United Kingdom
Hong Kong: Recent Economic Developments

This paper reviews economic developments in the United Kingdom—Hong Kong during 1990, focusing on the expansion and the subsequent slowing in domestic demand in the 1990s, against the background of the export-driven growth in the second half of the 1980s. Developments in aggregate demand and supply, labor and property markets, and inflation and competitiveness are analyzed. The paper reviews budgetary developments, discusses issues in the structure of revenue and expenditure, and describes the proposed Mandatory Provident Fund scheme. Monetary and exchange rate developments are also analyzed.


This paper reviews economic developments in the United Kingdom—Hong Kong during 1990, focusing on the expansion and the subsequent slowing in domestic demand in the 1990s, against the background of the export-driven growth in the second half of the 1980s. Developments in aggregate demand and supply, labor and property markets, and inflation and competitiveness are analyzed. The paper reviews budgetary developments, discusses issues in the structure of revenue and expenditure, and describes the proposed Mandatory Provident Fund scheme. Monetary and exchange rate developments are also analyzed.

I. Introduction 1/

This paper reviews economic developments in Hong Kong over the last several years, focusing on the expansion and the subsequent slowing in domestic demand in the 1990s, against the background of the export-driven growth in the second half of the 1980s. Developments in aggregate demand and supply, labor and property markets, and inflation and competitiveness are analyzed in Chapter II. Chapter III reviews recent budgetary developments, discusses issues in the structure of revenue and expenditure, and describes the proposed Mandatory Provident Fund scheme. Monetary and exchange rate developments are analyzed in Chapter IV, the equity market in Chapter V, and developments in the banking sector in Chapter VI. Chapter VII reviews the external sector and discusses medium-term projections of the trade balance. The main issues for trade policy for Hong Kong are described in Chapter VIII, and the main statistical issues in Chapter IX. Finally, the Annex to this paper discusses estimates of a consumption function for Hong Kong.

The last review of recent economic developments for Hong Kong was-prepared for the 1992 Article IV consultation discussions, and it covered developments in the late 1980s and early 1990s, when the pressure on inflation from rapid growth in domestic demand was rising. 2/ For the 1993 Article IV consultation discussions, the staff prepared background papers on developments in inflation and asset markets, and discussed alternative medium-term scenarios and implications of the then proposed Old-age Pension Scheme. 3/ Background papers prepared for the 1994 Article IV consultation discussions focussed on institutional developments (including the linked exchange rate system, budgetary performance, and the financial system and regulation), and on economic integration with China (including the impact on business cycles in Hong Kong, real and financial links with China, and the framework for transition in 1997). 4/ These background papers complement to a large extent the review of recent developments presented in this paper.

II. Developments in the Real Sector

1. Domestic demand and output

a. Overview

The pattern of growth in Hong Kong in the first half of the 1990s differed from that in the second half of the 1980s. Real GDP expanded by over 5½ percent per annum in 1990-94, compared with 7 percent in 1985-89 (see tabulation below). Growth in the first half of the 1990s was underpinned by domestic demand, which expanded by 7 ¾ percent per annum, compared with 5 ½ percent in the second half of the 1980s. The role of the external sector changed dramatically: while it contributed about 1 ½ percent per year to real GDP growth over 1985-89, over 1990-94 the external sector withdrew the stimulus to GDP growth at the average rate of -2 ½ percent per year, reflecting sharp deterioration in merchandise trade balance. However, growth in the 1990s was much more stable, ranging between a low of 3 ½ percent in 1990 and a high of 6.3 percent in 1992; by comparison, growth in the second half of the 1980s ranged between a low of ½ percent in 1985, and a high of 13 percent in 1987.

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A number of factors contributed to the shift in the growth pattern in the 1990s. Private consumption, boosted by rising real wages and negative real interest rates, surged by over 8 percent per year during 1991-93. Meanwhile, the Government started a massive program of infrastructure development, while the private sector began to invest heavily in machinery and equipment in order to offset the effects of rising labor costs. While export growth remained robust—total exports grew on average by 13 percent per year between 1991 and 1994–growth in imports, which was responding to buoyant domestic demand, was much faster. By end-1995, the balance on goods an nonfactor services trade thus turned to a deficit for the first time since 1982.

Successive increases in U.S. interest rates in 1994 and early 1995 aligned monetary conditions more closely with cyclical developments in Hong Kong. As a result, private consumption and asset markets consolidated during 1994-95. Overall growth remained strong, however, owing to increased expenditure on the new airport, a build-up in inventories in anticipation of spending on infrastructure projects, and a rebound in exports of goods and services in response to the deprecation of the U.S. dollar during the first half of 1995.

The following sections analyze in detail developments in the components of domestic demand, and provide an overview of external demand and output developments by sector.

b. Domestic demand

Private consumption, which accounts for almost 60 percent of GDP (Appendix Table 1), grew at an average annual rate of close to 8 percent between 1991 and mid-1994, compared with 4 ¼ percent between 1985 and 1989 (Table 1). Spending on durables was particularly buoyant, recording double-digit growth in each year during this period (Chart 1). Consumption growth peaked during the first quarter of 1994 at 11 ¼ percent (annual rate) and, after a gradual deceleration through the rest of 1994, became basically flat during the first three quarters of 1995. Retail sales were hit particularly hard: the overall volume of retail sales dropped by 1 ¼ percent during the first three quarters of 1995, and sales of motor vehicles by 32 percent (see tabulation below).

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Growth in private consumption over the past few years was driven primarily by changes in personal incomes and real interest rates. The labor market was extremely tight in the early 1990s, leading to strong growth in real wages and raising the expectations of future wage increases. At the same time, real interest rates became negative, providing a major boost to consumption, especially of durables. 1/ The empirical estimates of the consumption function for Hong Kong discussed in the Annex suggest that the swing in interest rates between the late 1980s and early 1990s raised the growth rate of private consumption by about 1.3 percentage points. Similarly, the return to positive real interest rates in late 1994 and 1995 slowed the growth rate of real consumption by about 1 percentage point, and the growth rate of durables consumption by close to 3 percentage points. Changes in real income growth, measured in terms of both real GDP and wages, were also pronounced between these periods. Given the high income elasticity of consumption demand, the observed swings in private consumption are not surprising.

