Positive surprise: accelerating private consumption expenditure

Although the overall pace of growth slowed by 35% in the Q2 from Q1, growth in private consumption expenditure bucked the trend and accelerated to 5.0%, the fastest in six quarters, and contributed over half of the growth momentum. The last time such a phenomenon took place was 2Q04 due to the low comparison base affected by SARS in 2003.

When compared to the 7.3% real GDP growth of 2005, Hong Kong's pace of growth will undoubtedly moderate this year. But growth in private consumption expenditure in the first half was faster than any quarters last year, showing divergence from the overall growth and is underpinned by numerous favorable elements. Firstly, 2006 marks the first year since the Asian Financial Crisis that wages in the private sectors are raised the most across the board. Secondly, the labor market continues to improve, with the latest unemployment rate declined to a five-year low of 4.9%. The employment prospects of all sectors, except construction, can be described as bright or improving. Thirdly, although the property market was relative quiet in the first half this year, the wealth effects from the stock market, which recorded double digit increase and robust turnover, proves to be positive. Last but not least, massive capital inflows related to IPO activities in the first half provides abundant liquidity to the Hong Kong's banking system and prevents banks from raising interest rates along with the US during the last several rounds of hikes.

As a result, the growth momentum has turned from external to internal, dominated by private consumption expenditure. This makes Hong Kong's growth pattern similar to that of the US, boosting our ability to deal with the volatile external demands and sustain the above trend growth in the next 6-12 months period.

Negative surprise one: declining government consumption expenditure

As for the expenditure components that slowed Q2's growth, the first was the contracting government consumption expenditure. It was down 1.3% against the backdrop of robust economic activities and the government's improving fiscal position, reflecting the resolve to continue to rein in spending. The ratings agencies rushed to upgrade Hong Kong's sovereign ratings or outlooks based on such developments. But generally speaking, the government can increase spending in line with the improving revenues. The lack of such spending in Q2 cost about 0.2% of growth. And it may also impact the consultation of GST as one of the opposing arguments suggests that reining in spending itself is sufficient to ensure long term fiscal health, and the current tax regime only needs to be fine tuned instead of dramatic reform.

Negative surprise two: marked slowdown in gross domestic fixed capital formation

Gross domestic fixed capital formation grew 4.3% in Q2, a 40% moderation from Q1, costing 0.8% of GDP growth and contributing only 19.2% of Q2's growth instead of the 22.5% in Q1. Yet the interpretation should still be positive because Q1's growth of 7.6% was underpinned by an unsustainable 23.3% growth in machinery, equipment and computer software investment. Their growth moderated to a more reasonable 12.8% in Q2, offsetting the still negative growth of -6.4% in building and construction investment. Moreover, the 4.3% overall investment growth is actually in line with the average in the two and a half year of recovery. The slowdown is nothing more than reversing to trend growth, and therefore should not be seen as a sign of deteriorating investment confidence.

Negative surprise three: significant moderation in goods exports

The largest impact to Q2's performance came from the slowdown of growth in goods exports. Compared to Q1's 14.4% growth, it slowed to 6.4% in Q2, the slowest pace since mid 2002. Goods imports also slowed down significantly from 14.0% to 6.7%. Net exports, as a result, contributed negatively to GDP growth. Even when combined with change in inventories, goods trade accounted for only 1.9% of the growth in Q2, a far cry from the 20.0% contribution in Q1.

In the 6.4% growth in goods exports, both domestic exports and re-exports showed significant moderation. Growth in domestic exports was still high at 25.7%, albeit down from Q1's 44.4% pace. It is the growth of re-exports, which accounts for 90% of total exports that slowed so markedly from 12.8% to 5.3%. Exports to the US, Taiwan and Singapore markets even recorded declines. And exports to China also slowed by half to 11.4%. China's goods exports grew by 24.1% in Q2 as opposed to 26.2% in Q1, only a slight moderation. Thus the gap between Hong Kong and China's exports widened significantly. Is this due to temporary or structural factors?

It is believed that special and/or seasonal factors played an important role in Q2. The trade protectionism imposed on Chinese textiles by the US and Europe in 2H05 triggered a rushing of shipments by exporters in Q2 last year. The rush even spilled over to goods that were not eventually threatened. As a result, the comparison base last year was exceptionally high for May and June. Domestic exports seemed to have returned to the era of quotas. As such impacts are deemed one time only, and with the normalization of trade flows in the second half last year, the gap between Hong Kong and China's trade should narrow going forward. As for concerns about structural shifts that China exports are taking less of the Hong Kong route and threatening Hong Kong's trade intermediary function, the Hong Kong Port Development Council's statistics tell a different story. They showed that container throughput of Hong Kong port reached two million TEUs in each month in Q2. The average growth was 10.9%, a rate faster than Q1's and the re-exports growth during the same period. This should help dispel concerns about Hong Kong ports being marginalized for now.

