This Selected Issues paper characterizes the rapid expansion of Hong Kong Special Administrative Region’s (Hong Kong SAR) economic ties with the Mainland over the last two decades. It examines the possible impact on Hong Kong SAR of policy developments in the Mainland. The paper concludes that as integration has progressed, developments in various sectors of the Hong Kong SAR economy have become increasingly tied to developments on the Mainland. This paper also analyzes the initial episode of strong-side pressures on the Hong Kong dollar and, in particular, the Hong Kong Monetary Authority response.

Abstract

This Selected Issues paper characterizes the rapid expansion of Hong Kong Special Administrative Region’s (Hong Kong SAR) economic ties with the Mainland over the last two decades. It examines the possible impact on Hong Kong SAR of policy developments in the Mainland. The paper concludes that as integration has progressed, developments in various sectors of the Hong Kong SAR economy have become increasingly tied to developments on the Mainland. This paper also analyzes the initial episode of strong-side pressures on the Hong Kong dollar and, in particular, the Hong Kong Monetary Authority response.

I. The Implications for Hong Kong SAR of Rising Integration with theMainland1

A. Introduction

1. Since 1978, Hong Kong SAR’s economic integration with the Mainland has expanded rapidly. This chapter first characterizes the rapid expansion of Hong Kong SAR’s economic ties with the Mainland over the last two decades. The process of integration has strengthened over the years and the two economic cycles have become increasingly synchronized. At the same time, the Mainland’s own integration with the rest of the world is deepening, and these factors together have led to significant changes in the structure of Hong Kong SAR’s economy.

2. The chapter examines the possible impact on Hong Kong SAR of policy developments in the Mainland (including macroeconomic tightening, trade and capital account liberalization). The chapter concludes that as integration has progressed, developments in various sectors of the Hong Kong SAR economy have become increasingly tied to developments on the Mainland, which implies that macroeconomic fluctuations in the Mainland could have significant spillover effects on Hong Kong SAR. However, Hong Kong SAR also stands to benefit from the recently signed free trade agreement between the two WTO member economies as well as gradual capital account liberalization in the Mainland.

B. Economic Linkages between Hong Kong SAR and the Mainland

3. Over the last two decades, the Hong Kong SAR and Mainland economies have become increasingly linked, resulting in marked changes in the structure of Hong Kong SAR’s economy.

  • Hong Kong SAR’s capitalmarkets have become an important fundraising center for Mainland companies as the Mainland’s capital markets are still underdeveloped. At end September 2004, Mainland issuers accounted for one-fourth of the listed companies, 30 percent of total market capitalization and 40 percent of total market turnover in Hong Kong SAR. Mainland and Hong Kong SAR banks increasingly operate in each others’ territories. Direct exposure of Hong Kong SAR banks to the Mainland is small (less than 3 percent of banking sector assets) reflecting the tighter requirements on lending to Mainland companies (Figure I.1).2

  • The structural transformation of Hong Kong SAR’s economy towards knowledge-based and high value-added activities, has led to the erosion of the demand for low-skilled workers in the labormarket (see Chapter IV). As manufacturing has moved to the Mainland over the last two decades, the share of the manufacturing sector in GDP has declined from 22 percent in 1980 to less than 5 percent in 2004. Most of the manufacturing and lower-end service sectors that have migrated to the Mainland are largely labor intensive. Thus, the unemployment rate has risen faster among low-skilled workers and the wage premium commanded by high-skilled labor has increased.

  • As the Mainland’s access to world markets has increased, the structureoftrade between Hong Kong SAR and the Mainland is changing rapidly. Thus, the share of Hong Kong SAR’s entrepot trade has declined significantly, and it is increasingly getting a share of “offshore” trade that takes advantage of its superior logistical, business and financial services.3 However, the value-added of offshore trade is significantly lower than that of traditional re-export trade.

Figure I.1.
Figure I.1.

Linkages between Mainland China and Hong Kong SAR and their Macroeconomic effects

Citation: IMF Staff Country Reports 2005, 062; 10.5089/9781451816914.002.A001

Source: Data provided by the Hong Kong SAR authorities, CEIC database, and staff estimates.1/. Part of the recent increase in the contribution of entrepot trade to Hong Kong SAR’s GDP reflects the increase in re-export margins.2/. Includes FDI in Mainland China by foreign enterprises based in Hong Kong SAR. However, it probably also includes FDI that is “round tripped” via Hong Kong SAR and back to Mainland China to take advantage of the favorable tax treatment for foreign firms.3/. Gross exposure as defined here has a broader coverage—it includes claims and liabilities of Hong Kong SAR banks to both banks and non-bank entities in the Mainland.

