People's Republic of China-Hong Kong Special Administrative Region
2012 Article IV Consultation Discussions

The Hong Kong Special Administrative Region (SAR)'s healthy labor market and supportive fiscal policy helped its domestic economy's resilience, while its gross domestic product (GDP) growth was marginally slow owing to its weak external environment. Its fiscal policy has been effective in reducing output volatility and providing timely support to help counter the impact from slowing external demand. The authorities have taken appropriate macroprudential measures to help safeguard the banking system, which should continue to be fine-tuned in line with evolving risks.


The Hong Kong Special Administrative Region (SAR)'s healthy labor market and supportive fiscal policy helped its domestic economy's resilience, while its gross domestic product (GDP) growth was marginally slow owing to its weak external environment. Its fiscal policy has been effective in reducing output volatility and providing timely support to help counter the impact from slowing external demand. The authorities have taken appropriate macroprudential measures to help safeguard the banking system, which should continue to be fine-tuned in line with evolving risks.

Developments and Outlook

1. Context. Hong Kong SAR is a small economy that is highly open to trade and capital flows and serves as an international financial center. As such, the economy is susceptible to regional and global shocks. Trade, tourism, and financial services are key: gross trade flows amount to some 450 percent of annual GDP, annual tourist arrivals are equivalent to some 600 percent of the population, and for three of the past four years the equity market has ranked number one globally in terms of money raised through public offerings. The economic framework is anchored by the combination of a currency board, flexible markets, a commitment to fiscal discipline, and a strong emphasis on safeguarding financial stability. This setup has continued to serve Hong Kong SAR well in cushioning the impact of external shocks and adapting to changes such as rapid growth in the Mainland.


Real GDP Growth

(In percent)

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001


Hong Kong SAR: Inflation

(In percent, 3mma, 3m-on-3m, saar)

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001

2. Growth. Recent weakness in the global economy is impacting Hong Kong SAR, and real GDP growth is projected to slow to 1¼ percent this year (Figure 1). The slowdown is being driven by trade developments, with net exports expected to subtract 1¾ percentage points from growth. However, domestic demand is proving resilient owing to a supportive fiscal stance and continued strength in the labor market. Unemployment is expected to remain low, especially in the low-skilled segment, reflecting buoyant activity in tourism-related sectors and construction. Next year, GDP growth is expected to recover to around 3 percent as the drag from net exports abates.

Figure 1.
Figure 1.

Macroeconomic Developments

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001

Sources: CEIC Data Company Ltd.; HKMA; Haver Analytics; and IMF staff calculations.

3. Inflation. In line with the cooling economy, consumer price pressures have eased. This has been helped by declining food inflation, tracking developments in the Mainland. Inflation is expected to remain moderate, averaging 3¾ percent this year and 3½ percent next year, despite continued upward pressure from higher housing costs. After a short respite late last year, the run-up in property prices has resumed, defying the general slowdown in economic activity (see below). The rental component accounts for 29 percent of the consumer price index and tends to track the 24-month moving average of housing rent.


Residential Housing Price and Rent Growth

(In percent, year-on-year)

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001

4. Fiscal policy. The 2012/13 Budget has provided some counter-cyclical support to the economy. Measures include waiving rates for each rateable property, reductions of public housing rents, increased transfers, additional capital spending, tax relief, and reductions in fees. Given the economic outlook, the 2013/14 Budget should continue to be tilted toward supporting growth, consistent with a modest positive stimulus. The stimulus should be temporary and could include reductions of public housing rent or tax relief for households. Measures targeted at lower-income households, in addition to supporting growth, also have social benefits.

Table 1:

Stimulus and Relief Measures in the 2012/13 Budget (HKD billion and percent of GDP)

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HKD amounts are from the 2012/13Budget. Percent shares of fiscal year GDP are based on staff estimates. Fiscal year is April 1-March 31.

5. Risk of an external shock. A renewed intensification of the euro area crisis and the U.S. fiscal cliff are the main risks, with potentially large spillover effects through the trade channel. A hard landing in the Mainland, although a low-probability risk, could also have a significant impact on Hong Kong SAR’s economy. If any of these shocks materialize, Hong Kong SAR should undertake a rapid fiscal stimulus that aims to support domestic demand while helping to shield low-income and vulnerable households. Options include targeted tax relief and increased direct transfers to poor and vulnerable households, extended support for smaller enterprises (which are important for employment), and accelerated public infrastructure spending where possible.

6. Authorities’ views. The authorities broadly agreed with staff forecasts. Uncertainty stemming from the euro area crisis and the U.S. fiscal cliff would likely weigh on activity in the near term. The authorities indicated that they had the policy space and the required flexibility to counter these external threats to activity, should they materialize. They noted that the budget process had become more forward-looking in recent years and that the 2013/14 Budget (for which the consultation process has started) would take into consideration the downside external risks.

Hong Kong SAR: Risk Assessment Matrix

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Property Sector

7. Recent developments. A combination of limited supply of new housing, strong demand from local and nonlocal purchasers, and low interest rates imported from the United States has been driving up housing prices. Prices have increased 23 percent in the first ten months of 2012 and are now double the trough of 2008 (Figure 2). The rise in mass market prices has been particularly pronounced of late and the rental market is following a similar trend, exacerbating concerns about housing affordability. The supply of new housing units has been relatively small over the last several years, averaging 9,700 private units per year, as compared with the authorities’ target of making available land for an average of 20,000 private residential flats each year. Meanwhile, mortgage interest rates have remained low in line with U.S. rates, although they have risen somewhat as banks moved back to using a prime rate (Best Lending Rate), instead of HIBOR, as the dominant basis for pricing mortgages. The Hong Kong Monetary Authority (HKMA) has implemented several rounds of macro-prudential measures (Text Table 1) that have helped to limit the growth in mortgage lending and cap household leverage (the average loan-to-value ratio for new mortgages is around 55 percent). Nonetheless, the low global interest rate environment is making real estate an attractive investment. Mainland buyers have also been active in the market and, in 2011, accounted for nearly 20 percent of primary market transactions (around 50 percent in value terms according to market estimates).

