors know the types of mortgages and the interest rates on the mortgages in the pool, which is the information that they need to manage interest rate risk. However, investors assume that they are entirely insulated from credit risk, because of the guarantee provided by Freddie Mac or Fannie Mae. The guarantees from Freddie Mac and Fannie Mae were credible because of the capital and historical record of those firms. Most of all, however, the guarantees were credible because of the perception that it would be politically unacceptable to allow those firms to fail. There are mortgages that Freddie and Fannie could not guarantee, because of legislated limits on the size of loan eligible for those agencies. Moreover, ten years ago there were loans that the agencies would not guarantee, because low downpayments or weak borrower credit history made the loans high risk for default. 38

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About ten years ago, a number of innovations emerged that substituted for an agency guarantee, allowing “private-label” securities to compete with those of the agencies. Borrower credit scores provided a simple, quantitative measure of the borrower’s credit. Structured securities allowed credit risk to be reallocated, with subordinated holders taking most of the risk and senior holders only taking what was left over. The various tranches were evaluated by credit rating agencies, so that investors could treat AAA private-label securities as equivalent to agency securities (a practice which was formally ratified by bank regulators in a policy that took effect on January 1, 2002). For extra comfort, the holder of a security could purchase a credit default swap, which would pay off in the event that the security’s principal repayment was jeopardized. With all of these layers of protection, holders did not have to examine the underlying mortgages. In fact, it is not clear where that responsibility lay. With agency securitization, it was clearly the responsibility of Freddie Mac and Fannie Mae for managing, measuring, and bearing credit risk. However, with private-label securitization, those functions were diffused. The Wall Street firms that packaged securities had no experience with the risk management functions needed to ensure quality standards in mortgage origination. The credit rating agencies had most of the responsibility for credit risk measurement, but they bore none of the risk. In retrospect, the incentive to be overly generous in rating securities was far too high. Toward the latter part of the housing boom, the risk management process also broke down at Freddie Mac and Fannie Mae. Private-label securitization and the growth of subprime mortgages were leading to a sharp fall in the market share at the two agencies. In retrospect, the agencies should simply have held on to their capital standards and risk management controls. However, at the time, they suffered from doubts about whether their traditional approach was still valid. They began to loosen standards for mortgage quality, to maintain insufficient capital relative to credit risk, and to purchase subprime mortgage securities based on agency ratings rather than on an assessment of the risks of the underlying loans. As a result, when the crisis hit, the agencies were not in a position to survive the losses that they incurred.

Fix securitization? On April 30, 2009, Gillian Tett lectured at the London School of Economics.1 Tett, the author of perhaps the

policy recommended for the crisis

best book published so far on the origins of the financial crisis,2 was asked a question about the impact of the failure of Lehman Brothers. In her response, she said that having the securities market break down was the equivalent of waking up one morning and finding that the Internet and cell phones had broken down. The consensus in the financial community is that securitization simply must be fixed. The question is how this can be done. Securitization worked because the holders of securities assumed that they were not bearing any credit risk. Securitization broke down when mortgage defaults reached a level where holders of securities were no longer confident that they were insulated from credit risk. For mortgage securitization to work again, the credit risk will have to be absorbed in a credible way by someone other than the holder of the securities. Mortgage credit risk includes both systemic risk and idiosyncratic risk. Systemic risk is the risk that conditions in the overall housing market will take a sharp turn for the worse. Idiosyncratic risk is the risk that mortgage originators will deliver faulty or fraudulent loans into the securitization process. The private-label securities operations did not seem to have strong mechanisms for dealing with idiosyncratic risk. Recently, the U.S. Treasury published recommendations for financial reform that included requiring mortgage originators to retain a 5% interest in the mortgage loans that they deliver for securitization. This strikes me as a crude approach. Five percent is too high for an honest but capital-strapped mortgage broker. At the same time, it is too low to deter serious fraud: retaining a 5% interest is no penalty at all if your intent all along is to abscond with 100% of the funds. A basic problem in private-label securitization is that the functions for managing idiosyncratic risk (procedures for qualifying sellers, establishing and enforcing guidelines, and so forth) are no one’s responsibility. Some party must take on those functions in order to address idiosyncratic risk. Another problem with all forms of mortgage securitization is that of systemic risk. At this point, there is no private sector firm that can credibly insulate security holders from systemic risk. If Freddie Mac, Fannie Mae, and AIG all are unable to proceed without government backing, then there is no way that securitization can come back without the government acting as a guarantor of last resort. One suggestion that I have heard is that government

