IV. Macroeconomic Policy Framework

Dubravko Mihaljek, and John Dodsworth
Published Date:
September 1997
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Since its settlement as an economic entity in 1842, the basic approach of the Hong Kong government has been to foster trade, industry, and commerce, and to leave legitimate business to operate at a profit without government interference. In line with this view, the government has adopted a policy of “positive noninterventionism” as a cornerstone of its involvement in the economy. This policy holds that the primary role of government is to provide the necessary infrastructure and a stable legal and administrative framework conducive to growth and development. A former Financial Secretary explained it (Haddon-Cave (1982)).

Positive non-interventionism involves taking the view that it is normally futile and damaging to the growth of an economy, particularly of an externally oriented economy, for a government to attempt to plan the allocation of resources available to the private sector and to frustrate the operation of market forces, no matter how uncomfortable may be their short term consequences. The implications of the adjective ‘positive’ are important: when faced with an interventionist proposal, the Hong Kong Government does not simply respond that such a proposal must, by definition, be incorrect.… in all cases, decisions are made positively, and not by default, and only after the immediate benefits and costs are weighed against the medium and longer term implications of the interventionist acts proposed (including the inevitable difficulties of unwinding them).

In adhering to this view, the government has maintained over time a coherent set of fiscal, monetary, and regulatory policies that has helped preserve the predominance of the private sector and the flexibility of the cost-price structure. Fiscal policy has traditionally followed a prudent approach, aimed at maintaining a small government and fostering a flexible and competitive private sector. Budgets have been kept broadly neutral and have not been used to moderate cyclical swings. This prudent approach was also followed in the budget for FY 1997/98, which straddles the transition to Chinese sovereignty.

Since 1983, the primary objective of monetary and exchange rate policies has been to maintain the exchange rate link with the U.S. dollar. The government has been of the view that any costs incurred through the loss of an independent monetary policy were far outweighed by the confidence and stability engendered by the linked exchange rate, which acted as an anchor for other policies. In addition, it has been argued that the flexibility of factor prices and the ability of Hong Kong firms to adjust quickly to changing circumstances gave the economy a resilience that would be weakened if the exchange rate link were abandoned. In this context, the authorities are according high priority to maintaining a banking supervision system and developing the financial regulatory framework in line with international standards appropriate for a major financial center.

In the labor market, the government has sought to ensure that labor market flexibility, supplemented with employee retraining and job matching schemes, enables the unemployed to return to work quickly. Social welfare policies have been targeted at those who are not expected to work—children, the elderly, the sick, and the disabled—and only to a limited extent at the unemployed. In the property market, land market, and provision of basic infrastructure, government intervention has come mainly through a large public housing program and provision of transportation facilities. Hong Kong has traditionally practiced free trade and open competition in domestic markets.

Fiscal Policy

In line with the basic noninterventionist approach, fiscal policy in Hong Kong has been guided by four broad principles: to maintain a simple and stable tax system with low tax rates, to keep current spending increases in line with GDP growth, to provide funding for key infrastructure projects, and to maintain an adequate level of fiscal reserves for dealing with contingencies. While the government has generally projected balanced budgets, its prudent revenue projections and frequent capital underspending have tended to result in surpluses—budget deficits were recorded in just ten years since 1947. This has enabled the government to build up substantial fiscal reserves, which have played a key role in supporting confidence and stability.

Budgetary Performance

Over FY 1984–96, Hong Kong has established an outstanding record of budgetary performance. The budget was in deficit only once—in FY 1995—and the annual budget surplus on average amounted to almost 2 percent of GDP (Figure 12).12 On average, the government collected about 17¾ percent of GDP a year in revenue and incurred about 15¾ percent of GDP a year in expenditure over this period. Hong Kong’s fiscal reserves had accumulated to 13½ percent of GDP at the end of FY 1996.

Figure 12.Consolidated Accounts

(In percent of GDP)

Sources: Government Secretariat, Finance Branch, The Budget (FY 1983–96 issues), and Estimates for the Year Ending March 31 (various issues); and IMF estimates.

Budgetary outcomes over this period were characterized by occasional sizable discrepancies between actual budget outcomes and projections in initial budgets, which resulted in some fiscal years in unexpected and substantial budget surpluses (up to 4 percent of GDP). Total revenue was typically higher than projected, and total expenditure was lower, with most of the variations occurring in capital revenue and expenditure (Table 4).

Table 4.Discrepancy Between Actual, Preliminary, and Projected Budgetary Outcomes, FY 1984–95(In percent)
Deviation of Actual Outcome from Initial BudgetDeviation of Actual Outcome from Preliminary Estimate
Total revenue6.91.3
Total expenditure–3.9–2.2
Source: IMF staff calculations.
Source: IMF staff calculations.

The discrepancy in revenue estimates largely reflects a cautious assessment of volatile sources of revenue—stamp duties on asset transactions and land sales revenue—in initial budgets. As such revenue is closely related to the turnover in the stock and property markets, it tends to overshoot the consistently conservative budget projections by a wide margin when the markets are very active.13 The underestimates of capital spending largely resulted from project delays; forecasts of the time needed to start public works contracts have been overly optimistic in the past.14 Owing to improvements in planning procedures for public works projects, capital underspending has been reduced since 1994.

Budgets in Hong Kong are not formulated to have a specific cyclical impact—this approach stands at the center of the rules-based fiscal policy framework. Nevertheless, it is revealing to analyze the macroeconomic impact of actual fiscal policy outcomes and to assess the fiscal outcomes implied by the original budgets. The former provides an ex post view of aggregate effects of fiscal policy, while the latter indicates what macroeconomic effects the budgets were expected to have—and the policymakers were prepared to contend with—at the time the budgets were formulated.

To assess the macroeconomic impact of fiscal policy outcomes, the fiscal impulse of the actual budgetary outcome is derived (Box 4) and then considered against the cyclical position of the economy. The budgetary outcomes did not have a major expansionary or contractionary effect. When considered against the cyclical position of the economy, the effects have generally been either countercyclical or neutral over the past two business cycles (Figure 13).15 In particular, the moderate fiscal expansion of FY 1995–96 was counter-cyclical, as real GDP growth slowed over this period and positive fiscal impulses helped to stimulate the economy.

Figure 13.Budget and Actual Effects of Fiscal Policy

Sources: Government Secretariat, Finance Branch, The Budget (FY 1983–96 issues), and Estimates (various issues); Census and Statistics Department, Hong Kong Annual Digest of Statistics, and Estimates of Gross Domestic Product, 1961–96; and IMF staff estimates.

To assess the effects the original budgets were expected to have, projections contained in initial budgets are compared with preliminary budget estimates for the preceding fiscal year, both of which are released at the same time. From 1984 to 1989, policymakers generally expected the original budgets to have a slightly contractionary effect, which was appropriate ex ante given that the economy was expected to grow rapidly in initial budgets during this period (Figure 13). Since 1990, the original budgets were expected to have an expansionary effect (except in FY 1991). As the economy was expected to grow at a strong pace and inflation was expected to accelerate in initial budgets during the early 1990s, it seems that policymakers were prepared to contend with the expected stimulative effects of the budgets.

In FY 1995 and FY 1996, the budgets were also expected to be slightly expansionary. As private consumption and asset markets were expected to consolidate (in FY 1995) or recover at a moderate pace (in FY 1996), this was expected to provide some stimulus to the recovery. It should be emphasized, however, that providing a stimulus for purely countercyclical purposes was not the main objective, but rather the expected consequence of fiscal policy. As discussed below, the underlying reason for the fiscal expansion in the 1990s was the need to develop Hong Kong’s transportation infrastructure and respond to demographic changes by providing adequate funding for social programs.

Box 4.Fiscal Impulse

The fiscal impulse measures the size of the initial stimulus to aggregate demand arising from discretionary and other changes in fiscal policy after eliminating the cyclical component of the change in the budget balance. A positive (negative) sign indicates that fiscal policy has become expansionary (contractionary) relative to the previous year. The estimates of the fiscal impulse presented in this paper are based on actual budget outcomes adjusted for government equity investments and revenue from land sales. These items are excluded because they represent an exchange of assets between the public and private sectors and therefore should not have a significant impact on aggregate demand. Since both equity investments and land revenue at times accounted for a large proportion of government expenditure and revenue in Hong Kong, the adjusted fiscal impulse sometimes provides a different characterization of fiscal policy outcomes than does a more conventional measure such as the change in the budget balance. The estimated fiscal impulse and the budget balance over FY 1984–96 (in percent of GDP) were as follows.

Fiscal impulse1.2–1.2–0.8–0.8
Budget balance10.
Fiscal impulse–0.50.2–
Budget balance12.52.31.3–0.31.3

Proceeds of government bond Issues (principal repayment) are excluded from revenue (expenditure).

Proceeds of government bond Issues (principal repayment) are excluded from revenue (expenditure).

Fiscal outcomes generally had a slightly contractionary effect in the second half of the 1980s and the early 1990s, as well as in FY 1994. The effect was slightly expansionary in FY 1993 and FY 1995–96. It should be noted that, in FY 1996, the budget balance swung from a small deficit at the end of FY 1995 to a moderate surplus—a change that normally would be associated with fiscal contraction. However, as the surplus partly resulted from a decrease in equity investments and an increase in land revenue, both of which are excluded from the impulse measure, the estimated fiscal impulse was (slightly) expansionary.

FY 1997 Budget

The budget for FY 1997 is unique in straddling the transfer to Chinese sovereignty. As the imperative for fiscal policy in the year of the transition was to maintain stability, the FY 1997 budget continued the prudent fiscal policies described above. No major changes in either expenditure or taxation policies were proposed. Despite the projected increase in the budget surplus, the macroeconomic impact of the budget remained broadly neutral, as much of the increase was expected to come from higher land revenue.

The overall budget surplus for FY 1997 is forecast at HK$27 billion (2 percent of GDP) (Table 5). Taking into account new spending initiatives, total government expenditure is projected to increase by 11 percent over the previous year, of which current expenditure is expected to increase by 12¾ percent (5½ percent in real terms), and capital expenditure by 7½ percent (½ percent in real terms). The low increase for capital spending reflects the winding down of financial commitments for the airport project.16 Although, on the revenue side, total receipts are projected to increase by 16 percent over FY 1996, this is mainly due to accounting and other changes to the treatment of land revenue after the transfer of sovereignty (Box 5). Fiscal reserves accounting in FY 1997 is also complicated by the transfer of a special Land Fund to the government of the Hong Kong Special Administrative Region on July 1, 1997.

Table 5.Consolidated Government Account1
FY 1996
FY 1993FY 1994FY 1995BudgetRev.est.FY 1997 Budget
(In billions of Hong Kong dollars)
General Revenue Account
Transfers to Funds22.539.132.515.013.44.3
Consolidated Account Funds2
Capital expenditure447.753.659.852.045.743.7
Total Consolidated Account
Net borrowing–1.2–2.4
Fiscal reserves balance5140.2151.0147.9150.2163.0359.3
(In percent of GDP)
Total Consolidated Account
Fiscal reserves balance515.614.913.611.913.626.5
(Percentage change)
Total Consolidated Account
Fiscal reserves balance515.97.7–2.11.610.2120.4
Sources: Data provided by the Government Secretariat, Finance Branch; and IMF staff projections.

Fiscal year begins April 1.

Consists of the Capital Works Reserve Fund; Capital Investment Fund and Loan Fund beginning FY 1990; Disaster Relief Fund beginning FY 1993; and Civil Service Reserve Fund beginning FY 1994.

Includes revenue from land sales.

Includes direct financing of airport-related projects as well as government equity injections into the Airport Authority and the Mass Transit Railway Corporation.

As of end-fiscal year. Fiscal reserves at the end of FY 1997 include the projected HK$170 billion balance in the Land Fund, which will revert to the Hong Kong Special Administrative Region on July 1, 1997.

Sources: Data provided by the Government Secretariat, Finance Branch; and IMF staff projections.

Fiscal year begins April 1.

Consists of the Capital Works Reserve Fund; Capital Investment Fund and Loan Fund beginning FY 1990; Disaster Relief Fund beginning FY 1993; and Civil Service Reserve Fund beginning FY 1994.

