This year, amid the rapidly deteriorating external economies and domestic structural problems, Hong Kong's economic growth declined substantially, despite the fact that there have been interest rate-cuts and salary increment. Overall economic performance has been far below expectations. Looking forward to the second half-year, Hong Kong's economy will continue to be frustrated by global economic slowdown and domestic structural problems. GDP growth for the whole year is forecast to fall to 2.6%.

External Environment: Global Economic Adjustment

The major factor presently affecting Hong Kong's economy is global economic adjustment. The U.S. economy, being the world economic engine, has suddenly "extinguished", causing serious repercussions for other economies and worldwide gloominess.

1. Major Economies Weakening

This year, the three major economies have successively experienced difficulties. Economic growth in the U.S. declined to 1% in the fourth quarter last year and remained low at 1.3% in the first quarter this year. The U.S. economy probably would not experience "soft-landing". Instead, it is lingering on the brink of recession, with the possibility of getting worse off. Japan's economy deteriorated again, with its GDP falling by 0.2% in the first quarter and its unemployment rate soared to record high in the last thirty years. Economic performance of the European Union has also been far below expectations, particularly for Germany and France. The European Commission has already trimmed its economic forecast to 2.8% from 3.1%, while the IMF's forecast has been lowered to 2.4%. Other Asian economies suffered from the decline in the U.S. and Japanese economies, with 32-42% of their exports destined to the two markets. All Southeast Asian economies experienced substantial decline in growth during the first quarter. As for China, with expansionary fiscal policy and other stimulating measures, first quarter economic growth still reached 8.1%. However, amid unfavourable external environment, growth momentum has been weakening. In order to maintain stable growth, China is expected to further stimulate domestic demand in the second half-year.

2. Reasons for Adjustment

The U.S. is the source of global economic slowdown. The continuous rapid expansion of the U.S. economy in the past 10 years has resulted in over-consumption and investment, giving rise to problems such as excess capacity and debt burden. Average debt ratio of the S & P 500 companies rose to 110% in the third quarter last year from 55% in the 1980s. Repayment burden of household consumer credit has already occupied 14.3% of disposable income, the highest since the 1980s. In order to cut debt, corporate investment and private consumption were lowered, leading to contraction of manufacturing activities. The National Purchasing Manager's Index had already been below 50 for ten consecutive months by May, whereas the Non-manufacturing Index also dropped drastically from last December's 61.6 to 46.6, the lowest level since the survey first conducted in 1999. All these imply that about 80% of the economic activities in the U.S. is going to remain sluggish in the coming months. As demand shrank, corporate profits registered the largest decline in eight years' time. Companies had to cut cost by shedding staff, causing the unemployment rate to rise from last year's 3.9% to the present 4.5%. By early June, initial jobless claims in the U.S. have risen to the highest level in the past eight years. Rising unemployment would certainly weaken consumption, further aggravating the economic slowdown.

3. Adjustment Takes Time

The U.S. has taken various measures to avoid economic recession, including interest rate cuts, tax cut and rebate. The Federal Reserve has cut rates by 2.75 percentage points, with the Fed Funds rate lowered to 3.75% from 6.5%. Nevertheless, the current structural problems of the U.S. will dampen the impact of rate cut significantly, as it takes time for firms and individuals to cut debt, and the banks have been contracting credit amid surging non-performing loans. Tax cut should boost investment and consumption. However, as firms and individuals are restructuring their finance, tax rebate will probably be used for debt repayment, minimising the immediate stimulating impact on the economy. In other words, the U.S. takes time to correct the imbalance created during the past 10-year boom. The U.S. economy will remain sluggish for a period of time and is expected to stabilise not until the fourth quarter. With economic fundamentals still sound, the U.S. economy probably would not follow the Japanese-style long-term recession and depression, and is expected to recover gradually next year. Long-term outlook is still cautiously optimistic. Should the U.S. economy fail to adjust properly, or oil prices increase rapidly causing U.S. inflation to rise, resulting in stagflation and drastic reversal of the U.S. dollar, U.S. economic development will be entirely different. Close attention has to be paid on the development of U.S. inflation and the U.S. dollar exchange rate.

Internal Factor: Structural Problems

Present domestic structural problems of the Hong Kong economy are also imposing severe restraints on economic recovery and development. In the recent year, Hong Kong's economic recovery was primarily led by external factors, with domestic demand remained sluggish. While GDP grew by 2.5% on average in the past 3 years, domestic demand fell by 2% each year, which was never seen in the past half-century.

1. Financial Stress

Asset depreciation caused by the Asian Financial Crisis has resulted in many people suffering from financial stress and being forced to restructure their debts, and hence affecting consumption and investment. (According to a rough estimate, the net asset value of the private residential property market has decreased by HK$ 1.9 trillion, or by HK$ 2 million for each household on average.) With slackened domestic demand and asset depreciation, deflation was resulted, further restraining consumption and investment. As the losses have been significant, duration of financial restructuring would deem longer. This is the main reason for the persistently weak domestic demand.