should provide support along the lines of “the GNMA model.” This strikes me as nonsense. The Government National Mortgage Association (GNMA or Ginnie Mae) packages loans that are guaranteed by the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA). GNMA is not taking any credit risk. Instead, losses are absorbed by the agencies from which it obtains the loans. The only way that the “GNMA model” could be used for the entire mortgage market would be if the FHA were to guarantee every mortgage. However, the FHA is not even capable of properly pricing the credit risk within its own niche. The FHA currently is suffering significant losses, creating large liabilities for taxpayers. Another proposal is what I refer to as “Wall Street’s Wet Dream.”3 The idea is that a government agency would behave like a late 1980s Freddie Mac. This agency would take all of the credit risk in the securitization process, but it would not hold any securities in portfolio. This would be ideal from Wall Street’s point of view, because it would maximize the circulation of mortgage securities, rather than keep them stuck inside Freddie Mac or Fannie Mae in their own portfolios. The result would be an agency that bears no interest rate risk (which Freddie and Fannie were able to manage successfully), but which bears all of the credit risk (which brought them down). The “Wall Street Wet Dream” model would ensure that mortgage securities can be traded safely and profitably. The government agency would be responsible for managing the idiosyncratic risk of dealing with mortgage originators. It also would have to price for the systemic risk that arises from fluctuations in regional and national housing markets. Ultimately, this systematic risk would be borne by the taxpayers. Thus, the profits of the securities business would be fully privatized, and the credit risk would be fully socialized. Given the way Washington and Wall Street relate to one another in our society, it is a good bet that this is the model that will gain the most political support.


t this point, there is no private sector firm that can credibly insulate security holders from systemic risk. Autumn 2009


policy recommended for the crisis

Returning to the savings and loan model Policymakers should consider returning to the mortgage finance system that we had forty years ago. Mortgages were originated and held by firms that financed their mortgage holdings with deposits. These were the savings and loans (S&L). The savings and loans did not suffer from the principal-agent problems that plague securitization. The loan originator is controlled by the institution that is going to hold the mortgage. The management of idiosyncratic risk is internalized. To manage systemic risk, regulators could subject depository institutions to capital regulations and stress tests. Mortgage holders that benefit from deposit insurance would have to hold enough capital to withstand a severe drop in house prices. The biggest flaw with the savings and loan model was that the savings and loans could not manage interest rate risk. When inflation and interest rates leaped higher in the 1970s, the savings and loans were stuck holding mortgages with interest rates that were well below the new prevailing market rates. There are various ways to make the S&L model work better than it did in the past. One is to conduct monetary policy in a way that stabilizes the inflation rate. In fact, since the early 1980s the Fed has been able to do that. Another approach would be to encourage variable rate mortgages. These do not have to be the sort of high-risk, “teaser” loans that became notorious in recent years. Instead, they could work more like Canadian rollover mortgages, in which the interest rate is renegotiated every five years. The loans would be on a thirty-year amortization schedule, and they would start out at a market interest rate, rather than an artificially low rate. If interest rates were to rise sharply over any given fiveyear period, we would expect that the borrower’s income would have risen as well, so that the burden of the loan would not be significantly larger. Defenders of securitization will argue that it is more efficient to fund mortgages in the capital market. I would make two counter-arguments. The first counterargument I would make is that the alleged efficiency of securitization has not been demonstrated in the market. Mortgage securities are the artificial creation of government, starting with GNMA and Freddie Mac. The second counter-argument is that adding efficiency to mortgage securitization serves to divert capital from other uses, and it is not necessarily the case that this capital diversion is best for society. More recently, bank 40

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capital regulations severely distorted the cost of holding mortgages relative to holding securities, strongly favoring the latter. In a completely free market, it is doubtful that securitization would emerge, particularly in light of recent experience. At its best, securitization appeared to lower mortgage rates about one quarter of one percentage point relative to loans that could not be placed into securities. Suppose that government-backed securitization could be put in place to achieve a comparable reduction in mortgage interest rates. Is that an outcome for which we should aim? Compared with the risks that the government must assume in order to make securitization work, it seems to me that lowering mortgage interest rates by one quarter of one percent is not a commensurate benefit. This is particularly so given the alternative uses of capital. If mortgage rates are a bit higher than they could be under the most efficient system, then some capital will go toward other uses – interest rates charged to businesses or to consumers for other loans will be slightly lower. It is not clear that mortgage loans are better for society than other uses of capital. If it turns out that the “originate and hold” model is not as efficient as securitization for delivering low mortgage interest rates, that would not be a tragedy. In order to revive securitization, taxpayers would have to absorb large risk. The social gains would be small, or perhaps even nonexistent. The best thing to do with the shattered Humpty-Dumpty of mortgage securitization would be to toss the broken pieces into the garbage. Arnold Kling is an economist and member of the Financial Markets Working Group of the Mercatus Center at George Mason University. In the 1980s and 1990s he was an economist with the Federal Reserve Board and then with Freddie Mac. First published in finreg21.com, Reforming Financial Services Regulation in the 21st Century. 1 The recording of this lecture is available at http://www. lse.ac.uk/collections/LSEPublicLecturesAndEvents/ events/2009/20090311t1935z001.htm or http://www.creditwritedowns.com/2009/05/fool’s-gold-gillian-tettlectures-on-shadowy-world-of-derivatives.html 2 Gillian Tett, Fool’s Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe (Free Press, 2009). 3 For an example of the type of proposal I am describing, see Harley S. Bassman, “GSE’s: The Denouement.” http://www.zerohedge.com/sites/ default/files/RateLab GSE Denouement.pdf

