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Asian Development Outlook 2004 : II. Economic Trends and Prospects in Developing Asia : East Asia
Hong Kong, China A rebound in the property market has laid the groundwork for a much broader-based recovery than any since the deep recession in 1998. Exports drove growth in 2003 and look set to remain strong. Investment will join the recovery in 2004. The authorities must now decide how they will strengthen the fiscal position-by raising taxes or by relying on the property market’s rebound to produce higher revenues. Economic Assessment The economy continued to operate well below potential in 2003, but started to rebound strongly after the SARS outbreak faded. Weakness in the US dollar, to which the Hong Kong dollar is linked, helped. So did the decision by the PRC authorities to ease travel restrictions to Hong Kong, China. A recovery in the property market and a stock market rally spurred consumption spending. Most encouraging was a recovery in business investment, as empty office space began to be taken up, sparking a rebound in office purchase prices. After grappling with various cyclical and structural problems for several years, the economy is showing clear signs of recovery. Growth rebounded from the third quarter of 2003, lifting overall GDP growth for the full year to 3.3%, the highest rate in 3 years. A key factor was the bottoming out of apartment prices in August 2003, after a plunge of about 60% from the 1997 peak. Between August 2003 and March 2004, prices of housing rebounded by about 40%.
The foundations of the recovery in housing were set late in 2002, when the authorities suspended sales of public apartments and land auctions and promised to minimize intervention in the housing market. (The application list system for the sale of land was resumed in January 2004.) Rising property prices greatly reduced the number of homeowners with “negative equity” (i.e., when borrowing exceeds the market value of the mortgaged property). According to figures from the Hong Kong Monetary Authority (HKMA), in September 2003 the number of negative equity cases based on first mortgages was 99,800, with a total loan value of HK$155 billion. The upswing in the housing market inflated total housing stock wealth by about HK$500 billion by February 2004. Retail sales hit their lows about the time that apartment prices hit theirs. By December 2003, retail sales in value terms had risen by 6.8% over 12 months, which was the first time in years that the increase in the value of retail sales was higher than the rise in real terms (of 5.8%). This suggested that price deflation was over. The January 2004 retail sales data were encouraging, too, with the volume index climbing to its highest level since January 1997. Overall investment spending regained some strength in the second half of 2003. After declining by 5.7% in the second quarter, gross domestic fixed capital formation rebounded by 2.5% in the fourth quarter. Although for 2003 as a whole, real gross domestic fixed capital formation declined by 0.1%, this is a significant improvement from the 2002 drop of 4.3%. The major element in GDP growth in 2003 was net exports, which contributed 2.7 percentage points. Exports of goods and services rose by 12.7%. Services exports, in particular, rebounded in the third quarter after SARS had petered out. The strong export performance benefited from (i) the improved global economic environment later in 2003; (ii) increased price competitiveness of Hong Kong, China’s exports, stemming from exchange rate movements and domestic cost reductions; and (iii) increasing exports from the PRC, the main source of the economy’s reexports. In line with strengthening domestic demand, inflation reappeared in September 2003 on a Employment continued to shrink in the first 3 quarters of 2003. The unemployment rate peaked at 8.7% during May-July 2003, then declined, partly because some people dropped out of the labor market. New hiring started toward the end of the year, with 41,000 jobs created in the last quarter, and employment continued to grow in the new year. The authorities made a major effort to reduce unemployment by creating new, low-paid jobs and by helping with traineeships, which provided relief to the large number of unemployed young people. (Fiscal restraint, however, kept growth in government consumption to 1.9% in 2003.) Over the longer term, the work force of Hong Kong, China is becoming more integrated with the PRC’s: more than 240,000 people from Hong Kong, China worked in the PRC in 2003, up sharply from 64,000 a decade earlier. The economic revival will help restore living standards. The number of people registered for Comprehensive Social Security Assistance rose quickly from 267,609 in January 2003 to 283,823 by June, then at a slower rate to peak at 290,206 in December. January 2004 saw the figure dip to 289,538, the first decline in 3 years, promising further drops in the months ahead. In other measures of living standards, median household income fell to HK$15,500 a month in 2003 from HK$18,000 2 years earlier. However, the number of personal bankruptcies fell in 2003 as the housing market recovered, after a worrying rise in bankruptcies over the previous 5 years. Hong Kong, China’s fiscal position, too, benefited from the rebound in the property market, because higher property prices and sales boosted government revenues in FY2003 (ended 31 March 2004). Also, HKMA almost doubled its investment income in 2003 to HK$89.6 billion. Of this, the fiscal reserves’ share amounted to HK$25.7 billion, more than double the amount budgeted in FY2003. On the other hand, the authorities spent an additional HK$9.1 billion as a result of SARS, as they reduced fees and charges, raised health