People’s Republic of China—Hong Kong Special Administrative Region: Staff Report for the 2019 Article IV Consultation Discussions

Hong Kong SAR economy has been hit hard by both external and domestic shocks and fell into a technical recession in the third quarter.

Abstract

Hong Kong SAR economy has been hit hard by both external and domestic shocks and fell into a technical recession in the third quarter.

Challenges Ahead But With Ample Buffers

1. Hong Kong SAR is a regional trading hub and a global financial center.1 The “one country, two systems” principle, adopted at the time of its handover to China in 1997, has allowed the city to retain its own government and legislative and administrative system. Hong Kong SAR’s competitiveness has depended on its sound rules and regulations, grounded in the common law and adapted to international best standards. Hong Kong SAR consistently ranks very high in international competitiveness, due to its high-quality regulatory framework, stable macroeconomic environment, transparent and efficient institutions, and flexible goods, labor, and financial markets.

2. Hong Kong SAR is one of the most open economies in the world. Conveniently situated next to one of the largest manufacturing centers in the world, Hong Kong SAR has long served as an entrepot for Mainland China, an important gateway for its exports to the world, and a processing and distribution center for other countries linked through the global value chains. External trade amounted to about 360 percent of GDP (not including the offshore trade, which amounted to another 167 percent in 2017). Trade and logistics, servicing re-exports as well as offshore trade, are one of the city’s key sectors, contributing around 20 percent to both GDP and employment. Tourism also contributes around 4½ percent to GDP and 6⅔ percent to employment.

uA01fig01

Exports and Imports of Goods and Services

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

1/ Data for Hong Kong SAR are as of 2019Q3.Sources: C&SD, WEO, and IMF staff calculations

3. Hong Kong SAR is a global financial center, with increasing links with Mainland China. The free movement of capital and information, a simple tax system, a sound regulatory system, rule of law, and quality professional services have provided solid foundation for competitiveness in its financial sector. Benefiting from the city’s open capital account, it has become a leading financing center for Mainland China’s firms through banking, bond, and stock markets, and is also a gateway for FDIs in and out of Mainland China. Financial, professional and other producer services account for about 30 percent of GDP and 20 percent of employment.

4. Trade tensions between the U.S. and China and social unrest have sent waves through the economy. Underpinned by the currency board arrangement—Linked Exchange Rate System (LERS)—Hong Kong SAR’s overall business cycle has traditionally been closely in sync with the U.S. business cycle, although Mainland China’s influence has gradually increased. Since the eruption of trade tensions between the U.S. and China, the value of Hong Kong SAR’s re-exports has been significantly affected, with ripple effects through the trade-related services sector (Annex 1). In addition, social unrest that has persisted since this summer has adversely affected the domestic economy.

5. Hong Kong SAR also faces structural challenges brought by deteriorating housing affordability, high income inequality, and aging population. With housing prices almost quadrupling since the Global Financial Crisis (GFC), the property boom has left the city with one of the least affordable housing markets in the world. High real estate-related revenues have helped boost the city’s coffers but increases in social spending have not been enough to address high levels of income inequality that are above that of its peers. A quarter of the city’s population is projected to be aged 65 and over by 2030, thus posing a challenge to productivity and competitiveness in the long run.

uA01fig02

Market Gini Index: Hong Kong SAR and Other Cities with Sizable Financial Industry

(Household Gini; Percentage points)

Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

Sources: U.S. Census, Statistics Singapore, HKSAR C&SD, OECD.1/ Southern Kanto region; 2/ Singapore’s Gini coefficient is reported based on household income from work per household member.

6. A history of sound macroeconomic and prudential policies left Hong Kong SAR with significant buffers to address both cyclical and structural challenges. FX reserves at around 120 percent of GDP or twice the monetary base, together with a large net international investment position of about 390 percent of GDP, provide a strong buffer against external shocks. Enhanced regulatory and supervisory frameworks have built up banks’ strong capital and liquidity buffers, with both capitalization and liquidity levels well above international standards.2 Prudent fiscal management under the balanced budget principle and strong revenue growth during the real estate market boom have helped accumulate large fiscal reserves of about 40 percent of GDP.

uA01fig03

Foreign Exchange Reserves

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

Sources: Haver Analytics.
uA01fig04

Monetary Base by Component

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

Sources: Haver Analytics.
Figure 1.
Figure 1.

