People’s Republic of China-Hong Kong Special Administrative Region: Staff Report for the 2002 Article IV Consultation Discussions

This 2002 Article IV Consultation for Hong Kong Special Administrative Region highlights that a recovery from the Asian crisis started in 1999, and GDP growth surged to 10½ percent in 2000. However, before sustained growth could take hold, the global slowdown in 2001 dealt another blow to the economy, and real GDP growth dropped to almost zero. Although the renewed downturn was led by falling exports, domestic demand also slowed. The outlook for 2002 is for a moderate recovery, spurred by the expected rebound in global activity.


This 2002 Article IV Consultation for Hong Kong Special Administrative Region highlights that a recovery from the Asian crisis started in 1999, and GDP growth surged to 10½ percent in 2000. However, before sustained growth could take hold, the global slowdown in 2001 dealt another blow to the economy, and real GDP growth dropped to almost zero. Although the renewed downturn was led by falling exports, domestic demand also slowed. The outlook for 2002 is for a moderate recovery, spurred by the expected rebound in global activity.

I. Background

A. Recent Developments

1. Over the last five years, the Hong Kong economy has suffered two rounds of external shocks, while also adjusting to growing integration with the Mainland of China. The highly open economy was hit hard by the Asian crisis, and under the linked exchange rate system, the brunt of adjustment fell on domestic asset and factor markets. Aided by favorable external conditions, a recovery started in 1999, and GDP growth surged to 10½ percent in 2000 (Chart 1, Table 1). However, before adjustment was completed and sustained growth could take hold, the global slowdown in 2001 dealt another blow to the economy. The cyclical shocks have come on top of structural adjustments needs, including from integration with the Mainland, which together pose a challenging policy environment.

Chart 1:
Chart 1:

Hong Kong SAR: Output and Demand,1995-2002

Citation: IMF Staff Country Reports 2002, 100; 10.5089/9781451816877.002.A001

Source: Data provided by the Hong Kong authorities;and funf staff estimates.1/Trade balance in billions of Hong Kong Dollars
Table 1.

Hong Kong SAK: Selected Ecnnomic and Financial Indicators,1997-2003

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Sources: Data provided by the Hong Kong SAR authorities; and staff estimates and projections.

Excludes loans to finance external trade

Includes land Fund assets from 1997(US$17.5 billion at end-1997)

2. Economic growth stalled and financial markets weakened in 2001:

  • Real GDP growth dropped to almost zero, with a decline in the second half. The downturn was led by exports, especially those produced in Hong Kong SAR (down by 11 percent in volume terms). Although domestic demand held up initially, it also fell in the course of the year, with a particularly sharp decline of inventories. The unemployment rate rose to 6.8 percent in February 2002, above the Asian crisis peak (Chart 2.

  • Deflation has continued now for over 3 years, bringing consumer prices to their early-1996 level(Chart 3).2 While domestic price flexibility is part of the adjustment process under the linked exchange rate system, the persistent deflation has raised concerns whether more long-term forces may be at work. Staff analysis suggests, however, that most of the deflation is attributable to cyclical factors (Box 1). In particular, the prolonged downward drift in property prices and rentals reflects a slow unwinding of the pre-1998 bubble as well as weak demand conditions.

  • Bank credit has declined further despite lower interest rates and ample liquidity. Hong Kong interest rates have fallen in line with US interest rates. However, credit (especially property-related lending) has remained weak reflecting the uncertain business outlook and weak asset prices; also, real interest rates, although down, remain quite high reflecting deflation (Chart 4).

  • Contagion from Argentina has been minimal, while equity prices have fallen in line with global markets. Hong Kong dollar forward rates increased slightly in March-April 2001 and in the last three months, but the increase was much smaller than during previous periods of global market turbulence. The stock market dropped by 24 percent last year; with selling pressures intense after September 11, the authorities cut back scheduled equity disposals to limit market disruptions.5

Chart 2.
Chart 2.

Hong Kong SAR: labor markets,1995-2001

Citation: IMF Staff Country Reports 2002, 100; 10.5089/9781451816877.002.A001

Source: Data provided By the HKMA and IMF Staff estimates1/ workers in fanancing and personal services sectors2/ Workers in manufacturing, distributive trade, and construction sectors
Chart 3.
Chart 3.

Hong Kong SAR: Prices and Exchange Rate,1995-2002.

Citation: IMF Staff Country Reports 2002, 100; 10.5089/9781451816877.002.A001

Source: Data provided by the Hong Kong authorites;and fund Staff estimates
Chart 4.
Chart 4.

Hong Kong SAR: Assets, Money, And Interest Rates,1995-2002

Citation: IMF Staff Country Reports 2002, 100; 10.5089/9781451816877.002.A001

Source: Data provided by the Hong Kong authorites;and fund staff estimates.1/Using 12-month CPI inflation.2/Using consensus foreast of inflation

Deflation: Cyclical or Structural?3

With deflation persisting for over three years, the question arises whether it reflects primarily cyclical factors or more long-term structural forces. The cyclical view posits that, given the linked exchange rate system, prices have had to decline in response to shocks so that competitiveness can be restored. The structural view sees deflation as a process of narrowing price differentials between Hong Kong SAR and the Mainland of China, as a result of growing economic integration.

