Executive Summary

• Still driven by strong external demand, the Hong Kong economy has continued to expand in the third quarter, albeit with signs of less dynamism in consumer spending. The near-record high number of visitors and impressive trade expansion continued to fuel economic growth. After surging by 12.6% in the first half, the real economy might grow by at least 8% year-on-year in the third quarter.
  
  
• Hong Kong export growth will ease in the coming quarters on the high base effect and the economic slowdown in key export markets. However, the surprisingly strong productivity gains in US will help to mitigate parts of the adverse effect caused by high oil prices. Amidst the imminent approval of China's WTO entry and ongoing corporate restructuring, Hong Kong real investment could probably maintain moderate gain, as reflected in the sustained pick-up in imports for capital goods retained for local use.
  
  
• Helped by strong economic rebound and the stabilization in rental prices as well as the low base effect, deflation dropped to 2.8% in the third quarter, improving remarkably from 4.5% in the second quarter. The recent upsurge in oil prices would inevitably exert upward pressure on fuel and transportation prices. Inflation will likely emerge next year on better consumer sentiment and continued economic improvement resulting from China' WTO entry.
  
  
• However, investors are concerned about the uncertain outlook of interest rate movement which greatly depends on the direction of new US administration's fiscal policy. If the next US government adopts the inflationary Bush campaign proposal, the Federal Reserve may likely need to raise rates next year to offset its impact. If Al Gore's plans with a greater debt pay-down pledge are adopted, the Federal Funds rate may ease next year.
  
  
• The apparent risk also arises from the recent surge in oil prices as the prolonged high level of oil price has started to feed through into higher headline inflation and thus interest rates across the world. Apart from anxiety over oil shortage, the market fears that lingering clashes between Israeli soldiers and Palestinians could finally destabilize the Middle East and affect oil flows from the region. The direct impact of higher oil prices on the service-based Hong Kong economy is believed to be relatively mild, given the territory's low reliance on oil. However, if oil prices stay at more than US$ 30 a barrel or go further up next year, it could adversely affect Hong Kong's key trading partners via mounting production cost and interest rates.
  
  
• We maintain our forecast of 3.8% economic growth next year with the assumptions of temporary oil price spike and oil price falling below US$ 30 a barrel. However, if the oil prices persistently exceed US$ 30 a barrel, it could slow global economic growth, and hence reducing Hong Kong's economic growth to below 3.6% next year.

The Hong Kong economy continued to expand in the third quarter, driven by strong external demand, albeit with signs of less dynamism in consumer spending. Having surged by 12.6% in the first half of this year, we expect the economy to grow by at least 8% YoY in the third quarter. The government will release growth figures on 24 November.

Firm Domestic Demand

Given the broad-based recovery in the local economy and the easing unemployment rate, consumer spending has continued to pick up. However, the removal of the low base effect led to a modest 4.8% rise in retail sales volume during July-August, hindered by high interest rates and negative equity. Job security remains a pressing issue as people are still less prone to buying big-ticket products, and more importantly, the sharp rise in the number of cross-broader shoppers continues to drag on the pace of consumption recovery.

Nevertheless, imports of capital goods, raw materials and intermediate goods retained for local use remained strong in the third quarter, suggesting that the growth momentum of domestic investment can probably be sustained in the next few months.

Robust Trade Performance

The near-record high number of visitors (22.5% rise in September to 1.08 million) and strong offshore financial activities have continued to support economic growth. More importantly, on the back of unexpected strong U.S. consumption growth, steady expansion in Euroland and the robust import demand from North Asian economies, the merchandise export performance was impressive, rising by 17.6% in the third quarter (against a 17.3% rise in the previous quarter). On the other hand, with the strong re-export growth and the rebound in domestic demand, the growth momentum of imports of goods sustained, achieving 20.1% growth in the third quarter.

Deflation remains but improves

As consumers remain price sensitive and cautious about spending, retailers have continued to cut prices to stimulate sales. The consumer price figures have revealed that Hong Kong is still in a deflationary mode. Nevertheless, helped by strong economic rebound and the stabilization in rental prices as well as the low base effect on the granting of 50% rebate on property rates during the third quarter of last year, the deflationary pressure has gradually eased. The Composite CPI dropped only 2.8% year-on-year in the third quarter, improving remarkably from 4.5% fall in the second quarter.