Table 1.

Hong Kong: Gross Domestic Product by Expenditure Component at Constant (1990) Market Prices, 1990-95

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Sources: Census and Statistics Department, Estimates of Gross Domestic Product, 1961 to 1994; and Quarterly Estimates of Gross Domestic Product. Third Quarter 1995.

Percentage changes calculated over corresponding year-earlier period.

Chart 1
Chart 1


Citation: IMF Staff Country Reports 1996, 029; 10.5089/9781451816792.002.A001

Sources: Census and Statistics Department. Quarterly Estimates of GDP, Third Quarter 1995; and Estimates of Gross Domestic Product 1961-1994: and staff estimates.

Other factors that are widely believed to have had an effect on private consumption are investment income for Hong Kong entrepreneurs from outprocessing operations in China, and the wealth effects of asset price changes. Data on investment income for 1993 indicate a net inflow of investment income of about 1 percent of GDP in 1993; however, no historical comparisons of this figure are possible as yet. 2/ As for the wealth effects of asset price changes, their impact could not be assessed because of lack of household balance sheet data.

Government consumption expenditure, which accounts for about 8 percent of GDP, slowed from 6-8 percent per annum in the early 1990s, to 3-4 percent per annum in recent years. The main reason for this shift was slower growth in compensation of government employees (see tabulation below). The size of the civil service has also declined since the beginning of the decade.

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Private investment, which accounts for one quarter of GDP and almost 90 percent of gross fixed capital formation, has been growing by over 8 percent per year since 1991 (Appendix Table 2). Most of this growth came from machinery and equipment investment, which raised the (gross) stock of capital goods in the private sector by more than 75 percent between 1991 and 1995. Retained imports of industrial machinery for manufacturing use, office equipment, and other capital goods (excluding transport equipment) have been particularly strong (see tabulation below). 1/

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Coupled with developments in employment, these data suggest that capital has been increasingly substituted for labor in both manufacturing and the services sectors. These changes have been largely associated with shifts in the relative prices of factors of production. Prices of imported capital goods have generally been growing more slowly than nominal wages since 1991, so that the relative price of capital with respect labor has declined through most of this period (see tabulation below).

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Private construction and property investment fluctuated considerably from year to year, but on balance remained flat between 1991 and 1994. What growth there was came mainly from infrastructure development, as residential and non-residential construction both advanced slowly. Other components of property investment—real estate developers’ margins and transfer costs of land and buildings—have by and large declined since 1991. Movements in price deflators suggest that construction costs were fairly stable and, on average, grew at half the rate of CPI inflation between 1991 and 1994. On the other hand, price deflators for real estate developers’ margins and transfer costs of land and buildings increased much faster than consumer prices, reflecting the strength of excess demand that had led to the property market boom of 1991-94 (discussed below).

Government investment has been the fastest growing component of GDP in the last five years. Public construction has doubled and public investment in machinery and equipment tripled in real terms since 1991. This expansion came entirely from infrastructure development; public investment in residential and nonresidential buildings has actually declined since the beginning of the decade. Most of the infrastructure development was associated with the Airport Core Program (ACP), but there have also been major projects involving river and container port facilities, road and rail transport, environmental projects, and land reclamation. The main impetus for infrastructure development has been the rapid expansion of Hong Kong’s external trade since the mid-1980s, which has intensified the demand for transport facilities and stretched Hong Kong’s otherwise well-developed infrastructure to the limit.

The Airport Core Program is a massive infrastructure development project which includes a new airport on Chek Lap Kok Island and nine largescale projects providing urban infrastructure services to the airport. 1/ Total cost of the ACP is estimated at HK$158 billion (US$20.3 billion) in current prices, equivalent to 13 percent of GDP over the construction period of the project. Major work on the ACP started in 1992, and the ACP was 43 percent complete in November 1995; it is expected that the airport will be opened in April 1998. The spending profile of the ACP calls for about 70 percent of spending to be incurred over FY 1994-FY 1996 (see tabulation below). As the ACP projects are contracted out on a “fixed price” basis involving lump-sum payments to contractors, the spending profile differs slightly from actual construction activity, which is expected to reach its peak by mid-1996, when an estimated 20,000 workers will be on the airport island.

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According to official estimates, construction of the new airport is expected to contribute about 0.4 percentage points to growth of GDP in 1995, and about 0.8 percentage points in 1996. The pressure on aggregate demand is being partly offset by the large imported component of the project (most of the required machinery and equipment as well as construction materials are imported), and the crowding-out effect on other capital works projects. The availability of foreign workers under a special labor importation scheme has helped to restrain construction wage increases to about 9 percent per year since the first quarter of 1994. Regarding the long-run impact of the ACP, the Government estimates that the new airport will increase Hong Kong’s GDP by at least HK$420 billion over the period 1997 to 2010. In addition, usable land area is expected increase by 1 ½ percent as a result of reclamation projects and new land released along the airport railway.

Like government investment, the accumulation of inventories exhibited unusually strong growth in the past two years. After having been reduced to a very low level by the end of 1993, the change in inventories contributed 3 ¼ percent to growth of real GDP in 1994, and as much as 4 ¾ percent during the first three quarters of 1995. The trends in retained imports on the one side, and domestic consumption and investment on the other, suggest that most of the increase in stocks was accounted for by production inputs and capital goods. 1/ However, there was also some accumulation of stocks of consumer goods (see tabulation below). 2/

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Several factors may have been responsible for this pattern of inventory accumulation. First, large-scale infrastructure projects, which were generally being constructed under very tight schedules, raised substantially the requirement for readily available stocks of imported raw materials, construction machinery, and equipment. Second, increased domestic exports required larger stocks of production inputs and capital goods than in recent years, when domestic exports declined. Finally, there was some unintended accumulation of stocks of consumer goods due to the unexpectedly sharp decline in retail sales in 1995.