around the world

Hong Kong Remains No. 1 Kavewall

Wallace Chan expands on Hong Kong’s highest level of economic freedom in Economic Freedom of the World: 2009 Annual Report

Economic freedom is the key building block of the most prosperous nations.


ong Kong continues its reign as the most economically free region on the globe, as it once again is ranked number one in the Economic Freedom of the World: 2009 Annual Report, released by independent research organization the Fraser Institute. Singapore is ranked second, followed by New Zealand, Switzerland and Chile. Zimbabwe once again has the lowest level of economic freedom among the 141 jurisdictions included in the study, followed by Myanmar, Angola, and Venezuela. The annual peer-reviewed economic freedom report uses 42 different measures to create an index ranking 141 countries around the world based on policies that encourage economic freedom. The cornerstones of economic freedom are personal choice, voluntary

exchange, freedom to compete, and security of private property. Economic freedom is measured in five different areas: (1) size of government; (2) legal structure and security of property rights; (3) access to sound money; (4) freedom to trade internationally; and (5) regulation of credit, labor and business. This year’s report also includes new research that examines the likely impact of the global recession on levels of economic freedom. It suggests that economic freedom may decline in the short-term in response to crises, but over a longer time economic freedom has a tendency to increase after a banking crisis. “Opponents of economic freedom are blaming the global recession on the operation of markets and hoping to use it as an excuse for a vast expansion in government. But even in recession, the quality of life in nations with free and open markets is vastly superior to that of nations with government managed economies,” said Fred McMahon, Fraser Institute director of trade and globalization studies. “To successfully navigate the global financial crisis, nations must focus on policies that support the principles of economic freedom. By choosing this path, the current crisis will be reversed and fade into history. But if we learn the wrong lessons and choose reforms and policies inconsistent with economic freedom, our destiny will be like the generation of 1930; we will face a decade of stagnation and decline.”

Hong Kong retains the highest level of economic freedom, with a score of 8.97 out of 10. Other top scorers are: Singapore (8.66), New Zealand (8.30), Switzerland (8.19), Chile (8.14), United States (8.06), Ireland (7.98), Canada (7.91), Australia and the United Kingdom (7.89), and Estonia (7.81). Hong Kong’s scores in key components of economic freedom (from 1 to 10 where a higher value indicates a higher level of economic freedom): • Size of government: 9.29 • Legal structures and security of property rights: 8.16 • Access to sound money: 9.51 • Freedom to trade internationally: 9.58 • Regulation of credit, labour and business: 8.31 “Economic freedom is the key building block of the most prosperous nations.” McMahon said. Wallace Chan is the Coordinator of Chinese Affairs at the Fraser Institute. Economic Freedom of the World measures the degree to which the policies and institutions of countries are supportive of economic freedom. The annual report is published in conjunction with the Economic Freedom Network, a group of independent research and educational institutes in over 70 nations. The 2009 report is based on data from 2007, the most recent year for which comprehensive data is available. The full report is available at www. fraserinstitute.org. Autumn 2009


around the world

Free Trade Agreements – Do They Really Free Trade? Dr. Khalil Ahmad on semantics aren’t FTAs only challenge – there’s a ways to go before trade is truly free


here are many opportunities and challenges to be found within Regional Free Trade Areas. Various issues highlight points of Free Trade Agreements that negate the very concept of Free Trade. Indeed, governments do not need any agreement to promote free trade; that is a contradiction in terms. Trade agreements are reached between trading parties, not between governments. In order to further explain this case, the South Asian Free Trade Area (SAFTA) agreement’s text will be used as a test case. This agreement was reached between Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan and Sri Lanka in January 2004. Free trade means freedom to trade. Naturally, everyone is free to enter an agreement with anyone in a voluntary manner to sell or purchase anything, no matter where they happen to live or be located. While one cannot be restricted to transact with this or that person only, it is the case under some Free Trade Agreements (FTAs). No doubt, it is merely political boundaries which have divided this world into various regions and countries and withdrawn this freedom from people by force. However, the fact is that free trade can flourish and bring benefits to all trading parties without disturbing these boundaries. It is necessary to 42

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The world is one big market.

not only change our perception, but to consider this world of ours as it is – one big market – and not compartmentalize markets which only serve special interests, ignoring the rest. In recent years free trade agreements have become fashionable. Thus, when two or more countries reach an agreement to allow free trade (the semantics of FTAs are incorrect because it is the country which, in the first instance, imposed restrictions on free trade), it is publicized as a Free Trade Agreement. This is both misleading and ridiculous. In reality, “free” trade is not being allowed between the contracting countries since there are more “strings” attached here than natural freedom allows.