spending, and refunded some income tax. The budget deficit for FY2003 was estimated at HK$49 billion, or 4.0% of GDP, well below an earlier estimate of more than HK$78 billion made in October 2003. Sentiment toward the Hong Kong dollar swung sharply in 2003. After a period of weakness, the currency gathered strength on several factors: (i) speculation that the Hong Kong dollar would strengthen alongside the yuan if the PRC currency was revalued; (ii) optimism over the CEPA agreement between the PRC and Hong Kong, China; (iii) an upgrade by Moody’s of Hong Kong, China’s credit rating; (iv) signs of improvement in the domestic economy; and (v) the bottoming out of the slide in the housing market. The Hong Kong dollar traded at around its linked rate of HK$7.8 to the US dollar for most of the year but in late September and early October it suddenly strengthened toward HK$7.7. To maintain monetary stability and avoid excessive currency deviation, HKMA purchased US dollars on the interbank market. As a result, the Hong Kong dollar eased to around HK$7.76-HK$7.77 by end-2003. The US dollar’s weakness, capital inflows, and HKMA purchases of US dollars produced very expansionary monetary conditions in the last quarter of 2003. With the return of inflation on a month-to-month basis in September 2003, real interest rates turned negative, creating a great incentive for holders of Hong Kong dollars to buy real assets. As the property market rebounded, the “credit crunch” effect that had been associated with falling property values was reversed. This was reinforced by a continuous decline in interest rates. The Hong Kong dollar interbank offered rate started 2003 at 1.6% and fell to 0.76% by December, although the prime rate stood at 5.0% throughout the year. The stock market also benefited from the low interest rates and rising property prices. The Hang Seng Index rallied by 35% in 2003, similar to several other East Asian markets. Overall bank deposits rose by 7.5%, compared with a decline of 2.6% in 2002, but the total value of loans fell by 2.0%, though this rate of decline slowed from 2002. The quality of bank assets has improved considerably, with the mortgage delinquency rate falling to 0.86% and the write-off rate for credit cards declining to 8.2% by end-2003. (Indeed, the jump in property prices and recovery in the labor market quickly improved the quality of assets on banks’ balance sheets.) This development, together with the launch of yuan accounts in 2004, is expected to improve the profitability of banks in Hong Kong, China. The amount of yuan circulating in the economy is estimated at CNY50 billion-70 billion, a figure that is projected to rise to CNY150 billion-300 billion by 2005. The development of this “offshore” yuan business could help pave the way for the yuan to become a fully convertible currency in the future, and the Bank of China’s role as the clearing bank for yuan business gives this bank a more prominent role in Hong Kong, China. While merchandise exports rose by 14.2% in 2003 and imports grew by 13.1% in constant dollar terms (on account of weakness in consumption and investment), both grew by about 12% in current market prices. The trade deficit widened slightly to US$5.8 billion but the current account surplus rose to US$17.4 billion, or 11.0% of GDP. The economy’s net international investment position improved rapidly over recent years, from HK$1.7 trillion at end-2000 to HK$2.7 trillion, or 210% of GDP, 2 years later. This reflects a growing net capital outflow because of a lack of confidence in the local economy, at least until the last quarter of 2003 when funds again poured into property and stocks. Policy Developments Recovery in the economy and asset markets has provided some relief to the fiscal position. Revenues from stamp duties leaped with surging property and stock transactions, and collection of profits tax saw a significant rise. Revenues from fees and charges have been progressively restored to the normal levels on expiry of the concessional measures introduced in previous years. Pressures on expenditures eased, too, as for example, the number of cases registered for Comprehensive Social Security Assistance fell slightly in January 2004. However, the bursting of the property bubble in the late-1990s and the subsequent long economic slump exposed the authorities’ vulnerability to the land-based revenue system, prompting debate on tax reform. A key policy challenge for the authorities is balancing the budget by FY2008. In the March 2003 budget, they referred to a three-pronged strategy: increasing revenues through economic recovery; reducing expenditures; and raising revenues by other means. Certainly, the economic recovery and rebound in property prices in the second half of 2003 boosted revenues. The authorities have, as well, moved to reduce expenditures by lowering civil service pay by a total of 6% over 2 years and reducing the ranks of the civil service through natural attrition and early retirement. The authorities are studying several possibilities to further raise revenues, including a goods and services tax. Broadening the tax base could hurt the working poor, though. A goods and services tax would provide a reliable, long-term source of revenues and would reduce the erosion of revenues lost to underground, or unreported, activities and to the PRC as more Hong Kong, China people live or work over the border. However, at times when the economy is weak and needs as much spending as possible, such a tax would reduce the amount that consumers actually have. For the longer term, the authorities need to decide if they want to depend so much on land-based revenues, both directly through land premiums collected and indirectly through taxes paid by developers, banks, and property owners. The