But conditions improved rapidly in the second half of 2003. The SARS epidemic came under control, the global macroeconomic environment improved, and growth on the mainland picked up. Certain steps taken by the mainland also helped. The easing of travel restrictions on mainland tourists traveling to Hong Kong SAR and the signing of the Closer Economic Partnership Arrangement—a framework for fostering economic integration between the two economies—boosted economic prospects and also had an important symbolic value in signaling the rapidly growing linkages between the two economies.
These developments quickly turned around consumer and business sentiment, which had been depressed by SARS. Retail sales picked up rapidly, fueled by tourists from the mainland, and unemployment is now down to about 7 percent. Our latest growth forecast for 2004 is about 5 percent, and we anticipate that deflation, which has now persisted for over five years, could end in late 2004.
Maintaining international competitiveness in the face of rising competition from other aspiring financial centers will remain a challenge.—Eswar Prasad
Fortunately, a number of recent developments appear to have reversed the downward pressure on prices. These include much stronger domestic demand conditions, supported by rising growth in the mainland; a significant depreciation of the U.S. dollar—to which the Hong Kong SAR dollar is linked; and emerging inflationary pressures on the mainland.
Another aspect supporting the end of deflation is the recovery in property prices. Property prices fell by almost 65 percent between their peak in 1997 and last year. In the past few months, prices in most sectors of the property market have stabilized or even increased gradually. While the evolution of property prices is difficult to predict, indications are that the property market has turned around for good. This has happened because overall macroeconomic prospects have improved and the effects of positive government measures are beginning to take hold.
The government has traditionally had a heavy hand in the property market by subsidizing housing and controlling the supply of land. Over the past two or three years, as Jorge Chan-Lau, another coauthor, documents in the Occasional Paper, the government has made a determined effort to decrease its role, and this has helped improve sentiment in the property market.
The composition of trade has also changed. Hong Kong SAR used to be an important intermediary for China’s trade with the rest of the world. Now that China has increasingly direct access to world markets, less of this trade goes through Hong Kong SAR. Instead, it is getting a larger share of “offshore” or “transshipment” trade that takes advantage of Hong Kong SAR’s superior logistical services. But the value-added component of this sort of trade is much lower.
In this context, Hong Kong SAR’s role as a financial services center will become more important over time. Even if China’s financial linkages with the rest of the world were to deepen, Hong Kong SAR is likely to continue to play a crucial role as a fund-raising center for Chinese firms. But maintaining international competitiveness in the face of rising competition from other aspiring financial centers will remain a challenge.
The other major policy challenge for Hong Kong SAR is its fiscal deficit. In fiscal year 1997-98, its budget was in surplus, its fiscal policy had a well-established conservative track record, and its fiscal reserves were large. The level of reserves has now declined to less than one year’s worth of government expenditures, and the deficit for the fiscal year ending this April is likely to be around 5 percent of GDP.
The authorities are very cognizant of this, and the financial secretary has indicated that he intends to balance the budget by 2008/09. Indeed, many substantive measures have already been put in place over the past year, despite the difficult circumstances.
The main effort will have to be on the expenditure side. Hong Kong SAR has traditionally had a small government that nevertheless delivers high-quality public services. But the level of government expenditure as a ratio to GDP, which was about 14 percent in 1997, has now ballooned to almost 20 percent. The financial secretary’s clearly stated objective is to reduce the annual nominal operating expenditures from about HK$220 billion at present to HK$200 billion by 2008/09. The challenge—which we think can be met—is to reduce expenditure without diminishing the quality and breadth of public services.
Further efforts will be needed on the revenue side as well. In recent years, Hong Kong SAR has increasingly relied on sales of its investments and properties to meet financing requirements. But asset sales are procyclical and not a reliable source of revenue. While maintaining Hong Kong SAR’s low tax environment is a good idea, we have argued strongly that there should be a change in the composition of revenues. The government is considering the introduction of a goods and services tax [GST], which would substantially broaden the tax base and make it more stable. The financial secretary feels that the economy needs to recover strongly and that deflation should end before a GST is introduced. We think it is important, given the long lead time required, to start preparing for its implementation as soon as possible.
This is a tribute to two factors: Hong Kong SAR banks compete internationally, and this requires them to maintain very high standards of internal prudential supervision. And the supervisory regime has been very effective in maintaining the soundness of the financial sector. The assessment did indicate that some steps could be taken to improve corporate governance; increase the transparency of the institutional policy framework; and better coordinate cross-industry supervision. The authorities have responded very favorably to these suggestions and taken a number of steps to further strengthen the financial system to deal with future challenges.
Hong Kong SAR will increasingly face competition from other financial centers, but its intrinsic advantages—which include easy access to the mainland, a strong legal framework, a world-class regulatory and supervisory apparatus, and a leading-edge financial infrastructure—are likely to keep it the dominant player in the region for quite some time to come.
Getting the education system ready to meet these challenges will be a key component of Hong Kong SAR’s structural transformation. In particular, our work suggests that there might be some scope for increasing the efficiency of expenditure at the university level. The authorities are also putting in place training and retraining programs to address skill mismatches in the job market.
The big challenge for the financial sector will be adapting to the opening of the mainland. This does provide a lot of opportunities—Hong Kong SAR banks are very familiar with the mainland and will be allowed to enter the mainland financial markets earlier than banks based elsewhere. But China itself is opening up more, and Hong Kong SAR’s role in raising finance for Chinese companies could become less important over time. Still, Hong Kong SAR banks will have an edge, given their familiarity with the Chinese economic structure.
A related challenge will be supervisory coordination between Hong Kong SAR and the mainland, which will become more important as financial integration continues. The authorities are cognizant of the need to harmonize standards and are taking steps to improve prudential supervision of banks that have operations in both economies. A recent initiative by the mainland has already given Hong Kong SAR banks a head start in doing renminbi business.
Hong Kong SAR’s traditional strengths—its flexible markets and strong legal and institutional structures—if they are complemented by sound macroeconomic and structural policies, will prepare it well for meeting the challenges of integration with the mainland.
For countries that are more direct competitors with China in international markets, the adjustment process could be much harder. But the general lesson from Hong Kong SAR’s experience is that the best way for these economies to prepare themselves for change is to improve the flexibility of their domestic product and labor markets, and here the quality and cohesiveness of their structural and macroeconomic policies can play a key role. Hong Kong SAR’s experience indicates that a strong market orientation and a sound institutional framework can make the adjustment process a lot smoother.
Hong Kong SAR’s traditional strengths—its flexible markets and strong legal and institutional structures—if they are complemented by sound macroeconomi and structural policies, will prepare it well for meeting the challenges of integration with the mainland.—Eswar Prasad
Copies of IMF Occasional Paper No. 226, Hong Kong SAR: Meeting the Challenges of Integration with the Mainland, are available for $25.00 ($22.00, academic rate). Please see below for ordering details.