The staff’s analysis suggests that, although structural factors have played a role, deflation has been mainly the result of a process of adjustment to cyclical shocks. Econometric analysis attributes a major part of the inflationary/deflationary process in Hong Kong SAR to cyclical factors, and only a small part to a price equalization process with the neighboring region in the Mainland.

A price equation for Hong Kong SAR finds unemployment, nominal credit, and the nominal effective exchange rate as powerful determinants of inflation/deflation, while the gap between prices in Hong Kong SAR and neighboring Shenzhen has only small explanatory power. Variations in unemployment, nominal credit, and the nominal effective exchange rate contribute 36 percent, 14 percent and 5 percent, respectively, to the explanatory power of the inflation equation. In contrast, the price equalization process contributes only 2 percent. To the extent that there has been price equalization, most of it seems to have come through greater inflation in the Shenzhen region rather than deflation in Hong Kong SAR.

Despite this evidence, the persistence of deflation for more than three years raises the question of why adjustment has taken so long. The persistence of deflation can be explained by the importance of wealth and balance sheet effects in Hong Kong SAR, and the fact that the Hong Kong economy was hit by two subsequent shocks. In particular, the large wealth and balance sheet effects from the fall of property and equity prices (given the large share of household wealth in those assets) have fed back into demand and thus amplified and prolonged the deflationary shock.

Anecdotal evidence from the property market confirms the view that the deflation is mainly cyclical.4 Various factors seem to limit price equalization in the residential property market, including commuting time and transportation costs. To the extent that there is increased demand from Hong Kong residents for property in Shenzhen, a large part of it is for second homes (demand creation) rather than relocation (demand displacement). Likewise, the cost of commercial property reportedly plays only a minor role in the location decision of firms. Overall, therefore, the sustained fall in housing prices over the past four years appears to be mainly a prolonged retrenchment from the pre-1998 property price bubble, exacerbated by last year’s renewed economic downturn.

3. The budget deficit widened sharply in FY2001 (Chart 5). Although a large part of the deterioration was cyclical (lower asset sales and investment income), there has also been a trend weakening in the structural budget position (Table 2). In addition, a set of measures to cushion the impact of the economic slowdown was announced in October 2001 (totaling about 1 percent of GDP, to be implemented over two years).

Chart 5.
Chart 5.

Hong Kong SAK: Fiscal Developments, FY1983-FY2001

Citation: IMF Staff Country Reports 2002, 100; 10.5089/9781451816877.002.A001

source: Data provided by the Hong Kong SAR authorites; and fund staff projection.1/ Excludes land premiunm, investment income, privatization receipts, equlity injection, and the effect of cyclical fluctuation.
Table 2.

Hong Kong SAR: Consolidated Government Account, FY1997-FY2006 1/

(In percent of GDP)

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Source: Data provided by the Authorities; and staff estimates.

Fiscal year begins April 1.

As presented in the FY2002/03 budget proposed in March 2002.

Includes cash payments made by the Exchange Fund for earnings on the government’s equity holdings and capital gains from Tracker Fund issues.

The “operating balance” is used by the authorities as a measure of the underlying fiscal position. It is defined to exclude land premium and capital revenue and expenditure, and include recurrent revenue and investment income.

Staff estimates. The “structural balance” is used by staff to measure the impact of fiscal policy on domestic demand.

Fiscal Balance, Hong Kong SAR,1997-2001

(in percent of GDP)

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Excludes asset-related transactions, investment income, and cyclical fluctuations.

4. Growing economic integration with the Mainland has raised structural unemployment and worsened income disparities. The economy’s transformation to a high value-added service-based economy has been accelerated by the growing integration with the Mainland. The resulting high demand for skilled labor has raised the wage premium for better-educated workers and contributed to widening income disparity (Box 2). The labor market imbalance has been exacerbated by immigration from the Mainland that has increased the supply of lower-skilled labor.

Income Distribution

As the Hong Kong economy grew rapidly over two decades before the Asian crisis, income disparity in Hong Kong SAR increased and is now one of the highest in the world.6 Significant structural change that brought about sustained growth has also led to a sharp rise in income inequality. Looking ahead, the need to continually move up the value-added chain as the economy integrates further with the Mainland may lead to even higher inequality. This trend has increasingly become a concern for the public and policy makers in Hong Kong SAR. Staff analysis of these issues concluded that:

  • Despite rising inequality, rapid economic growth brought higher standards of living for the entire population - real wages rose significantly across the wage distribution. Hong Kong SAR has highly flexible labor markets, which have allowed the economy to adjust well to the major structural changes of the last twenty years, and as a result of that process the return to advanced skills has increased. This is in contrast, for example, to developments in the United States, where rising income inequality in the 1980s and early 1990s had been accompanied by declining real wages in the lower deciles of the distribution.

