• Uncertainty over the US housing market's impact on private consumption will pose a challenge to the external environment in 2007. We expect a US rate cut in the third quarter of 2007 in response to a weakening US economy. However, the chance of a US recession appears low.
  
  
• For mainland China, the main macro challenges continue to be overinvestment and excessive liquidity build-up. The authorities will have little choice but to apply a mix of monetary-based tightening and trade measures in 2007.
  
  
• In Hong Kong, domestic demand is expected to continue to display strength and liquidity will be a central theme of the year. The Hong Kong economy is expected to again deliver above-trend growth in 2007, although at a slower pace than in 2006 given the projected slowdown in external trade.

Mainland China

• There exists little sign of a natural slowdown in the economy, with the possible exception of exports.
  
  
• The major task continues to be the restraint of the monetary expansion that is being driven by liquidity build-up due to persistent external surpluses.
  
  
• Real GDP growth is expected to moderate slightly to 9.8% in 2007 with tightening monetary policy, while inflation will stay low at 1.4%.

Hong Kong

• Sustaining job growth is providing a boost to private consumption, which will fill the gap left by a slowing re-export trade in 2007.
  
  
• Assets markets are likely to benefit from the benign interest rate environment with strong interbank liquidity arising from the extremely active financial sector.
  
  
• Real GDP is expected to remain above-trend at 5.6%, with inflation moderately higher at 2.5%.

External Environment - Where is the US Economy Heading?

• A lack of consensus on the US housing market, the inflation outlook and the direction of the economy clouds the outlook for mainland China and Hong Kong.

The global economic environment has remained largely favourable in 2006 despite the significant slowdown in the US economy that has occurred since the second quarter. The US Federal Reserve paused its latest round of rate hikes in the second half of the year, which triggered rebounds in global financial markets. According to the most recent OECD projections, the output of OECD countries will grow by 3.2% in 2006, compared with 2.7% in 2005.

In assessing next year's global economic environment, all eyes are on the US housing market outlook and its impact on the US economy. Weaknesses in the housing market are evident, as shown across all data such as housing starts and housing sales figures, with house prices falling. These have triggered debate over the potential effects on the economy. As house price appreciations have given a strong boost to consumption growth, significant drops may trigger a huge reduction in consumption expenditures. On top of this, next year's inflation outlook also needs to be watched as Fed members have repeatedly expressed concerns over sustained inflationary risks.

As usual, however, there is a lack of consensus on these issues. While less divergent views are expressed regarding the housing market downturn, a huge disparity of opinion exists over its effects on consumption. The optimists believe that the impact of housing market corrections will be limited to the property sector, while the pessimists' view is that it will spill over into private consumption and might even induce a recession.

Added to this uncertainty is the outlook for inflation and interest rates. As shown by recent Federal Open Market Committee minutes and the speeches of several Fed members, Fed officials are uncomfortable with core CPI's 2.7% year-on-year growth in October. A further rate hike thus cannot be totally excluded. However, the financial markets feel otherwise, judging from Fed Fund Futures and bond yields, which currently indicate that rate cuts are expected next year.

These issues are likely to linger throughout the first half of 2007 and are clouding the outlook for mainland China and Hong Kong. We view the chance of a US recession as quite low as this could be avoided through aggressive rate cuts when needed. A reduction in energy prices would curb future inflationary pressure, and we believe a US rate cut will be made in Q3 2007 in response to a weakening US economy.

Mainland China - Controlling Money Supply Growth

• The main macro challenges continue to be overinvestment and growing external imbalances. The authorities will have little choice but to apply a mix of monetary-based tightening and trade control measures in 2007.

Four Straight Years of Double-digit Growth

As 2006 draws to a close, mainland China has recorded another year of impressive economic growth. For the first nine months, real GDP growth reached 10.7% year-on-year. Full-year growth looks set to hit our revised forecast of 10.5%, which would make 2006 the fourth consecutive year that the Mainland has achieved a double-digit increase. Investment and exports continued to be the twin drivers of growth.

