People’s Republic of China—Hong Kong Special Administrative Region: Staff Report for the 2015 Article IV Consultation Discussions
Author: International Monetary Fund. Asia and Pacific Dept
Publication Date:
19 Jan 2016
eISBN:
9781498303835
ISBN:
9781498303835
Language:
English
Keywords:
ISCR; CR; HKMA; growth portfolio; portfolio; SAR.; stock index; open economy; U.S. dollar; banking system; debt service; mortgage loan; Global; financial system
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This 2015 Article IV Consultation highlights that the growth of Hong Kong Special Administrative Region is expected at 2.25 percent in 2015, with domestic demand acting as the principal source of momentum. Growth is likely to pick up modestly to 2.5 percent in 2016, with a smaller drag from external demand reinforcing resilient domestic demand. Inflation has declined and is expected to remain below 3 percent in 2015-16 on softer commodity prices. The current account has dropped to about 2.5 percent of GDP, but is projected to improve to about 3.5 percent over the medium term as the global economy recovers.

Abstract

This 2015 Article IV Consultation highlights that the growth of Hong Kong Special Administrative Region is expected at 2.25 percent in 2015, with domestic demand acting as the principal source of momentum. Growth is likely to pick up modestly to 2.5 percent in 2016, with a smaller drag from external demand reinforcing resilient domestic demand. Inflation has declined and is expected to remain below 3 percent in 2015-16 on softer commodity prices. The current account has dropped to about 2.5 percent of GDP, but is projected to improve to about 3.5 percent over the medium term as the global economy recovers.

Context and Recent Developments

1. Context. Hong Kong SAR’s economy has operated with short-term interest rates near zero and long yields at near-historic lows for the past seven years. During this time, the economy has also experienced generally favorable spillovers from Mainland China. These tailwinds may become less powerful going forward. Interest rates in Hong Kong SAR are poised to increase with the Fed liftoff, through their direct link to U.S. rates via the currency board. The spillovers to Hong Kong SAR from Mainland China could also prove more challenging than in the past as the Mainland transitions to slower, but more sustainable growth.

2. Recent developments. Heading into a potentially testing period ahead, activity momentum has remained steady while credit and asset prices present a mixed picture (Figure 1).

  • Activity. Growth in the first three quarters has been just over 2½ percent, similar to 2014. Domestic demand has been the mainstay of activity (particularly private consumption on the back of a tight labor market, although there are some signs of a moderation in retail sales in recent months). External demand has weakened gradually over the year, reflecting the global trade slowdown. The unemployment rate has remained low, at 3.3 percent. CPI inflation has drifted down to 2.4 percent y/y in October, on lower imported inflation and favorable effects of property rates waivers on the cost of living.

  • Credit. Overall credit growth has moderated since mid-2014, with a deceleration in foreign currency-denominated loans. Growth of loans for use in Hong Kong SAR has moderated somewhat, but remains robust, including to the property sector. The stock of outstanding debt securities where the ultimate domicile of risk is in Hong Kong SAR also appears to be leveling off, with about 75 percent of bonds maturing within 1–3 years.

  • Equity market. The Hang Seng index (HSI) experienced a correction in the wake of the Mainland equity crash, currently down 20 percent from its peak. The China Enterprises Index “H Share” is down 28 percent (compared to the 30 percent decline in Shanghai Composite since June 11).

Figure 1.
Figure 1.

Snapshot of Credit and Asset Price Developments

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Sources: CEIC Data Company Ltd.; HKMA; Haver Analytics; and IMF staff calculations.
A01ufig1

Consumer Confidence and Retails Sales

(In percent, year-on-year)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Sources: CEIC Data Company Ltd.; and IMF staff estimates.
A01ufig2

Exports of Goods and Services

(In percent, year-on-year; in current prices)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

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

  • Property sector. Prices resumed their upward rise in Q2:2014. House prices in mass market segments have tripled relative to their level at end-2008, while those in luxury segments have almost doubled. These increases reflect strong local end-user demand colliding against tight housing supply. Completion of private housing units has slowed this year and vacancy rates have declined. A similar dynamic appears to be at work in the nonresidential property segment as well. There are now some early signs of a pause in momentum, especially in the secondary market for residential property and the retail component of the nonresidential sector.

3. External position. The real exchange rate has appreciated 10 percent relative to the 2014 average, and 17 percent since 2012, a product of the link to the U.S. dollar and relatively higher inflation in Hong Kong SAR compared to trading partners. The current account balance has stabilized in the range of 1½–2 percent of GDP over this time (and is projected to increase to around 3½ percent over the medium term as global demand recovers).

4. Buffers. The economy has augmented its buffers even with the robust credit growth of recent years and the build-up of leverage in an era of low interest rates.

  • Banks. The regulatory framework is geared toward limiting the build-up of systemic vulnerabilities, ensuring that banks maintain healthy liquidity profiles and ample capital buffers. Multiple rounds of counter-cyclical macroprudential measures since 2009 (tighter ceilings on loan-to-value (LTV) and debt-service-to-income (DSR) ratios, risk-weight floors on property loans) have helped contain the growth in bank exposure to the run-up in property prices (Appendix I). In 2014, a bank-specific stable-funding requirement was introduced to ensure that banks with especially rapid credit growth had adequate stable sources of funding to support their loan book. A countercyclical capital buffer (0.625 percent of risk-weighted assets) will be introduced in Q1:2016 and domestic systemically important banks will be subject to additional loss absorbency capital surcharges of 0.250–0.625 percent. These measures will provide further protection to a banking system already capitalized in excess of Basel III levels: as of September 2015, the total capital adequacy ratio (CAR) for locally incorporated authorized institutions is 18.1 percent, Tier 1 CAR is 14.9 percent, and the common equity tier 1 (CET-1) ratio is 14.3 percent.

  • Fiscal. Budget over-performance in recent years has lifted fiscal reserves to 35 percent of GDP, or about 24 months of total government expenditure. Gross government debt is minimal (around 0.1 percent of GDP).

  • Households. Although the stock of household debt has risen to historic highs close to 70 percent of GDP (around two-thirds of which is residential mortgage debt), the Hong Kong Monetary Authority’s (HKMA’s) mandatory debt service stress tests on mortgage applicants has contained the debt service burden among new borrowers. New borrowers’ debt service relative to disposable income has declined from 41 percent in August 2010 to 35 percent in 2014. Furthermore, the number of owner-occupied households with mortgages or loans has contracted by nearly one-fourth since the global financial crisis with only one-third of owner-occupied households currently carrying mortgages or loans.

  • Corporates. While aggregate corporate debt has increased rapidly in recent years, listed company data suggest that the leverage ratio of corporates in Hong Kong SAR is relatively low in the region (Regional Economic Outlook; Asia and Pacific, 2014). In terms of corporate debt concentration, less than 10 percent of the total debt stock among listed firms is owed by firms with leverage ratios greater than 2. The maturity structure of the debt is generally favorable: the median ratio of short- to long-term debt among listed firms is among the lowest in the region. Furthermore, less than 10 percent of total debt among listed firms is owed by “stressed” companies (with interest coverage ratios below 1).

  • External. Vulnerabilities in the international investment position are low—net foreign assets are close to 330 percent of GDP; foreign exchange reserves, at 120 percent of GDP, are adequate for precautionary purposes.

A01ufig3

Asset Quality of Retail Banks 1/2/

(In percent of total loans)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Sources: CEIC Data Company Ltd; and IMF staff estimates.1/ Classified loans are those loans graded as "sub-standard," "doubtful" or "loss."2/ Figures related to retail banks’ Hong Kong office(s) and overseas branches.
A01ufig4

Liquidity Ratio of Retail Banks 1/

(In percent; quarterly average)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Sources: HKMA; and IMF staff estimates.1/ The ratio of liquefiable assets to qualifying liabilities.
A01ufig5

Loan-to-Deposit Ratios of All Authorized Institutions

(In percent)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Sources: CEIC Data Company Ltd; and IMF staff estimates.
A01ufig6

Corporate Debt by Interest Coverage Ratio 1/

(In percent)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

1/ Interest coverage ratio is measured by earnings before interest/total interest expense.Source: Worldscope, IMF staff estimates.