Text Table 1.

Hong Kong SAR: Selected Macro-Prudential and Other Property Measures

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Figure 2.
Figure 2.

The Property Market

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001

Sources: CEIC Data Company Ltd.; Haver Analytics; Transport and Housing Bureau, Government of Hong Kong SAR; HKMA; and IMF staff estimates.

New Approved Residential Mortgages

(In HKD billion)

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001

8. Risks. Staff housing price models paint a mixed picture regarding the degree of “froth” in the market (Box 1). Nevertheless, the sharp run-up in house prices raises the possibility of an abrupt correction, with associated risks to the banking system and domestic demand. In past cycles, the banking system has proven resilient to a substantial downswing in real estate prices. From their peak in 1997, housing prices fell by a cumulative 66 percent through mid-2003, yet nonperforming housing loans stayed below 2 percent (though total nonperforming loans peaked at around 8½ percent). Hong Kong SAR has full recourse mortgages, and owners generally continue to service mortgage debt even when they have negative equity. However, the property sector represents half of outstanding loans for use in Hong Kong SAR, with additional risks coming from the use of real estate as collateral. A sharp price correction would lead to falling collateral values and negative wealth effects, which could trigger an adverse feedback loop between domestic demand, bank lending, and the property market. Moreover, mortgage rates were falling in the early 2000s—which provided welcome support to the weak market—whereas during this cycle, a rise in Hong Kong SAR mortgage rates associated with the eventual normalization of U.S. interest rates could exacerbate or trigger a price correction.


New Loans Approved

(In HKD billion)

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001

Housing Prices

Assessing whether housing prices are out of line with economic fundamentals is an important yet inherently difficult exercise. Two different pricing models are examined, which provide some mild, but on balance inconclusive, evidence that prices are higher than suggested by current fundamentals.


Premium Property Price and Housing Affordability

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001

1 Median house price divided by median houshold income. Source: Global Property Guide Surveys as of 2012 Q2; Demographia International Housing Affordability Survey; and IMF staff calculations.

Housing in Hong Kong SAR is expensive. Compared to other regions, house prices in Hong Kong SAR are less affordable as measured by the ratio of median household income to median house price. In absolute terms, U.S. dollars per square meter, prices are also relatively expensive and premium real estate prices are on par or higher than in other high-cost housing.

A regression-based approach indicates prices are about 10 percent above the level suggested by current macroeconomic fundamentals.1 However, the fundamentals themselves are in some sense abnormal, as loose global monetary conditions have pushed down considerably Hong Kong SAR’s real interest rate. The real interest rate, moreover, is a key driver of housing prices in the model. To illustrate the impact of the eventual normalization of global monetary conditions, the regression estimates were used to calculate the price that would prevail if the real interest rate was at its 2003–07 average, with a concomitant change to credit. This exercise suggests that housing prices are some 30 percent higher than they would be if Hong Kong SAR’s real interest rate returned to the 2003–07 average.


Hong Kong SAR: Property Prices and Fundamentals

(In log terms)

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001

Sources: CEIC; and IMF staff calculations.

House Price Deviation from Medium-Term

(In percent)

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001

Sources: CEIC; and IMF staff calculations.

An asset pricing model, however, finds that prices are broadly consistent with fundamentals. The model compares the market price with a benchmark based on an equilibrium relationship between prices, rents, and cost of ownership. The basis for assessing misalignment from fundamentals is that the cost of owning a house (imputed rent) should be the same as the cost of renting a similar house for the same time period. By this measure, smaller-sized flats are found to be some 7 percent above the benchmark while the luxury end of the market is found to be slightly below the corresponding benchmark.2

1 Craig, R. S. and H. Changchun, “Determinants of Property Prices in Hong Kong SAR,” IMF Working Paper No. 11/227 (Washington: International Monetary Fund).2 Ahuja, A. and N. Porter, 2010, “Are Housing Prices Rising too Fast in Hong Kong SAR?” IMF Working Paper 10/273 (Washington: International Monetary Fund).

9. Property market policies. The HKMA has been proactively implementing macro-prudential measures, such as progressively tightening loan-to-value and debt service ratios (Text Table 1). As conditions evolve, these measures can continue to be adapted and potentially complemented by deploying additional tools, including higher risk weights or regulatory reserves. Such macro-prudential measures should remain focused on safeguarding the banking system, while other policies are best suited to fostering the stable development of the housing market, preventing unhealthy price dynamics, and addressing affordability concerns. The management of land supply, which in Hong Kong SAR is mainly provided by the government, is critical for ensuring sufficient availability of housing over the medium term. However, given the 3–5 years needed to develop a housing project, planned increases in land supply will have a limited upfront market impact (mainly through expectations). In the interim, measures to dampen housing demand, such as the recently adopted Buyer’s Stamp Duty and extension of the Special Stamp Duty, could help contain unhealthy price dynamics. As the impact is assessed over time, these stamp duties could be adjusted further if needed. Taken together, the government’s recent steps to promote demand-supply balance should help improve affordability, while public housing programs—which extend to nearly half of Hong Kong SAR’s households—continue to provide a safety net for residents that would otherwise be priced out of the market.