In response to a series of policy tightening measures, real GDP growth slowed from 11.3% in the second quarter to 10.4% in the third. Nominal urban fixed-asset investment eased considerably, from around 30% in the first half to 24% in the third quarter and around 15% in October.

The shortfall in investment growth has been made up for by a more rapid expansion of exports, which has exceeded even the most optimistic market forecast. For the first 10 months, export growth reached 26.8%, outpacing that of imports by six percentage points. For the three months up to October, exports were persistently running at the 30% mark. The trade surplus hit a record USD123.5 billion for the first 10 months, up sharply from USD80.7 billion during the same period last year. The result has been another surge in foreign exchange reserves, which had reached USD1 trillion at the end of October 2006.

Main Challenges

Since April, various government authorities have implemented a range of monetary-based tightening policies to contain investment growth, including "window guidance" credit controls, increases in reserve requirements and interest rates, and foreign exchange sterilisation. While fixed-asset investment has responded to these measures, the government's concerns of overinvestment, overcapacity and overheating of specific sectors, particularly the real estate sector, have not dissipated.

Most importantly, despite significant liquidity absorption, net liquidity creation due to rising trade surpluses has remained rampant, adding further to the abundant liquidity in the banking system that is still driving rapid loan growth. M2 and deposits both rose 17.0% year-on-year in October, while loan growth was only mildly lower at 15.2%. The risk is that lending and investment may well surge again as a result.

Moreover, lower investment growth without a corresponding increase in consumption will tend to reduce imports and boost the trade surplus. Such a trend will create more liquidity build-up, which will lead to problems for monetary stability and trade relations. Macroeconomic stability will therefore very much depend on how the trade surplus can be brought under control rather than at what level interest rates are being set. This will be the biggest policy challenge in 2007.

Looking for the Right Policy Mixes

In its Third Quarter Monetary Policy Report, the People's Bank of China (PBOC) expressed concerns over a possible rebound in loans and investment. Despite another rise in the reserve requirement ratio in early November, continuing to mop up liquidity remains an urgent task for the PBOC.

However, this task is about to become more difficult. This year, the PBOC has so far sterilised some 67% of the liquidity increases that have been created by rising foreign exchange reserves. Total net foreign exchange sterilisation through issuing short-term bills in the first nine months reached RMB1 trillion, in response to an accumulation of RMB1.48 trillion in foreign exchange reserves.

The PBOC is now going into the fifth year of this sterilisation cycle. It has stepped up its efforts in the past two years, particularly since the end of 2005. However, as more bills become mature, the central bank is facing increasing pressures of redemption and will have to issue bills to replace the old ones before it can sterilise new injections of liquidity. At the same time, the interest burden on the PBOC is rising rapidly. From a cost perspective, this makes a hike in the reserve requirement ratio a better way to curb liquidity surges. The more conventional interest rate adjustment approach will also be important, especially as liquidity management becomes an increasingly difficult job. We believe both reserve requirement and interest rate adjustments will be the preferred policy options in 2007 as far as monetary tightening is concerned. There will also be at least two interest rate rises next year, which would bring the benchmark one-year lending rate close to 7%.

On the fiscal policy front, the government will continue to increase spending in 2007, mostly on social projects. Fiscal revenue has outpaced expenditure to a considerable extent this year, and both have outpaced budgetary targets by a wide margin. Tax revenue rose 25.1% in the first 10 months of 2006, while expenditures increased 16.7%, compared with budgeted increases of 11.7% in revenues and 9.7% in expenditures for the year as a whole. As such, the fiscal deficit for 2006 will further narrow from last year's 1.2% of GDP. Fiscal policy next year, however, will place stronger emphasis on the need to narrow wealth gaps across regions and between urban and rural households. There will be more spending on health, education and social security. A modest level of fiscal deficit tends to help reduce the trade surplus, which is currently desirable.