While the accumulated inventories will inevitably be run down over the coming year, the net impact of stock decumulation on GDP growth is unlikely to be negative, as most of the stocks will appear in either increased investment or higher export and consumption figures.

c. External demand

Despite the rapid growth in both merchandise and services exports, the surplus on trade in goods and nonfactor services has declined substantially since the late 1980s, falling from 8 ¾ percent of GDP in 1989 to 1 ¾ percent of GDP in 1994, and further to a (probably small) deficit in 1995. As a result, there has been a substantial withdrawal of external stimulus since the late 1980s, equivalent to about 2 ¼ percent of GDP in each of the five years (see tabulation below).

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Net re-exports have on average contributed almost 3 percent per annum to real GDP growth since 1991, followed by net exports of nonfactor services, whose contribution averaged about ¾ percent. Net domestic exports, on the other hand, have been withdrawing the stimulus to GDP growth at the average rate of 6 percent per year since 1991. These developments reflect the rapid increases in real domestic demand during the first half of the decade, and the continuing real appreciation of the Hong Kong dollar. As noted above, retained imports of consumer goods, capital goods, and production inputs were buoyed in the past five years by rising real incomes, accommodative financial conditions, and the ambitious program of public infrastructure development. In addition, the surge in retained imports was attributable in part to the relative strength of the Hong Kong dollar, which appreciated by 30 percent in real effective terms since 1989 as a result of the relatively higher rates of inflation in Hong Kong compared with those registered in trading partner countries.

d. Sectoral composition of output

The shifts in the sectoral composition of output accelerated since the late 1980s (Appendix Table 3). Between 1989 and 1993, the shares of financing, social services, ownership of premises, and transportation sectors in GDP increased, while those of manufacturing, trade and tourism, and construction sectors declined. In particular, the share of manufacturing declined by 8 percentage points to 11.1 percent of GDP in 1993 (see tabulation below).

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The decline in the share of the manufacturing sector and the rising importance of the financing, social services, property, and transportation sectors are part of the secular trend of the maturing of the Hong Kong economy. During the past 15 years, this trend has been accelerated by the reforms and opening up of China, which have provided Hong Kong’s manufacturers with an opportunity to exploit a large differential in labor and land costs between Hong Kong and the mainland. 6 At the same time, Hong Kong’s services sectors were able to expand their operations on the back of the growing interest in China by foreign and domestic investors. The pace at which this process continues will, of course, depend on developments in China’s economy and the global economic environment. The process as a whole will, however, inevitably continue, given the underlying changes in the demographic structure and human capital of Hong Kong’s population.

2. Labor market

a. Overview

Following a long period of tight labor market conditions, Hong Kong’s labor market recently showed clear signs of easing, with a sharp rise in the unemployment rate attracting much popular attention. This section, after briefly describing the tight conditions until end-1994, discusses the factors behind the recent rise in the unemployment rate. It shows that the easing in the labor market was driven mainly by a strong surge in labor force growth, primarily reflecting a rise in returning migrants. The section also discusses the Government’s policy toward the rise in unemployment. The Government has resisted calls for activist macroeconomic measures to create jobs, and instead, has strengthened the retraining and job-matching program. More recently, a tightening of the labor importation scheme was proposed, but it is unlikely to have a significant influence on overall labor market conditions.

b. Recent developments

Labor market conditions tightened progressively during the 1980s, with the unemployment rate falling from 3-4 percent in the first half of the decade to an average rate of less than 1 ¼ percent in 1989-90 (Chart 2 and Table 2). A number of factors contributed to this tightening. On the demand side, the rapid output growth sustained over the decade added to labor market pressures. On the supply side, the labor force growth rate declined from about 2 ½ percent in the first half of the 1980s to virtually no growth in 1989-90, owing to a combination of natural demographic trends, a tightening of restrictions on the admission of unskilled workers from China, and a decline in the labor force participation rate. The labor supply situation was also exacerbated by a significant increase in emigration from Hong Kong, especially toward the end of the decade. To cope with the very tight conditions in the labor market, the Government introduced the General Labor Importation Scheme in 1989. Nevertheless, conditions in the labor market remained tight during 1991-94, with the unemployment rate remaining at about 2 percent.

The unemployment rate has risen sharply since early 1995 to 3 ¾ percent in the latter half of the year. Much of the rise in unemployment reflects a surge in labor supply. Between 1981 and 1992, labor force expanded by 1 percent a year. In contrast, labor force grew by as much as 3 ¼ percent in 1993-94, and 4 percent (annual rate) since the second quarter of 1995, the fastest increase in labor force since 1982. As the increase in the labor force participation rate was rather small, higher labor force growth came mainly from a surge in population growth. As shown in the tabulation below, most of the labor force growth was due to a net migration of people into the territory. The net inflow primarily reflected the larger number of returning Hong Kong emigrants; 1/ however, increases in the number of immigrants from China and incoming expatriate professionals also played a role. 2/

Chart 2
Chart 2


Citation: IMF Staff Country Reports 1996, 029; 10.5089/9781451816792.002.A001

Sources: Census and Statistics Department, Hong Kong Monthly Digest of Statistics.
Table 2.

Hong Kong: Labor Force, Employment, and Unemployment, 1989-95

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Sources: Census and Statistics Department, Hong Kong Monthly Digest of Statiatics: and Financial Services Branch, Third Quarter Economic Report 1995.

Period average.

End of period.

Wholesale, retail, import and export trades, restaurants, and hotels.

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In addition to the strong growth in labor supply, the recent rise in unemployment partly reflected the labor demand factors. In 1993-94, total employment expanded by over 3 percent per year, keeping up with the growth in labor supply. While employment continued to grow by over 2 ½ percent (year-on-year) in mid-1995, the growth in labor supply has been much faster. The easing of labor demand was concentrated in the restaurant and retail sectors, that traditionally absorbed much of the labor force released from manufacturing. As discussed above, the tightening of monetary conditions since mid-1994 has led to a considerable cooling off of consumer demand, resulting in slow growth in restaurant businesses and declining retail sales. As a result, there has been less demand for low-skilled manufacturing workers, and there have even been reductions in personnel in shops and restaurants. Meanwhile, the manufacturing sector continued to reduce employment. These sectoral developments have increased skill mismatches between the unemployed and job vacancies, and prolonged the job search process, thus partly contributing to an increase in the unemployment rate. However, the continued strength in overall employment growth suggests that the impact of such demand-side factors was limited.