Macro Outlook

5. Growth. Growth in 2015 is expected at 2¼ percent, picking up slightly to 2½ percent in 2016. Staff estimates indicate this pace of expansion is below potential growth of 3–3¼ percent (Box 1). The baseline projection assumes

A01ufig7

Contribution to Growth

(In percent, year-on-year)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Sources: Haver Analytics; and IMF staff estimates.

  • interest rates in Hong Kong SAR increase in line with the FOMC’s median target range forecast for the U.S. Federal Funds rate: staff analysis suggests that this pace of increase in interest rates will have a modest negative impact on domestic demand; furthermore, in light of the prudential measures deployed by the regulators, Hong Kong SAR’s financial system appears well placed to handle portfolio adjustments along this path of rising interest rates;

  • a slight moderation in credit for use in Hong Kong SAR: tighter macroprudential measures (additional capital surcharges from Q1:2016) will restrain supply, while higher borrowing costs will weaken demand;

  • Mainland China’s growth slows moderately to a range of 6–6½ percent: tourism spending in Hong Kong SAR and other activity in Hong Kong SAR with direct links to Mainland China’s economy (trade, financial sector) stabilize accordingly; bank buffers are adequate for absorbing associated asset quality deterioration on Mainland exposures; and

  • support from fiscal policy: based on the government’s budget projections, adjusted for revenue overperformance in line with historical outturns, the fiscal stance for FY2016/17 delivers an expansionary impulse of around 1 percent of GDP.

6. Inflation. Inflation is expected to remain below 3 percent in 2015 and 2016, compared to an average of 4 percent over the last five years. The softer pressure reflects weaker global commodity prices and the modest pick-up in real activity projected over 2015/16. In line with the developments over the last three years, nominal wages are expected to continue growing at a moderate rate despite the tight labor market. Unit labor costs are therefore likely to remain contained.

A01ufig8

Annual CPI Inflation

(In year-on-year percentage change)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

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

Potential Output Growth in Hong Kong 1/

The Hong Kong SAR economy has been growing moderately since 2012, after a strong recovery in 2010–2011 following the global financial crisis. A key question is whether this slowdown is cyclical or structural. Various estimation methods suggest that the annual growth rate of potential output has been around 3–3.5 percent in recent years, slower than the pace prior to the global financial crisis. The slowdown in actual output growth is in line with slower potential output growth.

There has been a growth deceleration since 2012. The average growth rate since 2012 is about 2.5 percent per year, about 2 percentage points lower than 2000–2007. Although some slowdown might be a natural consequence as the economy becomes more advanced, the pace of adjustment seems to be less gradual than expected. A critical question for policy makers is whether the slowdown is reflecting weaker potential output growth or just a cyclical phenomenon.

The Hodrick-Prescott filter method implies that the pace of potential output growth is still at about 3½ percent per year. The sample period is from 1961 to 2014. Except for the years during the Asian financial crisis, there has been a clear long-run pattern of gradual deceleration in trend output. The average growth of trend GDP from 2012 to 2014 is about 3.6 percent. The level of actual real GDP has been lower than the HP trend since 2012.

The multivariate approach suggests slower potential growth in recent years, although it is still above 3 percent per year. One of the drawback of the HP filter approach is that it is a pure statistical method without relying on any economic theory. A multivariate approach, which includes some underlying relationship among output, inflation and unemployment rate through the Philips curve and Okun’s law, would provide an estimate of potential output that does not create an upward or downward inflation bias. Thus, the moderate inflation and relatively tight labor market conditions in recent years would suggest a stronger cyclical position than that implied by HP filter method. As a result, relative to the trend growth estimated by HP filter method, the average growth rate of potential output estimated by multivariate approach is lower in recent years.

The production function approach also points to average potential growth above 3 percent per year. Based on the recent research by HKMA, average TFP growth has dropped from 4.0 percent per year (2000–2008) to about 2.6 percent (2009–2013). The estimation is based on a sectoral growth accounting exercise, covering several key sectors accounting for over 90 percent of GDP in Hong Kong. Since part of the TFP drop is likely to be a cyclical phenomenon (TFP is pro-cyclical), a moderate contribution from physical capital deepening and human capital growth (at least in the medium term) would bring annual real GDP growth rate back to 3 percent or above.

A01ufig9

Actual and Potential Output

(In logarithm)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Sources: CEIC Data Company Ltd, and MF staff estimates.
A01ufig10

Growth Rates of Output and Potential Output

(In percent)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Sources: CEIC Data Company Ltd; and IMF staff estimates.
1/ IMF working paper, forthcoming, by Si Guo.
A01ufig11

Global Commodity Prices

(Index, 2005=100)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Source: IMF World Economic Outlook, October 2015.
A01ufig12

Nominal Wage Growth and Unemployment Rate

(In percent)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Sources: CEIC Data Company Ltd,; and IMF staff estimates.

Authorities’ Views

7. Outlook. The authorities noted that weaker tourism inflows and subdued global trade throughput are weighing on activity, even as domestic demand remains resilient. Labor shortages in many sectors, rising wages, and improvements in job security have supported consumer sentiment. High infrastructure spending has provided additional momentum. However, external headwinds are likely to remain strong into next year and, as such, Hong Kong SAR’s GDP growth is expected to remain subpar, similar to recent outturns. The authorities further noted that inflation is easing and likely to remain contained owing to lower commodity prices, weaker pressure from property rental rates, and the tentative outlook for real activity.

8. External position. The authorities expected a gradual improvement in the current account as the global economy recovers. However, they did not see the external balance returning to the relatively high levels of the precrisis years, in part because of the rebalancing that has occurred in the Mainland since then. In addition, they noted a solid increase in Hong Kong SAR’s domestic demand with the sustained rise in property prices, which has had the effect of compressing the current account surplus.

Risks and Spillovers

9. Risks are tilted to the downside (Appendix II) and arise from four main sources. High household and corporate leverage leave the private sector exposed to rising debt service costs in the event of a sharper-than-anticipated increase in interest rates. Spillovers from the Mainland have been strong and may intensify. The run-up in property prices over the past year raises the probability of a correction. Finally, there is a low probability-high impact risk of sharper-than-anticipated increases in interest rates coinciding with a faster-than-expected slowdown in Mainland China.

A. Interest Rates: A Bumpy Ascent?

10. A principal near-term risk is higher volatility in global financial markets in the aftermath of the Fed liftoff, with interest rates rising more sharply than anticipated in the baseline (Figure 2). The highly compressed term premium (the yield on Hong Kong SAR 10y government bonds is currently some 50 basis points below that on U.S. 10y treasury bonds) also raises the possibility of a strong snap back at longer maturities. Long yields could rise faster than expected if the target range for the Fed Funds rate follows a path closer to the upper bound of FOMC forecasts rather than the median (with short rates in Hong Kong SAR and the entire yield curve shifting up in response). A second possibility is that the Fed Funds target range follows the median path, but aggressive portfolio rebalancing back toward U.S. dollar assets leads to a rapid decompression of spreads globally and, as a result, long yields in Hong Kong SAR rise faster than expected.

Figure 2.
Figure 2.

