The growth characteristics in 2006

(a) High growth for three consecutive years

Given the growth in the first three quarters averaging 6.8%, the full year growth rate will reach 6.5% if the economy decelerates to no less than 5.7% in the forth quarter. If realized, it will be far greater than the trend growth of 3.9% in the past decade despite the moderation from 8.6% and 7.3% gains in 2004 and 2005 respectively. The real GDP could average 7.5% for 2004-2006, which was not seen even in those bubble years such as 1997 and 2000. A higher three year average growth will have to be traced back to 1987-1989. The strength and longevity of this recovery are rare without the usual ups and downs.

To make it more significant, the US economy slowed markedly in the third quarter to 2.2% from 2.6% in the previous quarter. Meanwhile, China's economy expanded at 10.4%, also decelerating from 11.3%. It was Hong Kong's virtuous internal economic cycle that helped shrug off the external weakness. On the seasonally adjusted basis, growth hit 3.5% in the third quarter, the highest since 3Q03 after staying flat in the second quarter. If using the US methodology to calculate the annualized growth rate, it could reach double digits.

(b) Internal demands dominated the growth spectrum

External demands had been the major driver of growth in Hong Kong until 2005. Then things take a sharp turn, with internal demands contributing the majority of the growth momentum nowadays. In the third quarter, private consumption expenditure and gross domestic fixed capital formation contributed 2.3% and 2.8%, or three quarters of the total 6.8% growth. In other words, net exports of goods and services only contributed a quarter of the overall growth. This is the exact opposite of the past few years. Year to date, domestic demands have contributed two thirds of the overall growth, suggesting that there is still room for pickup even though they already account for most of the economic growth. They will help the economy to shrug off any external weakness. This explains why Hong Kong's economic growth accelerated amid slowdown of the external economies.

It is noteworthy that gross domestic fixed capital formation rose 12.7% in the third quarter, the highest since 4Q00, sparked by a 22.4% surge in machinery, equipment and computer software investment. The contribution to growth from investment in the third quarter surpassed that from consumption for the first time in three years, signaling that current growth momentum is underpinned by both consumption and investment instead of relying solely on consumption. Although it is too much to ask for a repeat of double digit growth, the more balanced growth will be crucial for sustaining the relatively fast growth in the future.

(c) The finance sector saw accelerating growth

The finance sector has long been hailed as pivot of Hong Kong's pillar industries. This year, it is experiencing accelerating growth at rates well above other sectors. Its weight in the overall economy is further increasing to 22.2%. According to GDP by economic activity in real terms, the financial services industry surged 22.2% in 2Q06, the greatest gain amongst all industries and far greater than the growth in overall services sector and the economy. Moreover, exports of finance, business and other services rose 11% in the third quarter, also beating the 8.6% increase of the entire services exports. The growth of business receipts indices for financing (other than banking) and banking was also the highest among all sectors in 2Q06, surging 57.2% and 24.1% respectively. These spurred the average labour earnings in the financing, insurance, real estate and business services to jump 5.0% in the second quarter to lead all sectors.

Besides the remarkable growth and size, Hong Kong's robust financial markets have bolstered the value-added capability of the sector. Amongst all the expenditure components, gross domestic fixed capital formation, with nominal growth at 19.3% and real growth at 12.7%, and export of services, with nominal growth at 14.1% and real growth at 8.6% in 3Q06, registered much more significant nominal growth despite the overall GDP growth is roughly the same in both nominal and real terms. With the value of services exports being about 1.4 times of gross domestic fixed capital formation, the former contributes more to value added. With the financial services registering a 45.3% nominal growth in the third quarter that topped the 11.0% real growth of its group, it demonstrates the enhanced its pricing power and value-added capability.  

(d) High growth with low inflation

Notwithstanding consecutive high growth for three consecutive years and wage hikes, inflation remains subdued in Hong Kong. The GDP deflator slipped 0.2% in the third quarter mainly due to the terms of trade. And CCPI increased modestly by 2.3%, demonstrating high growth with low inflation. The increase in investment and some services prices were offset by tangible goods prices. Such a phenomenon is no unique to Hong Kong. The US and China are also experiencing only mild inflation, attributable to globalization. Even when the global and Hong Kong financial markets are flooded with liquidity, asset price appreciation has not spilled over to consumer price. That helps maintain robust growth with low inflation in Hong Kong.