The easing in labor market conditions alleviated the pressure on wages. After growing by 2 ¾ percent in 1993, real wage growth slowed to 1 ¼ percent in 1994, and further to -1 ¾ percent in 1995, the first drop in real wages since 1991.

c. Policy responses

The Government has regarded the rise in unemployment largely as a supply-side phenomenon and has rejected calls to take macroeconomic measures for job creation. Instead, it focused on the microeconomic aspects of the problem and strengthened job retraining and job-matching programs. In April 1995, the Government launched a new job matching program that combines conventional retraining with customized job search assistance. The motivation for these actions came from the observation that in the second quarter of 1995 there were 51,700 job vacancies compared with 113,000 unemployed. So far this program has been successful, with over 60 percent of applicants finding new jobs. However, due to its labor intensive design, the program has reached only a small portion of unemployed.

As much of public concern about unemployment has focussed on imported labor, the Government has recently proposed a tightening of the General Labor Importation Scheme. Under the GLIS, a total of 25,000 workers—typically with two-year nonrenewable contracts—were allowed to work in Hong Kong at any one time. The Government proposed replacing the GLIS by a more limited Supplementary Labor Scheme (SLS). Under the proposed SLS, the quota would be reduced to 2,000 workers and allocated directly to individual employers rather than by industry. The downsizing of the labor importation quota is unlikely to have much impact on the labor market. The number of new workers brought into Hong Kong under the GLIS has been very small relative to the overall increase in the size of the labor force. In 1994, the imported labor accounted for less than 5 percent of the increase in total labor force. 1/ As the government stopped issuing new quotas for imported workers in August 1994, even the complete elimination of labor importation would not have significantly reduced the strong growth in labor force registered in 1995.

3. Property market

a. Overview

The property market has undergone a prolonged correction since its peak in April 1994. The market downturn was prompted by sharp increases in interest rates in 1994, and also by government measures to dampen speculation in the property market. Although the residential market has been most affected by the downturn, prices of office and retail properties also declined. However, land sales have been little affected and there have been no significant financial repercussions for developers or banks.

b. Residential property market

About 52 percent of Hong Kong’s population lives in private housing, mostly apartments. 1/ Among private housing units, about 70 percent are owner-occupied. Because of strong demand and relatively tight supply, residential property prices and rents rose continuously between 1984 and 1994. The capital value of apartments doubled, on average, in real terms between 1985 and 1994 (and more than tripled for luxury apartments). The largest gains in prices were realized in 1991-92 (about 40 percent per year), and during the first quarter of 1994, when apartment prices rose by 33 percent (annual rate) on average, and by 60 percent for luxury apartments (Table 3). Such large price increases were widely viewed as excessive. In response, the Government took measures to cool the property market (see the Box). Meanwhile, interest rates firmed as U.S. monetary conditions were tightened: between March 1994 and February 1995, the Best Lending Rate, to which mortgage rates are tied, rose by 2 ½ percentage points to 9 percent. Following these developments, residential prices began to fall; prices of apartments in new developments declined by 20 percent between the second quarter of 1994 and the third quarter of 1995. 2/

Given the prolonged nature of the decline in the market and the fact that it was the first downturn in more than a decade, consumer confidence and investor sentiment were profoundly affected. On the macroeconomic level, the impact was evident in the slowdown in growth of private residential construction and private consumption, and in the decline in the value-added component of property investment. The financial health of the property sector has been little affected by the downturn, however. Developers have generally followed conservative financial policies and avoided high gearing. These policies have been acknowledged by international rating agencies, which have rated the debt of some major property companies the same as Exchange Fund Notes. The property sector is generally considered to be highly competitive, with a large number of well diversified, listed companies.

As for the banks, although property related loans have accounted for over 40 percent of loans for use in Hong Kong, banks have regarded such lending as relatively safe, as about 60 percent of property lending was to end-users and the mortgage failure rate has traditionally been exceptionally low. Banks had also voluntarily adopted high loan-to-value ratios for mortgage loans (70 percent on average, and 50 percent for luxury apartments), and were not providing fixed-rate loans.

Table 3.

Hong Kong: Real Estate Price and Rental Indices, 1990-95 1/

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Source: Census and Statistics Department, Hong Kong Monthly Digest of Statistics.

Data are period averages.

Percentage chances are calculated over corresponding year-earlier periods.

Government Measures for the 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. 1/ 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 Bong Kong, the rising affluence of the population, negative real interest rates, and strong inflows of foreign capital. The stain 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. However, measures ware 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.

Measures announced on March 2. 1994:

1. Change in town planning rules:

  • Re-Zoning of land for commercial purposes;

  • Relaxation of limits on office expansion in industrial/office use buildings.

2. Increasing the supply of new sites.

3. Speeding up the processing of new land grants, land exchanges, and lease modifications.

4. Facilitating the redevelopment of existing sites.

5. Involving the private sector in supplying the infrastructure for major private sector projects.

Measures announced on June 8, 1994:

1. Measures to increase housing and land supply:

  • Increasing the overall supply of apartments built on new land by 45,000 units by 2001;

  • Increasing land supply for housing development by 120 hectares before FY 1997;

  • Speeding up the processing of land transactions and building applications;

  • Speeding up the redevelopment of old buildings and underutilized sites.

2. Measures to dampen speculative activities:

  • Lowering the quota for private sales of uncompleted apartments;

  • Restricting forward sales of apartments to not more than 9 months before the date of assignment;

  • Increasing the initial deposit to 10 percent of the purchase price and raising the penalty for default of purchase to 10 percent of the purchase price.

