FROM THE OFFICE OF PUBLIC AFFAIRS

INTRODUCTION

Hong Kong never ceases to amaze me. My recent visit to Hong Kong was no exception. I wasimpressed not only by the city’s spectacular architecture,but for what those buildings house -- one of world's most activecurrency markets, Asia's second largest stock market, keyoperations of 85 of the world's top 100 banks, and some of theworld's shrewdest financial professionals in both the public andprivate sectors.

As recently pointed out by mycolleague and friend, Andrew Sheng, the Deputy Chief Executive ofthe Hong Kong Monetary Authority, Hong Kong is perhaps theworld’s leading example of the economy of the future -- avirtual economy -- where services account for about 82% of GDP,as compared to 76% here and 62% in Japan, and the bulk of themanufacturing activity of its firms is done outside itsterritorial boundaries. It is thus by its very nature, perhapsmore so than any other economy in the world, highly dependent onthe free flow of information (over 700 newspapers and periodicalsare based there), the rule of law and the transparency of theregulatory environment.

The importance of the future ofHong Kong to the United States is measured not just by the hugevalue of trade between our two economies, the scale of ourinvestment there, or by the volume of financial flows, but alsoby number of our citizens whose livelihoods depend on Hong Kong'sprosperity.

¨ Some 36,000 American citizens live in Hong Kong. The 1100 US firms that have invested $14 billion in Hong Kong employ some 250,000 people, nearly 10% of the work force.

The reversion process has focuseda great deal of attention on Hong Kong, and rightly so, given itsimportance to the global economy.

But it occurs to me, as I lookforward, that many people are missing a very important facet ofHong Kong reversion. The majority appear to view transition assomething that China is "doing to" Hong Kong, but thereversion process is hardly a one-way street. The transition willpotentially have just as big an impact on China.

Today, I'd like to say a few wordsabout what the interplay between the two great economies withinthe "one country two systems" framework means for HongKong, for China and for the world. And what we are doing tocement the commitment to two systems.

FRAMEWORK FOR TRANSITION

Hong Kong's reversion to China isin many ways a political event unparalleled in history. It marksthe takeover of a capitalist, democratic society -- perhaps, thepurest example of an open market economy -- by a society in themidst of transition from a socialist, command economy.What’s even more striking, the new sovereign power has madestrong commitments that guarantee the continued existence of thesystem and life-style of the former.

A great deal of attention has beenpaid to the process surrounding this shift. On the economic andfinancial aspects, of which I feel more competent to speak, theauthorities involved have taken many of the steps necessary for asmooth transition.

In terms of a legal framework, the Joint Declaration and Basic Law lay the basis for a transition that can preserve what has made Hong Kong so special and so successful as an economy.

¨ Hong Kong is to retain its autonomy in economic affairs, including its independent fiscal and monetary policy under the guidance of its extremely competent civil service.

¨ Hong Kong is also to retain its status as an international financial center, and its own currency -- separate from the yuan.

Hong Kong's financial and economic civil servants are recognized as world class by their global counterparts. Secretary Rubin and I frequently meet with our Hong Kong counterparts. In my most recent trip to Asia, I met with my Hong Kong counterpart at the Six Markets gathering of finance and monetary officials in Tokyo.

¨ Thus, the February decision by Hong Kong’s Chief-Executive designate, C.H. Tung, to leave current cabinet members in their posts -- including Hong Kong's extremely competent economic team -- is very welcome. It adds weight to the reassurances that have been given at the highest political levels that Hong Kong's sound financial and economic system will remain intact.

Hong Kong has also taken measures to ensure that it has the resources to preserve economic and monetary stability should market confidence be rocked by some unanticipated development.

¨ Hong Kong's foreign exchange reserves are now about $64 billion -- a sizeable cushion against exchange rate instability or shock to the balance of payments.

¨ The Hong Kong dollar is further backed up by China's pledge to protect it with its own massive reserves of over $100 billion should it come to that.

At least so far, the markets haveevaluated these aspects of the transition favorably.

The Hang Seng Index peaked in January at its highest levels since 1994, before following the U.S. market down and then back up again.

It is also noteworthy that Hong Kong's government borrows in Hong Kong dollars at rates nearly equal to those of the United State government for periods of up to two and a half years.

But as one central banker'sfavorite cliches has it: Credibility is not owned; it is rented.

¨ After the all the excitement, when legalities of reversion are concluded and after Hong Kong hosts this year's annual meetings of the IMF and World Bank in the Autumn, it will be essential for all political authorities to continue to behave in a way conducive to the maintenance of market confidence.

It is crucial that this transitiongo well, not just for Hong Kong but for China as well. Apart fromquestions of international politics and prestige, the transitionis a matter of economics for both.

