The government has recently released details of Hong Kong's balance of payments (BoP) account for 2001. The following is an analysis of the account performance, as well as an assessment of its implications for Hong Kong, particularly the banking sector.

Developments of the BoP Account

Summing up Hong Kong's BoP account in the past four years, the following characteristics can be identified.

(1) Large fluctuations - The BoP account reported a deficit in 1998, but reverted to surpluses in the subsequent three years. Yet, deficits of $ 26.32 billion and $ 8.03 billion* respectively were registered during the last two quarters of 2001. The reduction of foreign exchange reserves by US$ 1 billion during the first quarter of this year implies a BoP deficit of approximately $ 7.8 billion.

(2) Huge current account surpluses - Large surpluses have been maintained in the current account since 1998.

(3) Increasing net outflows in the capital and financial account - Substantial net outflows in the capital and financial account have been reported since the compilation of BoP statistics, amounting to $ 85.72 billion in 2001. Capital transfers constantly reported net outflows, but with decreasing volume. As for net changes in financial non-reserve assets, no particular trend can be identified. Net outflow in 1998, net inflows in 1999 and 2000, and eventually a net inflow of $ 40.13 billion in 2001 were reported respectively. Among the various financial account components, substantial net inflows were reported on direct investment except in 1998. A dramatic change in portfolio investment took place in 2001: a huge net outflow of $ 309.32 billion was registered after reporting substantial net inflows during the last three years. It was the major factor leading to the decline in annual BoP surplus and the emergence of a deficit in the second half of the year. Nevertheless, net inflows have been maintained consistently in financial derivatives in the past four years. As for "other investment", substantial net outflows have been recorded for three years consecutively before registering a net inflow in 2001.

An Analysis on Account Movements

Maintaining BoP balance is undoubtedly a widely sought objective. In analysing the BoP account, the first glance is often on the balance. Nevertheless, since the account covers a wide range of transactions, its contents should be thoroughly investigated as well. An assessment of Hong Kong's BoP account in the past four years reveals some of Hong Kong's economic and financial conditions and problems.

I. The shift from surplus to deficit raises concern

For an economy short of resources and implementing a linked exchange rate system like Hong Kong, maintenance of BoP balance is particularly important. Fortunately, surpluses have been maintained in the last three out of the past four years. Accumulated surplus totalled $ 140.14 billion during the period, with foreign exchange reserves increased by US$ 18.35 billion. However, a deficit totalling $ 42.15 billion was accumulated in the last three quarters, with foreign exchange reserves reducing as well. The falling trend calls for special attention.

II. Potential problem in the current account

Hong Kong has been enjoying persistent current account surplus, which is more than sufficient to offset the capital and financial account deficit. Merchandise trade deficit is inevitable, given Hong Kong's lack of resources and declining domestic manufacturing activities. The annual deficit of about $ 13 billion in current transfers, brought about by the SAR Government's assistance overseas and residents' outward remittances, also cannot be avoided in light of Hong Kong's developed status. Nonetheless, with Hong Kong being restructured into a service economy, surplus in services has been rising from $ 74.51 billion in 1998 to $ 135.28 billion in 2001, the largest single source of surplus. Surplus in trade services reflected Hong Kong's position as a net capital supplier and its external investment has begun to pay back.

Persistent current account surplus is a good indication of Hong Kong's external competitiveness. It enables Hong Kong to export capital, enlarging the scale of the economy. Nevertheless, there are some issues worth attention. The credit and debit items of the current account did not register constant increases, with surplus mainly brought about by the shrinking balance on the debit side. This demonstrates that our current account surplus has been a result of weak or even contracting domestic demand. In other words, in case domestic demand strengthens, there is no guarantee that deficit will not appear in the current account.

III. Slowing emigration but rising capital outflow

Given the persistent current account surplus, continuous net outflow in the capital and financial account should be normal. Moreover, as a small and matured economy, Hong Kong can only expand its business and hinterland through investing its current account surplus overseas. Therefore, the net outflow in the capital and financial account should not cause too much worry. As BoP deficit has already appeared consecutively in the last three quarters, it deserves more detailed study.

(1) Falling net capital transfers indicates slowing emigration

As defined, non-government capital transfers represent the bank deposits and the value of property owned by emigrated Hong Kong residents. Hence, it can be seen that although emigration of Hong Kong residents continued during the past four years, the number is falling.

(2) Little real impact from direct investment inflow

Statistics showed a rather substantial inward and outward direct investment flows in Hong Kong. However, little impact can be felt in the economy such as in the newly formed companies and employment rate.

To comply with international standards, the coverage of direct investment has become much broader, bringing larger investment flows. For example, a mainland-incorporated enterprise has to establish a company in Hong Kong in order to be listed as a red chip company. As long as 10% or above of its shareholding is held by foreign investors, it would be classified as overseas direct investment in Hong Kong. The purchase of mainland assets from the parent by this red chip company would be classified as Hong Kong's external direct investment. Over the past few years, substantial direct investment flows have been generated in this manner. As actual business conducted in Hong Kong has been very limited, it has made little impact on the real economy.