10. Authorities’ views. The authorities emphasized that they had been actively implementing policies to mitigate property sector risks. They considered boosting land supply as critical to the stable development of the property market over the longer term. However, the lags involved with development created the need for measures (such as the recent stamp duties) to discourage exuberance in the short run. They also placed high priority on ensuring that the financial system would remain resilient to a downturn in prices. The authorities underscored that the five rounds of macro-prudential measures since 2009 had left bank and household balance sheets in a strong position to weather such a downturn. They planned to continue to closely monitor property market developments, and stood ready to take additional macro-prudential steps if needed. The authorities emphasized that affordability was also a critical concern, and that they remain committed to ensuring an adequate supply of public housing and ensuring all eligible families receive an offer of public housing on average within three years of applying.

Financial Sector

11. Financial developments. Bank credit growth, a key concern in recent years, has decelerated significantly in line with slowing economic activity, tighter macro-prudential policy, and less new lending to the Mainland (Figure 3). Hong Kong SAR’s banking system remains well-capitalized and liquid, while asset quality and profitability have proven resilient to the recent turmoil in the global economy. Although IPO activity has been slow this year, the equity market has rebounded recently and corporate bond issuance has been strong. This includes issuance by local companies who have increasingly used capital markets as the supply of longer-term bank lending has tightened.

Figure 3.
Figure 3.

Credit Growth

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001

Sources: CEIC Data Company Ltd.; HKMA; Haver Analytics; and IMF staff calculations.

12. Macro-prudential measures. The preemptive use of macro-prudential tools has been effective in protecting the financial system. In addition to the measures deployed to contain real estate risks, the HKMA has set bank-specific regulatory reserves—reserves that banks are required to hold beyond individual and collective impairment allowances—to contain risks such as those arising from rapid credit growth. Macro-prudential measures should continue to be adjusted in line with the evolving credit cycle, and consideration could be given to using additional instruments such as increasing provisioning or risk weights for certain types of lending.

Hong Kong Banks (All incorporated banks)

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Source: HKMA Half Yearly Monetary and Financial Stability Report and Fitch.

13. Financial integration with the Mainland. Hong Kong SAR is benefiting from the ongoing financial integration with the Mainland and should continue to build on its competitive advantage. Over the past few years, claims on Mainland borrowers have grown significantly and accounted for 28 percent of Hong Kong SAR banks’ total external claims as of end-June 2012. Some analysts warned about the risks of rapid Mainland portfolio expansion by some banks, especially in an environment where nonresident banks may be effectively subordinated in the case of payment problems and where collateral enforcement procedures are largely untested. To identify emerging risks, the HKMA should continue to stress test and closely monitor banks’ exposures, including through close cooperation with the Mainland authorities, and to ensure that banks maintain prudent underwriting standards and hold adequate buffers that reflect the specific risks from Mainland-related exposures.


Hong Kong SAR Exposure to Mainland

(In percent of GDP, end period)

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001

14. Cross-border use of renminbi. Renminbi internationalization continues to benefit Hong Kong SAR, which remains the main offshore renminbi center. After growing rapidly through late 2011, the share of renminbi deposits has stabilized at around 9 percent of total system deposits, which reflects an increase in alternative renminbi assets (especially certificates of deposit), as well as a change in market expectations on renminbi appreciation (Figure 4 and Box 2). The extension of operating hours for the renminbi real-time gross settlement system, introduction of dual-counter equities (issued and traded in both Hong Kong dollar and renminbi), allowing nonresidents to hold unlimited renminbi deposits, and introduction of investment funds providing exposure to Mainland bonds and equities have helped Hong Kong SAR’s status as the preeminent offshore renminbi center. To consolidate Hong Kong SAR’s first-mover advantage, the authorities should continue to develop the renminbi financial infrastructure.

Figure 4.
Figure 4.

Offshore Renminbi Market

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001

Sources: Bloomberg; CEIC Data Company Ltd.; IMF staff calculations.

15. Financial spillovers. To gain insights on how a financial shock could reverberate through Hong Kong SAR, staff applied a network analysis to BIS data. The results show that in the event of distress in a foreign banking system, a rise in counterparty risk (similar to that observed after the collapse of Lehman) could lead to a sharp decline in cross-border interbank funding, fire-sale of bank assets, a fall in banks’ capital, and a reduction in bank credit (Box 3). In the event of a large shock, the authorities could respond by providing liquidity via the discount window, foreign exchange swaps, term repos, and other suitable tools, such as the renminbi liquidity facility. The existing Deposit Protection Scheme should be sufficient to provide confidence to depositors. If needed as a last resort, the broad-based guarantee of deposits introduced after the fallout of Lehman could be reconsidered, in close coordination with other jurisdictions. The network analysis also illustrates how preventing market dislocation in Hong Kong SAR would help limit contagion arising from a global shock.

16. Basel III. There was a general consensus among officials, private analysts, and staff that Hong Kong SAR banks are well positioned to meet the Basel III standards. Some analysts argued that the capital and liquidity rules are likely to have a larger-than-expected impact on the business models of banks in Hong Kong SAR. For instance, they could discourage trade finance and long-dated (syndicated) loans, and create a heavy demand for liquid assets (such as sovereign debt) that, depending on the eventual rules, may be in short supply in some jurisdictions. Others, however, highlighted that the financial system was highly adaptable and would adjust to the new rules—the recent growth in bond issuance in Hong Kong SAR was cited as an example whereby firms go straight to the capital markets for longer-term funding that under Basel III will be more expensive for banks to provide.