Includes revenue from land sales.

Includes direct financing of airport-related projects as well as government equity injections into the Airport Authority and the Mass Transit Railway Corporation.

As of end-fiscal year. Fiscal reserves at the end of FY 1997 include the projected HK$170 billion balance in the Land Fund, which will revert to the Hong Kong Special Administrative Region on July 1, 1997.

The Medium Range Fiscal Forecast prepared in conjunction with the FY 1997 budget projects budgetary surpluses of 1–1½ percent of GDP per year over FY 1998–2000 (Table 6). However, the medium-range forecast omits a substantial contribution that may be needed for high-priority projects under the Railway Development Strategy. This contribution is estimated at up to HK$50 billion, compared with total surpluses of HK$59 billion during FY 1998–2000. The medium-range forecast did not cover this item because the precise amount and the timing of the investments were not yet determined, although it is expected that the government of the Hong Kong Special Administrative Region would need to contribute this sum between 1998 and 2001.

Table 6.Medium-Range Fiscal Forecast1
FY 1996FY 1997FY 1998FY 1999FY 2000
EstimateBudgetOfficial projection
(In billions of Hong Kong dollars)
General Revenue Account168.0177.8200.5224.8257.7
Consolidated Account Funds34.356.951.755.359.7
Of which: Capital Works Reserve Fund229.049.440.046.949.4
General Revenue Account3141.5164.4181.5206.5235.5
Consolidated Account Funds45.743.647.455.264.7
Of which: Capital Works Reserve Fund430.435.740.848.054.9
Capital Investment Fund59.
Fiscal reserves balance6163.0359.3382.6401.0418.2
Balance in the Land Fund of the HKSAR7163.5
(In percent of GDP)
Of which: Land sales82.
Fiscal reserves balance613.626.524.923.021.2
Balance in the Land Fund of the HKSAR712.1
Adjusted fiscal impulse80.
Sources: The 1997/98 Budget; and IMF staff estimates.

Fiscal year begins April 1.

Includes mainly revenue from land sales. From July 1, 1997, onward, land revenues that previously accrued to the Land Fund will be included in the budget of the Hong Kong Special Administrative Region.

The FY 1997 figure includes the proposed HK$5 billion injection in the Mandatory Provident Fund.

Includes financing of airport-related projects.

Includes government equity investments into the Airport Authority and Mass Transit Railway Corporation.

As of end-fiscal year. Fiscal reserves at the end of FY 1997 include the projected HK$170 billion balance in the Land Fund (including the projected interest earnings between July 1, 1997, and March 31, 1998), which will revert to the Hong Kong Special Administrative Region on July 1, 1997.

Balance shown is as of July 1, 1997.

Staff estimates. It is assumed that land revenue accounts for 90 percent of the projected revenue of the Capital Works Reserve Fund.

Sources: The 1997/98 Budget; and IMF staff estimates.

Fiscal year begins April 1.

Includes mainly revenue from land sales. From July 1, 1997, onward, land revenues that previously accrued to the Land Fund will be included in the budget of the Hong Kong Special Administrative Region.

The FY 1997 figure includes the proposed HK$5 billion injection in the Mandatory Provident Fund.

Includes financing of airport-related projects.

Includes government equity investments into the Airport Authority and Mass Transit Railway Corporation.

As of end-fiscal year. Fiscal reserves at the end of FY 1997 include the projected HK$170 billion balance in the Land Fund (including the projected interest earnings between July 1, 1997, and March 31, 1998), which will revert to the Hong Kong Special Administrative Region on July 1, 1997.

Balance shown is as of July 1, 1997.

Staff estimates. It is assumed that land revenue accounts for 90 percent of the projected revenue of the Capital Works Reserve Fund.

Tax Policy

The basic approach of the Hong Kong government with regard to taxation has been to derive revenue from a limited number of sources and to maintain low tax rates with a flat profile. The structure of taxation has remained basically unaltered since 1947. Despite the small number of taxes and their elementary structure, Hong Kong’s tax system has, over the years, generated sufficient revenue to meet budgetary commitments and maintain a healthy growth of fiscal reserves. The revenue system has worked well because of the sustained growth of GDP, low administrative and compliance costs associated with the simple tax structure, and appropriate incentives that the low and stable tax rates have provided for domestic and foreign enterprise and investment. In particular, the income tax system has favored quick turnover of capital and reinvestment of retained profits and has obviated the pressure for special tax incentives.

Income taxes, comprising a salaries tax and a profits tax, are the main source of revenue, accounting for 43 percent of total revenue (7 percent of GDP) in FY 1995. Hong Kong has arguably the simplest income tax and the lowest tax rate of any industrial economy. Income taxes are limited to income derived from sources within Hong Kong, with no tax levied on capital gains, dividends, or interest income.17 The salaries tax payable is based on a sliding scale that progresses from 2 percent to 20 percent of income after the deduction of allowances.18 However, the total amount payable is subject to a limit of 15 percent of total income, the so-called standard rate. The current allowances are generous, so that almost half of the workforce is not subject to any income tax at all.19 The profits of corporations are taxed at a rate of 16½ percent.

Box 5.The Land Fund and Fiscal Reserves

The Land Fund of the Hong Kong Special Administrative Region is a special trust fund set up under the terms of the Joint Declaration and managed on behalf of the future government of the Region, in which half of all proceeds from land sales have been deposited since 1986. (The other half of land revenue has been credited to a capital account of the Budget and has financed capital projects.) On July 1, 1997, the Land Fund reverted to the government of the Special Administrative Region; its assets were projected to stand at HK$164 billion (12 percent of GDP) as of that date.

Fiscal reserves arise from budgetary surpluses accumulated over the years. They are deposited with the Hong Kong Monetary Authority’s Exchange Fund, which manages them along with other assets that serve as backing for the Hong Kong currency, and pays the government interest realized by investing the reserves. At March 31, 1997, fiscal reserves were estimated to stand at HK$163 billion (13½ percent of the 1996 GDP).

Future arrangements for the management of the Land Fund were clarified in May 1997, when the Chief Executive-Designate of the Hong Kong Special Administrative Region, Mr. Tung Chee-Hwa, nominated the Financial Secretary to manage the assets of the Land Fund as part of fiscal reserves. Initially, the Land Fund would be managed by the Hong Kong Monetary Authority under Financial Secretary’s direction as a separate portfolio from the Exchange Fund. The Land Fund has been operating under a set of investment criteria that differs from that of the Exchange Fund and hence embodies a more diversified portfolio.

The transfer of sovereignty will also mark an important change in accounting arrangements for land revenue. The government of the Region will start receiving full proceeds from land sales as of July 1, 1997, and will collect rents equivalent to 3 percent of the rateable value from the extension of leases in the New Territories and New Kowloon. The latter measure alone is expected to generate additional revenue of about HK$5 billion per year (2 percent of total revenue). As a result, fiscal reserves are projected to jump by HK$196 billion (13 percent of GDP) to HK$359 billion (26½ percent of the 1997 GDP) at March 31, 1998, representing about two years’ worth of current expenditure. IMF staff estimates of the contribution of various factors to this increase in reserves are tabulated below:

(In billions of Hong Kong dollars)(In percent of GDP)
Land Fund at March 31, 1998169.612.6
Land Fund at July 1, 1997163.512.1
Interest from July 1, 1997-March 31, 19986.10.5
Fiscal surplus at March 31, 199826.72.0
Of which: New Territories leases3.20.2
Full proceeds of land sales111.00.8
Total increase in fiscal reserves196.314.6
Total fiscal reserves at March 31, 1998359.326.6

Represents the share of land revenue from July 1, 1997 which, under the arrangements applying before that date, would have been paid to the Land Fund.

Represents the share of land revenue from July 1, 1997 which, under the arrangements applying before that date, would have been paid to the Land Fund.

About 30 percent of total fiscal revenue in recent years was directly related to land and property.20 A large part resulted from land sales under Hong Kong’s peculiar system of land tenure. However, the income from land sales has been a rather unstable source of revenue, reflecting the difficulty of planning an even release of land over the years and the sometimes large increases in land prices. Another important revenue source in this category has been the stamp duty on property transfers and stock market transactions. Although the stamp duty—like the land revenue—complicates financial planning because of the volatility of the underlying tax base, it has useful automatic stabilizer properties: during asset market booms, stamp duty revenue soars, generally producing a budget surplus and dampening a boom. Hong Kong also has standard property taxes (“rates”), which are adjusted every three years to take account of the effects of inflation on property values.

By virtue of its status as a free port, Hong Kong has no international trade taxes. Domestic taxes on goods and services have been few and applicable only to nonessential items. Proposals for introduction of a broad-based sales tax have been repeatedly rejected on grounds that such a tax was not needed for revenue purposes. Another unusual feature—at least from a developed country perspective—is the high yield of motor vehicle taxes (1½ percent of total revenue). The use of this tax base can be justified in Hong Kong on both environmental and distributional grounds.

Nontax revenue features prominently in Hong Kong’s tax structure. One reason for the relatively high yield of nontax revenue has been the government’s firm adherence to the principle of full cost recovery in setting user fees and charges.

Data for the period 1981–95 indicate that the revenue system is quite buoyant: a 1 percent increase in GDP raised tax revenue by 1.1 percent, and capital revenue by 1.6 percent.21 It is interesting to note that buoyancy for the income tax is quite high—1.1 percent for a 1 percent increase in GDP. In other words, frequent increases in tax allowances and the granting of other tax concessions have been more than compensated for by the broadening of the tax base brought about by rapid increases in individual income.

Expenditure Policy

The basic approach of the Hong Kong government with regard to expenditure policy has been to provide a relatively narrow range of public goods for which government supply is deemed efficient, while keeping spending increases in line with the growth rate of nominal GDP.

There have been several shifts in the structure of public expenditure since 1984, reflecting shifts in spending priorities and demographic factors. In particular, spending on social welfare, health, housing, and the environment has grown rapidly (Figure 14), while infrastructure spending has been boosted mainly by the implementation of the Airport Core Program. Relatively less spending was directed at security and community and external affairs.

Figure 14.Expenditure Developments

(Percent of GDP)

Sources: Data provided by the Government Secretariat, Finance Branch; and Census and Statistics Department, Annual Digest of Statistics (various issues).

In comparison with OECD countries, public spending in terms of GDP is fairly low in Hong Kong (Figure 15). Most notable is the absence of high spending on social security and defense. The cost of social security is low because pension funds are for the most part in the private domain. With regard to defense spending, under the 1988 Defense Costs Agreement, the Hong Kong government covers 65 percent of the recurrent cost of defense services provided by the United Kingdom as well as all capital costs. However, the amount involved (about 0.1 percent of GDP in recent years) is negligible compared with the cost of defense in most other countries. Public expenditure on administration, education, and health also is fairly low, while spending on housing, community affairs, and economic services (such as transportation) is comparable to that in the OECD countries. Except for defense costs, Hong Kong’s level and pattern of public expenditure are similar to those of Singapore.

Figure 15.Public Expenditure in Hong Kong and Selected Countries1

(In percent of GDP)

Sources:National Accounts, Detailed Tables, Volume II, 1985–93 (OECD, 1996); data provided by the Government Secretariat, Finance Branch (Hong Kong); and the Government Budget (Singapore).

1 Average shares in GDP for the period covered. Period coverage is 1985–93, except for France (1985–91) and Singapore (1988–93).

Transportation Infrastructure

The rapid increase in regional and overseas air and sea transport involving Hong Kong and the expansion of cross-border trade with China have put considerable pressure on the physical infrastructure in the territory. In addition, domestic rush-hour congestion problems have increased because of the continuing geographic separation of work and residential areas. In particular, the rapidly growing services sectors tend to be concentrated in the central business district on Hong Kong Island, despite the availability of less expensive locations. In response to these developments, public expenditure on expanding and upgrading transportation infrastructure has increased markedly, by 16 percent a year on average from 1985 to 1995.

The Airport Core Program (ACP) is the largest public infrastructure program in Hong Kong and one of the largest in the world. The Program includes a large new airport on the Chek Lap Kok island and nine related projects providing urban infrastructure services to the airport.22 The total cost of the program, which is to be completed in 1998, is now projected at the equivalent of about 15 percent of GDP (Box 6).

