A trade theoretic analysis of outward capital flows: with special reference to Hong Kong

This paper sets up a trade theoretic model to explain the output, price and welfare consequences of the outward investment from Hong Kong to the Pearl River Delta. A four-good trade theoretic model is set up to incorporate some special features of the Hong Kong Economy. We assume that the economy produces four goods: an exportable good, an importable good and two non-traded goods. A special feature of the model is that one of the non-traded goods (locally produced) is also consumed by foreigners and produced under the assumption of non-competitive market framework. As tourist or business-centre trade is of great significance to Hong Kong, this model allows us to capture this phenomenon. First, precise conditions are derived regarding the decline in manufacturing output in Hong Kong. Second, it is shown that, in spite of the supply side determination of the relative price of non-traded goods, income effects in this market are of great significance in both income (welfare) and output movements. These income effects cannot be captured in industrial organization type applied work. Third, it is shown how outflow of capital affects labour productivity. A surprising result obtained for this part of the analysis is that a fall in productivity (outflow of capital and de-industrialization) creates a favourable terms-of-trade effect in the monopolized sector. The welfare effect consists of four terms: (1) a terms-of trade effect via the price of non-traded goods consumed by tourists/foreigners; (2) the loss (gain) in productivity due to an outflow of capital; (3) repatriation payments; and (4) the gains from exporting from the Special Economic Zones as well as other Pearl River Delta cities. Our decomposition has two very important features in contrast to traditional models: a terms-of-trade effect from the consumption of services and productivity gains or losses. The last point is exceedingly important for policy makers specifically if outward flow of capital affects productivity negatively.