Several more years would probably be needed to completely heal the wounds caused by the substantial asset depreciation. First, it takes at least 3-4 years further for the present 200,000 households (approximately) to correct the negative asset position. If property prices drop further, it will take even longer. Second, property supply is still abundant. The recently released "Property Review" forecasts that residential flats completed in the coming 2 years will reach 28,700, 18% more than the average in the past five years. Coupled with the 54,590 vacant units at the end of last year, it takes time for them to be taken up. Third, although home purchase affordability is now at the peak since early 1990s, ability to switch flats is the lowest with property prices drastically declined. Fourth, with the economic outlook still uncertain, little increase in people's income can be expected, thereby restraining people's ability to correct the negative asset position. Last, people will continue to be attracted to buy flats in the Pearl River delta, thus lowering their interest to buy flats in Hong Kong. Nevertheless, in view of the presently relaxed home-buying conditions, it is expected that property transactions will rise in the second half-year. This will help stabilise the property market, but property prices still lack substantial rising momentum.

2. Economic Transformation

Hong Kong has not yet succeeded in seeking a way for her economic transformation. This new round of economic transformation seems to face much more difficulties. The major reason is that Hong Kong lacks the favourable conditions as in the previous two rounds of economic transformation. Hong Kong may possess advantages in developing high value-added services, including information technology and financial services, but is no longer maintaining the monopoly status. Besides, there are bound to be obstacles in the development process. The first concerns the market. For example, the internet market is limited, telecommunications and financial services are still subject to restrictions in market access, capital movement and debt structuring in the Mainland, unlike the convenience experienced in the northward relocation of the manufacturing sector. The second concerns competitive pressure. Hong Kong's information technology is less developed than the U.S., Singapore and Taiwan. Though potential exists in e-commerce, logistics and etc., Hong Kong has been a late starter and has to face competitive pressure at early stage. Third, weak scientific research base and limited supply of experts deprive Hong Kong of the technological foundation in the new round of transformation. Fourth, there has been no breakthrough in the traditional framework and concepts. For example, though the government recognised the development direction, it has not rendered active support. Investment concepts and modes remain conventional, with no financial conglomerates investing in high technology industries yet.

While a new leading industry is yet to be developed, competitive pressure faced by traditional industries has been accelerating. Production of the Mainland has been substituting imports, posing threat for Hong Kong's export and re-export activities. The Mainland market is absorbing Hong Kong's consumption ability. The rise of the services sector in the Mainland has also been gradually taking over the role played by Hong Kong's services sector, e.g. in shipping and finance. Frustration in economic transformation has weakened people's confidence.

3. Fiscal and Employment Structure

There are problems in Hong Kong's fiscal revenue and expenditure structures. On the revenue side, it is over-dependent on non-tax items, especially property and related items. Besides, the tax base is too narrow. While salaries tax is the major source of tax revenue, it is contributed by less than 40% of the salaried people. On the expenditure side, as more resources have been allocated for social welfare, financial commitment in scientific research and infrastructure is being affected. Now the Hong Kong economy is developing high value-added industries. It is difficult for the low-skilled labour to shift to these industries. Together with the vast low-skilled immigrants migrating to Hong Kong every year, the market can hardly absorb all of them. This has resulted in structural employment problem: while some fail to find jobs, positions remain vacant and overseas professionals have to be introduced. The government's current effort in creating more low-skilled jobs would be helpful, but still cannot solve the problem completely.

Impacts and Outlook

This year, the Hong Kong economy has already suffered significantly due to global economic slowdown and domestic structural problems. This can mainly be reflected in the decline of GDP growth from 6.9% in the fourth quarter last year to 2.5% in the first quarter this year. The government has trimmed its growth forecast from 4% to 3%. Impacts of such development include: the deterioration of Hong Kong's external growth momentum; the further weakening of domestic demand; persistent deflation amid the strong U.S. dollar and falling commodity prices; the blow to the asset market and employment market.

Under such circumstances, Hong Kong's economic performance would not improve during the second half-year. (1) Unfavourable external factors, including the strong U.S. dollar and weak overseas demand, will continue to dampen merchandise and services exports. Nevertheless, since Hong Kong's outward processing trade mainly involves basic necessities that have more solid demand and domestic demand in the Mainland remains robust, Hong Kong's merchandise exports should maintain growth. As for services exports, outlook for tourism is still positive, with support from active promotion by the government and the tourist sector, and relaxation of quotas on visitor from the Mainland. But shipping will suffer from slowdown in trade growth and competition from the Pearl River Delta, whereas financial services probably will not show any surprise in view of the change in market environment, the growth of financial markets in the Mainland and Hong Kong's role yet to be re-established. (2) Domestic demand will remain sluggish. Soaring unemployment, persistent deflation and negative wealth effect will continue to depress consumption while some of Hong Kong's purchasing power will continue to be absorbed by the Mainland. Investment will slow with slowdown in export, weak consumption, falling new company registrations and reduced government housing expenditure. Nevertheless, public works, railway development and investment in IT equipment will keep investment on the rise.

Hong Kong's GDP growth will decline from last year's 10.5% to around 2.6% this year. Both external and internal growth momentum will weaken. Deflation will moderate, with the Composite CPI forecast to fall by 1.3% for the whole year. Employment will only improve slowly, with the unemployment rate forecast to remain at 4.5% by year-end. Nevertheless, the Chinese economy will bring us stimulus. China's forthcoming accession to the WTO will bring us more business opportunities associated with the Mainland. This will help create conditions for Hong Kong to transform to a global business centre from a regional one. The SAR government has been fostering Hong Kong's economic development, proposing to develop Hong Kong into "Manhattan Plus", considering to establish here the largest logistics centre in Asia and strengthening full economic integration with the Pearl River Delta. Besides, external factors currently frustrating Hong Kong will not persist. Hong Kong's economic growth would improve should the U.S. recover gradually next year.

Forecasts of Hong Kong's Real Gross Domestic Product and Other Indicators for 2001