Outlook for 2007

Global growth continues to be robust while oil prices have settled to much lower levels. There are no strong signs of inflationary pressures on the Mainland, making it a weak case for economy-wide overheating. The old infrastructure bottleneck problems have largely been addressed as investments are turned into new capacity. Although raw material prices have been driven higher by hikes in oil and other commodities, rising by 6.2% in the first 10 months, the CPI came in only at a modest 1.3% during the same period.

Underlying demand conditions are supportive of rapid growth in the medium to long term. Private consumption has remained relatively unaffected by the ongoing tightening cycle, growing briskly but still lagging behind investment and exports. Real urban per capita disposable income jumped by 10.3% year-on-year in the first 10 months of 2006. Domestic demand continues to benefit from rising household incomes driven by buoyant export and manufacturing activities. Policy tightening has achieved orderly results without having an adverse effect on enterprise profits or unintended consequences for the banking system.

On the external front, global imbalances - large current account deficits in some countries (most notably the US) and large surpluses in China - have not been addressed and will take time to successfully tackle. A housing-led slowdown in the US is another risk factor looming over the horizon. However, robust growth in Europe, Japan and Asia would make up for much of the likely drop in demand from the US should this occur.

On balance, our base-case assumes a moderate slowdown of global demand. Along with recent changes in trade policies such as rules to restrict processing trade, reductions of tax rebates and increases of import and export taxes, this will undercut Chinese export performance in 2007. Our forecast points to an easing of growth of both exports and fixed-asset investment, to 22% and 20% respectively.

Together with a likely slowdown of global demand, we expect real GDP growth to ease to 9.8% in 2007, from an estimated 10.5% in 2006. The recent retreat of oil and commodity prices supports our view that inflationary pressures will remain benign. We expect headline CPI to stay at 1.4% in 2007.

Hong Kong - Watch Domestic Demand

• The pace of economic growth will depend on whether domestic demand can be sustained, which is in turn influenced by liquidity flows and interest rates.

Momentum Not on the Wane

While slowing to real growth of 5.5% in the second quarter of the year, the Hong Kong economy has since reaccelerated with a rebound in exports and sustaining growth in domestic demand. The 6.8% real growth registered in the third quarter was a nice surprise and puts the economy well on its way to achieve the revised full-year forecast of at least 6.6% real growth.

The resilience of the economy and its ability to deliver persistently above-average growth over the past three years has not been totally anticipated, but has been underpinned by a number of factors. Mainland China's stellar export performance and economic growth since 2002 is one major element, boosting goods passing through Hong Kong through re-export trade. Hong Kong's booming financial services sector is another area of growth. Government statistics show that the value-added of this sector grew by over 21% year-on-year in the first half of this year.

The continuous improvement in the labour market has also played an important role. Job growth regained momentum recently, with a net addition in employment of 69,000 in the third quarter alone. Employment growth is now running at a rate of about 3% year-on-year over the past three months and the unemployment rate fell to a five-year low of 4.5% for the three months ending October 2006. The tighter labour market also bodes well for salary growth prospects next year. All these factors have contributed to private consumption growth, which has stayed solidly above the 4% level in recent quarters.

While the external environment suggest a less rosy export outlook for 2007, the pace of economic growth will depend in large part on whether domestic demand can be sustained by the buoyant financial and job markets.

Liquidity Driven Growth

Interest rates will have a critical impact on the Hong Kong economy next year. Apart from the direction of US rates, a number of factors are likely to play a role in shaping the level of Hong Kong interest rates, including the renminbi exchange rate and the interbank liquidity, which will in turn be determined by the funds flow situation. Current signs indicate the strong likelihood that liquidity will remain abundant next year, thus pushing down interest rates and driving asset prices higher. Coupled with a buoyant labour market, this would underpin private consumption and also be conducive to growth in capital formation.