One measure that received a great deal of attention among market analysts was the restriction on forward sales of apartments. Before June 1994, developers were allowed to put their uncompleted apartments on the market for pre-sale up to 18 months before the anticipated date of assignment to buyers. This market innovation had allowed the developers to act as wholesalers, i.e., 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. The counterargument has been that, while the speculators may have played a useful market role, their activities had generally amplified price fluctuations. In the event, the measure restricting the pre-sale of uncompleted apartments proved very 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. 2/

c. Office property market

The office property market is predominantly a rental market. Price and rent levels vary considerably (as much as five to six times) with the district and the quality of accommodation. Over the past 15 years, cyclical variations in the supply, take-up, and vacancy rates of office space were clearly discernible, with each cycle lasting 4-5 years; net supply has generally responded to demand and rent levels with a lag of 1-2 years.

The latest upswing in prices and rents of office property started in 1991, coinciding with a surge in demand for high quality offices, especially in the Central business district on Hong Kong Island. The demand came from both overseas investors—who were attracted by the prospects of strong growth in trade with China—and Chinese enterprises seeking to establish a presence in Hong Kong. 1/ The supply of office premises, however, turned downward in 1993, with the take-up exceeding supply by 30 percent and the vacancy rate dropping below 5 percent for prime office space. Prices of high quality office accommodation increased by about 34 percent per year between the first quarter of 1991 and the first quarter of 1994, and rents by about 13 percent. At the height of the office market boom in mid-1994, rents for prime office space were among the highest in the world (about US$120 per square meter per month), raising serious concerns about Hong Kong’s competitiveness.

The Government considered intervening in the office market in 1994, but decided against it for a number of reasons. 2/ First, it was concluded that the office market, unlike the residential market, had followed the historical pattern of price/rental movements and was adjusting automatically through processes such as increasing supply in the pipeline and relocation to less expensive areas. Second, the supply of office space was expected to increase significantly from late 1995 through 1997 with redevelopment of sites and land reclamations in the Central district, and development along the airport railway. Third, unlike in the residential market, speculation in the office market was not seen as a problem. Finally, despite concerns about the impact of high rents on Hong Kong’s competitiveness, the evidence did not support the fear that companies might be moving their operations out of Hong Kong. 3/ The Government, therefore, saw no need to intervene in the office market and encouraged instead the process of office decentralization and relaxed regulations on the conversion of industrial into office space.

In the event, office prices began to decline in mid-1994, and rents in early 1995. Office prices fell on average by 13 percent between mid-1994 and mid-1995, and office rents by about 7 percent since the end of 1994. The forces that brought the market down were rising interest rates, the expected increase in the supply of office space, and the withdrawal of Chinese and overseas capital following the monetary tightening in China and reassessment by overseas investors of the prospects for continued strong expansion in the region. In November of 1995, rents for prime office space were again competitive with office rents in Singapore.

d. Land releases

Virtually all land in Hong Kong is owned by the Hong Kong Government. 1/ Land disposed of by the Government is subject to a lease term. Land for noninstitutional uses is generally leased to the highest bidder at public auctions, with lease terms of 75 years or longer (up to 1,000 years). The reservation price for a given site is based on the market price prevailing one week before the auction. Each lease term requires a large lump-sum premium and a small annual rent. Because the rent serves only as a legal symbol to maintain the lessor and lessee relationship, the premium attached to any given land lease approximates the land value. Most leases are transferable, and the land market is a market for land leases.

Despite the downturn in the property market, prices achieved in auctions in late 1994 and 1995 were generally higher than expected. In particular, better than expected prices were achieved for residential sites in prime urban areas, and for office and commercial sites in well-established commercial and business areas. However, sales of several commercial sites in more remote areas and of industrial-cum-office sites met with little interest and were withdrawn from auction. These developments suggest that the overall cautious sentiment continued to prevail among developers.

Given the special characteristics of the land market in Hong Kong and the steady increase in property prices in recent years, an important 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. 1/

  • Since 1984, land releases have been subject to an annual limit of 50 hectares agreed to in the Sino-British Joint Declaration. This limit has been more or less 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 by developers through redevelopment of old sites. Evidence suggests that the incentive of developers 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 driven by overall 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. 2/

  • Finally, recent research indicates that, rather than depressing the supply of property, the restrictive land policy may actually encourage the production of housing units in the short run because the anticipated higher future rents are capitalized into higher current housing prices. 3/ In the long run, the main effect of the current land policy seems to be to promote substitution of capital for land by encouraging the construction of high-rise apartment buildings and raising the density of development.

4. Inflation and competitiveness

a. Overview

Consumer price inflation rose steadily in the late 1980s and early 1990s, reaching 12 percent in 1991 (Chart 3 and Table 4). This trend arose from a combination of excess demand pressures and structural factors. The rapid economic expansion in the second half of the 1980s, coupled with the sharp drop in labor force growth, brought the economy to a very high level of resource utilization. 1/ At the same tine, structural shifts associated with the relocation of manufacturing to southern China, as well as Hong Kong’s strategic advantages in providing services to support China’s external trading and investment relationships, led to large productivity gains in the traded goods and traded services sectors. 2/ Taken together, the high level of resource utilization (reflected in the exceptionally low rate of unemployment) and the large productivity gains exerted strong upward pressure on wages and, hence, prices, especially the prices of labor-intensive goods and services in the nontradable sector. Beyond these two factors, low interest rates in the United States at a time of a cyclical upswing in Hong Kong buoyed private consumption and investment in the early 1990s. Given the high level of capacity utilization at home, these excess demand pressures spilled over into the trade balance in the case of demand for tradables, and into prices in the case of demand for nontradables.

Table 4.

Hong Kong: Selected Price Indicators, 1990-95

(Percentage change)

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Sources: Cansus and Statistic Department, Consumer Price Index Report: Hong Kong Monthly Digest of Statistics: and Quarterly Estimates of GDP, Third

Increase over corresponding year-eariler period.

Data are on a national accounting basis.