Direct investment activities between residents and non-residents are also classified as inward or outward direct investments. As many Hong Kong holding companies have re-incorporated overseas since the 1980s, fund transfers between parents and subsidiaries have generated inward and outward investments. Such kind of investment flows to or from places like British Virgin Islands, Bermuda, Cayman Islands and Panama etc. did occupy a significant portion of the overall direct investment flows. However, strictly speaking, they are not real inward or outward direct investments.

Apart from the above offshore financial centres, the mainland has been the most important source and destination of Hong Kong's inward and outward direct investments, with their respective shares being 23% and 78% in 2000. This reflects a number of things: the increasingly closer economic ties between the mainland and Hong Kong, the red chip companies' purchase of mainland assets from their parent companies, as well as the strategy of Hong Kong Chinese enterprises to treat the mainland as their expansion target. In addition, it has also been suggested that the mainland companies move their funds to Hong Kong in order to enjoy the privileges offered to foreign investors by the mainland authority. It is estimated that over 30% of Hong Kong's direct investment in the mainland are of this nature. Similarly, such capital flows have little contribution to Hong Kong's real economic activities.

(3) Portfolio investment: from net inflow to net outflow

Portfolio investment represents investment in stock and debt securities. As mentioned, dramatic changes took place in portfolio investment in Hong Kong's BoP account during the past four years, turning to a significant net outflow after three consecutive years of net inflows. While residents increased substantially their holdings of foreign securities amounting to $ 305.18 billion in 2001, non-residents trimmed their holdings or even sold their Hong Kong securities (mainly debt securities), resulting in a fall in Hong Kong's overseas liabilities.

(4) The worry on "other investment" components

Although the largest net inflow of $ 122.01 billion was recorded under "other investment" in 2001, its development warrants our attention. "other investment" includes trade credits, short and long-term loans, currency and deposits, other assets and liabilities, and is mainly related to banking business. It reflects business of the domestic banking sector with non-residents. Despite the fluctuations reported in the net balance, both the assets and liabilities shrank under this item.

Falling assets under "other investment" was mainly attributable to the decline in offshore loans, which accounts for 92% of the overall decrease. The main reason was the retreat of foreign banks (mainly Japanese banks) from Hong Kong, causing the Euro-yen loans booked in Hong Kong to shrink. The liabilities under "other investment" also fell, though at a moderating pace. This mainly represented the decrease in currency and deposits, which accounts for 97% of the overall decrease. The shrinkage of Euro-yen loans brought along with it a decline in interbank borrowings from abroad, which provided funding for the loans. Hong Kong's monetary statistics also revealed similar development. This indicates that Hong Kong's status as an international banking centre is declining.

Implications for the Banking Sector

As the financial account is composed mainly of transactions conducted by financial institutions, particularly banks, the trend revealed poses major implications on the banking sector.

(1) The need to explore into new international banking practices to maintain Hong Kong's international banking centre status.

It may be quite difficult to reinvigorate Hong Kong's international banking business. Firstly, affected by huge non-performing loans, Japanese banks will probably continue their strategy to focus on domestic business and trim overseas network. In fact, even if Hong Kong resumes as the centre for booking euro-yen loans, the actual effect on the economy would not be significant. Secondly, Asia-Pacific region, the major focus of Hong Kong's international banking services, has made progress in liberalizing their financial sector. Operations of offshore financial business or international banking facilities in places like Taipei, Bangkok, Manila and Labuan in Malaysia have also become matured, posing direct competition to Hong Kong. While there are still development prospects in international banking business, statistics from the BIS showed that some Asia-Pacific banking centres have out-performed Hong Kong.

Instead of calling for international banks to book their loans here, Hong Kong should focus on promoting actual banking business. It should continue to play the role of a financial intermediary, absorbing offshore deposits and promoting offshore loans, including loans to Southeast Asia and the mainland. Again, statistics from the BIS showed that Hong Kong's offshore deposits have maintained continuous growth since 1997. Hong Kong still possesses advantages in absorbing offshore deposits. The recent financial turmoil in Argentina would probably weaken the confidence of some Southeast Asian depositors, thereby offering Hong Kong more opportunities to solicit deposit business from these customers. As for offshore loans, while non-bank business is more difficult to develop, interbank business should be promoted, e.g. with the mainland banks. In addition, Hong Kong should speed up the development of debt securities and derivatives markets in order to enhance its competitiveness.

(2) The need to provide customers with tailored services on wealth management and investment.

Hong Kong has maintained continuous growth in bank deposits during the past few years. However, since July last year, deposits have been falling for 7 consecutive months, with an accumulated decline of 6%. This may be attributable to Hong Kong's economic recession and deflation, but the fact that deposit growth sustained during 1998 suggests that there should be other reasons accounting for the recent decline. The increase in foreign securities holdings by domestic residents, together with the decrease or sale of domestic securities by non-residents, should be significant factors. Incidentally, the amount of net outflow was similar to the decline in bank deposits.

The extremely low interest rate environment and poor performance of the Hong Kong stock market may have prompted residents to increase their foreign investment so as to secure a higher return, resulting in huge net outflow in portfolio investment. If such market conditions prevail, the trend would continue. This may pose another new challenge to banks: deposit growth may slow down or even turn negative; banks may lose customers. Under such circumstances, banks have to develop wealth management business to meet customers' needs. In fact, this has already become, and will continue to be, a major operational strategy for banks in Hong Kong.

