For the first three quarters of this year, the Hong Kong economy maintained an above trend real growth of 6.1%. As long as growth in the fourth quarter is no lower than 5.5%, the full year average can top 6.0%, culminating the best four-year average at 7.1% since the period from 1986 to 1989, even though growth has decelerated for the fourth consecutive year.

Not only so, with inflation rising, 3Q07's GDP deflator recorded the largest increase in nine and a half years at 3.4%. Nominal growth of 8.5% for the first three quarters is the fastest since 1997. The divergence of real and nominal GDP growth helps reinforce the sentiment that the economic recovery is still running strong. Through improving businesses, appreciating asset prices and salary hikes, the fruits of economic recovery are shared by all.

Domestic consumption and investment contributed most of the growth impetus. Private consumption expenditures, government consumption expenditures and gross domestic fixed capital formation accounted for 83.7% of the 6.1% growth for the first three quarters of the year. The traditional drivers of goods and services exports prove to be marginal to the overall growth. Instead of being lackluster, real exports of goods and services actually rose 7.6% and 11.0% respectively in the same period. It was the greater increase of goods imports that reduces net exports' contribution to GDP, a phenomenon first seen since the recovery. Hong Kong's dependence on the external trade is greatly reduced.

Driven by such internal drivers, the unemployment rate declines to new low, the inflation rate rises to new high, and the stock and property markets also hit the fresh highs. The unemployment rate dipped to 3.6% for the period of September to November, the lowest since February to April 1998. And its momentum to improve remains intact. Meanwhile, a weak US dollar, an appreciating RMB, imported inflation and end of the Government's rates concession all helped push the CCPI to 3.4% in November, a new high since June 1998.

Although the US subprime woes and China's tightening measures led the Hang Seng Index to correct by more than 10% from its historical high by the end of November, it is still up 43% from last yearend, gaining for the fifth consecutive year on rate cut hopes, continuing capital inflows, H shares becoming index constituents, and expectations of fund flows from China. As for the property market, private residential property price rose by 14.7% in the first ten months of the year, making a recovery high. Some luxury flats' prices even exceed 1997's records.

Under such circumstances, the HKSAR Government's consolidated surplus for the fiscal year 2007-08 could more than double the original budget of HKD25.4bn. And its fiscal reserves could surpass 1997's record within a year or two. The Policy Address therefore announces cuts to salary and profit tax rates, further rates concessions, and pursuit of ten mega-infrastructure projects. If successfully implemented, they will help reinforce domestic investment impetus.

External tests

But for the growth prospects in 2008, Hong Kong will face numerous external tests, the severity of which will be the most since the recovery. Internally, there are also challenges that should not be overlooked.

The external economies will likely experience synchronized slowdown, while the United States even comes under the threat of recession. Even China's growth will likely moderate for the first time in six years following tighter macro control measures. In the global financial markets, the risks of credit crisis, stock market crisis and/or dollar crisis are on the rise. China's asset prices are also ripe for deep correction that could substantially impact Hong Kong.

According to IMF's latest report of the World Economic Outlook, global growth is expected to peak in 2007 after the best two year performance in two decades. Its forecast of 4.8% global economic growth in 2008 will be the slowest in five years. All major economies are expected to experience slowdown, with the US projected to slow to 1.9% and China to 10.0%. Against such a global backdrop, the Hong Kong economy is unlikely to buck the trend.

Moreover, recession risk to the world's largest economy and Hong Kong's second largest trading partner, the US, though still minor, can not be ignored. Even though its Q2 and Q3 growth rates this year were high at 3.8% and 4.9% respectively, the full year growth will likely decline to 2.3-2.5%, a rate considered below trend. And next year, the possibility of a quarterly contraction cannot be completely ruled out because the headwinds are strong.

The slump in the US property market will most likely continue. Data all point to further downside, with new home and existing home sales shrinking, inventories rising, and building permits and new home construction declining. OFHEO's property price index was down 0.4% on a quarterly basis in Q3 for the first time in thirteen years. Since both cyclical forces and structural forces are depressing the US property market, the correction could be protracted and painful. A few interest rate cuts will not be enough to stem the fall. As the housing slump will weigh on construction investment and hold back consumption, with no new drivers emerging to replace it, the US economy looks set for further slowdown.

Moreover, the relapse of subprime woes could trigger a credit crisis. In case of bankruptcy of a major financial institution, a stock market crisis could ensue. A credit crisis will cap consumption and investment activities, while a bear market that features twenty percent or more decline in major stock indices will take away the only asset price pillar left to support consumption. In this case, the recession risk will become prevailing. The Federal Reserve's substantial interest rate cuts may save the day, but they could risk a dollar crisis instead.

The dollar index against six major currencies in the world is making a historical low. And the US dollar is being used as a carry trade currency due to the market's conviction that the Fed has no choice but to continuing to cut rates. Although favorable to improving the current account balance, a weakening dollar could invite massive dumping of dollar assets, which in turn could lead to US stock and bond market collapse. To avoid such a dire scenario, the Fed cannot do it alone and the world's major central banks will have to cooperate to ensure of orderly dollar depreciation.

Impacts from China

As for China, it faces completely different challenges from the US. The policy objectives of preventing economic overheating and distinct inflation pressure are formally set, suggesting that macro tightening will continue until satisfactory results are produced. Consequently, it is believed that China's economic growth will slow after six years of acceleration. As domestic consumption remains healthy, it is fixed asset investment and trade surplus that need to be curbed. Monetary policy has shifted into the tightening gear. Although the current 6.9% inflation is almost entirely caused by food price inflation, it should not be ignored because wide spread inflation expectations are being formed. It may be too late to address if it is allowed to climb to double digits. As such, policies will be further tightened to achieve multi-prone objectives.

