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p. 21 of 77 BACK | NEXT Foreword, Acknowledgments, Acronyms and Abbreviations, Definitions 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. Promoting competition for long-term development Statistical appendix

Asian Development Outlook 2005 : II. Economic trends and prospects in developing Asia : East Asia

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Hong Kong, China

The recovery strengthened and broadened in 2004, benefiting from buoyant consumption--supported by a rebounding property market--and rising exports. While export growth will ease, it will remain robust over the forecast period, and consumption and investment will be strong. The authorities are considering a goods and services tax to help stabilize revenues in the longer term, even though the fiscal position has improved with the economic upswing.

Macroeconomic assessment of 2004

The economy grew faster than expected in 2004, expanding by 8.1%, compared with 1.9% average growth in the previous 3 years. Private consumption, benefiting from the property market rebound, stronger household balance sheets, and rising employment, grew by 6.7% and contributed 3.7 percentage points to GDP growth. Total investment grew by 3.2%, contributing 0.8 percentage point to GDP growth.

Services, which account for nearly 90% of the economy, rebounded after being hit hard by the SARS outbreak in 2003. Inbound tourism was particularly strong, with a record 21.8 million foreign visitor arrivals, up by about 6 million from 2003. More than half of the visitors came from the PRC, a result of a further easing of restrictions on individual travel to Hong Kong, China. The surge in tourism helped lift retail sales by 9.1% in volume terms.

Exports of goods and services rose by 15.2%, boosted by the continued strength of the PRC economy, the weak US dollar to which the Hong Kong dollar is linked, and the robust inbound tourism. Strong domestic demand led to import growth of 13.8%. Net exports, which had been the driving force in GDP growth in 2003, contributed 3.5 percentage points in 2004, about the same as private consumption.

The strong economic recovery created 78,100 jobs in 2004 and reduced the unemployment rate to 6.5% by end-2004 from a SARS-induced peak of 8.6% in mid-2003. Median monthly employment earnings during the fourth quarter of 2004 stood at HK$9,500, the same as a year earlier; median household income edged up to HK$15,500 in the fourth quarter, from HK$15,000. Yet poverty remains a concern. According to the Hong Kong Council of Social Service, for every 100 children below the age of 15 in Hong Kong, China, almost 25 live in families with household income below half the median.

Residential property prices, as measured by the Centaline Leading Index, bottomed out in August 2003 and had risen by over 60% by end-February 2005, in part reflecting supply management policies introduced by the authorities late in 2002. Rising prices reduced the number of apartment owners suffering from negative equity, i.e., when mortgages exceed the value of the property, though apartment prices in the first quarter of 2005 were still well below their 1997 peaks. Prices of commercial property--offices and retail--rebounded even more strongly, some by as much as 80-100% in 2004. The recoveries in the economy and property market also lifted corporate earnings and the stock market, with the Hang Seng Index finishing the year with a modest gain of 13%.

Bank earnings and the quality of bank assets also benefited from the stronger property market. The recovery in investment and consumption stimulated demand for bank loans, and robust external trade increased trade financing activity. The launch of yuan business further helped the environment for banks.

The Closer Economic Partnership Arrangement (CEPA) between Hong Kong, China and the PRC, which was fully implemented in January 2004 and was expanded to cover more goods and services in January 2005, has helped strengthen investor confidence. Under the agreement, Hong Kong, China products covered by 1,108 PRC tariff codes have tariff-free access to the PRC market, and suppliers in 26 service areas receive preferential treatment from the PRC.

Inward FDI rose sharply to US$34.0 billion in 2004, more than double the 2003 figure. The increase apparently was related in part to PRC enterprises taking advantage of CEPA and setting up businesses in Hong Kong, China.

Government revenues, too, received a lift from the economic rebound and buoyant property market. General revenues, including operational and capital income, rose by 14.0% in FY2004 (ended 31 March 2005), while operating expenditures declined by 1%. The Government reported a small consolidated surplus equivalent to 0.9% of GDP, but after excluding receipts from bond issues the result was a deficit of 1.0% of GDP. This compared with a FY2003 deficit of 3.3% of GDP (Figure 2.2). Fiscal reserves at March 2005 rose to HK$287 billion, equivalent to 14 months of government expenditures.