Upon taking a cursory look at the text of SAFTA, it is clear that many clauses nullify the spirit of free trade. Article 3, “objectives” clause b reads: “promoting conditions of fair competition in the free trade area, and ensuring equitable benefits to all Contracting States, taking into account their respective levels and pattern of economic development;” Article 3, “principles” clause c reads: “SAFTA shall be based and applied on the principles of overall reciprocity and mutuality of advantages in such a way as to benefit equitably all Contracting States, taking into account their respective levels of economic and industrial development, the pattern of their external trade and tariff policies and systems;”

around the world

Article 3, clause f reads: “The special needs of the Least Developed Contracting States shall be clearly recognized by adopting concrete preferential measures in their favour on a non-reciprocal basis.” Article 14, “General Exceptions” deals the final blow. Its two clauses read: “a) Nothing in this Agreement shall be construed to prevent any Contracting State from taking action and adopting measures which it considers necessary for the protection of its national security. b) Subject to the requirement that such measures are not applied in a manner which would constitute a means of arbitrary or unjustifiable discrimination between countries where the similar conditions prevail, or a disguised restriction on intraregional trade, nothing in this Agreement shall be construed to prevent any Contracting State from taking action and adopting measures which it considers necessary for the protection of: (i) public morals; (ii) human, animal or plant life and health; and (iii) articles of artistic, historic and archaeological value.” Article 15, “Balance of Payments Measures” clause 1 reads: “Notwithstanding the provisions of this Agreement, any Contracting State facing serious balance of payments difficulties may suspend provisionally the concessions extended under this Agreement.” In article 16, its 7 clauses provide for “Safeguard Measures.” In the final analysis, these articles and clauses (and others not cited here) may not seem as safeguarding interests, but in practice allows for doing anything on the part of contracting states as regards

implementation of the agreement. Of course, there are limits, such as what is not provided for in the agreement cannot be implemented; on the other hand, the implementation of whatever has been provided for in the agreement can always be delayed, obstructed, or manipulated. These practices don’t free trade, they enslave it. For instance, the contracting states can institute measures to protect their domestic interests from foreign competition in the form of tariffs, negative or sensitive lists, exemptions, quotas, and subsidies. All the while, it is these very measures which are considered inimical to the promotion of free trade. Thus, under such agreements, it remains in the hands of a state to determine how much freedom it is willing to extend. Or it remains with the state to decide what to import or export, from whom to whom, and how and under what conditions. This is far from free. There are other items in this agreement which serve to strengthen the contracting states’ tendency towards protectionism, such as gradual reduction (or reduction under specified conditions) of tariff rates for those items on Sensitive Lists. These sensitive or negative lists define the domestic products that are particularly susceptible to competition and implement measures to safeguard the products such as tariffs or exemptions. These socalled free trade agreements allow for a restricted freedom to trade, in

other words, all but free trade. They cannot achieve what free trade, in fact, offers. As to the tag of “Regional” attached to the free trade agreements, it is yet another restriction, similar to restricting one’s movement within a specified area. Thus, regional free trade agreements allow trading with contracting countries only, and under definite restrictions. In simple terms, the model here can be defined: Any one state (S1) orders or restricts another to sell or purchase with others (X, Y, and Z) under conditions already decided upon and imposed by S1. The argument is that this setup is not free trade, but on the other hand, at least these circumstances allow the freedom to transact with X, Y, and Z under some specified conditions if not with A, B, and C and on our own conditions. What is important here is the spirit with which the government of a country implements the agreement. Thus, if conceived and implemented in good faith, Regional Free Trade Agreements may be the first step in the right direction. They allow something of freedom to trade rather than having no freedom at all. Challenges remain to expand a true free trade to this model of restricted “free” trade, but even a small step in the right direction is a step forward. Khalil Ahmad is the founder and head of the think tank Alternate Solutions Institute in Pakistan, http://asinstitute.org


hey allow something of freedom to trade rather than having no freedom at all. Autumn 2009


leader’s bookshelf

State of the Nation LC PPD LC-USZ62-662

Eamonn Butler is interviewed on his most recent book, The Rotten State of Britain

The way to grow poor, the way to grow rich.


