People’s Republic of China—Hong Kong Special Administrative Region: Selected Issues
Author: International Monetary Fund
Publication Date:
08 Jan 2007
eISBN:
9781451816952
Language:
English
Keywords:
ISCR; CR; revenue; revenue volatility; Hong Kong SAR; market; Hong Kong's attractiveness; labor market; government policy; indicators of competitiveness; Global competitiveness; Productivity
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This Selected Issues paper reviews medium-term fiscal challenges for Hong Kong Special Administrative Region (Hong Kong SAR). It focuses on key considerations that need to be evaluated when formulating a medium-term reserves policy in the face of fiscal challenges, such as accommodating future spending pressures and revenue fluctuations. The broad conclusion of the paper is that fiscal reserves will likely remain an important feature of future fiscal policy. The paper also discusses more general aspects of Hong Kong SAR’s economy’s competitiveness, and the outlook for Hong Kong SAR’s financial center.

Abstract

This Selected Issues paper reviews medium-term fiscal challenges for Hong Kong Special Administrative Region (Hong Kong SAR). It focuses on key considerations that need to be evaluated when formulating a medium-term reserves policy in the face of fiscal challenges, such as accommodating future spending pressures and revenue fluctuations. The broad conclusion of the paper is that fiscal reserves will likely remain an important feature of future fiscal policy. The paper also discusses more general aspects of Hong Kong SAR’s economy’s competitiveness, and the outlook for Hong Kong SAR’s financial center.

II. Competitiveness: Trends and Prospects24

A. Introduction

1. After deteriorating markedly in the lead up to the Asian crisis, competitiveness has, by most measures, rebounded over the last few years. Strong productivity growth and downward adjustments in factor and asset prices have contributed, supported by the economy’s traditional strengths—notably free and flexible markets, sound financial systems, and well-developed infrastructure. In turn, this has strengthened Hong Kong SAR’s status as the premier financial center in East Asia, attracting global investors and businesses.

2. While price competitiveness has improved, further steps are likely to be needed with regard to some non-price dimensions of competitiveness. Since the latter half of the 1990s, Hong Kong SAR’s rankings have deteriorated on a number of global competitiveness indices assessing the attractiveness of the business environment. Such assessments highlight a few potential areas for improvement such as labor force skill levels, the regulatory framework, domestic competition and living conditions. In addition, with Hong Kong SAR facing a steep rise in the old age dependency ratio, demographics could adversely affect competitiveness over the medium-term, while competition from other regional financial centers is also likely to intensify.

3. At the same time, given the importance of financial services in the economy, much will depend on how well financial integration with the Mainland is managed and advanced. Chapter III discusses these specific challenges and the outlook for Hong Kong SAR’s financial center in more detail. This chapter focuses on more general aspects of the economy’s competitiveness.

B. Trends and Patterns

The Fall and Rise of Price Competitiveness

4. The real effective exchange rate, a common measure of competitiveness, has returned to early 1990 levels. Hong Kong SAR’s real effective exchange rate rose sharply in the lead up to the Asian crisis (Figure 1), appreciating by more than 50 percent between 1990 and 1998. This largely reflected the persistence of higher consumer price inflation than in trading partner countries, with rapid wage growth and property price inflation also fueling cost pressures. Since the crisis, however, the real effective exchange rate has been on a steep downward trend and is now almost back to the level observed in 1990, some 30 percent below its 1998 peak. Therefore, on this measure, it appears that Hong Kong SAR has regained any price competitiveness that it may have lost during the period preceding the Asian crisis.

Figure 1.
Figure 1.

Trends in Price-Based Indicators of Competitiveness

Sharp falls in domestic factor and asset prices have helped to reduce business costs and strengthen Hong Kong SAR’s business center.

Citation: IMF Staff Country Reports 2007, 004; 10.5089/9781451816952.002.A002

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

5. Underlying this recovery in competitiveness was a prolonged period of generalized deflation. Under the linked exchange rate system, domestic factor and asset prices shouldered much of the burden of adjustment following the Asian crisis. Reflecting the highly flexible nature of these markets, consumer and property prices fell sharply and helped to bring domestic prices back in line with those in trading partners. Driven by six years of deflation and the recent weakness of the US dollar, Hong Kong SAR’s indicators of price competitiveness have improved significantly in the last few years. In turn, this has helped to reduce business costs and strengthen Hong Kong’s attractiveness as a financial center (Table 1).