Chart 3
Chart 3


(Percentage change)

Citation: IMF Staff Country Reports 1996, 029; 10.5089/9781451816792.002.A001

Sources: Census and Statistics Department. Consumer Price Index Report, and Hong Kong Monthly Digest of Statistics; and staff projections.

b. Recent developments and medium-term prospects

Despite strong economic activity, consumer price inflation moderated in recent years to about 8-9 percent per year, aided in 1992-93 by falling prices of imported food and energy and, more recently, an easing of labor market pressures. In particular, owing to more abundant labor supply, wage growth decelerated from 11 percent in 1993 to 8 percent in 1995. Consumer price inflation actually picked up in late 1994 and early 1995, but soon resumed a moderating trend, falling to 6 ½ percent per annum by December 1995. The pick-up in inflation in late 1994 and early 1995 was due to both domestic factors (including the lagged effects of property price inflation from early 1994) and external factors, including the uptrend in world commodity prices, a weaker U.S. dollar, and relatively high inflation in China. As the impact of the depreciation tapered off in mid-1995, and as the labor market slackened and rents eased further, locally generated inflationary pressures began to recede in the second half of the year, providing a relief to the overall inflation rate despite the large concurrent increases in imported prices.

The rate of CPI(A) inflation for 1995 as a whole was 8.7 percent, compared with 8.1 percent in 1994 and a (revised) official forecast of 9 percent. Core inflation, which excludes the volatile prices of (mostly imported) food and energy items, was unchanged from 1994, and about half a percentage point lower than in 1992-93. Among the components of the consumer price index, the subindices for goods with a large import content were generally higher in 1995 than in 1992-93, while the increases in rents and prices of services were generally lower.

The GDP deflator rose by just 4 ½ percent over the first three quarters of 1995, compared with a 7 ½ percent increase in 1994. The moderate increase partly reflected the sharp decline in the component deflators for real estate developers’ margins and for property trading activities, and, more importantly, the deterioration in the terms of trade by 2 ½ percent during the first three quarters of the year. The growth in both import and export prices doubled from those registered in 1994: import prices rose by 5 ½ percent, and export prices by 2 ¾ percent over the first three quarters of 1995. Prices of imported and exported services both rose in 1995, albeit at a slower pace than goods prices. Cost saving measures, including job upgrading programs and investment in machinery and equipment, helped to cushion to some extent the adverse effects of higher import prices.

As discussed in Chapter VII, should the current trend of rapid appreciation of the real exchange rate and high growth of domestic demand continue in the medium term, the external balance would decline to an unsustainable level. For the external balance to stabilize, domestic inflation would have to decline to about 4-5 percent per year over the medium term. While this rate of inflation would still exceed that in trading partners’ countries, the effect on Hong Kong’s external competitiveness would be offset by higher growth in activity in trading partners than in Hong Kong.

c. Trends in competitiveness

During the 1980s, Hong Kong’s competitiveness in low-technology light manufacturing industries began to erode as a result of rising wages and the emergence of lower-cost regional competitors. Following the liberalization of foreign investment regulations and the onset of market-oriented reforms in China, Hong Kong firms started to relocate their labor-intensive operations to southern China, where labor and land costs were a fraction of those in Hong Kong. The decline in employment since the mid-1980s and the upgrading of skills in industries that remained in Hong Kong (to supervisory and technical functions, such as product design and marketing), led to strong productivity growth. Labor productivity in manufacturing thus rose at an average annual rate of 12 ½ percent between 1986 and 1994, while unit labor costs declined by 2 ½ percent per year over the same period (Charts 2 and 4 and Table 5). Although productivity growth has been maintained at a high level throughout the period, the gains in productivity in recent years seem to have come from different sources than in the mid-1980s. Between 1986 and 1988, real output growth was still strong and large-scale employment reductions had not yet started as wage growth remained tolerable. After 1988, nominal wages started to grow at double-digit rates and layoffs in manufacturing accelerated. However, real output declined by much less than employment, suggesting that there has been a significant increase in the use of labor-saving technology.

In the services sector, the advantages initially enjoyed by Hong Kong firms providing services related to trade and investment in China were gradually eroded by stronger regional competition and the cumulative effects of high wage and property price inflation. As relocation options have been more limited in this sector, services firms initially responded to eroding competitiveness by trying to restrain price increases and temporarily absorb higher costs. These actions led to continued growth in business but falling profit margins. Since 1994, many services firms have therefore stepped up investment in labor-saving capital equipment and reduced employment. The macroeconomic implications of these actions have been, among others, the reduced ability of the services sector firms to absorb surplus workers released from the manufacturing sector, higher unemployment among workers with low skills, longer durations of unemployment, and a higher merchandise trade deficit. Because of these implications, the Government has been under pressure to consider policy measures (including tax incentives) to maintain Hong Kong’s competitiveness.

Table 5.

Hong Kong: Wages, Labor Productivity, and Unit Labor Costs, 1990-95

(Percentage change)

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Sources: Census and Statistics Department, Hong Kong Annual Digest of Statistics: Hong Kong Monthly Digest of Statistics; Estimates of Gross Domestic Product. 1961 to 1994; Quarterly Estimates of Gross Domestic Product. Third Quarter 1995; and staff estimates.

Based on averages of semiannual data.

Includes wholesale, retail, import and export trades, restaurants, and hotels.

Includes financing, insurance, real estate, and business services.

Based on employment data; data on person-hours are unavailable. Data for 1995 are staff estimates, based on data for the first three quarters.

Given the Government’s noninterventionist approach in economic policy matters, the proposals for policy actions to maintain competitiveness have been highly controversial. Part of the problem is that it is difficult to assess whether the services sector has a competitiveness problem in the first place. Data on value added by sector in constant prices are not available, and attempts to construct such data from various indicators of real activity have to overcome considerable methodological difficulties.