(e) The construction sector has yet to recover

As a blemish in an otherwise perfect thing, the construction industry has yet to participate in the economic recovery. The building and construction investment still posted declines along with government consumption expenditure, extending the loss by 5.7% in the third quarter. Although building and construction activities by the private sector picked up, fall-off in public sector output overshadowed the overall sector. In view of this, the Policy Address suggests increasing public investment to meet future challenges. In fact, the Government can afford to increase public investment given rapid economic growth and improved public finance. Boosting investment in trade, logistics, tourism and culture related infrastructures can add to economic expansion, improve construction employment and consolidate Hong Kong's long-term advantages.

The economic outlook in 2007

(a) Moderating but more balanced external growth

Further slowdown in external economies seems inevitably in 2007. The IMF calls for the global economy to grow at a decent 5.1% this year. Although the US economy succumbed to 2.2% growth in the third quarter, rebound in the fourth quarter could carry it to the forecasted 3.4% growth for the year. The Euro zone and Japan are projected to grow by 2.4% and 2.7% respectively this year, all accelerating from the previous year to different extent. China, the fourth largest economy in the world, has grown 10.7% through September, making the full year target of 10.0% within easy reach. But this year's acceleration could easily give way to deceleration due to higher comparison base and growing headwind.

According to the IMF, the US, Europe, Japan and China are poised to grow by milder 2.9%, 2.0%, 2.1% and 10.0% respectively next year. Separately, the IMF sets the 2007 global growth target to 4.9% or 0.2% lower than this year. But the growth gap between the world's major economies may narrow in the midst of slowdown, which looks more cyclical than structural. For the US, Europe and Japan, the slowdown mainly reflects impacts from the lagging effects of higher energy prices, interest rate hikes and housing market corrections. For China, the slowdown can be traced to the macro-control measures and efforts to fine-tune the growth structure. Barring any unforeseeable disastrous outcomes from geopolitical tension and financial shocks, the global economic outlook next year should not deviate much from IMF's forecasts.

The Hong Kong economy is small and open. But that doesn't necessarily mean its economic cycle will move exactly in sync with the external ones. Its merchandize trade will no doubt be affected by the global environment. But trade with China and other Asian markets registered double digit growth in the third quarter, whilst exports to Europe and Japan's markets only inched up 1.9% and 0.6% respectively. Exports to the US even slid 1.1%. 49% of our total exports are destined for the Mainland. The US and Japan nowadays only accounts for 15% and 5% of our goods exports. Therefore as long as China maintains high growth, Hong Kong's goods exports can maintain high single digit growth next year despite the slowdown in demands from the US, Europe and Japan.

On services exports, robust merchandise trade should stimulate related trade and transportation services. Travel services exports should remain upbeat supported by growth of tourism. The active financial markets should lend further support to the already booming finance and business services. Thus services exports are expected to only experience marginal slowdown next year.

(b) Virtuous cycle of domestic consumption will be sustained

Private consumption expenditure is contributing more to growth as the growth impetus shifts from external to internal. Judging from the various developments on this front, it is believed that the virtuous cycle of domestic consumption will be sustained. Moreover, it seems to be lagging behind the overall GDP growth, picking up pace in spite of the slowdown in headline growth. It is this unique feature that will keep it maintain healthy growth in the coming year.

Real GDP growth jumped 8.2% in the third quarter of 2005, the fastest quarterly growth in this economic upturn since 2003 if stripping out the low comparison base effect caused by SARS. But private consumption expenditure only manage to grow 3.6% in that quarter before accelerating to 5.1% in the second quarter this year. This adds to the evidence that private consumption expenditure lags behind GDP growth under normal circumstance. Such a lagging effect can be attributed to factors including change in labour market, wage increase and wealth effect, etc.

Unemployment rate is lagging economic indicator. Even though both the yearly and quarterly GDP growth may have already peaked, the unemployment rate and underemployment rate still make new lows of 4.5% and 2.3%, and total employment surges to an all-time high of 3.5 million. Even the manufacturing and construction sectors are showing signs of revival. The labour market prospects do not seem to be deteriorating with economic moderation, which in turn lends support to consumer confidence.