Open and Competitive Economy; but Structural Issues Persist

Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

1/ Data for Hong Kong SAR are as of 2019Q3.Sources: C&SD, WEO, and IMF staff calculationsSources: Global Competitivenss Index 2019 editionSources: U.S. Census, Statistics Singapore, HKSAR C&SD, HKSAR R&VD, OECD.1/ Southern Kanto region; 2/ Singapore’s Gini coefficient is reported based on household income from work per household member.Sources: Asian Development Bank Input-Output Tables, and Fund staffSounds: HKEx, and WIND.Sources: Haver Analytics; and IMF staff calculations.

Slowing Growth Amid Rising Uncertainty

7. After robust growth of 3 percent in 2018, economic activity weakened significantly in 2019 and the economy fell into a technical recession in Q3. GDP contracted by 0.5 and 3.2 percent (q/q, sa) in the second and third quarters, respectively. Rising trade tensions between the U.S. and China and heightened uncertainty took a toll on exports and investment while private consumption and visitor arrivals have declined significantly due to the social unrest that started this summer. With slowing economic activity, core inflation fell to 2.6 percent in September, with headline inflation rising to 3.3 percent driven by food prices. The seasonally adjusted unemployment rate has edged up to 3.1 percent in August-October as displaced workers from trade-related sectors continued to be absorbed by other industries. The current account balance widened to 5 percent of GDP in the first half 2019 compared to 2018 due to a sharp decline in imports amid weakened domestic demand.

uA01fig05

Real GDP Growth and Contributions

(Percent, quarter-on-quarter SA)

Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

Sources: C&SD, and IMF staff calculations.

8. Slowing growth in Hong Kong SAR and Mainland China has moderated demand for credit. Hong Kong SAR provides funding through banks and financial markets not only to domestic households and firms, but also to foreign firms, mostly from Mainland China. As escalating trade tensions and weakening global economic activity have lowered demand for credit, its growth slowed to 6.3 percent (y/y) in September 2019, from a peak of 21.4 percent in October 2017. The moderation was broad based, including trade finance and domestic loans as well as Mainland-related lending. Slower credit has helped narrow the domestic credit-to-GDP gap to 11.2 percent in 2019Q2, from a peak of 20.6 percent in 2017Q4. Together with the decline in stock prices and increase in Hibor rates, overall financial conditions have tightened accordingly.

uA01fig06

Financial Conditions Index

Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

Sources: Bloomberg, and IMF staff calculations

9. The economy is expected to start recovering next year. As the cyclical downturn continues, GDP is expected to contract by 1.9 percent in 2019. Growth is projected to rise only to 0.2 percent in 2020 led by a recovery of private consumption but remain well below the potential growth of about 2½ percent. Key assumptions underpinning the baseline projections are: (i) the current tariffs between the U.S. and China stay in place and no new tariffs are imposed; (ii) ongoing social unrest stabilizes in the first quarter of 2020 although underlying factors persist; (iii) growth in Mainland China softens further in 2020, with some effects of tariffs countered by additional stimulus measures; (iv) the global economy expands at a moderate pace; and (v) interest rates fall in line with a U.S. rate loosening cycle and credit conditions improve gradually while house prices stabilize. The slowing economy is expected to shed jobs, thus raising unemployment, though the flexible labor market should allow for a significant share of affected workers to be absorbed by the public and other services sector.3 With an estimated negative output gap of about 4½ percent of GDP in 2020, inflation is projected to fall to about 2½ percent in 2020 as food prices stabilize.

uA01fig07

External Merchandise Trade

(Year-on-year growth, 3mma)

Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

Sources: CEIC, and IMF staff calculations.