Impact of Rising Interest Rates

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

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

11. If such a shock were to materialize, domestic demand in Hong Kong SAR could be adversely affected (Box 2). Private consumption would be disrupted if interest rates were to spike (with the debt service ratio for new mortgage borrowers rising from its current relatively low level of around 35 percent to between 50–60 percent, depending on the magnitude of the rate increase). Rising costs of refinancing and rolling over corporate debt could inhibit investment, although staff analysis suggests that for a given rate increase the impact is likely to be less severe than in the case of private consumption. The overall slowdown in domestic demand could impair asset quality and hurt banking sector profitability, while higher interest rates would affect the value of banks’ securities holdings, thereby constraining their ability to lend.

Authorities’ Views

12. Repricing of the yield curve. The authorities considered the possibility of asset price corrections and a repricing of the yield curve in Hong Kong SAR a tangible risk as part of a generalized regional sell-off. They noted that parts of Emerging Asia, where U.S. dollar-denominated debt is high, could be vulnerable to tighter external financial conditions and a potentially stronger dollar in the aftermath of the Fed liftoff. Any resulting financial instability in the region could generate contagion effects in Hong Kong SAR and, depending on the severity of the shock, could also hurt domestic demand.

13. Financial system resilience. The authorities highlighted that the prudential measures, taken ever since liquidity began flooding into Hong Kong SAR with the onset of unconventional monetary policy elsewhere, have strengthened buffers in the financial system and prepared it for the eventual normalization of interest rates. The financial system is therefore expected to remain resilient in the face of rising interest rates even if real activity slows. Furthermore, an overall favorable international investment position would distinguish Hong Kong SAR from economies with weaker fundamentals once investors become more discerning as the era of ultra-cheap money ends.

B. Exposures to Economic and Financial Stress on the Mainland

14. Closer integration with the economy of Mainland China has brought several benefits to Hong Kong SAR, but also leaves it vulnerable to inward spillovers. The real sector linkages, especially in tourism, have grown rapidly after the easing of entry visa restrictions on Mainland visitors. Financial linkages have also deepened in recent years with the increase in cross-border bank lending, securities issuance in Hong Kong SAR by Mainland entities, and the internationalization of the RMB. Vulnerabilities from the various channels appear manageable provided the ongoing adjustment to slower and more sustainable growth in the Mainland remains orderly.

The Impact of Rising Interest Rates on Domestic Demand in Hong Kong SAR 1/

Since the Linked Exchange Rate System (LERS) was adopted in 1983, the Fed has had six rate hike cycles. Interest rates in Hong Kong SAR have risen in tandem with U.S. rates over these cycles. Comparing pre- and post-rate hike years, growth in Hong Kong SAR has slowed in three instances of these six Fed tightening episodes. Private domestic demand in Hong Kong SAR—particularly household consumption—has generally grown at a slower pace in the aftermath of U.S. rate hikes, but has remained resilient. A key difference this time is that private sector debt is much larger compared to past tightening phases, raising the possibility of a significant retrenchment in spending if interest rates increase more steeply than expected.

Provided interest rates in Hong Kong SAR rise in line with the projected median path of the FOMC’s target forecast range for the Fed Funds rate, domestic demand will not be adversely affected. It is likely that the pace of interest rate increases will be gradual especially since the monetary base has expanded considerably since 2009. This will allow households and corporates to adjust spending patterns smoothly. If household income and corporate profitability grow at a steady pace in line with Staff’s baseline scenario for the economy, the increase in debt service burdens will be manageable.

To quantify the potential impact of higher interest rates on private sector activity, Staff estimate private consumption and corporate investment functions for Hong Kong SAR. Aggregate consumption is modeled as a function of income (proxied by real payrolls), wealth (real property and stock price), and the debt service burden (ratio of mortgage payments relative to household income, as reported by the Centaline Agency in Hong Kong SAR). Two specifications are estimated – ordinary least squares (OLS) and an error-correction model (ECM)—over 1994:Q1–2015:Q2. Private investment is modeled as a function of lagged investment and cash flow, both scaled by capital stock; leverage ratio (debt / equity); and a variant of Tobin’s Q (sum of market capitalization and total debt, relative to total assets). The model is estimated using annual data from Worldscope, covering about 1000 firms in Hong Kong SAR’s manufacturing and service sectors over 1995–2014.

The relationships estimated over the past two decades suggest that private consumption would be affected more severely than investment for a given interest rate shock. A shock of 300bps increase in mortage rates is considered. Households’ mortgage payment-to-income ratio would rise by about 16 percentage points, assuming that there is no income growth at all. The OLS and ECM model coefficients indicate that the elasticity of consumption with respect to debt service burden is around 0.5, suggesting that household consumption would decline by about 7-8 percent if mortgage rates rise by 300 bps. This estimate is potentially a lower bound since the effect on household consumption of a large increase in interest rates will most likely be nonlinear (reflecting an accelerating retrenchment in spending as interest rates rise).

In the case of private investment, estimation results show that the direct effect of a 300 bps increase in interest rates is to reduce corporate investment by ½ to 1 percent (assuming that there is no change in other factors including expected future profitability, as captured by the Q ratio, and leverage). As of 2014, the median effective interest rate in the sample of 1000 firms studied was about 4½ percent and the median cash flow-to-capital stock ratio was 0.214. The 300 bps increase in interest rates would reduce the cash flow-to-capital stock to 0.179. In the presence of credit constraints that prevent smoothing of the shock to cash flows, investment declines as reported above. This modest impact based on the response of corporate investment to previous rate tightening cycles is likely to be a lower bound for the overall effect of higher interest rates. Additional indirect effects are likely to be expressed through lower expected profitability.

1/ IMF working paper, forthcoming, by Joong Shik Kang.

Trade and tourism

  • A sharper-than-anticipated slowdown in the Mainland would hit trade and wholesale warehousing in Hong Kong SAR, with large employment losses (13 percent of the labor force is occupied in these activities). Mainland visitors accounted for around 40 percent of overall retail sales in 2014, up from almost 25 percent in 2009. A downturn on the Mainland would therefore also hurt tourism and retail sales in Hong Kong SAR. This year, with growth in the Mainland slowing, tourist arrivals in Hong Kong SAR have already seen declines, as have re-exports to and from the Mainland. The contraction on both fronts has affected the aggregate amounts of tourist inflows and re-exports noticeably, reflecting the importance of the Mainland components for both categories.

A01ufig13

Hong Kong SAR: Tourist Arrivals

(In percent, year-on-year growth of 3 months moving average)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Sources: CEIC Data Company Ltd; and IMF staff estimates.
A01ufig14

Re-exports Growth

(In percent, year-on-year change of 3 month moving average)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Source: CEIC Data Company Ltd; and IMF staff estimates.

Financial channels

  • Banking system claims on Mainland banks. Hong Kong SAR-based banks have gross claims on onshore Chinese banks amounting to HK$2.1 trillion (around 90 percent of GDP). These include surplus RMB funds parked at Chinese correspondent banks or the People’s Bank of China, trade settlement claims, and debt securities issued by the Chinese banks.

  • Banking system claims on nonbank Mainland entities are now at HK$4.6 trillion (195 percent of GDP), nearly four times as large as in 2010 (Figure 3). So far, asset quality on these exposures has remained broadly in line with overall asset quality in the Hong Kong SAR banking system. However, the ultimate risk exposure remains unclear due to possible on-lending in some instances by immediate borrowers. If Mainland growth and financial stresses emerge in some key sectors such as export-oriented manufacturing or real estate, these risks could come to the fore. Local Hong Kong SAR banks—including Mainland subsidiaries of locally incorporated banks—account for close to sixty percent of these claims, with branches of foreign banks in Hong Kong SAR accounting for the rest. Since forty percent of the exposure is accounted for by foreign banks, the direct impact on the financial system in Hong Kong SAR may not be as large as the size of the headline claims suggests. However, depending on the severity of the downturn, the unfolding of events in the Mainland could lead to a sharp deterioration in asset quality in the Hong Kong SAR banking system, leading banks to slow their lending more broadly.