y his own admission, Eamonn Butler spent several fruitless years trying to generate enthusiasm from publishers for his book chronicling what he perceives as our nation’s decline from sceptr’d isle to septic embarrassment. But even he could scarcely have imagined how, when it did eventually see the light of day, The Rotten State of Britain would end up chiming so perfectly with the funereal mood of the times. In the book, Butler takes a forensic scalpel to all aspects of modern British society, from the broken economy to abuses of political privilege via the rise of spin, surveillance culture and the nanny state. As you might expect from the head of the Adam Smith Institute – the U.K.’s leading free market think tank – it’s an unashamedly


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polemical piece, railing against the “dishonesty, deceit and incompetence” of the leaders Butler charges with bringing a once proud country to the edge of financial and moral bankruptcy. But despite the book’s subtitle: How Gordon Brown Lost A Decade And Cost A Fortune – Butler insists he has no party political axe to grind. “The problem is not necessarily New Labour – it’s bigger than that,” he says over tea in the conservatory of his central Cambridge home. “The Adam Smith Institute works with the government of the day, and when Blair and co. came in 1997, we were prepared to give them the benefit of the doubt.” “They had seemed to grasp the essential message: they weren’t going to tax and spend and they were going to be a much more open type of government. During the first couple of years of New Labour I turned up

at Downing Street more often than I did under Mrs. Thatcher.” But it was not a marriage destined to last. “They disappointed us, really,” says the 57-year-old. “We saw the real tax burden go up through stealth taxes, we saw the government sector expanding, we saw there was no enthusiasm to carry on with privatising state industries or even making them more efficient. And similarly with the culture of spin – they were trying to convince us everything was absolutely fantastic when it quite clearly wasn’t.” “And it’s not a party political thing at all. It’s that we’ve got a Government that’s become hugely centralised that doesn’t actually understand the idea of the rights of the individual. So that was the disappointment – it was principally how governments can apparently ride roughshod over our rights, which have been built up over hundreds of years, and over the bodies of many brave souls.” “When you look into it line by line and subject by subject, it begins to overwhelm you how bad things have become. The relationship between government and officialdom and the rest of us has changed. We used to be the masters – we should be the masters, and now they’re our masters. I feel that in the way policing is done, in the nanny state, in the number of CCTV cameras pointing at me – all this I find very unnerving as a libertarian.” Butler also claims to have anticipated the bust at the end of

leader’s bookshelf New Labour’s economic boom some years ago. “A lot of us predicted it,” he says. “You could see, despite all the talk of prudence, that Gordon Brown was expanding the public sector faster than it had ever been expanded before.” But whatever it says about the Government’s fiscal credibility, doesn’t Britain’s current economic crisis also leave one of the sacred shibboleths of the Adam Smith Institute – the deregulated free market – looking more than a little bruised? “I don’t actually accept that,” he says. “It’s still the case that every bit of a bank’s business, from how they deal in the securities markets to how quickly they answer the phone to their customers – all of that is regulated. We have the most incredible weight of regulation on our banks. If you get Michael Phelps and weight him down with chains and he sinks, you don’t call that a crisis of swimming. That’s a failure of regulation weighting him down.” So is he saying the city actually needs less regulation? “It needs better regulation. We’ve had the regulation there but the regulators weren’t doing their job – they were looking the other way. It’s very fashionable to attack bankers and their bonuses, but I don’t think you can blame bankers for a boom created by politicians.” Much of The Rotten State of Britain – which Butler researched over a period of nine years – rings


true, especially on issues like spin, surveillance, the breakdown of family values and the true cost of the country’s debt. Other parts – the harrumphing about familiar bogeymen like red tape and tax burdens and the welfare bill – have the shrill air of a Daily Mail leader column about them. There is also a persuasive counter-argument to be made that, if anything has brought Britain low, it is the excesses of the very free market that Butler holds so dear: the insatiable drive for profits and “efficiency” that has eroded our job security; the relentless pressure to accumulate more and more consumer goods – and more and more personal debt – in the erroneous belief it will make us happy, rather than just creating more landfill; the ruthless, shameless Britain of asset-stripping private equity firms, Kafkaesque call centres, tabloid humiliation and the sort of corporate hegemony that leaves CEOs wielding more power than prime ministers. Besides, by focusing exclusively on the bad apples in the barrel, isn’t The Rotten State of Britain in danger of overstating the extent of our nation’s malaise? Whatever the doom-mongers and naysayers and pettifoggers of all political stripes would have us believe, isn’t this, at the end of the day, still a great country to live in? “It’s a great place to live and we do enjoy a great quality of life,” Butler concedes. “That has taken a knock just recently and I think it’s taken a bigger knock than in most

t was principally how governments can apparently ride roughshod over our rights, which have been built up over hundreds of years, and over the bodies of many brave souls.

