A More Mixed Domestic Demand

As at the end of September 2007, the Hong Kong economy had achieved 16 consecutive quarters of above-trend growth, expanding 6.1% in the first three quarters of this year. Robust consumption spending has been a key factor, driving 64% of the GDP growth, while investment spending has been less impressive.

Private consumption jumped 9.7% year on year in Q3, faster than the 5.7% gain recorded in Q2. The government has twice revised its full-year forecast upward, from 4.5%-5.5% to 5.5%-6% in February and then to 6% following the announcement of these impressive consumption numbers. The revised official estimate is in line with our full-year forecast of 6.1%.

Signs of robust consumption spending have been evident in many leading indicators, including retail sales, retained imports of consumer goods and credit demand. This has occurred against a backdrop of an improving labour market, falling interest rates and soaring wealth from rising asset prices. Hong Kong's October unemployment rate dropped to a nine-year low of 3.9%. The value and volume of retail sales accelerated by 15.1% and 12.6% respectively year on year in Q3, after growing 9.1% and 7.9% respectively in Q2. Retained imports of consumer goods jumped 20.7% year on year in Q3. Loans for use in Hong Kong surged by 20.2% year on year in Q3, after growing by 14.9% in Q2.

The picture for investment spending has been more mixed. Investment spending was up a meagre 2% year on year in Q3 2007, after 10% growth in Q2. The moderation was due partly to a high base of comparison. It should be noted that company inventories were at high levels after expanding sharply in the first three quarters of 2007. Moreover, retained imports of capital goods - a leading indicator of business investment spending, dropped 19.7% yoy in Q3 2007, after declining 4.9% in Q2. This suggests that investment spending is likely to stay weak in Q4. Nevertheless, business sentiment remains positive. The government's Q4 2007 business survey showed that more respondents are expecting their volume of business to expand, and all sectors, except construction, expected to increase employment. We see a likely pickup of investment spending in 2008. However, the external sector looks less optimistic.

Cooling External Demand

With the full impact of the downturn in the US housing market yet to be felt, the growth momentum of Hong Kong's exports has already slowed. Total export growth eased from 10.1% yoy in Q2 to 6.4% in Q3 in view of waning US demand and mainland China's cut in export tax rebates. The openness of the Hong Kong economy, with the trade sector accounting for over 340% of GDP, means that the territory is highly susceptible to cyclical swings in external demand.

Global economic growth is expected to moderate due to the weakening of the US economy. Credit jitters and record oil prices also pose challenges to global demand. The latest data show no improvement in the US housing slump. The US Federal Reserve has reduced the US GDP growth forecast for 2008 from 2.5%-2.75% to 1.8%-2.5%. There are heightened fears of a US recession. It seems highly likely that the Fed will continue to cut rates to avoid such a scenario.

Notwithstanding the weakness of the US economy, the fundamentals of the global economy remain sound. For instance, the IMF is still forecasting solid world growth of 4.8% in 2008 despite an expected slowdown in the industrial economies. Also, continued strong growth on the Mainland and in other emerging markets will partially cushion the impact of a sharp slowdown in the external sector. We therefore anticipate only a moderate deceleration in Hong Kong export growth in 2008.

Upside Consumer and Asset Price Inflation Risk

A seemingly decoupling of Hong Kong from the US slowdown, however, may mean upside risk of consumer and asset price inflation. Although consumer price inflation for the first 10 months of 2007 was mild at 1.7%, the reading was distorted by government rates concessions and waiving of one month's public housing rental. October consumer prices climbed to a nine-year high of 3.2% yoy immediately after the rates concession ended. More importantly, underlying inflationary pressure is increasing.

Notwithstanding the strong domestic demand, Hong Kong has to follow the downward trend of US rates due to the link of the Hong Kong dollar to the US currency, pushing local real interest rates to historical low levels. Real interest rates, as measured by saving deposit rates minus the CPI inflation rate, have dipped into negative territory. This, in turn, will drive demand for goods and services, as well as financial and real assets. The Hong Kong dollar's peg to a weakening US dollar also makes local assets more attractive to international investors.

The property sector has turned in a strong performance this year. As of September, prices of luxury residential properties have gone up 17% while those in the mass market segment are 10% higher. Gains from financial assets have been even more impressive. The benchmark Hang Seng Index has climbed over 40% since August, with investors anticipating an influx of Mainland funds to the Hong Kong stock market via the extended Qualified Domestic Institutional Investors scheme and the new "through-train programme".

In view of the low interest rate environment that will be created by more rates cuts in the US in coming quarters and more inflows of funds, there seems to be plenty of fuel to drive consumer and asset prices up in 2008.

Forecast for 2008

The Hong Kong economy is expected to maintain growth momentum. With buoyant domestic demand likely to help offset softer exports, overall GDP growth of 5.0% seems within reach in 2008.

Domestic demand, in particular private consumption, is expected to continue to display strength and will remain the key driver of growth. Consumption spending is projected to record another year of strong growth at 6.4% yoy, compared with an estimated 6.8% in 2007. Overall investment spending is projected to show faster growth of 6.8%, up from an estimated 5.6% for 2007.

In contrast, the external sector is set to moderate on waning global demand. Exports and imports are expected to slow to 7.1% and 8.3% respectively, slightly lower than the estimated growth of 7.4% and 8.8% in 2007.

Against a background of steady demand growth, further US dollar and therefore Hong Kong dollar weakness, the accelerating pace of renminbi appreciation and low interest rates, consumer prices look set to rise by 3.5% in 2008.