  • The structural changes have favored the better-educated. The premia to higher education are substantial and have increased over the period, despite a rapid increase in the average education level (suggesting that growing demand for skilled labor has outpaced the rise in supply). In addition, unemployment among the low-skilled has been rising much faster than among the skilled, especially in recent years.

The analysis suggests that the most effective policies to address rising income disparity, as well as to support growth, are those which increase the skill levels of the labor force. Hong Kong SAR has relatively low enrollment in post-secondary education compared to OECD and many of the Asian economies, despite the large premium that higher education commands. Government policies to promote higher the education levels and to improve the quality of education should help the economy to sustain growth and adjust to the challenges of integration with the Mainland. In recognition of the importance of this issue, the government has recently adopted a new program for education reform, as well as a number of measures to support education including building of new schools, provision of loans for higher education and for continuous education, and creation of retraining programs. Immigration policy is also being reviewed with a view to easing restrictions on inflow of qualified specialists from the Mainland.

B. Outlook and Vulnerabilities

5. The near-term outlook is for a moderate recovery, depending on a pick-up in external demand. The staff projects that real GDP will grow by about 1½ percent in 2002, assuming a recovery in global growth. A pick-up in global activity will boost the Hong Kong economy through several channels: exports and re-exports (the latter depending on Mainland exports), tourism, and demand for financial services. Deflation is projected to continue through 2002. although it should moderate during the year as property prices are expected to bottom out and activity recovers.

6. Standard vulnerability indicators remain robust (Box 3). The current account surplus is sizable and external reserves exceed US$100 billion, four times the monetary base. In addition, Hong Kong has no public debt, and fiscal reserves are nearly 30 percent of GDP (Table 3). Although, as a regional financial center, Hong Kong SAR may be exposed to contagion from global and regional financial market disturbances, local financial markets proved resilient after September 11 and during recent events in Argentina.

Table 3.

Hong Kong SAR: Standard Vulnerability Indicators

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Sources: Hong Kong SAR authorities, BIS, and staff estimates.

Broad Money refers to M2.

Short-term debt from joint BIS-World Bank statistics on External Debt, Feb. 2002, BIS website.

For all authorized institutions, unless otherwise specified.

For all locally incorporated institutions.

Refers to total gross classified: “substandard”, “doubtful” and “loss”.

For 2001 refers to a new retail banking measure instead of all locally incorporated banks.

Vulnerability Assessment

Hong Kong SAR’s vulnerability to external crises remains small using standard methods of assessment.

  • Relevant standard external indicators are strong (Table 5). Despite the slowdown in export growth, the current account surplus is large and reserves are high, covering the monetary base four times. Short term debt is low, and forward exchange rates indicate little pressure on the domestic currency.

  • Macro stress testing indicates that further external deterioration would affect Hong Kong SAR, but is very unlikely to cause serious balance of payments strains (Table 1.1). In the baseline scenario, flat growth in 2001 is followed by a moderate recovery in 2002. In a scenario with weaker external demand, growth and the external position of Hong Kong SAR would suffer, but foreign reserves would still be ample to cover any external requirements as well as the monetary base.

  • Hong Kong SAR has a sound and well-regulated financial system. The banking system is well capitalized, with adequacy ratios significantly above Basel standards and healthy performance indicators (Table 5). The forthcoming FSAP will further analyze the performance and vulnerability of the financial sector, and suggest areas where vulnerability to shocks could be further reduced.

Table 1.1

Hong Kong SAR - Real Growth Scenarios

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Source: CEIC Database, Fund Staff estimates

7. The longer-term outlook depends on how Hong Kong SAR meets the challenges of Mainland integration (Box 4). In the next few years, the Hong Kong economy will likely benefit from increased trade in goods and services after China’s entry into WTO (Tables 4 and 5). For satisfactory growth in the long run, however, Hong Kong SAR will need to push ahead with the transformation into a center for high value-added financial and business services as the importance of entrepôt trade for the Mainland diminishes.

Table 4.

Hong Kong SAR: Medium-term Macroeconomic Framework

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Sources: Data provided by the Hong Kong SAR authorities; and staff estimates and projections.

The budget numbers refer to the fiscal year (April through March)

Table 5.

Hong Kong SAR: Medium-term Balance of Payments

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Source: Hong Kong SAR authorities and staff estimates.

II. Report on the Discussions

8. Hong Kong SAR thus faces the twin challenge of a sharp cyclical downturn and structural changes as the economy integrates further with the Mainland. Since the Hong Kong economy is highly open, focused on intermediating regional trade and capital flows, the role of counter cyclical demand management has been limited, with economic policy emphasizing prudent institutional arrangements and long-term capacity building. Against this background, the discussions focused on how best to cope with the sharp cyclical downturn under the rules-based policy framework embodied in the Basic Law and the linked exchange rate system, and on how to enhance Hong Kong SAR’s long-term growth potential and meet the challenges arising from growing integration with the Mainland of China.

