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January, 1999
Introduction
After more than a year of financial turbulence, the Asian economies (including Hong Kong) are finally showing signs of stabilising. Many of the worst hit Asian currencies have rebounded by more than 30 percent from their lowest levels, and interest rates have eased. Hong Kong can be said to have weathered the worst of economic times.
However, it will take time to heal Hong Kong¡¦s economic wounds. Real GDP has declined for three consecutive quarters, and company closures, wage cuts, and layoffs are constantly in the news. Consumer confidence has taken a hammering. In the third quarter of 1998, private consumption expenditure in real terms dropped 10.0 percent from the year before. As wholesalers and retailers scrambled to cut prices to attract business, inflation has nosedived.
There are fears that as people expect continued declines in prices, they will postpone spending. When this happens, it will accelerate the fall in consumption expenditure. As a result, manufacturers will reduce production, and the economy may fall into a deflationary spiral. In Hong Kong, however, this is less likely to happen. The deflationary pressures are mainly externally driven, and the economy is small and open in nature. Any signs of external economic recovery should reverse the deflationary trend. In this analysis, we will discuss the relationship between wages and private consumption, and the deflationary trend in Hong Kong.
Relationship Between Wages and Private Consumption
Common sense tells us that with less cash in hand, people will cut spending. However, in the real world, this is not always the case. During the period from the fourth quarter of 1995 to the third quarter of 1997, nominal annual growth of private consumption expenditures accelerated, even though the growth of nominal payroll per person ("wages") decreased moderately (see Chart 1).
The deceleration in wage growth did not affect consumer sentiment, mainly because of the declining unemployment rates and the rising wealth effect. From the fourth quarter of 1995 to the third quarter of 1997, the unemployment rate fell from 3.5 percent to 2.2 percent, while stock and property prices surged by an average 53.5 and 62.5 percent respectively.
The Asian financial turmoil changed the whole picture when it hit Hong Kong in October 1997. In particular, the positive wealth effect vanished as the property and stock markets collapsed. Wages assumed a new and more important role, as the possibility of pay cuts and job insecurity increased. The decline in consumer confidence has caused private consumption expenditure to fall more than twice as fast as wages.
People anticipating a fall in income reduce their spending and increase savings. BEA Economic Research estimates that a one percent fall in wages in 1998 would have reduced private consumption expenditure by about HK$648 million. However, if people in 1998 had expected wages to drop by one percent in 1999, private consumption expenditure in 1998 would drop by about HK$1.2 billion. These results are well understood because people may not change their lifestyles to which they are accustomed, unless they expect their lifestyles to sever ahead. Throughout 1998, companies announced plans to freeze or even cut wages/bonuses in 1999. People have already cut their expenditure at that time. As a result, the momentum of the fall in private consumption expenditure is expected to ease in 1999.
Disinflation and Deflation
An Era of Disinflation
Overall inflation as measured by the Composite CPI has been moderating since 1991 (see Chart 2), especially since 1995. In particular, prices of meals away from home have been deflating rapidly since 1991, and prices of basic food (same as "food exclude meals away from home" in the Government¡¦s statistical reports) have done the same since 1995 (see Chart 3).
The declining trends in these two components appeared to be sustainable. In our previous Economic Analysis (April 1997 issue), we pointed out that competition in the restaurant industry has put a lid on the growth of prices of meals away from home. This would remain so as long as competition remains fierce. In addition, prices of basic food were kept in check, thanks to the increasing supply of food from Mainland China and the calming of inflation there. (Retail prices for food in China rose 35.2 percent in 1994, and fell 0.2 percent in 1997. Inflation in China continued to decline in 1998.)
The growth of the housing rental (including rents and rates) component has also been drifting downward since 1995, though at a slower, maybe less noticeable, momentum. Rents for fresh lettings of private domestic premises ("spot market rental") increased 21.4 percent in 1994, yet fell 1.7 percent in 1996. The surge in spot market rentals by an average of 13.5 percent during the first three quarters of 1997 is best seen as stemming from the over optimism at that time. Future rises in housing rentals are expected to be tempered by the SAR Government¡¦s policy to stabilise the property market by increasing housing supply in the long-term.
Implications of Disinflation
Except for the prices of basic food, which were mainly determined by the Chinese factors, the lower inflation rates were the results of over expansion or over supply stemming from the pre-crisis bubble economy. The positive wealth effect particularly spurred inflation in housing rental and clothing & footwear between 1995 and 1997. These had offset the declining inflation rates. When demand in these two categories collapsed, the disinflationary trend became much steeper.
With prices continuing to rise slowly in the overall food component, and the liberalization of telecommunications will likely cause fierce price competition, inflation rates should stay low in the long-term.