4. More recently, two Mainland-led initiatives were adopted with a view to further broaden the areas of integration.

  • The Pan-Pearl River Delta (PRD) Cooperation Initiative brings together nine provinces in the region in addition to Hong Kong SAR and Macao SAR to increase economic efficiencies by better leveraging regional synergies, and to compete more effectively with the Yangtze River Delta Region. The Pan-PRD region has the potential to become a very attractive market for Hong Kong SAR’s financial, logistical and other services. 4

  • The Closer Economic Partnership Arrangement (CEPA) which was signed in mid-2003 aims to strengthen trade and investment cooperation between Hong Kong SAR and the Mainland. It also includes a liberalization of the Mainland tourist visa scheme (that allows individual, rather than just group, visits) which has resulted in a surge in tourist arrivals from the Mainland to Hong Kong SAR (see Box I.1 for details).

C. Integration and Business Cycles

5. The growing integration of Hong Kong SAR and the Mainland economies has led to increasing correlation between their economic cycles. To assess the degree of synchronization of Hong Kong SAR’s and the Mainland’s business cycles, we use the concordance statistic originally proposed by Harding and Pagan (2002a, b) and recently applied by Cashin (2004).5 These statistics show that the correlation between the two economies’ output as well as the components of output (based on the concordance statistics in Figures II.2 and II.3) have increased since the mid-1990s, which suggest that integration has advanced in many sectors of the two economies. Although consumption and investment correlations have increased, they are lower than output correlations.6 Real exchange rate changes for the two economies also exhibit significantly high correlation (Figure II.3). Forward exchange rates have become highly correlated and equity market developments in the two economies have generally followed each other.

6. The structural transformation of Hong Kong SAR’s economy to a predominantly service-based economy has been associated with a reduction in the cyclical variability of output. Rolling standard deviations of output growth (year-on-year) show that output growth volatility has declined in the past few years and a variance decomposition analysis shows that the decline in output volatility largely reflects the changes in sectoral composition of GDP and the dominance of the service sector. Reflecting the same structural shift, the amplitude of Hong Kong SAR’s business cycles has also declined since the 1980s.

D. Macroeconomic Implications of Policies in the Mainland on Hong Kong SAR

7. As Hong Kong SAR becomes more integrated with the Mainland, the potential spillover effects of macroeconomic fluctuations in the Mainland on Hong Kong SAR could increase. An economic slowdown in the Mainland could affect Hong Kong’s SAR’s economy through a variety of channels including trade links, lower revenues from Mainland tourists to Hong Kong SAR and lower investment earnings.7 The likely impact on Hong Kong SAR’s economy can be gauged in three ways:

  • A restricted partial equilibrium analysis suggests that, if a slowdown in domestic investment growth in the Mainland were to lead to a one-time 10 percentage point decline in Mainland’s import growth for domestic consumption, it would have a limited macroeconomic impact on Hong Kong SAR. 8 For simplicity, imports of textiles and electronics products (which serve as a proxy for processing exports to industrial markets) were assumed to remain unaffected. The impact of such a shock could lower Hong Kong SAR’s growth by about ½ percentage point, after the multiplier effects of a change in demand on aggregate income are taken into account. The current account surplus would be reduced only marginally since both its imports and exports would be affected almost proportionally.

  • The impact of policy tightening in the Mainland on Hong Kong SAR can also be assessed by drawing upon the empirical results on the level of synchronization of the two economies’ business cycles. As discussed in Section C above, although the two economies’ output are highly correlated, lower correlations between their consumption and investment variables suggest that the direct impact of macroeconomic tightening in the Mainland is likely to be felt mainly through the effect on Hong Kong SAR’s exports.

  • Lessons could also be drawn from the impact of previous boom/bust cycles in the Mainland on Hong Kong SAR’s economy. During the period 1986-90, the Mainland experienced a hard landing. In 1989-90, Hong Kong SAR’s real GDP growth rate declined to an average of 3 percent from an average of 12 percent in 1986-87. In general, the lesson from the impact of previous boom/bust cycles in the Mainland on Hong Kong SAR’s economy suggests that the overall impact of a slowdown in the Mainland on Hong Kong SAR might be slightly larger than what the results from the partial equilibrium analysis indicate. 9

8. Simulation results on the macroeconomic impact of CEPA on Hong Kong SAR suggest that the impact of the zero-tariff aspect of the CEPA agreement by itself is likely to be small. This is because the zero-tariff policy in CEPA applies only to direct merchandise goods exports from Hong Kong SAR to the Mainland which account for less than 10 percent of Hong Kong SAR’s total exports. 10Box I.1 provides details of the CEPA agreement. The simulation uses the Global Trade Analysis Project (GTAP) model to set tariff rates as zero on 100 percent of direct exports of goods from Hong Kong SAR to the Mainland. Table I.1 summarizes the GTAP simulation results. Using the central elasticities in the GTAP model as the baseline scenario, the simulation results show that:11

Table I.1.

