The growth characteristics in the second quarter

Almost all sectors, including domestic consumption, investment and exports, grew at a faster pace than in the first quarter. Growth impetus in the first half of the year continues to surprise to the upside. Private consumption expenditure shot up 6.0% last quarter, after registering a better-than-expected growth of 5.3% in the first quarter. Growth of government consumption expenditure also accelerated from 2.4% to 2.8%. Gross domestic fixed capital formation marked the sharpest improvement. Whilst building and construction investment reversed the decline to add 5.3% last quarter, machinery equipment and computer software investment posted a double-digit growth of 13.1%. The overall growth of investment was hence lifted to 11.1%, following the relatively mild increase of 4.7% in the first quarter. In external trade, both exports of goods and services grew at faster pace, which raced up 11.3% and 10.9% in the second quarter respectively.

Separately, the seasonally adjusted growth rate on the quarter-over-quarter basis increased remarkably from 0.6% to 2.0%. If using the US methodology to calculate the annualized rate, growth topped 8.0%. Taking the price factor into account, the nominal economic growth hit 7.7% in the second quarter. Not only was it higher than the nominal growth of 6.7% in the first quarter, but it also exceeded the average quarterly growth of 6.6% last year by a substantial margin. The benefits are wide spread among community, supported by higher nominal economic growth.

Measuring the contribution from different components in the second quarter, internal demands provided the vast majority of the growth momentum, leaving a slim share to external demands even though exports growth showed no signs of weakening. Private consumption expenditure added 3.6 percentage points or 53% to total real GDP growth of 6.9% last quarter. Government consumption expenditure added another 0.2 percentage points or 3.0%, while gross domestic fixed capital formation contributed 2.6 percentage points or 38%. These three internal drivers combined contributed 94% of the total momentum. If we further take the contribution from the buildup of inventory by HKD5.1bn into account, it can be safely said that the growth momentum in the second quarter came almost exclusively from the internal demands.

However, it is noteworthy that surging internal demands do not necessarily reflect diminishing external forces. In contrast, exports of goods and services recorded double digit growth in the second quarter, even though the contribution from net exports to GDP was capped by the skyrocketing imports growth. Imports of goods increased considerably by 12.9% in the second quarter, underpinned by surging domestic consumption, investment, inventory replenishment and re-exports. As the total size of external trade is at a substantial portion of our economy, with total value of imports and exports of goods equaling 1.6 times of gross domestic product, widening trade deficits amidst rising goods imports acted as a drag on our GDP growth instead. Consequently, net exports of goods and services deducted 0.6 percentage points from the GDP last quarter, which had to be compensated by internal demands. For the first time since 2003, the contributions from net export has turned negative, suggesting that the dependence of our economy on external trade has been reduced to the smallest degree in the past four years.

Thanks to solid economic growth, tightened labour market and rising wages, domestic consumption and investment sentiment remained buoyant. The unemployment rate in the second quarter stayed at the nine-year low of 4.2%. Wages in the private sector registered the greatest increase since the Asian Financial Crisis. The Government also approved wage hike for civil servants whose salaries have been cut or frozen for years. The robust labour market is lending support to internal demands. In addition, measures adopted by Government, including rates concession and the recent cut in public housing rentals, have kept inflation in check, with CCPI gaining only 1.3% in the second quarter. Netting out the effect of rates concession, the CCPI still stayed mild at 2.4%. To sum up, the Hong Kong economy remained healthy and generally outperformed expectations in the first half of this year.

Direct impacts from the subprime crisis

Nevertheless, rising delinquencies on the subprime mortgages spread rapidly to other sectors and markets in the last two months, triggering credit crunch and market turmoil on the global scale. In light of this, Hong Kong's economic prospects in the second half would hinge critically on the evolvement of the subprime crisis and its related impacts on various markets. Up to this point, the questions about the seriousness and persistency of the subprime turbulence are left without concrete answers. The crisis is still evolving. In the worst case scenario, the US economy may slide into recession. As a small and open economy, Hong Kong would probably experience slower growth under the shadow of a slowdown in US, the largest economy in the world and the second largest trading partner of Hong Kong.

According to the latest economic figures, we expect the US economy to experience marked slowdown in the second half of the year. That could be attributable to cyclical slowdown, negative impacts on consumption and investment from the housing slump, and even worse, the contagion from the subprime fallout. IMF has downwardly revised the forecast of the US economic growth in 2007 to 2.0% in the latest version of World Economic Outlook released on 25 July, marking the smallest gain in the last five years. In the first two quarters this year, the US economy expanded at 0.6% and 4.0% respectively. Based on the IMF's forecast, its growth in the second half would not exceed 2.0% on average. In Hong Kong, our residential property market has no exposure to the subprime mortgages, and the extent of financial institutions engaging directly in the US subprime market or having exposures to the US subprime-related debt securities seems to be limited. Thus the spillover from the US subprime market is not expected to lead to systematic risks. Yet, our goods exports and re-exports could suffer in the midst of an economic downturn in the US.

But there are two developments that could help take some of the sting off the US slowdown. IMF has revised upward the forecasts of growth in the Euro-zone, Japan and China to 2.6%, 2.6% and 11.2%, concluding that the global economy could grow at a brisk pace of 5.2% in 2007. In other words, barring a catastrophic outcome from the subprime turmoil, burgeoning demands from other major economies could make up for the slowdown in US. Furthermore, China, as Hong Kong's largest trading partner, helps propel the regional trade in Asia that matters more than the direct trade with the US. Like other Asian economies, the dependence of China's exports on the US demands is declining gradually. The European Union has now emerged as China's largest trading partner, with the values of exports from China to EU rising 36% in the first six months of this year, doubling the gain in exports to the US. Providing that the major economies other than US remain healthy in the second half of this year, Hong Kong is in a better position to withstand slower US growth.

