Growth Characteristics in 2005

(a) The first back-to-back high growth since the handover.

Based on 3Q's stronger than expected growth, the Government has significantly revised upward its full year growth estimate from the original 4.5-5.5% to 7.0%. Taking this into account, we also revised our forecast upward to 7.2%. If realized, this will mark the first back-to-back high growth since the handover, breaking the old pattern of a plunge in growth after a strong year.

In the year 1997 and 2000, Hong Kong economy grew 5.1% and 10.2% respectively, supported by the property and stock market bubbles. But in the year after, growth slowed significantly to -5.0% and 0.5% respectively, a plunge of roughly ten percentage points. In 2005, the curse will be lifted. Hong Kong will witness two consecutive years of above trend growth, which is around 4.0% according to the Government.

3Q's strong performance was actually acceleration from 2Q's strong 7.3% real growth. Netting off the low comparison base effect of SARS, the real GDP growth should be around 7.5% last year. If so, Hong Kong economy is expanding at similar pace in these two years.

(b) Growth is broad based, but trade dominates.

Just like last year, growth is again broad based. Amongst the average 7.3% growth from Q1 to Q3, private consumption contributes 2.2%, fixed capital formation 0.6%, net exports of goods plus change in inventories 2.7%, and net services exports 2.1%. The only drag is Government consumption and expenditure, which deducts 0.3% due to the honoring of its commitment to cut civil servants salaries by another 3.0% this year.

The way that trade and consumption account for most of the growth differentiates from the pattern before 1997. During 1995 to 1997, growth averaged 4.4%, with private consumption and investment contributed 6.1% and balanced by large trade deficits. This was a sign of domestic overheating and bubbles. Nowadays, trade dominates growth again, demonstrating the small, open and externally oriented characteristics of Hong Kong economy. The reward is that there is no immediate threat of domestic bubble. But the concern is that our economy is prone to volatility cause by the external environment.

(c) The labor market continues to improve and inflation continues to firm.

As lagging indicators, these two are still trending favorably. For the period from August to October, the unemployment rate has improved to 5.3% from the peak of 8.6% in 2003, with the 5.0% barrier at sight. More importantly, there has not been a single month of hiccup in its course of improvement, suggesting steady progress of the economic recovery.

Inflation rose to 1.8% in October, underlining the ideal combination of high growth and low inflation. Because of this, the Government is expected to restore balanced budget earlier than expected, and the private sector shows signs of wage hike pressure. As the housing sub-index within the CCPI is lagging the overall rental market, inflation should accelerate modestly in the future.

(d) New growth engine has yet to emerge.

What concerns us more is the robust growth in these two years has yet quickened the pace of the economic transformation or fostered new growth engines. Supports from the individual visitor scheme and the Disneyland are wearing out. Investment is still relatively weak, which can be interpreted as the lack of success in fostering new growth driver and the resulting lack of new investment.

The traditional financial and business and commercial service sectors enjoyed the most stable developments amongst all. But for the tourism sector, inbound tourists growth has already returned to trend at single digit. And for the logistics sector, Hong Kong container port throughput is growing at rates much slower than that of Shenzhen. Recent disclosure of the massive investment plans by a local tycoon in a Mainland container port project adds to the unease and threatens Hong Kong position in this area. As the progress of the Hong Kong, Macau and Zhuhai Bridge as well as the No. 10 container port project leave much to be desired, Hong Kong logistics sector is facing mounting challenges.

(e) Impacts from higher oil prices and rates are starting to bite. The Avian flu threatens.

Hong Kong's better than expected growth in 2005 seems to be a testimony to its immunity from higher oil prices and rate hikes. But we believe that such talks are premature. Hong Kong is well positioned to withstand higher oil prices because  services sector accounts for 90% of its economy. But indirectly, if oil wreaks havoc in the global economy, Hong Kong will suffer inevitably. And it is simply too early to confirm that oil prices have peaked.

Interest rate hikes always have a six to twelve month lagging effect. And Hong Kong banks' practice of hiking rates more aggressively than the US counterparts in recent months is putting pressure on both the property and stock markets, which are the main sources of the wealth effect. Therefore, it is believed that the full blown impacts will come next year.

The Avian flu could also threaten global trade and capital flows, which in turn could hinder Hong Kong's economic performance. Unfortunately, this is beyond our control.

Growth Prospects in 2006

(a) The global economy will inevitably slow down.

