In recent months, Hong Kong's consumer price indices have experienced continuous decline. When will prices stop falling and what are the resultant impacts?

The Trend of Deflation

Hong Kong's consumer price indices have been registering year-on-year declines since November 1998. A broader measure - the Implicit Price Deflator of GDP (GDP Deflator) - also recorded similar decline since the third quarter of 1998. Taking the broadly accepted definition of deflation, i.e. falling prices for two consecutive years, Hong Kong's deflation has indeed posed a very serious problem. In fact, if we compare the peak value recorded in May 1997 with that of September this year, the Composite Consumer Price Index of September this year has already gone down by 10%.

Table 1. Changes in Hong Kong's Major Price Indices (year-on-year changes %)

Since July 2000, the year-on-year declines on both consumer price indices and GDP Deflator have begun to moderate. Such performances revealed in a way people's expectation that deflation might come to an end by mid 2002. However, recent development indicates otherwise: deflation is likely to persist and it is hard to predict when it will bottom out.

External factors have become unfavourable for the correction of deflation in Hong Kong. As Hong Kong's consumer goods are mainly imported, continual declines of import prices during the past three years constitute a major factor for persistent deflation in Hong Kong. As global excess capacity expands following the terrorist attacks in September, import prices in Hong Kong are likely to fall further. Since 1995, production growth has outpaced consumption, resulting in excessive production capacity, hence the current global economic downturn. Although inventories have been gradually depleted, the problem of excess capacity remains unresolved. Amid keen competition, prices are prone to fall further.

According to the Commodity Price Index compiled by "the Economist", overall commodity prices fell by 7.3% in early September, compared to those at the beginning of 2001. It fell further by 8% from mid September to the end of October. Current commodity prices are nearly 40% below the levels recorded in 1995. U.S. import prices have registered declines for six months during the first nine months of this year and reported a 2.4% downfall in October, the largest monthly decline in 12 years. The U.S. Producer Price Index registered a 1.6% month-to-month decline in October, again the largest downturn ever recorded since the compilation of the index in 1947. Moreover, oil prices are set to fall further. Though the OPEC may cut oil production, non-OPEC oil-producing countries may raise their output so as to generate more revenue. Amid the sluggish global economy, oil demand has already shrunk significantly. Prices through winter may repeat similar performance as those of 1998. In Hong Kong, prices for retained imports during the first half of 2001 has dropped by 2%. In light of the above, further fall in prices would seem inevitable.

Domestic factors are also attributive to worsening deflation in Hong Kong. Firstly, demand has softened further. While retail sales volume and value grew by 3.1% and 0.6% respectively during the first eight months, both have dropped simultaneously by 1.7% and 4.4% respectively in September. As consumption contracts, deflationary pressure will obviously intensify. Secondly, amid economic recession, the SAR Government has decided to reduce rates and public housing rentals. Meanwhile, requests from the public to freeze price or to reduce public utilities charges have been growing, and may possibly be accepted.

Based on the above analysis, we can therefore expect that consumer prices will fall by a wider margin. If the U.S. dollar exchange rate does not fall sharply, Hong Kong's Composite Consumer Price Index may fall by 1.5% during the fourth quarter, following a 1% drop in the third quarter. As a result, the average decline of the index will reach 1.5% instead of the original forecast of 1.3%. As for the coming year, Hong Kong's situation will probably worsen amid global deflation. Annual decline of the Composite Consumer Price Index may reach 2.5%. Significant decline is also expected in the GDP Deflator during the fourth quarter, though not in the third. Annual decline will likely exceed Government's August forecast of 1%.

Implications on Banking Operation

The impacts of deflation on the economy are mixed, as evidenced by the developments over the past three years. Indeed, deflation has brought some positive impacts such as lower costs of living and business operation. Nevertheless, the negative effects are also imminent, particularly on the banking sector.

From a macro perspective, low inflation or deflation alters the relationship between the values of real and nominal GDP, and also affects the nominal GDP growth rate.