Work on the Airport Core Program has progressed on schedule and, by the end of 1996, was about 75 percent complete. The airport is scheduled to open in April 1998. The Airport Railway, which will connect the new airport to the main terminal on Hong Kong Island in 23 minutes, is expected to open by June 1998. According to the current plans, the site of the existing Kai Tak airport will, after the airport’s closure in 1998, mainly be used for housing, roads, commercial development, and open space.

Other important infrastructure projects in the transportation sector include the expansion of Hong Kong’s container handling capacity. The Sino-British Land Commission allocated land for the provision of a ninth container terminal, to be constructed by private sector developers. The terminal is scheduled to be completed in the coming five years. The government is also planning to seek private sector bids for the construction of two additional container terminals on northeast Lantau Island in the early 2000s. Separately, the government has awarded a tender to a private sector operator to design, build, and operate a river trade terminal in northwest New Territories to cater to the fast-growing river trade with China. The project is planned for completion by the end of 1999.

Planning is under way for new road and railway facilities connecting China, the urban areas in the New Territories, and the Central Business District. In particular, the government has recently decided to proceed with the implementation of the Western Corridor Railway by phases. The first phase of the project, comprising a passenger line connecting the northwestern parts of the New Territories with the existing network, would be completed by the end of 2003, at an estimated cost of HK$50 billion. The government has also decided to extend the existing Mass Transit Railway in the east of the New Territories, at an estimated cost of HK$25 billion.

Box 6.Cost of the Airport Core Program

The projected total costs of the Airport Core Program have been revised downward several times: in 1994 from HK$163.7 billion to HK$158.2 billion, and at the end of 1996 to HK$154.4 billion. The financing is distributed between public and private sources as follows:

(In billions of Hong Kong dollars)
Airport-related projects48.948.9
Airport Railway23.710.335.0
Western Harbor

Seven airport-related projects are directly funded by the government through the Capital Works Reserve Fund at HK$48.9 billion. The airport and the airport-railway are developed and will be operated by statutory bodies—the Airport Authority and Mass Transit Railway Corporation, respectively. These two bodies will receive a total of HK$60.3 billion in equity injections from the government through the Capital Investment Fund, and will issue debt to meet their remaining financing requirements. Some airport facilities will be managed not by the Airport Authority, but by private tenants contributing HK$15.4 billion in franchises to the project’s financing. Finally, the Western Harbor Crossing is a fully privately financed project. The projected spending profile of the Airport Core Program is as follows:

Fiscal yearBillions of Hong Kong dollarsPercent of total costPercent of GDP

The Airport Core Program and the other transportation infrastructure projects are likely to have sizable spinoff effects on private sector investment, as new sites will become attractive locations for business and residential use. In addition, as the overall size of government investment is reduced with the completion of the huge airport, there will be less crowding out of private sector investment through the use of specialized labor and other scarce construction inputs.

Linked Exchange Rate System

Hong Kong’s monetary system and exchange rate regime, known as the linked exchange rate system, was established in October 1983 against the background of a severe currency crisis. The Hong Kong dollar, then on a floating regime, depreciated by almost a third against the U.S. dollar between mid-1981 and the autumn of 1983, when concerns about Hong Kong’s future degenerated into a confidence crisis. The linked rate system is a variant of a conventional currency board, the Exchange Fund, which operated in Hong Kong between 1935 and 1972 (Box 7). Under this system, monetary policy has a simple and transparent objective to maintain a stable exchange rate between the Hong Kong and U.S. dollars. Currency stability has been maintained in the face of considerable political uncertainties and a massive structural change that took place in the economy since 1983. By preserving confidence in the Hong Kong dollar and making the exchange rate a credible and transparent benchmark, the linked rate system has acted as an anchor for other macroeconomic policies and facilitated real adjustments in the private sector. The link has also played a crucial role in maintaining confidence and stability in the runup to the transfer of sovereignty.

This section describes the main characteristics of the linked rate system, provides examples of the use of monetary instruments developed over the years, analyzes movements in interest rates and exchange rates under the system, and reviews recent institutional and market infrastructure developments in the area of monetary policy.

Note-Issuing Mechanism

Under the linked exchange rate system, bank notes are issued and redeemed against U.S. dollars at a fixed exchange rate of HK$7.80 per US$1 (the “linked rate”). The government has authorized three private commercial banks (“note-issuing banks”) to issue currency notes in Hong Kong. They are the Hongkong and Shanghai Banking Corporation Limited, the Standard Chartered Bank, and the Bank of China. The bank notes issued bear the name of, and are the liabilities of, the note-issuing banks. The Hong Kong Monetary Authority issues only coins.

Box 7.Evolution of the Hong Kong Monetary System

From 1845 to 1935, Hong Kong was on the international silver standard.1 Banknotes issued by various private commercial banks became the dominant customary means of payment, despite their lack of legal tender status. In 1895, the Bank Notes Issue Ordinance restricted the issue of banknotes to the Hongkong and Shanghai Banking Corporation and the Chartered Bank of India, Australia, and China (now the Standard Chartered Bank). As China went off the silver standard in November 1935, Hong Kong followed suit.

Under the Exchange Fund Ordinance of 1935, an Exchange Fund was set up, to which note-issuing banks were required to submit their silver holdings in exchange for Certificates of Indebtedness, which have since then served as legal backing for all bank notes. New bank notes issued by the note-issuing banks between December 1935 and June 1972 had a 100 percent sterling cover, and Hong Kong dollars could be exchanged into sterling at a fixed exchange rate. This monetary system, known as the sterling exchange standard, operated as a classical currency board.

In July 1972, following the United Kingdom’s decision to float the pound sterling, the Hong Kong government linked the Hong Kong dollar with the U.S. dollar at the rate of HK$5.65 to US$1, with provision for a percent fluctuation either way. However, the note-issuing mechanism was changed. The note-issuing banks were no longer required to pay foreign currency to the Exchange Fund when issuing additional Hong Kong dollar banknotes. Instead, the backing could be provided in Hong Kong dollars, which were used by the Exchange Fund to acquire foreign currency assets equivalent to the nominal value of the note issue at the current exchange rates.

After a global speculative attack on the U.S. dollar in November 1974, the Hong Kong government found it impossible to maintain the existing parity, and allowed the Hong Kong dollar to float. To administer the Exchange Fund and handle other central banking functions not yet assumed by the note-issuing banks, the government created a separate Monetary Affairs Branch in 1976.

In a separate move, the government transferred the fiscal reserve balances to the Exchange Fund, which has thus become the sole repository of the government’s financial assets, including the foreign exchange reserve backing for the note issue and fiscal reserves.

The note-issuing mechanism that was introduced in July 1972 remained unchanged, so that any increase in the note issue was reflected in an increase in the Exchange Fund’s Hong Kong dollar balances at the note-issuing banks. Although the authorities mostly used such balances to purchase foreign exchange assets, there was no formal obligation on them to do so. Monetary policy had thus become potentially discretionary. However, the authorities had no mechanisms for actually exercising discretionary monetary control. At the same time, the banking sector was unrestricted in creating currency, subject to prudential and commercial considerations. Hong Kong thus entered a period devoid of an effective anchor for monetary policy.

As the Hong Kong dollar was a strong currency at that time, floating in effect meant revaluation. Overall, the first two years of the floating rate regime worked relatively well. After mid-1977, however, the performance of the floating rate regime began to deteriorate. The growth of money supply and bank credit accelerated sharply, and the exchange rate of the Hong Kong dollar depreciated persistently, pushing inflation to the double-digit range during 1979–83. The depreciation of the Hong Kong dollar was aggravated by the confidence crisis engendered by China’s announcement in the summer of 1982 that it intended to regain sovereignty over the whole Hong Kong area, and the subsequent protracted negotiations between China and the United Kingdom on the future of Hong Kong.

The crisis peaked on September 24, 1983, when the exchange rate fell to an all-time low of HK$9.60 to US$1 (from HK$5.91 per US$1 in July 1982), panic buying of staples and imported goods broke out, and some banks temporarily suspended payment as a large number of customers tried to switch their deposits to U.S. dollar cash (see Jao (1990)).

To address the crisis, the Hong Kong government unveiled a two-point program for currency stabilization on October 15, 1983. The first measure was the requirement that the note-issuing banks pay U.S. dollars to the Exchange Fund as full cover for banknotes issued, at a fixed rate of HK$7.80 to US$1.

The second measure was the abolition of the 10 percent withholding tax on interest income from Hong Kong dollar deposits held with financial institutions, which removed the tax advantage from holding foreign currency deposits. These two measures effectively stabilized the Hong Kong dollar and laid the foundation for the linked exchange rate system.

1 This box draws on Jao (1990 and 1994), Latter (1994), and Nugée (1995).

To issue Hong Kong dollar banknotes, the three note-issuing banks are required to deliver to the Exchange Fund an amount in U.S. dollars that is equivalent to the local currency issued at the linked rate as backing for their Hong Kong dollar note issues. The Exchange Fund, in turn, issues to each note-issuing bank non-interest-bearing Certificates of Indebtedness denominated in Hong Kong dollars, which serve as legal backing for the note issue. Other banks may acquire local currency notes from the note-issuing banks against Hong Kong dollar deposits for Hong Kong dollar value. To redeem U.S. dollars from the Exchange Fund, the note-issuing banks are required to deliver Certificates of Indebtedness to the Exchange Fund and withdraw local banknotes from circulation at the linked exchange rate.

Currency supply is determined entirely by demand considerations under this note-issuing mechanism—the monetary authority has virtually no control over the amount of currency in circulation. At the end of 1996, banknote circulation in Hong Kong was about HK$83 billion and coin circulation was about HK$4 billion. With Hong Kong’s foreign reserves standing at close to US$64 billion (over HK$490 billion), Hong Kong dollar currency circulation was backed almost six times by foreign currency assets.

Exchange Rate of the Hong Kong Dollar

As noted above, transactions conducted for note-issuing purposes between the Exchange Fund and the note-issuing banks are carried out at the linked exchange rate of HK$7.80 per US$1. For all other transactions, the exchange rate of the Hong Kong dollar is set in the exchange market at freely negotiated rates. In particular, foreign exchange transactions between the public and banks (including the note-issuing banks), as well as all interbank transactions involving foreign exchange, are conducted at the market-determined exchange rate.

The market exchange rate has, of course, remained very close to the linked rate (Figure 16, top panel). Indeed, since mid-1991, the market rate has been on the “strong side of the link,” that is, slightly appreciated—typically less than 1 percent—relative to the linked rate. This development arose from a number of factors, including persistent, strong capital inflows, which reflect Hong Kong’s growing role in financial intermediation in the region, and the sound fundamentals of Hong Kong’s own economy. In support of the linked rate system, the authorities have accumulated substantial international reserves (Box 8) and given priority to improving prudential supervision of the banking system.

Figure 16.Exchange Rate Developments

Sources: IMF staff estimates; and WEFAS/UKFT.

Monetary Management

When the linked exchange rate system was set up in 1983, the clearing and payment system was operated by the Hongkong and Shanghai Bank. This bank could at the time adjust the net clearing balance of the banking system on its own and thus offset any impact on interbank liquidity—and, hence, the exchange rate—of the monetary authorities’ transactions with the banking system. This implied that the monetary authorities did not have control over interbank liquidity.23 To address this problem, in July 1988 the Accounting Arrangements between the Exchange Fund and the Hongkong and Shanghai Bank were established, under which the bank was required to adjust its net clearing balance with the rest of the banking system so that it was equal to “the Balance,” which the bank in turn held with the Exchange Fund. Policymakers could thus affect interbank liquidity by varying the amount of the Balance, initially through lending and borrowing of Hong Kong dollars or sale and purchase of foreign currencies in the interbank market, and later through open market operations and the transfer of funds between the Treasury and the Exchange Fund. When the Exchange Fund would reduce the level of the Balance, it would tighten liquidity of the banking system, and vice versa.24 The changes in interbank liquidity, in turn, would influence interbank interest rates and ultimately the market exchange rate of the Hong Kong dollar.