Deflation concerns faded in the first half of 2004. In July, the consumer price index rose by 0.9% from July 2003, the first year-on-year increase since November 1998. For the full year, though, the composite CPI recorded a small decline of 0.4%. Meanwhile, the money supply (M2) growth rate picked up to 9.3% in 2004 from 8.4% in 2003, and domestic credit rose through the year.

Hong Kong, China has for many years maintained a current account surplus on its balance of payments, with a surplus on trade in services exceeding the merchandise trade deficit, while net investment income usually offsets unilateral transfers. This pattern recurred in 2004, with the merchandise trade deficit widening to US$9.3 billion and the current account surplus representing 9.7% of GDP.

Macroeconomic policy developments

With a target to balance the budget by FY2008, the authorities in 2004 maintained a policy of expenditure cuts, including reducing the number of civil servants and cutting the pay of the remaining personnel by 3% from January 2005. While the economic recovery pushed up revenues in 2004, the debate on a goods and services tax (GST) continued. About 40% of Hong Kong, China's income in its general revenue account is derived from salary and profit taxes; 30% comes from direct land-based revenues and investment receipts; the balance is indirect taxes and fees. A GST would be a way to broaden the narrow tax base, ensure a more stable revenue flow, and reduce the number of people who do not pay any taxes. The 5% GST under discussion could raise US$3 billion-4 billion a year. The financial secretary noted in the March budget that it usually takes about 3 years in any jurisdiction between making a decision to introduce a GST and actual implementation. He said that the authorities would consult the public before making a decision.

The authorities expect to balance the operating account by FY2008 and the consolidated account by FY2007. Over the next 5 years, fiscal reserves will be maintained in a range of HK$270 billion-340 billion, equivalent to 13-17 months of expenditure.

The March 2005 budget proposed the abolition of estate duty (a tax on the estate of a deceased person). Many bankers and the Hong Kong General Chamber of Commerce had contended that repealing this tax would spur the development of asset-management services since wealthy people would not take assets offshore to avoid estate duty.

With a view to enhancing corporate governance, the authorities propose to establish a Financial Reporting Council, with two main functions. The first is to investigate irregularities of auditors of listed companies, and the second is to inquire into the financial reports of such companies to help ensure that they comply with legal and accounting requirements. The proposed law is expected to be introduced into the legislature around midyear.

Decisions in 2004 to securitize future toll income from government-owned tunnels and bridges with an offering of HK$6 billion-worth of bonds and the launching of a separate HK$20 billion government bond issue were aimed in part at stimulating the underdeveloped bond market.

Legislation for a deposit insurance plan was passed in May 2004. It will provide insurance for the first HK$100,000 of deposits per depositor per bank and is expected to come into effect in 2006. Also in 2004, banks were allowed to offer personal banking and credit cards in yuan. Together with a sharp increase in the amount of yuan that can be taken in and out of the PRC to CNY20,000 ($2,417), effective 1 January 2005, this signals closer financial ties between Hong Kong, China and the PRC, mirroring the closer CEPA trade ties.

On the monetary front, the Government and the Hong Kong Monetary Authority reaffirmed their intention to maintain the exchange rate link at HK$7.8 to the US dollar. Under this arrangement, interest rates should move in tandem with US rates. However, a combination of speculation about a revaluation of the yuan, weakened sentiment toward the US dollar, and improved economic conditions led to strong capital inflows. This resulted, in 2004, in a persistently large aggregate balance held by banks with the Monetary Authority. Consequently, Hong Kong, China's interest rates could remain below US rates, giving impetus to the property market and domestic credit expansion.