As is widely known, nominal GDP measures the current value of production and services while real GDP reflects their volume. In practice, nominal GDP is compiled first and real GDP is calculated by making adjustments for inflation and price changes. While real GDP has been recognized as an ideal measure for economic development, the implications of nominal GDP should not be overlooked. Based on prevailing prices, nominal GDP can reflect actual economic activities, i.e. the actual expenditure in consumption, plant and machinery investment, and the actual amounts of import and export.

At times of high inflation, the absolute values and growth rates of real and nominal GDP vary greatly. Putting aside the double-digit inflation in Hong Kong from 1987 to 1993, this is true even when inflation is only moderate, e.g. in 1997, when nominal and real GDP growth were 11.7% and 5% respectively. During low inflation or deflationary period, the situation reverses. For example, in 2000, real GDP growth was 10.5% while nominal GDP increased only 3.2%. In 1999, real GDP grew by 3%, but nominal GDP decreased 2.5%. As real GDP rises and nominal GDP falls, it indicates that there are increases in production and services rendered, but revenues received are less. This explains why people had little feeling about the robust economic rebound in the past two years.

Slowing or negative nominal GDP growth is becoming more common. The worst case is Japan where deflation has made its nominal GDP plummeted since 1997. The Bank of Japan recently forecast that such a situation would remain until 2003. Contraction in nominal GDP can also be seen in Singapore, Taiwan, Malaysia and Argentina. What worries us most is that the U.S. economy is currently under similar situation. The third quarter nominal GDP of the U.S. still registered positive growth, but at a much lower rate of 1.8%, decreasing drastically from the second quarter's 8%. As both production and inflation decline, nominal GDP growth in the U.S. would probably continue to fall and may even turn into negative. It is forecast that U.S. nominal GDP growth in 2001 and 2002 will be at its slowest since the 1930s. For the whole world, the situation is similar, with nominal GDP growth reaching zero, again the lowest since the 1930s.

As for Hong Kong, after falling by 4.9% and 2.5% respectively in 1998 and 1999, nominal GDP rebounded in 2000, but only by 3.2%. In value terms, it is still 4.3% lower than the peak in 1997. This year, as real GDP is expected to drop by 0.6%, the GDP Deflator would probably fall by 1.2% and nominal GDP would fall by 1.8%. For next year, nominal GDP performance should be deemed satisfactory if real GDP can level off. The GDP Deflator, however, is expected to fall by more than 2%. Towards the end of next year, Hong Kong's deflation and nominal GDP performance may become the worst after Japan.

Implications of decelerating or negative nominal GDP growth for the banking sector are as follows :

Falling nominal GDP is unfavourable to loan business. Firstly, loan demand will be suppressed. Generally speaking (and this does not apply to all sectors), if nominal GDP growth is negative, the overall return on investment will also be negative. Since interest rate is unlikely to be negative, therefore, regardless of how low it is, the return on liquid financial assets will be higher than that on fixed investment. Under these circumstances, private enterprises will be reluctant to invest. Loan demand for investment, as a result, will be weakened.

Secondly, bad and doubtful debts may soar. As debts and related interest expenses are fixed in amounts, repayment burden will gradually shrink with high inflation and nominal GDP growth. On the contrary, repayment burden will become heavier at times of deflation and decline in nominal GDP. In Japan, the rise of the ratio of national debt to GDP to 130% is also attributable to the fall in nominal GDP amid deflation, in addition to increase in borrowings. As business revenues fall but repayment liabilities remain unchanged, the possibility of losing repayment ability becomes higher.

Impacts on deposit business may be twofold: the weakening of deposit strength and the growing intention to hold bank deposits.

The decline in nominal GDP implies falling profits, reduced salaries, as well as shrinking money supply, making fewer deposit funds available (assuming there is no change in capital flows). On the other hand, with people spending less due to falling prices, the desire to defer consumption and to suppress investment at times of deflation, savings will increase. Since interest rates offered to depositors are also minimal, it is expected that investment products with low risks and slightly higher returns should be well received.