Separately, labour earnings as measured by payroll per person engaged in the private sector rose 2.2% in 2Q06, with Salary Indices for Managerial and Professional Employees picking up 3.7%. Gains in those two indices exceeded that in CCPI, which increased 2.1% in the same period. As for next year, numerous surveys find that the private sector may see the largest wage increase in a decade at 3% or more on average. Civil servants who have suffered from wage freeze and pay cut in recent years may also have pay raise next year. Hence, that would mark the first time since 1997 when both private sector wages and CCPI increase, with the former exceeding the latter by notable margins. It is the conservative stance of private employers that help create such lagging effects, which also lends support to future consumption.

Another critical factor to consumption is the wealth effect. This year is quite unique in that stock market is skyrocketing but the property market is basically flat. The wealth effect is overwhelmingly geared toward the stock market. The trend is consistent with the global asset prices. Tremendous liquidity retreating from the housing and commodities markets is put in stocks as short-term official interest rates are lifted amidst economic slowdown. After all, interest rake hikes and economic slowdown will hurt returns from housing and commodities. But the outlook of corporate profits remains sanguine (the S&P 500's EPS growth hit 20% in the third quarter despite the US GDP only grew at 2.2%), and speculations of rate cut make stock markets the safe heaven for capitals. As a result, stock markets rally around the world, with the Hang Seng index surging about 30%. Its rally accelerates from last year and extends into the fourth straight year thanks to the China factor. The uneven performances and wealth effect of the stock and property markets look set to persist in 2007.

In 1997, both the stock market and the property market surged. But in 2000, only stocks racked up hefty gains while the property market continued to tank. The resulting consumption bubbles were thus much bigger in 1997. The current wealth effect bears more similarities to the year 2000 due to the divergence of the stock and property markets, alleviating some concerns of consumption bubbles and arguing for sustainable growth.

(c) Investment expansion set to continue

Investment is another driver for domestic demands. The gross domestic fixed capital formation's 12.7% increase in the third quarter is the fastest in six years, contributing more to GDP growth. But the surge in investment may be distorted by the low base last year when investment only rose 2.8% in the third quarter, lagging behind the headline growth 8.2%. Under normal circumstances, it should grow roughly at par with the overall economy, just like the first two quarters this year.

Decisions by private enterprises to invest in machinery, equipment and computer software are mainly driven by the economic outlook, corporate profits and business confidence. Currently, the business society is optimistic toward the economy in the future. The record run of the stock market is not only driven by capital inflows, but more importantly, solid corporate profit growth. According to the latest Report on Quarterly Business Tendency Survey, corporations generally view the near term business environment as positive. Thus corporate investment is expected to maintain healthy expansion, as supported by the greatest wage increase to be granted in almost a decade and Hong Kong's enhanced attractiveness to foreign direct investment.

The experiences in 1997 and 2000 suggest that a buoyant stock market or property market would be sufficient to spur investment to grow faster than the overall economy. This adds to the evidence that wealth effect would also help foster expansion in investment. 

(e) Moderating but still solid growth

The case for sustainable growth in both the global and Hong Kong economies remains solid even though incidents such as higher oil prices, interest rate hikes, geopolitical conflicts, financial shocks, natural disasters and public health scares took place occasionally. Barring any unforeseeable disastrous outcomes, the cyclical downturn of the economy will likely remain mild even though the same risks may well persist throughout 2007. However, close attention must be paid to new uncertainties arising from the possible collapse of asset prices triggered by reversal of capital flows and their impacts.

We have revised upward our full year growth estimate to 6.5% to from 5.0% for 2006 in midst of better-than-expected expansion in Hong Kong. After reviewing the various factors, we project the Hong Kong economy to grow by 5.0% in 2007, a rate still higher than the trend growth rate. Average inflation as measured by CCPI will accelerate to 2.5% from 2.2% whilst the unemployment rate is expected to fall further to around 4.0% next year.

It is noteworthy that the tenth anniversary of Hong Kong's Handover next year may trigger commemorating activities that may further bolster economic activities and the financial markets. The above forecast has not taken into account the extra boost to consumption and investment and is thus a neutral one.

Hong Kong Real GDP Forecasts (%)