Supported by the central government's favorable policies and the improving global economy, Hong Kong has recorded strong and comprehensive growth in 1Q04, as opposed to the external sectors faring much better than the domestic ones in the past. And continuous improvements in lagging economic indicators such as the CCPI and the unemployment rate suggest that growth momentum remains strong in the second quarter.

The SARS disease caused shutdown of most economic activities in the second quarter last year, resulting in a GDP growth of –0.6%, down five percentage points from 1Q03's 4.4% growth. Because of such a low base, even if Hong Kong's economy maintains steady growth in 2Q this year, the year-over-year growth could shoot up to double digits, producing a 1H growth of at least 8.4%, which is the second highest half-year growth rate since the 1990s. Economic indicators such as April's surging goods exports and imports, inbound tourists and retail sales all point to such direction. In summary, Hong Kong's economic growth in the first half of this year is not only strong but comprehensive as well. All expenditure components have recorded respectable growth. In nominal terms, the economy has resumed growth as well, thanks to the more balanced performances of both the domestic and external sectors.

Externally: Uncertainties Persist

As a small and open economy, Hong Kong is till susceptible to external shocks. Therefore, the way the global economy moves is of vital importance. As concerns about the US Presidential Elections remain unabated, new threats emerge in terms of imminent US rate hikes, surging oil price, and China's macro tightening.

The US looks set to enter into a new rate hike cycle. As Mr. Greenspan and other Federal Reserve officials made it quite clear recently on the back of strong economic data, the US interest rates are on the verge of being raised in the upcoming June FOMC meeting. As the US remains a major trading partner of Hong Kong, and our Currency Board system requires similar adjustments of HKD rates in line with the US, their rate hikes will pose challenges to Hong Kong's economic growth. Luckily, the widely expected rate increases are believed to be aimed at bringing interest rates to more neutral levels given the rapid economic growth as well as the reviving labor market, instead of warding off the inflation threat or cooling down the economy. This suggests that the total amount of rate hikes within this year will likely be 75bp. Even more aggressive rate hikes of 100bp still only yield a real interest rate of roughly zero percent given the current inflation level. As the market has fully priced in such scenarios and rate hikes tend to affect the real economy with time lags of at least six months, the impacts on the US economy and the financial markets are deemed limited. Hong Kong is unlikely to follow the US closely in raising rates at the beginning of the rate hike cycle because it did not cut rates as much in the past. And ample liquidity in the banking system also argues against such moves.

It is also worthy of mentioning that a new rate hike cycle is the byproduct of an expansionary global economic cycle. As forecasted by the Fed, the US economy is expected to grow between 4.5-5.5% in 2004. Even its labor market has shown signs of revival with more than 1.2 million payroll jobs created in the first five months of this year. As for the Euro zone, 1Q04 growth surprised to the upside at a 2.4% annualized rate. And Japan has beaten the US in terms of real GDP growth in the past two quarters. For the year, a 3% growth estimate now seems conservative. Therefore, moderate rate hikes should not choke off global growth. Instead, it simply mirrors such developments.

The surging oil price in recent months pose a greater threat, with New York futures price still hanging around USD38 a barrel. Oil crisis in the past had sunk many economies. Yet this time around, it doesn't seem to be another supply shock. Instead, rising demands caused by global economic recovery, heightened speculation and terror premiums are to blame. As the US has almost completed building its strategic oil reserves and OPEC has decided to increase production to counter price surges, oil price is expected to stabilize within the range of USD30-35 a barrel in the third or fourth quarter this year. Although an oil crisis can be largely ruled out at this juncture, high oil price can still hinder our economic growth as it may complicate monetary policies, cause unnecessary tight credit conditions, weaken domestic consumptions, and compromise our efforts to lower costs.

China's macro tightening will have greater impacts on Hong Kong as our economic ties with the Mainland have become closer by the day. Since China embarked on the tightening track last year, except for the laggard CPI that is still rising, rise in other important indicators such as money supply, bank credits, FAI, industrial production and some raw material prices all showed signs of slowing in the last two months. Evidences are gathering for successful tightening efforts and a soft landing. As the SARS disease last year also created a low base, China's real GDP growth in 1H04 can reach double digits as well. Even if growth decelerates by 2-3 percentage points in 2H04, China can still produce respectable growth of at least 8.5% for the year. The soft landing in China may reduce demands for service exports and goods re-exports of Hong Kong. And if the China concept becomes unattractive to investors, hot money may flow out of Hong Kong, causing declines in local financial markets and reducing wealth effects. It is therefore conceivable that Hong Kong's economic growth may have synchronized slowdown of about three percentage points in the 2H as well.

Internally: Confidence Matters

There should be little doubt that growth rate in Hong Kong will slow in 2H due to the high base in 1H and the hanging uncertainties. But many favorable internal elements should be able to offset many of the impacts, which are deemed moderate at best, and safeguard our recovery.