III. Fiscal Policy

1. Overview

Fiscal policy in Hong Kong has traditionally followed a noninterventionist approach, aimed at maintaining a small government and fostering a competitive private sector. To this end, policy has been guided by four broad principles: to maintain a simple tax system with stable and low tax rates; to keep current spending increases in line with nominal GDP growth; to provide funding for key infrastructure projects; and to maintain an adequate level of fiscal reserves for contingencies. Under this prudent approach, budgetary outcomes have generally been stronger than projected in initial budgets. The resulting, sometimes large, surpluses have enabled the authorities to build up substantial fiscal reserves. The macroeconomic impact of the surpluses has been broadly neutral over the past decade. 1/

This chapter reviews recent budgetary developments and the medium-term fiscal outlook (Section 1), growth and structure of the main revenue sources (Section 2), the level of public expenditure and recent shifts in spending priorities, including the Airport Core Program and the public housing program (Section 3), and the proposed Mandatory Provident Fund scheme (Section 4).

2. Recent budgetary developments

a. Developments in FY 1992 - FY 1994

The main issue for fiscal policy over 1992-94 has been the need for fiscal restraint in the face of strong economic growth and relatively high inflation. The budgets for FY 1992 and FY 1993 provided for substantial declines in the overall surplus. In the event, the projected declines did not materialize; as revenue growth was much stronger than envisaged and capital spending was delayed, large surpluses of 2 ½ percent of GDP and 2 ¼ percent of GDP were realized in FY 1992 and FY 1993, respectively (Table 6). As a result, fiscal reserves grew by close to 20 percent in both years, reaching 15 ½ percent of GDP at end-1993. The estimated fiscal impulse was -½ percent of GDP in FY 1992, and ¼ percent of GDP in FY 1993. 1/ By this measure, fiscal policy was contractionary in FY 1992 and slightly expansionary in FY 1993.

The FY 1994 Budget provided for a decline in the overall surplus to about 1 percent of GDP from an average of 2 ¾ percent of GDP in the three preceding fiscal years. This decline was to come about mainly as a result of generous tax cuts granted in the FY 1994 Budget. In particular, the tax rate on corporate profits was reduced by 1 percentage point, and the personal income tax allowances were raised substantially, removing about one fourth of taxpayers from the tax net. 2/ The tax concessions were partly offset by an increase in business registration fees and additional revenue from the property tax. 3/ Total expenditure was projected to rise in line with nominal GDP growth, with somewhat faster growth for social welfare, health, and education.

The budgetary outcome for FY 1994 was again stronger than projected, but by a smaller margin than in the preceding two years. The consolidated surplus for FY 1994 was HK$13 billion (1.3 percent of GDP). Compared to the original projection, there was a shortfall in total revenue of about 0.3 percent of GDP, and an underspending of about 0.6 percent of GDP. The revenue shortfall was due to lower revenue from land sales (reflecting the downturn in the property market); this shortfall was partly offset by higher-than-projected interest earnings on fiscal reserves and additional collections from the salaries tax. As for the underspending, about one third came from lower current expenditure, and two thirds from lower capital expenditure. The main factors contributing to the underspending were lower personnel-related expenses and subsidies, delays in negotiations on the airport financing package, and lower costs of acquiring land for public projects. The estimated fiscal impulse for FY 1994 was -¼ percent of GDP, suggesting that fiscal policy was slightly contractionary, excluding the effects of government equity investments and revenue from land sales.

Table 6.

Hong Kong: Consolidated Government Account, FY 1991/92-FY 1995/96 1/

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

The fiscal year runs from April 1 to March 31.

Consists of the Capital Works Reserve Fund; Capital Investment Fund and Loan Fund beginning 1990/91; Disaster Relief Fund beginning 1993/94; and Civil Service Reserve Fund beginning 1994/95.

The Government Bond Program was launched in November 1991 in an effort to develop a market in fixed-income securities and facilitate the funding of long-term government infrastructural projects. The bonds are issued before the Government actually requires the funds. The Program limits the size of gross debt outstanding to HKSS billion as of June 30, 1997.

b. The FY 1995 Budget

The spending profile of the Airport Core Program called for the acceleration of works on the airport project in 1995-96, requiring large capital and equity investment by the Government. The Budget for FY 1995 therefore envisaged a small deficit of ¼ percent of GDP. As total revenue was projected to grow more slowly than GDP, and total expenditure faster than GDP, the budget balance was set to swing by 1 ½ percent of GDP. Reflecting this reduction in the surplus, the fiscal stimulus built into the Budget was estimated at about 1 percent of GDP in FY 1995.

On the revenue side, the FY 1995 Budget provided for a broad-based 10 percent increase in salaries tax allowances and for some modest concessions for the needy, while keeping salaries tax rates and tax bands unchanged. The inheritance tax and excises on tobacco and fuel were also adjusted for inflation. Total revenue was projected to decline by ¾ percent of GDP due to delayed effects of tax concessions granted in the FY 1994 Budget, and lower expected profits in the banking and financial sectors. 1/

On the expenditure side, the FY 1995 Budget called for accelerated spending on the airport project and social programs. In particular, real expenditure on education was projected to increase by 6 percent, on health by 8 percent, and on social welfare by as much as 24 percent. Overall, current expenditure was projected to increase by 1/3 percent of GDP, and capital expenditure by ½ percent of GDP.

Total revenue on the General Revenue Account was slightly lower in the first half of FY 1995 (April-October) than in the same period last year (Appendix Table 4). In particular, receipts from earnings and profits tax, motor vehicle taxes, and stamp duties were lower than in the same period last year, mirroring the slowdown in wage growth and private consumption, and the continuing weakness in the property market. Current spending growth was in line with the budget projection, while capital spending was substantially higher than in the first half of FY 1994 because of the huge equity injection of HK$14 billion into the airport project (Appendix Table 5). As the bulk of revenue normally is collected during the first quarter of the calendar year, the half-yearly results are not entirely indicative of the likely position of the budget at the end of the fiscal year. At this stage, however, it seems that the projected small deficit might indeed materialize at end-March 1996.

c. Medium-tern outlook

According to the Medium-Range Fiscal Forecast prepared in conjunction with the FY 1995 Budget, the overall balance would revert to a small surplus in FY 1996, and register a surplus equivalent to about 2 percent of GDP by FY 1997 (Table 7). About two thirds of this surplus would result from the fact that, beginning with July 1997, all revenue from land sales would be credited to the Capital Works Reserve Fund, compared with just one half under the present arrangements. Revenue buoyancy is projected to improve after FY 1996 as the impact of tax concessions granted in the FY 1994 Budget tapers off, while the expenditure/GDP ratio is projected to stabilize at around 15 percent of GDP. Based on this forecast, fiscal policy would be neutral in FY 1996, and would begin to withdraw stimulus from the economy in FY 1997 and FY 1998 as airport spending winds down and revenue buoyancy improves.

d. Fiscal reserves and the Land Fund

While many governments have been saddled with substantial public debt, the Hong Kong Government has over the years built up a reassuring cushion of fiscal reserves by accumulating large budgetary surpluses. Fiscal reserves are deposited with the 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. The interest is credited to the General Revenue Account, and in recent years it represented 2-3 percent of total government revenue.

