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November, 1999
Introduction
Hong Kong's real GDP returned to positive growth in the second quarter of 1999. Although this exceeded market expectations, it did not generate optimism. Businessmen and academics recognized that this is not an ordinary cyclical economic recovery. Hong Kong is experiencing deflation alongside deregulation and other fundamental economic changes. At the same time, there is uncertainty surrounding the implications for Hong Kong of China's accession to the World Trade Organization (WTO). Furthermore, there is concern about the slowness of Hong Kong's recovery compared with other Asian economies.
In the following analysis, we argue that the slowness of Hong Kong's economic recovery is a good sign. What we are seeing is a market correction, unguided by government, which will eventually strengthen the cost and quality competitiveness of Hong Kong. In addition, it will provide opportunities for deeper economic reforms that will enhance economic efficiency in the long run.
China's WTO accession looms large over this process. As the Mainland moves toward a market economy, the differences between the economic systems of Hong Kong and the Mainland will narrow. In the long run, this will undermine Hong Kong's traditional middleman role vis-a-vis China. The only way out for Hong Kong is to move up the value-added ladder and enhance overall economic efficiency.
Why is Hong Kong's Economic Recovery Slower than other Asian Economies?
Since early 1999, many Asian economies have showed signs of strong recovery from the financial crisis that struck the Region in 1997. Hong Kong, however, appears to be an exception. Does this mean that there are serious problems in the Hong Kong economy? We believed that Hong Kong slower recovery is due to its resort to domestic prices adjustment and economic restructuring rather than devaluation.
Hong Kong's market-centred economy
Many Asian economies are strategically targeted at building an industrial base to maximize the countries' market shares in the global market. State regulations and non-market mechanisms were designed to restrain domestic market competition in order to concentrate more resources in strategic industries and maintain orderly economic growth. In this state-centred economic system, banks, rather than equity and bond markets, are the primary suppliers of funds. By manipulating the banking system, the Asian governments are able to control interest rates and influence the allocation of funds. Hence, the state is in a much better position to influence the economy.
During the Asian currency crisis, the Asian governments were forced to forsake their linked exchange rate systems. Devaluation resulted to financial chaos in the Region but at the same time enhanced their export prices competitiveness. This has helped the industry-oriented Asian economies to export their ways out of recession. Together with the governments' aids to the struggling businesses, the Asian economies are able to recover at a faster pace.
Hong Kong, on the other hand, has a market-centred economic system. This system is characterized by a government that is restrained to the role of referee. The government protects property rights, enforces regulations, ensures a level playing-field, and provides social infrastructure, without which markets could not function well. However, any government involves more than these would consider as interfering the market and would undermine market efficiency. This philosophy has successfully nurtured a dynamic business community that responds swiftly to market demand, and has enabled Hong Kong to capture economic opportunities arising in the Region in the past two decades.
In response to the Asian financial crisis, the SAR Government chose to maintain the pegged exchange rate system. Without a flexible monetary system to fine-tune the economy, Hong Kong's market-centred system at work resolves its problem of competitiveness through price adjustments and economic restructuring. The process is longer and harder, but it is the right path for Hong Kong economic system.
Bursting of the asset bubble
In the past decade, the combination of negative real interest rates, limited land supply, and strong housing demand, led a surge in the prices of property-related assets. The positive wealth effect boosted domestic demand, pushing up the costs of living and doing businesses. This seriously undermined Hong Kong's cost competitiveness. Many non-property-related businesses were crowded out. With bursting of the asset bubble, contraction of the domestic demand has left an economic vacuum to fill. This development makes high prices and wages unable to sustain. As such, the Hong Kong economy has fallen into deep recession and deflation.