Table 1.

Prices and Earnings Rankings

article image
Source: UBS: Prices and Earnings: 2003 and 2006 editions.

Includes rent.

Out of 70 cities.

Out of 71 cities.

6. A similar adjustment took place in the labor market, where nominal wages fell. In recent years, productivity growth has also been high in the trade and tourism, transport and financial services sectors (Figure 2). By contrast, productivity growth in manufacturing and the non-tradable personal services sector has generally been more subdued. However, with nominal wages generally falling over the last five years, unit labor costs have declined significantly across all sectors. These trends have also led to an improvement in cost competitiveness relative to other regional economies across all sectors, especially in financial services.

Figure 2.
Figure 2.

Sectoral Trends in Productivity and Unit Labor Costs

(2000=100)

Citation: IMF Staff Country Reports 2007, 004; 10.5089/9781451816952.002.A002

Sources: CEIC and staff calculations.

7. The increased price competitiveness has also been associated with rising economic efficiency (Table 2). Indeed, factor accumulation (both physical and human capital) has contributed less to the recent turnaround than during previous time periods. The same is true when Hong Kong SAR’s recent growth experience is compared against other newly industrialized economies (NIEs). Rapid TFP growth accounts for much of the strong rebound in labor productivity over the last five years. During the initial phase of its restructuring from manufacturing to services in the 1980s and early 1990s, Hong Kong SAR experienced similar periods of strong TFP growth. After detracting from growth during the Asian crisis, TFP has again contributed more than 1½ percentage points to growth over the last five years. This trend is positive, as growth is more likely to be sustainable when it reflects increased productivity through technological progress as opposed to pure factor accumulation. As Hong Kong SAR matures into a higher value-added service economy, productivity growth should be supported by further efficiency gains.

Table 2.

Growth Accounting: Sources of growth in labor productivity

(Annual percent changes)

article image
Sources: Barro and Lee (2000), Fajnzylber and Lederman (1999), IMF (2006b), Nehru and Dhareshwar (1993), CEIC and Fund staff calculations.

Output per worker.

Simple average.

Perceptions of a Fall in Non-Price Competitiveness

8. Hong Kong SAR is generally ranked very highly in external assessments of competitiveness, which encompass non-price dimensions (Figure 3). A number of agencies have developed indices to reflect the attractiveness of business environments based, inter alia, on investor perceptions. The most well-known are published in the International Institute for Management Development’s (IMD) World Competitiveness Yearbook, the Economist Intelligence Unit’s (EIU) Global Country Forecast, the World Economic Forum’s (WEF) Global Competitiveness Report, and the World Bank’s Doing Business Survey. Most of these competitiveness indices routinely rank Hong Kong SAR among top performing economies, not only in Asia but also globally. In addition, Hong Kong SAR has consistently been ranked as the freest economy in the world over the last decade by the Heritage Foundation and the Fraser Institute. Hong Kong SAR’s business environment tends to perform particularly well in terms of government efficiency, labor market flexibility, and infrastructure. The territory’s low-tax environment, openness, and business-friendly policies are also considered to be among its strengths. In addition, indicators of corporate governance and financial market efficiency place Hong Kong SAR among the best performing economies in the region, underpinning its status as the leading financial center in East Asia.

Figure 3.
Figure 3.

Global Competitiveness Indices

Global competitiveness rankings highlight Hong Kong SAR’s strong business environment.

Citation: IMF Staff Country Reports 2007, 004; 10.5089/9781451816952.002.A002

Sources: Credit Lyonnais, Economist Intelligence Unit, International Institute for Management Development, World Bank, and World Economic Forum.

9. That said, Hong Kong SAR has slipped in international ranking along several non-price dimensions of competitiveness since the latter half of the 1990s (Figure 4). While most economies in the region also saw their rankings fall in the aftermath of the Asian crisis, Hong Kong SAR experienced some of the sharpest declines—falling from 1 to 3 according to the EIU, 2 to 8 according to the WEF, and 3 to 14 according to the IMD.

Figure 4.
Figure 4.

Potential Weaknesses in Business Environment

Business perceptions suggest that some non-price based indicators of competitiveness may warrant attention.