A. Fiscal Policy

9. Near-term fiscal policy is set to remain mildly expansionary. The authorities explained that most of the FY2001 increase in the budget deficit reflected a cyclical revenue shortfall which they had decided not to counteract, given the economic downturn and the large cushion of fiscal reserves. For FY2002, although the budget presented in March targets an overall deficit of 3.6 percent of GDP (down from 5.2 percent of GDP in FY2001), the improvement reflects mainly the planned privatization of the Mass Transit Railway postponed last year. The structural deficit, however, is projected to rise by 1.0 percent of GDP. A set of one-off reductions in various fees and charges and a significant increase in capital expenditure is partly offset by an assumed 4.75 percent cut in civil service pay (from October 2002) and increased revenues from tobacco and wine duty. The authorities explained that maintaining a mildly expansionary fiscal stance was appropriate in light of the weak demand conditions.

10. The authorities recognized that structural pressures could threaten the long-term health of the public finances. A government Task Force on the Review of Public Finances reported in February 2002 that a narrowing revenue base and medium-term spending pressures risked undermining the stability of Hong Kong SAR’s long-term public finances (Box 5). Unless corrective measures were taken, persistent fiscal deficits would threaten eventually to exhaust fiscal reserves and force the government into a net debtor position. To ensure medium-term fiscal sustainability, the Task Force advised that priority should be given to controlling the growth of government expenditures, with measures to broaden the tax base to be taken as necessary and when the economic situation permits. A concurrent Advisory Committee on New Broad-Based Taxes concluded, in a report

Integration with the Mainland of China: Opportunities and Challenges

Over the coming years, the Hong Kong economy will become increasingly integrated with the Mainland of China, which itself is opening up its economy further following WTO accession.

For Hong Kong SAR, this process will bring major opportunities…

  • Increased trade between the Mainland and the rest of the world will benefit Hong Kong SAR, which now handles about 40 percent of the Mainland’s trade. Mainland’s external trade is projected to increase by 80 percent over the next five years.

  • Increased financing needs of the Mainland should help boost Hong Kong SAR’s financial sector. Trade financing, equity listing and corporate bond issuance by Mainland enterprises will increase as will public bond issuance to finance reforms and infrastructure as well as FDI flows. Part of these flows should continue to be channeled through Hong Kong.

  • The opening of China’s services market should offer Hong Kong companies a larger market and deepen integration with the Mainland beyond the traditional trade links. As a services-dominated economy. Hong Kong SAR has a comparative advantage especially in areas such as trade and trade financing, banking, and distribution, which are underdeveloped in the Mainland.

…and challenges:

  • Hong Kong SAR’s role as a traditional “middleman” will diminish. As China’s port infrastructure improves, restrictions on trade are lifted, and more foreign businesses operate directly in the Mainland, Hong Kong’s entrepôt role will decline.

  • Hong Kong companies will face increased competition from both foreign and Mainland companies. As the Mainland opens up further, Hong Kong companies will face increased competition from foreign companies who are larger and financially stronger (especially in the financial sector), and from Mainland companies that are gaining efficiency and international experience.

  • Hong Kong SAR will have to sharpen the focus on higher value-added sectors. As more manufacturing and services activities shift to the Mainland, Hong Kong will need to move from a trade-dominated economy to a regional center for business, trade, and financial services.

  • Hong Kong SAR could suffer from higher structural unemployment and shortage of skilled labor. The authorities estimate that by 2005, Hong Kong will have a shortage of some 120,000 people with higher education and a surplus of 160,000 with only secondary school education or less.

  • There could be increased pressure on the medium-term fiscal position. Labor market mismatch, education system upgrades, and infrastructure development will put pressure on spending while the revenue base might erode as businesses shift activities to the Mainland.

Over the next few years, the benefits are expected to outweigh costs as trade creation dominates trade diversion. The long-term outcome will depend on implementation of appropriate policies to meet the challenges of integration.

Medium-Term Fiscal Outlook

While recent budget deficits are partly cyclical, there has also been a structural deterioration in the fiscal position. A government Task Force on the Review of Public Finances has found rising structural deficits in recent years that will continue in the future unless corrective measures are taken:

  • Revenues from land sales and taxes will remain much lower than during the asset bubble of the mid-1900s. Lower property prices and active competition have also eroded profit tax revenue.

  • Investment income from fiscal reserves has fallen as a share of revenues, and would fall further if fiscal deficits persist.

  • Direct tax revenue may decline as Hong Kong SAR businesses increase investments abroad, as only Hong Kong SAR-based profits and salaries are subject to tax.

  • The government expenditure deflator has tended to rise faster than the general price level, raising the expenditure/GDP ratio even if real spending growth has not exceeded real GDP growth.

  • Demographic trends will put pressure on health and social security expenditures.