17. Authorities’ views. The authorities noted that closer financial integration with the Mainland had provided an important growth opportunity for the banking system. At the same time, they were closely monitoring Mainland exposures and highlighted that 60 percent of them were collateralized, often by deposits at a Mainland bank or assets held in Hong Kong SAR. The HKMA, in collaboration with the Mainland bank regulator, has been conducting annual on-site inspections at Mainland subsidiaries of Hong Kong SAR banks to ensure that their underwriting standards are similar to the ones maintained in Hong Kong SAR. In addition, higher regulatory reserves had been imposed on banks whose loan books had expanded more rapidly. More broadly, the HKMA indicated that they would continue to adjust macro-prudential measures as the cycle evolves, and were open to considering additional tools. Regarding international regulatory reform, the authorities reiterated their commitment to Basel III and noted that the implementing regulations had been presented for Legislative Council vetting. More broadly, they considered robust and evenly implemented standards critical for ensuring confidence in the global financial system and flagged the importance of avoiding a watering-down of the standards or delays in implementation.

Has Renminbi Internationalization Led to an Integration of Offshore and Onshore Markets?

Several significant steps have been taken to expand offshore renminbi intermediation in Hong Kong SAR since 2004. The range of renminbi financial products and services offered in Hong Kong SAR has steadily widened to now include deposits, Dim-Sum bonds, trade settlement, and structured deposits linked to underlying indices such as property, gold, and equity. Furthermore, the channels that allow offshore renminbi to flow back to the Mainland have been increased and include interbank bond, equity and fixed income markets (subject to quotas) and inward FDI (subject to approval). The expansion in trade settlement in renminbi has contributed to a rapid buildup in offshore renminbi liquidity with renminbi deposits stabilizing more recently at RMB 571 billion. Similarly, measures facilitating FDI in renminbi has supported the expansion of the offshore Dim-Sum market to RMB 237 billion at end-November. Also, Hong Kong banks have rapidly increased renminbi lending, which doubled this to RMB 68 billion at end-September 2012.

To assess how effective these developments have been in integrating the offshore renminbi (CNH) and the onshore renminbi (CNY) markets, staff analyzed whether arbitrage opportunities exist between the two exchange rates. The CNY and the CNH trade at different, but generally close, exchange rates against the dollar most of the time. Some divergence within a narrow range defined by transaction costs is consistent with no arbitrage. A key question is whether the flows mentioned above are sufficient to keep the exchange rate within this range.

A Threshold Autoregressive Model (TAR) is used to estimate a “no-arbitrage band” around the CNY-CNH differential.1 The results show that the differential was within the no-arbitrage band 56 percent of the time, but that there were also extended periods when the differential was large and outside the band. The fact that the differential converges fairly slowly to the band is consistent with the CNH and CNY markets being somewhat segmented, at least enough to prevent financial arbitrage from immediately closing the differential. Nonetheless, the markets are also integrated enough that capital flows work over time to close the differential.


Onshore and Offshore Renminbi Spot Exchange Rate Differentials

(in pips)

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001

1/ Band is estimated with the TAR model on the sample of 1 September 2010 - 30 November 2012. Around 56 percent of observations are with in the band. Sources: Bloomberg L.P.; and IMF staff estimations.
1 The TAR model estimates a band around a variable (the CNY-CNH differential) such that within the band the variable follows a random walk (meaning arbitrage is not taking place) and outside the band in which the variable mean reverts to the band, consistent with arbitrage. R. S. Craig, C. Hua, P. Ng, and R. Yuen, IMF Working Paper, forthcoming.

Analysis of the Spillover Risk of the Domestic Banking System 1/

As a hub for global financial intermediation, Hong Kong SAR’s banking system would be impacted by financial distress elsewhere in the world. At the same time, by securing its own financial stability, Hong Kong SAR could help prevent the propagation of financial shocks. This box examines the linkages of Hong Kong SAR’s banking system with the global financial system to assess the potential for such outward and inward spillovers.

Network analysis is used to model how distress could spread from one economy to another. The methodology follows Espinosa-Vega and Sole (2011) and Arslanalp and Lam (2012), which was applied in several FSAP analyses (such as Australia, Japan, and Spain), and uses the same key assumptions and parameters.2 It exploits data on cross-border claims and economy-specific measures of banking system resilience. Distress is modeled as a credit shock that causes a banking system to default on its cross-border obligations, a funding shock that results in a liquidity squeeze and fire sale of assets, or a combined credit and funding shock. The analysis considers scenarios that allow for progressively wider spillover channels: Scenario 1 (S1) considers just interbank exposures; Scenario 2 (S2) adds contingent cross-border claims, such as outstanding derivative contracts or contingent liabilities (for example guarantees or credit commitments); and Scenario 3 (S3) adds nonbank and sovereign exposures.

Hong Kong SAR’s banking system is most exposed to shocks from the United States, United Kingdom, and China (see heat maps). The Mainland has become the most systemically important for Hong Kong SAR in terms of a shock to interbank markets, while U.S. and U.K. banking systems remain more important in terms of potential contingent, nonbank, and sovereign exposures. Credit exposure of Hong Kong SAR banks to Mainland have more than doubled since 2009 and represent the largest exposure. However, the U.S. and U.K. financial systems continue to generally be the more systemically-important for Hong Kong SAR, even though Hong Kong’s cross-border exposures to the Mainland are larger. The U.S. (23 percent of global capital) and U.K. (15 percent of global capital) financial systems have large outward spillovers to other economies that would be infected by a U.S. or U.K. distress, which creates a domino effect of global distress that ultimately has a large impact on Hong Kong SAR. The Mainland, in contrast, is less integrated globally and, in particular, a Mainland funding shock would have fewer repercussions for Hong Kong SAR then a similar shock in the U.S. or U.K. banking systems.