BENEFITS FOR CHINA

China is -- and has been for thepast 19 years - in the midst of an economic transformation ofimmense proportions. This transformation has progressed fromexperimentation with market pricing of goods to the developmentof highly active capital markets in Shanghai and Shenzhen.

Each phase of China's reformprocess has introduced a greater reliance on market forces. Mostrecently, China's has managed its first soft macroeconomiclanding, and is now turning in earnest to the structuraldeficiencies -- such as the state enterprise system and thefinancial sector -- that badly need reform.

At this juncture in China'stransformation, more than ever, Hong Kong has a great deal tooffer China.

Perhaps Hong Kong's greatest potential value to China is as a source of good ideas, technical expertise, and as an exemplar or model for the kind of system that can bring China the most economic success.

¨ First, Hong Kong has a very impressive record on macroeconomic management: High economic growth, prudent fiscal management and government surpluses, and experience in dealing with capital flows and an open foreign exchange system. Hong Kong has the people to convey this kind of knowledge.

¨ Second, Hong Kong's regulators have invaluable experience in financial systems and regulation. The bumps that have occurred on this road, and the improved market oversight and regulation that have emerged as a result, have only increased Hong Kong's credentials as a source of wisdom for China.

¨ Third, China could draw on Hong Kong's example of clearly delineating the role of government in the economy.

¨ Fourth, Hong Kong is a sterling example of the benefits of integration with the world economy. Hong Kong's economic success has depended on its ability to take advantage of the opportunities in global markets -- making it a trade leader in Asia and a living example of the benefits of open markets.

® This is especially true for financial services, where Hong Kong has generally maintained a high standard for market access. Hong Kong's example of the value of financial liberalization, accompanied by strong prudential supervision, should be studied by other emerging Asian economies as they consider their offers in the current round of financial services negotiation.

¨ Finally, Hong Kong, and the Hong Kong people, have a deep understanding of how markets are supposed to work. This is exactly the kind of knowledge that China will have to draw on again and again if it wants to build the kind of economy that will work in the 21st century.

 

FREEDOM AND ECONOMIC PROSPERITY

Any accurate economic history ofthe latter part of the 20th century will have to give dueattention to two striking developments: the transformation ofindustrial economies into information-intensive economies basedon services (Sheng’s virtual economies); and the inclusionof millions of Asians in an unparalleled rise in globalprosperity. Hong Kong, with its world-class financial sector, hasbeen at the vanguard of both of these developments. In the 21stcentury, China, with its vast resources and Hong Kong as anexemplar, has the potential to follow suit.

I noted earlier that authoritieson both sides have made good preparations to permit a smootheconomic transition. I pointed out for example that Hong Kongborrows at a lower cost that U.S. Treasuries. But if you lookfurther out on the yield curve the markets are saying somethingless reassuring.

Markets have evaluated thetransition developments and preparations favorably and do notexpect negative developments in the near terms. But the yieldcurve starts to rise significantly after two and half years, andby 10 years out the spread over U.S. Treasuries is nearly 80basis points. This is the market’s way of speaking toBeijing. Few predict problems in the short term, but there iswariness about the longer term.

Such wariness is understandablefrom my visit. I sensed that some believe that politics andeconomics are somehow mutually exclusive. My impression has beenreinforced by a recent decision of the National People’sCongress to repeal certain amendments to some Hong Kong laws,including to the Bill of Rights Ordinance and the societies andpublic order ordinances. This decision has fueled widespreadconcern in Hong Kong and abroad that Hong Kong’s civilliberties and individual freedoms will be restricted afterreversion.

On this my message is simple:There is no firewall between economic freedom and freedom in itsmany other dimensions. The free flow of information is essentialto free society, to free markets, and to a strong financialsystem. It is essential to Hong Kong's prosperity -- and toChina’s -- that information flow freely.

Integrity also is central to botheconomics and politics. Hong Kong's success as a financial centerhas been based to no small extent on its civil service'sprofessionalism and honest administration, and on thetransparency of its regulation. If prosperity is to bemaintained, these too must be maintained.

It is important to recognize thateconomics, and particularly finance, is driven by expectationsand perceptions. Even a perceived risk that China is seeking toundermine Hong Kong's autonomy or tamper with the formulas thathave made it so successful could severely damage Hong Kong'sstanding in international financial circles and, by association,its economic prospects.

I stress these points because I amconvinced that in the global economy of the 21st century, evenmore than in the economy of the 20th century, the quality ofgovernance will be a key determinant of prosperity. Capital,skilled manpower and other factors of production are ever moremobile and responsive to changes in the quality of the businessenvironment. And as we move from an industrial to an informationera, the degree of freedom becomes an ever more importantprerequisite for economic success.