The Rotten State of Britain: How Gordon Brown Lost a Decade and Cost a Fortune Author: Eamonn Butler Gibson Square Books London, United Kingdom 314 pages

other countries because our public finances have been overstretched and we have been living off borrowing and debt, both personal and public.” “But it’s still a great place – we’ve got the English language and cosmopolitan attitudes and a mixed, interesting society. At the same time, I feel we’ve allowed ourselves to drift into a situation where the basic rules that once protected our liberty have been suspended.” “It’s not like we’re living in Stalin’s Russia – but we’ve actually put in place the mechanism whereby if some bad people got into power, they could make it Stalin’s Russia without any problem at all.” Before we take away his belt and shoelaces, though, Butler offers a glimmer of hope for the future. “I’m an unremitting optimist I’m afraid,” he smiles. “I have this great faith in human nature that it will out. But I think we’ve got a big repair job to do.” © Cambridge Newspapers Ltd. Autumn 2009


leader’s bookshelf

More Dangerous in Death than in Life Peter Morgan

Pierre Gave reviews Prisoner of the State: The Secret Journal of Premier Zhao Ziyang

Plain clothes officers often carry umbrellas in Tiananmen Square to block reporters’ cameras from view.


ao Pu, one of the editors of Prisoner of the State, is the son of Bao Tong, a former aide to Zhao Ziyang who helped record his memoirs which have recently been released as: Prisoner of the State: The Secret Journal of Premier Zhao Ziyang. The memoirs were released ahead of the 20th anniversary of the crackdown on June 4th this year. The book is not available on the mainland, but is in Hong Kong and sold out earlier this year with many awaiting reprints. Around the book’s release, Bao Pu spoke at numerous events as the Hong Kong public wanted to know more about the controversy surrounding the publication. He said that he had to


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insist on his father’s words, that Zhao had just as much right as Mao Zedong to publish his memoirs. Bao Pu was accepted as a Hong Kong permanent resident this summer which speaks volumes about Hong Kong’s freedom. One of Asia’s biggest literary events of the year has been the publication of the clandestine memoirs of Zhao Ziyang, the Premier of the People’s Republic of China from 1980 to 1987, and General Secretary of the Communist Party of China from 1987 to 1989, until Tiananmen. The memoirs have the dramatic title: Prisoner of the State: The Secret Journal of Premier Zhao Ziyang. As Zhao tells it, this is the story

of a man who tried to bring about liberal change to the Mainland and who, at the height of the Tiananmen Square protests in 1989, tried to stop the massacre and was dethroned for his efforts. When China’s army moved in on June 4th killing hundreds of demonstrators, Zhao was placed under house arrest at his home on a quiet Beijing alley. China’s most promising agent for change had been disgraced, along with the policies he stood for. The former premier spent the last 16 years of his life up until his death in 2005 in heavily monitored seclusion. The story behind the book is compelling and is a throwback to the world of John Le Carre-like spy shenanigans. After a few years of house arrest, Zhao Ziyang, fearing that his legacy would be tainted, started to meticulously record his memoirs on an old cassette recorder. These tapes were hidden in full view among his children’s toys and were only marked with very faint numbers, indicating the tape’s place in the sequence. Over the years, copies of these tapes were smuggled out by friends and relatives and have now been compiled for the first time. The book opens at full speed with the events leading up to the Tiananmen massacre, giving the reader a first-hand view of the power plays that, ultimately, led to martial law and the deadly assault by the People’s Liberation Army on the unarmed protestors.

leader’s bookshelf cromacom

was the point of no return: once these comments had been made, there was no way that the Chinese leadership could ever back down. At the same time, the students’ fervor remained undeterred and a violent confrontation seemed

PLA Troop Movement – Beijing, China

From the onset of the unrest, Zhao says he wanted the Party to take a conciliatory approach. In his mind, the student leaders’ main concern – rampant government corruption – was a valid one and something he had been at pains to try to crack down on. Unfortunately, his views were not shared by the hardliners in the Chinese Communist Party who saw this unrest as a dangerous anti-establishment movement, threatening to overthrow the very foundations of the Party. During the weeks of ensuing unrest, Zhao engages in a titanic struggle with Li Peng, the sitting Premier of China and the man leading the hardliner faction within the Party. At the time, the Party was still very much run by Deng Xiaoping, so Li Peng and Zhao Ziyang try by all means available to win him over to their views. Crucially, Zhao is sent off on a mission to North Korea, which is when Li Peng and his associates make their move, convincing Deng Xiaoping to label the protests as anti-socialist, anti-patriotic, and bourgeois liberal. These were labels that had not been used since the purges of the Cultural Revolution and greatly upset the students who saw their cause as righteous indignation against corruption. This