Hong Kong SAR: Effects of the Zero-Tariff aspect of the CEPA FTA 1/ Summary of the Simulations using GTAP Model

(percentage deviation from the baseline, unless otherwise indicated)

article image
Source: Simulations with the GTAP model, as described in the text.The GTAP model uses the Armington demand elasticites (see footnote 10 in the main text for details).

The percentage change numbers are not changes in the growth rates of the variables. These are changes in the levels of the variables benchmarked against the baseline which assumes no CEPA trade agreement between Hong Kong SAR and the Mainland.

Constant nominal wages and medium levels of elasticities.

Half of the central elasticities. Constant nominal wages.

Double of the central elasticities. Constant nominal wages.

Nominal wages are fully indexed to the CPI.

Wages are fully flexible to maintain current employment.

Higher capital accumulation in Hong Kong SAR as firms have wider market access to the Mainland’s service sector due to the removal of restrictions.

Higher productivity of Hong Kong SAR firms due to service sector liberalization in the Mainland.

In changes in equivalent variation—in billions of US$.

  • A zero tariff policy under CEPA will increase Hong Kong SAR’s annual GDP by 0.3 percentage point (compared to the baseline of no-CEPA scenario) and increase total employment by about 0.2 percentage point; 12

  • The overall trade balance for Hong Kong SAR will improve by about 0.4 percentage point;

  • CEPA will give rise to some welfare gains through four main channels: (i) more efficient resource allocation; (ii) improvements in the terms of trade; (iii) expansion of production endowments and (iv) technology innovation and productivity improvements.

9. However, the direct and indirect impact of the service sector liberalization component of CEPA (including tourism), which is not captured by the GTAP model, is expected to become increasingly significant over time.13 The removal of entry barriers to the Mainland is likely to benefit a large number of service industries in Hong Kong SAR, which together account for about 40 percent of GDP. Since CEPA applies to Hong Kong SAR companies regardless of the nationality of their shareholders and investors, overseas companies should find it more attractive than before to use Hong Kong SAR as a regional headquarters location to support their Mainland operations. Thus, CEPA will allow Hong Kong SAR firms to expand their businesses in the Mainland rather than relocate to the Mainland and would attract FDI to Hong Kong SAR. Simulations were conducted in which capital accumulation and productivity variables were shocked as a proxy for assessing the direct impact on Hong Kong SAR of the service sector liberalization component of the CEPA agreement. The results show that the service sector liberalization in CEPA would have a significantly larger impact on Hong Kong SAR than the zero-tariff policy on direct exports of merchandise goods to the Mainland (it would yield almost 3 times the size of the estimated impact of the zero-tariff policy on the level of GDP—the sum of the GDP effects in scenarios 6 and 7 of Table I.1) Service sector liberalization in CEPA would also have a positive impact on business confidence in Hong Kong SAR.

Impact of Capital Account Liberalization in the Mainland on Hong Kong SAR

10. Hong Kong SAR is well placed to benefit from gradual capital account liberalization in the Mainland. While the Mainland authorities still have strict controls on most capital account transactions, over the past couple of years they have taken some steps toward capital account liberalization. As integration deepens, Hong Kong SAR, which is still an important financial gateway to the Mainland, is likely to play an important role in reforming and strengthening the Mainland’s capital market since: (i) it has a world class financial infrastructure, and (ii) it is a natural testing ground for the Mainland’s liberalization measures.

  • Following the lifting of the ban on emigrants’ transfer of legitimate assets abroad by non-Mainland residents and the restrictions on cross-border transfer of foreign exchange capital by multinationals, portfolio outflows to Hong Kong SAR are likely to increase. Ma and McCauley (2003) estimate, that of the US$40 billion increase in net claims of Mainland banks on the international banking system (based on data by BIS reporting banks for the period 1999-2001), US$14 billion flowed through banks located in Hong Kong SAR.

  • Another possibility of further capital account liberalization being considered by the Mainland authorities is through the Qualified Domestic Institutional Investor (QDII) scheme. The QDII scheme would allow domestic institutional investors to invest in capital markets abroad which would be a source of liquidity for Hong Kong SAR’s stock market.