10. The pace of recovery is expected to be gradual with a negative output gap over the medium term. Increased trade barriers and disruptions to global supply chains would be a drag on Hong Kong SAR’s trade-related activities for a prolonged period, lowering potential output by about 1 percent over the medium term, compared to the level projected before the eruption of the trade tensions.4 As growth is expected to recover toward its potential rate at a slower pace than in previous recoveries, partly due to large uncertainty and its negative impact on confidence and investment, the negative output gap that opened in 2019 is projected to persist over the medium term at around 1.5 percent.

uA01fig08

Retail Sales and Visitor Arrivals

(Percent, y-o-y growth, 3mma)

Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

Sources: CEIC, and IMF staff calculations.

11. Risks to outlook are tilted to the downside (Annex 2).

  • Downside. On the external side, further escalation of trade tensions between the U.S. and China could dampen global trade and lower the volume of trade passing through the city, with negative spillovers for business and employment in trade-related industries. Staff analysis suggests that real GDP in advanced Asia could decline by about 0.3 percent over the next two years if trade-related uncertainty remains at peak levels as in May 2019, with the impact on Hong Kong SAR likely bigger, given the importance of international trade for its economy.5 Additional barriers, including potential restrictions by the U.S. against China in technology and the financial sectors, could reduce growth through adverse confidence effects and greater financial market volatility. A significant slowdown of Mainland China or a disorderly adjustment in its financial markets could exert significant impact on Hong Kong SAR given the close connectedness through both real and financial channels. On the domestic side, a deterioration of the sociopolitical situation and delays in addressing structural challenges of insufficient housing supply and high income inequality could further weaken economic activity and negatively affect the city’s competitiveness in the long term. As house prices are highly procyclical, a significant slowdown of the economy could trigger an adverse feedback loop between house prices, the real economy and the financial sector. Staff’s growth-at-risk analysis indicates that, as of 2019Q3, GDP could contract by 1.8 percent or more over the next four quarters under a severely adverse scenario (5th percentile of the distribution), with a similar downside risk of 1.7 percent or more over the next three years.6

  • Upside. An easing of trade tensions between the U.S. and China could lift global trade and spur confidence and investment, including in Hong Kong SAR. Comprehensive structural reforms in Mainland China and addressing the economic factors behind the social unrest could improve medium-term growth outlook. The development of the Greater Bay Area (GBA) could further improve medium- and long-term growth prospects.

Authorities’ Views

12. The authorities broadly agreed with the mission’s assessment of the macroeconomic outlook. They noted that the economy was facing both external and domestic headwinds. Although the value of re-exports involving the U.S. and China only accounted for about 8-9 percent of Hong Kong SAR’s total exports of goods, uncertainties stemming from the U.S.-China trade tensions, softening global economic growth, and deteriorating business sentiment have taken a toll on exports and investment while tourism-related sectors were hard hit by the ongoing social incidents. The authorities underscored that the financial markets as well as the LERS continued to function smoothly and that the Hong Kong SAR continued to fulfill its role as a leading banking and financial center. They were confident that the sizable fiscal and FX buffers, the strong capital and liquidity position of the banking sector, and robust policy frameworks enjoyed by the city would help it navigate these challenges. The authorities agreed that an easing of the trade tensions would help improve business sentiment and the growth outlook, and the development of the GBA could lift potential growth over the medium and long term.

Figure 2.
Figure 2.