unavoidable. Upon returning from his trip, Zhao quickly understood that the tide had turned and that it was no longer in his favor. In a last-ditch effort – which effectively sealed his fate – Zhao visited the students at the square (with his chief of staff, the current Premier Wen!), beseeching them to disperse and trying to convince them of what would inevitably come if they did not. The students, however, refused to budge. We all know the tragedy that followed. In a poignant passage, Zhao describes how he could hear the incessant gunfire a few days later from his house arrest as the army finally overran the square in a largescale military operation that he failed to stop. From here on, the rest of the memoir deals with Zhao’s efforts to get his name cleared. He feels that proper Party procedures were not followed and that his dismissal was, therefore, illegal. From someone

so intimately involved with the reality of Chinese politics, this seems somewhat strange and even naïve. Surely, Zhao knew that his case was hopeless? Nevertheless, the book is well worth reading, if just for the chapters about the Tiananmen tragedy. This is a rare opportunity to get a peak of one of the secret regimes of its time and read firsthand of how the Chinese leadership panicked. And it still leaves the reader with a question: how would China look today had Zhao prevailed? Would it be any freer?

Prisoner of the State: The Secret Journal of Premier Zhao Ziyang Author: Zhao Ziyang (Translation copyright by Bao Pu and Renee Chiang (Editors)) Simon & Schuster New York, NY 336 pages

Pierre Gave is the Head of Global Research at Gavekal. First printing by Gavekal.


rom someone so intimately involved with the reality of Chinese politics, this seems somewhat strange and even naïve. Surely, Zhao knew that his case was hopeless? Autumn 2009


odds and ends

“Careful Design” in Policy Making C-Monster

If policy engineered with careful design actually worked, we’d be living in utopia


n an oped to the public recently, Secretary of Labour and Welfare Matthew Cheung cited that Minimum Wage was a safe policy because of “careful design,” saying that the “possible economic downside of a Statutory Minimum Wage can be mitigated through careful design.” His comment raised a few eyebrows: is careful design not always used in government’s policymaking? We are confident that every project has undergone “careful design.” The 85,000 units of housing policy were implemented under careful design, as was Hong Kong’s Disneyland, Cyberport, and today’s West Kowloon. The mother tongue teaching language policy must have been just as carefully designed as the fine tuned policy to fix it.


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Careful design is used in all policy making, but it does not make any policy immune to unforeseen consequences or future problems. The government might not realize yet that the budget for welfare expenditure will increase if jobs are lost under minimum wage. In removing job opportunities, the minimum wage permanently condemns the least competitive workers to underemployment or unemployment. When Sec. Cheung cited that capitalist countries such as the United States and Britain have laws for minimum wages, he neglected to mention the welfare classes that have developed there. A welfare class is a group of people that are systematically excluded from the job market and subsist off of the state. Both the U.S. and the U.K. have their own class of citizens that rely on welfare alone to get by. Rest assured these countries employed “careful design” in their minimum wages policies, but it hasn’t stopped their welfare classes from forming. It is immoral to condemn a whole group in society to CSSA for the rest of their adult lives. Our officials don’t

seem to understand what’s at stake with a Minimum Wage Bill. Sec. Cheung is the Sec. of Labour and Welfare, but hasn’t mentioned the welfare costs that could rise post minimum wage. Another example is a question posed to Leung Chun-ying at a recent luncheon: “what will happen when someone loses their job from minimum wage?” Leung replied that there is always welfare. He continued, you have a choice to be on welfare. He might as well have said: “let them eat cake.” Even the most careful designs have facilitated unforeseen consequences and the examples are numerous. The difference with this Minimum Wage Bill, however, is that typical unforeseen effects have been identified. Imagine if our Chief Executive Donald Tsang didn’t take his first steps on the career ladder, working for Pfizer in the 1960s and receiving the training necessary to communicate to the public as he does today. When individuals like our Chief Executive, who the education system has failed and need low paying first jobs for acquiring greater skills, are buried under policies such as minimum wage, the loss is not only borne by the individual, but by society as a whole. Perhaps Sec. Cheung should ask the Chief Executive himself, if he was not able to take the first step on his career ladder, and hence never given the chance to serve the people of Hong Kong today, whose loss would it be?

odds and ends

Guangzhou Express Rail Link innoxiuss

The Runaway Train that is the XRL Express Rail Link

Awaiting the Runaway Train...


t a cost of HK$ 63.2 billion (which was HK$ 35.4 billion only a year ago, and expected to increase before completion), the Hong Kong portion of the Express Rail Link, covering a distance of 26 km., could be the most expensive of its kind per kilometer in the world. With such a hefty price tag, one must question if the link, being built at local taxpayers’ expense, is truly for their benefit or their own good.