Without measures, continued sizable deficits are projected into the future (Chart A). Assuming unchanged revenue and expenditure policies and a return to a trend growth of about 3-3.5 percent, fiscal deficits of 4-5 percent of GDP are projected in the medium term. This would exhaust fiscal reserves by 2008/09, followed by a rising debt burden.

Chart A.
Chart A.

Projected Fiscal Balance and Reserves,2001-2011, Current Policies Scenario

Citation: IMF Staff Country Reports 2002, 100; 10.5089/9781451816877.002.A001

The FY2002 budget proposed in March outlines the government’s strategy for returning to a balanced budget over the next four years (Chart B). It envisages to eliminate the overall budget deficit as well as that on current operations; reduce the public expenditure/GDP ratio to 20 percent or lower; and stabilize fiscal reserves at the level of one year’s expenditures.

To achieve these goals, measures averaging about 1 ½percent of GDP per annum will be required. The government’s medium-term plan emphasizes expenditure restraint, limiting real spending growth to 1.5 percent per year starting in FY2003. The authorities intend to review the entire public administration for possible cost savings (with an up-front 4.75 percent cut of civil service pay assumed in late 2002). On revenues, an Advisory Committee on New Broad-Based Taxes has concluded that a low-rated broad-based goods and services tax (GST) is the best choice for broadening the tax base, with higher taxes on the assessed rental value of properties, lower personal income tax deductions, and a land and sea departure tax cited as additional options (albeit with significantly smaller yields than GST). The government proposed to introduce a land departure tax in FY2003 and explained that it would consider the other options carefully, for implementation if necessary.

Chart B.
Chart B.

Government Medium Term Budget Projections,2001-2006

(percent of GDP)

Citation: IMF Staff Country Reports 2002, 100; 10.5089/9781451816877.002.A001

published in early March, that a low-rate broad-based goods and services tax (GST) would be the best option to broaden the tax base. The staff noted that while the strong fiscal track record provided a cushion to absorb temporary deficits, a comprehensive medium-term deficit reduction plan was needed to address the underlying structural fiscal problem.

1. The FY 2002 budget spells out the government’s commitment to balance the budget over the next four years. This is to be achieved by reducing, from FY2003 onward, the growth of public expenditure and modestly raising revenue, with a view to stabilizing fiscal reserves at around one-year’s expenditures level (from 1.3 times expenditures currently—Table 2). While this plan does not contain further specific measures (beyond the FY2002 budget) in support of those goals, the authorities emphasized their commitment to taking the necessary steps, including a comprehensive review of the public administration for possible cost savings and careful consideration of all the options proposed by the Advisory Committee on broadening the tax base. The staff agreed with the authorities that the current cyclical juncture was not propitious for introducing a GST, but stressed that because of the substantial lead time required, preparations for it should start as soon as possible.

B. Exchange Rate Policy

2. The authorities remain firmly committed to the linked exchange rate system, which has served Hong Kong SAR well. They noted that the record of strong fundamentals, including prudent fiscal management and large reserves, flexible markets, and a strong financial system had enabled the economy to adjust well to shocks under the link. In turn, they agreed with the staff that keeping those conditions in place was critical to the continued smooth operation of the link in the future. The authorities also observed that the link underpinned confidence in Hong Kong SAR as a stable financial center, and provided a transparent anchor for economic decision-making and market expectations.

3. The linked exchange rate system is likely to remain the best option for Hong Kong SAR, even with growing integration with the Mainland. The authorities explained that the conditions in favor of a link with the U.S. dollar were likely to remain, including the high correlation of cyclical movements between the two economies (given the importance of entrepot trade with the United States); the different stages of development of the Hong Kong SAR and Mainland economies; and the role of the link as an anchor of expectations, economic policy decisions, and confidence in Hong Kong SAR as a regional financial center. The authorities considered that, based on fundamental economic linkages, a wider renminbi trading band should not have adverse effects on the Hong Kong dollar, given the negligible amount of trade competition with the Mainland and the limited impact of exchange rate differentials on Hong Kong SAR’s major export to the Mainland—financial services. They noted that while a wider trading band for the renminbi might attract more speculative proxy trading of the Hong Kong dollar, the correlation between the Hong Kong dollar forward rates and the renminbi non-deliverable futures rates had become substantially decoupled in recent years.

C. Structural Policies

14. How best to enhance Hong Kong SAR’s long-term growth potential and meet the challenges arising from growing integration with the Mainland was the overarching theme of the structural policy discussions (see Box 4). Economic activity in Hong Kong SAR will have to shift increasingly to higher-value added sectors, as low-value added services will migrate to the Mainland. This transformation, and the trade creation from further liberalization in the Mainland, offer major opportunities for the Hong Kong economy, but also challenges that will continually test the flexibility of the economy and policies.

Bank Indicators

(For all authorized institutions, in percent)

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Sources. HKMA. U S. Federal Reserve

For 2001, figures refer to a new banking measure instead of all locally incorporated banks.

For all locally incorporated authorized institutions.