Weakening of the Economy Accelerates

Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

Sources: C&SD, and IMF staff calculations.Value on Y axis depicts growth rate between 2017 Q4 and 2019 Q3. Size of the bubble depicts share in employment in 2017. Red bubbles indicate trade-related sectors.Sources: CEIC: and IMF staff calculationsSources: Bloomberg.Sources: CEIC, and IMF staff calculations.Notes: 1/ Tourism-related retail sales are defined as sales of jewelry, watches and clocks; Chinese drugs and herbs; medicines and cosmetics; and sales in optical shops.Sources: CEIC, and IMF staff calculations.Sources: CEIC, and Fund staff calculations

Fiscal Support for Macroeconomic Stability

13. Public fiscal management has been prudent, following a balanced budget principle. The Basic Law of Hong Kong SAR stipulates that the government is to keep “...expenditure within the limits of revenues in drawing up its budget, and strive to achieve a fiscal balance, avoid deficits and keep the budget commensurate with the growth rate of its gross domestic product.” Hong Kong SAR experienced fiscal deficits in the late 1990s and early 2000s after the Asian Financial Crisis (AFC). However, adherence to a balanced budget principle, combined with consistent revenue overperformance and expenditure underperformance, has resulted in fiscal surpluses in every year since 2004 and accumulation of fiscal reserves of about 40 percent of GDP (Annex 3). While it has helped build a strong buffer to maintain the currency board arrangement, it has also resulted in mostly a-cyclical fiscal policy in part due to weak expenditure-side automatic stabilizers.

14. The fiscal surplus narrowed in 2018 and 2019, providing some fiscal impulse to the economy.

15. Going forward, the fiscal surplus is expected to widen over the medium term. The government’s medium-term budget announced in February 2019 envisages a surplus of around 0.9 percent of GDP in 2020, narrowing to around 0.2 percent of GDP in the medium term. With slower growth, staff projects the overall fiscal surplus of 0.3 percent of GDP in 2020, widening to around 1 percent over the medium term as actual expenditures are expected to underperform, in line with developments over the last two decades (expenditures underperformed by a median of 0.8 percent of GDP). Barring another round of property market boom or a sharp correction, revenues are expected to remain relatively stable.

16. Greater countercyclical fiscal policy, coupled with the existing fiscal buffers, would help the economy navigate through negative shocks while maintaining long-term sustainability. As monetary policy is determined through the direct link to U.S. interest rates through the currency board arrangement, fiscal policy needs to support economic stabilization when there is a sizeable output gap and external demand is weak. With a comfortable level of fiscal reserves and the existing flexibility of the budgetary framework that permits deficits during economic downturns, expansionary fiscal policy is needed to support the slowing economy in the near term. However, the near-term need of boosting aggregate demand should be balanced against longer-term weakening of the structural fiscal position arising from rapid population aging and the corresponding increase in social expenditure. This can be achieved by aligning short-term measures with long-term goals and shifting spending forward (e.g., on identified infrastructure projects) in a manner that helps ensure long-term sustainability.

17. In the near-term, government spending should be increased significantly, including additional fiscal stimulus in the current fiscal year, to cope with the cyclical downturn and address structural challenges of insufficient housing supply and high income inequality. (Annex 4).

  • Targeted transfers. Additional fiscal spending of about 2½ ppt of GDP over two years, with significantly frontloaded spending in the current fiscal year, would help those severely affected by the cyclical downturn. As overall tax rates are already low, fiscal stimulus could be better delivered by targeted spending to vulnerable households and SMEs, including through extra allowances, rent relief, and subsidies for low-income students.

    uA01fig11

    Recommended Fiscal Package

    (Percent of GDP, compared to the projected baseline)

    Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

    Sources: Fund Staff calculations.

  • Housing/infrastructure. Given the urgent need to increase housing supply, additional spending on housing and related infrastructure developments is warranted. Bringing forward planned spending on infrastructure projects and scaling it up after the above-mentioned targeted transfers are unwound would not only expedite the supply of land and housing but would avoid an early withdrawal of the fiscal impulse needed to close the negative output gap over the medium term. Cumulative increase in spending of 3½ ppt of GDP over the next five years would increase real GDP by about 2¼ ppt during this period.

  • Education/training. Despite the very flexible labor market, unemployment would increase given the significant slowdown of the economy and the persistence of external headwinds, highlighting the urgency of retraining affected workers. As Hong Kong SAR also faces increased competition from other financial centers, it is also important to upgrade “soft” infrastructure through education and R&D to further improve competitiveness. Increasing spending on education and job training, cumulatively by 2 ppt of GDP over the next five years, would increase real GDP by about 2½ ppt in the long run through higher productivity and increased labor supply.