Total Foreign Claims

(in millions of USD)

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001

Source: HKMA.

Likewise, a strong policy response in Hong Kong SAR could help break this domino effect to the benefit of other economies. Safeguarding Hong Kong SAR’s banking system through strong capital and liquidity buffers, providing timely liquidity support, and bolstering confidence would prevent a shock in another economy from propagating through Hong Kong SAR’s banks. For example, in the case of a combined credit and funding shock in China under Scenario 1, a strong policy response by Hong Kong SAR would reduce the impact on the global banking system by an amount equivalent to 1½ percentage points of total global capital (see table, China row, far right two columns).

Global Impact of Banking Distress (percent global capital) 1/

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Source: Staff estimates.

The amount of capital of all failed banking systems in percent of world financial system’s total capital; simulation results refer to credit and funding shocks on cross-border interbank exposures (Scenario 1).

Hong Kong SAR implements policies to be prevent propagation of distress through its banking system.

1 Prepared by W. Raphael Lam (APD).2 Espinosa-Vega, M. and J. Solé, “Cross-border Financial Surveillance: A Network Perspective,” Journal of Financial Economic Policy, vol. 3(3), August 2011; Arslanalp, S. and R. Lam “Financial Spillovers from Cross-border Exposures–A Network Analysis on Asian Banking System,” mimeo.

External Assessment

18. Exchange rate regime. The Linked Exchange Rate System (LERS) has served Hong Kong SAR well for nearly three decades. The system is transparent, well-understood, and credible. The HKMA buys or sells U.S. dollars from licensed banks in a passive and nondiscretionary manner based on what are called convertibility undertakings (HKMA buys U.S. dollars at HK$7.75/US$ and sells at 7.85). The recent purchases of U.S. dollars, which mark the first triggering of the convertibility undertaking since 2009, are therefore part of the normal functioning of the LERS. Through December 5, the HKMA had purchased 6.7 billion U.S. dollars, which is significantly less than the 83 billion U.S. dollars purchased in 2008–09 (Figure 5).

Figure 5.
Figure 5.

Spillovers from U.S. Quantitative Easing

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001

Sources: Bloomberg; CEIC Data Company Ltd.; Haver Analytics; and IMF staff estimates.

Hong Kong SAR: Effective Exchange Rate

(Index, 1990=100)

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001

Sources: IFS; INS; and IMF staff calculations.

19. External assessment. The REER has appreciated modestly over the past year. Empirical estimates of Hong Kong dollar misalignment show a range from 15 percent undervalued to 7 percent overvalued (Box 4). Hong Kong SAR’s current account surplus has fallen substantially since the global financial crisis and is expected to be under 5 percent of GDP this year, compared to 15 percent of GDP in 2008. Over the medium term, as global growth recovers and integration with the Mainland deepens, the current account surplus is projected to rise to around 7 percent of GDP. A structural current account surplus of this magnitude is assessed as consistent with Hong Kong SAR’s status as an international financial center. Both external financial assets and liabilities are very high, around 10 times GDP, reflecting Hong Kong SAR’s status as a major international financial center with considerable cross-border investment. These assets and liabilities could pose vulnerabilities, including through maturity mismatches, though these risks are mitigated by Hong Kong SAR’s large official reserve holdings (of over 100 percent of GDP). The net foreign asset position is expected to rise gradually over time given the persistent current account surplus, and IIP vulnerabilities are low. Overall, the currency and external position are assessed to be broadly in line with fundamentals.


Current Account and Components

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001

External Assessment

While the ongoing structural changes in the Hong Kong economy and its financial center status make it difficult to draw a definitive conclusion on the presence of misalignment, available empirical methodologies do not indicate that the current level of the Hong Kong dollar is out of line with medium-term fundamentals.

As in previous years, a number of empirical methodologies were employed. The table reports estimates from the macroeconomic balance (MB), equilibrium real exchange rate (ERER), and external sustainability (ES) methodologies. The MB and ERER are based on regressions estimated over a sample of 55 developed and emerging economies, as well as a separate subsample of six international financial centers (Singapore, Hong Kong SAR, Switzerland, Netherlands, Luxembourg, and Belgium). The subsample of financial centers is included to capture the particular features of small international financial centers—service-oriented economies, with generally high savings rates (as wealthy individuals work in these centers and retire elsewhere), low dependency ratios, and driven more by investments in human rather than physical capital. The ES is based on the relationship between the current account, trade balance, the stock of net foreign assets, and the real exchange rate. Hong Kong SAR is not included in CGER or the External Balance Assessment (EBA), in part because these techniques are not well suited for offshore financial centers. However, a CGER-type methodology is also reported along with estimates provided by the HKMA.

  • The macroeconomic balance approach compares the projected medium-term current account balance with an estimated equilibrium current account position and assesses the exchange rate adjustment needed to eliminate the gap between the two. Estimates for Hong Kong SAR generally indicate an equilibrium medium-term current account in the range of 6–7 percent of GDP. Consistent with last year’s assessment and the pilot External Sector Report, the current account balance is assessed to be broadly in line with fundamentals and estimates of misalignment from the two panel regression approaches are near zero. The CGER-type regression yields a 14 percent undervaluation, with around half of the difference coming from the assumptions on real exchange rate (the panel regressions include some future real appreciation resulting from Hong Kong SAR having somewhat higher inflation than its trading partners, consistent with the medium-term macro-framework, whereas the CGER-type assumes an unchanged real exchange rate).

