Driven by external economic recovery, the Hong Kong economy improved somewhat in the first half-year. Yet, domestic demand remained sluggish. As a result, Hong Kong failed to catch up with the recovery progress of other major Asian Pacific economies. During the second half-year, though Hong Kong will still be under a mixed environment, gradual and moderate recovery can be anticipated.

First Half: Slight Improvement but Mounting Pressure

This year, the Hong Kong economy has shown initial signs of bottoming out. However, persisting problems have become more severe, bringing about no less pressure to the economy.

Improvement was demonstrated by the slowing GDP decline. Real GDP for the first quarter was down 0.9% year-on-year, which was less than the 1.4% decline in the fourth quarter of last year. Seasonally adjusted first quarter GDP actually rose by 0.3% from the previous quarter, which was better than the 0.1% drop recorded in the fourth quarter of last year. It is expected that positive year-on-year growth will be recorded in the second quarter. Recovery in externally led sectors was evident. Boosted by tourism, offshore trade and transport service, services export recorded 5.3% real growth in the first quarter. Merchandise export has also resumed growth since March, after successive declines for 12 months. With encouraging signs from orders received and external transport, further improvement in merchandise export can be expected.

Nonetheless, Hong Kong has also been facing mounting pressure. First, the unemployment situation has deteriorated further this year, with the unemployment rate during the March-May period reaching 7.4% and the number of unemployed rising by 43,000 in the first 5 months. For those employed, they inevitably have to face larger workload and lower job security. Second, property prices continued to shrink despite rising volume of transactions in the first five months, causing property owners to suffer further wealth contraction and negative equity households to face greater pressure. Third, per capita income continued to fall amid persisting recession and worsening deflation, together with rising population. Fourth, bankruptcies increased significantly, reaching a record high in May this year.

Mixed internal and external factors have resulted in the above economic performance. On the external side, Hong Kong benefited from global recovery and sustained growth in the Mainland. The U.S. experienced a mild recession after the 9.11 crisis, but consumption remained steady. Expansionary fiscal and monetary policies helped foster a quick rebound in the U.S., registering an annualised growth rate of 6.1% during the first quarter. Propelled by the U.S. economy, other major economies gradually bottomed out. The Euroland GDP grew by 0.2% during the first quarter, reversing the downward trend. The Japanese economy stabilised and recorded a 1.4% quarterly growth rate in the same period while most Asian economies also rebounded.

Contributions from the Mainland factor increased, with the State Government's effort to expand domestic demand and encourage export sustaining rapid growth in Mainland China. First quarter GDP growth reached 7.6%. Measures in favour of Hong Kong, such as relaxing the control over visitors to Hong Kong, have brought about additional benefits. A rough calculation revealed that excluding trade with the Mainland, Hong Kong's GDP would have declined by 2.4% in the first quarter. In other words, just taking merchandise and services trade into account, the Mainland factor has boosted Hong Kong's GDP growth by 1.5 percentage points.

Since the third quarter of last year, the Hong Kong economy has reported negative growth for three successive quarters, experiencing the second recession in four years. Compared with the previous recession happened just after the Asian financial turmoil, the current one is less severe in terms of duration as well as GDP contraction. Nevertheless, recurrence of recession within a short period, together with persisting structural problems, have made the situation more awkward.

In recent years, Hong Kong's structural problems have actually been aggravating. With respect to finance, corporate and household positions have worsened due to the burst of the "technology bubble" and persistently weak property prices. Progress on financial restructuring has been slow and the number of negative equity households has been growing. Considering economic restructuring, as it takes time to develop a "knowledge-based" economy, proactive government policies have not brought about much progress so far. Investor confidence has inevitably been affected. In addition, Hong Kong's fiscal problem has become more severe than expected, with a large deficit in the previous year. This has hindered the government's ability to employ expansionary fiscal policy so as to boost the economy, alleviate people's burden and foster restructuring. Furthermore, amid the weak economy, employment has been falling since mid 2001. However, owing to the growing labour force, particularly low-skilled labour, unemployment has soared.

Comparison between the Two Recessions since the Financial Turmoil

Second Half: Slow Recovery with Lingering Difficulties

The Hong Kong economy is expected to recover gradually during the second half-year. The major reason is that the external environment will continue to improve, particularly the softening USD exchange rate will favour Hong Kong's exports, creating a momentum for the economy to bottom out. Besides, a low base-year figure will also favour a technical rebound in the second half-year.

Strong U.S. economic recovery in the first quarter was particularly remarkable. Recent development, however, reflected that U.S. recovery has been losing momentum. Weak stock prices and U.S. dollar exchange rate are also weighing on the U.S. economy.

Stock market plunge, provided not too drastic, should not pose a significant adverse impact. Moderate decline of the U.S. dollar, on the other hand, will help strengthen the corporate competitiveness of the U.S. and lower the trade deficit. Therefore, a soft-landing of the U.S. dollar will be beneficial to the U.S. economy. Other favourable factors should also be noted, including the rapid growth in productivity, resilient consumer confidence, expanding production activities, stabilising investment demand, as well as low interest rate environment and proactive fiscal policy. Undoubtedly, the U.S. is also facing many uncertainties, including the high corporate and household debt levels, excess capacity, lack of new growth spots, after-effects of the 9.11 attacks as well as tension in the Middle East and its potential threat to oil prices. Nevertheless, it is expected that the U.S. economy can maintain growth in the second half, though at a slower pace. GDP growth for the whole year is expected to be around 3.2%.