Deflation in 1998 and 1999
Disinflation was already underway when the Asian financial crisis plunged Hong Kong into an economic recession.
Hong Kong slides into the first economic recession in 13 years. The rate of contraction of GDP accelerated from -2.7 percent in the first quarter to -7.1 percent in the third quarter of 1998. This directly introduced nominal deflation. The year-on-year growth of the Composite CPI dropped from 5.4 percent in January 1998 to -0.7 percent in November, the lowest level since the compilation of such data in 1981. However, the deflation in Hong Kong should be highlighted as being externally led.
Firstly, domestic demand in Hong Kong is highly dependent on imports. The downward trend in commodity prices, the deflationary pressures in China and the devaluation of Asian currencies (in particular, the Japanese Yen) suppressed import inflation to almost zero. Imports and retained import prices dropped by 5.0 and 7.0 percent respectively during the first nine months of 1998.
Secondly, the financial troubles in Japan and other parts of Asia have sent shockwaves through the domestic economy. Foreign financial entities and foreign investors downsized their Asian operations, leading to a liquidity crunch throughout the region. After growing at double-digit rates over the last ten years, the broad measure of money supply (M3) expanded by just 3.2 percent in September 1998.
Thirdly, the HK Dollar - pegged to the US Dollar - could not fall in value as other Asian currencies did. Instead, the currency board system took effect. Interest rates surged to prevent a vast outflow of HK Dollar assets. Then, asset prices, including those of stocks and property, tumbled by around 45 percent from their peaks. The wealth effect turned from positive to negative. The economic downturn is now creating unemployment and increased vacancy rates, reducing labour costs and rentals. All these downward adjustments together with banks¡¦ tightening of credit led to a contraction in domestic demand, which then depressed the general price levels.
As the economy is expected to remain bleak, the deflationary trend will probably continue during 1999. Much of it can be attributed to the decline of retail and restaurant prices due to sluggish consumer spending. Meanwhile, the deflationary trend of food prices in China, and downward correction in housing rentals and wages should continue. BEA Economic Research estimates that the Composite CPI for 1999 would fall to around -1.0 percent.
Implications for the Economy
The most devastating result of deflation is high real interest rates, which would discourage investment and invite savings. For example, if inflation falls to -1.0 percent and the prime lending rate is reduced to 8.5 percent, real interest rates will be 9.5 percent, making the cost of investment very high. In addition, deflation will swell the real value of debt, prompting people to unload their debts as much as possible. The incentive to save, on the other hand, is high, with a fixed deposit rate of around 6.5 percent, yielding a real return of 7.5 percent. In all, consumption expenditure is undermined.
BEA Economic Research forecasts that private investment will record zero growth and consumption will decline by 1.2 percent in 1999. Moreover, GDP will decline by 1.0 percent in real terms (see Table).
| Forecast of Major Indicators |
| |
Real Growth Rate |
| |
1998@ |
1999@ |
| 1. |
Domestic Sector
Private Consumption Expenditure
Government Consumption Expenditure
Gross Domestic Fixed Capital Formation |
-5.5
1.5
-5.0 |
-1.2
5.0
0.0 |
| 2. |
External Sector
Total Exports of Goods
Domestic Exports
Re-exports
Imports of Goods
Exports of Services
Imports of Services |
-5.0
-8.0
-4.0
-8.0
-5.5
1.0 |
-5.1
-5.5
-5.0
-4.4
0.5
1.0 |
| 3. |
Real Gross Domestic Product |
-5.0 |
-1.0 |
| 4. |
Inflation Rate# |
2.8 |
-1.0 |
Unit: Percent
@ BEA Economic Research Forecasts
# Based on Composite Consumer Price Index |
Nevertheless, the deflation induced by weak consumption may not be too worrying, as long as it doesn't spiral and lead to Japanese style stagnation (Notes 1).
Firstly, Hong Kong is a highly externally-oriented economy. A large portion of the domestic consumption is supplied by imports rather than local production. Moreover, the major engines of the economy are driven by exports of goods and services (such as services related to trade or international finance).
Secondly, Hong Kong is a small and open economy, which does not have barrier on the flow of capital and information. Market adjustments reflect all the bad news very quickly - so quickly that stock and property prices plunged by around 45 percent, and rentals fell by some 21 percent within a year. Even wages are on their way down, as unemployment rose fairly rapidly. Overall nominal wages (index of payroll per person) fell from the annual average growth of 9.0 percent in 1997 to the year-on-year growth of 3.0 percent in the third quarter of 1998. The new year, however, should be comparatively stable, preparing the economy to bounce back at the first signs of good news. Any signs of improvement in external economies would quickly lift the local economy back to a recovery track, and put the deflation to a total end.