  • The equilibrium real exchange rate approach compares the current level of the real exchange rate with an estimated equilibrium level based on medium-term fundamentals. Estimates of the equilibrium real exchange rate generally show the Hong Kong dollar to be undervalued by 6–15 percent.

  • The external sustainability approach calculates the exchange rate adjustment needed over the medium term to bring the current account to a position that would stabilize the net foreign asset position at a benchmark level. The range of assessments generated by this approach is much broader going from modestly overvalued to moderately undervalued, and is largely due to different assumptions regarding the benchmark level, growth, and rates of return on assets and liabilities.

Overall, the results are sensitive to specification and sample coverage, with estimates of misalignment ranging on both sides of zero.

Exchange Rate Assessment: 2011 and 2012

Percent misalignment

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Update of “HK Team” estimates from 2011 Staff Report.

20. Policy discussions. Following the extensive discussion in last year’s Article IV consultation, the mission reviewed the exchange rate regime options and concluded that the LERS remains superior to the alternatives. The arguments for maintaining the LERS are compelling, given that it has generated substantial benefits in terms of monetary and financial stability, built up a stock of credibility over the decades, and kept the real exchange rate broadly in line with fundamentals. It works because Hong Kong SAR’s economy is highly flexible, with nominal prices and wages adjusting to the changing environment to prevent sizable or persistent misalignments. The additional requisites to sustain the LERS, besides the aforementioned economic flexibility, are in place including a track record of fiscal discipline that is anchored by significant fiscal reserves, and robust financial sector regulation and supervision. As for the alternatives, a step revaluation would undermine the credibility of the system and fuel expectations of future adjustments, and in any event is unnecessary as the exchange rate is not out of line with fundamentals. Moving to a different peg or a crawling arrangement would suffer from similar drawbacks, and in practice would not yield any greater monetary policy autonomy. Regarding the option of linking to the renminbi, it would also prove problematic at this juncture because the renminbi is not convertible, the Mainland has substantial capital account restrictions, and renminbi financial markets are not sufficiently developed to manage a large portfolio of renminbi assets. Moreover, Hong Kong SAR’s productivity and competitiveness is likely to evolve more in line with those of the United States than of the relatively less developed and faster growing Mainland. Finally, a floating regime could give some scope for an independent monetary policy, but would be difficult to manage for a very small, very open, international financial center where capital flows dwarf the size of the domestic economy. The nominal exchange rate would be subject to large fluctuations that would lead to significant volatility in domestic prices or the real exchange rate.

21. Authorities’ views. The authorities remained firmly committed to the LERS, which they considered to be the most appropriate arrangement for Hong Kong SAR. They assessed the real exchange rate to be in line with fundamentals, and highlighted that it is through the adjustment of prices and wages that this equilibrium is maintained. This economic flexibility, on top of their firm commitment to fiscal discipline and financial stability, has underpinned the success of the LERS. They noted that the recent triggering of the convertibility undertaking is not a source of concern and that the LERS can accommodate such movement in capital flows.

Inequality and Economic Volatility

A. Inclusive growth

22. Social protection. Income inequality in Hong Kong SAR has registered one of the larger increases in the region. This to some extent reflects the skill-based wage premiums inherent in a flexible, open, and free-market economy. Nevertheless, the authorities are concerned with inequality and have taken measures to redress it. A minimum wage of HK$28 (US$3.6) per hour was introduced in 2011, and the rate is currently undergoing a periodic review as envisaged under the law. The 2012/13 Budget includes tax and other forms of relief for low-income groups, such as reductions of public housing rent. A key area of concern is housing, where rising prices and rent are squeezing many lower and middle income residents out of the private property market. Some observers commented that the absence of an official poverty line makes it difficult to assess developments.


Asia: Change in Gini Index, Last Two Decades 1

(In Gini points, since 1990)

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001

Sources: World Bank; national authorities and IMF staff calculations.1 In parentheses, the latest available year and corresponding Gini coefficients.

23. Authorities’ views. The authorities noted that the significant rise in the Gini coefficient over the past decade was not representative of developments and questioned whether Gini comparisons between city-scale financial centers and larger economies were appropriate. Moreover, once government programs were taken into account, inequality had not risen over the past five years. Official data show that a Gini coefficient that takes into account the effect of government programs has remained unchanged at 0.475 between 2006 and 2011. A set of poverty indicators developed by a former Commission on Poverty (in existence during 2005–07) have shown a broad-based improvement over the past decade (some examples include the declining number of recipients of Comprehensive Social Security Allowance (CSSA) and improvements in education enrollment). Moreover, the government recently reinstated the Commission on Poverty and tasked it to establish a poverty line for Hong Kong SAR, examine current poverty situation and causes of poverty, review existing policies, and formulate new policies to improve livelihoods, promote social mobility, and provide a safety net to better help the disadvantaged.

B. Economic volatility

24. Is Hong Kong SAR’ economy more volatile? Without an independent monetary policy or an exchange rate to absorb shocks, a currency board system could result in higher economic volatility. Staff analysis examined both the average level and volatility of GDP growth, consumer price inflation, and housing price inflation, while controlling for factors such as the exchange rate regime, policy stance, and terms of trade. 1 The results show that GDP growth in Hong Kong SAR has indeed been somewhat more volatile than in other economies (Figure 6). However, the averages of GDP growth and inflation (for both consumer goods and housing prices) have been on par with other economies.

Figure 6.
Figure 6.

Hong Kong’s Macroeconomic Performance: Does the Exchange Rate Regime Matter?