Fiscal reserves stood at HK$151 billion (15 percent of GDP) on March 31, 1995 (Chart 4). Over the past ten years, fiscal reserves grew on average by 22 percent per year, compared with nominal GDP growth of about 18 percent per year. The growth in fiscal reserves slowed in FY 1994 and is expected to remain subdued in the current and next fiscal years because massive investment in the airport project will trim budgetary surpluses. Nevertheless, on March 31, 1997, shortly before the transfer of sovereignty to China, fiscal reserves are projected to stand at an impressive HK$154 billion (12 percent of GDP). One year later, at the end of FY 1997, there would be an enormous, one-time jump in reserves to HK$331 billion (22 percent of GDP), representing about 1.4 times total government expenditure projected for FY 1998. This increase is expected to result from three factors. First, the Land Fund of the Hong Kong Special Administrative Region will revert to the HKSAR Government on July 1, 1997. Second, the HKSAR Government will start receiving full proceeds from land sales as of the same date. Third, the HKSAR Government will collect rents from the extension of leases in New Territories. 1/ After FY 1997, fiscal reserves are projected to resume growth at a more moderate rate.

Chart 4
Chart 4


Citation: IMF Staff Country Reports 1996, 029; 10.5089/9781451816792.002.A001

Sources: Census and Statistics Department, Annual Digest of Statistics; and data provided by the Government Secretariat. Finance Branch.
Table 7.

Hong Kong: Medium-Range Fiscal Forecast, 1995/96-1998/99 1/

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Sources: Government Secretariat, Financial Services Branch; The 1995/96 Budget; and staff estimates.

Fiscal year beginning April 1.

Includes mainly revenue free land sales.

Includes financing of airport-related projects.

Includes Government equity in actions into the Airport Authority and Mass Transit Railway Corporation.

The Government Bond Program was launched in November 1991 in an effort to develop a market in fixed-income securities and facilitate the funding of long-tern government infrastructural projects. The bonds are issued before the Government actually requires the funds. The Program limits the size of gross debt outstanding to HKSS billion as of June 30, 1997.

Balance shown is as of March 31, 1994 and July 1, 1997.

The Land Fund of the HKSAR was set up in 1986 in order to implement Annex III of the Joint Declaration, which contains provisions on land leases extending beyond the transfer of sovereignty. According to the agreement, revenue from land transactions that confer a benefit that extends beyond June 30, 1997 and are completed on or before May 27, 1985, are shared equally between the Hong Kong Government and the future HKSAR Government, after deducting the cost incurred by the Hong Kong Government in developing the new sites. The Hong Kong Government’s share of land revenue is credited to the “Works Account” of the Capital Works Reserve Fund and it can be used only to finance capital works projects. The future HKSAR Government’s’share is credited to the “Suspense Account” of the Capital Works Reserve Fund and is managed by trustees.

Over the past ten years, assets of the Land Fund have grown quickly to an estimated HK$78 billion (8 percent of GDP) at end-March 1995 (Chart A). By July 30, 1997, the Land Fund is projected to grow to HK$143 billion. The balance of the Land Fund is expected to be consolidated with the general fiscal reserves from April 1, 1998.

3. Revenue developments

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. In comparison with OECD countries, Hong Kong has a very simple tax structure: income tax rates are low and generally uniform (15 percent for individuals, 16 ½ percent for companies); liability to income tax is limited to income derived from sources within Hong Kong; capital gains, dividends, and interest income are not taxed; 2/ while indirect taxes are levied on a few, primarily nonessential items.

Despite the snail number of taxes and their simple structure, Hong Kong’s tax base has, over the years, continued to generate sufficient revenue to meet the budgetary commitments and to maintain healthy growth of fiscal reserves. Data for the period 1980-94 indicate that the overall tax system is quite buoyant: a one percent (one dollar) increase in GDP raises total revenue by 0.96 percent (17 cents) (Table 8). Capital revenue (mostly premia from land sales), stamp duties, and motor vehicle taxes have particularly high buoyancy coefficients. The earnings and profits tax, which is the largest source of revenue, is also highly buoyant, indicating that the income tax base has expanded despite generous allowances that have been periodically granted to taxpayers. One of the main factors responsible for this broadening of the income tax base is an increase in the share of middle-aged population in Hong Kong’s labor force, and higher level of education of the workforce.

Table 8.

Hong Kong: Estimates of Revenue Buoyancy and Marginal Propensity to Tax, 1980-94

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Source: Staff estimates.

Although historically Hong Kong’s revenue system has been buoyant, in recent years there have been concerns that some major revenue sources are vulnerable to cyclical downturns. In particular, it is estimated that about 30 percent of total revenue in recent fiscal years is directly related to land and property. 1/ In addition, given its flat rate profile, Hong Kong’s income tax system lacks the built-in automatic stabilizer properties of graduated income tax systems.

Judging from the yield of various taxes and the long-run stability of Hong Kong’s revenue structure, there seems to be little ground for concerns about stability of the revenue base in Hong Kong. The yield of the earnings and profits tax increased from about 6 percent of GDP in the early 1980s, to about 7 ½ percent in recent years, despite the fact that profits fluctuated considerably over the course of two business cycles that spanned this period (Chart 4). Excise revenue, stamp duties on property and stock market transactions, and revenue from property and motor vehicle taxes also maintained a stable share in GDP over the years, notwithstanding the volatility of