* Figures are in Hong Kong dollars unless specified

Developments of the BoP Account

Summing up Hong Kong's BoP account in the past four years, the following characteristics can be identified.

(1) Large fluctuations - The BoP account reported a deficit in 1998, but reverted to surpluses in the subsequent three years. Yet, deficits of $ 26.32 billion and $ 8.03 billion* respectively were registered during the last two quarters of 2001. The reduction of foreign exchange reserves by US$ 1 billion during the first quarter of this year implies a BoP deficit of approximately $ 7.8 billion.

(2) Huge current account surpluses - Large surpluses have been maintained in the current account since 1998.

(3) Increasing net outflows in the capital and financial account - Substantial net outflows in the capital and financial account have been reported since the compilation of BoP statistics, amounting to $ 85.72 billion in 2001. Capital transfers constantly reported net outflows, but with decreasing volume. As for net changes in financial non-reserve assets, no particular trend can be identified. Net outflow in 1998, net inflows in 1999 and 2000, and eventually a net inflow of $ 40.13 billion in 2001 were reported respectively. Among the various financial account components, substantial net inflows were reported on direct investment except in 1998. A dramatic change in portfolio investment took place in 2001: a huge net outflow of $ 309.32 billion was registered after reporting substantial net inflows during the last three years. It was the major factor leading to the decline in annual BoP surplus and the emergence of a deficit in the second half of the year. Nevertheless, net inflows have been maintained consistently in financial derivatives in the past four years. As for "other investment", substantial net outflows have been recorded for three years consecutively before registering a net inflow in 2001.

An Analysis on Account Movements

Maintaining BoP balance is undoubtedly a widely sought objective. In analysing the BoP account, the first glance is often on the balance. Nevertheless, since the account covers a wide range of transactions, its contents should be thoroughly investigated as well. An assessment of Hong Kong's BoP account in the past four years reveals some of Hong Kong's economic and financial conditions and problems.

I. The shift from surplus to deficit raises concern

For an economy short of resources and implementing a linked exchange rate system like Hong Kong, maintenance of BoP balance is particularly important. Fortunately, surpluses have been maintained in the last three out of the past four years. Accumulated surplus totalled $ 140.14 billion during the period, with foreign exchange reserves increased by US$ 18.35 billion. However, a deficit totalling $ 42.15 billion was accumulated in the last three quarters, with foreign exchange reserves reducing as well. The falling trend calls for special attention.

II. Potential problem in the current account

Hong Kong has been enjoying persistent current account surplus, which is more than sufficient to offset the capital and financial account deficit. Merchandise trade deficit is inevitable, given Hong Kong's lack of resources and declining domestic manufacturing activities. The annual deficit of about $ 13 billion in current transfers, brought about by the SAR Government's assistance overseas and residents' outward remittances, also cannot be avoided in light of Hong Kong's developed status. Nonetheless, with Hong Kong being restructured into a service economy, surplus in services has been rising from $ 74.51 billion in 1998 to $ 135.28 billion in 2001, the largest single source of surplus. Surplus in trade services reflected Hong Kong's position as a net capital supplier and its external investment has begun to pay back.

Persistent current account surplus is a good indication of Hong Kong's external competitiveness. It enables Hong Kong to export capital, enlarging the scale of the economy. Nevertheless, there are some issues worth attention. The credit and debit items of the current account did not register constant increases, with surplus mainly brought about by the shrinking balance on the debit side. This demonstrates that our current account surplus has been a result of weak or even contracting domestic demand. In other words, in case domestic demand strengthens, there is no guarantee that deficit will not appear in the current account.

III. Slowing emigration but rising capital outflow

Given the persistent current account surplus, continuous net outflow in the capital and financial account should be normal. Moreover, as a small and matured economy, Hong Kong can only expand its business and hinterland through investing its current account surplus overseas. Therefore, the net outflow in the capital and financial account should not cause too much worry. As BoP deficit has already appeared consecutively in the last three quarters, it deserves more detailed study.

(1) Falling net capital transfers indicates slowing emigration

As defined, non-government capital transfers represent the bank deposits and the value of property owned by emigrated Hong Kong residents. Hence, it can be seen that although emigration of Hong Kong residents continued during the past four years, the number is falling.

(2) Little real impact from direct investment inflow

Statistics showed a rather substantial inward and outward direct investment flows in Hong Kong. However, little impact can be felt in the economy such as in the newly formed companies and employment rate.

To comply with international standards, the coverage of direct investment has become much broader, bringing larger investment flows. For example, a mainland-incorporated enterprise has to establish a company in Hong Kong in order to be listed as a red chip company. As long as 10% or above of its shareholding is held by foreign investors, it would be classified as overseas direct investment in Hong Kong. The purchase of mainland assets from the parent by this red chip company would be classified as Hong Kong's external direct investment. Over the past few years, substantial direct investment flows have been generated in this manner. As actual business conducted in Hong Kong has been very limited, it has made little impact on the real economy.