These points bear emphasis.China's actions regarding the Legislative Council and efforts torepeal or amend several key provisions of Hong Kong's civilliberties laws raise some concerns about its appreciation for thefundamental importance of freely flowing information, and for theintegrity and autonomy of Hong Kong's economic system.

¨ The danger is that, if China handles the transition poorly, if it encroaches or is perceived to encroach upon Hong Kong's autonomy, Hong Kongers have the ability to make such actions extremely costly -- either by leaving Hong Kong (their skills are very welcome elsewhere) or by transferring their funds out of the territory.

A poor handling of the transitionwould not only be disastrous for the Hong Kong economy, the lossto China would also be immense: not just in nominal terms, thelost capital and economic strength of Hong Kong, but in terms ofpotential benefits. For as I've stressed in my remarks, there ismuch that China can glean from Hong Kong that would aid in itsown development.

In short, the transition is asmuch for China to make as it is for Hong Kong. And it isessential that China allow Hong Kong to be Hong Kong. And ifthere is to be some convergence of systems over time, it would bebeneficial for all involved for China's system to become morelike Hong Kong's than the other way around.

HONG KONG RETAINS SEPARATE STATUSIN U.S. POLICY

Suffice it to say that the U.S.Administration will be watching closely how events unfold in HongKong, including with regard to how these events affect U.S.interests and our stake in both Hong Kong and China's success.

It is reassuring to us that whenVice Premier Qian was in Washington last week he reaffirmedChina’s commitment to two systems. We are going to take himliterally and continue to treat Hong Kong as autonomous economicentity. We will continue to promote a framework of bilateral andmultilateral agreements that support Hong Kong’s autonomyfrom China, an objective made clear in the U.S./Hong Kong PolicyAct.

The U.S./Hong Kong Policy Actestablishes domestic legal authority to continue to treat HongKong as an entity distinct from the PRC for certain purposes.

Hong Kong will continue to be treated as a separate partner in trade by the United States. This means that Hong Kong will be retain its separate textile quota; we will maintain separate statistics on our bilateral trade with Hong Kong; and we will negotiate trade agreements with Hong Kong. We have, in fact, just recently signed an air services agreement with Hong Kong.

Hong Kong will also be treated as a distinct entity for the purposes of U.S. taxation.

We will continue to work directly with Hong Kong officials on law enforcement issues --where success depends on [1] the structure provided by bilateral agreements, [2] a significant law enforcement presence, and [3] close collaboration with our counterparts.

¨ Last month, we signed a prisoner transfer agreement and a mutual legal assistance agreement with Hong Kong. A U.S./Hong Kong extradition agreement which was signed earlier is now before the Senate for its advice and consent to ratification.

¨ Our enforcement presence has been expanded in recent years with additional FBI and INS officers stationed in Hong Kong and the opening of an office of the Secret Service in Hong Kong last year. There are no plans to reduce this presence.

¨ Finally, in the realm of enforcement, we at Treasury look forward to continuing and intensifying our close collaboration with Hong Kong authorities on a wide array of efforts to fight organized crime -- narcotics trafficking, money laundering and smuggling.

As I noted earlier, our people and our enterprises have strong ties with Hong Kong. Reflecting the breath and depth of our relationship with Hong Kong, our Consulate in Hong Kong is one of our largest in Asia, with over 140 direct-hire U.S. officials and a dozen separate USG agencies.

¨ Negotiations with the government of China to maintain our Consulate General in Hong Kong, after July 1, have been concluded. We have successfully reached an agreement with no limitations on size of our Consulate or existing operations.

¨ We are, in fact, discussing within our government the possibility of stationing a Treasury official in Hong Kong to more closely manage our growing financial relationship with Hong Kong and the region. This would be our only presence in Asia outside of Tokyo.

Reinforcing its role as a separateplayer in the financial arena, we will continue to support andencourage Hong Kong’s participation in the multilateralfinancial institutions and organizations. Hong Kong has ensconceditself well in the international financial system. These aremoves that China has supported.

Hong Kong is a participant in the New Arrangements to Borrow established by the international financial community last year. It was among the select few recently invited to join the Bank for International Settlements. Hong Kong will continue to be a key member of APEC, and will retain its separate membership in the major international financial institutions.

 

CONCLUSION

We at the U.S. Treasury willcontinue to work with our colleagues in Hong Kong as theymaintain their separate economic system. We will continue to meetregularly with our financial counterparts in the context ofgatherings of the IMF, APEC, BIS, and as partners in the NAB. Andwe will continue to deliver our message that there is no firewall between economic and other freedoms.