  • Offshore U.S. dollar securities issuance by Chinese firms. In recent years, Chinese corporations have increasingly issued U.S. dollar bonds with relatively short maturities in Hong Kong SAR to take advantage of the low interest rates on offer. The outstanding amount of such bonds with the Mainland listed as the ultimate domicile of risk reached US$191 billion (around 70 percent of GDP) as of October 2015. The investor base includes Hong Kong SAR banks, global bond funds, and private banking clients. The issuers, some with relatively weak credit profiles, span a range of sectors. B- or BB-rated property developers account for 26 percent of the total amount outstanding. However, the recent opening of cheap funding options via the onshore bond market appears to have lowered the financing risks of these borrowers.

  • Offshore RMB market. The international appeal and use of RMB has grown rapidly since 2010. Measures introduced by the Hong Kong SAR authorities—setting up a RMB Real Time Gross Settlement System, streamlining liquidity facilities, facilitating a CNH Hibor fixing—have consolidated Hong Kong SAR’s position as the premier offshore RMB center during this time. As the Mainland capital account opens further, the volume of RMB transactions in Hong Kong SAR and prospects for revenues (including securities issuance fees, fx option premia, and interest income) from this business are expected to continue on an upward path. While RMB activity in other financial centers (Singapore, London) has picked up in the last 2–3 years, the spread of offshore liquidity pools will complement Hong Kong SAR’s first-mover advantages in this area by increasing the demand for wholesale RMB services. However, as seen in recent months, when markets worry about Mainland growth prospects and RMB depreciation pressures intensify, this temporarily slows the growth of the offshore RMB business in Hong Kong SAR. RMB deposits declined and the CNY/CNH spread widened significantly in the summer as the Mainland authorities tightened their monitoring of arbitrage flows (Figure 4). Staff analysis suggests that dim sum (offshore RMB-denominated) bond issuance is negatively affected when markets expect the CNH to depreciate (Box 3). Going forward, if RMB depreciation pressures re-emerge, this may hurt revenue streams for financial institutions. Pressures in the spot CNH market could also test the derivatives market (the U.S. dollar/CNH cross-currency swap has grown to become one of the most liquid fx options in Asia) and expose financial intermediaries to bunched redemption requests at particular thresholds for the exchange rate.

  • Shanghai-Hong Kong Stock Connect and Mainland–Hong Kong Mutual Recognition of Funds. New channels for two-way flows between the Mainland and Hong Kong SAR have been opened over the past year. The Connect scheme (launched in November 2014) permits individuals and institutions with brokerage accounts in either Shanghai or Hong Kong SAR to trade stocks in the other market, subject to daily and aggregate quotas, while the Mutual Recognition of Funds (inaugurated in July 2015, with the first batch of funds currently going through the approval process) permits mutual funds in either location to mobilize investments from the other jurisdiction, subject to regulatory approval and also within an overall quota. The closer integration of the stock markets facilitates greater trading volumes and enhances market liquidity, but also creates new channels for volatility and financial stress in one location to be transmitted to the other. Staff analysis shows that correlations between Hong Kong SAR stock indices and the Mainland indices have grown in recent months, with particular sectors (construction, financials) more sensitive to spillovers (Box 4). The schemes are in their early stages of rollout at this point but, going forward, should extended periods of high volatility occur, this may hurt real activity in Hong Kong SAR and affect financial intermediation services (including lower appetite for initial public offerings; outflows from mutual funds; losses and debt service difficulties by leveraged investors in the equity market).

Figure 3.
Figure 3.

Exposures to the Mainland: Financial Channels

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Sources: Bloomberg; CEIC Data Company Ltd.; HKMA; and IMF staff calculations.
Figure 4.
Figure 4.

Developments in the Offshore RMB Market

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

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

Determinants of Dim Sum Bond Issuance 1/

Since the first issuance in 2007, dim sum bonds have served as a key asset class for offshore renminbi and an alternative source of funding. Among factors that have determined dim sum bond issuance, exchange rate expectations are important but not the only driving influence.

A diverse range of issuers has tapped the dim sum bond market. The Chinese government has issued dim sum bonds every year since 2009. Other issuers include financial institutions and corporates from China and elsewhere. In terms of sectoral breakdown, real estate accounts for about 23 percent. Although nonresident issuers are accounting for an increasing share over time, Chinese issuers continue to dominate the issuance.

A01ufig15

Dim Sum Bonds Outstanding

(In billions of RMB)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Sources: Bloomberg; and IMF staff estimates.
A01ufig16

Net Issuance of Dim Sum Bonds by Issuer Type

(In billions of RMB)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Source: Bloomberg; and IMF staff estimates.

Possible factors that influence dim sum bond issuance include monetary conditions in China and global markets, expectations of exchange rate movements, interest rate differentials between onshore and offshore markets, effective funding cost if bond proceeds are swapped into dollars, excess demand for RMB assets offshore, and policy changes in China and other offshore RMB centers.

Regression analysis shows that the net issuance of dim sum bonds has been driven mainly by expectations of the renminbi appreciation. However, in some sub-samples of bonds, other factors are important as well. In a separate regression for nonfinancial corporate bonds, the interest differential between onshore and offshore markets has a statistically significant association with net issuance, but the exchange rate expectation does not. The CNH-CNY basis spread, which reflects in part a measure of excess demand for RMB assets by offshore investors, decreased with net issuance.

1/ IMF working paper, forthcoming, by Tak Yan Daniel Law.

Financial Connectedness between Hong Kong SAR and Mainland: Evidence from Equity Markets 1/

Hong Kong SAR’s ties to Mainland China have increased significantly during the last decade or so, especially as the Mainland started liberalizing its financial markets and opening its capital account. Developments in Mainland equity markets inevitably have increasingly spilled over into Hong Kong SAR’s equity market.

To understand how the interdependence of financial markets across the Mainland and Hong Kong SAR has evolved over time, this box applies the connectedness index (CI) proposed by Diebold and Yilmaz (2009, 2012). The CI allows one to quantify the contribution of shocks from the Mainland (and other markets) to Hong Kong SAR’s equity returns and volatilities at different points in time.

The results suggest that financial interlinkages between the Mainland and Hong Kong equity markets are strong and growing over time. Given the size of China’s economy, it is not surprising that developments in China’s financial markets have become increasingly more important for Hong Kong SAR (as well as the rest of the global economy).

  • First, average connectedness (which measures the gross spillovers from China to other economies) shows that China’s equity markets explain a larger share of Hong Kong SAR’s equity returns (and volatility) than other economies.

  • Second, financial connectedness between China and Hong Kong SAR has increased sharply over the last decade or so, consistent with continuing trade integration and rapidly rising financial integration (evidenced by, inter alia, the volume of cross-border loans and equity listings). In terms of the CI, equity market spillovers from China to Hong Kong have risen sharply (both returns and volatilities). The return spillover has been on the rise (with a spike in late 2014, which may be due to increased market connectedness in November), while the volatility spillover reached a peak in 2011.

  • China’s stock market spillover effects to Hong Kong SAR’s stock market appear to be broad based, affecting several key sectors. However, there is considerable sectoral heterogeneity, possibly reflecting differences in the real/operational linkages with Mainland China. Financials, properties and construction, consumer goods, and information technology have seen a sharper rise in their connectedness with the Mainland.

A01ufig17

Gross Equity Spillovers: Mainland China to Hong Kong SAR

(Index)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Sources: Haver Analytics; and IMF staff estimates
A01ufig18

Gross Spillover of Equity Returns: Mainland China to Hong Kong SAR

(Index)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Sources: Haver Analytics; and IMF staff estimates
1/ IMF working paper, forthcoming, by Roberto Guimarães and Gee Hee Hong.