Direct investment activities between residents and non-residents are also classified as inward or outward direct investments. As many Hong Kong holding companies have re-incorporated overseas since the 1980s, fund transfers between parents and subsidiaries have generated inward and outward investments. Such kind of investment flows to or from places like British Virgin Islands, Bermuda, Cayman Islands and Panama etc. did occupy a significant portion of the overall direct investment flows. However, strictly speaking, they are not real inward or outward direct investments.

Apart from the above offshore financial centres, the mainland has been the most important source and destination of Hong Kong's inward and outward direct investments, with their respective shares being 23% and 78% in 2000. This reflects a number of things: the increasingly closer economic ties between the mainland and Hong Kong, the red chip companies' purchase of mainland assets from their parent companies, as well as the strategy of Hong Kong Chinese enterprises to treat the mainland as their expansion target. In addition, it has also been suggested that the mainland companies move their funds to Hong Kong in order to enjoy the privileges offered to foreign investors by the mainland authority. It is estimated that over 30% of Hong Kong's direct investment in the mainland are of this nature. Similarly, such capital flows have little contribution to Hong Kong's real economic activities.

(3) Portfolio investment: from net inflow to net outflow

Portfolio investment represents investment in stock and debt securities. As mentioned, dramatic changes took place in portfolio investment in Hong Kong's BoP account during the past four years, turning to a significant net outflow after three consecutive years of net inflows. While residents increased substantially their holdings of foreign securities amounting to $ 305.18 billion in 2001, non-residents trimmed their holdings or even sold their Hong Kong securities (mainly debt securities), resulting in a fall in Hong Kong's overseas liabilities.

(4) The worry on "other investment" components

Although the largest net inflow of $ 122.01 billion was recorded under "other investment" in 2001, its development warrants our attention. "other investment" includes trade credits, short and long-term loans, currency and deposits, other assets and liabilities, and is mainly related to banking business. It reflects business of the domestic banking sector with non-residents. Despite the fluctuations reported in the net balance, both the assets and liabilities shrank under this item.

Falling assets under "other investment" was mainly attributable to the decline in offshore loans, which accounts for 92% of the overall decrease. The main reason was the retreat of foreign banks (mainly Japanese banks) from Hong Kong, causing the Euro-yen loans booked in Hong Kong to shrink. The liabilities under "other investment" also fell, though at a moderating pace. This mainly represented the decrease in currency and deposits, which accounts for 97% of the overall decrease. The shrinkage of Euro-yen loans brought along with it a decline in interbank borrowings from abroad, which provided funding for the loans. Hong Kong's monetary statistics also revealed similar development. This indicates that Hong Kong's status as an international banking centre is declining.

Implications for the Banking Sector

As the financial account is composed mainly of transactions conducted by financial institutions, particularly banks, the trend revealed poses major implications on the banking sector.

(1) The need to explore into new international banking practices to maintain Hong Kong's international banking centre status.

It may be quite difficult to reinvigorate Hong Kong's international banking business. Firstly, affected by huge non-performing loans, Japanese banks will probably continue their strategy to focus on domestic business and trim overseas network. In fact, even if Hong Kong resumes as the centre for booking euro-yen loans, the actual effect on the economy would not be significant. Secondly, Asia-Pacific region, the major focus of Hong Kong's international banking services, has made progress in liberalizing their financial sector. Operations of offshore financial business or international banking facilities in places like Taipei, Bangkok, Manila and Labuan in Malaysia have also become matured, posing direct competition to Hong Kong. While there are still development prospects in international banking business, statistics from the BIS showed that some Asia-Pacific banking centres have out-performed Hong Kong.

Instead of calling for international banks to book their loans here, Hong Kong should focus on promoting actual banking business. It should continue to play the role of a financial intermediary, absorbing offshore deposits and promoting offshore loans, including loans to Southeast Asia and the mainland. Again, statistics from the BIS showed that Hong Kong's offshore deposits have maintained continuous growth since 1997. Hong Kong still possesses advantages in absorbing offshore deposits. The recent financial turmoil in Argentina would probably weaken the confidence of some Southeast Asian depositors, thereby offering Hong Kong more opportunities to solicit deposit business from these customers. As for offshore loans, while non-bank business is more difficult to develop, interbank business should be promoted, e.g. with the mainland banks. In addition, Hong Kong should speed up the development of debt securities and derivatives markets in order to enhance its competitiveness.

(2) The need to provide customers with tailored services on wealth management and investment.

Hong Kong has maintained continuous growth in bank deposits during the past few years. However, since July last year, deposits have been falling for 7 consecutive months, with an accumulated decline of 6%. This may be attributable to Hong Kong's economic recession and deflation, but the fact that deposit growth sustained during 1998 suggests that there should be other reasons accounting for the recent decline. The increase in foreign securities holdings by domestic residents, together with the decrease or sale of domestic securities by non-residents, should be significant factors. Incidentally, the amount of net outflow was similar to the decline in bank deposits.

The extremely low interest rate environment and poor performance of the Hong Kong stock market may have prompted residents to increase their foreign investment so as to secure a higher return, resulting in huge net outflow in portfolio investment. If such market conditions prevail, the trend would continue. This may pose another new challenge to banks: deposit growth may slow down or even turn negative; banks may lose customers. Under such circumstances, banks have to develop wealth management business to meet customers' needs. In fact, this has already become, and will continue to be, a major operational strategy for banks in Hong Kong.