  • Mainland authorities may allow some residents to invest in Hong Kong SAR’s property market, which is an important component of the Hong Kong SAR’s economy. At present, capital controls have constrained the ability of Mainland residents to acquire property in Hong Kong SAR.

  • The addition of the renminbi to Hong Kong SAR’s financial infrastructure, in however modest a manner, is of strategic importance to the maintenance of Hong Kong SAR’s status as an international financial centre and would enable it to capture international financial intermediation activities denominated in renminbi. The Hong Kong SAR authorities’ medium-term goal is to have a real time gross settlement system for the renminbi in Hong Kong SAR.

11. However, further capital account liberalization in the Mainland could pose some challenges for Hong Kong SAR.

  • Greater exposure of Hong Kong SAR’s stock and real estate markets to the Mainland implies that a significant component of Hong Kong SAR’s economy will be vulnerable to cyclical and structural shocks emanating from the Mainland.

  • Relatedly, capital flows constitute a potential source of financial sector procyclicality which tends to result in excessive credit growth during booms and a credit crunch during a recession (see Chapter III). Increased capital flows from the Mainland to Hong Kong SAR, which would be largely intermediated through the banking system, could influence financial sector procyclicality in Hong Kong SAR.

12. More generally, as financial integration between the two economies deepens, there would be further challenges for financial sector supervision and regulation in Hong Kong SAR as Mainland and Hong Kong SAR banks increasingly operate in each others’ territories. The need for better coordination of cross-border supervision would therefore become increasingly important.

E. Conclusions

13. This chapter has documented the economic impact on Hong Kong SAR of the ongoing integration between Hong Kong SAR and the Mainland and analyzed the likely impact of policy developments in the Mainland on Hong Kong SAR. The chapter’s main conclusions are as follows:

  • Increased integration between the two economies has deepened across various sectors over the past decade and this has led to significant changes in structure of Hong Kong SAR’s economy.

  • As integration has progressed, the business cycles in Hong Kong SAR and the Mainland have become increasingly synchronized, which implies that macroeconomic fluctuations in the Mainland could have significant spillover effects on Hong Kong SAR.

  • Hong Kong SAR stands to benefit from the recently signed free trade agreement between the two economies (CEPA) and the gradual capital account liberalization in the Mainland. At the same time, capital account liberalization in the Mainland could also give rise to some challenges for Hong Kong SAR as greater exposure of Hong Kong SAR’s stock and real estate markets to the Mainland implies that a significant component of Hong Kong SAR’s economy will be vulnerable to cyclical and structural shocks emanating from the Mainland.

Box The Closer Economic Partnership Arrangement—Free Trade Agreement between Hong Kong SAR and the Mainland

The closer economic partnership arrangement (CEPA) that was signed in June 2003 and became effective January 1, 2004 presents significant opportunities for Hong Kong SAR. The second phase of CEPA was signed in August 2004. CEPA gives Hong Kong SAR substantial long-term advantages compared to the Mainland’s commitments to other countries under the WTO. Specifically:

  • On January 1, 2004, goods from Hong Kong SAR that fell under 273 Mainland product codes (equivalent to 90 percent of Hong Kong SAR’s direct exports to the Mainland—and which excludes re-exports) became eligible for a zero-tariff treatment under CEPA.

  • On January 1, 2006, the remaining products will also be given a zero-tariff treatment.

  • Market access under CEPA is wider than under the Mainland’s WTO commitments and includes several sectors including trade in goods, services and investment promotion.

  • Many of the trading quotas imposed on Hong Kong firms by the Mainland would also be lifted under CEPA.

The service sector in Hong Kong SAR stands to benefit the most from CEPA, including through the lowering of entry barriers.

  • 18 service sectors are eligible for favorable treatment under CEPA (including telecommunications, banking, insurance and management consultancy and other sectors that were not included in the Mainland’s WTO commitments); additional service sectors were added to the CEPA list in August 2004.

  • CEPA lowers the minimum assets requirement for banks planning to open branches in the Mainland from US$20 billion to US$6 billion, thus making most local banks eligible for it.

  • It relaxes equity share restrictions for foreign investors in the service sectors.

CEPA’s rules of origin are less stringent than those set under similar free trade agreements. Manufacturing firms are required to have only 30 percent of their value added in Hong Kong SAR in order to qualify for CEPA’s benefits. Although labor costs are relatively high it may nevertheless be profitable to carry out high value added processes—especially those with intellectual property content—given the zero tariff, and low tax rates in Hong Kong SAR.