Authorities’ views

15. Credit risks. The authorities viewed the credit risks on Mainland exposures as manageable despite the concerns about Mainland growth prospects and the health of key sectors such as property, steel, and export-oriented manufacturing. They noted that the NPL ratio for Mainland subsidiaries of Hong Kong SAR banks has risen in recent months. But since Mainland exposures incurred by these subsidiaries account for less than 20 percent of the banking sector’s total, the impact on the overall asset quality of Mainland exposures is not significant. In fact, the NPL ratio of the banking sector’s total Mainland exposures has remained low and is only slightly above the overall NPL of the banking sector’s total credit exposures (0.49 percent as of end-June 2015). Furthermore, they noted that under close monitoring by the regulators, Hong Kong SAR banks and their Mainland subsidiaries have maintained high origination and underwriting standards: large Mainland SOEs and other nonprivate entities account for around half of the total borrowing, international corporations and Hong Kong SAR-based conglomerates with operations in the Mainland constitute a third of the borrowing, and the rest is accounted for by private entities backed by Mainland bank letters of credit or secured by collateral.

16. Offshore RMB business. The authorities viewed the recent stall in activity as a temporary interlude while markets adjust exchange rate expectations. The decline in RMB deposits in Hong Kong SAR was attributed in part to an unwinding of the carry trade converting RMB deposits into Hong Kong dollar or U.S. dollar. The drop in dim sum bond issuance was also viewed as a cyclical phenomenon since onshore funding costs had fallen sharply, making it more attractive to raise funds on the Mainland instead. The authorities also observed that global risk appetite was a significant contributor to the CNH/CNY spread, especially during the summer months. However, they noted they did not see any systemic risks related to activity in the CNH derivatives markets, as speculation on one-way RMB appreciation had eased following some weakening of the currency in the first half of 2014, well ahead of the August 2015 changes to the CNY central parity fixing mechanism. The Shanghai-Hong Kong Stock Connect scheme was also viewed as functioning in orderly fashion even during and after the Mainland equity markets correction during the summer. Looking ahead, the authorities expected that further opening of the Mainland capital account with the extension of the stock connect scheme to Shenzhen, the ‘One Belt, One Road’ initiative, expansion of inward RMB Qualified Foreign Institutional Investor (R-QFII) and outward RMB Qualified Domestic Institutional Investor (R-QDII) schemes, and greater take up of RMB cash-pooling programs by firms to facilitate regional corporate treasury operations, would increase the volume of RMB flows through Hong Kong SAR and maintain the steadily expanding international use of the currency.

C. Property Prices: Ripe for a Correction?

17. The propensity for property price run-ups in Hong Kong SAR is rooted in a fundamental demand-supply imbalance at work for some time (Figure 5). Nevertheless, around the rising trend, there have been times when prices have slowed or hit a plateau before accelerating again. Prices have also declined around periods of heightened financial volatility (2008–09 and 2011–12). At present, the market appears to be experiencing the onset of relative calm after having gathered steam over the past 18 months.

Figure 5.
Figure 5.

The Property Market

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Sources: CEIC Data Company Ltd.; Haver Analytics; Transport and Housing Bureau, Government of Hong Kong SAR; HKMA; and IMF staff estimates.
A01ufig19

Property Price 1/

(Index; 2003=100)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Source: CEIC Data Company Ltd.1/ Data until Sep 2015.

18. In the recent run-up, despite the well telegraphed increases in U.S. interest rates, households have continued to opt for floating rate mortgages which will reset in the aftermath of the Fed liftoff. Over 80 percent of new mortgages have been priced off HIBOR in recent months, up from close to zero in 2012. A turbulent and faster-than-expected increase in interest rates could therefore sharply slow property price growth if demand softens in response to the higher cost of borrowing.

19. Nonresidential property price growth has also accelerated, with particularly sharp increases seen in the category of flatted factories (that is, vacant former manufacturing sites acquired for commercial redevelopment). Prices have run far ahead of rents and average yields are currently around half their levels pre-2009. With early signs now evident of a slowdown, particularly in the retail segment, there is the risk that a price reversal would reduce collateral values and make it difficult for corporates to rollover credit, thus exposing banks to losses in their corporate loan book.

A01ufig20

Proportion of New Mortgage Loans Priced with Reference to HIBOR

(In percent)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Source: Haver Analytics.
A01ufig21

Nonresidential Property Price Indices and Rental Yields

(Index; 1999 = 100 unless otherwise specified)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Sources: CEIC Data Company Ltd; and IMF staff estimates

Authorities’ Views

20. Residential property, domestic demand and the banking sector. The authorities noted that the property market may lose some momentum with the interest rate upcycle, but the overall impact was hard to predict. Much will also depend on how the demand-supply imbalance evolves. With wages and job security likely to remain firm, household demand was expected to stay solid. Adverse turns in price dynamics were unlikely to have a major impact on banks’ asset quality, provisioning, or capital positions since the macroprudential measures have been effective in increasing buffers. History provides reassurance as well—the 70 percent property price correction over 1997–2003, when starting buffers were smaller than at present, had not severely dented bank balance sheets.

21. Exposures to nonresidential property. The authorities did not view the nonresidential segment as posing a systemic risk to the banking system since banks’ exposure to business loans backed by nonresidential property collateral was regarded as limited. Furthermore, the macroprudential measures apply to commercial property loans as well. Together with the double ad valorem stamp duty on purchases, the measures have made leveraged purchases of nonresidential property an expensive proposition. Corporates would rather use their cash to expand their core business than engage in property investment activities.

D. Perfect Storm

22. In the low probability event of heightened global financial volatility post-Fed liftoff coinciding with a sharp deterioration in Mainland growth, Hong Kong SAR’s small open economy would suffer a sharp falloff in growth.

  • While the headline trade balance may not register a large impact (since imports and re-exports decline proportionately), tourism and other support services such as logistics, insurance, warehousing, and trade finance will inevitably contract. Staff analysis suggests the contribution to growth from external demand would decline by 1–2 percentage points relative to the baseline, similar to previous episodes of a severe worsening of the external environment.

  • On top of this, the contribution of domestic demand to growth will fall by 3–5 percentage points compared to the baseline. The scenario assumes the Mainland’s growth rate is lower by 1½–2 percentage points than in the baseline, stock and house prices decline by 20–30 percent—generating significant negative wealth effects on consumption—and interest rates rise by 200 basis points. As was the case during extreme downturns such as in 1998–99 and 2008–09, the unemployment rate could increase by as much 2–3 percentage points (although the integration with the Mainland has increased since these previous episodes and they may therefore underestimate the extent of the negative impact). Job losses will be widespread, with construction and retail likely to take the biggest hit. The direct negative impact on private spending may be further compounded by banks reining in credit and provisioning for souring loans.

  • In sum, without factoring in a policy response, overall growth will likely fall by 4–7 percentage points relative to baseline. This is along the lines of the calibrated model-based analysis of N’Diaye and Ahuja (2012).

A01ufig22

Unemployment Rate by Industry during GFC

(In percent)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

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

23. Additional risks arise from the presence of globally active banks and the prominence of foreign currency loans in the overall loan book of the banking system in recent years. Funding strains at the bank group level could restrain the ability of local branches of foreign banks to expand credit while, conversely, impaired assets in their Hong Kong SAR loan book could transmit to weaker overall group profitability and retrenchment in other locations. At the same time, if credit risks on overseas exposures of locally-incorporated banks materialize, this could hurt their ability to lend domestically. In particular, fx mismatches (U.S. dollar-denominated corporate and sovereign securities funded by Hong Kong dollar or CNH liabilities; dollar loans to emerging markets) leave Hong Kong SAR banks vulnerable in the event of sustained dollar appreciation against the currencies of the EMs where the lending is concentrated, or a slowdown of these economies. Either outcome would create difficulties for the borrowers to service their debt to Hong Kong SAR creditors.