The severe economic downturn leads to surplus of production factors and this results to falls in prices and wages. When cost adjusts to a more competitive level, new businesses will be emerged. Hong Kong is now in the process of redeveloping a non-asset-based economy, which includes industries like tourism and cyber business. As it does so, the Territory is effectively taking the opportunity to undergo thorough economic restructuring. This is being stimulated by industries' deregulation and a leaner government, allowing market forces more room to operate. Although it may slow the pace of recovery, this process will improve the overall efficiency of the economy - something that mere currency devaluation cannot do. From this perspective, the current adjustments in prices and wages, and other economic hardships are not only the necessary rearrangements for the fixed exchange rate; it is an overdue correction of Hong Kong's competitiveness.
Survival Strategies for Hong Kong after China Enters the WTO
To the unemployed or to the owners of struggling firms, economic restructuring may seem an abstract concept that is unable to provide quick solutions to their pressing problems. However, this perception reflects unawareness of the seriousness of the economic challenges facing Hong Kong, as China will further liberalize its economy after the accession to the WTO. Hong Kong's past economic success was built upon the systemic differences between the Mainland and the Territory's economies. Hong Kong occupied a unique position as a conduit for goods, capital, human resources, and information to the rapid growing Chinese economy.
However, a China that is more integrated into the global economy after joining the WTO will be far more like Hong Kong in many ways. Foreign investors will have freer access to the Chinese markets for goods and services, and competition will enhance market efficiency in the Chinese economy. Such changes would impair Hong Kong's advantages over the Mainland, and many lower value-added middleman businesses would be gradually undermined in three to five years of time. Therefore, Hong Kong must reposition itself and explore new economic possibilities.
Repositioning in the Chinese markets
With its 1.3 billion population, a more liberalised Chinese market represents numerous business opportunities for Hong Kong businessmen. But at the same time, they have to face stiff competition from multinational corporations. Hong Kong businessmen have long invested into the Mainland, which earn them better network of connection and understanding of the Mainland markets. This together with their close cultural link to the market will give them the edge. Although this will not last long, it will buy them time to explore a niche market that they have a comparative advantage. Hong Kong businessmen will then have to shift their mentalities from middlemen to direct market participants, from "front shop, rear factory" to "strategic alliance" relationship.
For the domestic economies, Hong Kong must develop its higher value-added industries to replace the lower end one, which will be gradually taken over by other cities in the Mainland. This is where the latest economic restructuring in the Territory will make a difference. Not only Hong Kong has improved its cost competitiveness, current reform from government to various industries will lift the efficiency of the economy to another level. This, together with its existed world class infrastructures, positions Hong Kong as a high value-added centre for the Mainland. It will focus on areas where Hong Kong systemic advantages are still far ahead.
Cyber business is one area that has the potential. Hong Kong has virtual no restriction on the flow of information and ideas, efficient telecommunication infrastructure and legal system. As such, Hong Kong will be at a good position to develop cyberspace businesses and service needs of the Mainland market. We believe the process has already started as foreign Internet firms have shown interest in boosting their investment in the Territory.
Also, in the foreseeable future, Hong Kong will keep its role as a leading financial centre in the Region. In contrast to other state-centred economies in Asia, Hong Kong's financial industries are more liberalised and advance. Banking deregulation will make the industry more efficient. The equity market has just introduced the second board market, while debt market is beginning to grow into maturity. These developments, however, could not accomplish in overnight, it takes time and steadfast commitment from the Government. The favourable track record of the financial industry is the most valuable asset we can depend on. This will ensure its position as the main capital-processing centre for China and much of Asia.
In sum, Hong Kong will rely increasingly more on economic efficiency for its prosperity, and industries that could generate high value-added services and stay competitive will faire well in the future.
The Keys for a High Value-Added Economy
Labour quality
In this new circumstance, the challenge for Hong Kong is to provide a business-friendly environment in which companies can produce high value-added services and compete in the Chinese markets. An essential ingredient of such a knowledge-based economy is the quality of the labour force. Global economic integration and advances in information technology require an entirely different labour force, with communication, creative and analytical skills and the ability to use information technology. For instance, bankers in the future will have to complete sophisticated financial deals through Internet within short notices. Or managers will have to co-ordinate nationwide marketing campaign for new products or services in cyberspace. Therefore, the new focus for Hong Kong's educational system is the abilities to learn and master new skills and ideas. In this respect, the government's policies towards education are critical. It determines whether Hong Kong's knowledge-based economy can be successful and the future graduates could survive in this new economic environment.