Box 8.Foreign Exchange Reserves

Hong Kong’s international reserves have accumulated rapidly since 1983 owing to strong external sector performance and prudent fiscal policies. When the linked exchange rate system was introduced, foreign assets of the Exchange Fund stood at about US$6 billion; 13 years later, after growing by over 20 percent annually, the reserves reached US$63 billion (see tabulation below). A major part of foreign reserves (about 30 percent) is the counterpart of the fiscal reserves, which had accumulated steadily over the years, reflecting large budgetary surpluses. The foreign reserves are sufficient to cover more than ten months of retained imports of goods and, at close to US$10,000 per capita, are among the highest in the world.

Foreign currency assets of the Exchange Fund (end of period; in billions of U.S. dollars)15.916.324.743.063.3
Growth over the preceding subperiod (average annual percentage change)
In months of retained imports4.46.07.910.010.7
In months of total merchandise imports3.
Per capita foreign reserves (in U.S. dollars)1,0002,8704,3207,1709,940
Sources: Hong Kong Monetary Authority, Monthly Statistical Bulletin; Census and Statistics Department, Hong Kong Monthly Digest of Statistics; and IMF staff estimates.

Converted into U.S. dollars at the linked exchange rate of HK$7.80 per US$1.

Sources: Hong Kong Monetary Authority, Monthly Statistical Bulletin; Census and Statistics Department, Hong Kong Monthly Digest of Statistics; and IMF staff estimates.

Converted into U.S. dollars at the linked exchange rate of HK$7.80 per US$1.

Unlike the quantity of banknotes in circulation, which adjusts to demand, with the Accounting Arrangements the level of interbank liquidity came under direct control of the Exchange Fund. From the beginning, however, the power to control interbank liquidity has been used with restraint. For example, the authorities would inject additional liquidity into the system in the days before large new share offerings in the stock exchange to relieve the tightness arising from the sharp increase in the volume and value of interbank payments.

Since the introduction of the Accounting Arrangements, the exchange rate has been considerably smoother, and overnight interest rates in general have also been less volatile (Table 7).

Table 7.Financial Indicators, Pre- and Post-Accounting Arrangements(In basis points, daily data)
January 1984–June 1988October 1988–September 1996
Average absolute change in:
Hong Kong dollar/U.S. dollar (in percent)0.040.02
Overnight HIBOR14126
Overnight U.S. Federal Funds Rate2522
Three-month HIBOR217
Average absolute difference between:
Overnight HIBOR and LIBOR29162
Three-month HIBOR and LIBOR15432
Source: Data provided by the Hong Kong Monetary Authority.
Source: Data provided by the Hong Kong Monetary Authority.

Major innovations in monetary management in the post-1988 period include the introduction of the Liquidity Adjustment Facility (Hong Kong’s version of a discount window) in 1992,25 a revised mode of money market operations in 1994,26 and the introduction of a Real Time Gross Settlement system in 1996. The introduction of these instruments of monetary management led to a further (small) reduction in exchange rate and interest rate volatility. Such interest rate smoothing is limited to the very short term because of the high degree of capital mobility in Hong Kong and the absence of any exchange controls. More important, interest rate smoothing is a secondary objective to the primary goal of defending the exchange rate.

When pressures on the exchange rate become evident, the power to influence the supply of base money may be used to magnify rather than attenuate the impact of the reserves outflow on the monetary base and thereby raise interest rates. A recent example of such action—and the most important test of the linked exchange rate system to date—took place in January 1995. Following the Mexican peso crisis, during the second week of January 1995 the Hong Kong dollar came under speculative attack. The Hong Kong dollar depreciated from HK$7.7375 per U.S. dollar at the beginning of 1995 to a low of HK$7.7725 per U.S. dollar on January 12 (Figure 17). In response to selling pressures, the Monetary Authority tightened interbank liquidity and intervened directly in the foreign exchange market.27 Banks, concerned that the Monetary Authority would also raise bid and offer rates on its discount window, began actively to bid for funds on the interbank market. The overnight Hong Kong interbank offered rate (HIBOR) surged to an intraday high of 12 percent—rising by almost 5 percentage points in one day—and closed the day some 2½ percentage points higher. During the following days, as interbank liquidity was kept tight and HIBOR remained at an elevated level, the exchange rate began to recover quickly, rising to HK$7.734 per U.S. dollar on January 20. The prompt squeeze of interbank liquidity by the Monetary Authority successfully halted the speculative attack and, reflecting the prompt demonstration of the Monetary Authority’s ability to defend the link, there have been no speculative pressures since then.

Figure 17.Financial Market Developments

Sources: IMF staff estimates; and WEFA/UKFT.

Market Infrastructure and Institutional Developments

On April 1, 1993, the Hong Kong Monetary Authority was established against the background of the growing importance of Hong Kong as an international financial center and the recognition that monetary stability, the soundness and integrity of the financial system, and the efficiency of the financial infrastructure are closely interrelated and should be coordinated in a single body. The Monetary Authority was formed by merging the Office of the Exchange Fund with the Office of the Commissioner of Banking. The Monetary Authority has, in recent years, sought to boost Hong Kong’s role as a major international financial center by upgrading financial market infrastructure, promoting the development of the Hong Kong dollar debt market, and expanding the scope of its own international activities.

Real Time Gross Settlement System

Monetary operations conducted by the Hong Kong Monetary Authority have further evolved with introduction in December 1996 of a Real Time Gross Settlement system. Under this system, the clearing account held by the Hongkong and Shanghai Bank with the Exchange Fund was replaced with 182 clearing balances, one for each licensed bank. The Monetary Authority directly operates each of the clearing balances and has become, in effect, the underwriter for interbank settlement transactions.

Clearing transactions under this system are settled continuously on a gross basis, compared with settlement on a net basis on the morning of the business day following the transaction under the old system. While the Real Time Gross Settlement system does not allow overdrafts, banks requiring intraday liquidity may sell their holdings of Exchange Fund paper, or enter into repurchase agreements with the Monetary Authority for such paper. Such intraday repurchases using Exchange Fund paper are interest-free. Liquidity shortfalls at the end of the day must be met by borrowing funds from the Liquidity Adjustment Facility at the offer rate. To help banks to meet their bulk clearing obligations at specified time of the day, the Monetary Authority introduced a Liquidity Adjustment Window that accepts all private sector paper eligible under the Liquidity Adjustment Facility in exchange for liquidity at the Facility’s offer rate.

The Real Time Gross Settlement system is expected to enhance the robustness of the linked exchange rate system. In the past, the Hongkong and Shanghai Bank often found it difficult to project the amount of clearing transactions of the entire banking system, particularly large deposits and withdrawals that took place close to the end of the business day. As a result, the Hongkong and Shanghai Bank was unable to ensure that the net clearing balance was always equal to the Balance and, consequently, liquidity management operations by the Monetary Authority were often not fully and immediately reflected in the net clearing balance of the banking system. Under the new system, liquidity operations—managed through open market operations and foreign exchange transactions with banks—would become more direct and effective, since each bank would have to ensure that its own clearing balance with the Monetary Authority was sufficient to cover its settlements, plus all transactions it had engaged in with the Monetary Authority.

The Real Time Gross Settlement system also is expected to reduce liquidity and solvency risks—since clearing transactions are settled continuously, banks experiencing a shortage of funds will be detected immediately. Under the old system, such liquidity or solvency problems would not have been discovered until the following business day.

Interest Rate Deregulation

In 1981, after a period of intense competition among banks, the Hong Kong Association of Banks reached an agreement on Interest Rate Rules, under which the Association, after consultation with the monetary authorities, determined maximum interest rates paid by licensed banks on Hong Kong dollar deposits of less than HK$500,000 and of maturity less than 15 months. In addition, the Interest Rate Rules prohibited the payment of interest on current or checking accounts. Before interest rates were liberalized, the Rules affected almost one half of all deposits. While defended on the grounds that they promoted stability in the banking system in Hong Kong’s potentially volatile financial environment by enabling banks to build substantial reserves against external and internal shocks, the Rules were criticized by Consumer Council and foreign banks. The Consumer Council (1994) complained that the Rules enabled large local banks to earn monopoly rents by virtue of their extensive branch networks. Foreign banks, particularly those that did not enjoy large branch networks and were forced to borrow funds at a premium from local banks or engage in currency swaps, argued that the Rules simply boosted profits of the major local banks.

In response to these criticisms and in view of the growth of swap deposits, a plan to deregulate the payment of interest on time deposits was approved in 1994 (HKMA (1994)).28 Demand and savings deposits affected by the Interest Rate Rules, which comprised the bulk of affected deposits, were not part of the deregulation plan. Restrictions on time deposits were removed in stages between October 1994 and October 1995, when the Monetary Authority lifted the ceilings on interest rates of time deposits of exactly seven days. Further deregulation would not be considered until after 1997, as concerns were expressed about the effect of increased liberalization on the stability of the banking system.

As interest rates were liberalized, deregulated Hong Kong dollar time deposits grew sharply. This mainly reflected a shift in funds from swap deposits. By mid-1996, deposit movements had stabilized and the growth of deregulated time deposits had slowed to 10 percent. Spreads between Hong Kong and U.S. time deposit rates returned to the levels prevailing prior to the interest rate liberalization.

Hong Kong Dollar Debt Market

Compared with the large stock market, Hong Kong’s domestic debt market is relatively undeveloped. At the end of 1995, bonds outstanding issued by Hong Kong private issuers represented only 12 percent of GDP, while the stock market capitalization was more than double the size of GDP. Historically, the development of the Hong Kong dollar debt market has been constrained by the lack of benchmark risk-free government securities, the absence of a bond rating, and the dominance of banks in the financial sector relative to securities firms (World Bank (1995)). However, the bond market began to grow rapidly in recent years, in large part owing to the authorities’ efforts.

In 1990, the Exchange Fund Bills program was launched to facilitate open market operations and develop the domestic debt market. In 1993, the program was extended to Exchange Fund Notes with maturities longer than one year. The proceeds of the bills and notes are not used to fund government spending. Instead, these proceeds are invested by the Monetary Authority, which also took over the government Bond Program in March 1993.

The gradual lengthening of the maturity of the Exchange Fund bills and notes has provided a benchmark for the issuance of debt instruments of longer maturities. The first issue of 5-year notes was launched in 1994, and 10-year notes were launched in 1996. New issues of Exchange Fund notes have been favorably received by the market, and investor confidence for the notes that straddle the 1997 handover date appears to be high. The average accepted yield of the first issue of the 10-year notes launched in October 1996 was 90 basis points above corresponding U.S. treasury bills. The yield spread has since fallen to around 50 basis points.

A very active primary and secondary market has developed in Exchange Fund bills and notes. As the value of bills and notes outstanding has grown from HK$8 billion at the end of 1993 to HK$92 billion in March 1997, the average daily trading volume has risen steadily to almost one-fifth of total bills and notes outstanding in 1996. The Monetary Authority has taken measures to boost the liquidity of the debt market by extending the eligibility of repurchase securities under the Liquidity Adjustment Facility to Mass Transit Railway Corporation and Airport Authority debt instruments, as well as to certain other privately issued Hong Kong dollar bonds.

Regarding the private debt market, the Stock Exchange of Hong Kong has been successful in attracting new bond listings from overseas corporations, supranational organizations, and sovereign issuers whose bonds trade on a regional or global basis. However, debt securities and warrants together account for less than 1 percent of the market capitalization of the Stock Exchange. In 1995, HK$60 million was raised through private debt issues, compared with HK$7.6 billion raised in the Stock Exchange through initial public offerings of equity.

Hong Kong Mortgage Corporation

The growth of the Hong Kong dollar debt market has been hindered by the absence of a broad range of debt instruments, including mortgage-backed securities. The development of a market in mortgage-backed securities, in turn, has been constrained by the lack of standardization in mortgage loans, which has prevented the pooling of such loans into marketable instruments that could be easily analyzed by prospective investors. Moreover, it was difficult for any single bank to launch a securities issue of sufficient size to form a market for mortgage-backed securities.