The stimulating effect of abundant liquidity on the economy has already been happening. The foremost impact has been lower interest rates in Hong Kong than in the US. With deposits rising at double-digit rates for most of this year and loans only growing at around 6%, the surplus liquidity has worked to suppress interbank rates for the Hong Kong dollar, which has been trading at a discount of 1 to 1.5 percentage points to the US dollar throughout 2006 (Chart 4). As a result, banks in Hong Kong cut their prime lending rates by 25 basis points in November without a lead from the US. Such an unexpected cut in interest rates delivered a positive signal to financial markets, which subsequently surged to record highs.

This is reminiscent of the period that started in the fourth quarter of 2003 as Hong Kong emerged from its lowest point since the 1997 Asian financial crisis. Strong liquidity flows, a result of strong speculation in the market on a possible appreciation of the renminbi, had triggered banks to cut deposit rates to essentially zero in the first quarter of 2004, setting the stage for the subsequent strong rally in the residential property market with property prices rising by 43% from mid-2003 to end-2004. Real GDP grew by 8.1% in the first quarter of 2004, and did not fall below 6% again until the second quarter of this year.

Many have expressed surprise at the moderate rate of consumer price inflation this year, projected at an average growth of 2.1% for the composite CPI, despite the rapid growth in money supply, the sustaining strong economy, higher energy prices and an appreciating renminbi. While many factors have contributed to price stickiness, not least the ongoing price pressure on durable goods, price inflation has in fact manifested itself in the assets market. Over the past four years, although the composite CPI has only risen by a total of 4%, residential property prices and the stock market, as represented by the Hang Seng Index, have surged 45% and 50% respectively.

Recent studies by the Bank of International Settlement have argued that the coincidence of low consumer price inflation and high asset prices in many countries has not occurred by chance. Instead, inflationary pressure has shown up in asset price inflation rather than in the conventional indicator of consumer prices. Apparently, extremely low interest rates have prompted investments in housing and financial assets, thus driving up asset prices, while prices of consumer goods have been curbed by expanding global capacity.

Outlook

The liquidity situation in Hong Kong is not expected to show much change in 2007 for several reasons. With fund flows to the Mainland displaying no signs of reversing given the huge growth differentials, the role of the Hong Kong capital market as a key venue for Mainland enterprises to raise capital is likely to continue to induce fund flows into the territory.

More important is the steady appreciation of the renminbi against the US dollar. The renminbi has now climbed to close to parity with the Hong Kong dollar (Chart 5). The local currency might exhibit a tendency to rise along with the renminbi at some stage given deepening Mainland/Hong Kong economic relations. With the two-side convertibility arrangement, new liquidity will be injected into the monetary system in the event that the Hong Kong dollar touches the upside limit of 7.75 to the US dollar. Should this occur, interest rates in Hong Kong would have further room to fall, even disregarding a likely US interest rate cut in the second half of 2007.

Forecast for 2007

Against such a background, the Hong Kong economy is expected to deliver above-trend growth of 5.6% in 2007 (Table 3).

Domestic demand is expected to continue to display strength and liquidity will be a central theme of the year. Overall investment spending is projected to show faster growth in 2007, expanding by a forecasted 9.5% compared to 9% growth in 2006. Private consumption is projected to attain solid growth of 4.5% in 2007, supported by better job prospects and rising income. CPI inflation is expected to go up from this year's estimated 2.1% increase, but remain benign at 2.5%.

The recent trend of strong momentum in job creation is expected to carry over into next year. Companies have to get additional hands, as increases in output cannot be achieved by rising productivity from existing staff. The unemployment rate has room to fall further if GDP growth outpaces labour force growth and productivity gains.

Hong Kong's labour force has been growing steadily by about 1.5% per annum and the average productivity gain was about 3% for the period 2000-2005. Real GDP growth of over 5% would therefore help create additional employment and drive down the unemployment rate in Hong Kong. It is expected that the unemployment rate will get down to 4% by the end of 2007.

Nevertheless, external sector performance is expected to be less impressive. In real terms, exports and imports are expected to grow at moderate rates of 7.5% and 7.9% respectively, slightly lower than the estimated growth of 9.3% for both in 2006.