A01ufig23

Contribution to Total Loans Growth

(In percent, year-on-year, 3mma)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Sources: CEIC Data Company Ltd; and IMF staff estimates

24. Cross-border contagion could also be catalyzed via the asset management industry, which has grown rapidly in Hong Kong SAR, on average 10 percent y/y since the global financial crisis, to over HK$17 trillion (US$2.2 trillion) across close to 600 domiciled funds. Centralized investment mandates, strategic asset allocation imperatives, and position limits could force globally-active fund managers to sell Hong Kong SAR assets based on events elsewhere (and not directly in response to local developments), while, equally, poor returns on Hong Kong SAR exposures could trigger sales in other markets. As an illustration, during the Fed taper tantrum episode in 2013, bond exchange traded funds (ETFs) and mutual funds flows rapidly turned negative once the U.S. Treasury 10y yield volatility spiked and markets reassessed prospects of the Fed tapering its purchases of longer maturity securities. These flows are only a subset of the overall flows into Hong Kong SAR. Furthermore, since 2013, liquidity has become more of a concern in global markets, particularly in high yield corporate and EM bonds, suggesting that price sensitivity to shifts in sentiment has likely increased over the intervening period (see the April and October 2015 Global Financial Stability Reports for more discussion).

A01ufig24

2013 Taper Tantrum: Net Bond Flows into Hong Kong SAR

(In millions of USD unless otherwise specified)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Sources:Haver Analytics; and IMF staff estimates.

Authorities’ Views

25. Perfect storm. The authorities viewed the adverse scenario as a very low-probability event, but were nevertheless prepared via internal contingency planning since Hong Kong SAR as a small open economy will inevitably experience inward spillovers from global stress. The several rounds of prudential measures were seen as essential preparation for an eventual return to more normal funding conditions. The authorities felt that bank and household buffers provided substantial padding against adverse outcomes, and the track record of bouncing back quickly after large global shocks suggested that the risk of a protracted downturn in Hong Kong SAR is low.

26. Banks. The HKMA has been particularly watchful of how banks (including branches of globally active institutions) have managed liquidity through tenor matching of assets and liabilities and compliance with stable funding requirements. The authorities noted that the introduction of the stable funding requirement in 2014 had induced branches of foreign banks to rely more on head office funding. Local banks have limited exposure to foreign bank branches through the interbank market, thereby containing potential contagion from global developments to the banking system in Hong Kong SAR. Furthermore, the authorities observed that banks in general had been prudent in managing fx risk exposures.

27. Asset managers. The authorities noted that on account of the long-term institutional investor base in Hong Kong SAR, daily redemptions tended to be relatively low even during periods of stress such as the Mainland equity market correction in the summer. Furthermore, they emphasized that fund managers are required to demonstrate at the product approval stage that they have a robust liquidity risk management program in place to reduce their vulnerabilities to bunched redemption requests. They also considered that fund managers had tools to minimize the risk of large withdrawals—for instance, through passing on trading costs to exiting shareholders so as to protect the remaining shareholders from dilution of net asset value. Nevertheless, they agreed the situation bears close watching, including, if needed, via daily reporting of redemptions relative to assets under management, as they had introduced over the summer. This may become more relevant as global fund managers domicile in Hong Kong SAR and redirect internationally mobilized funding to access the Mainland stock markets through the Mutual Recognition of Funds program.

Policy Mix to Build Resilience

A. Fiscal

28. Casting fiscal policy in a medium-term framework as laid out in the 2014 Report on Long-Term Fiscal Planning is appropriate and warranted, considering the future needs of an aging population. However, since growth has been subpotential in recent years and inflation is moderating, there is merit in privileging the short-term stabilization needs of the economy should activity disappoint in the months ahead. Favorable debt dynamics provide latitude to flexibly implement the medium-term strategy (Appendix III).

29. The fiscal stance for FY 2016/17 implied by this year’s budget strikes a balance between providing near-term support to the economy while maintaining fiscal reserve accumulation consistent with the long-term needs of an aging society (Figure 6). In the event that growth underperforms in the Q4 outturn and momentum heading into 2016 appears to be severely weakened (for example, in retail sales, tourism, retained imports, and credit growth for use in Hong Kong SAR), an additional expansionary bias in the 2016/17 fiscal stance would be appropriate, with an emphasis on

  • expanded relief measures for vulnerable households (extra allowances for the elderly and physically challenged; lower thresholds for providing rental relief to families in public housing; additional property rates waivers);

  • small businesses (tax relief, subsidized / concessionary access to funding through credit guarantee schemes); and

  • accelerated urban renewal and development in Kowloon and the New Territories.

Figure 6.
Figure 6.

Fiscal Policy: Striking a Balance between Intergenerational Needs and Supporting the Economy in the Near Term

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Sources: CEIC, Financial Service and Treasury Bureau, Immigration Department, Census and Statistics Department; and IMF staff calculations

30. Looking beyond near-term considerations, demographic change will place additional demands on public finances. The labor force is projected to decline from 2019, accompanied by the rise of total population and the elderly dependency ratio. With the aging population, GDP and government revenue may grow at a slower pace than expenditure and the fiscal balance would eventually weaken on a structural basis.

The current pace of fiscal reserve accumulation is therefore broadly appropriate from an intergenerational perspective. The initiative to invest a portion of the fiscal reserves in higher-return assets via the proposed Future Fund will provide a useful mechanism to generate additional resources for an aging population. Once the Fund is operative, the investment strategy should be regularly monitored to ensure that the government’s liquidity needs are adequately safeguarded even as the portfolio allocation strives to achieve higher returns.

31. Authorities’ views. The authorities noted that ever since the Global Financial Crisis the budget has incorporated relief measures for the vulnerable and small businesses, which they assess to have been effective in protecting jobs. They further noted that the fiscal reserves provided them policy headroom to respond based on the needs of the business cycle, as they had done so during the SARS epidemic and the Global Financial Crisis, and they would take steps as required to support the economy, while remaining mindful of looming fiscal challenges over the long run.

B. Linked Exchange Rate System (LERS)

32. The LERS is the best arrangement for Hong Kong SAR, particularly at a time when the outlook for the global economy and financial markets is turning more tentative.

  • The currency board remains an anchor of stability for this small open economy with a large, globally integrated financial services industry highly exposed to cross-border portfolio adjustments. The supporting policy and institutional apparatus that guarantees the smooth functioning of the currency board remains firmly in place and is viewed as credible and robust—ample fiscal reserves that can be rapidly deployed to cushion macro shocks, strong regulatory and supervisory frameworks, and a healthy financial system. The most recent evidence of the credibility markets attach to the system was seen during the heightened regional financial stress in August-September 2015: the LERS anchored expectations and the Hong Kong dollar traded close to the strong side of the convertibility undertaking even as other currencies in the region depreciated sharply.

  • The possibility of further U.S. dollar appreciation (and therefore Hong Kong dollar against other currencies as well) in the near-term raises concerns of diminishing competitiveness, amplified at times such as the present conjuncture where the RMB faces depreciation pressures. Nevertheless, Hong Kong SAR’s flexible markets allow rapid adjustment and help ensure that departures from the equilibrium REER do not persist.

  • The July 2015 External Sector Report concluded that Hong Kong SAR’s external positions in 2014 and 2015 (through May) were broadly consistent with medium-term fundamentals and desirable policy settings. The large total gaps implied by EBA-type regressions (about 10½ percent of GDP in 2014) mainly came from regression residuals while the contributions from policy gaps were neutral. An updated EBA-type regression, which reflects the developments through September 2015, delivers essentially the same results (Appendix IV). The overall assessment remains that the external position is broadly consistent with medium-term fundamentals and desirable policy settings.