China's asset prices constitute another uncertainty. After ten increases of reserve requirement ratios and six hikes of interest rates this year, the property market fever along coastal cities seems to come under control, with price gains moderating and transactions plunging. If the overall price begins to decline under policy pressure, China will then join the rank of declining global property markets, and it will surely have economic consequences. As for the Mainland stock market, by November, the Shanghai and Shenzhen 300 composite index has corrected nearly 20% from its historical high of 5891.22 made on October 17, closing in on the bear market definition by common wisdom. But the volatile market is nowhere as scare as the slow and painful bear market that preceded this great bull run starting in 2005. Nevertheless, with greater financial integration and market interaction, its volatility could still ripple through Hong Kong and have mixed implications.

Challenges from within

Now that Hong Kong has reduced its dependence on goods and services exports, the impacts from global synchronized slowdown will be less severe than before. Even though demands for Hong Kong's goods and services will likely slow, further reducing net exports' contribution to growth, internal demands will take up the slack. In this case, the overall economic growth will hinge on domestic growth impetus.

Domestic consumption will continue to be supported by improving labor market, declining unemployment rate, greater salary hikes, and favorable outlook for corporate earnings. But the wealth effects form five consecutive years of rise of stock market and property market will be heavily influenced by external shocks. If asset price appreciation is checked by external market volatilities, capital inflows dry up or even reverse, the wealth effects could turn negative. And domestic consumption and investment will suffer accordingly. Along with decelerating exports, the Hong Kong economy will again experience volatile ups and downs.

The endgame depends on the interaction of several forces. What are the chances of a crisis in global financial markets and how will it impact Hong Kong? Will Hong Kong's capital inflows be reversed? Are there offsetting forces? As long as the world's major central banks do not make strategic mistakes, risks of financial crisis are still considered minor. Hong Kong's domestic demands should be able to escape with little scratch. Two forces will further alleviate the gravity of the situation.

The first is interest rate cuts. The US rate cut cycle is expected to progress deep into next year after three consecutive cuts this year. Such cuts are needed to lessen the damages from the property market bubble bursting as well as to forestall subprime induced credit and stock market crises. As Hong Kong's Hibor remains at deep discount to Libor, Hong Kong banks are likely to follow suite when the US cuts rates again. With far superior economic fundamentals, such interest rate cuts mandated by the Peg will offset the multiple risks posed by the external economies and markets. The HKMA's prior intervention to bring down Hibor has paved the way for the Hong Kong and US interest rates to move in sync, buying another insurance policy for Hong Kong's asset prices and their wealth effects.

The second is China's opening policies, which are expected to continue next year, directly injecting funds into Hong Kong and helping Hong Kong to attract international inflows as well. The reasons for optimism lie in that in order to prevent economic overheating and inflation spiral, to combat excess liquidity from excessive balance of payment surplus, and to alleviate the RMB appreciation pressure, expanding outward direct and portfolio investment remains an effective option.

Hong Kong will likely run into renewed inflation pressure and widening income gaps. In Q4 this year, CCPI will likely top 3% or more. And on this year's low basis, next year's CCPI will shoot up to 3.5% or higher without the Government introducing more rates concessions. Multiple forces are at work to lift imported inflation, including the HKD depreciating along with the USD, oil price making new high, and the RMB appreciation. Internally, wages and rents are surging as well. As a free market economy, such side effects to growth are inevitable, and only the Government's fiscal measures could produce partial offsets.

During these several years of economic expansion, the financial sector has led the way, resulting in uneven performances across all sectors, such as between high end and low end service sectors, and between service and manufacturing sectors. The income gap is widening. The issues of wealth redistribution, sharing of economic fruits and reducing social conflicts pose new challenges. Again, thanks to the Government's fiscal strength, the job is made easier.

2008 forecasts

The global synchronized economic slowdown will certainly reduce demands for Hong Kong's goods and services. And if the global stock market and foreign exchange market are thrown into tumult, they will create havoc to Hong Kong's financial markets and reduce the wealth effects. But as long as the US monetary and fiscal policy makers do not stand on the sideline due to misguided optimism, they should be able to help avert credit and stock market crises, restore market confidence, and eventually help sidestep a confidence induced recession. Meanwhile, higher alert and closer cooperation by the world's major central banks can go a long way toward forestalling a dollar crisis. Under such circumstances, Hong Kong will stand a better chance of weathering the perfect storm.

As for China, albeit slowing, real growth is still expected to remain robust at double digits. Assuming any Mainland asset price corrections remain orderly, the spillover effects should not be too negative for Hong Kong. And more opening policies should continue to lend support to Hong Kong's asset prices. With good internal fundamentals, the baseline forecast continues to call for healthy economic expansion in Hong Kong next year.

Therefore, we forecast that real economic growth will reach 5.0% next year, above trend for the fifth consecutive year, with domestic consumption and investment remaining the main growth engines. Under pressure from multiple sources and providing fewer new offsetting measures, the CCPI will shoot up to 3.5% or higher next year. Taking price changes into account, Hong Kong's nominal economic growth will increase rather than decrease, probably reaching 8.5-9.0%, a new high since the recovery. Hong Kong's economic vibrancy may not subside after all. And the unemployment rate will decline further toward 3.5% by next yearend with such economic resilience.

Hong Kong Real GDP Forecasts (%)

Sources: the Census & Statistics Department, BOCHK Research