The Latest Assessment of the Deflation Situation

Although declining for a 59^th month in September by 3.2%, the decrease in Hong Kong's CCPI narrowed for a second month after plunging by 4.0% in July. And the magnitude of improvement exceeded market expectations. Moreover, the general price index was higher than it was in July and August, signaling stabilization ahead. However, history shows that improvements over several months period were not uncommon in the past five years and general price still could not avert further drops. Therefore, precaution must be taken when interpreting the latest figures. Amongst various components, housing (hereinafter referred to as "Housing Index") continued to register the largest YoY decrease of 8.1%. From the peak reached in May 1998, the cumulative decline in CCPI is 16.1%. Meanwhile the drop in the Housing Index amounted to 28.5%. Multiplied by the Housing's weight of 29.91% in CCPI, it contributes 8.5 percentage points or 52.8% to the total decline of prices. Thus, if the property market stabilizes, half of the deflation problem could be solved. The following chart shows the YoY changes in CCPI, the contributions from the Housing component and Non-Housing component calculated based on the methodology mentioned above.

In order to alleviate the pain brought by SARS, the government made rates concession for 3Q03 and waived water and sewerage charges for the four months from August to November, distorting the trend of price decline. Past experience shows that rates concession could dampen CCPI by 0.9 percentage points per month and charges waivers could cut another 0.2 percentage points, bringing the total impact by government measures to -1.1%. But bear in mind that rates are housing expenditures already reflected in the Housing Index. Taking this into consideration and netting out all effects from housing and government measures, we find in the following table that deflation has already eased to -0.6% in September. The sudden plunge in price in June was due to electricity rebates for SARS relief. This signals that Hong Kong's deflation is inching toward a solution. As long as the property market continues to rebound and the government waiver measures come to an end, deflation could improve further.

Such a finding naturally begs for a question that why the Housing Index continues to register large decrease when the property market has obviously rebounded strongly in recent months after the signing of CEPA. For example, some housing prices have rebounded by double-digit percentage points from the bottom recently and transactions numbers have also surged. But meanwhile the Housing Index still declined by 8.1% YoY in September. A plausible explanation is that the Housing Index is indeed a rent index reflecting the movements of rent paid by Hong Kong households. It also includes rates and government rent and can be decomposed into private housing rent index and public housing rent index. Therefore, rising or declining property prices may not directly affect its trend. As housing transaction prices are recorded under the latest market environment but rent could be set months or even one year ago depending on the tenure of the leases, changes in rent indices usually lag behind market price movements. This indicates that improvements in deflation could well lag the overall property market trend. And we must take this aspect into consideration when assessing the deflation situation.

The Effects of the Property Market on Deflation

The Housing Index's survey proves to be less helpful in analyzing the effects of the property market on deflation. Firstly, it can be further broken down into Public and Private Housing Rent Indices, with the former having its own distinctive price trend. In fact, public housing rent has stopped falling on a YoY basis, and the current level is higher than 2002's average. Public housing project provides housing to half of Hong Kong's population, with 2/3 of whom renting public housing. But since there are strict guidelines governing public housing rent's setting and adjustment, its volatility is far less than private housing rent. Secondly, public housing rent commands only a 2.07% weight in CCPI, rendering it a less effective indicator for deflation. Nevertheless, attention must be paid to the pending lawsuit on public housing rent reduction because if a verdict is reached to cut rents, it will exert further downward pressure on the general price level. Thirdly, amongst the 29.91% weight of the Housing Index in CCPI, 3.25% covers items such as management fee and other housing charges and tools and materials for house maintenance, which may not be directly affected by the property market's ups and downs. All these make it difficult to properly evaluate the property market's related effects on deflation.

A barometer for Hong Kong's property market is the Private Domestic Housing Price Index (hereinafter referred to as "Price Index") and Rental Index (hereafter referred to as "Rental Index") compiled by the Rating & Valuation Department (RVD). From the peak reached in October 1997, the Price Index has declined by 66.9%, which is often quoted as the cumulative decrease in Hong Kong's property price. As for the Rental Index, the drop is slightly smaller at 48.7%. The Rental Index and CCPI's Housing Index differ in many ways, with the former covering rental movements for new and fresh lettings only while the latter also covering renewed and existing leases, changes in rates and government rent, public housing rent and some miscellaneous expenditures. As a result, the Rental Index is more volatile and leading the Housing Index because new leases tend to be driven by the market but existing leases may not be modified in one to two years. Thus, the Rental Index can be seen as a leading indicator for deflation. Our quantitative analysis of the two time series shows that since 1997, movements in the Rental Index explains 63% of movements in the Housing Index. And further filtering finds that the lead-time of the YoY percentage change in the Rental Index is about 10 months. Using the same method, we find that the Price Index is correlated with the Housing Index 60% of the time and leads it by about 11 months, similar to that of the Rental Index.