Citation: IMF Staff Country Reports 2007, 004; 10.5089/9781451816952.002.A002

Sources: EIU, WEF, IMD, and World Bank.

10. Somewhat surprisingly, most of the rankings have not improved significantly even after the economy staged a remarkable sustained recovery since 2003. While the IMD (whose coverage of institutional variables is more limited) reports a substantial recovery, the other three indices all suggest that the decline in competitiveness has continued—since 2000, the SAR’s rankings have fallen from 3 to 9 according to the EIU, from 16 to 20 according to the WEF’s Business Competitiveness Index (BCI) and from 8 to 28 on its Growth Competitiveness Index (GCI). Rankings based on 2006 data are still being compiled for some of these indices, but those available suggest a perceived improvement in competitiveness over the last year. However, Hong Kong SAR’s rankings are still some way below those in 2000. This protracted decline is somewhat surprising given the strength of the economy, since these assessments generally tend to be pro-cyclical. While in the case of the BCI, the fall may be justified by the index’s heavy reliance on R&D-related factors which are arguably less relevant to a predominantly service-based economy, the fall in its GCI ranking is more troubling—between 2004 and 2005 alone, it has fallen by 7 places, reflecting a decline in the rating of Hong Kong SAR’s public institutions.25

C. Key Challenges

11. While these rankings are subjective, they do serve a purpose in identifying areas where Hong Kong SAR is perceived to have lost its competitive edge. Given that Hong Kong SAR is essentially a business hub, investor perceptions perhaps matter more than in other economies (Table 3). A recent study identifies a number of factors critical to the success of financial centers (Corporation of London, 2005). While Hong Kong SAR performs well on most of these factors, some others—notably non-price features such as labor force skill levels, language, quality of life, and the regulatory environment—could present challenges going forward:

  • Population aging. While demographic changes in Hong Kong SAR have supported economic growth over the last two decades, they could soon start to detract from it—indeed, it is estimated that, with the population set to age dramatically, such effects could set in within the next ten years (Leigh, 2006).

  • Human capital. Public expenditure on education in Hong Kong SAR remains below that in the average OECD country, and higher education attainment lags behind. In particular, despite a large premium on higher education, enrollment in post-secondary education is much lower than in many Asian economies.26 The government estimates that by 2007, Hong Kong SAR will face a shortage of nearly 100,000 people with higher education.27 Such shortages of skilled labor tend to increase the economy’s reliance on overseas professionals, although there are concerns that the SAR’s attractiveness in this context may also be falling (see below).

  • Living conditions. Concerns are emerging that rising pollution levels may be adversely affecting living conditions and deterring the inflow of overseas talent into Hong Kong SAR. Singapore is, by most measures, among the cleanest cities in Asia in terms of air quality, while Tokyo, Seoul and Taipei also enjoy better air quality.28 In a recent survey by the American Chamber of Commerce in Hong Kong SAR, nearly 80 percent of the executives polled felt Hong Kong SAR’s allure for foreign investors was falling based on environmental trends. The survey also found that a quarter of companies have experienced difficulties in recruiting professionals.29 The SAR’s deteriorating air quality is largely blamed on factories in the Pearl River Delta (especially Guangdong province, many of which are Hong Kong SAR-owned), although local coal-fired power plants and diesel-powered buses, in addition to high population density, also contribute.

  • Public institutions and regulatory burden. In addition to recent deteriorations in the perceived quality of public institutions discussed earlier, some specific weaknesses in the regulatory environment have also been identified by the World Bank’s Doing Business Survey. Notwithstanding some reservations about the appropriateness of the representative businesses chosen in the Survey, registering property, dealing with licenses and business closure is reportedly more cumbersome in Hong Kong SAR than in the region as a whole, taking 3 to 5 times as long as in Singapore. In addition to increasing the cost of doing business, such entry and exit barriers may, as discussed below, perpetuate existing market structures and undermine domestic competition.

  • Domestic competition. While the external sector of the Hong Kong SAR economy operates under intense global competition, there are some concerns that domestic (particularly non-tradable service sectors) sectors may be more vulnerable to anti-competitive behavior.30 Insufficient competition in domestic sectors can feed into the cost structure of the tradable sector through inflated input prices: indeed, there is evidence that the degree of domestic competition can affect trade performance and external competitiveness (Sakakibara and Porter, 2001). Hong Kong SAR currently has a sectoral approach to competition, with different rules across sectors potentially distorting the allocation of resources. Other problems with the existing system that have been cited include the exclusion of structural issues, lack of enforcement authority, and conflicts of interest associated with a single agency acting as both regulator and enforcer of competition policy (see, e.g. Chen and Lin, 2002).31

Table 3.