Put it simply, the revival in consumption and investment confidence is believed to be the most important internal driver of growth. In 1Q04, both private consumption expenditure and gross domestic fixed capital formation grew at rates of more than 5%, a phenomenon not seen in the past three years. And in April, retail sales and volume surged by 23.0% and 19.9% year-over-year from the low bases caused by SARS last year. And the trend of strong growth should continue until November, based on last year's sales figures. Without a doubt the major contribution comes from surging tourists. But the recovery will not be as significant without the participation of Hong Kong consumers. For example, in 2003, retail sales declined by 2.3% even though tourist spending was slightly up according to the Hong Kong Tourism Board, implying it was the retreat of Hong Kong consumers that was responsible. By the same reasoning, retail sales could not have rose so strongly without local residents' consumptions as they account for 75-80% of the total sales. Moreover, faster growth in consumer products and durable goods lend support to such an argument.

Besides consumption, even though overall building and construction output was still weak, overall investment spending was up 5.8% in 1Q04, supported by rising machinery, equipment and software investments amidst growing confidence in improved business outlooks. This serves as evidence of reviving investment confidence.

The still weak building and construction activities have much to do with the Government's policies to stabilize the property market, including suspension of land sales, suspension of public housing construction, coordination of the Two Railway Companies' property development projects and diminishing land reserves of developers. As a result, new building projects have yet to gather momentum to offset the successive winding down or completion of projects started some years ago. As a matter of fact, the property market's rise since the SARS bottom has been almost nonstop. Only until May did signs of consolidation emerge, namely contraction of transaction volume and rolling over of price, which are contradicting the signals sent by the Government's recent successful land sales that fetched prices 70-80% over the initial indications. How do we explain such a phenomenon?

The consolidation is the natural outcome after nonstop surges for almost a year. According to the Rating & Valuation Department, private domestic flats, private offices, private retail shops, and private flatted factories have recorded price increases ranging from 19-50% from the SARS bottom. During the process, some pent-up demands have been met and new demands need time to develop. And the emergence of new uncertainties did not help. Even so, the trend of demand and supply moving towards balance remains intact. As deflation and unemployment are expected to continue to improve, the property market should resume normal and balanced rise in the third or fourth quarter.

In July or August this year, Hong Kong will probably bid farewell to the deflation that has haunted the territory for almost six years. In fact, for six months in a row, retail sales have outgrown retail volumes, suggesting renewed pricing power in the retail sector already. It is the lagging nature of the rental component in the CCPI that is still causing price declines on the year-over-year basis. As CCPI bottomed in July and August last year, even if we assume a flat CCPI from now on, a positive reading of year-over-year comparison will emerge in July or August this year, signaling the end to deflation.

Hong Kong's latest unemployment rate was 7.0% for the March to May period, demonstrating small improvements over the past several months. This has much to do with more job seekers, encouraged by the reviving economy, deciding to rejoin the labor force, thus more or less matching the new jobs created by the economy. As Hong Kong's nominal GDP resumes growth, the economic expansion should continue to create more jobs that will ultimately benefit more people.

Raising Full Year Forecasts Amidst Uncertainties

Based on the analysis above, we have made the following revisions to our 2004 growth forecasts first made at the end of 2003:

• Private consumption expenditure growth is revised upward from 3.0% to 5.0%, matching 1Q's growth.
• Government consumption expenditure growth is revised upward from 0.0% to 1.5%, matching the Government's own estimate.
• Gross domestic fixed capital formation growth is revised upward from 3.7% to 6.0%, slightly better than 1Q's 5.8% growth. It reflects the comprehensive nature of the recovery, with expenditure on building and construction also improving on developers' optimistic expectations.
• Goods exports and imports growths are revised upward from 10.0% and 9.5% to 10.5% and 10.9% respectively. The higher imports growth has already factored in the effects of rising domestic demands and re-exports.
• Services exports and imports are revised upward from 11.0% and 4.5% to 13.5% and 5.0% respectively, reflecting strong performances of the tourism and trade services sectors.
• The growth of Gross Domestic Product (GDP) is revised upward from 5.0% to 6.5%, reflecting strong 1H growth and moderating growth in 2H.
• Decline in CCPI is revised upward from –1.0% to –0.5%, due to the rising consume price and last year's low base. The GDP deflator is expected to decline by 1.5%, as estimated before.
• The target of unemployment rate at yearend is revised upward from 6.0% to 6.3%, with the annual average also revised upward from 6.5% to 6.7%, reflecting moderating pace of improvement.

Although we revise upward of our full year growth forecasts, we remain wary of the economy's vulnerability to external shocks as the economic transformation is still underway. Besides those known uncertainties such as rate hikes and oil price surge, there could be others such as new terror attacks, structural deficiencies embedded in the global economy and markets, or unpredictable financial crisis. We must do our best to treasure and safeguard the growth momentum. Only by taking advantage of the opportunities offered by CEPA and expediting the economic transformation can we reshape the growth model that will rely more on sustainable internal growth rather than fluctuating violently with every external shock.