To address unemployment, the authorities adopted a combination of approaches--direct job creation, offering training to young workers and displaced workers, and more education opportunities. These approaches have been effective in reducing the jobless rate. On the poverty front, the authorities have recently established a commission on poverty to identify the needs of the poor, as well as make policy recommendations to reduce poverty and promote self-reliance.

Despite 6 years of generally weak growth up to 2004, Hong Kong, China's trend growth rate appears to be around 5%. Over the longer term, an aging of the population and low fertility rates could cause labor shortages, leading to wage inflation and lower economic growth. An aging population will also require much higher spending on welfare, care facilities, and health. The authorities have acknowledged the need for a sound population policy, which will require new approaches to immigration issues.

Outlook for 2005-2007 and medium-term trends

Growth is expected to slow to more sustainable rates of 5.7% in 2005, 4.1% in 2006, and 5.6% in 2007. Factors underpinning growth will be continued expansion of the PRC economy; low, though rising, interest rates; a soft US dollar; and FDI inflows. Private consumption and investment, rather than exports, are forecast to be the locomotives for growth. Buttressed by a surging tide of PRC visitors, declining unemployment, and rising wealth, private consumption is expected to grow by around 6-7% each year through 2007.

Investment growth is forecast in the 7-9% range. Construction activity is likely to revive now that the property market recovery is well under way. A revival of building activity--residential, commercial, and public works--will further reduce unemployment. Some of the major projects in the pipeline are extensions of railway lines; a 29 kilometer bridge to link the city with Macau and Zhuhai; and a new ocean liner terminal.

CEPA will continue to benefit the economy as implementation moves ahead, and is expected to help attract greater inflows of FDI. Other positive influences in the near term include: the PRC's liberalization of travel restrictions so that individuals from more PRC cities can travel to Hong Kong, China, which benefits hotels, restaurants, and retail businesses; improved investor sentiment toward the local stock market, which will boost new share offerings; and higher levels of confidence among SMEs, which will fuel investment.

Growth of goods and services exports will ease from 2004's strong rate to the 10-12% range, supported by a weak US dollar and a growing PRC economy. Services exports are expected to strengthen somewhat because of the buoyant inbound tourism--receiving a further fillip when a major theme park opens later in 2005--and the export of financial services. Imports of goods and services will grow faster than exports, by 11-13% through 2007, as a consequence of the continuing expansion of private consumption and investment. As a result, net exports will not add to growth.

Further improvement in the labor market is expected to reduce unemployment to 6.0% in 2005 and to below 5.0% in 2007. An increasing number of employees will reach retirement age in the medium term, so that the unemployment rate will continue to fall even though the pace of job growth may be only moderate. This trend may also put more upward pressure on wages over the next few years. Inflation, though, is expected to be mild at 1.5% in 2005, edging higher through 2007.

With the banking sector awash with liquidity, Hong Kong, China banks opted several times to not follow US interest rates up when the Federal Reserve raised its target for the Federal Funds rate. This widened the interest rate gap and funds started to move out of Hong Kong dollars in early 2005. In March, major banks raised rates closer to US levels. Domestic interest rates will probably continue to move up gradually, though the impact on the property market may be softened by changes to the housing finance market, under which banks are now able to grant mortgages on older buildings and are offering to lend up to 95% of the appraisal value of properties under a mortgage-insurance program. These changes will continue to support the property market recovery and, by raising land premiums collected and taxes on the profits of developers, banks, and brokerage houses, as well as stamp duties on both property and stock market transactions, bolster government revenues.

Risks to this medium-term outlook include a steeper than expected rise in US interest rates or sharper decline in world trade, and an outbreak of protectionist measures against the PRC from the US and European Union. Higher world energy costs have raised electricity charges in Hong Kong, China, but as a mainly services economy the damage is limited. Higher oil prices do hurt the economy's export destinations, though. Concerns that Shanghai could seriously erode Hong Kong, China's role as a financial center and gateway to the PRC in the medium term seem overstated. In terms of regulation, rule of law, transparency, and corporate governance, other cities in the PRC are unlikely to be competitive for many years.

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