In light of these constraints, the authorities approved in July 1996 the establishment of the Hong Kong Mortgage Corporation, with a capital base of HK$1 billion. The operations of the Mortgage Corporation are expected to commence in the fourth quarter of 1997. The intention is for the Mortgage Corporation to intermediate between mortgage loan originators and investors by purchasing mortgage loans for its own portfolio and funding these purchases through the issue of unsecured debt securities.29 Once it becomes more established, the Mortgage Corporation will also package the mortgage loans from its own portfolio (or from banks) into mortgage-backed securities, guaranteeing the timely payment of principal and interest on these securities. By helping to reduce the maturity mismatch in the structure of commercial banks’ assets and liabilities, the Mortgage Corporation is expected to contribute to overall banking stability.30 While almost all mortgages are at floating rates—and thus there is little interest rate risk—the maturity mismatch can result in substantial liquidity and funding risks. To reduce such risks, the Mortgage Corporation would help the banks to unload the mortgage loans as and when needed. Similarly, it would help the banks to reduce the risk of high concentration of mortgage lending in their loan portfolios.31

The Hong Kong Mortgage Corporation will initially be owned by the government, but will operate on commercial principles and will eventually be turned over to the private sector.

International Activities of the Hong Kong Monetary Authority

The Monetary Authority has played an active role in promoting regional and international monetary cooperation. Following the Mexican financial crisis, the central banks of Hong Kong, Australia, Indonesia, Malaysia, and Thailand signed, in 1995, a series of bilateral repurchase agreements. Under these agreements, a central bank could borrow amounts reported to be up to US$500 million on a one-week basis from another central bank in the region against the security of U.S. treasury bonds in order to boost its U.S. dollar liquidity in times of market stress. In 1996 and early 1997, the Hong Kong Monetary Authority also signed similar bilateral agreements with the central banks of China, Japan, the Philippines, Korea, New Zealand, and Singapore.

Reflecting the international financial community’s recognition of the arrangements for two mutually independent monetary authorities after the transfer of sovereignty, both the People’s Bank of China and the Hong Kong Monetary Authority joined the Bank for International Settlements (BIS) in 1997. The Hong Kong Monetary Authority will also participate in the IMF’s New Arrangements to Borrow.

Financial System and Regulatory Framework

With about 500 banks and representative offices of foreign banks present in Hong Kong, the financial sector makes a significant and rising contribution to the economy in terms of employment, payroll, value added, and foreign exchange earnings. Accordingly, the authorities have given increasing prominence to the prudential supervision of banks and development of the financial regulatory framework in line with international standards. In response to episodes of instability in the financial sector, a concerted effort to strengthen the regulatory framework was begun in the late 1980s. Hong Kong’s financial sector now meets major international prudential standards, such as those of the Basle Committee and the International Organization of Securities Commissions.

Bank Soundness

Overall, Hong Kong banks are profitable and well capitalized. During the first half of the 1990s, the Hongkong and Shanghai Bank and its subsidiary Hang Seng Bank were often among the most profitable banks in the world. Many other Hong Kong banks also reported posttax returns on equity approaching 20 percent during this period, compared with rates of return of about 15 percent for banks in industrial countries. In 1996, posttax profits of local banks increased by about 13 percent.

Banks’ capital bases have strengthened since the early 1990s. The average risk-weighted capital adequacy ratio for the entire banking sector rose from 13 percent in 1991 to 17.8 percent in 1996, well above the international minimum standard of 8 percent.

In 1995, when the property market was severely depressed, only 1.7 percent of loans made by all banks in Hong Kong were classified as nonperforming (the share was 2.8 percent for local banks). In 1996, the proportion of nonperforming loans increased as many foreign banks were affected by the decline in offshore lending. Bad debt charges more than doubled in 1996 to 0.18 percent from 0.08 percent in 1995. Nevertheless, these levels remain relatively low by international standards.

The reasons underlying the high profitability of Hong Kong banks have been the subject of some debate.32 In this context, an important question has been whether the caps on interest on time deposits, as well as demand and savings deposits, contributed to bank profitability in Hong Kong. The available evidence suggests that, although banks in Hong Kong have enjoyed a higher interest rate spread relative to their counterparts abroad, the net interest income of Hong Kong banks is not high by international standards.33 Rather, operating expenses and provisions for bad loans and other losses are substantially lower for Hong Kong banks, resulting in a higher return on assets. The low operating expenses reflect the fact that banks in Hong Kong are relatively efficient, despite increases in the costs of doing business in recent years.

The impact of property price fluctuations on the financial sector has been a perennial concern in view of the concentration of bank lending to the property sector. As of the end of 1996, residential mortgages represented a quarter of loans for use in Hong Kong. If loans for building, construction, and property development and investment are included, then the share of property-related lending in total loans for use in Hong Kong rises to 46 percent; however, the share of property-related lending in total loans is much lower (19 percent). The historical record indicates that the rate of mortgage loan default is very low by industrial country standards. One reason is that more than half of property-related loans are to end-users, who have traditionally serviced mortgage loans diligently. Banks have also voluntarily adopted conservative loan-to-value ratios for mortgage lending—70 percent on average, and 50 percent for luxury properties—giving them a cushion against property price declines (the effective loan-to-value ratio is on average about 55 percent). Also, banks have traditionally avoided loans at fixed interest rates. As a result, the sharp decline in property values experienced over 1994–95 did not have a significant impact on banks’ balance sheets.

As for the property developers, they have generally followed conservative financial policies and avoided high gearing. These policies have been acknowledged by international rating agencies, which have assigned the debt of some major property companies a rating equivalent to that of Exchange Fund Notes.

Owing to the large share of loans to the property sector, there is a mismatch between the maturity structures of banks’ assets and liabilities. Although interest rates on the bulk of assets and liabilities reprice relatively quickly—for the banking sector as a whole, 75–80 percent of interest-bearing assets and liabilities reprice within three months—the Monetary Authority has supported the establishment of a mortgage corporation that would, inter alia, standardize the procedures for banks to sell their mortgage loans in the secondary market.

Banking Supervision

The strong performance of Hong Kong’s banking sector in recent years belies its volatile past (Box 9). Banking crises occurred in 1982–86, and to a lesser extent in 1991, when the worldwide collapse of the Bank of Commerce and Credit International led to the closure of BCCI (HK) and bank runs on some of the other local banks. However, a major source of potential banking sector instability—regulatory weakness—has been addressed through a series of regulatory and supervisory measures taken since the mid-1980s.

With the establishment of the Hong Kong Monetary Authority in 1993, the powers and duties of the Office of the Commissioner of Banking to develop standards and regulations, supervise banks, and oversee the stability and the development of the banking system as a whole were vested in the Monetary Authority. The Monetary Authority has adopted as one of its cornerstones the policy of ensuring the safety and stability of the banking system. In its approach, it aims to balance the need to preserve the general stability of the banking system with the provision of sufficient incentives for banks to operate efficiently.

Banks in Hong Kong are monitored on a continuous basis using a variety of techniques with the goal of detecting any problem at an early stage. At the core of the Monetary Authority’s approach is the on-site examination of individual financial institutions. About one-half of the Monetary Authority staff are bank examiners. Banks are examined, on average, once every two years, with banks based in OECD countries examined once every two to three years, and banks based in developing countries once every 18 months. Bank examinations are supplemented with off-site reviews, prudential meetings, and analyses by external auditors. The Monetary Authority also maintains direct communications with home regulators of foreign banks in Hong Kong. In supervising banks with international operations, it follows international practice as embodied in the principles of the revised Concordat issued by the Basle Committee. In addition, the Minimum Standards of the Basle Committee have been incorporated into the authorization criteria for overseas applicants for banking licences.

Box 9.Banking Crisis of the Early 1980s

Hong Kong’s most serious recent banking crisis evolved over 1982–86.1 The crisis affected a wide range of banks and was caused by, among other factors, ineffective prudential supervision. A general crisis of confidence and macroeconomic instability contributed to banking instability. As a result of the crisis, the authorities have adopted strengthening of prudential supervision and improving bank soundness as top priorities for monetary policy.

The crisis began with a run in September 1982 on Hang Lung Bank, then suspected of high-risk exposure. Quick support actions by other leading banks temporarily suppressed the incipient bank run. In November 1982, following the disclosure of financial difficulties of two large property firms (Eda Investment and Carrian Holdings), several deposit-taking companies found themselves on the brink of insolvency. To avert a crisis, the Hongkong and Shanghai Bank issued a statement pledging its support for “soundly-based and well-managed” deposit-taking companies. However, by early 1983 seven of these companies had failed, causing heavy losses to their depositors. These failures created a mounting sense of apprehension about the soundness of the banking system.

On “Black Saturday,” September 24, 1983, when the Hong Kong dollar plunged to a record low of HK$9.60 per US$1, rumors also spread quickly about the difficulties of certain banks. In response, the government announced that it was considering a currency stabilization plan, which a few weeks later led to the creation of the linked exchange rate system. In addition, the government took over Hang Lung Bank, which was unable to meet its obligations, and organized with the Hongkong and Shanghai Bank a joint rescue packagefor the Sun Hung Kai Bank.

For a while, these actions helped restore confidence. But in mid-1985, the Overseas Trust Bank, then Hong Kong’s fourth largest domestically incorporated bank, declared insolvency. The Hong Kong government took over the bank by using an estimated HK$2 billion from the Exchange Fund. Despite this rescue action, several other banks suspected of imprudence once more became the targets of deposit withdrawal.

Three main causes of the banking crisis were identified (see Jao (1992)). First, the owners or managers of individual banks or deposit-taking companies were guilty of various forms of imprudence, mismanagement, malpractice, or even criminal offences. Second, the banking regulatory framework was inadequate and enforcement of prudential regulations was lax. Third, adverse changes in the general environment, including political shocks and the worldwide economic downturn, affected the viability of financial institutions and public confidence in them.

With regard to regulatory deficiencies, the Banking Ordinance at the time had a number of loopholes. The liquidity ratio could be manipulated easily, there were no capital ratio provisions to cushion losses and defaults, and there was no control over insider transactions. The enforcement of the Banking Ordinance was relatively lax. Finally, the inability of the authorities to control growth of money and credit during the floating-rate regime of 1974–83 contributed to macroeconomic overheating and deterioration in the quality of bank management.

The most lasting consequence of the crisis has been a radical overhauling of the whole system of prudential supervision, which began in 1985. In 1986, a revised Banking Ordinance was passed with the following features:

  • The separate ordinances for licensed banks and deposit-taking companies were consolidated.
  • A minimum capital-to-risk-assets ratio of 5 percent was introduced for all Hong Kong banks and deposit-taking companies. The Banking Commissioner was empowered to increase the ratio for particular institutions to 8 percent in the case of banks and 10 percent in the case of the deposit-taking institutions.
  • A minimum liquidity ratio of 25 percent against qualifying liabilities was introduced for all banks and deposit-taking companies.
  • The powers of the Banking Commissioner were widened, and he was also empowered to appoint a second auditor for banks and deposit-taking companies, and to call a tripartite meeting between the Banking Commission, the auditors, and the institution concerned.
1 This box draws on Jao (1992), pp. 58–61.

In recent years, bank disclosure requirements have been enhanced in order to encourage market participants to influence banks’ commercial decisions more directly. In 1994, banks were for the first time required to publish information on transfers to inner reserves and, in 1995, to disclose the level of these reserves. The 1996 disclosure package covered such areas as cash flow statements and market risk exposure. It is expected that in due course regulators would increasingly focus on evaluating banks’ risk management systems.

Box 10 summarizes the key features of Hong Kong’s banking regulatory framework.

Regulatory Framework for the Securities Market

The stock market crash of October 1987 brought to light serious flaws in both the regulation and operation of Hong Kong’s securities markets. In response to these flaws, the Securities and Futures Commission was established in 1989, with responsibility for supervising the stock and futures exchanges, regulating other financial intermediaries, enforcing codes of conduct, and recommending securities market legislation. The Stock Exchange of Hong Kong and the Hong Kong Futures Exchange were reorganized, and the Securities and Futures Commission has increased market transparency and efficiency, and strengthened investor protection, surveillance, and investigative work. Hong Kong’s securities markets have adopted international regulatory standards.