15. Financial Sector. The financial condition of the banking sector remains strong, despite the Asian crisis and the recent slowdown. The authorities explained that prudent lending practices, effective supervision, and strong legal institutions remained the systemic pillars of sound banking.7 In addition, lower interest rates had contributed to containing nonperforming loans (NPLs) in the recent downturn. Nonetheless, they noted that classified loans might increase somewhat in the coming months if economic conditions—especially unemployment—deteriorated, although they were confident that no bank was at risk of breaching minimum capital adequacy standards. The staff observed that an increasingly competitive banking environment was spurring a search for new products, increased efficiencies, and consolidation. While this was helpful and necessary to sustain industry profitability, the authorities agreed with the staff that increased vigilance was warranted to ensure that the new activities and products offered by banks did not overtax their risk management capabilities. The planned establishment of full-fledged credit reference agencies for consumer and small and medium-sized enterprises should improve banks’ capacity for risk-based lending. The staff also welcomed the authorities’ plans to introduce a deposit insurance scheme, with features designed to minimize moral hazard (such as a differential premium system). On the experience with fully liberalized interest rates (the last ceiling, on savings deposit rates, was lifted in July 2001), the authorities explained that because of the ample liquidity conditions (with interest rates below the previous ceilings) the move did not have an immediate impact, although over time greater competition for deposits would likely erode interest margins somewhat.

16. Continued efforts are being made to improve Hong Kong SAR’s financial regulations and market oversight. The recently enacted Securities and Futures Ordinance (SFB) consolidates and modernizes existing legislation, with a view to enhancing competition, transparency, investor protection, and regulatory oversight. Newly established cross-market supervisory arrangements8 have improved coordination of monitoring efforts, including of cross-market risks that often escape the reach of individual agencies. Increasing attention globally to corporate governance standards has also prompted the Hong Kong authorities to review company practices, with input from a wide process of consultation including market participants. The staff welcomed these efforts, noting that the effectiveness of market oversight depended both on a strong framework of laws and regulations and active enforcement of those rules (for example, in the area of de-listing from the stock market). The staff welcomed the authorities’ agreement for Hong Kong SAR to participate in the Financial Sector Assessment Program (FSAP), which will provide a useful peer review and in depth assessment of codes and standards, regulatory practices, and financial sector vulnerabilities.9

17. Hong Kong SAR is also upgrading further its financial infrastructure, and has strengthened its anti-money laundering capacity. In addition to the interbank U.S. dollar clearing system, the authorities are now exploring the possibility to implement euro and yen clearing systems, which will also be integrated with the debt securities clearing system. The authorities explained that these improvements would provide investors with state-of-the-art risk management, clearing, and settlement systems, as part of their efforts to enhance Hong Kong SAR’s attraction as a regional financial center. Hong Kong SAR is also taking a leading role in coordinating the global effort against money laundering and terrorist financing. Basic anti-drug trafficking and anti-money laundering (AML) legislation, in place since the early 1990s, has been supplemented by regulations and guidelines for their application to financial institutions, and AML rules were extended to money changers and remittance agents in June 2000. Hong Kong SAR is in the course of introducing legislation to implement the relevant requirements under the UNSCR 1373 relating to countering terrorist financing. These issues also will be examined in more detail in the upcoming FSAP.

18. Labor Market and Income Distribution. Structural change, accelerated by integration with the Mainland, has contributed to labor market pressures and rising income disparities. While a large part of the recent increase in unemployment is cyclical, a growing mismatch of skills in the labor force has raised structural unemployment (Chart 12) and income disparities (Box 2). The premium for high-skilled labor has risen as the economy has been drawn to higher-value added activities, while unemployment among low-skilled workers has increased, exacerbated by the economic slowdown.

19. The authorities’ approach to dealing with these issues focuses on upgrading workforce skills and providing well-targeted social support. The staff observed that considerable scope existed to improve educational services (as indicated, for example, by low post-secondary enrollment compared with most OECD countries). The authorities agreed that improving the quality of education as well as promoting lifelong learning were priorities, while also noting that greater cost sharing by the private sector—with safeguards for the needy—was appropriate. In addition, they are reviewing immigration policy, partly with a view to attracting more high-skilled talent to Hong Kong SAR than under current policies. On social support, the authorities explained that the most vulnerable were eligible for social assistance, on which outlays had been rising significantly in recent years; they also pointed to the substantial assistance in the form of public housing10 and heavily subsidized health care and education.

20. Housing. The authorities have initiated a comprehensive review of housing policies, with a view to moving toward better targeted and more efficient subsidy schemes. A growing overlap between Home Ownership Scheme (HOS) flats (government-constructed flats sold to qualified buyers at a large discount from market prices) and private (unsubsidized) flats had exacerbated the distortions in the housing market. In September 2001, the government announced a ten-month moratorium on the sale of HOS flats and initiated a broad review of the entire HOS program. The intention was to gradually reduce the scale of the government’s intervention in the housing area, with greater emphasis on targeted loan subsidies for buyers of privately constructed flats. The authorities are also piloting a program of rental subsidies in lieu of low-cost government-provided rental flats.