* Figures are in Hong Kong dollars unless specified

Developments of the BoP Account

Summing up Hong Kong's BoP account in the past four years, the following characteristics can be identified.

(1) Large fluctuations - The BoP account reported a deficit in 1998, but reverted to surpluses in the subsequent three years. Yet, deficits of $ 26.32 billion and $ 8.03 billion* respectively were registered during the last two quarters of 2001. The reduction of foreign exchange reserves by US$ 1 billion during the first quarter of this year implies a BoP deficit of approximately $ 7.8 billion.

(2) Huge current account surpluses - Large surpluses have been maintained in the current account since 1998.

(3) Increasing net outflows in the capital and financial account - Substantial net outflows in the capital and financial account have been reported since the compilation of BoP statistics, amounting to $ 85.72 billion in 2001. Capital transfers constantly reported net outflows, but with decreasing volume. As for net changes in financial non-reserve assets, no particular trend can be identified. Net outflow in 1998, net inflows in 1999 and 2000, and eventually a net inflow of $ 40.13 billion in 2001 were reported respectively. Among the various financial account components, substantial net inflows were reported on direct investment except in 1998. A dramatic change in portfolio investment took place in 2001: a huge net outflow of $ 309.32 billion was registered after reporting substantial net inflows during the last three years. It was the major factor leading to the decline in annual BoP surplus and the emergence of a deficit in the second half of the year. Nevertheless, net inflows have been maintained consistently in financial derivatives in the past four years. As for "other investment", substantial net outflows have been recorded for three years consecutively before registering a net inflow in 2001.

An Analysis on Account Movements

Maintaining BoP balance is undoubtedly a widely sought objective. In analysing the BoP account, the first glance is often on the balance. Nevertheless, since the account covers a wide range of transactions, its contents should be thoroughly investigated as well. An assessment of Hong Kong's BoP account in the past four years reveals some of Hong Kong's economic and financial conditions and problems.

I. The shift from surplus to deficit raises concern

For an economy short of resources and implementing a linked exchange rate system like Hong Kong, maintenance of BoP balance is particularly important. Fortunately, surpluses have been maintained in the last three out of the past four years. Accumulated surplus totalled $ 140.14 billion during the period, with foreign exchange reserves increased by US$ 18.35 billion. However, a deficit totalling $ 42.15 billion was accumulated in the last three quarters, with foreign exchange reserves reducing as well. The falling trend calls for special attention.

II. Potential problem in the current account

Hong Kong has been enjoying persistent current account surplus, which is more than sufficient to offset the capital and financial account deficit. Merchandise trade deficit is inevitable, given Hong Kong's lack of resources and declining domestic manufacturing activities. The annual deficit of about $ 13 billion in current transfers, brought about by the SAR Government's assistance overseas and residents' outward remittances, also cannot be avoided in light of Hong Kong's developed status. Nonetheless, with Hong Kong being restructured into a service economy, surplus in services has been rising from $ 74.51 billion in 1998 to $ 135.28 billion in 2001, the largest single source of surplus. Surplus in trade services reflected Hong Kong's position as a net capital supplier and its external investment has begun to pay back.

Persistent current account surplus is a good indication of Hong Kong's external competitiveness. It enables Hong Kong to export capital, enlarging the scale of the economy. Nevertheless, there are some issues worth attention. The credit and debit items of the current account did not register constant increases, with surplus mainly brought about by the shrinking balance on the debit side. This demonstrates that our current account surplus has been a result of weak or even contracting domestic demand. In other words, in case domestic demand strengthens, there is no guarantee that deficit will not appear in the current account.

III. Slowing emigration but rising capital outflow

Given the persistent current account surplus, continuous net outflow in the capital and financial account should be normal. Moreover, as a small and matured economy, Hong Kong can only expand its business and hinterland through investing its current account surplus overseas. Therefore, the net outflow in the capital and financial account should not cause too much worry. As BoP deficit has already appeared consecutively in the last three quarters, it deserves more detailed study.

(1) Falling net capital transfers indicates slowing emigration

As defined, non-government capital transfers represent the bank deposits and the value of property owned by emigrated Hong Kong residents. Hence, it can be seen that although emigration of Hong Kong residents continued during the past four years, the number is falling.

(2) Little real impact from direct investment inflow

Statistics showed a rather substantial inward and outward direct investment flows in Hong Kong. However, little impact can be felt in the economy such as in the newly formed companies and employment rate.

To comply with international standards, the coverage of direct investment has become much broader, bringing larger investment flows. For example, a mainland-incorporated enterprise has to establish a company in Hong Kong in order to be listed as a red chip company. As long as 10% or above of its shareholding is held by foreign investors, it would be classified as overseas direct investment in Hong Kong. The purchase of mainland assets from the parent by this red chip company would be classified as Hong Kong's external direct investment. Over the past few years, substantial direct investment flows have been generated in this manner. As actual business conducted in Hong Kong has been very limited, it has made little impact on the real economy.