RVD's provisional figures for August show that the Rental Index was still down 13.5% YoY and the Price Index down 16.1%, narrowing their decline from three months ago. Indeed, the Rental Index was up MoM by 0.85% and the Price Index's monthly change was close to zero. Moreover, Monthly Price Index for Selected Popular Developments has already risen to a four-month high. These all tell the story of the property market rebounding from the bottom reached during SARS. Although oversupply still plagues the property market, it should continue to stabilize or even climb slightly barring any external or internal shocks. Not only so, the SAR government has turned more optimistic by raising this year's real GDP forecast to 3.0% and medium growth forecast to 3.5%. The private sector is even more encouraged by predicting a 4.0%+ growth next year. Based on our findings that the property market leads deflation by nine to twelve months, Hong Kong's general price level may stop falling in 4Q04, putting an end to deflation for good.

Possible Impacts of CEPA

In the short run, CEPA provides instant stimulus to Hong Kong's economy. The revivals in market sentiment, economic activities and the property market halt the worsening trend of deflation. The leading Rental and Price Indices' stabilization owes much to CEPA. But in the medium to long run, concerns linger that as close economic relationship is forged, pressure will mount on Hong Kong's higher costs because general price levels are vastly different in the two economies. In other words, Hong Kong and Mainland's price levels may continue to converge under factor price equilibrium theory. As a result, Hong Kong may continue to encounter deflationary forces.

At first glance, such a scenario indeed sounds plausible. Imagine when the land customs are merged into one as many suggests, the cross border mass transportation system are perfected, and Hong Kong's service sector further expands into the Mainland under CEPA's blessing, Shenzhen could well become the first choice of residence for some of Hong Kong's medium to low income populations. And higher income service personnel would also face the option of living in the Mainland. Under such circumstances, price convergence may accelerate and Hong Kong's deflation may be here to stay. Although such an outcome is possible, there are many other new factors and channels emerging to influence Hong Kong's price. A more comprehensive evaluation will have to take them into consideration.

An empirical study conducted by the HKMA staff in June 2002 finds that there was indeed price convergence between Hong Kong and the Mainland. Yet no statistical evidence has been found regarding the eventual price equalization between the two areas. The China factor reduced Hong Kong's price by about 2% in the past four years, equivalent to 1/5 of the total price decline of 10% during the same period, suggesting that the Mainland contributed to 20% of Hong Kong's deflation. This finding is in line with our own assessment. The Mainland factor has certain effects on Hong Kong's price level, but not the driving force as many fears. Hong Kong's deflationary problem has much to do with its own economic cycle, the bursting of the property and stock market bubbles, and the economic transformation. The Mainland should not be singled out to blame for our deflation.

Under the closer economic relationship design of CEPA, the Mainland can influence Hong Kong's price level by attracting more investment and consumption across the border, by exporting goods to Hong Kong, and by exporting investment and consumption to Hong Kong. And the exchange rate effect will become more prominent. Before CEPA was signed, Hong Kong residents already enjoyed high degree of freedom to invest and consume in the Mainland. Even though such activities will be further expanded post CEPA, marginal increase in cross border consumption should not be significant simply because the base was too high. It is the investment and consumption that follow the service sector's explorations in the Mainland market that will have greater increase. But if we look at it from an interactive and broader angle, mutual flows of personnel, goods and capitals will result in much more Chinese investment and consumption flows into Hong Kong from a much lower base.

Moreover, successful integration will further showcase Hong Kong's intermediation role and attract more overseas capitals and consumption to Hong Kong. Therefore, on a net basis, it is far from clear that Hong Kong will suffer net consumption loss to the Mainland because of CEPA. Thus the effects on the price level may not be negative after all. In terms of Mainland's goods exports to Hong Kong, the marginal impacts should be limited, as the model of trade and Hong Kong's population are not expected to have dramatic changes. In recent years, unit import price indices from Hong Kong's main trading partners such as China and the USA have been declining due to global overcapacity and tradable goods deflation. But in July this year, unit import price index from China had been rising for a 5^th month, indicating that the goods deflationary pressure from China had largely gone. And Hong Kong may even stand to import some inflation from China in the future should the current trend continue. China's goods exports to Hong Kong mostly concentrate on food, apparels and beverages, which combined have a weight of about 15% in CCPI, limiting the negative impacts, if any, on Hong Kong's price level.

This demonstrates that CEPA would not result in more pressure on Hong Kong's prices. Thus, the exchange rate effect may become more prominent. The HKD will continue to weaken against other Asian currencies as the US continues to seek a weaker USD. This would reverse its painful rise during and after and Asian Financial Crisis along with the dollar and further alleviate Hong Kong's deflationary pain. Although the RMB is also pegged to the dollar, China saw much larger capital inflows on RMB revaluation prospects. As a result, China's money supply and bank loans have grown by 20%+ in recent months. Barring any hard landing of China's economy, China may be facing rising inflation instead of deflation, especially in financial assets. To Hong Kong, at least the effects won't be deflationary any more. The revaluation pressure is more significant in the RMB forwards than in the HKD forwards. Even if sport rates are of little change, the HKD still gains competitiveness against the Chinese counterpart. And if the RMB exchange rate reform results in expanding the trading band or pegging to a basket of currencies, then its rise should help lift Hong Kong's price level instead of dampening it.

To conclude, closer economic relationship between Hong Kong and the Mainland does not necessarily lead to further deflation at home. On the contrary, if China can maintain its current growth course, Hong Kong's price level may benefit by rising instead of falling.

Dai Daohua
Economist