Hong Kong SAR: Behind the Global Competitiveness Indices 1/

(Rankings, unless otherwise indicated)

article image
Sources: EIU: Country Forecast (July, 2006); World Economic Forum: Global Competitiveness Report (2005/06), IMD: World Competitiveness Year Book (2006); World Bank: Doing Business Survey (2007).

Strengths (weaknesses) are classified as those factors where Hong Kong SAR ranks higher (lower) than its overall ranking under the respective global index.

To simplify the table, regional comparators (which Hong Kong SAR generally outperforms on these factors) are not shown.

Numbers in parentheses show rank out of 17 regional economies: Australia, Bangladesh, China, Hong Kong SAR, India, Indonesia, Japan, Malaysia, Pakistan, Philippines, Singapore, Korea, Sri Lanka, Taiwan POC, Thailand, and Vietnam.

D. Conclusion

12. To enhance Hong Kong SAR’s competitiveness in global markets and secure its position as the leading financial center in the region, a number of steps are likely to be needed. The authorities recognize these challenges and are taking some encouraging steps to address them. Over the medium-term, initiatives such as those discussed below should go a long way towards further strengthening the foundations of Hong Kong SAR’s economy, and enabling it to compete effectively in regional and global markets:

  • Upgrading skill levels. Continuously upgrading the skill levels of its labor force will be key to facilitating Hong Kong SAR’s transition to a knowledge-based economy, especially as further integration with the Mainland increases the relative demand for skilled labor and returns to education. Government policies to promote higher education—e.g., providing loans for higher and continuing education, and investing in retraining programs—could help in this regard. Immigration schemes aimed at attracting skilled workers and professionals from overseas (including the Mainland) could also be worthwhile, while at the same time helping to alleviate some of the problems posed by population aging. In recent years, the government has undertaken a number of initiatives to address this issue, through education reforms designed to increase tertiary education take-up, schemes to promote skills upgrading, and targeted immigration policies.

  • Tackling pollution. Dealing with pollution—inter alia, through tougher emissions regulations, greater co-operation with Guangdong authorities, and the use of market-based mechanisms—is likely to be important for preserving international investment and continuing to attract the best overseas talent. Reflecting an increasing recognition of the problems posed by worsening pollution, the government has begun monitoring air quality and is developing an environmental protection action plan in collaboration with Guangdong province.

  • Lowering business costs. Reducing business costs, particularly by streamlining some regulations, improving English-language skills and preserving the quality of market institutions, will be key to maintaining Hong Kong SAR’s advantage as a regional financial center. Appropriately, this year’s budget reiterates the government’s commitment to lowering the costs of operating in the SAR by streamlining business regulations.

  • Promoting domestic competition. There may be scope for increasing competition in selected (particularly non-tradable) sectors, possibly under the aegis of a general competition law. Encouragingly, the authorities have recently completed a review of existing competition policy which recommends a general competition law, and a public consultation has been launched.

At the same time, maintaining the SAR’s traditional strengths—flexible and open markets, commitment to market forces and sound financial systems—will remain crucial for the economy’s competitiveness.

References

  • Barro, R. and J. Lee, 2000, “International Data on Educational Attainment: Updates and Implications,” CID Working Paper No. 42 (Cambridge: Center for International Development at Harvard University).

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  • Chen, K.Y. and Ping Lin, 2002, “Competition Policy under Laissez-Faireism: Market Power and its Treatment in Hong Kong,” Review of Industrial Organization, 21(2), pp. 145 –66.

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  • Corporation of London, 2005, “The Competitive Position of London as a Global Financial Center,” (November, 2005).

  • ECA, 2006, International Location Ranking Survey, Euan Barty Associates Ltd. (Hong Kong SAR).

  • EIU, Global Country Forecast (London: Economist Intelligence Unit) (various issues).

  • Fajnzylber, P. and D. Lederman, 1999, “Economic Reforms and Total Factor Productivity Growth in Latin America and the Caribbean (1950–95): An Empirical Note,” Policy Research Working Paper No. 24 (Washington: World Bank).