  • In sum, staff analysis suggests that fiscal spending increases of around 1½ percent of GDP per year (8 ppt of GDP in total over 2019-24) on the above areas, relative to the projected baseline, would help close the negative output gap over the medium term with a drawdown of fiscal reserves of about 5½ ppt of GDP.7

18. If growth falters more than expected, the authorities should provide more near-term fiscal support. Additional targeted spending to vulnerable households and SMEs could help cushion the negative impact of a more severe economic downturn. Retraining programs as well as housing and infrastructure projects could be scaled up further to support the displaced workers and expedite the supply of land and housing.

19. In the medium term, the authorities should also consider measures to ensure fiscal sustainability and greater equity. The economy faces rapid population aging and the corresponding increase in social expenditures in the medium to long term, with one in six people currently 65 or above rising to about one in four by 2034. Therefore, the authorities could consider the following measures to avoid scaling back social safety net, which would incur undesirable social costs and hinder inclusive growth.

  • Raising revenues. The current taxation regime of a narrow tax base and low tax rates has supported the city’s competitiveness in the financial and service industries but resulted in a low tax revenue-to-GDP ratio of less than 15 percent. International benchmarking of other global financial centers suggests that there is room to introduce VAT, raise excise taxes, and increase the top personal income tax (PIT) rate and tax rate under personal assessment while maintaining competitiveness.8 The lowering of the effective PIT rates through changes to the tax bands since 2018 should also be reversed once macroeconomic conditions improve. Any tax relief measures should be carefully designed to be well targeted to the most vulnerable and not to undermine the progressivity of personal income taxation. Introducing a carbon tax for some sectors (e.g., energy, building, and transportation) may help reach the 2030 carbon intensity target laid out in the government’s Climate Action Plan 2030+ and raise revenues in the long run.9

  • Optimizing spending. Regular comprehensive expenditure reviews would help identify any wasteful spending and ensure that long-term goals of increasing productivity, raising labor force participation, and tackling income inequality are addressed. The authorities should also prepare a long-term healthcare spending strategy. Proceeds from issuance of green bonds could be used for investment in environmentally-friendly projects.

  • Improving the effectiveness of budget planning and execution. Reducing reliance on property-related revenues and avoiding systematic under-execution of operating expenditures would help increase the countercyclicality of fiscal policy and ensure the effectiveness of the fiscal response to the economic downturn.

  • Increasing labor force participation. Measures to increase the number of childcare services, especially for children below two years of age and at subsidized rates for poor/single parent families, in line with the findings of the 2019 Report of the Research Office of the Legislative Council, would help encourage female labor force participation. The authorities could also expand programs to raise elderly employment, in line with findings of the 2018 Research Office of the Legislative Council report.

Authorities’ Views

20. The authorities agreed that additional fiscal support was needed to counter the effects of the economic slowdown as well as to address longer-term challenges.

  • Near-term support. The authorities noted that the measures already announced aimed to protect the most vulnerable members of society, as well as to provide relief to SMEs affected by the significant slowdown so as to preserve jobs. As the economic downturn deepened, the government stood ready to roll out additional fiscal measures in the current fiscal year ending next March and noted that the size and composition would be carefully determined to maximize their effectiveness. The authorities also agreed that the accumulated fiscal buffers should be put to good use, and that sizable additional fiscal measures might be necessary in the coming years to counter the effects of the economic slowdown. The authorities noted that the overarching requirement of a balanced budget in the Basic Law allowed some degrees of flexibility and fiscal deficits indeed took place during economic downturns as in the case of the late 1990s and early 2000s. The key was in ensuring fiscal balance over a sustained period of time.

  • Longer-term challenges. The authorities agreed that higher revenues would be needed in the long term to ensure fiscal sustainability amid population aging. However, public consultation would be needed to enlist broad support for any proposed tax-generating measures. Given the existing large fiscal buffers, no tax increases were planned in the immediate future.