Box 10.Summary of Banking Regulations

Exchange controls


Types of financial institutions

Licensed banks, restricted license banks, and deposit-taking companies are authorized banking institutions. “Nonauthorized institutions” are representative offices of overseas banks, insurance companies, mutual funds, securities brokers, finance companies. Nonauthorized institutions are subject to a number of different regulatory frameworks.


Licensed banks are akin to retail or “high-street” banks; restricted license banks are specialized in merchant banking services, whereas deposit-taking companies are mainly engaged in business such as trade finance and personal loans. Restricted license banks and deposit-taking companies are restricted according to the types of deposits they can accept, rather than the types of activities they can engage in.

Entry/ownership requirements

  • Domestic entities applying to become licensed banks: entity must not be a subsidiary of a local or overseas bank already licensed in Hong Kong, and must have been an authorized institution for 10 years, with deposits not less than HK$3 billion and assets not less than HK$4 billion. The Hong Kong Monetary Authority exercises control over shareholding issues, and over banks’ controllers and executives.
  • Foreign entities: An overseas bank must obtain the Monetary Authority’s approval, and have assets in excess of US$16 billion, and reciprocity in the bank’s home country must be available to Hong Kong banks.

Reserve requirements


Capital adequacy

  • BIS standards applied to domestic licensed banks (the minimum 8 percent ratio may be increased for any particular institution, up to 12 percent for licensed banks and 16 percent for a restricted license bank or a deposit-taking company).
  • Quarterly capital adequacy ratio reporting system.


  • A 25 percent minimum liquidity ratio in each calendar month.
  • Monthly liquidity ratios reporting system.

Deposit insurance

None. A small depositors’ prior claim scheme on the liquidation of a bank was adopted by the Legislative Council in 1995.

Interest rate controls

The Interest Rate Rules, which set maximum rates paid on certain Hong Kong dollar deposits, were removed on all time deposits with a maturity of seven days or more. Interest cannot be paid on current (that is, checking) deposits.

Lending restrictions

  • Loans to one borrower limit: 25 percent of capital base.
  • Sectoral exposure limits: Moral suasion used to urge prudence in real estate lending, in particular with regard to loan-value ratios for mortgage lending. Banks may not hold real estate of an aggregate value exceeding 25 percent of their capital base (exceptions are the bank’s own premises and land for which the bank is mortgagee).
  • Country exposure limits: Guidelines on provisioning, based on the Bank of England matrix, exist. There are controls on exposure to foreign banks.
  • Aggregate value of unsecured specified liabilities to connected parties: 10 percent of authorized institution’s capital base.
  • Security market exposure: An authorized institution may not hold shares to an aggregate value exceeding 25 percent of capital base. Underwriting permitted if the commitment is disposed of in seven working days.
  • Exchange rate risk: Industry guideline issued to banks. Overnight open position agreed with authorized institution. Monthly reporting of foreign exchange position.


Liquidity return is submitted on a monthly basis. In addition to the returns mentioned in this box, there are other returns that authorized institutions need to submit on a monthly, quarterly, and semiannual basis.

Prudential supervision

Approximately annual to biannual on-site examinations to check bank records and management practices, particularly asset quality. Off-site annual reviews of bank statistics, followed by prudential interviews with senior management of banks. Auditing of banks’ systems for compiling prudential returns and ensuring compliance with certain banking regulations. Tripartite meeting would also be held with management of banks and external auditors.

Public disclosure

Audited annual financial statements are required under the Companies Ordinance, which apply to locally incorporated authorized institutions regardless of whether they are incorporated under the Ordinance. Disclosure of inner reserves required for all authorized institutions. Banks incorporated outside Hong Kong, subject to auditing and accounting requirements of their home country, can apply for an exemption to these requirements. Audited annual financial statements (inner reserves not allowed). “Reports of Condition and Income” are available to the public. Financial disclosure is applied to all authorized institutions.

In establishing a framework for H share listings for Chinese enterprises, the Securities and Futures Commission, the Stock Exchange of Hong Kong, and the Chinese authorities recognized that a sound regulatory framework was critical. In this context, H share companies were required to meet all the listing and reporting standards that apply to Hong Kong listings. Efforts were also coordinated between the Chinese and Hong Kong authorities to curtail backdoor listings, the practice whereby Chinese enterprises entered the Hong Kong stock market by purchasing listed Hong Kong companies and used them as shell companies to raise equity finance in Hong Kong.

Other recent regulatory developments include the introduction of Codes of Conduct for futures and securities dealers by the Futures Exchange and the Securities and Futures Commission, and new disclosure requirements for all listed companies, which require companies to report on directors’ and managers’ salaries, liquidity and capital resources, material changes in operational items, investments, and prospective merger negotiations. In addition, a new Securities and Futures Bill, to be introduced in 1997, will consolidate existing legislation on the regulation of the securities and futures market, and will streamline the regulatory framework.

Factor Markets and Social Policies

The Hong Kong government has generally refrained from direct intervention in factor markets, focusing instead on measures to facilitate market-based adjustments. In the labor market, the government has been involved mainly through its role in social policies, which has expanded rapidly in recent years, but nevertheless remains relatively small by international standards. In the property market, the main intervention has come through the large public housing program and, to a lesser extent, as a by-product of the government’s title to ownership of all land in the territory.

Labor Market Policies

During the past decade, the main labor market issue has been labor shortage rather than unemployment. To address this issue, in 1989 the government put in place a General Labor Importation Scheme, under which no more than 25,000 low- and semiskilled workers (about 1 percent of the labor force) were allowed to work in Hong Kong at any one time.34 In 1992, a special labor importation scheme was approved to meet the temporary surge in demand for construction workers on the airport project. Labor imports of up to 17,000 workers were allowed under this program. A new pilot program to recruit about 1,000 Chinese professionals began in 1994 in order to meet the excess demand for labor in the financial sector.

The sharp and somewhat unexpected rise in unemployment during 1995 led to calls for the government to reexamine its noninterventionist labor market policies. Unemployment was concentrated in the restaurant and retail sectors, which traditionally have absorbed a part of the low-skilled workforce released from manufacturing. As employment in manufacturing continued to contract at a double digit rate in 1995, the weakening of the demand for low-skilled service jobs was interpreted by many observers as a structural phenomenon. In addition, the skill mismatches between the unemployed and job vacancies had increased and prolonged the job search process, contributing to an increase in unemployment.

The continuing strength in overall employment suggested, however, that the impact of demand-side factors was limited. The government therefore focused on the microeconomic aspects of the problem. The Employees Retraining Scheme, introduced in 1992 to provide vocational training to workers displaced from the manufacturing sector, was expanded to teach new skills (such as computing), and a separate Job Matching Program was introduced in order to fill the large number of vacancies.35 Under the program, more than 10,000 workers (75 percent of participants in the program) found jobs between April 1995 and December 1996. In addition, as public concern about the unemployment problem initially centered around imported labor, the government tightened the General Labor Importation Scheme by cutting the quota on imported labor to 2,000 workers. In the event, the decline in real wages brought about by these adjustments led to increased demand for labor and easing of unemployment pressures in 1996.

Social Policies

Over the past ten years, social services, comprising health, education, and social welfare, have been the fastest growing category of government spending. The growth in social spending partly reflected secular trends, such as the structural shift to a services economy, which required the workforce to obtain new skills, and demographic changes, such as increased immigration and the aging of the population. However, at about 8½ percent of GDP in FY 1995 (including the budgetary cost of the public housing program), the level of social spending is still low in comparison with the OECD countries, and accounted for slightly less than half of total public expenditure:

In billions of Hong Kong dollarsIn percent of GDPIn percent of public expenditure
Health care24.32.212.7
Social welfare14.11.37.4
Public housing19.11.810.0

Social Welfare

Social welfare in Hong Kong comprises social security and other targeted programs aimed at supporting vulnerable groups and those who are not expected to work, for example, children or the disabled. For the working population, as discussed above, the government has sought to ensure that labor market flexibility, combined with the schemes for employee retraining and job matching, enable the unemployed to return to work quickly. In comparison with the OECD countries, Hong Kong does not have an extensive social safety net—total public expenditure on social security only reached 1 percent of GDP in FY 1995. The following programs constitute Hong Kong’s social safety net.

  • The Comprehensive Social Security Assistance scheme raises income to a minimum level for eligible persons in five categories: the elderly, the disabled, children, the sick, and able-bodied adults. Able-bodied adults, with certain exceptions, have to register for job placement in order to qualify. The scheme includes a means test and requires residence in Hong Kong for at least one year. The Comprehensive Social Security Assistance scheme covered about 130,000 cases at the end of 1995 at a cost of HK$4.2 billion.36 The number of its recipients grew by 14 percent a year over 1991–95.
  • The Social Security Allowance (SSA) scheme provides modest flat rate allowances for the elderly and severely disabled who do not qualify for the Comprehensive Social Security Assistance. Eligibility for the old-age allowance requires Hong Kong residency for at least five years prior to receiving assistance under the scheme. Except for those aged between 65 and 69, the scheme does not include a means test. At the end of 1995, the Social Security Assistance scheme covered almost half a million people at a cost of HK$3.6 billion. The program grew by 2 percent a year since 1990.
  • There are also three other schemes, for victims of crime and law enforcement acts, traffic accidents, and natural or other disasters, who are not means-tested.

The welfare schemes are funded entirely from government’s current revenue. Grants and loans for capital projects with a welfare content are provided out of the Lotteries Fund. Apart from schemes providing financial assistance, the government and nongovernmental organizations run welfare programs to help families, children, the disabled, and the elderly.

Pension System and Care for the Elderly

The aging of the population has increased assistance for the elderly in recent years. The number of people aged 65 and above increased from an estimated 390,000 in 1984 (7 percent of total population) to 630,000 by mid-1996 (10 percent) and is projected to increase to about 1 million by 2016 (13 percent). Public spending on health and welfare services for the elderly increased by 55 percent in real terms from FY 1992 to FY 1996, reaching about HK$12 billion in FY 1996.

Care for the elderly is provided through income-support schemes (discussed above), government and private pension schemes, and residential care institutions. The coverage of these schemes is as follows.

  • About half a million elderly people received old-age allowances under the Social Security Assistance and Comprehensive Social Security Assistance schemes in mid-1996.
  • The government operates three retirement schemes: a pay-as-you-go pension scheme for about 180,000 civil servants (6 percent of the employed), a similar scheme for those employed in the judiciary, and a fully funded provident fund scheme for about 50,000 teachers.
  • About 15,000 private pension schemes cover about 830,000 employees in the private sector (about 29 percent of the employed). During FY 1995, total value of assets of some 8,800 retirement schemes registered with the Office of the Registrar of Occupational Retirement Schemes amounted to about HK$84 billion, while the total annual contributions to these schemes amounted to about HK$18 billion, three-fourths of which were funded by employers.
  • The government provides residential care for about 15,000 elderly who can no longer be cared for at home and funds community support services for the elderly.

Under the present system, the government encourages the establishment of voluntary retirement protection schemes and monitors and regulates them under the Occupational Retirement Schemes Ordinance. However, the possibility of introducing some form of compulsory retirement benefit scheme has been discussed in Hong Kong for many years. In December 1993, the government tabled a proposal for a pay-as-you-go old-age pension scheme, which would have provided a fixed monthly benefit to every eligible resident aged 65 and over. The scheme was to be financed by a levy of 3 percent on assessable income, to be split equally between the employees and employers, while the government proposed to make a HK$10 billion (1¼ percent of GDP) one-time contribution. The key benefit of the scheme, according to the original proposal, was that it would have provided immediate benefits upon implementation to all eligible elderly residents, including low-income employees, homemakers, and retirees. The proposal gave rise to a number of concerns, including the lack of relationship between the contribution and benefit rates and the risks of creating a large unfunded liability for the future government. After public consultation in early 1995, the old-age pension scheme proposal was withdrawn due to lack of public support.

In March 1995, the government unveiled a new pension proposal—the privately managed Mandatory Provident Fund scheme—that would cover about 2 million employees (Box 11). It has been proposed that existing private pension schemes could continue to operate if they met some minimum requirements, including providing employees with a choice of staying with or joining existing occupational retirement schemes or opting for Mandatory Provident Fund coverage. The government has elaborated various aspects of the Mandatory Provident Fund with consultants, the financial industry, and representatives of the employers and employees during 1996, and has presented to the Legislative Council the draft subsidiary legislation in the second quarter of 1997. If approved, the Fund could start operation in 1998.

