The Structure of the HKD's Decline

To start with, we must carefully examine the way the US dollar weakened because its trading partners and competitors are different from those of Hong Kong's, and the USD's depreciation was uneven at best, which may have different implications to Hong Kong.

Since peaking in February 2002, the Broad Dollar Index, the Major Currencies Index and the OITP (Other Important Trading Partners) Index compiled by the US Federal Reserve have been down 8.8%, down 17.5% and up 2.9% respectively. It can be seen that the depreciation of the USD was largely against major industrial currencies. When measured against most Asian currencies or emerging market currencies, the USD either declined only modestly or even rose slightly. Hong Kong's main trading partners or competitors such as China, Taiwan, Singapore and Korea are included in the OITP Index that was actually up during the period. This casts doubts on the prospects of benefits to Hong Kong.

Nevertheless, the reference value of the USD indices based on the US foreign trade may only be secondary to Hong Kong. We therefore turn to the nominal effective exchange rate index (NEERI) compiled by the Census and Statistics Department and the real effective exchange rate index (REERI) complied by the HKMA, with the latter also taking into account of the relative movements in consumer price indices against those selected trading partners. In effect, the REERI measure adjusted by inflation is often cited as an indicator of Hong Kong's price competitiveness. During the same period when the USD weakened, the NEERI and the REERI declined by 5.3% and 7.8% respectively. Hong Kong's lingering deflation contributed to the larger decline in the REERI. If calculated from August 1998 when the HKD peaked, the decrease in the NEERI was only 5% while the REENI dropped by more than 20% due to deflation, a result seemingly beneficial to Hong Kong's economy. But it should be pointed out that the decline was accumulated in 5 years. Its benefits, if any, may not be as dramatic as depreciation within a shorter timeframe of 12-18 months.

Exports

It is generally believed that a weakening HKD is good for exports. But to confirm this, it must be proved that export growth exceeds import growth as a result of currency depreciation, thus improving the trade balance and contributing positively to GDP growth. An attribution analysis needs to be performed regarding the effects on domestic exports and re-exports of the goods trade and the services trade.

GDP Goods and Services Components at Constant (2000) Market prices
(Billions of HKD)

The above calculations show that Hong Kong's trade balance as calculated in GDP's main expenditure components using constant market prices has indeed been improving during the past 5 years. Goods plus services trade balance amounted to HKD102.8bn in 2002, up substantially from a deficit of HKD15.7bn in 1998. On the surface, the declining REERI seems to rewrite Hong Kong's trade story. However, further analysis reveals that the breakthroughs mostly come from the services trade, the size of which is only 1/5 of goods trade. Deficits in goods trade seem to be rising instead of declining in recent years. This phenomenon warrants greater attention because normally speaking, changes in nominal exchange rates are more effective in influencing goods trade. This is a main reason why the US and Japan have been pursuing a weaker currency of its own. Since the NEERI only moderately declined over the years, Hong Kong's goods trade received little help as a result. But the more prominent decline in the REERI due to deflation did help Hong Kong's services dominant economy to regain some competitiveness. Consequently, with much smaller proportion, the services trade makes much greater contribution to Hong Kong's GDP growth.

Within goods trade, domestic exports have been on steady decline while re-exports on steady rise over the years. The lagging domestic exports hinder growth in overall goods exports, thus failing to improve goods trade balance. Domestic exports have been declining each month since November 2000, recording double digits decrease in recent months and falling to only 7% of overall goods exports and showing few signs of turnaround. This demonstrates that a weakening HKD does little to help the manufacturing sector that is witnessing declining competitiveness and looking to relocate. But does the rapid rise in re-exports that account for 93% of goods exports have much to do with the exchange rate? The answer should be negative. It is the China factor instead of the exchange rate factor that leads to the re-exports surge. The latest statistics show that 45% of Hong Kong's re-exports are destined for China, with 38% to the rest of the top ten destinations. Re-exports to China are mostly heading to processing centers and re-exports to other countries are mostly Made-in-China final products. No wonder 80-90% of Hong Kong's re-exports are China related. Under such a structure, it is China's competitiveness instead of the HKD exchange rate that determines the fate of Hong Kong's re-exports. For example, when SARS hit China in 2Q, its exports maintained growth rates well above 30% YoY, which made Hong Kong's re-exports rise in sync. Therefore, the exchange rate factor is only supplementary to the China factor. The modest decline in NEERI cannot halt the decline in domestic exports or manufacturing relocation. Interestingly, because the RMB is also pegged to the USD, the competitiveness of China's foreign trade that Hong Kong so heavily relies on does not come from the exchange rate. Instead, it is China's low cost and high productivity that attract global manufacturers. Although the RMB remains unchanged against the USD, China has been posting trade surplus with the US. And although the RMB depreciates against currencies of its main Asian trading partners, China has been running trade deficits with them.

Investment

Investment is generally considered a measure gauging our internal competitiveness as opposed to exports in gauging our external competitiveness. However, FDI statistics from Hong Kong's BoP accounts or UNCTAD's own calculation paint a distorted picture of Hong Kong's attractiveness to investment. From 1998 to 2002, the annual FDI flows into Hong Kong exceeded HKD100bn per annum on average, approaching HKD200bn in 1999 and 2001 and even HKD500bn in 2000. With a GDP around HKD1200bn, Hong Kong should have reaped huge benefits from such inflows. Instead, the reality remains that we have two recessions in 5 years, deflation has lasted for 56 months and unemployment rate has just made a new high, which are grossly inconsistent with such large amounts of FDI inflows. Why is that?