33. Authorities’ views. The authorities noted that the currency board has continued to function smoothly through repeated episodes of stress in global financial markets in recent years. They did not see the LERS as compromising Hong Kong SAR’s competitiveness and viewed the real effective exchange rate as in line with fundamentals. Domestic wage and price flexibility, together with smooth reallocation of resources across sectors, have allowed the economy to adjust without costly disruptions to activity. The authorities noted that the minimum wage (introduced in 2011 and subsequently raised in 2013 and 2015), has not reduced flexibility in the labor market. As another example of flexibility, the authorities pointed to recent reductions in unit prices in the retail sector as evidence of the domestic adjustment mechanism at work.

C. Financial Sector

34. In its capacity to assess systemic risks, and its track record of closing regulatory and data gaps, Hong Kong SAR’s regulatory and supervisory framework is a global standard setter. With regard to banks, the emphasis is on preserving ample loss absorption buffers, limiting leveraged exposures to asset prices, and containing vulnerabilities to sudden stops in short-term funding. Specifically on Mainland exposures, onsite examination of banks’ credit underwriting has been intensified, asset quality is closely monitored and, where necessary, additional provisioning for losses is required. Nevertheless, there is room to further strengthen aspects of the defenses. The main areas that warrant continued attention are

  • completing the process underway for enacting legislation on a comprehensive recovery and resolution framework;

  • further strengthening the oversight regime for securities markets, broker dealers and asset managers as their business model evolves with new channels connecting Hong Kong SAR and Mainland markets; and

  • fully implementing a risk-based capital regime for insurance companies.

35. In addition, the emerging risk from new channels connecting Hong Kong SAR with the Mainland may call for stricter eligibility criteria for participation in stock connect schemes and, if needed, steps to contain risks to the broader financial system (prudential measures including greater provisioning and tighter risk weights on banks’ securities exposures via the new connect schemes). Continued strict implementation of anti-money laundering controls (building on measures already taken last July, when the HKMA issued its first sanction for breach of compliance with the 2012 AML/CFT Ordinance), together with steps to additionally strengthen transparency of legal persons and trusts, would help further protect Hong Kong SAR’s hard-earned reputation as a premier global financial center.

36. Authorities’ views. The authorities reported significant progress in implementing the recommendations of the 2014 Financial Sector Assessment Program (FSAP).1 The legislation for establishment of the independent Insurance Authority (IIA) was enacted in July 2015. The IIA is expected to be set up by end-2016. Components of a risk-based capital regime for insurance companies are being put in place, and the authorities expect to complete the preparation work for the new regime in 2–3 years mainly because determining the capital requirements for each company based on its risk exposure (Pillar I) will take time on account of the diverse insurance landscape in Hong Kong SAR. The other pillars of the regime—corporate governance standards, enterprise risk management, and self-assessment of risks and solvency position (Pillar 2) as well as disclosure standards and enhancing transparency (Pillar 3)—may be instituted sooner. For life insurance companies, the regulators have required weekly reporting of solvency ratios (the ratio of total assets at fair value minus total liabilities, normally adjusted with prevailing interest rates, to the required margin of solvency should be at least 150 percent). General insurance companies are required to maintain at least 200 percent solvency ratio. The authorities further noted that periodic stress testing on assets is also performed. Risks from the new channels connecting the Mainland and Hong Kong SAR were seen as manageable so far. The regulators are attuned to preventing funds from engaging in regulatory arbitrage (for instance, Mainland funds listing in Hong Kong SAR to principally invest back in the Mainland, rather than listing directly in the Mainland itself). More broadly, they view asset management as a potential high growth area and have streamlined taxes, stamp duties, and the legal framework governing fund structures to attract asset managers to domicile in Hong Kong SAR.

D. Property Sector

37. While there are some early signs that the property sector is beginning to slow, the potential for a renewed pick up remains high considering the underlying demand pressures and tight supply. Therefore, the three-pronged approach deployed to limit risks—efforts to boost supply; stamp duties on transactions; macroprudential measures to protect banks—should continue to remain in place.

A01ufig25

Hong Kong SAR Public Housing Supply: Planned and Actual Annual Completions

(In thousands of units)

Citation: IMF Staff Country Reports 2016, 017; 10.5089/9781498303835.002.A001

Source: Housing Authority.

  • Efforts to raise supply. The recent reaffirmation by the government to boost supply, made through the 2014 Long-Term Housing Strategy, is welcome, as is the concerted cross-agency cooperative effort to project demand and identify the land needed to support the construction activity. Of the 480,000 units projected to be supplied over the next 10 years from 2015–16 to 2024–25, 290,000 are public sector units (rental and for sale). Over the next decade, this entails producing an annual average number of units that is nearly twice the yearly average produced in recent years. There is merit in expediting the process for identifying the land and building sites, together with conducting the relevant environmental, transport, and community facility assessments so as to cement public expectations that the target will be met. This will help alleviate affordability concerns, particularly for low-income households, although the full impact will necessarily be felt only with a lag once the actual construction nears completion.

  • Stamp duties. The three stamp duties currently in place—Special Stamp Duty on resale of residential properties within 36 months of purchase; Buyer’s Stamp Duty on purchases by nonresidents; and double ad valorem stamp duty on nonresidential and multiple residential property purchases—have helped curb excess demand by limiting speculative transactions. Barring a precipitous fall in transactions, the stamp duties should not be rolled back.

  • On counter-cyclical macroprudential policies, staff sees a case for holding firm on the tight ceilings on LTV and DSR ratios and the floor on risk weights tied to property loans as a way of continuing to limit banks’ exposure to property sector. These policies have strengthened banks’ mortgage loan origination standards without getting in their way of intermediating credit to the real economy. Adjustments to the property-related macroprudential measures should be made based on evolving financial stability risks and not in response to aggregate demand developments (unless the measures are deemed to impair credit intermediation and disrupt the banking system’s ability to support the real economy).

38. Authorities’ views. The authorities emphasized that boosting supply is a priority. Land for constructing 254,000 of the 290,000 public housing units, which is the target set by the Long-Term Housing Strategy over the next decade, has already been identified. As for private housing land supply, the authorities aimed to maintain land supply from various sources for about 190,000 units over the next decade. With regard to stamp duties, the authorities considered these as effective tools for restraining excess speculative demand, but agreed they would consider adjustments in the event of a sustained decline in transaction volumes with the potential to generate adverse spillovers to the broader economy. On counter-cyclical macroprudential measures imposed on banks, the authorities observed they will continue to monitor the property market closely and introduce appropriate measures as and when necessary to safeguard banking stability. In considering financial stability risks, it is inevitable that broader macro factors would need to be taken into account.

E. Labor

39. With the labor force expected to peak within the next 10 years, there is a need to ensure that dependency burdens remain in check. The proposed Low-income Working Family Allowance is a useful mechanism to incentivize labor force participation while providing supplementary income to employed individuals and families with incomes and assets under a certain threshold. The minimum wage, introduced in 2011 and raised twice since then (latest in May 2015), has placed a floor under hourly wages while also helping to raise participation among segments more distanced from the mainstream labor force. Labor force participation at the lower end of the income and skills distribution will be further incentivized by regulating working hours and mandating over-time pay for low-income workers with minimal bargaining power. Sustained efforts should therefore be made to move forward with legislation on standardizing working hours.

40. Authorities’ views. The authorities viewed the minimum wage as an important policy tool for alleviating working poverty. They also regarded it as helping to bring into employment those who might otherwise be discouraged by the very low wages on offer and not have participated in the labor force. Increases in employment for female workers have been particularly significant, especially those aged 50 and above and those in the lower-skilled segment. Income growth in the lowest decile has substantially outpaced that in other segments ever since the minimum wage was introduced. Together with the Low-Income Working Family Allowance, a major employment-focused initiative to encourage self-reliance and ease intergenerational poverty that will take effect from 2016, investment in retraining and retooling early retirees, and means-tested work transport subsidy, they saw these policies as important levers for encouraging labor force participation as well as for mitigating the impact of an aging population and shrinking labor force in the near future.