On October 20th the MTR Corporation proudly announced that the Chief Executive and Executive Council had approved continuation of the planning and construction phase of Hong Kong’s section of the Express Rail Link (XRL) to Guangzhou. All that’s left for the project to proceed is for the


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Legislative Council and Finance Committee to give their thumbs up to the funding agreement and then it’s full steam ahead. Construction is expected to begin in late 2009, being completed in 2015. The long term benefits of the project are: joining Hong Kong with China’s national high speed rail network, positioning it to be a participant in the southern region’s overall development, and the immediate creation of over 15,000 jobs amid the recession. Secretary for Transport and Housing Eva Leung was quoted as saying the express service will benefit Hong Kong and so cannot be held back. No questions asked. This attitude, rather than providing assurance of the project’s necessity, has only further angered villagers being displaced by the construction, conservation groups, and journalists skeptical about the government’s hard-headed eagerness with which it is proceeding with the project. For example, the fact that the XRL doesn’t go to downtown Guangzhou, but rather a district of Guangzhou called Shibi, which is 18 metro stops west of the city’s business centre, has raised a number of questions as to whether Hong Kong’s investment is really supposed to make it easier for Hong Kongers to travel to downtown Guangzhou. Apparently those travelers can rest easy with the knowlegde that the extra commute can be easily covered within an estimated one hour’s time saved with the new link (after finding their way through the 140,000

square metre terminus, of course). That said, we will be able to take advantage of the discount shopping, massages, and other entertainment to be found in Shenzhen a massive 12 minutes sooner than currently. And where will the XRL begin? The congested heart of Tsim Sha Tsui. It is a wonder why forcefully extending the link into denser Hong Kong is necessary or even more convenient for anyone when the Link’s purpose is to reach into the mainland. A group called the “New XRL Expert Group” has advanced an Integrated Option plan as an alternative, beginning the XRL at Kam Sheung Road MTR station. This would make use of existing infrastructure and reduce the overall cost among a number of other purported benefits. As of yet, there are a plethora of other critical issues that have yet to be addressed by the government. For example, details concerning how long it will take for the government to break even, what the operating costs will be, how much ticket prices will be, or the details of the terminus (which will represent half the cost of construction), all of which are still blurry. With so much to consider, one might think that it would be prudent for the government to ask for some help. Proceeding with such blind urgency rather than making a cautious investment cannot possibly be seen as best practice for a government. Michael Ying

odds and ends

Onshore vs. Offshore Onshores not willing or able to compete – just like in any game – start playing dirty.


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between offshores and onshores for revenue and underlining a lack of respect of offshore sovereignty, onshores have been acting as bullies with their unchecked demands. In reality, the onshores which lack the competitive environments to attract business seek a bigger cut of revenue. In a bid to regain tax revenue, onshores not willing or able to compete – just like in any game – start playing dirty. This is where the name calling and unchecked demands come into play in order to bolster onshore interests. Jurisdictions which do not share tax information are labeled “uncooperative” and punished with blacklists and/or sanctions. Some “uncooperative” jurisdictions aren’t allowing themselves to be victimized, they are fighting back or refusing compliance – but not Hong Kong. Hong Kong received attention once the financial centre was threatened to be placed on the blacklist for not sharing tax information. Hong Kong’s tax law only allows tax information to be collected for domestic use. If Hong Kong was to accept new agreements to share information internationally,



he media has well covered the significant negative publicity that Offshore Financial Centres (OFCs or offshores) have received. The Dark Knight’s shooting in Hong Kong is one example where the SAR features as the dodgy offshore centre where gangsters hide their dirty money. Although the part Hong Kong plays is about as real as Batman himself, it’s an idea popularized by media, pop culture and politicians. This negative reputation weaseled its way into reality without substantial challenge from offshores rebelling against being given a bad name – at least up until now. Problems with the financial system have little to do with havens, but it’s much easier for onshores to deflect the part they played in the crisis by employing a witch hunt. The OECD defines a tax haven not as having a competitive tax rate, but refusing “to provide information to foreign tax authorities.” The idea that offshores are shady jurisdictions that must be policed is gaining ground and has substantial backing from G20 countries like France, Germany, the United Kingdom, and the United States. At the G20 Summit, U.K. Prime Minister Gordon Brown said, “For the first time we are on the verge of an agreement which will mean that every country that was previously a tax haven will have to exchange tax information on request …we will get agreement at this summit.” Signifying increased competition

it would need to change its tax law first. Hong Kong would also have to add – and fund – another division in its Inland Revenue Department. Of course, the OECD hasn’t offered to help offset the costs the Hong Kong taxpayer incurs to fund a brand new department to serve non-domestic, international onshore interests. For Hong Kong, it’s a lose-lose situation. Hong Kong hasn’t been blacklisted before; the SAR has been considered but Big Brother is known to have acted as the deterrent. Even still, Chief Executive Donald Tsang has “ordered” that the bill changing the tax law be introduced to the Legislative Council. Nearly all of Hong Kong’s legislators are in favor of kowtowing to onshore demands. Where other jurisdictions are retaliating, seeking to balance onshores’ unchecked demands, Hong Kong has its tail between its legs. Mainland must be proud.

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