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  • IMD, World Competitiveness Report (Lausanne: International Institute for Management Development) (various issues).

  • IMF, 2006, World Economic Outlook, September 2006 (Washington: International Monetary Fund).

  • Leigh, Lamin, 2006, “Hong Kong Special Administrative Region: Macroeconomic Impact of an Aging Population in a Highly Open Economy,” Working Paper No. 06/87 (Washington: International Monetary Fund).

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  • Nehru, V. and A. Dhareshwar, 1993, “A New Database on Physical Capital Stock: Sources, Methodology and Results,” Revista de Análisis Económico, 8 (1), pp. 37 –59.

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  • Sakakibara, M. and M. Porter, 2001, “Competing at Home to Win Abroad: Evidence from Japanese Industry,” Review of Economics and Statistics, 83 (2), pp. 310 –22.

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  • UBS. Price and Earnings, (Zurich: UBS) (2003 and 2006 editions).

  • World Bank, 2007, Doing Business in 2007, (Washington: World Bank).

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24

Prepared by Murtaza Syed.

25

Hong Kong SAR’s ranking fell from 9 to 23 on the public institutions index, reflecting a deterioration on all its components—falling from 14 to 25 in terms of judicial independence, 3 to 15 on property rights and 15 to 32 on government impartiality. In addition, scores on irregular payments (corruption) also fell below Hong Kong SAR’s previous high performance. In a similar vein, the EIU has recently raised concerns about the business environment deteriorating “due to regulatory and political changes after the handover.”

26

At just over 30 percent, tertiary enrolment rates are well below those in Japan and the other NIEs.

27

These concerns are echoed in investor perceptions. According to the WEF, for example, nearly a quarter of respondents to their Executive Opinion Survey identify an “inadequately educated workforce” as the most problematic factor for doing business in Hong Kong SAR, compared to less than 5 percent in Japan and the other NIEs. Similarly, the business community has expressed some concerns about the reduced use of English in secondary schools over the last decade.

28

According to the Civic Exchange (a local think tank), Hong Kong SAR is one of the most polluted cities in the world, with health damaging particulate levels worse than those in Paris, London and New York and more than 200 percent higher than WHO guidelines.

29

Hong Kong SAR’s ranking in the ECA International Location Ranking Survey for expatriate living conditions plummeted from 20 in 2005 to 32 in 2006, with worsening air quality blamed for the decline.

30

The WTO (2002) cautioned that “the absence of a comprehensive policy to address anti-competitive practices, and the entrenchment of a few dominant conglomerates in the domestic market, could constitute an obstacle to greater competition from foreign and domestic firms, especially in the provision of services, thereby possibly discouraging FDI.”

31

Critics argue that since the current competition policy focuses only on business conduct, such as anti-competitive practices and abuse of market power, it cannot deal effectively with structural issues, such as mergers and acquisitions.

Same Series

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Cover IMF Staff Country Reports
People’s Republic of China—Hong Kong Special Administrative Region: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 2007: Issue 004
Publisher:
International Monetary Fund
ISBN:
9781451816952
ISSN:
1934-7685
Pages:
42
DOI:
https://doi.org/10.5089/9781451816952.002
  • View in gallery

    Trends in Price-Based Indicators of Competitiveness

    Sharp falls in domestic factor and asset prices have helped to reduce business costs and strengthen Hong Kong SAR’s business center.

  • View in gallery

    Sectoral Trends in Productivity and Unit Labor Costs

    (2000=100)

  • View in gallery

    Global Competitiveness Indices

    Global competitiveness rankings highlight Hong Kong SAR’s strong business environment.

  • View in gallery

    Potential Weaknesses in Business Environment

    Business perceptions suggest that some non-price based indicators of competitiveness may warrant attention.

Trends in Price-Based Indicators of Competitiveness

Sharp falls in domestic factor and asset prices have helped to reduce business costs and strengthen Hong Kong SAR’s business center.

Sectoral Trends in Productivity and Unit Labor Costs

(2000=100)

Global Competitiveness Indices

Global competitiveness rankings highlight Hong Kong SAR’s strong business environment.

Potential Weaknesses in Business Environment

Business perceptions suggest that some non-price based indicators of competitiveness may warrant attention.