Direct investment activities between residents and non-residents are also classified as inward or outward direct investments. As many Hong Kong holding companies have re-incorporated overseas since the 1980s, fund transfers between parents and subsidiaries have generated inward and outward investments. Such kind of investment flows to or from places like British Virgin Islands, Bermuda, Cayman Islands and Panama etc. did occupy a significant portion of the overall direct investment flows. However, strictly speaking, they are not real inward or outward direct investments.

Apart from the above offshore financial centres, the mainland has been the most important source and destination of Hong Kong's inward and outward direct investments, with their respective shares being 23% and 78% in 2000. This reflects a number of things: the increasingly closer economic ties between the mainland and Hong Kong, the red chip companies' purchase of mainland assets from their parent companies, as well as the strategy of Hong Kong Chinese enterprises to treat the mainland as their expansion target. In addition, it has also been suggested that the mainland companies move their funds to Hong Kong in order to enjoy the privileges offered to foreign investors by the mainland authority. It is estimated that over 30% of Hong Kong's direct investment in the mainland are of this nature. Similarly, such capital flows have little contribution to Hong Kong's real economic activities.

(3) Portfolio investment: from net inflow to net outflow

Portfolio investment represents investment in stock and debt securities. As mentioned, dramatic changes took place in portfolio investment in Hong Kong's BoP account during the past four years, turning to a significant net outflow after three consecutive years of net inflows. While residents increased substantially their holdings of foreign securities amounting to $ 305.18 billion in 2001, non-residents trimmed their holdings or even sold their Hong Kong securities (mainly debt securities), resulting in a fall in Hong Kong's overseas liabilities.

(4) The worry on "other investment" components

Although the largest net inflow of $ 122.01 billion was recorded under "other investment" in 2001, its development warrants our attention. "other investment" includes trade credits, short and long-term loans, currency and deposits, other assets and liabilities, and is mainly related to banking business. It reflects business of the domestic banking sector with non-residents. Despite the fluctuations reported in the net balance, both the assets and liabilities shrank under this item.

Falling assets under "other investment" was mainly attributable to the decline in offshore loans, which accounts for 92% of the overall decrease. The main reason was the retreat of foreign banks (mainly Japanese banks) from Hong Kong, causing the Euro-yen loans booked in Hong Kong to shrink. The liabilities under "other investment" also fell, though at a moderating pace. This mainly represented the decrease in currency and deposits, which accounts for 97% of the overall decrease. The shrinkage of Euro-yen loans brought along with it a decline in interbank borrowings from abroad, which provided funding for the loans. Hong Kong's monetary statistics also revealed similar development. This indicates that Hong Kong's status as an international banking centre is declining.

Implications for the Banking Sector

As the financial account is composed mainly of transactions conducted by financial institutions, particularly banks, the trend revealed poses major implications on the banking sector.

(1) The need to explore into new international banking practices to maintain Hong Kong's international banking centre status.

It may be quite difficult to reinvigorate Hong Kong's international banking business. Firstly, affected by huge non-performing loans, Japanese banks will probably continue their strategy to focus on domestic business and trim overseas network. In fact, even if Hong Kong resumes as the centre for booking euro-yen loans, the actual effect on the economy would not be significant. Secondly, Asia-Pacific region, the major focus of Hong Kong's international banking services, has made progress in liberalizing their financial sector. Operations of offshore financial business or international banking facilities in places like Taipei, Bangkok, Manila and Labuan in Malaysia have also become matured, posing direct competition to Hong Kong. While there are still development prospects in international banking business, statistics from the BIS showed that some Asia-Pacific banking centres have out-performed Hong Kong.

Instead of calling for international banks to book their loans here, Hong Kong should focus on promoting actual banking business. It should continue to play the role of a financial intermediary, absorbing offshore deposits and promoting offshore loans, including loans to Southeast Asia and the mainland. Again, statistics from the BIS showed that Hong Kong's offshore deposits have maintained continuous growth since 1997. Hong Kong still possesses advantages in absorbing offshore deposits. The recent financial turmoil in Argentina would probably weaken the confidence of some Southeast Asian depositors, thereby offering Hong Kong more opportunities to solicit deposit business from these customers. As for offshore loans, while non-bank business is more difficult to develop, interbank business should be promoted, e.g. with the mainland banks. In addition, Hong Kong should speed up the development of debt securities and derivatives markets in order to enhance its competitiveness.

(2) The need to provide customers with tailored services on wealth management and investment.

Hong Kong has maintained continuous growth in bank deposits during the past few years. However, since July last year, deposits have been falling for 7 consecutive months, with an accumulated decline of 6%. This may be attributable to Hong Kong's economic recession and deflation, but the fact that deposit growth sustained during 1998 suggests that there should be other reasons accounting for the recent decline. The increase in foreign securities holdings by domestic residents, together with the decrease or sale of domestic securities by non-residents, should be significant factors. Incidentally, the amount of net outflow was similar to the decline in bank deposits.

The extremely low interest rate environment and poor performance of the Hong Kong stock market may have prompted residents to increase their foreign investment so as to secure a higher return, resulting in huge net outflow in portfolio investment. If such market conditions prevail, the trend would continue. This may pose another new challenge to banks: deposit growth may slow down or even turn negative; banks may lose customers. Under such circumstances, banks have to develop wealth management business to meet customers' needs. In fact, this has already become, and will continue to be, a major operational strategy for banks in Hong Kong.