F. Contingencies for a Perfect Storm

41. In the low probability event of the perfect storm described above, a comprehensive and coordinated policy approach involving elements of the 2008/9 response—large and proactive fiscal stimulus; expanded credit guarantees for SME loans through the Hong Kong Mortgage Corporation—together with loosening of macroprudential policies would need to be implemented quickly to stem the collapse in confidence, tightening of liquidity conditions, and steep decline in private sector activity that will likely transpire in such a scenario. Continued strong collaboration between Hong Kong SAR regulators and counterparts in other jurisdictions will ensure close monitoring of evolving cross-border risks, and enable the appropriate liquidity support and backstopping of liabilities needed to limit two-way transmission of financial stress via globally active intermediaries.

42. Authorities’ views. The authorities emphasized that protecting jobs is key. A large, pre-emptive fiscal stimulus together with expansion of SME credit guarantees would be considered to forestall bankruptcies and safeguard employment. Counter-cyclical macroprudential measures as well as property stamp duties could be scaled back to ease the pressure on the property market. The authorities also noted that they are actively participating in supervisory colleges for cross-border banking groups, including G-SIFIs, and cooperating closely with securities regulators in other jurisdictions to stay abreast of globally active financial institutions’ risk profiles and business strategies.

Staff Appraisal

43. Growth and resilience. Despite being repeatedly buffeted by powerful global cross-currents, Hong Kong SAR’s economy has grown steadily in recent years. Real GDP is about 25 percent higher than the global financial crisis trough in early 2009; employment has expanded close to 9 percent since then, with net job creation over 300,000; and the unemployment rate has declined to 3.3 percent. The resilience of the economy and financial system was displayed most recently during the summer months, when markets continued to function in orderly fashion despite higher volatility in equity prices and currencies after the correction in the Mainland indices. However, with the external outlook still tentative, growth in Hong Kong SAR will likely remain subdued below potential in 2015/16.

44. The main challenges ahead are three-fold. Interest rates—tracking the U.S. Federal fund’s rate—are set to increase for the first time in seven years. Financial and real activity spillovers from Mainland China may re-emerge. The run-up in property prices over the past year raises the probability of a correction (with some signs now evident of a pause in momentum). Overall, considering the strong fiscal and financial buffers in place in Hong Kong SAR, these risks will likely have limited impact provided (i) interest rates rise at the modest anticipated pace based on the U.S. Federal Reserve’s FOMC median forecasts for the Federal Funds rate; and (ii) the ongoing adjustment in Mainland China’s growth remains orderly.

45. Fiscal policy. If high-frequency indicators in early 2016 point to a significant weakening of activity, the FY2016/17 budget should proactively provide additional support than currently envisaged, with an emphasis on expanded relief measures for vulnerable households, small businesses, and accelerated urban renewal and infrastructure spending where possible.

46. Long-term fiscal challenges. Beyond cyclical considerations, there is a need to address the long-term fiscal challenges presented by an aging population and shrinking workforce in the future, as laid out in the 2014 report by the Working Group on Long-Term Fiscal Planning. Planned initiatives such as the Low-income Working Family Allowance Scheme will incentivize labor force participation and help mitigate rising dependency burdens, while the proposed Future Fund will create a mechanism for raising long-term investment returns of the fiscal reserves, thereby generating additional resources to cope with demographic change.

47. Property sector. The government’s reaffirmation through the 2014 Long-Term Housing Strategy to identify additional housing sites and expand supply will provide respite to affordability concerns over the medium-term. Sustained efforts should be made to ensure implementation stays on track and the targets are met. In the interim, the Buyer’s Stamp Duty, Special Stamp Duty and doubled ad valorem stamp duty will help filter out speculative transactions and restrain excess demand. Adjustments to these duties could be considered if there is a sustained decline in transactions volumes with the potential to generate adverse spillovers to the broader economy. Mortgage loan origination standards have been appropriately strengthened through multiple rounds of macroprudential measures since 2009, encompassing tighter loan-to-value and debt service-to-income ceilings and risk-weight floors on property loans. These measures have limited leveraged exposures to the property price run up without impairing the banking system’s key function of expanding credit commensurate to the needs of the real economy. The property-related macroprudential measures should continue to remain in place; any adjustments should be made based on evolving financial stability risks and not in response to aggregate demand developments (unless the measures are deemed to impair credit intermediation and disrupt the banking system’s ability to support the real economy).

48. Financial sector policies. Hong Kong SAR has a strong track record of filling regulatory and data gaps, assessing systemic risks, and strengthening financial institutions’ loss absorption buffers in a preemptive manner. The authorities have also provided infrastructure support for healthy market development, for instance in offshore RMB services. In line with the recommendations of the 2014 FSAP, important progress has been made with regard to establishing an independent authority for the insurance sector; crisis management and recovery plans for financial market infrastructures; and cross-border cooperation across the banking, insurance, and securities regulators. Areas that warrant further attention include completing the process underway for enacting legislation on a comprehensive recovery and resolution framework; continuing to strengthen the oversight regime for securities markets, broker dealers and asset managers as their business model evolves with new channels connecting Hong Kong SAR and Mainland markets; and fully implementing a risk-based capital regime for insurance companies.

49. Exchange rate regime and external position. The LERS remains the best arrangement for Hong Kong SAR and serves as an anchor of stability for this small open economy with a globally integrated financial services industry. The smooth functioning of the LERS derives from the robust institutional, legal and policy framework in place in Hong Kong SAR; the ample fiscal reserves available to cushion the economy from adverse shocks; the healthy financial system that can accommodate large portfolio adjustments; and, more generally, flexible asset, goods, and labor markets that can adjust quickly to ensure misalignments in the real effective exchange rate (REER) do not persist. The external position is broadly consistent with medium term fundamentals and desirable policies.

50. Contingencies. The attributes from which Hong Kong SAR’s small open economy derives its dynamism—an international trading and tourism hub and a premier financial center—also leave it exposed to global economic forces beyond its control and place a premium on contingency planning. In the low probability event that a sharper-than-expected slowdown on the Mainland coincides with a turbulent turn in global financial markets following the Fed liftoff, a range of measures may need to be deployed to forestall a deep slide in activity in Hong Kong SAR—large and proactive fiscal stimulus; expanded credit guarantees for SME loans; together with loosening of macroprudential policies. The experience of 2008/09 suggests that a comprehensive policy response can contain the domestic fallout of a large global shock and quickly set the economy back on track.

51. 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, 2010–16

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Sources: CEIC; and IMF staff estimates.

Data published using the Balance of Payments Statistics Manual 6 (BPM6) format

Table 2.

Hong Kong SAR: Balance of Payments, 2010–16 1/

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Sources: CEIC and Census and Statistics Bureau.

Data published using the Balance of Payments Statistics Manual 6 (BPM6) format

Table 3.

Hong Kong SAR: Consolidated Government Account, 2011/12–2020/21 1/

(In percent of fiscal year GDP)

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Sources: CEIC; and IMF staff estimates.

Staff projections assume government spending targets in the latest medium-term budget document and staff revenue forecasts, including stamp duties from demand-management measures on property. Fiscal year begins on April 1.

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

Balance excluding investment income.

Table 4.

Hong Kong SAR: Monetary Survey, 2010–16

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Includes savings, time, demand, and negotiable certificates of deposits.

Sources: IMF, International Financial Statistics ; Haver Analytics, and staff calculation.
Table 5.

Hong Kong SAR: Medium-Term Macroeconomic Framework, 2010–20

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Sources: CEIC; and IMF staff estimates.

External balances expressed in Balance of Payments Manual 6 (BPM6) format.