Figure 3.
Figure 3.

Strong Fiscal Position Remains

Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

Sources: CEIC; and Fund staff calculations.Sources: Budget statements, IMF.Sources: Budget statements, IMF.Sources: Government budget statements, and IMF staff estimates.Sources: CEIC, government budget statements, and IMF staff calculations.Sources: C&SD, and IMF staff calculations.

Containing Housing Market Risks

21. After resuming their upward trend, housing prices have softened recently. Property price growth resumed for the first five months of 2019 amid expectations of monetary easing in the U.S, erasing the previous decline in the second half of 2018. However, more recently, property prices declined by about 4 percent between May and September 2019. From a longer perspective, residential property prices have almost quadrupled since the GFC, and even more in mass market segments.

uA01fig12

Property Prices and Transactions

(Percent change, y-o-y, 3mma; thousand units, SA, right-hand scale)

Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

Sources: HKSAR R&VD, Haver Analytics, and IMF staff

22. Hong Kong SAR’s housing market remains the least affordable in the world due in part to the demand-supply imbalance. Subdued housing production amid rising demand due to low interest rates, increasing household formation, and immigration has resulted in large supply-demand imbalances over the last decade. House price-to-income and house price-to-rent ratios have increased rapidly and remain well above international peers. Staff analysis indicates that house prices exceeded fundamentals by around 15-30 percent as of 2019Q3. Around 30 percent of households live in public rental housing and another 15 percent live in subsidized sale flats.

uA01fig13

Domestic Housing Affordability Indicators

(Index, 2009Q1 = 100)

Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

Sources: Haver, and IMF staff calculations.

23. A sharp adjustment in the property market could pose a risk to the economy. Despite recent signs of stabilization, property price outlook remains uncertain, as the effects of the U.S. monetary policy easing plays out against slowing economic activity. Systemic risks from housing market remain elevated given the high house price overvaluation and rising household debt. Staff analysis suggest that the probability of a price correction has grown over the past few months amid greater downside risks to growth and rising uncertainty.10 A disorderly house price correction could trigger an adverse feedback loop between house prices, debt service ability, and lower consumption, with weakening growth leading to second-round effects on banks’ balance sheets. A recent stress test by the Hong Kong Monetary Authority (HKMA) found that a 50 percent drop in house prices in one year could result in a credit loss of about 2.3 percent of total loan portfolio, about half of the loan losses sustained during the AFC.11

24. The three-pronged approach to containing housing market risks and increasing housing affordability remains valid and should continue. The authorities’ three-pronged approach involves boosting housing supply to match demand, macroprudential measures to limit stability risks, and stamp duties to contain speculative activity and external demand. The authorities have implemented and progressively tightened a mix of macroprudential policies and stamp duties to limit household vulnerabilities and contain risks to the financial sector. While these policies helped build buffers and contain demand, a sustained supply increase remains the most needed course of action to alleviate price pressures and improve affordability.

25. Increasing housing supply is critical to resolving the structural supply-demand imbalance and should be accelerated by increasing land allocation for residential housing.

  • Housing supply increases declined to an annual average of 25,000 units between 2006 and 2015, compared to more than 50,000 units in the previous decade, contributing to strong house price growth. While housing production has increased to around 30,000 units on average over 2015-18 with the implementation of the government’s Long Term Housing Strategy and the Hong Kong 2030+ Strategy, it has been falling short of target by around 30 percent on average. Given the difficulties in increasing land supply, meeting the revised housing supply target may prove challenging.

    uA01fig14

    Housing Production

    (Thousand)

    Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

    Sources: R&VD, C&SD.Note: 1) Public Housing includes both rental and subsidized sale flats completed under Hong Kong Housing Authority (HKHA) and Hong Kong Housing Society (HKHS), and does not include the 322 subsidised sale flats provided by the Urban Renewal Authority on a one-off basis in 2015/16, 2) Private flats from 2003 onwards exclude village houses; 2004 figures include subsidized flats converted to private during the year; 2015 figures include flats completed and designated as subsidised sale flats in the year but sold to the public in the open market at prevailing market prices in 2017.