* Figures are in Hong Kong dollars unless specified

Developments of the BoP Account

Summing up Hong Kong's BoP account in the past four years, the following characteristics can be identified.

(1) Large fluctuations - The BoP account reported a deficit in 1998, but reverted to surpluses in the subsequent three years. Yet, deficits of $ 26.32 billion and $ 8.03 billion* respectively were registered during the last two quarters of 2001. The reduction of foreign exchange reserves by US$ 1 billion during the first quarter of this year implies a BoP deficit of approximately $ 7.8 billion.

(2) Huge current account surpluses - Large surpluses have been maintained in the current account since 1998.

(3) Increasing net outflows in the capital and financial account - Substantial net outflows in the capital and financial account have been reported since the compilation of BoP statistics, amounting to $ 85.72 billion in 2001. Capital transfers constantly reported net outflows, but with decreasing volume. As for net changes in financial non-reserve assets, no particular trend can be identified. Net outflow in 1998, net inflows in 1999 and 2000, and eventually a net inflow of $ 40.13 billion in 2001 were reported respectively. Among the various financial account components, substantial net inflows were reported on direct investment except in 1998. A dramatic change in portfolio investment took place in 2001: a huge net outflow of $ 309.32 billion was registered after reporting substantial net inflows during the last three years. It was the major factor leading to the decline in annual BoP surplus and the emergence of a deficit in the second half of the year. Nevertheless, net inflows have been maintained consistently in financial derivatives in the past four years. As for "other investment", substantial net outflows have been recorded for three years consecutively before registering a net inflow in 2001.

An Analysis on Account Movements

Maintaining BoP balance is undoubtedly a widely sought objective. In analysing the BoP account, the first glance is often on the balance. Nevertheless, since the account covers a wide range of transactions, its contents should be thoroughly investigated as well. An assessment of Hong Kong's BoP account in the past four years reveals some of Hong Kong's economic and financial conditions and problems.

I. The shift from surplus to deficit raises concern

For an economy short of resources and implementing a linked exchange rate system like Hong Kong, maintenance of BoP balance is particularly important. Fortunately, surpluses have been maintained in the last three out of the past four years. Accumulated surplus totalled $ 140.14 billion during the period, with foreign exchange reserves increased by US$ 18.35 billion. However, a deficit totalling $ 42.15 billion was accumulated in the last three quarters, with foreign exchange reserves reducing as well. The falling trend calls for special attention.

II. Potential problem in the current account

Hong Kong has been enjoying persistent current account surplus, which is more than sufficient to offset the capital and financial account deficit. Merchandise trade deficit is inevitable, given Hong Kong's lack of resources and declining domestic manufacturing activities. The annual deficit of about $ 13 billion in current transfers, brought about by the SAR Government's assistance overseas and residents' outward remittances, also cannot be avoided in light of Hong Kong's developed status. Nonetheless, with Hong Kong being restructured into a service economy, surplus in services has been rising from $ 74.51 billion in 1998 to $ 135.28 billion in 2001, the largest single source of surplus. Surplus in trade services reflected Hong Kong's position as a net capital supplier and its external investment has begun to pay back.

Persistent current account surplus is a good indication of Hong Kong's external competitiveness. It enables Hong Kong to export capital, enlarging the scale of the economy. Nevertheless, there are some issues worth attention. The credit and debit items of the current account did not register constant increases, with surplus mainly brought about by the shrinking balance on the debit side. This demonstrates that our current account surplus has been a result of weak or even contracting domestic demand. In other words, in case domestic demand strengthens, there is no guarantee that deficit will not appear in the current account.

III. Slowing emigration but rising capital outflow

Given the persistent current account surplus, continuous net outflow in the capital and financial account should be normal. Moreover, as a small and matured economy, Hong Kong can only expand its business and hinterland through investing its current account surplus overseas. Therefore, the net outflow in the capital and financial account should not cause too much worry. As BoP deficit has already appeared consecutively in the last three quarters, it deserves more detailed study.

(1) Falling net capital transfers indicates slowing emigration

As defined, non-government capital transfers represent the bank deposits and the value of property owned by emigrated Hong Kong residents. Hence, it can be seen that although emigration of Hong Kong residents continued during the past four years, the number is falling.

(2) Little real impact from direct investment inflow

Statistics showed a rather substantial inward and outward direct investment flows in Hong Kong. However, little impact can be felt in the economy such as in the newly formed companies and employment rate.

To comply with international standards, the coverage of direct investment has become much broader, bringing larger investment flows. For example, a mainland-incorporated enterprise has to establish a company in Hong Kong in order to be listed as a red chip company. As long as 10% or above of its shareholding is held by foreign investors, it would be classified as overseas direct investment in Hong Kong. The purchase of mainland assets from the parent by this red chip company would be classified as Hong Kong's external direct investment. Over the past few years, substantial direct investment flows have been generated in this manner. As actual business conducted in Hong Kong has been very limited, it has made little impact on the real economy.

Direct investment activities between residents and non-residents are also classified as inward or outward direct investments. As many Hong Kong holding companies have re-incorporated overseas since the 1980s, fund transfers between parents and subsidiaries have generated inward and outward investments. Such kind of investment flows to or from places like British Virgin Islands, Bermuda, Cayman Islands and Panama etc. did occupy a significant portion of the overall direct investment flows. However, strictly speaking, they are not real inward or outward direct investments.