Outlook

Although the growth momentum of external trade accelerated again in September, we still believe that export growth will ease in the coming quarters due to the high base effect and the economic slowdown in the major export markets. In particular, the pace of U.S. economic growth as measured by real gross domestic product (GDP) slowed considerably in the third quarter to an annual rate of 2.7%, far lower than the market forecast of 3.4%.

Amidst the imminent approval of China's WTO entry and ongoing corporate restructuring, we expect real investment spending in Hong Kong's private sector to show moderate gains, as reflected in the sustained pick-up in imports for capital goods retained for local use. Consumer demand will remain slack in the fourth quarter, thanks to the recent stock market slump and high interest rates. China's imminent WTO entry will help to lure more direct investment and bring about more business opportunities to improve consumer sentiment in 2001. In the public sector, spending will continue to gather pace on the gearing up of several key infrastructure projects, including the Disney theme park.

The recent upsurge in oil prices will inevitably exert upward pressure on fuel and transportation prices. Moreover, the price increases of local Chinese newspapers and the lower base effect will see deflationary pressure ease slightly in the reminder of this year, but the improvement will be affected by the high level of interest rates and slow rental rises. However, inflation will likely emerge next year due to better sentiment, wage increases and continued economic improvements resulting from China's WTO entry.

Major Concerns

As recent economic figures showed more signs of a soft landing in the US, the Federal Reserve will keep interest rates unchanged before the presidential election. However, investors are concerned about the uncertain outlook of interest rate movements which greatly depend on the direction of the new US administration's fiscal policy. If the next US government adopts the inflationary Bush campaign proposal, the Federal Reserve may need to raise rates next year to offset its impact. If Al Gore's plans for a greater debt pay-down pledge are adopted, the Federal Funds rates may ease next year.

However, the recent surge in oil prices could accelerate a global economic slowdown if oil prices remain at the same levels next year. The price of crude oil hit almost US$ 38 per barrel late September, more than treble the price at the end of 1998. The prolonged high level of oil prices has started to feed through into higher headline inflation figures and thus interest rates across the world, even though inflationary pressure has been much more muted recently than in the 1970s. Apart from concerns over oil shortages, lingering clashes between Israeli soldiers and Palestinians could finally destabilise the Middle East and affect oil flows from the region, which holds most of the world's petroleum reserves.

The direct impact of higher oil prices on the service-based Hong Kong economy is believed to be relatively mild, given the territory's low reliance on oil (oil imports accounted for only 2.2% of Hong Kong's GDP in 1999). However, if oil prices increase further next year, it could adversely affect Hong Kong's transport-related sectors and key trading partners via mounting production costs.

Following the recent plunge in global equity markets, corporations and consumers may start to curtail their spending. Together with the disappointing corporate results and fears over the outlook of the telecommunications sector in the near future, there is an ever-increasing risk of a hard landing for the US economy, which would adversely affect the global economy as well as Hong Kong's export performance.

In the labour market, the unemployment rate has dropped from a peak of 6.3% in mid-1999 to 4.8% in July-September 2000 and nominal wages have increased modestly. However, as Hong Kong is transforming itself to a knowledge-based economy, the problem of structural unemployment will persist next year with an unemployment rate averaging around 4.2%, higher than the pre-crisis level of 2%-3%. There is anxiety about Hong Kong's income inequality as corporate restructuring and slow wage growth will drastically change the livelihoods of most people, affecting consumption recovery.

Projection

After rebounding by 12.6% in the first half, the Hong Kong economy would grow by at least 8% year-on-year in the third quarter on the back of robust export growth and firm local demand. However, growth will likely slow to below 2.5% in the last quarter of 2000 mainly due to slower export momentum and very high base effect. The whole year growth is still forecast at 8.8%.

Given that Hong Kong is a service-based economy, high oil prices will have a minimal effect this year. More importantly, China's pending WTO entry and the surprisingly strong productivity of HK's key trading partner - US - help to mitigate parts of the adverse effect caused by high oil prices. Growth in 2001 will be underpinned by foreign investment flows once China joins the World Trade Organisation. Against this background, we maintain our forecast of 3.8% economic growth next year assuming a temporary oil price spike before falling back below US$ 30 a barrel. However, if oil prices remain over US$ 30 a barrel, it could slow global economic growth and hence reduce Hong Kong's economic growth to below 3.6% next year.

Updated Projections of Main HK Economic Indicators

Daniel Chan (Senior Economist, Economic Research, DaoHengBank)

Tel: (852) 2218 8230???E-mail: Danielch@guoco.com