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p. 12 of 68 BACK | NEXT I. Developing Asia and the World II. Economic Trends and Prospects in Developing Asia East Asia People's Republic of China Hong Kong, China Republic of Korea Mongolia Taipei,China Southeast Asia South Asia Central Asia The Pacific III. Competitiveness in Developing Asia Statistical Appendix

Asian Development Outlook 2003 : II. Economic Trends and Prospects in Developing Asia : East Asia

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Hong Kong, China

The economy continued to grapple with weak domestic demand, falling property prices, persistent deflation, high unemployment, and a deteriorating fiscal position in 2002. Recent statistics, however, have given rise to cautious optimism as both merchandise and services exports posted strong growth in the second half of the year. Anticipated strengthening of the global economic environment should feed through to domestic demand, and economic activity is expected to gradually pick up over the next 2 years, though the outbreak of SARS may slow the pace of recovery in the first half of 2003.

Macroeconomic Assessment

The economy of Hong Kong, China continued to face structural and cyclical problems in 2002. Recent data, however, suggest somewhat firmer grounds for optimism. After weak performance in the first half of the year, GDP on a year-on-year basis grew by 3.3% in the third quarter and by 5.0% in the fourth, lifting overall growth for 2002 to 2.3%, from only 0.6% in 2001.

Growth was underpinned by strong export performance. After a sluggish start to the year, merchandise and services exports registered double-digit growth rates in the second half of the year. Exports benefited from strong demand in the PRC and other Asian economies, and growth in offshore trade and transportation services. The recent weakening of the Hong Kong dollar, along with the US dollar to which it is pegged, also assisted export growth. However, significant differences characterized performance of different export components. Strong demand from Asian economies led to a 10.9% growth in the volume of reexports in 2002, while domestic exports fell by 11.3%.

In contrast, the domestic economy remained subdued. Consumer spending declined further in the third and fourth quarters of 2002 against a backdrop of falling property prices and high unemployment. Overall, private consumption fell by 1.6% in 2002—the first yearly fall since 1998. Having declined for four consecutive quarters, real investment spending posted marginal growth of 0.5% in the fourth quarter. Nevertheless, investment in 2002 as a whole still fell by 4.4% (Figure 2.2). Growth also varied among sectors. Output growth in services was strong while manufacturing output fell due to the continued weakness in domestic exports and relocation of labor-intensive production to the PRC.

The seasonally adjusted unemployment rate rose from 7.2% in the period November 2002-January 2003 to 7.4% for December 2002-February 2003. This rise can, in part, be attributed to a downturn in construction where there has been a slowdown in new private sector building projects, government cuts to the Public Housing Programme, and reduced work on decoration and maintenance immediately after the Lunar New Year period. The consequent sharp rise in construction sector layoffs, particularly temporary and part-time workers, outweighed the additional hiring within the retail trade and hotel sector in response to increasing inbound tourism. The current high unemployment rate is in stark contrast to the full employment norm before the Asian financial crisis.

Due to the weakness of the labor market, the nominal average wage has been falling since early 2002. Nevertheless, real wages still rose because nominal wage decreases fell short of the decline in consumer prices. This stickiness in wage adjustment has contributed to the inability of the labor market to adjust to sluggish demand and to continued high rates of unemployment.

Deflation continued. The Composite Consumer Price Index fell by 3.0% in 2002, its fourth consecutive year of decline. The prime cause has been declining property prices and rentals. The residential property market slid further in 2002, with apartment prices falling by 12% and rentals by 14%. Greater integration with the Pearl River Delta has created pressures for price convergence between the two areas. Lower import prices also put downward pressure on prices. Average import prices fell by 3.9% in 2002, reflecting subdued prices in the international economy, especially in the PRC and Japan, the two leading suppliers of imports.

The current account surplus of 10.7% of GDP in 2002 was even larger than that of the 7.5% of GDP in 2001. The merchandise trade account deficit remained stable, while the services trade surplus continued expanding. The external factor income account also recorded a further surplus, though net outflows from financial non-reserve assets rose further.

Taken together, the balance of payments had a deficit of 3.5% of GDP in the fourth quarter of 2002, resulting in a corresponding fall in reserve assets, as against a deficit of 2.4% of GDP in the third quarter. Nevertheless, the external debt position remains sound and the Government is debt free.

The new budget released on 5 March 2003 estimated a consolidated deficit of HK$70 billion for FY2002 (ended 31 March 2003), or 5.5% of GDP. Loose monetary policy in the US has kept nominal interest rates in Hong Kong, China low. Deflation, while not conducive to domestic demand, has helped external competitiveness and contributed toward the recent surge in exports.