Negative surprise four: surge in services imports

In the second quarter, services exports grew 8.6%, roughly at par with Q1's 8.9%. But growth in services imports accelerated markedly from 4.9% to 7.9% in Q2, reducing the contribution from net exports of services to GDP to about 1.5%, lower than the 2.1% in Q1. Outbound tourism and offshore trade related demands for transportation services accounted for the majority of the difference. But again, seasonal and/or technical factors are believed to have distorted last year's comparison base.

Second half prospects and forecast revision

The goods exports and services imports that impacted Q2's growth are related to the external demands. With their normalization in 2H05, the external growth momentum should resume. In July, Hong Kong's goods trade recorded double digit growth with imports and exports growing at 11.4% and 10.7% respectively, supporting the above conjecture. Moreover, even though there may be some migration of growth momentum from external to internal, Hong Kong economy has always been an externally oriented one, such changes should be gradual. Q2 is more of an exception than the norm with domestic consumption and investment accounting for 70% of overall growth. Thus, Hong Kong should see more balanced growth both internally and externally in the second half this year.

Internally, private consumption and investment should maintain their pace of growth in the second half because rising wages, improving labor market and positive wealth effects look set to continue. With the lagging effects of private consumption, internal demands should continue to underpin the above trend GDP growth.

Property market was subdued in the first half this year, with price stalling the transactions falling. But the tide will turn in the second half because developers will adopt a more active approach to sell flats to protect their full year earnings. The recent strategy of offering new flats at prices close to the second hand market is successful in boosting transactions. Thus, the property market should at lease recover in terms of volume in the second half. And although the land application system saw little action in the first half, the government still took in about HKD14 billion in land related revenues due to the railway projects and developers paying land premiums to modify lease conditions so as to replenish their land reserves. This suggests that the property market has not stalled because of the land application system.

But externally, the situation gets delicate. The US economic growth will slow in the second half from 4.3% to about 3.0% or less due to high comparison base and lagged effects of higher oil prices and interest rate hikes. The consolidation in its property market has an ominous feeling, which will no doubt affect the all important private consumption. But on the other hand, the improving European and Japanese economies should be able to partially offset the slowdown in the US, lending supports to Hong Kong's exports. The Euro zone's Q2 growth amounted to an annualized 3.6% growth, higher than the 2.9% in the US. And Japan was confident enough to end its zero interest rate policy and started raising interest rates.

In the early 1980s and then 1999-2000, synchronized interest rate hikes by the US, European and Japanese central banks foreshadowed global recessions. But this time the result should be different as high oil prices are unlikely to trigger oil crisis and hyperinflation. Nor is there any major stock market and property bubble on the edge of bursting. Besides, the three central banks have vastly different blueprints as to the total magnitude of hikes and the phase in the rate hike cycles. The US is set to wrap up its rate hike campaign, which should help stabilize the world's largest economy. Hong Kong's interest rates should peak as well.

In China, the growth momentum remains too strong to have meaningful decline. But rounds after rounds of fiscal, administrative and monetary polices are lunched to curb the overheating investment, its effects are still rather moderate. The impacts on Hong Kong therefore will be two folded. Real economic activities will remain robust, especially trade, because the final demands are coming globally. China's efforts to fine-tune its trade structure lie mainly in boosting imports instead of restricting exports. But the macro tightening measures may negatively impact Hong Kong's asset prices and wealth effects, which in turn may be partially offset by the pending large IPOs. Thus, the net effects from China are believed to remain rather positive.

As Hong Kong still registered a decent 6.6% growth in the first half, and momentum is strong in domestic consumption and investment, the growth prospects in the second half should remain favorable if the technical and seasonal factors plaguing the Q2 growth recede. As a result, the full year growth reaching our original forecast of 6.5% is still quite probable. To conclude, we have decided to maintain our forecast and continue to monitor the trend of the US economy and interest rates and await more data before making any revisions.

Hong Kong Real GDP Forecasts (%)

Source: Census & Statistics Department, BOCHK Research