21. While the authorities remain committed to their sector-specific approach to competition policy, they have stepped up efforts to combat anti-competitive behavior. A number of measures have been taken to strengthen competition in key regulated sectors such as telecommunications, broadcasting, and transport. The authorities are also keeping a close watch on possible anti-competitive behaviors, with a view particularly to ensuring fair competition in the non-regulated sectors and introducing sector-specific measures to promote competition if necessary. The staff recommended continued close attention to competition issues in unregulated sectors, especially in the absence of a general competition law.

D. Statistical Issues

22. Hong Kong SAR provides statistics to the Fund on a timely basis for surveillance and publication in IFS, and has subscribed to the SDDS. The authorities noted their plan to start publishing data on external debt and the international investment position in mid-2002, and production-based quarterly real GDP estimates in the second half of 2002. They also intend to report Government Finance Statistics (GFS) data from 2003, following adoption of accrual accounting standards. The staff welcomed these developments, and suggested that efforts be made to report bank assets and liabilities by residency (Annex II).

III. Staff Appraisal

23. After a difficult period of adjustment, the economy is set to recover moderately this year. Successive downturns from the Asian crisis and the recent global slowdown have hit hard the highly-open economy, and came on top of the structural adjustment needs from growing integration with the Mainland. Even so, confidence in the economy has remained strong, the financial system sound, and the external position robust. Led by exports, economic activity is projected to pick up from the second half of 2002. Although there are risks to this outlook, these have become more evenly balanced in recent months as prospects for global recovery have improved.

24. The authorities’ approach to dealing with the twin challenges of a sharp cyclical downturn and Mainland integration is appropriate. It centers on maintaining the rules-based and transparent economic policy framework that has served the economy well over the past two decades; focusing near-term policies on facilitating the adjustment process and helping those most affected; and continuing reforms to bolster competitiveness. The record of prudent economic management, with the institutional disposition to fiscal discipline and market-orientation embodied in the Basic Law, gives comfort that these challenges will, once again, be met.

25. While this year’s widening of the fiscal deficit was mainly cyclical, recent years have seen a structural deterioration in the budget that needs remedy. While the staff sees no case for a sharp fiscal correction in the midst of the cyclical downturn, the recent drift into a sizable structural deficit needs to be reversed to ensure healthy public finances in the longer run (when additional pressures from structural change and demographic trends will come to bear). The staff commends the authorities’ proactive and transparent approach to these issues, and supports the conclusions of the two government commissions set up to review them. The FY2002 budget outlines commendable goals for restoring budget balance over the medium term; it will now be important to support these goals with measures to reverse the rising trend of expenditure as a share of GDP and to strengthen the revenue base. The staff supports the initiative to review all public expenditures, including to contain the cost of education and health services—with safeguards for the needy—and the civil service. Strengthening the revenue base should include introduction of a low-rated, broad-based consumption tax. Since implementation will take time, preparations for these measures should start without delay.

26. As in the past, the staff supports Hong Kong SAR’s commitment to the linked exchange rate system. The economy has adjusted well to shocks under the link, which has been a centerpiece of the rules-based policy framework. Its stability has also played a critical role in boosting confidence in Hong Kong SAR as a financial center. Underpinning the smooth functioning of the link have been prudent fiscal policy, flexible goods and factor markets, a robust financial system, and large foreign reserves, factors that will continue to play a key role in supporting the link in the future.

27. The banking sector remains well capitalized, notwithstanding the Asian crisis and the recent downturn. An increasingly competitive banking environment is spurring a search for new products, efficiencies and consolidation. While this is desirable, vigilance is needed to ensure that the new activities and products offered by banks do not overtax their risk management capabilities. The staff supports the plan to introduce a deposit insurance scheme, with appropriate features to minimize moral hazard, and recommends establishment of full-fledged credit reference agencies covering both commercial and individual borrowers.

28. Continued progress in upgrading financial infrastructure and regulation will enhance Hong Kong SAR’s role as a financial center. The staff welcomes the enactment of the Securities and Futures Ordinance, which will consolidate and modernize existing legislation, increase transparency, and improve investor protection. Looking ahead, growing competition from global financial markets as well as those emerging on the Mainland will require continuous upgrading of the regulatory framework and its enforcement. The staff also commends the authorities’ efforts to strengthen the financial infrastructure to provide investors with the most secure and efficient operating environment. The staff welcomes Hong Kong SAR’s agreement to participate in the Financial Sector Assessment Program.

29. Economic integration with the Mainland offers many benefits for Hong Kong SAR, but also implies significant restructuring. To remain a center of trade-related and financial services, Hong Kong SAR will need to continue upgrading its infrastructure, human capital, and business environment. Structural change has also contributed to pressures in the labor market and rising income disparities. The staff supports the government’s approach to addressing these issues by improving the skills of the workforce through better education and training, and by providing well-targeted social support to the needy. The staff commends the authorities’ efforts to promote competition and lower costs in regulated sectors, and urges continued close attention to domestic competition issues especially in unregulated sectors, given the absence of a comprehensive competition law. The staff also welcomes the ongoing review of housing policies and encourages a move toward better targeted and more efficient subsidy schemes.

