Summary

The Hong Kong economy is adjusting to both a cyclical downturn and a structural transformation. The external environment has further deteriorated after the 11 September terrorist attack on the US and the following military action in Afghanistan, dashing any hope of a recovery by end-2001. Economic restructuring, which brings rising unemployment, declining property prices and persisting deflation, has exacerbated the pain. Aggressive interest rate cuts so far have failed to fuel domestic demand. The room for more government stimulus is limited as the fiscal deficit is ballooning. Our GDP growth forecast for 2001 is revised down to -0.7%. As global economic conditions are unlikely to turn around until at least Q2 next year, growth for 2002 will probably be slow. We expect the economy to grow by 1.1% in 2002.

Decline in exports to continue

As the world's major economies are now in a synchronised downtrend, Hong Kong's export growth is expected to post steep declines in the coming 3-6 months. Before 11 September, Hong Kong's export growth was already in a declining trend and there had been doubts as to whether US consumer spending could be sustained. The terrorist attacks expedited the fall in US consumption. Export orders from US buyers have been put on hold. The economies of Europe and Japan are also weakening, and may get worse as the US economy falters. But the impact of the slide in global demand on Hong Kong's exports will not surface until late-2001 and early-2002. This probably means exports will not recover until the second half of 2002, and it is likely that export growth for 2002 as a whole will also be negative. It is true that China's robust growth will continue to cushion the adverse trading environment faced by our exporters. Yet the downside risk is that if US consumer spending collapses, it will eventually take its toll on China's exports, and hence Hong Kong's re-exports.

Tourism industry is another victim

The tourism industry was doing quite well before 11 September. Tourist arrivals were up 7.4% yoy in the Jan-Aug period and tourism receipts up 7.2% yoy in the first half of the year. But the terrorist attacks have completely changed the scene. Tourist arrivals and revenue may see double-digit contraction in the coming months and layoffs in the hospitality industry are expected. The government has announced in the Policy Address measures to boost the tourism industry. The quota system limiting the number of Mainland visitors travelling to Hong Kong has been abolished. According to an estimate by the Hong Kong Tourism Board, the measures will attract an extra 300,000 Mainland visitors and bring in an additional HK$ 1.5 billion tourism receipts each year.

Domestic demand deteriorating rapidly

Domestic demand held up reasonably well in the first half of the year. Private consumption expenditure rose 3.8% yoy. But things are deteriorating rapidly. Retail sales have weakened substantially for the past 2 months. The expected drop in visitor arrivals and an increase in unemployment in the next few months will further weigh on spending. Fixed capital investment, which already saw a sharp slowdown in Q2, remains lacklustre, as shown by the low loan growth for domestic activities. As to the property market, transactions increased after the government announced a moratorium on the sale of subsidised housing until June 2002. Nevertheless, sentiment turned negative again after the 11 September terrorist attacks, while property prices remain under downward pressure.

Deflation to persist

Subdued domestic demand continues to put downward pressure on domestic prices. The prices of clothing and durable goods are some 5% and 7% below their year-ago levels. Deflation eased a little bit in the past few months, but is likely to worsen again as consumer demand weakens. Deflation may improve if the USD weakens. The dollar did depreciate a bit after the terrorist attacks, but has recouped some lost ground. While the fear of a prolonged warfare may prompt investors to switch to other safe-haven currencies, the USD is likely to remain attractive to a certain extent because of the stronger fundamentals of the US economy. Besides, the strong dollar policy is likely to be maintained to keep inflation in check, so as to leave room for further rate cuts.

Unemployment rate to climb higher

The unemployment rate, at 5.3% for the Jul-Sept period, is expected to climb higher in the months ahead. Total employment has stayed flat in the past few months but is expected to fall very soon. There have been more layoffs, which have spread from low-skilled jobs to professional positions. Some firms are also relocating their labour intensive operations into Mainland China. The government has announced that over 30,000 job opportunities targeting low-skilled workers will be created shortly. This counter-cyclical measure will surely help stabilise the labour market. But in the medium term, when the economy is undergoing structural change, it takes time for the skill mismatch between job seekers and job vacancies to resolve. Structural unemployment is likely to stay high for a few years.

Monetary and fiscal policies offer little help

Interest rates have been cut by 400 bps this year, and the US easing cycle has yet to complete. Lower interest rates help to alleviate the debt burden of many homeowners and companies. Yet unless the uncertainties over the economic outlook are cleared and confidence is restored, a low interest rate environment alone is not enough to revive domestic demand.

The Policy Address offered little fiscal measures to stimulate the economy or to relieve the current economic hardship. This is perhaps the right move. For one thing, the effectiveness of fiscal boosting measures may be limited as the leakage of the Hong Kong economy is high. Second, the ballooning fiscal deficit needs to be managed. Revenues from land sales, investment income and privatisation of the MTR (around HK$ 70 billion according to budget estimates) for this fiscal year will be substantially lower. The 01-02 fiscal deficit is expected to be a record high. In the medium term, the government needs to broaden the tax base. It is proposed that a consumption tax be introduced, but it is unlikely to be implemented in the next few years.

The 3 rigidities of the economy

The Financial Secretary said earlier that the currency board, the oversized public sector and the border restrictions were the 3 rigidities of the economy. His view sparked concerns over the future of the peg, but the Financial Secretary has re-iterated that it is not the right time to consider a change to the exchange rate system. We believe the peg will not be changed in the near term. It may be true that a cheaper currency lowers the cost of doing business, but it will also postpone the necessary economic restructuring. Higher productivity, instead of lower cost, is what Hong Kong needs in the long run.

It is appropriate to relax the border controls between Hong Kong and the Mainland, especially when economic integration with Guangdong or the Pearl River region takes place. But the inevitable consequence of increased mobility is that prices between the 2 places will converge. This means more downward pressure on Hong Kong's property prices and wages.

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