• September's composite CPI fell 3.7% yoy, marking Hong Kong's 47th consecutive months of deflation. Hong Kong's weak domestic demand continues to be a severe drag on the economy. With uncertain global outlook coupled with sliding property rentals, we see no relief in deflation in coming months.
  
  
• Despite weak domestic demand and slowing export growth, we believe HK will not slide into recession but grew moderately in 4Q, supported by revival in trade-related and tourism sectors.
  
  
• Nevertheless, we expect growth of exports could slow on uncertain US growth in the first half of 2003. Meanwhile, US west coast port issue will also create uncertainty on the territory's export momentum. As a result, we lower our 2003's growth forecast from 3.5% to 1.8%.

Deflation: No respite with weak consumption and sliding property prices

The territory has locked in a structural deflationary spiral under the linked exchange rate system. Composite CPI fell 3.7% yoy in September, extending the territory's deflationary trend to a 47th straight month. Prolonged decline in property rentals (30% weight of CPI), cheaper food prices from the Mainland (27% weight of CPI) and government's relief measures (dampening the composite CPI by 1.1 percentage points over a year earlier) are the key sources of deflation.

Looking ahead, amidst uncertain global outlook, weak domestic demand and easing property prices, we see no respite at least for next few months (Chart 1). Good news is we don't think it will deteriorate much further from here as the effects of relief measures dissipate and low base effect kicks off. Further, the government indicates that it plans to step in to boost property prices. This, in turn, could help stabilize general prices.

Economy: Bottoming out despite deflation, thanks to rise in exports

Despite strong deflationary pressure, Hong Kong's 2Q02 real GDP rose by 0.5% on year, slightly better than our expectation of 0.2%. As expected, exports of goods and services continued to be the key drivers of economic recovery, rising by 8.6% and 5.9% respectively. Consumption, however, weakened further amidst concerns over job security and deepening deflation (Table 1).

Looking ahead, facing weaker job security and volatile financial markets, consumers are encouraged to save more. In fact, after the territory being hit by the Asian crisis, marginal propensity to consume is found to ease to 0.26 in 1998-2001 from 0.41 in 1994-1997. Weak domestic demand does not mean Hong Kong will slide into recession but grows moderately in 4Q, as the revival in trade-related and tourism sectors helps support the economy.

In 4Q02, we expect growth of exports of goods could slow on uncertain US growth, despite a low base in the same period a year ago due to 911 incident. Meanwhile, US west coast port lockout will cast shadow on the territory's export momentum (Chart 2). However, August visitor arrivals in Hong Kong leaped 20.5% yoy to a record 1.5 million. We expect the influx of mainland visitors would continue to boost the tourism sector in 4Q (tourism receipts accounted for 5% of GDP in 2001), in particular, during October's National Day holidays this year. While tourism expands robustly, exports of financial and business services could sustain as more Chinese enterprises such as the heavyweight, China Telecom, plans to list in HK by the end of Oct.

Nevertheless, we expect growth of exports of goods could slow on Mid-East war threats and uncertain US growth in the first half of 2003. Meanwhile, US west coast port issue will also create uncertainty on the territory's export momentum. On the domestic front, consumption will still be weak, constraining by high unemployment, negative mortgage equity and deflation. As a result, we lower our 2003's growth forecast from 3.5% to 1.8%.

Daniel Chan
Economic Research
Tel: 2218-8230