Economic recovery in the European Union was evident, both in the manufacturing and service sectors. Low inflation also reduced rate rise pressure. A stable Euro exchange rate, market liberalisation and labour reform measures are also favourable for further recovery of the E.U. economy. Economic growth of the region was forecast to reach 1.5% and 2.9% in 2002 and 2003 respectively by the IMF. No doubt, there remain risks to the E.U. economy, such as the weak domestic demand in Germany and France, oil price movement, etc.

Japan's economy began to rebound in the first quarter of this year. However, in view of the recovery primarily led by exports as a result of the weak yen, with many structural problems remained unresolved and persistent deflation, the IMF maintained this year's growth forecast of -1% for Japan. Whether Japan can resume normal economic growth remains to be seen.

The Southeast Asian countries experienced wide economic fluctuations in the past year. They suffered from a sharp fall in demand for electronic products, but have recovered since the end of 2001 due to revival of the semiconductor market and domestic expansionary policies. The IMF forecast the newly industrialised Asian countries to grow by 3.6% this year and 5.1% next year.

The Mainland economy remains strong, with a more balanced growth momentum. Stimulating policies succeeded in boosting domestic demand. In particular, real estate investment grew by 38.8% in the first four months this year, contributing to a 27.1% growth in overall investment. Consumption demand remained steady, with retail sales growing by 8.4% in the same period. External trade performance was better than expected, rising by 13.2% in the first five months. Together with a 12.4% rise in actual foreign investment, the WTO accession effect was quite apparent.

Although problems such as deflation, rising unemployment, falling corporate profits and severe natural disasters remain to be resolved, other favourable developments in the Mainland should bring along a faster growth rate. With further structural adjustment, various consumption spots are gaining momentum, such as in real estate, automobile, information, tourism and education. Multinationals are speeding up their relocation of production lines to the Mainland. Reform and readjustment of monopolised sectors have already commenced. Furthermore, monetary policy will be employed to combat deflation. Coupled with another pay rise for civil servants to be implemented and the softening U.S. dollar, a favourable impact on economic growth and price stability can be expected. Economic growth in Mainland China could possibly reach about 7.5% this year, slightly above the official target of 7%.

Besides the external economy, Hong Kong's economic performance in the second half will depend on domestic administrative efficiency, interest rate and exchange rate movements, capital market and property market performance. The implementation of the accountability system should enhance administrative efficiency, fostering economic restructuring. Finance, logistics, tourism and business support services, as well as domestic economy will become new development spots. Limited rate rise pressure in the U.S., together with local interest rates not having fallen as much as the U.S. in the recent cycle, should ensure a low interest rate environment in the second half. Weak U.S. dollar will be a significant positive factor. A strong Hong Kong dollar following the greenback has long been a major constraint on the local economy. Thus, the steady decline of the U.S. dollar, and hence the Hong Kong dollar, will help boost Hong Kong's export competitiveness, alleviate the downward pressure on asset prices and labour costs, as well as reduce imported deflation. Further economic recovery will help sustain a stock market boom, creating positive wealth effect and better conditions for capital raising activities. The gradual withdrawal of public participation will lay more healthy foundation for the property market. However, abundant supply and weak home-buying sentiment will continue to weigh on property prices. This will affect consumption and investment.

In summary, Hong Kong will still be under a mixed environment in the second half. Nonetheless, favourable factors will gradually strengthen and dominate. Under such circumstances, the Hong Kong economy should recover slowly, with the momentum mainly from external sources. Merchandise and services export growth will increase, with annual growth surging to around 2.5% and 6% respectively. Domestic demand will also improve, but more slowly. Consumption growth will still be constrained by high unemployment and persistent deflation. Only zero growth is anticipated. Investment will not rebound substantially either. Amid lingering uncertainties, falling corporate profits and excess capacity, machinery and equipment investment will only stabilise, while private construction work will be hampered by the significant drop in public housing construction activities. Gross domestic fixed capital formation is therefore still expected to register a decline of 6.2%. On the whole, Hong Kong's GDP growth is expected to reach around 2% this year, higher than the previous year's 0.2%. Since only slight recession has been experienced in this occasion, the rebound that follows will not be that significant. Further constrained by decreasing domestic demand, it is expected that only partial recovery can be achieved in the second half.

Although economic performance will improve, the pressure faced by the public will not be much relieved. There have been new jobs created in response to the economic rebound, but corporate restructuring and streamlining are still underway and will continue to add pressure on the job market. The unemployment rate may surge to above 7.8% before coming down by the end of the year. Deflation will be no less severe due to the government's measures to ease people's hardship. Yet, the softening U.S. dollar will help bring deflation down slightly, resulting in a 2.5% decline in the Composite CPI for the year.

Forecasts of Hong Kong's Real Gross Domestic Product and Prices for 2002