Can Hong Kong Teach London and New York About Financial Regulation?

The following is a review of Reluctant Regulators: How the West Created and China Survived the Global Financial Crisis, by Leo F. Goodstadt.

As the world struggles to recover from the wreckage of the 2008 financial meltdown the appetite for regulatory reform is waning. Leo Goodstadt (顧汝德) is determined to see that the importance of sound financial regulation is learned.

This thoroughly researched book argues that when it comes to the importance of good regulation Hong Kong has much to teach London and New York.

Goodstadt’s thesis is simple: an anti-regulatory bias led by Anglo-American cheerleaders mesmerized the world for three decades. This led to the financial crisis in the West and, tangentially, a budding crisis in China. Goodstadt argues that Hong Kong’s experience with effective regulation shows that good regulation can minimize crises.

Goodstadt will be well-known to many Hong Kong readers. A former journalist with the Far Eastern Economic Review and other publications, he went on to be the chief policy adviser at the Central Policy Unit, Hong Kong’s government think-tank. This is his third book on Hong Kong policy and displays Goodstadt’s skilled reading of official sources.

Goodstadt shows how U.S. and U.K. policy makers were bewitched by the idea that markets were self-correcting. With the increased complexity of financial markets, officials, most prominently former U.S. Federal Reserve Bank chairman Alan Greenspan, simply gave up trying to proactively regulate. Greenspan and others didn’t believe that it was possible to pre-emptively let the air out of bubbles. The prevailing ideology held it as an article of faith that the cost of periodic financial crises was well worth paying because it led to higher long-term growth. Although Goodstadt doesn’t say so, defunding of regulators like the S.E.C. was part of the ideological assault on regulation. The disastrous sub-prime mortgage meltdown was, at least in retrospect, the rather predictable result of lax regulation and increased borrowing

The most striking part of the book is the detailed discussion of China’s response to the 1997-98 and 2008 financial crises. China’s massive US$586 billion stimulus program announced in November 2008 has been widely applauded. More critical observers have assumed that the extraordinary increase in lending that resulted would lead to a corresponding increase in bad loans. What’s useful about Goodstadt’s work is that he shows in great detail how the desperate measures prompted by the crisis led the Chinese to roll back more than a decade of banking reform. Policy loans and relationship lending, both of which had been painstakingly whittled away in the decade following the 1997-98 crisis, were back. Distressingly, the central government ignored the legal prohibition against local governments borrowing money or guaranteeing loans.

Goodstadt’s follow-up of the results of the 1997-98 financial crisis and the costly recapitalization of the banking sector that followed is also striking. The World Bank and other foreign experts had projected that 40 percent of bad loans could be recovered. In fact the actual loan recovery rate was less than 20 percent as a result of fraud, corruption and the eagerness of local officials to protect local businesses and jobs.

Goodstadt is circumspect here, as he is throughout the book when writing about both Hong Kong and China. But the obvious conclusion is that the Chinese financial system is in far worse shape than normally recognized. The inference is that serious trouble lies ahead.

What’s most disappointing about Goodstadt’s book is the cursory treatment he gives to Hong Kong. This is puzzling both because Hong Kong’s supposed regulatory toughness is the crux of Goodstadt’s argument that there is a viable alternative to the Anglo-American hands-off regulatory touch. The dramatic and ultimately successful intervention in the stock and currency markets in 1998 should form the core of Goodstadt’s argument, yet they are glossed over. The controversial introduction of deposit insurance, to protect depositors in the event of a bank failure, goes unmentioned. The tendency of Hong Kong banks to hold extremely high levels of capital doesn’t rate even a mention.

Goodstadt makes much of the fact that Hong Kong was attacked for, alone of major stock markets, closing its stock market during the 1987 crisis. Goodstadt ignores the fact that the then-head of the exchange was a corrupt insider who was subsequently sent to jail. This led to the Securities and Futures Commission (SFC) and a more robust but far from effective regulatory regime.

Neither is Hong Kong’s regulatory environment as effective or rigorous as Goodstadt implies. The SFC remains weak and reluctant to use its hard-won regulatory powers. The embarrassing climb-down by the SFC and the Hong Kong Exchange over quarterly reporting standards in the face of complaints from business marked a stark reminder of the limits of a regulatory culture. Certainly, few people would claim that Hong Kong has anything approaching a world-class financial regulatory environment.

Strikingly, Canada and Australia are not mentioned even in passing in Goodstadt’s book. This is a curious omission because they are, like Hong Kong, a peripheral part of the Anglo-American financial world. Yet both countries, like Hong Kong, adopted a much more pro-active regulatory structure. Both of them came through the financial crisis in far better shape. Most of the remaining AAA-rated banks in the world today are from Canada and Australia.

Goodstadt doesn’t tackle some of the issues he raises. Are heavily regulated or even repressed financial systems better? Under what circumstances? How proactive should regulation be? What lessons can we learn from Hong Kong’s experiences in 1987, 1997-98 and in the latest crisis? This is a useful book with a wealth of good material. But it leaves the readers wanting more.

Originally published in the Hong Kong Economic Journal. Can be accessed at