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001

Sources: CEIC; Haver Analytics; WEO; and IMF staff calculations.1/ The average performance and volatility are estimated after controlling for a range of macroeconomic fundamentals and exchange rate regimes.

25. Counter-cyclical fiscal policy. The absence of an independent monetary policy means that fiscal policy the main tool for managing demand and reducing output volatility. Hong Kong SAR has ample fiscal space for counter-cyclical fiscal policy thanks to a history of prudence, which has built fiscal reserves to over 30 percent of GDP. Since automatic stabilizers in Hong Kong SAR are small, a heavier burden is put on discretionary policy. Staff research indicates that despite smaller automatic stabilizers, Hong Kong SAR’s fiscal policy has been effective in reducing output volatility (Box 5).2

Has Fiscal Policy been Counter-Cyclical? A Cross Country Comparison

The nature of Hong Kong SAR’s economy makes it susceptible to external shocks. Moreover, since the currency board takes away the option of using monetary policy, fiscal policy is the main lever for demand management. In comparison with other advanced economies, Hong Kong SAR has been relatively effective in using this lever to reduce output volatility.

At first sight, budget policy in Hong Kong SAR appears to be counter-cyclical. The surplus tends to decline when the output gap widens and then reverses when the gap closes. A simple regression of the change in the overall balance on the output gap confirms this relationship and suggests that the fiscal surplus is reduced by ½ percent of GDP for each 1 percentage point widening of the output gap.

Still, fiscal policy in Hong Kong SAR seems to be less counter-cyclical than in other advanced economies. One factor is that Hong Kong SAR has small automatic stabilizers, which is a direct reflection of the relatively small size of government (spending averages less than 20 percent of GDP). Indeed, Hong Kong SAR has among the smallest automatic stabilizers in the sample.

However, Hong Kong SAR has been relatively successful in using discretionary fiscal policy—as measured by changes in the cyclically adjusted balance—to help compensate for the small automatic stabilizers. The above regressions provide a simple measure of counter-cyclicality, but do not control for the reverse causal impact of fiscal policy on the output gap. This is a potentially significant shortcoming. For example, a government that succeeded in adjusting the deficit to eliminate all fluctuations in the output gap would be found to have no counter-cyclicality (the regression coefficient would be zero).


Overall Balance

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001

We untangle the impact of fiscal policy on the output gap in an innovative way. The underlying shocks that hit the economy are estimated conditional on the fiscal multiplier, which is assumed to be one rather than estimated. Counter-cyclicality is then measured by how much, in percent, fiscal policy succeeded in reducing output gap volatility compared to a counterfactual of no fiscal policy (technically a constant fiscal balance).1 Using this measure, Hong Kong SAR is about average in the sample in terms of how much fiscal policy reduced output gap volatility. However, considering that automatic stabilizers are smaller, the results imply that the authorities have been fairly successful in using discretionary fiscal policy. The findings are qualitatively similar using a fiscal multiplier that is smaller (0.5) or bigger (1.5).


Reduction in Output Volatility

(In percent)

Citation: IMF Staff Country Reports 2013, 011; 10.5089/9781475584738.002.A001

1 Specifically, for a given economy the shocks ϵt are derived from the regression: Gapt = c + ρ * Gapt-1 + Multiplier * ΔOverall balance t + ϵt.The reduction in volatility from fiscal policy is equal to: 1 - σgapσ˜gap, where σgap is the standard deviation of the output gap and σ˜gap is the standard deviation of the hypothetical no fiscal policy case (constructed as: Ga˜pt = c^ + ρ^*Ga˜pt1 + ϵ^t,, where the “hats” refer to the estimated values from the initial regression.

Staff discussed whether it could be beneficial to make the budget even more responsive to the business cycle, such as by developing a list of “shovel-ready” infrastructure projects or making it easier to adjust policies and spending to changes in the economy. In doing so, it would be critical not to undermine Hong Kong SAR’s hard-won fiscal credibility, by ensuring that any stimulus during economic slowdowns was offset by tightening during economic booms. The openness of Hong Kong SAR suggests that fiscal multipliers are likely somewhat smaller than in other economies since part of fiscal spending leaks abroad via imports. Nonetheless, counter-cyclical fiscal policy would still be warranted given the beneficial social impact, and could usefully focus on shielding the poor and vulnerable from shocks.

26. Authorities’ views. The authorities agreed that fiscal policy had been counter-cyclical, and underscored that this reflected their intent. They noted that the existing budget institutions already provided enough flexibility to respond to changing circumstances, including during the fiscal year when necessary. Additional room for maneuver is provided by the possibility of introducing a supplementary, mid-year budget as was done during the 2009/10 fiscal year following the collapse of Lehman Brothers. Infrastructure spending, moreover, was being scaled up in line with medium-term plans, but the size, complexity, and planning involved made it less amenable to being fine-tuned to match the business cycle. They considered other measures they have used to be more effective, such as social spending and support to small businesses. They agreed that multipliers were probably somewhat smaller in Hong Kong SAR given the import leakage. Finally, they emphasized that preserving fiscal discipline was of paramount importance and critical for fostering macroeconomic stability and supporting the LERS.

Staff Appraisal

27. Macroeconomic context. Hong Kong SAR is weathering the global economic storms fairly well. Weakening external demand is dragging down growth, but the domestic economy is proving resilient buoyed by supportive fiscal policy and continued strength in construction and tourism-related sectors. Unemployment remains low. Inflation has declined on the heels of the slowing economy and easing of food price pressures in the Mainland. Looking forward, growth is expected to recover in line with the improved global economy while inflation is forecast to remain within a comfortable range. Nonetheless, as a small and highly open economy, Hong Kong SAR remains susceptible to external shocks and would strongly feel the effects of a worsening of the euro area crisis, the U.S fiscal cliff, or a hard-landing in the Mainland.