30. Hong Kong SAR disseminates a comprehensive set of reliable economic statistics. The staff welcomes its full compliance with the Special Data Dissemination Standard, as well as the plan to publish data on external debt and the international investment position from mid-2002. The staff also looks forward to the presentation of Hong Kong fiscal data in the standardized GFS format. One area where statistics can be improved further is the reporting of assets and liabilities by residency in the banking survey.

31. It is recommended that the next Article IV consultation with the People’s Republic of China in respect of Hong Kong SAR take place on a 12-month cycle.

ANNEX I Hong Kong SAR—Fund Relations

I. Membership Status

As a Special Administrative Region of the People’s Republic of China, Hong Kong SAR is not a member of the Fund. However, annual consultation discussions have been held with the Hong Kong SAR authorities since October 1990, and the staff also holds discussions with the authorities in connection with the staffs International Capital Markets reports. STA has provided Hong Kong SAR with technical assistance in the area of balance of payments statistics and Hong Kong SAR officials have attended INS courses on balance of payments and monetary statistics, and financial programming.

II. Exchange Rate Arrangement

Hong Kong SAR has its own currency, the Hong Kong dollar, which has been linked to the U.S. dollar under a currency board arrangement since October 1983 at a rate of HK$7.8/US$1. The market rate fluctuates around the linked rate, usually within a margin of less than 1 percent. There are no restrictions on current or capital transactions in Hong Kong SAR, and the Hong Kong dollar is freely convertible. The People’s Republic of China has accepted the obligations under Article VIII, Sections 2,3 and 4 of the Articles of Agreement on December 1, 1996.

III. Resident Representative

The Hong Kong SAR sub-office of the Beijing resident representative’s office was opened on September 23, 2000. Mr. William Lee, who since July 2000 has been informally functioning as the Resident Representative, formally assumed the position on that date.

ANNEX II Hong Kong SAR—Statistical Issues

Hong Kong SAR provides statistics to the Fund on a timely basis for surveillance and publication in International Financial Statistics. Hong Kong SAR subscribes to the SDDS and is fully compliant with its requirements.

The Hong Kong SAR authorities plan to disseminate statistics on its international investment position starting June 2002 for the reference year 2001. They have also brought forward the time table for publishing external debt data from September 2003 to June 2002. The authorities plan to begin publishing estimates of GDP by type of economic activity at constant prices starting in the second half of 2002.

However, there are areas where data deficiencies remain, including:

  • Hong Kong SAR does not report GFS for publication in the GFS Yearbook or in IFS. The authorities have initiated work on introduction of accrual accounting and aim to start reporting fiscal data in a GFS format in 2003, following the new recommended methodology (Government Finance Statistics Manual 2001).

  • Foreign assets and foreign liabilities of the banking system are derived from data collected through a separate survey and are not based on banking institutions’s balance sheet information, the primary source data for banking sector’s analytical accounts.


Survey of Reporting of Main Statistical Indicators As of March 6, 2002

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Fiscal year beginning April 1.


The term “country,” as used in this paper, does not in all cases refer to a territorial entity that is a state as understood by international law and practice; the term also covers some territorial entities that are not states, but for which statistical data are maintained and provided internationally on a separate and independent basis.


The CPI fell by 2.9 percent (y/y) in January-February 2002, partly due to a one-off cut in the tax on the assessed rental value of properties (accounting for about 1 percentage point of the decline).


he issue is explored in greater detail in a forthcoming Selected Issues Paper.


bout half of the decline in the overall CPI since 1998 reflects a decline in the housing component.


In August 1998, the government bought HK$118 billion of stocks to stabilize markets against suspected manipulation by speculators. After subsequent increases in market value and sales through the independently managed Tracker Fund, there remain about HK$37 billion (at end-2001 valuations) to be sold.


As measured by standard indicators (see the Selected Issues Paper SM/02/117). These measures do not take into account implicit transfers to low-income households through the public housing program.


For analysis of how the Hong Kong banks weathered the Asian crisis, see SM/01/23 (1/26/01),Chapter II.


The high-level Financial Stability Committee meets monthly to monitor developments and potential risks in the banking, securities, and insurance markets. In addition, a Risk Management Committee monitors cross-market risks at the operational level.


The results of the FSAP will be incorporated into the next Article IV consultation.


About half of the population lives in government-provided or subsidized accommodation.


Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country’s economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country’s authorities. This PIN summarizes the views of the Executive Board as expressed during the May 1, 2002 Executive Board discussion based on the staff report.

People’s Republic of China-Hong Kong Special Administrative Region: Staff Report for the 2002 Article IV Consultation Discussions
Author: International Monetary Fund