Perspective of the Improvement of the Deflationary Situation

Hong Kong economy has been undergoing a V-shaped recovery since the second half last year. The Individual Visit Scheme has boosted the retail market and consumers' confidence. The inflation in the Mainland mainly caused by the price increase of the agricultural products may drive import prices up. In addition, the continuous softening of the US dollar may also lift the prices of commodities from the non-US-dollar regions. All these factors are helpful in improving Hong Kong's deflation situation. According to statistics, the CCPI for January 2004 declined 1.5% compared with the same period last year. It is further narrowed from 1.9% for the previous month and has been the smallest drop since December 2002. (CCPI's drop by 2% yoy in February, larger than the previous two months, was due to the base year factor with last lunar new year festival season falling in February. Nevertheless, it does not alter the trend that the decline of the CCPI has been narrowing since last August). Although Hong Kong has been in severe deflation for 64 months in a row if compared on the yoy change basis, the deflation situation has improved for 6 months consecutively up to January if compared on the monthly change basis. The CCPI itself also went up for 5 months in a row with an accumulative increase of 1.5%. For that reason, Mr. Joseph Yam wrote in his column Viewpoint on January 29 2004 that consumer prices in Hong Kong might have stopped falling around August 2003.

Continuous narrowing of the decline in the CCPI represents the steady improvement of consumption demand in Hong Kong. On the one hand, the Individual Visit Scheme has boosted retail, tourist and restaurant industries and the turnover of consumer durables and luxury goods such as electronic appliances, cosmetics, watches, gold and jewelry and etc. have remarkably increased. On the other hand, the V-shaped economic recovery and the restoration of market confidence have pushed up local consumption. For instance, many Hong Kong residents traveled abroad during the Spring Festival, lifting the tour group fees by 17.6% compared to the same period last year.

The improvement of deflation situation can also be justified by the changes in both value and volume indices of the total retail sales. Both indices in November 2003 synchronically grew by 5.2%. This was the first time that both indices had recorded growth since September 1998. The decline in the value index had been larger all the way than that of the volume index since Hong Kong fell into the deflation. And even when retail sales started to improve in August last year, the increase in the value index was slower than that of the volume index, indicating that retail prices had been dropping all the time and the retailers needed to cut prices in order to maintain business. The synchronous growth of both indices for November 2003 indicated that pricing power of the retailers was enhanced. The figures for December and January are even encouraging, not only both indices growing for 6 months in a row but also the increase in the value index outstripping that of the volume index. This is the first time that the increase in total value of retail sales surpasses that of the total volume since Hong Kong was trapped into deflation late 1998. This shows that the general price level of the retail industry began to rebound and also symbolizes that the retail component in the CCPI has got rid of the deflation.

Since the CCPI had increased by an average 0.4% each month for the past half year till January 2004, some expected that the decline in the CCPI would shrink to 0 in four months' time, i.e. by mid-year. It is hardly sure whether the decline in Hong Kong's CCPI can continue to shrink at the same pace experienced in the past six months till January 2004, owing to seasonal factors, time effect of policy and comparison base that affect the changes in the CCPI. However, it is estimated that the decline in the CCPI will continue to shrink and the CCPI will cease to drop and begin to climb within this year based on the following analysis.

Firstly, fostered by a series of favorable factors, Hong Kong's economy this year will continue to rebound and grow. According to the most recent forecast of the government, the Hong Kong economy this year will grow by 6% after experiencing a 3.3% growth last year. The medium range economic growth forecast is also raised to 3.8% from 3.5%. The forecasts from the private sector for this year are even more optimistic, ranging from 6.5% to 7.8%. Driven by economic growth, the unemployment rate will gradually decline; consumption confidence will further rise. These, together with the wealth effect resulting from the strong rebound of asset prices will further enhance consumption demand, thus laying a solid foundation for the CCPI rebound.