Policy Developments

Rising fiscal deficits—deriving from the financial crisis, the restructuring of the economy, and a cyclical downturn—have become a major concern for the authorities. The bursting of the property bubble has caused a significant decline in real estate-related revenues, while ongoing relocation of production to the PRC has also weakened government revenues. With the exception of FY1999, Hong Kong, China has registered fiscal deficits every year since FY1998.

Prolonged fiscal deficits increase the risk of macroeconomic instability, though this possibility remains low due to the authorities' prudent fiscal policies and the cushion provided by the large fiscal reserves accumulated during the sustained economic boom before the financial crisis. Despite recent deficits, the fiscal reserves are expected to be over HK$300 billion at the end of March 2003 (close to US$40 billion). Foreign exchange reserves are also high.

The combination of weak economic growth and a rising fiscal deficit presents a dilemma for policy makers. In March 2002, the previous budget set medium-term targets of restoring fiscal balance by FY2006. It also proposed stimulating domestic demand through measures such as reducing charges for certain public utilities. It contained tough measures to rein in the deficit, such as pay cuts for civil servants. These cuts, however, turned out significantly smaller than assumed in the 2002 budget because of the rigidity of the civil service pay structure. The budget deficit widened in FY2002 as a result of weak economic growth, countercyclical fiscal measures, and the rigidity in reducing government expenditures.

The new budget for FY2003 suggests that containing the deficit has become the authorities' top priority. The authorities committed to bring the budget into balance by FY2006 and to tackle the deficit with a three-pronged strategy: boosting economic growth, cutting public expenditures, and raising revenues. Expected economic recovery will provide some relief to the fiscal position. A series of revenue-generating measures has been proposed, including selling public assets; increasing departure, payroll, profit, and property taxes; and increasing fees and charges for public services.

Operating expenditures will be reduced from HK$213 billion (US$27.3 billion) in FY2003 to HK$200 billion (US$25.6 billion) as targeted for FY2006, by phases. Concrete measures include a 6% civil service pay cut; a 10% reduction in the civil service establishment (through a freeze on recruitment and a second phase of the voluntary retirement scheme); and an 11.1% adjustment of the Comprehensive Social Security Assistance payment, in line with deflation.

Reacting to the difficult state of the property market, the authorities introduced, in November 2002, measures to reduce the supply of new public apartments and increase demand for private apartments, while still providing public rental housing for low-income earners. While it is important to exercise fiscal discipline, the authorities need to tread a fine line between the need for fiscal restraint and the need to use fiscal policy to stimulate domestic demand.

The recent economic downturn has exposed weaknesses in the tax base. Government finances have been overly dependent on revenue from land sales and property transactions. While a broad-based goods and services tax is probably the best alternative to adopt in the future, the authorities remain cautious. Increased taxation is always unpopular and may dampen domestic demand in the short term. Furthermore, Hong Kong, China's low tax rates have long been considered an advantage for attracting skilled labor and capital. As such, the introduction of a goods and services tax is ruled out for the next few years.

The economy is generally associated with minimal government intervention, though spending on infrastructure and education has been significantly increased since the mid-1990s, partly in response to the need to upgrade facilities and the skills base as the economy matured. The authorities have also financed a large proportion of health care costs, subsidized rents for low-income earners, and provided unemployment benefits. The share of public expenditures in the economy has risen from 15.6% in 1993 to 21.5% in 2003. The FY2003 budget proposes more infrastructure upgrades, including the construction of new tourist attractions.

Although delaying or reducing infrastructure projects has been mooted, the FY2003 budget boosted annual capital expenditures, to around HK$29 billion from FY2003 to FY2007.

To facilitate economic integration between Hong Kong, China and the PRC, the Hong Kong, China authorities are considering relaxing restrictions on mainland professionals coming in to work. A Closer Economic Partnership Arrangement (CEPA) with the mainland is being pursued to boost bilateral flows of trade, services, and investment. Discussions are already under way regarding the construction of a bridge linking Hong Kong, China; Macao, China; and the western part of the Pearl River Delta, as well as a Guangzhou-Shenzhen-Hong Kong, China express railway.

Outlook for 2003-2004

Hong Kong, China may have already embarked on an export-led recovery in the second half of 2002. This process is expected to continue over the next 2 years on the back of strong growth in the PRC and a pickup in world demand. Improved exports would feed into the domestic economy. However, the recovery of the domestic economy will be gradual due to the structural transformation it is undergoing. The recent outbreak of SARS has also undermined the prospects for a rapid economy recovery. However, provided that SARS is quickly brought under control, GDP growth is likely to strengthen from the second half of 2003. GDP is expected to grow by 2.0% in 2003 and by 4.0% in 2004.