Current bout of deflation should be taken as a process of correction after the bursting of the bubble economy, which has overblown levels of labour costs, rentals, property prices, and hence, the general level of prices. The lower level of costs and prices brought about by deflation will boost Hong Kong's competitiveness in the long-term. Along the process of deflation and economic contraction, the inefficient and redundant areas of the economy will be eliminated through market adjustments. Healthy economic growth would be restored.
Conclusion
If 1998 is considered to be the year during which Hong Kong economy took the blow from the Asian financial turmoil, 1999 will be the year for healing. The positive wealth effect has vanished with the bubble economy. Instead, fears of future salary cuts are affecting people's level of expenditure, reducing consumption and exerting downward pressures on the general level of prices. This is how half of the deflationary picture is formed. The other half has long been in the pipeline in the form of a disinflationary trend since 1995 - mainly the results of lowering restaurant and food prices.
Deflation, arising from a collapse in consumption, draws the most concern of people. However, it is not as great a threat as some might think, because the nature of Hong Kong's economy is externally-oriented - domestic consumption depends heavily on imports, and economic growth is external driven rather than production based. Moreover, the small and open nature of the economy should allow it to bottom out relatively quickly, once foreign investment returns to Asia.
Nevertheless, if one believes in "The Death of Inflation (Notes 2)" in the industrialised economies, import inflation may no longer be a threat to our local economy in the future. To secure the trend of disinflation, the SAR Government should further enhance competitions, particularly in telecommunications, fuels, and transportation, etc.
Chart 1 : Employment
From September to November 1998, the seasonally adjusted unemployment rate rose from 5.0 percent to 5.5 percent. The higher unemployment rate mainly resulted from corporate downsizing and layoffs, particularly in the manufacturing, business services, import/export trades and transport sectors. The unemployment rate will surge even higher, as more companies are expected to close down before the Lunar New Year.
Chart 2 : Inflation
Inflation measured by the Consumer Price Index (A) plunged from 2.0 percent in August to -0.9 percent in November, the lowest level since the data series was first compiled in 1981. The downward trend is caused by contracting domestic and external demand, and is likely to continue in 1999.
Chart 3 : Retail Sales
Retail sales dropped by an annual average of 16.5 percent and 17.0 percent respectively in value and volume terms during the first ten months of 1998. Consumer goods continued to lead the drop during the period, as consumer sentiment remained low due to the record high unemployment rate. Consumer confidence slightly improved in the final quarter of 1998, after the SAR Government implemented various measures to stabilize the property market and banks cut interest rates. It is anticipated that retail sales may improve moderately.
Chart 4 : Orders-On-Hand
The value of manufacturers' orders-on-hand fell by an annual average of 17.0 percent during the period from August to October 1998. The negative effects of the strong HK Dollar continue to bite into the Territory's competitiveness. In addition, the clothing industry was again overclouded by the US's tightening of rules of origin. In the months to come, the value of manufacturers' orders-on-hand should continue to decline.
Chart 5 : External Trade
Total merchandise trade deficits for the first ten months of 1998 shrank to HKD73.9 billion from HKD137.5 billion recorded in the same period of 1997. During this period, imports dipped by 10.7 percent on a yearly basis due to flagging domestic demand. Meanwhile, exports fell by 6.6 percent over the same period. The outlooks for both domestic exports and re-exports may become more negative, as the Territory's exports continue to lose competitiveness in value terms and exports in China also slide. The total merchandise trade deficits are expected to widen in the medium-term.
Chart 6 : Deposits
The rebound of HKD deposits continues. Growth of HKD deposits increased to 8.9 percent in October from a low of -0.6 percent in June. This indicates that measures introduced by the HKMA in September successfully boosted liquidity in the banking system. We believe that this is the turning point of the tight liquidity situation, and deposit growth should stay steady in 1999.
Chart 7 : Loans and Advances
The falling trend of total loans continues. Growth of total and advanced loans slid to -18.7 percent in October from -17.9 percent in July. The contraction of offshore loans is particularly acute, as Japanese banks withdraw from the Territory. Starting from August, the growth of domestic loans also fell to negative territory. As economic conditions remain difficult in the coming months, banks will remain cautious to their lending. As a result, the current contraction of loans and advances will continue.
Chart 8 : Effective Exchange Rate Indices
The annual change in the trade-weighted effective exchange rate index fell to 0.6 percent in November from 7.5 percent in August. With the downward trend of US interest rates, the US Dollar and the Hong Kong Dollar would turn weaker in coming months. | 