28. Fiscal policy. The absence of an independent monetary policy means that fiscal policy is the main tool for demand management. Overall, Hong Kong SAR’s fiscal policy has been effective in reducing output volatility thanks to the active use of discretionary policies. That includes 2012, with fiscal policy providing timely support to help counter the impact from slowing external demand. The 2013/14 budget should continue to be supportive of demand and, in the event of an external shock, fiscal policy should be deployed to provide further stimulus and protect low-income and vulnerable households. To prevent an erosion of fiscal discipline, it would be critical to ensure that policies are applied symmetrically through the business cycle, with stimulus being withdrawn as the economy recovers. Hong Kong SAR’s history of fiscal prudence, which has built fiscal reserves to over 30 percent of GDP, provides an important backbone to the economy.

29. Property sector. While the probability of a correction large enough to generate major macroeconomic and financial consequences is fairly low in the near term, the property sector is the main source of domestic economic risk. Policies on a variety of fronts are needed to contain macroeconomic and financial risks from the housing market. The authorities have taken appropriate macro-prudential measures to help safeguard the banking system. These measures should continue to be fine-tuned in line with evolving risks and, if needed, additional measures could be deployed. Macro-prudential measures should, however, remain focused on safeguarding financial stability, while other policies—such as fiscal measures—can best be used to address broader concerns about demand-supply imbalances and affordability. Improving affordability ultimately hinges on a sufficient provision of new housing. Therefore, the government’s efforts to ensure a steady and adequate supply going forward, including through public housing, are welcome, although the impact may be limited in the short run given planning and construction lags.

30. Financial sector. Hong Kong SAR’s banking system remains well capitalized, putting it in a good place to start implementing Basel III standards in 2013. The authorities have moved proactively to contain risks in the financial system. The slowdown in credit growth is welcome, as are the targeted measures to contain risks in real estate lending and efforts to closely monitor and supervise Mainland exposures. The HKMA should continue to assess evolving risks and, as needed, could deploy additional macro-prudential measures, tighten underwriting standards, and ask banks to increase buffers. As a financial center, Hong Kong SAR would feel the impact of a global financial shock. Bank distress elsewhere in the world could spill over into Hong Kong SAR, with shocks emanating in the United States or the Mainland having the largest potential impact. Hong Kong SAR’s existing liquidity facilities and deposit protection scheme should prove sufficient to maintain financial stability, but, in an extreme shock, additional measures could be considered in conjunction with other jurisdictions. The ongoing opening of the Mainland’s capital account and expanded international use of renminbi provide further opportunities for Hong Kong SAR to strengthen its position as an international financial center. The FSAP scheduled for next year will afford an opportunity to explore financial sector issues in greater depth.

31. Exchange rate regime. The Linked Exchange Rate System (LERS) is a transparent, credible, and effective exchange rate regime and warrants continued support as the best arrangement for Hong Kong SAR. Hong Kong SAR has an economic system that adjusts to the changing environment through movements in nominal wages and prices. The preconditions to sustain such a system—including a strong fiscal position, robust and proactive financial oversight, and flexible labor, product, and asset markets—are in place. Hong Kong SAR’s economic flexibility facilitates a quick and effective adjustment of the real exchange rate so as to avoid sizable or persistent misalignments. The Hong Kong dollar and external position are assessed to be broadly in line with fundamentals.

32. Income inequality. Fostering inclusive growth is an ongoing concern. Hong Kong SAR’s economic flexibility and reliance on free-market principles are sources of economic strength and resilience which, however, can also result in income inequality given the importance of skill-based wage premiums. Moreover, the high and rising cost of housing is straining the budget of many lower- and middle-income families. The authorities have implemented an array of measures—including the statutory minimum wage and planned increases in public housing—geared toward improving the living standards of lower-income households. Weight should continue to be placed on policies to reinforce the existing social welfare programs and provide support and opportunities to lower-income households.

33. It is recommended that the next Article IV consultation discussions take place on the standard 12-month cycle.

Table 1.

Hong Kong SAR: Selected Economic and Financial Indicators, 2006–13 1/

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Sources: CEIC Database; and staff estimates.

Unless otherwise stated, all growth rates are for year-on-year.

In 2006-07, 2008-09, and 2009-10 fiscal years, expenditure excludes bond repayments.

Balance of Payments BPM6 basis.

National Accounts SNA 08 basis.

Includes Land Fund assets.

IMF staff estimates.

Table 2.

Hong Kong SAR: Consolidated Government Account, 2006/07–2017/18 1/

(In percent of GDP, unless otherwise stated)

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Sources: CEIC Database; and staff estimates.

Staff projections assume government spending targets in the latest medium-term budget document and staff revenue forecasts. Fiscal year begins on April 1.

In 2006-07, 2008-09, and 2009-10 expenditure excludes bond repayments.

This refers to the authorities’ measure of operating expenditure.

Operating balance, as defined by the authorities, is akin to the current balance.

Balance excluding investment income.

Staff estimate used to measure the impact of fiscal policy on domestic demand. It excludes asset transactions and cyclical fluctuations.

Table 3.

Hong Kong SAR: Medium-Term Balance of Payments, 2006–17

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Sources: CEIC Database; and staff estimates.
Table 4.

Hong Kong SAR: Medium-Term Macroeconomic Framework, 2007–17

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Sources: CEIC Database; and staff estimates.