current system allows personal and corporate income taxes to stay low, but inevitably leads to high land prices. The alternative route would bring down land prices and raise these taxes. Given that Hong Kong, China recorded large budget surpluses as late as 1996 and 1997, that a deficit emerged only after a plunge in the housing market, and that the long-run elasticity of revenues with respect to housing prices is 0.8, the deficit problem might well be resolved, at least for the medium term, by a continued recovery in the housing market. In FY2004, the authorities will issue Hong Kong dollar bonds for the first time in more than a decade. Issuance will be capped at HK$20 billion and the funds used only for capital expenditures. The bonds, issued in a period of low interest rates, will provide funds at a reasonable cost and add both breadth and depth to the local bond market. HKMA and the authorities have repeatedly reasserted their commitment to maintaining the exchange rate link to the US dollar. Under a weak US dollar, inflation tends to rise, although as long as the yuan remains fixed to it, imported pressure on inflation should be mild. Economic integration with the PRC took some important steps in 2003. CEPA, between Hong Kong, China and the PRC, was signed in June. Under CEPA, 273 types of goods made in Hong Kong, China gained tariff-free entry into the PRC from 1 January 2004 and more goods will be added to the list by 1 January 2006. This will help some of the economy’s manufacturing industries, but overall benefits are likely to be modest given the small manufacturing base-its share of economic output had fallen to about 4% of GDP by 2003. Benefits to the services sector from CEPA are likely to be more significant. The PRC services subsectors opened to Hong Kong, China firms include transportation, advertising, telecommunications, construction, tourism, banking, insurance, and legal and accounting services. Firms in these subsectors will gain access to the PRC market ahead of the deadlines stipulated in the PRC’s WTO accession agreement. This may give the firms some first mover advantage. The move to allow Hong Kong, China banks to offer bank accounts, credit cards, remittances, and foreign exchange services in yuan also strengthens the links between the two economies. In January 2004, HSBC, in cooperation with the Bank of Shanghai, became the first bank to provide credit card services for PRC residents traveling abroad. The credit cards enable PRC travelers to spend more money in Hong Kong, China. Prior to this change, each PRC visitor could only bring CNY6,000 into Hong Kong, China, and could not use credit cards issued by PRC banks. Outlook for 2004-2005 The outlook is optimistic, with economic growth expected to strengthen to 6.0% in 2004 before settling to around 5.0% in the following 2 years. This is attributable partly to CEPA and to the approval for individuals to travel to Hong Kong, China from more PRC cities. This decision helped inbound tourism recover late in 2003, which boosted employment in hotels and brightened prospects for retailers. Retailers’ rents have jumped, often by half. The strong housing market is benefiting several other areas (e.g., builders, appliance retailers, decorators, lawyers, banks) and will give impetus to private consumption through the increased wealth effect. It will also boost investment, since owners of small and medium enterprises can increase borrowings using their homes as collateral. This will help drive business investment in 2004 and beyond. Fixed capital formation is expected to grow by double digits in 2004, but slow a bit to around 7% and 9%, respectively, in 2005 and 2006. With a continuing recovery in the economy, the fiscal deficit will gradually close, most probably by the target date of FY2008. Worries that the property market is becoming overheated appear unfounded at this stage because a recovery of 40% in apartment prices still puts them at more than 40% below the 1997 peak. Several infrastructure projects are in the pipeline, the most noteworthy of which is the Zhuhai-Macau-Hong Kong Bridge, which has the approval of all governments concerned. Macau, China’s gambling industry is being revamped with additional casinos and hotels and the participation of overseas casino companies. Construction of new facilities and a revival of tourism after SARS boosted that economy’s growth rate to over 20% in the second half of 2003 and to 16% for the full year. International tourism to Macau, China will grow rapidly, and Hong Kong, China will benefit from the spillover. The Hong Kong, China Disneyland will provide further impetus to tourism when it opens in 2005 or 2006. Exports are expected to remain strong, benefiting from fast economic growth in the PRC, steady growth in the US and Japan, and a recovery in the EU. Imports will rise as consumption and investment pick up. The current account surplus as a share of GDP is expected to fall slightly to 7-8%. Government consumption is the weakest component in GDP; it is forecast to rise moderately by 1.7% in 2004 and then decline slightly in 2005, amid government efforts to reduce the budget deficit. CPI inflation is projected in the 1-2% range. This outlook assumes that economic growth in the US and PRC remains robust, that no significant protectionist measures are taken against either Hong Kong, China or the PRC, and that current exchange rate arrangements remain in place.
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month-to-month basis, though deflation was still in evidence year on year. The composite CPI rose every month after hitting a trough of 91.0 in August. By January 2004, it had reached 92.4, before slipping to 91.7 in February (Figure 2.2).
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