Charter cities: The future trade centres of the world?

Read our article in the Cayman Financial Review Magazine, eversion 

At a now famous TED talk in July 2009, (then) Stanford University Professor Paul Romer proposed a simple, yet shocking idea. The progress of civilisation was determined not only by our technological advancement, but also by the evolution of rules. Simply put, rules matter.  

He proposed the establishment of cities run by different rules – rules that would promote enterprise and eliminate poverty for all who came. He called these cities ‘charter cities’ and outlined the basics of how they would work.

Three years later, it seems like his wish will come true. Honduras is currently working with a council of distinguished academics, business people and others to create a charter city on the north coast of Honduras that will exist apart from and have different rules from the rest of the country.

If it sounds unique, it isn’t. Many of the world’s greatest centres of trade were created under distinct rules from their surrounding countries. Think about Hong Kong and Shenzhen in China, Singapore separating from Malaya and Dubai’s special role in the UAE.

If this idea takes off, the world could see the creation of scores, if not hundreds, of little Hong Kongs. The opportunities arising from similar levels of wealth generation are potentially enormous. Many questions remain about these jurisdictions and how they will relate to the rest of the world from a trade and finance perspective.

Charter cities: An old idea made new

Paul Romer’s concept of a charter city is quite simple: Rules matter. Proper rules motivate people to come, create wealth, save and invest. Terrible rules motivate people to leave, strip assets, be corrupt and work only for the short term. The charter is the rule book, one of four elements that must be in place.

From Mr Romer’s site on charter cities1, four elements must be in place:

  • A vacant piece of land, large enough for an entire city.
  • A charter that specifies in advance the broad rules that will apply there.
  • A commitment to choice, backed by voluntary entry and free exit for all residents.
  • A commitment to the equal application of all rules to all residents.

The absence of coercion is key and distinguishes this concept from a new colonialism. A country may choose to turn part of its territory over to another administrator, but does so willingly.

Everyone who moves to the city does so willingly. The vacant piece of land is essential to avoid displacing current interests and make it an enclave of the willing, allowing purely voluntary entry.

The equal application of rules lends to the building of a civil commitment to the charter, much like Americans and Canadians feel for their Constitution and Charter of Rights and Freedoms, respectively.

There are three key players who must be present:

“There are three distinct roles for participating nations: host, source, and guarantor. The host country provides the land. A source country supplies the people who move to the new city. A guarantor country ensures that the charter will be respected and enforced for decades into the future.”2 

The guarantor, in particular, plays a key role in building confidence that will attract businesses to make long term investment.

Charter cities : They’re out there

Professor Romer was inspired by the success of ‘accidental’ and deliberate charter cities. Pennsylvania was established by a charter granted to William Penn by Charles II in 1681. Lubeck was established as a trade centre by Henry the Lion in the 12th Century. In the modern world, the gold standard is Hong Kong.

Hong Kong

Hong Kong did not acquire the core elements of its success overnight. Imitators will seek to emulate what took Hong Kong over 100 years to achieve.

The territory of Hong Kong was acquired by the British from the Qing Dynasty in parts from 1841 to 1898 (an essentially vacant piece of land). The British ran Hong Kong under very different rules from the rest of China and the UK. Hong Kong maintained very low tax rates, was an open port, and had an open immigration policy. The effects, compared to development in China, were dramatic.

Hong Kong took in over 3 million refugees in the five years following World War II. The British maintained law and order and otherwise mostly kept out of people’s way. While modern charter cities, would seek to establish Hong Kong’s best features from day one, Hong Kong evolved them over time.

Spectacular mismanagement of the British economy and the collapse of the pound led to Hong Kong pegging the Hong Kong dollar to the USD – a peg that stands to this day. Corruption was reduced dramatically in the 70’s with a number of measures including a purge of the police force, a division of police and customs and other disciplinary forces, and the creation of the Independent Commission against Corruption.

Infrastructure was dramatically expanded in this decade as well, including the launch of possibly the world’s most efficient public transport system.
The British Labour government of the 1960’s tried to impose upon Hong Kong the same welfare state (and required tax system) they were building in Britain.

They were denied by strong leadership in Hong Kong ranging from an obstinate financial secretary, the legendary Scot Sir John Cowperthwaite, to local Chinese business people who rioted over the suggestion of an income tax. Hong Kong has no payroll tax, no import or export taxes, no machinery tax, no tax on dividends, no tax on capital, no tax on interest earnings. It does have well-funded public education (including universities), free quality healthcare and half the population lives in some form of government subsidised housing.

To this day, Hong Kong’s top tax rate is 15.5 per cent and the government derives most of its income from real estate sales and transaction duties. The city runs huge budgetary surpluses and has massive cash reserves.

Hong Kong reduced poverty in the 1960’s from 50 per cent to under 16 per cent of the population (those earning less than $400/month). It ranks #6 on the IMF’s GDP per capita – just ahead of the United States3 and far outstripping China (#92) and The United Kingdom (#22). Different rules, different outcomes indeed.