Unlike the previous years during which external demands acted as the main driver for growth, internal demands dominated the growth spectrum in the first half of this year. They help our economy to shrug off the external shocks, adding to the evidence that direct impacts from the subprime fallout on Hong Kong could remain mild.

After all, the judgment about the impacts of the subprime crisis would ultimately fall on the endgame of the subprime woes itself. Although the spillover from the subprime turmoil is extensive, the biggest concern is neither the slowdown in consumption or investment, nor the retreat of stock markets or reduced carry trade but the global credit crunch and earthquake in the fixed income market stemming from the opaque subprime securities. Elevating subprime fallout rattles investors and triggers a broad based reluctance to lend, regardless of the credit conditions of borrowers. Real economic activities thus suffer from the abrupt credit contraction. Recovery of investors' confidence is of paramount importance in this case. Globally, central bankers have taken prompt actions to prevent the crisis from further deteriorating. Policymakers in major economies have intervened at the early stage of the crisis, and explicitly expressed the willingness to take any measures necessary. Due to such efforts, global economic recession and financial crisis are less likely to emerge despite that the subprime ripples are likely to spread further amidst persisting housing slump in the US.

Indirect impacts from the subprime crisis

On the other hand, one must stay alert that in case the depressed sentiment rooted from the subprime crisis is not adequately addressed, global equity, bond and property markets would presumably stay volatile, and may eventually head south. Risks from the negative wealth effects and backlashes from investors' sentiment on internal demands should not be overlooked.

Yields on the US Treasury bills dropped sharply lately on demands for the safest securities as investors feared that mortgage papers could not be fairly priced. The flight to quality helped the three-month T-bill yield fell nearly 2 percentage points in a single month. On the other hand, serious withdrawal of liquidity caused the short-term commercial paper market to seize. Even the most creditworthy borrowers have to face the difficulties on fund raising after the fixed income market was plunged into fear mode. Fortunately, Hong Kong has yet to face such challenges in the local credit market. Corporate financing in Hong Kong is primarily conducted through banks loans rather than issuance of short term commercial papers. Lending standards of local banks remain largely unchanged due to the limited extent of local lenders engaging in the US subprime mortgages and related investments, even though slight tightening in short term interbank market was observed with short term Hibor rising some 30-50bp. The HKMA has not joint in the liquidity injection actions by other central banks, suggesting that the market order has to yet be disrupted.

Besides, confidence crisis should pave the way for earlier interest rate cuts in the US, which should help cushion investors' sentiment. The US central bank has already used most of the tools including liquidity injection and discount rate cut, fulfilling its role as lender of last resort to restore order to the markets. The only major weapon left is a cut in the federal funds target rate. The interest rate futures is projecting a 100% chance of an imminent rate cut on or before the FOMC's September 18 meeting, and should the Fed lower its benchmark interest rate, the measure would not be an isolated event. Indeed, market expectations are pushing the Fed to the corner. If policymakers fail to cut rates as expected, market sentiment that is already on the verge of collapse could be fatally hurt. Commencement of a rate cut cycle can be considered an effective measure to stabilize the credit and bond markets. Although bankers in Hong Kong may not adjust their prime lending rates on the Fed's first rate cut, Hong Kong's credit environment could still benefit.

The story of the stock market is a different one. The Hang Seng index experienced thousand point plus daily fluctuations in August. The total market capitalization of Hong Kong stocks was ranked the 6th largest in the world, so volatilities similar to those of emerging markets were indeed unusual, suggesting heavy distortion by the subprime crisis. And it remains possible that confidence crisis and fund redemption stampede could lead to liquidations by international investors in our market despite solid fundamentals. But thanks to China's financial liberalization measures, especially SAFE's announcement allowing direct individual investment in Hong Kong securities, such a worst scenario was averted on fund inflows as well as US rate cut expectations. Hong Kong stocks have not only recouped all losses but scaled new highs already. Yet, they remain vulnerable as long as the surprime woes continue.
 
Hong Kong's property market was vibrant before the crisis and remains stable during the crisis. There is no inherent bubble and the supervision is top notched. Besides, the growth prospects of both China and Hong Kong, the opening of the West Corridor and individual investment scheme all help sustain property investment confidence. The surprime crisis that is ravaging the US housing market is unlikely to impact the local market directly.

Therefore, so long as the Fed and other major central banks do not turn a blind eye to the subprime crisis, and the global stock markets can escape the Armageddon, the impacts on Hong Kong's financial markets and asset prices should be limited. With increasing income and purchasing power, the boom in internal demands should be sustainable and help buffer the moderating of the wealth effects in the second half of the year. Our economy should be able to maintain decent growth under such circumstances.

Revision of full year growth estimates

In view of these, although the US subprime crisis is far from over, strong Chinese growth as well as its liberalization measures will help offset the impacts. Barring catastrophes in the global stock markets and central banks becoming complacent, the Hong Kong economy should be able to maintain above trend growth in the second half of the year even though the pace could be moderating. Thus, we decide to raise the full year estimate of Hong Kong's real GDP growth from 5.0% to 5.8%. As for inflation, it should remain at the mild 1.5% level with the government's tariff waivers offsetting imported inflation, etc. The labor market should continue to improve with the unemployment rate probably declining to 4.0% or lower by yearend.

Hong Kong Real GDP Forecasts (%)

Dai Daohua
Senior Economist