Secondly, the property market recovery will push forward the improvement of deflation. The real estate sector has been strongly reviving since 3Q2003. The overall property price has accumulated more than 20% increase from the bottom. Nevertheless, the recovery of property prices has not been reflected in the changes of the CCPI. On the contrary, the decline in January's CCPI housing index continued to broaden to 7.9%. Yet, the CCPI actually increased by 0.9% if excluding the effect of the housing sub-index. The reason for this discrepancy lies in the fact that the housing index is actually a lagging indicator reflecting the changes in rent paid by the Hong Kong households. The housing index can be further broken down into public and private housing rent indices. Since rent could be set months or even one or two years ago depending upon the tenure of the leases, changes in the hosing index usually lags behind property prices. This explains why that the improvement of deflation goes well behind the recovery of the property market. According to conventional wisdom, the rent usually lags 9 to 11 months behind the property market trend. Therefore, the ongoing recovery of the property market will finally be reflected in the hosing index by 4Q this year the latest. Public housing rent may be cut further because of the pending lawsuit on public hosing rent reduction and thus exerting further downward pressure on the housing index. However, since public hosing rent casts only approximately 2% weight on the CCPI calculation, its impact on the improvement of deflation will be minimal and will not alter the trend led by the property market recovery.

Thirdly, the quick reversal of deflation to inflation in the Mainland may expedite the improvement of deflation in Hong Kong. The CPI in the Mainland barely saw the increase even during the first eight months last year, with deflationary pressure still lingering. However, due to poor harvest and grain price increase as well as short supply of certain raw materials, the CPI has suddenly increased substantially since September. The inflation rate reached 3.2% YoY growth by December, the highest increase since 1997. The momentum of the CPI increase has ever since maintained strong. The PBOC forecasts that inflation rate for the year will be around 2.2% and therefore switched its monetary policy to address inflation instead of deflation as the primary policy target. Since Hong Kong imports most of its consumption goods from the Mainland, the inflation mainly driven by grain price increase in the Mainland will inevitably result in price increases in certain goods in Hong Kong and therefore help to stop further decline in the CCPI.

Fourthly, the steady softening of the US dollar and the resultant price increase of the imported goods will be another driving force of the rebound of Hong Kong's general price level. In the past, the strong US dollar once drove down the prices of world commodities denominated in the US dollar. During the period of 1996 to 2001, Hong Kong's import prices experienced steady decline with an average annual rate of 2%. This constitutes one of important reasons of the long-lasting deflation in Hong Kong. Beginning in 2001, Hong Kong dollar index has been plunging along with depreciation of the US dollar from 138.9 in 2001 to 98.9 at present, dropping by 28,7%. This has not only improved Hong Kong's competitiveness and boosted foreign trade, but also slowed the declining trend of Hong Kong's general price level. It can be safely said that in the foreseeable future, "imported inflation" will continue to help in improving Hong Kong's deflation situation as the US dollar continues softening.

In summary, even through we are not able to predict precisely when deflation will disappear, it is quite clear that the CCPI will cease to decline and begin to climb within this year. As the CCPI continues to record the negative growth in the most of time this year before deflation disappears, Hong Kong will still be in the situation of deflation if compared on the yoy basis. It is estimated that the CCPI is still going to decline further by 1% to 1.5% this year. From this point of view, it can be said that deflation will not disappear and inflation will not show up until 2005.

Two Sides of the Improvement of the Deflationary Situation

Having suffered from deflation widely, Hong Kong would certainly welcome the improvement. Both the government and the community showed their joys for the sign. The improvement of deflation would not only reverse the trend of economic contraction and stagnation and lift the deflation-twisted nominal GDP growth rate, but also help to boost consumption and investment, drive up asset price and eliminate the fiscal deficit.

The most evident consequence resulted from 5 years plus long deflation has been the sharp decline of a series of economic indicators measured in the monetary terms, especially the contraction of nominal GDP. According to statistics, since Hong Kong fell into the deflation at the end of 1998, the GDP deflator that measures the overall price movement has been declining all the time, and severely contracting nominal GDP. Apart from that the nominal GDP in 2000 recorded 3.4% positive growth because of the exceptionally high real GDP growth of 10.2% in the same year, nominal GDP in all other years has experienced negative growth even though real GDP in the same period has had more or less positive growth. Deflation has severely checked consumption and investment and thus resulted in economic stagnation, asset depreciation, price decline, and high unemployment.