Property Market and Land Policy

Public Housing Program

Hong Kong’s government operates an extensive public housing program, which covers almost half the population (about 3.1 million people). The program was started in 1954 in response to an acute housing crisis that developed after World War II. The program received a major boost in 1972, when the government revealed a long-term plan calling for an acceleration of public housing construction to provide accommodation for 1.8 million people over 10 years. In the early 1980s, public housing policy shifted from massive production to a more quality-oriented approach. Housing production in the public sector nevertheless continued to exceed that in the private sector:

Public rental units14,55918,560141,000
Subsidized housing units22,02318,968175,000
Units under the Home Ownership Scheme121,141151,000
Units for “sandwich class” families88224,000
Subsidized loans for private purchase16,000
Private housing units20,351195,000

Including the Private Sector Participation Scheme, which is complementary to the Home Ownership Scheme but uses private sector resources. Under this scheme, 66,000 apartments had been built by March 1996, and a further 62,000 are planned for the period up to March 2001.

Including the Private Sector Participation Scheme, which is complementary to the Home Ownership Scheme but uses private sector resources. Under this scheme, 66,000 apartments had been built by March 1996, and a further 62,000 are planned for the period up to March 2001.

Total housing stock of 2 million units as of mid-1996 included 700,000 public rental units and about 220,000 subsidized housing units.

The main areas of the public housing program are public rental housing, subsidized home ownership schemes, financial assistance for home buyers, and facilitation of private housing production.

  • The Home Ownership Scheme was introduced in 1978 to build new public housing units for sale to qualified applicants at about half the market price. It has since become the largest public housing scheme. Households with an income below HK$26,000 and public housing tenants (for whom there is no income limit) are eligible for this scheme. The subsidy mainly comes in the form of land granted by the government to the Housing Authority and the Housing Society. In addition, favorable mortgage terms are available under the scheme.
  • The Sandwich Class Housing Scheme targets families with monthly income of HK$26,000-50,000. These families have too high an income to qualify for public housing, but cannot afford mortgages for private housing. This scheme is also based on the granting of land to the Housing Authority on concessional terms, and it provides for mortgages at a 2 percent interest rate.
  • Financial assistance under the Home Purchase Loan Scheme consists of interest-free loans or a monthly subsidy to low- and middle-income families. The income limits are the same as those for the Home Ownership Scheme.

Box 11.Mandatory Provident Fund Scheme Proposal

The main elements of the proposed Mandatory Provident Fund scheme are as follows.1

  • Coverage: All employees and self-employed between the age of 18 and 65 are covered, except civil servants, judicial officers, and teachers covered by statutory pension schemes, and domestic employees and persons who entered Hong Kong to work for a limited period or who already have a home country scheme.
  • Contributions: For monthly incomes of HK$4,000–20,000, both the employee and employer have to contribute 5 percent of the employee’s income each. If the monthly income exceeds HK$20,000, the employee and employer have to contribute up to the first HK$20,000 of the monthly salary; for the portion of salary above this amount contributions are not mandatory. An employee with monthly income below HK$4,000 is not required, but may elect to contribute; the employer must, however, contribute 5 percent of the employee’s income.
  • Vesting and preservation of benefits: All contributions to the Fund must be fully and immediately vested with the employee’s account. All benefits derived from the Fund must be preserved until the employee reaches the age of 65, or retires between the ages of 60 and 65.
  • Portability of benefits: The accrued benefits of an employee can be transferred to another scheme when an employee changes an employment, or left with the trustee of the scheme maintained by the previous employer.
  • Mandatory Provident Fund Schemes Authority will administer and regulate the system. The Authority will also approve trustees, regulate their operations, and make rules and guidelines for administration and regulation of the system.
  • Trustees are responsible for all aspects of a scheme and must comply with regulations and duties imposed by the Authority. Trustees may be corporate or individuals; overseas trustees and master trusts can be established if they meet certain requirements.
  • A compensation fund will be established to compensate employees for losses due to fraud or misfeasance. Losses due to poor investment will not be compensated. The government intends to contribute HK$300 million as seed money toward the compensation fund.

The authorities estimated the size of annual contributions to the Mandatory Provident Fund at about 4 percent of GDP. Assuming a 3 percent real rate of return and a 40-year contribution period, benefits under the Fund are projected at about 50 percent of the average wage. The Fund is not expected to affect the gross flow of saving significantly because it would mainly rechannel saving from personal to organized funds. Given the requirement to invest 30 percent of the funds in Hong Kong dollar assets, the scheme could help accelerate the development of the Hong Kong dollar debt market, although currently pension funds already allocate a comparable share of their portfolio to such assets.

1 Hewitt Associates and GML Consulting (1995).

The demand for housing has increased over the past few years, and future demand may surpass the current production targets for the period up to 2001.37

The most important agency involved in the implementation of the public housing program is the Housing Authority, a quasi-autonomous nongovernmental organization with 15,000 employees. The practice of granting land outright for public housing projects has resulted in a large implicit subsidy that is not transparently classified as social spending in the fiscal accounts. The total market value of land granted to the Housing Authority and the Housing Society during FY 1991–95 was HK$126 billion (up to 3½ percent of GDP a year). The value of all land granted to the Housing Authority alone was HK$142 billion (valued at historical cost) at the end of FY 1995.

A number of concerns about the allocative efficiency and equity aspects of the program have been expressed over the years.38 In particular, there have been concerns about long waiting periods for public housing (about 6½ years on average), while many current occupants had sufficient means to move to private housing. The government estimated that in 1995 at least 13 percent of families living in public housing owned other property.39 In 1996, the Housing Authority decided to strengthen the means tests for tenants and applicants, so that those with means above prescribed levels will be required to pay market rents. In January 1997, the government also proposed to raise public housing rents to 15–18½ percent of household income from the current average of 9 percent. These measures are aimed at increasing the home ownership rate from 52 percent to 60 percent of the households by the year 2001.

Private Residential Property Market

The government has only rarely intervened in the private residential market, generally leaving the property cycle to run its course. In recent years, however, prompted by signs of widespread speculation, the government intervened twice to cool the escalating property prices—in early 1994 and again in early 1997 (Box 12). Many of these measures were aimed at the forward sales of apartments, which have spontaneously developed during the early 1990s in response to persistent housing shortage. This market innovation had allowed the developers to act as wholesalers, that is, to unload their stock to speculators (or end-users), who then served as retail distributors for developers. It has been argued that restrictions on forward sales would raise both the risks of property development (by eliminating an important leading indicator for private developers), and the overall costs of property development (by forcing developers to hold on to their stock until final sale), thereby reducing the incentives for developers to acquire developable land. However, while the speculators may have played a useful market role, their activities were regarded as having generally amplified price fluctuations. In the event, the measures restricting the presale of uncompleted apartments taken in 1994 proved effective, as the share of speculative sales in total sales stood at about 10 percent in November 1995, compared with over 20 percent in early 1994.40

Land Policy

As land in Hong Kong is owned by the Hong Kong government, the land market is essentially a market for land leases, most of which are transferable. The leases for newly released land are generally allocated to the highest bidder at public auctions.41 As each lease term requires a large lump-sum premium and a small annual rent, the premium attached to any given land lease approximates the land value. In view of these special characteristics of the land market in Hong Kong and the steady increase in property prices in recent years, a key issue has been whether the policy of auctioning off land to the highest bidder has negatively affected the supply of property and amplified the secular rise in prices. Several factors suggest that this has generally not been the case.

  • In the residential market, the historical correlation between land supply and net private housing supply is relatively weak, even allowing for a lag of 2–3 years between the land sales and housing completions. However, the negative correlation between land sales and housing prices (with about a year’s lag) is relatively strong.42
  • Since 1984, land releases have been subject to an annual limit of 50 hectares agreed to in the Sino-British Joint Declaration (see Section VI). Under agreements negotiated in the Sino-British Land Commission, this limit has been consistently breached, especially with respect to land for housing development, suggesting that the pressure on the government has been to increase rather than withhold the supply of land.
  • The bulk of land for commercial development has traditionally been supplied through redevelopment of old sites. Evidence suggests that the incentive to acquire land for redevelopment (from both the government and private owners) and the speed of redevelopment depend primarily on the market response in the forward sales market, which is generally driven by market sentiment about the macroeconomic outlook.
  • While land sales are a major source of revenue for the government, the Hong Kong government share of this revenue is earmarked for capital works projects.
  • Rather than depressing the supply of property, the restrictive land policy may have actually encouraged the production of housing units in the short run because the anticipated higher future rents have been capitalized into higher current housing prices (Peng and Wheaton (1994)). In the long run, the main effect of the current land policy seems to have been to promote substitution of capital for land by encouraging the construction of high-rise apartment buildings and raising the density of development.

Despite the downturn in the property market, prices achieved in land auctions during 1994–96 were generally higher than expected. As property companies typically acquire land long before developing the sites in order to build up strategic “land banks,” the intensive bidding in land auctions indicated their confidence in the longer-term outlook for the Hong Kong economy.

Box 12.Government Measures for the Residential Property Market

Following the sharp escalation in property prices and the intensification of property speculation in 1993 and early 1994, the government took the unusual step of intervening directly in the property market in March and June of 1994. A government task force identified a number of factors underlying the rapid price increases (Planning, Environment, and Lands Branch (1994)).

The demand-side factors included the exceptionally high population growth since 1990 (over 2 percent per year), the decline in household size, a growing number of expatriate professionals working in Hong Kong, the rising affluence of the population, negative real interest rates, and strong inflows of capital.

The main supply-side factor was the small net increase in the housing stock (about 3 percent per year between 1990 and 1993). The task force concluded that there was no reason to be concerned about the overall stability of the residential property market, but measures were needed to address concerns about social stability and Hong Kong’s competitiveness. The measures announced by the government were, therefore, directed at curbing speculation and increasing the supply of land and housing:

  • Changes in town planning rules, including rezoning of land for commercial purposes
  • Increasing the supply of new sites and facilitating redevelopment of existing sites
  • Speeding up the processing of new land grants, land exchanges, and lease modifications
  • Involving the private sector in the supply of infrastructure for major private sector projects
  • Increasing housing and land supply, including a plan to increase the overall supply of apartments built on new land by 45,000 units by 2001
  • Measures to dampen speculative activities, including
    • (1) Lowering the quota for private (insider) sales of uncompleted apartments;
    • (2) Restricting forward sales of apartments to not more than nine months before the anticipated date of assignment to buyers; and
    • (3) Increasing the initial deposit and the penalty for default of purchase to 10 percent of the purchase price.

In March 1997, following the strong runup in residential property prices in the second half of 1996 and early 1997, the government passed additional measures.

  • The presale period was extended from 12 months to 15 months before the estimated date of completion of the development.
  • Property developers were required to put all apartments for presale onto the market within six months of the date of consent given, and to increase the proportion of apartments for presale.
  • It was agreed to release 587 hectares of land for housing development (327 hectares for public housing and 260 hectares for private housing) by the year 2002.

Trade and Competition Policies

Trade Policy

Free trade is one of the founding principles of Hong Kong as an economic entity. Long before the worldwide process of trade liberalization began and the multilateral trading system was established, Hong Kong had been practicing free and open trade with no tariffs, no trade restrictions, and no unilateral trade policy instruments to protect domestic industries or promote exports. The commitment to this principle has derived from the simple reality that Hong Kong has a small domestic market, limited usable land, and no natural resources other than its deep-water harbor. Against this background, Hong Kong’s economy has benefited enormously from the world trade liberalization and, in particular, the opening up of China to foreign trade and investment. China’s anticipated accession to the World Trade Organization (WTO) would bring to Hong Kong enhanced access to China’s vast market and the resulting increase in trade between China and other countries, a large part of which would continue to be conducted through Hong Kong.

The Hong Kong Special Administrative Region will possess full autonomy in the conduct of its external economic relations with separate membership in the WTO, the Asian Development Bank, and the Asia-Pacific Economic Cooperation (APEC) forum, among others.