Hong Kong is governed by the Basic Law, a mini-constitution that is administered by an independent judiciary that can only be appealed, on matters relating to Hong Kong and China relations, to the Standing Committee of the National People’s Congress in Beijing. Almost all processes remained in place over the handover, essentially preserving the system evolved under the British. Its stock market is the world leader in IPOs (top since 2009) and it is the financial centre of Asia.

Other charter cities?

Other jurisdictions may have some of the four elements as laid out by Romer, but few have all of them. Singapore arose as a partition of Malaya and had a pre-existing population (not vacant land). Dubai comes close, but has a three tiered system for rights of people living there, separating the UAE citizens, the high end expats and the low end workers. However, since launching the Jebel Ali Free Zone in 1979, allowing free movement of people and capital, Dubai has seen a massive influx of people and capital to become a major world trade centre.

Shenzhen, also in China and adjoining Hong Kong, is an excellent example of a charter city.

Looking across the border from Hong Kong to Shenzhen in the 1970’s a landscape of rice paddies and marshes could be seen across the river. In 1980, it was designated a Special Economic Zone as part of Deng Xiao Peng’s efforts to open and normalise China’s economy. Its status was promoted repeatedly until, in 1992, it was granted the right to pass its own laws and answered directly to the Central government. The Shenzhen Municipal Government passes its own laws.

The results have been dramatic. While not open to all comers from around the world, it has attracted millions of people from China. According to the Shenzhen government, the city has over 10 million residents 4.

Estimates range widely given the proliferation of undocumented persons. The fact remains that over 10 million people have flocked to this centre of industry and trade over the last 30 years.

Presumably the people there now, who hail from all over China have benefitted from the massive domestic and foreign investment that flooded into this investment friendly enclave. GDP per head was the highest in China for years until similar reforms were enacted around the country. It still has the highest GDP per capita of any mainland city. People came poor, got jobs and prospered.

The new kid on the block: Honduras

Professor Romer has had some false starts in getting someone to actually put the charter city concept to the test. He seems to have found fertile ground in Honduras. The Honduran government received widespread support to amend its constitution to allow for the founding of a new charter city: La Región Especial de Desarrollo (RED).

It has put in place a Transparency Commission headed by Professor Romer and peopled by Nobel laureates in economics, Singaporean business heavyweights and other academic and business leaders5. They will be responsible for selecting administrators in the initial phases until a democratic system can be appointed.

Details are still being worked out, but the aim is to replicate the success of Hong Kong, Shenzhen, Singapore and Dubai and create a vibrant and wealthy populace of over 10 million souls – 2 million more than Honduras’s population of 8 million.

Mauritius has offered to provide an independent judiciary – itself ultimately backed up by the Judicial Committee of the Privy Council of the UK. It serves as “the court of final appeal for the UK overseas territories and Crown dependencies, and for those Commonwealth countries that have retained the appeal to Her Majesty in Council or, in the case of Republics, to the Judicial Committee6.” And soon maybe Honduras’s RED.

But really, how will it work?

If the Honduran RED is successful, many more could follow in its wake. Low tax and business friendly environments will likely attract disproportionate amounts of investment, trade and finance from neighbouring regions. They could become the new network of global trade.

Many questions remain. Some are academic, but many will be technical, especially with regard the world of finance and offshore banking. Some of relevance to the industry are briefly discussed below. Astute readers engaging in the debate will no doubt have many more questions.

Will corporate law be purely that of Mauritius with appeal rights to the UK? If so, would there need to be the creation of a skein of bilateral agreements that mirror those between Mauritius and other jurisdictions? Would Hounduran bilateral and multilateral agreements apply? Or neither?

Hong Kong, for example, negotiates its own bilateral agreements with regard to exchange of information agreements and is a unilaterally free port with attractive low taxes (as outlined above). Shenzhen was made open to the rest of the world in a way the rest of China was not.

However, anything coming out of Shenzhen still fell under China’s multi and bilateral arrangements.

What would the tax regime look like to back the development of infrastructure?

Professor Romer and others examining the charter city question have not explicitly addressed the question of taxation and government funding. However, the implications are clear. All of the jurisdictions they point to as models share certain characteristics. They are generally open ports, have minimalist taxes, and rank well in indexes of economic freedom7.

The Transparency Board being assembled by Professor Romer for the RED includes Ong Boon Hwee, and ex-milltary businessman from Singapore 8 – no stranger to generating value and building out infrastructure in a city state.

So how will these cities pay for themselves? The suggestion has been through the increasing value of land9 as the cities attract investment. Hong Kong works much along these lines with most government funding coming from land derived income.

The Canadian West was settled through railway development funded by land grants to the builders, CP Rail. The firm was paid, in large part, via an increase in value of the land near railway stations, as chronicled in Pierre Berton’s book, The Last Spike (McClelland and Stewart, 1971).