Strong export growth is likely to continue in 2003. Reexports will be bolstered by robust exports from the PRC, while exports of services should expand in conjunction with merchandise trade. However, the vibrant performance of inbound tourism in 2002 is likely to slow substantially in the first half of 2003 as a result of mounting concerns over the emergence of SARS.

SARS is also affecting domestic demand. As an economy dominated by the services sector (over 80% of GDP), Hong Kong, China is likely to feel the pinch more than other economies in this regard. Tourism, transport, retailing, and entertainment have already felt the strain. As the number of infected cases is small relative to the population, SARS is unlikely to significantly affect production capacity. However, it could have a severe impact on demand by causing uncertainty and panic. Domestic demand is thus likely to be weak in the first half of 2003.

The impact of SARS is likely to be short lived, once it is brought under control. In the second half of 2003, private consumption and investment are forecast to recover slightly, as the effects of export expansion filter through to domestic sectors. Nevertheless, consumer spending is likely to remain subdued in 2003 due to high unemployment and falling property prices. Investment spending is expected to rebound moderately. There will probably be renewed acquisition of machinery, equipment, and computer software to boost productive capacity. On the other hand, building and construction may decline again, as public housing construction is cut back and work on the KCR West Railway winds down. In addition, few new projects are planned. The persistent budget deficit will constrain government fiscal expansion.

Export growth will outpace import growth in 2003 due to weak domestic demand. The current account surplus is forecast to widen to 11.5% of GDP, before settling to 8.5% of GDP in 2004 as imports pick up.

Employment will be strained in the short term by the uncertain business outlook. The unemployment rate is expected to stay at around its current level for the immediate future. Over time, however, strong exports and strengthening domestic demand will gradually lift labor market performance. Unemployment is forecast to be around 7.4% in 2003 and to fall to 6.2% in 2004.

The ending of the earlier special relief measures by the authorities will lift prices somewhat, although deflation will only gradually abate. Further adjustment of the property market, relatively high unemployment, and ongoing price convergence between the PRC and Hong Kong, China will continue to exert downward pressure on prices. A weaker US dollar may increase import prices, although keen competition among local retailers and distributors may keep in check price rises. Furthermore, deflation in the PRC and Japan will reduce external price pressures. The Composite Consumer Price Index is forecast to fall by 1.5% in 2003, then increase by 0.5% in 2004. Interest rates in the US, and thus in Hong Kong, China, are likely to remain low for most of 2003. This should encourage consumer spending and corporate investment.

The economy will continue to face a range of longer-term structural problems. High unemployment, persistent deflation, and serious fiscal deficits are symptomatic of two interrelated phenomena: prolonged sluggishness in the property market and increasing integration with the PRC, though the latter has proven to be a double-edged sword. It has boosted Hong Kong, China's economic growth, but also lured firms to relocate to the mainland to lower their production costs. Growing movements of goods and services between the two economies have promoted price convergence as wage and land costs rise in Guangdong province and fall in Hong Kong, China. The fact that properties in Shenzhen are only one third to one fifth the price of their Hong Kong, China equivalents means that the property market is likely to fall further, especially as border restrictions will be lowered steadily in the coming years.

Although property prices have fallen by about 60% from their peak in 1997, Hong Kong, China remains one of the world's most expensive places to buy and lease property. Labor costs are also fairly high, certainly compared with those in the PRC. Lower production costs in the PRC will place considerable pressure on Hong Kong, China and force substantial structural changes. However, the economy still possesses many advantages, including a flexible labor market, efficient public institutions, sound legal and financial systems, a good location, and a well-developed infrastructure. Nevertheless, income and living standards between Hong Kong, China and the mainland will continue to narrow, as economic liberalization and development in the PRC proceed.

The openness of the economy makes it highly dependent on the strength of its trading partners. This is especially true when the domestic economy is beset by various structural difficulties. Reexports, which are strongly affected by economic conditions among Hong Kong, China's trading partners, have been the main driver of overall export growth. Thus, economic rebound hinges on global economic recovery, and particularly on continued robust growth in the PRC.

This forecast is based on the assumption that the global economy will slowly pick up in 2003, and strengthen in 2004. It also assumes continued strong growth in the region, especially in the PRC, and that the conflict in Iraq will not significantly affect the oil supply and dampen investor confidence. In addition, it is based on the assumption that the recent outbreak of SARS will soon be brought under control. If not controlled soon, SARS could disrupt the overall functioning of the economy, especially certain services-related industries. Any risks in these regards could significantly alter the outlook.

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