Import and Export System

Hong Kong is a duty-free port and does not levy any tariffs on imports. Apart from import quota control on rice and certain ozone-depleting substances, Hong Kong does not maintain any quantitative restrictions. Import licensing requirements are kept to a minimum and either stem from obligations under international agreements, or are applied for reasons of health, safety, or access to high-technology products, or for environmental reasons. Uniform excise taxes are imposed for revenue-raising purposes on imports and domestic production of tobacco, cosmetics, alcohol, and some hydrocarbon oils.43 A substantial tax (40–60 percent published retail price) also is imposed on the initial registration of motor vehicles, which are all imported, to raise revenue and contain vehicle growth. Voluntary export restraint arrangements and marketing arrangements do not exist, either at the government or the industry level. Government procurement policies treat all local and overseas suppliers on an equal footing. Export controls apply only in the textiles and clothing sectors, required by commitments under the Multi-Fiber Arrangement.44 The Hong Kong government does not provide subsidies, tax exemptions, or other financial incentives to assist the promotion of exports from Hong Kong.45 Finally, there is no foreign exchange control in Hong Kong. Movement of funds into and out of Hong Kong is completely free and the Hong Kong dollar is freely convertible.

Trade Policy Objectives and Issues

Consistent with its belief in free trade, the Hong Kong government strongly supports the multilateral trading system and does not participate in any preferential trading arrangements. To the extent that Hong Kong participates in such arrangements, however, the objectives of trade policy are to safeguard Hong Kong’s rights and fulfill its obligations under relevant agreements and to maintain and improve access for Hong Kong exports (GATT (1994)).

Hong Kong played an active role in the Uruguay Round of multilateral trade negotiations and was one of the founding members of the WTO.46 At the first WTO Ministerial Conference in Singapore in December 1996, Hong Kong proposed a broad-based review of WTO rules to assess their interaction with globalization and investment and competition policy. Hong Kong has also participated in services negotiations in several areas, and supported China’s accession to the WTO. On the regional trade front, Hong Kong has actively participated in the APEC forum since becoming a member in 1991. Hong Kong has taken the position that trade and investment liberalization within APEC should be consistent with the multilateral trading system.

While the full impact of the phaseout of quantitative restrictions under the Agreement on Textiles and Clothing, which replaced the Multi-Fiber Arrangement, has yet to be felt, Hong Kong’s textiles and clothing sectors have already adjusted to structural changes over the past decade by shifting to production of high value-added items such as fashion clothes, relocating labor-intensive production processes to China and other low-cost economies, and setting up production facilities in the United States and Europe to gain better access to these markets. Hong Kong has thus increasingly become a control and support center for production bases in foreign countries.

In recent years, the trade policy issues of greatest importance for Hong Kong have been market access for Hong Kong exports and trade relations between the United States and China. In regard to market access, several countries have taken antidumping measures against Hong Kong exporters. Although there have been no legal rulings against Hong Kong on charges of dumping, the accusations often inflicted considerable economic damage during the protracted period prior to the resolution of legal proceedings. The government has therefore pressed, in the context of the Uruguay Round, for strengthening the WTO rules on the settling of antidumping disputes.

With regard to U.S.-China trade relations, the main issue for Hong Kong has been the annually recurring renewal of China’s Most Favored Nation trading status. According to official estimates, a withdrawal of China’s favored status would reduce Hong Kong’s reexports to the United States by up to 45 percent. As various trade-related services would also be affected, this could result in losses of up to 60,000 jobs in Hong Kong, and a reduction in the annual growth rate of real GDP of between 2 and percentage points.47 There would be further losses in income and jobs for Hong Kong if China were to cut back on its imports from the United States, and if there was a consequent weakening of investment in China by Hong Kong and foreign companies. In view of the magnitude of this impact, the Hong Kong authorities have actively advocated the renewal of China’s Most Favored Nation status before the U.S. authorities.

Competition Policy

Owing to Hong Kong’s openness, firms in the traded goods and services sectors are subject to strong competition from abroad. In the nontraded goods and services sectors, the degree of competition also is generally high, as restrictions on entry exist only in a few industries. However, there has been increased attention paid to competition policy in the nontraded sector with the realization that a fair and open competition in this sector is an essential element in Hong Kong’s efforts to maintain its status as an international business center.

Questions concerning the degree of competition are largely limited to those few markets where, owing to scale economies or specific entry restrictions, only a limited number of firms are active. Important examples are property development, telecommunications, public utilities, broadcasting, and supermarkets. Also, licensing requirements in the legal, accounting, and medical professions, while serving a legitimate cause, have the effect of reducing entry and competition. Because many nontraded services are used as inputs for traded goods and services, elevated costs resulting from a lack of domestic competition can affect Hong Kong’s pattern of comparative advantage as well as its attractiveness to foreign capital and labor.

Hong Kong has no comprehensive competition policy based on laws against collusive agreements, the abuse of market power, or mergers and acquisitions that create a dominant market position. Instead, for certain activities with a recognized oligopoly, the government controls private firms’ behavior under clearly defined schemes of control, which list strict performance criteria and prescribe a specific formula on the basis of which agreed profits can be generated. Such regimes exist for power utilities, telecommunications, and public transportation. The gambling sector is a regulated monopoly, run by the Hong Kong Jockey Club. For other sectors, the government follows a case-by-case approach in determining the need for controls on anticompetitive behavior.

Responding to a call by the governor to work toward the development of a comprehensive competition policy, the Consumer Council has examined the degree of competition in domestic sectors in a series of studies since 1992.48 The studies covered banking (in particular, the issue of caps on interest rates on time deposits, discussed above), domestic gas supply, broadcasting, telecommunications, private residential property, and supermarket industries. In 1996, in a general study of Hong Kong’s competition policy, the Consumer Council argued that transparency and effectiveness of the regulatory framework could be enhanced, and recommended the adoption of a comprehensive competition law, with a competition authority to investigate breaches of the law (Consumer Council (1996d)).

The degree of competition in domestic sectors also was examined in a recent study commissioned by a private group, the Vision 2047 Foundation (Enright and others (1997)). The nontraded sectors, by and large, scored good marks in this study for quality and—when compared with other countries in the region—the price of services provided. However, the study also found scope for greater efficiency and more competition in a number of important areas, including in the self-regulated legal and accounting professions, where the lack of competition has led to relatively high costs and charges. The study also concluded that, while Hong Kong has the potential to become a significant supplier of medical and educational services to the region, this opportunity has not been exploited. High barriers to entry into local medical practice and a virtual government monopoly in both sectors were considered to have contributed to the loss of such potential.

Sectoral Competition Issues

The market for residential property development is dominated by a small number of firms. According to the Consumer Council (1996c), between 1991 and 1994, one firm supplied 25 percent of the housing units, 55 percent came from four developers, and seven suppliers supplied 70 percent of new private housing. Since 1981 no new firm has been able to secure a market share larger than 5 percent, indicating a low degree of contestability. The Consumer Council noted a number of de facto barriers to entry, including large resources needed to enter the sector, high finance costs for entrants owing to the lack of a track record, and entrants’ weak bargaining power in hiring professionals and contractors. The Council also noted that prolonged apartment vacancies, downward price rigidity, and the release of apartments in batches rather than on a continuous basis may indicate oligopolistic behavior within the sector. Enright and others (1997) concluded, however, that concentration had not made the domestic property developers inefficient, since they successfully sold their services outside Hong Kong. According to this study, the high property costs in Hong Kong should primarily be attributed to the scarcity of land and the government’s ability to influence land supply, rather than developers’ oligopolistic behavior.

Hong Kong’s two privately owned electricity suppliers are subject to both profit and price controls. Their tariffs depend on a user’s level of consumption, but there are no sector-specific concessions. The terms of these schemes of control rewarded the companies for capital investment. Enright and others (1997) found that this had led to the creation of one of the highest quality power supply infrastructures in the world, that, while not among the most expensive in Asia, was arguably more expensive than it should be, given the low overhead costs of delivering such services in Hong Kong’s geographically compact territory.

In the gas supply market, the sole piped-gas supplier, Hong Kong & China Gas, has not been subject to price regulation or operated under franchise, since it is deemed to have to compete with electric power companies and suppliers of bottled liquefied petroleum. The Consumer Council (1995) argued that these policies helped Hong Kong & China Gas earn high profits to the detriment of its customers, and recommended that it be regulated proactively by imposing profit or price controls in the public interest. The Consumer Council also proposed the introduction of a “common carrier” system to eliminate the entry barrier into gas supply transmission and distribution networks. The government, while viewing the rate of return earned by the Hong Kong & China Gas as being in line with those of electric power companies, has engaged a consultant to conduct a study on the feasibility of the common carrier system.

Box 13.Regulation of the Telecommunications Industry

The regulatory framework governing Hong Kong’s telecommunications sector currently adopts an open market approach. Except for certain international circuits and services, competitive conditions exist in local telephony (four carriers), radio paging (with over 30 licenses and more than 1 million subscribers), cellular phone services (four operators, with more than 1.3 million subscribers), and a wide variety of other communications services.

By far the largest operator, the Hong Kong Telecom Group comprises three entities operating telecommunications services. Hong Kong Telephone Company holds one of the four local telephone network licenses. Hong Kong Telecom CSL provides liberalized telecommunications services. Hong Kong Telecom International holds an exclusive licence, expiring in 2006, for certain international circuits and services.1 The separation into three entities, with their own accounting requirements, is intended to ensure transparency and prevent crosssubsidization between regulated and nonregulated areas. Hong Kong Telephone Company is subject to a system of price caps, limiting annual price increases to the increase in the CPI less 4 percent. Hong Kong Telecom International must comply with a tariff ceiling on its international calls. Both arrangements were intended to induce the companies to share productivity gains with consumers. All other segments of the industry are free of price or profit controls.

In the area of local fixed telephone services, residential users are charged a flat-rate monthly tariff for unlimited local calls. The government allowed three new companies into the market in July 1995 when Hong Kong Telephone Company’s monopoly franchise expired. Net proceeds from international calls are shared between Hong Kong Telecom International and local providers in compensation for delivering basic access. At the beginning of 1996, Hong Kong Telephone Company still accounted for 99 percent of basic telephone calls. Official estimates have put the consumer savings from the opening of local telephony at about HK$1.7 billion over 1995–2005.

In the area of international telecommunications, Hong Kong Telecom International was granted in 1981 a 25-year exclusive licence to provide certain external circuits and services. The Consumer Council (1996b) recommended that the Telecommunications Authority of Hong Kong monitor the accounting rates negotiated by the Hong Kong Telecom International with its counterparts in foreign countries. The government agreed to this recommendation, and proposed in the Telecommunication (Amendment) Bill that adequate power be conferred on the Telecommunications Authority to influence the implementation of the international accounting rate system in Hong Kong so that public interest is not hurt.

The government has reviewed the Telecommunications Ordinance and published in March 1997 a consultation document setting out a series of legislative amendments to update the regulatory framework for the industry.

1 Private companies may operate their own international circuits for intracorporate traffic by certain specified means.

Water is supplied by a government department to all commercial users at a flat rate set to recover full productions costs plus a return on assets; the tariffs are determined by the Executive Council.

Hong Kong’s two railway operators, the Kowloon Canton Railway Corporation and the Mass Transit Railway Corporation, are publicly owned and their Board members appointed by the governor. Under existing legislation, both corporations are free to determine their fares. Though the Governor in Council is empowered to give directions to ensure the public interest, this has never occurred. The increase in fares over the past ten years has been in line with inflation.

Bus and ferry services are provided mainly by franchised operators. Their fares are determined by the Executive Council and their services monitored by the Legislative Council. The largest bus operator, Kowloon Motor Bus, has been subject to a profit control scheme specifying maximum annual profits. The companies face competition from other modes of transport, including public light buses and the railways. In the latest survey of household expenditure, transportation expenses were found to constitute a relatively high proportion—around 7 percent—of average household expenditure.

Owing to rapid pace of technological progress, the regulatory framework for the telecommunications industry has undergone significant changes in recent years (Box 13).

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