Low taxes, Hong Kong style, are key for attracting investment, suggesting other income must be found. This will likely drive tax competition for both industry and among financial jurisdictions. Cash-poor developed economy governments are already, through the OECD, putting significant pressure on low tax jurisdictions – how would they respond to a potential wave of such jurisdictions if the RED succeeds?

Who will stand up for the new RED and other charter cities when they begin to provide serious competition for industry and finance? How will they respond when money hungry American and European governments want people and firms to collect financial data on their behalf?

OECD attempts to blacklist (or ‘greylist’) Hong Kong in 2009 were resisted by China. The OECD frequently sees jurisdictions with reasonable privacy laws and low taxes as potential centres for facilitating tax evasion – an opinion not shared by all. Hong Kong benefited from a strong parent in China to avoid censure10. A Honduran RED will not have such a strong global backer.

While the backers of these projects see them as poverty reducing programmes designed to elevate millions of families to a new level of living, the OECD countries will likely see them as threats to what they perceive as ‘their income’. Local competitors for manufacturing may erect trade barriers against them to try and protect their local industry. They may make it difficult for their beleaguered business people to travel to these places in a vain attempt to stop them relocating investment there.

It is conceivable that if successful enough, a parallel system of trade and finance among fast growing charter cities could emerge. They could collect enough productive capacity to opt out from the global financial system. European governments in particular have shown no compunction in using their clout to engage in questionable activities (such as buying stolenprivate data) to strongarm smaller jurisdictions into complying with their wishes11. One Honduras could not likely face such pressure – but could 20 vibrant charter cities?

Conclusion

Charter cities present a fascinating concept for replacing the traditional global aid model with a genuine development model with potential to save billions from penury. Cities that share elements of the model, such as Hong Kong, Shenzhen and Dubai, have created wealth for millions and enriched their lives, usually in one generation. They may show the way for a new future of global trade and economic development.

Honduras seems ready to move forward and give the world its first charter city by design. However, many questions remain ranging from the legal to the technical. It seems that bright minds using the best practice from successful jurisdictions can overcome the challenges, clarify the unknown elements and drive the first experiment.

However, the biggest threat to charter cities may be their success. Successful jurisdictions would attract industrial investment, become global trade centres and attract foreign capital. Tax competition globally would increase and capital would be diverted to, as well as generated in, these centres of growth. They could very well come under attack from powerful, but economically sclerotic, OECD countries desperate to save jobs and tax revenue in their uncompetitive economies.

Many questions remain for the daring willing to create a new model for wealth generation. Charter cities, if they proliferate, could become an alternative system for circulating people, goods and capital. Or they could be killed in the cradle by incumbent economies with their grip on global trade. One wishes Professor Romer and Honduras all the best in their endeavour – it may be the future of global trade.

Endnotes 

  1. 1 http://chartercities.org/concept
  2.  ibid.
  3. http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/index.aspx
  4. http://english.sz.gov.cn/gi/
  5. http://www.economist.com/node/21541392
  6. http://www.jcpc.gov.uk/
  7. Heritage Foundation’s Index of Economic Freedom http://www.heritage.org/index/ and The Fraser Institute’s http://www.freetheworld.com/index.html
  8. http://www.a-star.edu.sg/AboutASTAR/CorporateProfile/ASTARBoard/tabid/70/astar/AboutASTAR/CorporateProfile/ASTARBoard/MrOngBoonHwee/tabid/272/Default.aspx
  9. http://www.ted.com/talks/paul_romer_the_world_s_first_charter_city.html
  10. http://app1.hkicpa.org.hk/APLUS/0905/TaxHaven.pdf
  11. http://www.panamalaw.org/lichtenstein_bank_secrecy_scandal.html
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G. Andrew Work

Andrew Work is a Founder of The Lion Rock Institute, Hong Kong's first economic think tank.  He was the Executive Director of The Canadian Chamber of Commerce in Hong Kong, instrumental in growing membership and advancing business policy objectives.  He has lived in Hong Kong for 16 years.   

  

G. Andrew Work 
Co-Founder and Director
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The Lion Rock Institute

The Lion Rock Institute was founded in 2004 by Andrew Work, Simon Lee and Andrew Shuen. Lion Rock believes in the potential of the individual and free market values to provide the strongest base for guiding successful government policy in Hong Kong.

The Institute was created to ensure that freedom and prosperity would continue to thrive in Hong Kong. The Institute’s mission is to promote free market ideas throughout Hong Kong to improve the lives of Hong Kongers. The Institute does this through having a direct and demonstrable impact on government policy by advancing concrete solutions to keep government small, taxes low and restrictions on business and the individual minimal.

It educates policy makers, active political participants and the general public on the virtues of free enterprise in building a prosperous Hong Kong through various media outlets. The Institute globally promotes Hong Kong's excellence in public policy that exemplifies free market values.

The people of Hong Kong have a right and the capability to be involved in the debate about the economic policy of today that will affect their future.
 

 

Suite 1207
Kai Tak Commercial Building
317-319 Des Vouex
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T: +852 8101 2112
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