Government coordination
In the past, there was relatively little need for government coordination between the Territory and the Mainland. But Hong Kong companies now are to compete in the Chinese markets against foreign multinational corporations, the SAR Government may need to play a greater role as a bridge between Hong Kong and local governments in China. For example, the Government could establish higher-level "business coordination offices" in strategic locations in China to provide necessary supports for Hong Kong businesses. This undertaking is crucial especially to Hong Kong's small-and-medium-size enterprises to enter the Chinese markets.
Conclusion
With China enters the WTO and deregulation of the Chinese markets, Hong Kong's advantage can no longer rely on exploiting the stark differences between the two economic systems. The key for Hong Kong's future is economic efficiency. If Chinese businesses will come to Hong Kong to raise funds in the future, it is not because it cannot be done in other Chinese cities, but because it is more efficient to do so in the Territory. Only this can help Hong Kong to stay ahead in the future.
From this perspective, deregulation of strategic industries, corporate restructuring, trimming of Government's apparatuses, and improvements to education and environmental issues will not be distant concerns, but are critical to the Territory's economic survival in the future. If Hong Kong endures the pain and restructuring, it will bring about a more impressive and lasting recovery than those currently seen elsewhere in Asia.
Chart 1: Unemployment
Unemployment rate rose further to 6.2 percent in October 1999. However, the labour market condition is not worsening. Instead, the number of people being unemployed has started to stabilise since May this year.
Chart 2: Inflation Rate
Deflation spiralled further from 5.5 percent in July to 6.1 percent both in August and September. This is mainly due to the continuous downward adjustment of housing rentals. If discounting this factor, the composite CPI fell at a slower rate of 4.5 percent and 4.1 percent respectively in August and September. Nevertheless, the adjustment in housing rentals takes time due to the limitation in rental contracts. As such, deflation would persist despite of the positive signs of economic recovery.
Chart 3: Real Interest Rate
Real interest rate could be calculated by minus expected inflation rate in the next twelve months from nominal prime rates. This is the real interest rate perceived by the public. Spot inflation rate is commonly used as denoted by Ri(Adaptive). It is, however, misleading as it only accounts for prices changes in the past. Ri(Rational) uses the projected inflation rate to estimate the real interest rates. It is noticed that the rates had gradually declined and stabilised at the 9 to 10 percent levels.
Chart 4: Retail Sales
Retail sales in volume terms started to record positive growth since July and August, even though the total retail value continued to drop. This reflected that consumer sentiment is improving, as prices fell to attractive levels. Moreover, values dropped at slower momentum in the July and August, indicating that downward adjustment in prices at retail levels may be near to an end.
Chart 5: Hong Kong External Trade
Hong Kong external trade improved on the back of Asian economic recovery and the recovery in China trade. Imports increased by a yearly average of 4.4 percent in the third quarter, while re-exports rose by an average of 6.8 percent during the same period.
Chart 6: Property Prices of Major Estates
On the average, property prices have only increased in a monthly rate of 0.5 percent during the first half of this year. Uncertainties in US and Hong Kong's interest rate trends drove prices down by an average of 1.6 percent in the third quarter. Moreover, the price rebound since October 1998 has only reached the level of November 1995. All these indicated that the property market is still far from a full-fledged recovery.
Chart 7: Residential Property Transactions
The sluggishness in the residential market is further evidenced by the declines in both values and transactions since May 1999.
Chart 8: Loans & Deposits
HKD loans continued to contract in 1999, although the situation appeared to cease from worsening. Meanwhile, HKD deposits have been growing steadily. The diverging growth trends lowered loans-to-deposits ratio to 94.1 percent, the lowest level in recent years. | 