In our May 2002 issue of Economic Review titled "An Analysis of Hong Kong's Balance of Payments Accounts", we concluded that by complying with international standards, the coverage of Hong Kong's direct investment had become much broader, resulting in larger investment flows statistics. Firstly, many Mainland based companies were listed in Hong Kong's stock exchanges. The capitals they raised became FDI inflows statistically. Yet the funds were eventually channeled back into the Mainland and created little business in Hong Kong, producing limited economic impact. Secondly, some Hong Kong holding companies were re-incorporated in overseas tax havens. Fund transfers between the parents and subsidiaries were counted as FDI inflows. Thirdly, funds originated from the Mainland were rerouted through Hong Kong back into the Mainland, being counted as FDI inflows in the process. These are unique features of Hong Kong being a free port. But the FDI statistics reflect more of its intermediation role than its actual internal competitiveness. Thus the study on effects of HKD exchange rate change on investment prospects proves inconclusive.

The statistics compiled by InvestHK may provide a partial hint. From 1998 on, the number of regional headquarters and regional offices established in Hong Kong has steadily risen to more than 3000, arguing for improving competitiveness of Hong Kong. But in terms of investment capitals, the average size of new operation or expansion projects amounted to less than HKD10mn each, displaying mismatch between rising numbers and declining investments. Thus conclusion about rising attractiveness to investments after years of deflation proves premature.

Deflation

In recent years, the US and Japanese governments have utilized foreign exchange policy as an important tool to fight deflation. The same expectation can be found in Hong Kong where deflation has lingered for 5 years. But we should bear in mind that the NEERI only had moderate decrease. And the larger downward movement in the REERI was actually caused by deflation. Thus high expectation of it putting an end to deflation may be misplaced.

Using currency devaluation to fight deflation works by raising import prices denominated in local currency through the conversion effect. This seems to be a viable option as Hong Kong imports most of its consumer products. Nevertheless, two aspects have to be considered. First, property deflation is the most important source of the general deflation. From the peak of May 1998, the CCPI declined by 15.4% with the Housing Index dropping 24.7%. As housing commands a weight of approximately 30% in the CCPI, it accounts for about 7.4% or half of the overall price decline. Therefore it seems rational to expect Hong Kong's deflation to improve by half if the property market stabilizes. But the role of exchange rate change in this mechanism is neither direct nor necessary. It is the confidence of Hong Kong people that matters the most. Second, it is unclear how people will react to the artificially imported inflation. To most consumers threatened by high unemployment rate and wage pressure during the economic transformation, deflation somehow mitigates the pressure on the living standard. Thus it is unclear if they are willing to accept such inflation. The unsuccessful attempt by the MTRC to raise fares serves as a good reminder. There is vast difference between inflation accompanying economic recovery and inflation artificially made.

Statistics from the past ten years also show that Hong Kong's unit import price index exhibits a different cycle from that of the CCPI. They may not move in sync or even in the same direction. And twice in the past 5 years the YoY change in import price turning positive failed to bring CCPI back to positive territory. This argues for different components and impacts of the two indices. Therefore a reasonable discount must be added to the effectiveness of fighting deflation by raising import price through devaluation.

Corporate Earnings

The substantial depreciation of the US dollar in the past one and a half years was music to the ears of many large US multinational corporations because their earnings received a big boost when overseas profits were converted back to US dollars. The translation effect is also one of the major reasons behind Japan's obsession with a weaker Yen. Then how much benefit can Hong Kong companies reap in terms of improving earnings with a weakening HKD? The answer should be limited. For one, among the publicly traded companies, the number of truly large multinational corporations is limited. For two, most business transactions are conducted in US dollars, and commonly used currency hedging neutralizes foreign exchange impacts. Among the 33 component stocks of the benchmark Hang Seng Index, only HSBC and Hutchison can be regarded as true multinational corporations with sizable overseas businesses. The others’ businesses are concentrated either in Hong Kong or the Mainland. Since China and Hong Kong are de facto US dollar blocks, not many companies’ earnings can benefit from a weaker HKD, and this go for the stock market as well. Nevertheless, HSBC and Hutchinson combined account for 40% of the HSI. Thus if their earnings are boosted by their European profits, then the overall stock market can still benefit. As Hong Kong is an international financial center, exchange risk management is sophisticated enough so that US dollar denominated transactions or currency hedging is common, which reduces the FX risks but also diminishes the benefits when the exchange rate movement becomes favorable.

The above analysis examines the effects on Hong Kong's exports, investment, deflation and corporate earnings when the HKD weakened with the USD. The evidence has yet to confirm substantial benefits, which may have much to do with the unique structure of Hong Kong's economy. In theory, currency devaluation can provide solutions to many of Hong Kong's problems such as property deflation or wage deflation, and boost Hong Kong's competitiveness. But let's keep in mind that devaluation is simply price competition, which is a most primitive measure, easy to use and may be effective in the short term. However, doubts linger about whether Hong Kong can regain prosperity by currency devaluation. Take Japan for example, it is frequently criticized for heavy on manipulating the Yen exchange rate and light on structural reforms. It chooses the easier option of FX manipulation. In certain ways, Hong Kong bears similarities. Devaluating the HKD is easy but successful economic transformation of finding a new growth engine is difficult. Hong Kong also has an extra concern about its international financial center status that relies heavily on its being a de facto dollar block with stable exchange rate and interest rate. Taking into account of all these aspects, the case for Hong Kong to abandon its currency regime is less than compelling.

Dai Daohua
Economist