The current economic cycle for the global economy peaked in 2004. As predicted by the IMF, world production will slow modestly from the multi-year record of 5.1% in 2004 to still respectful 4.3% in both 2005 and 2006.

However, the performances of individual economies are expected to diverge. The US and China, which drove the global economy in the last two years, are expected to take a breather. Europe and Japan, on the other hand, might see better growth. But they are unlikely able to make up for the lost momentum caused by the moderation of the US and China. In 2005, the US economic growth might beat our forecast of 3.5%. And China growth might top 9.4%. But for these two dynamic economies, the writing of a cyclical slowdown is all over the wall. Higher oil prices and rising interest rates are beginning to curb the US private consumption. And the huge trade surplus of China will narrow on trade protectionism and pressure on the RMB. Therefore, our forecasts call for mild slowdown to 3.2% and 8.5% respectively for the US and Chinese economies in 2006.

Meanwhile, supported by a softer Euro and delayed rate hike actions by the ECB, the European economy is picking up pace and will accelerate further to about 2.0% in 2006 as compared to the 1.0%+ growth this year. Japanese economic growth in the first three quarters this year is decent on progress made in various structural reforms initiatives. Consensus is now calling for a 2.0%+ growth again in 2006. Nonetheless, the global trend is still set by the US and China, resulting in mild slowdowns across the globe, barring any major accidents, of course.

(b) The marginal effects of the central government policy favors are wearing out.

On the macro level, it was the trade performance of China that lifted Hong Kong trade and growth. To counter external pressures, China is likely to let its trade moderate, probably bringing growth in Hong Kong's total exports to a high single digit from this year's double digit pace. Absent any major stimulants, domestic consumption and investment might not be able to pick up the slack.

On the micro level, the growth of the tourism sector, which led Hong Kong to recovery two years ago, will revert to trend, meaning single digit growth in inbound tourists due to normalization of the base effects. As for the manufacturing sector, CEPA is likely to benefit a handful of industries such as clock and watch making only. The fate of textile and garment industry will still be subject to China's bilateral trade agreements. The further widening of RMB businesses is also more effective psychologically than practically. Therefore for the financial, manufacturing, business and commercial service sectors, the marginal benefits from the central government policy favors are wearing out. Logistics is even under intensive competitions before major infrastructure constructions are underway.

(c) Impacts from rate hikes should not be ignored.

Since the launch of the three measures by the HKMA to refine the Currency Board System in May, Hong Kong interest rates began to catch up with the US counterparts. Big banks have raised the Prime Rate by 225bp since mid May, outstripping the 100bp increase in the US. Under such pressure, the property market began to consolidate in both volume and price in recent months, so did the stock market, which are the main sources of Hong Kong wealth effects and consumption and investment confidences. Although the SAR Government is believed to stick to its current land supply mechanism for stability purposes, the property market's consolidation not yet over given more rate hikes are on the way. The overall economy is also reacting to the series of rate hikes, with investment bearing the brunt. And if the US dollar continues to rally, the boost from a weak dollar could also vanish.

(d) Growth momentum remains intact, the economy should be on the course of returning from above trend to about trend growth.

Barring any major accidents, the global economic slowdown should be mild next year. Therefore, Hong Kong's economy should be on a course of returning from above trend to about trend growth. Our forecast calls for the real GDP growth in 2006 to be at 5.0%, still higher than the SAR Government own estimate of the 4.0% trend growth. Inflation, as measured by CCPI, is expected to accelerate from 1.2% to 2.5% on average, and the unemployment rate should improve toward 4.5% by the end of next year.

But it must be pointed out that there are some risk factors ahead, including higher oil prices, interest rate hikes, terror attacks, financial meltdowns, natural disasters and diseases, etc. The uncertainties to growth are the greatest in three years.

The reason why impacts of potential uncertainties are expected to be greater is a direct result of the lack of success in Hong Kong's economic transformation and the creation of new growth engines. Hong Kong's economy is more prone to volatility caused by the global economic swings as its growth is dominated by external trade. Its pillar industries are all facing various degrees of challenges. The lack of any new core industries contributes to the fragile nature of domestic consumption and investment confidences. Any disturbance in the external sector as well as marked adjustments in asset prices could turn off the domestic growth engine, sending the economy back to a volatile pattern. This warrants our close monitoring.

Hong Kong Real GDP Forecasts (%)