Apart from the above offshore financial centres, the mainland has been the most important source and destination of Hong Kong's inward and outward direct investments, with their respective shares being 23% and 78% in 2000. This reflects a number of things: the increasingly closer economic ties between the mainland and Hong Kong, the red chip companies' purchase of mainland assets from their parent companies, as well as the strategy of Hong Kong Chinese enterprises to treat the mainland as their expansion target. In addition, it has also been suggested that the mainland companies move their funds to Hong Kong in order to enjoy the privileges offered to foreign investors by the mainland authority. It is estimated that over 30% of Hong Kong's direct investment in the mainland are of this nature. Similarly, such capital flows have little contribution to Hong Kong's real economic activities.

(3) Portfolio investment: from net inflow to net outflow

Portfolio investment represents investment in stock and debt securities. As mentioned, dramatic changes took place in portfolio investment in Hong Kong's BoP account during the past four years, turning to a significant net outflow after three consecutive years of net inflows. While residents increased substantially their holdings of foreign securities amounting to $ 305.18 billion in 2001, non-residents trimmed their holdings or even sold their Hong Kong securities (mainly debt securities), resulting in a fall in Hong Kong's overseas liabilities.

(4) The worry on "other investment" components

Although the largest net inflow of $ 122.01 billion was recorded under "other investment" in 2001, its development warrants our attention. "other investment" includes trade credits, short and long-term loans, currency and deposits, other assets and liabilities, and is mainly related to banking business. It reflects business of the domestic banking sector with non-residents. Despite the fluctuations reported in the net balance, both the assets and liabilities shrank under this item.

Falling assets under "other investment" was mainly attributable to the decline in offshore loans, which accounts for 92% of the overall decrease. The main reason was the retreat of foreign banks (mainly Japanese banks) from Hong Kong, causing the Euro-yen loans booked in Hong Kong to shrink. The liabilities under "other investment" also fell, though at a moderating pace. This mainly represented the decrease in currency and deposits, which accounts for 97% of the overall decrease. The shrinkage of Euro-yen loans brought along with it a decline in interbank borrowings from abroad, which provided funding for the loans. Hong Kong's monetary statistics also revealed similar development. This indicates that Hong Kong's status as an international banking centre is declining.

Implications for the Banking Sector

As the financial account is composed mainly of transactions conducted by financial institutions, particularly banks, the trend revealed poses major implications on the banking sector.

(1) The need to explore into new international banking practices to maintain Hong Kong's international banking centre status.

It may be quite difficult to reinvigorate Hong Kong's international banking business. Firstly, affected by huge non-performing loans, Japanese banks will probably continue their strategy to focus on domestic business and trim overseas network. In fact, even if Hong Kong resumes as the centre for booking euro-yen loans, the actual effect on the economy would not be significant. Secondly, Asia-Pacific region, the major focus of Hong Kong's international banking services, has made progress in liberalizing their financial sector. Operations of offshore financial business or international banking facilities in places like Taipei, Bangkok, Manila and Labuan in Malaysia have also become matured, posing direct competition to Hong Kong. While there are still development prospects in international banking business, statistics from the BIS showed that some Asia-Pacific banking centres have out-performed Hong Kong.

Instead of calling for international banks to book their loans here, Hong Kong should focus on promoting actual banking business. It should continue to play the role of a financial intermediary, absorbing offshore deposits and promoting offshore loans, including loans to Southeast Asia and the mainland. Again, statistics from the BIS showed that Hong Kong's offshore deposits have maintained continuous growth since 1997. Hong Kong still possesses advantages in absorbing offshore deposits. The recent financial turmoil in Argentina would probably weaken the confidence of some Southeast Asian depositors, thereby offering Hong Kong more opportunities to solicit deposit business from these customers. As for offshore loans, while non-bank business is more difficult to develop, interbank business should be promoted, e.g. with the mainland banks. In addition, Hong Kong should speed up the development of debt securities and derivatives markets in order to enhance its competitiveness.

(2) The need to provide customers with tailored services on wealth management and investment.

Hong Kong has maintained continuous growth in bank deposits during the past few years. However, since July last year, deposits have been falling for 7 consecutive months, with an accumulated decline of 6%. This may be attributable to Hong Kong's economic recession and deflation, but the fact that deposit growth sustained during 1998 suggests that there should be other reasons accounting for the recent decline. The increase in foreign securities holdings by domestic residents, together with the decrease or sale of domestic securities by non-residents, should be significant factors. Incidentally, the amount of net outflow was similar to the decline in bank deposits.

The extremely low interest rate environment and poor performance of the Hong Kong stock market may have prompted residents to increase their foreign investment so as to secure a higher return, resulting in huge net outflow in portfolio investment. If such market conditions prevail, the trend would continue. This may pose another new challenge to banks: deposit growth may slow down or even turn negative; banks may lose customers. Under such circumstances, banks have to develop wealth management business to meet customers' needs. In fact, this has already become, and will continue to be, a major operational strategy for banks in Hong Kong.

* Figures are in Hong Kong dollars unless specified