The economic contraction, together with decline in nominal income and steadily falling prices has made consumers delay consumption, awaiting prices to fall further. Under the deflationary situation, not only the jobless people restrain spending, those employed are also cautious to consume. Deflation has also discouraged investment. Whether or not investors decide to inject money into business activities depends upon the perspective and return of investment. The nominal GDP growth rate actually represents the rate of return of the overall economic investment activities. The fact that deflation shrinks the nominal GDP growth rate means that the overall economic investment activities will gain the negative return. Furthermore, the deflation zooms up the real interest rates and increase investment cost therefore further check investment activities. Due to income decline and gloomy economic outlook, property or other asset markets that lack support from buyers suffer from further price declines and scant transactions. In addition, as contraction of nominal GDP reduces government revenue, government expenditure would not fall, therefore increasing the fiscal deficit.

With the improvement of deflation, economic indicators measured in monetary terms no longer decline, and the nominal GDP goes up along with economic growth. The problems derived from deflation will gradually disappear. Consumers will decide to go ahead to spend because of expectation of higher prices in the future while investors will actively seek for investment opportunities since deflation can no longer eat up the return of investment. The rebound of the CCPI also means the decline of the real interest rate, thus lowering consumption and investment cost, stimulating domestic demand and revitalizing economic activities. The improvement of deflation can also boost asset prices and activate the equity and property markets. Furthermore, the improvement of deflation helps to recover the economy and lift the nominal GDP growth rate, and therefore increase government revenue and improve the government's fiscal position.

Thus, it can be seen that getting rid of deflation in Hong Kong is basically beneficial to the overall economy. However, if the CCPI rebounds too fast and results in earlier coming of inflation, exceeding the support from the economic fundamentals and the affordability of the society, i.e., the price increase is pushed by booming asset prices or external factors such as "imported inflation" rather than economic recovery or improvement of economic fundamentals, then the improvement of deflation can also bring about concerns.

Deflation means that prices continue to decline. Its positive impact on economy thus lies in lowering both living and business operation costs. The improvement of deflation or a shift to inflation then reflects that prices steadily go up. At a time when the jobless rate is still high and may not be lowered any time soon, economic recovery still need to be confirmed and enhanced, and also economic growth momentum need to be further cultivated, an increase in price or even a shift to inflation means lowering living standard, deteriorating business operating conditions, containing consumption and investment, and thus hindering economic recovery.

Hong Kong has been experiencing deflation for many reasons. Some of the most important ones include the burst of the asset babble, the adjustment of high prices including property prices, wages and business operation costs, as well as the necessary adjustment under the linked exchange rate system. Through continued price declines, deflation has successfully lowered to a certain degree the high cost in Hong Kong, and partially restored its competitiveness. Furthermore, economic links between China and Hong Kong has been getting closer and closer, resulting in the convergence and adjustment of the productive factors in two places. This is another reason resulting in deflation in Hong Kong. Through more than five years of painful adjustment, the discrepancy of the productive factors between two sides has been narrowed, but the process is far from finished, especially in the labor cost area.

Supported by various policies from both the central and SAR governments, market confidence has quickly recovered and the Hong Kong economy started V-shaped rebound in 4Q last year. However, the recovery of Hong Kong's economy needs more impetus and economic growth momentum also needs further boost. More importantly, the process of economic transformation is yet to complete. At the same time, pushed by the strong rebound of the equity and property markets and heavy transactions, wealth effect has been quickly spreading. The Individual Visit Scheme has also boosted the consumption-related sectors and the retail industry has quickly walked out of deflation and starts to encounter to the emerging inflation. In addition, as the US dollar continues softening, "imported inflation" will continue to play its role as an external shock. All of these factors have expedited the price rebound in Hong Kong. But if the CCPI goes up too quickly and exceeds the support form the improvement of economic fundamentals, then it is quite possible that the long process of cost adjustment may be forced to cease, and on the contrary, the costs for living and business operation may lift up, thus weakening Hong Kong's competitiveness and severely impairing the on-going economic recovery.

Therefore, the present situation of the deflation improvement should be carefully perceived and the different driving forces behind price increases should also be clearly classified. We should further boost economic recovery and enhance economic growth momentum by utilizing the rebound of price to vitalize consumption and investment. At the same time, we should also keep vigilant attention to the emerging sign of inflation and protect economic recovery from risks brought by the over-heat asset markets or external shocks.

Huang Shaoming
Senior Economist