CEPA also includes a liberalization of the Mainland tourist visa scheme (allowing individual, rather than just group visits) that resulted in an immediate surge in tourist arrivals from the Mainland to Hong Kong SAR.

Figure I.2.
Figure I.2.

Hong Kong SAR and Mainland China: Degree of Concordance between the Growth Rates of GDP and its Components

Citation: IMF Staff Country Reports 2005, 062; 10.5089/9781451816914.002.A001

Sources: CEIC database and staff estimates.1/ The data on quarterly real consumption and investment for China are staff estimates.2/ Concordance ratios based on four quarter growth rates and a rolling window of 15 quarters.
Figure I.3.
Figure I.3.

Hong Kong SAR and Mainland China: Degree of Concordance between Financial Market Indicators

Citation: IMF Staff Country Reports 2005, 062; 10.5089/9781451816914.002.A001

Sources: IMF, Information Notice System, CEIC database, and staff estimates.

References

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1

Prepared by Lamin Y.M. Leigh, ext. 36518.

2

However, banks also have some indirect exposure arising from the Mainland activities of borrowers, although data to assess these activities are lacking.

3

Between 1995 and 2003, growth in re-exports of trade-related services, at 15 percent in real terms, significantly outpaced growth in re-exports involving the Mainland, which was at 7.3 percent in real terms.

4

The potential offered by the Pan-PRD Cooperation initiative is enormous. The Pan-PRD region stretches from Fujian in the east to Sichuan in the west, with the Pearl River Delta in between. This area makes up one-fifth of China’s land mass, contains almost a third of its population and accounts for a third of its GDP. However, the differing stages of development and income/wealth disparities will be key challenges.

5

The measure of concordance is a simple non-parametric statistic that describes the proportion of time two series are in the same phase (see Harding and Pagan (2002) and Cashin (2004) for more details). The concordance statistics are estimated using year-on-year growth rates over 15-quarter rolling sub-periods. Similar results were arrived at using Hodrick-Prescott filtered cyclical components over 15-quarter rolling sub-periods. These statistics could be influenced by structural breaks, but it is difficult to test this formally since the data span a relatively short period.

6

Test of the null hypothesis of no association between the Hong Kong SAR and the Mainland’s business cycles was strongly rejected for output, consumption, investment and exports, which suggests that the comovement between the two economies cycles is statistically significant and corroborates the results of the contemporaneous concordance ratios that are described above.

7

Staff analysis presented in Occasional Paper 226 shows that price convergence with the Mainland played an important role in explaining the deflationary process in Hong Kong SAR.

8

It is estimated that such a decline in the Mainland’s imports would be consistent with an initial drop of 5% percentage points in its real investment growth and a 4Vi percentage point decline in GDP growth, after multiplier effects are taken into account.

9

The partial equilibrium analysis discussed above does not take into account the effects a slowdown in the Mainland on Hong Kong SAR that work through financial channels.

10

Re-exports are the dominant form of exports for Hong Kong SAR and account for over 90 percent of total exports.

11

The GTAP model uses the Armington demand elasticities—(i) elasticity of substitution between domestic Mainland goods and imports from Hong Kong SAR, which reflects the trade creation effect of the CEPA FTA for Hong Kong SAR; (ii) elasticity of substitution between imports by country of origin, this elasticity reflects the trade diversion effect as the removal of the tariff on imports from Hong Kong SAR would stimulate those imports to substitute those from the other trading partners for the Mainland. Sensitivity tests reported in Table I.1 indicate that the simulation results are generally robust to the values chosen for these elasticities.

12

The higher level of GDP comes from the reduction in tariff payments by Hong Kong SAR exporters, the increase in export volumes, the increase in investments in sectors that will become more competitive, and the additional consumer spending by those who experience income growth under CEPA.

13

Total expenditure by Mainland tourists was HK$37.8 billion in Hong Kong SAR (about 3 percent of GDP) in 2003. However, this is likely to increase significantly in 2004 and over the medium term, following the relaxation of restrictions on tourist travel from the Mainland to Hong Kong SAR in July 2003 and the launch of the “individual visit” scheme.

People’s Republic of China—Hong Kong Special Administrative Region Selected Issues
Author: International Monetary Fund
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    Linkages between Mainland China and Hong Kong SAR and their Macroeconomic effects

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    Hong Kong SAR and Mainland China: Degree of Concordance between the Growth Rates of GDP and its Components

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    Hong Kong SAR and Mainland China: Degree of Concordance between Financial Market Indicators