  • Measures have been taken to increase housing supply. The government has scaled up the public share of new housing supply from 60 to 70 percent for the next 10 years. The authorities have also announced new initiatives to increase the transitional housing by a total of 10,000 units within the next three years. The proposed vacant property tax (“Special Rates” tax) on unsold new private residential units is expected to be passed at the Legislative Council around early 2020.

  • Land supply for residential housing should be increased. The shortage in housing supply was mainly due to increasing difficulties in securing land. The Task Force on Land Supply noted in their December 2018 report that the government’s estimated land shortage in the long run is too conservative and supported building a land reserve by creating more land than the estimated shortfall. The government announced to invoke the Lands Resumption Ordinance to resume privately-owned land to increase supply of housing, aiming to resume 400 hectares in the next five years, compared to 20 hectares resumed in the last five years. Staff welcome the newly announced measures to boost land supply for residential housing, including development of brownfield sites, re-zoning of land, land sharing, and the Lantau Tomorrow Vision, and encourage the authorities to implement these initiatives as planned. It is also urgent to expedite the process for identifying land and building sites, together with streamlining the environmental, transport, and other relevant assessments.

26. The macroprudential stance should stand ready to adjust to address financial stability risks. Policies in place have helped contain vulnerabilities in the banking system, and any changes should be data-dependent with due attention to the emerging risk of regulatory leakages.

  • Since 2009, the authorities have introduced a series of demand-side macroprudential measures, including: (i) ceilings on loan-to-value (LTV) ratio; (ii) caps on debt service-to-income ratio (DSR); and (iii) stress testing of the DSR against interest rate increases (Annex 5). These measures have helped limit banks’ exposure to the housing boom without impeding intermediation of credit to the real economy. For example, the average LTV ratio for newly approved mortgages has declined to 46 percent in September 2019 from 64 percent before the imposition of the measures in 2009. Staff analysis finds that macroprudential policies were effective in containing leverage but played a limited role in containing house price appreciation.12

  • However, amid tight macroprudential regulations for banks, some property developers started offering mortgage financing to borrowers not able to secure credit from banks. While the total amount of such financing remains small compared to regular mortgage financing, it has been growing much faster than banks’ mortgage lending. In response, the authorities introduced supply-side macroprudential measures, such as: (i) financing caps for lending to property developers by authorized financial institutions; and (ii) floors on risk weights for credit exposures to property developers that offer high LTV mortgages.

    Macroprudential Measures: International Comparison 1/

    Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

    Source: IMF’s Annual Macroprudential Policy Survey.1/ For Mainland China, the average LTV limit on first-home buyers is shown. Data as of end-November 2018 for Hong Kong SAR, and lastest data avaialble for the other countries.

  • Despite weak economic activity and some signs of housing market stabilization, adjustments to macroprudential measures should be based on evolving financial stability risks. If housing prices and mortgage lending start to increase rapidly again, further tightening of the macroprudential measures would be warranted, with due attention paid to the emerging risk of regulatory leakages to the non-bank financial sector (e.g., mortgage financing by property developers). International experience suggests that regulators should apply the same macroprudential policies to all mortgage providers to prevent leakages and strengthen effectiveness of the measures.

27. Stamp duties have helped contain house price growth by curbing excess demand, especially by cash buyers and, consequently, helped contain household leverage and systemic risks.

  • The government has introduced three types of stamp duties to curb excess demand by limiting speculative transaction (Annex 5): (i) Special Stamp Duty (SSD) on resale of residential properties within 36 months of purchases; (ii) Buyers’ Stamp Duty (BSD) on purchases by nonresidents; and (iii) New Residential Stamp Duty (NRSD) on all residential property purchases except for primary residences of permanent residents who do not own any other residential property in Hong Kong SAR at the time of purchase.13 Staff analysis indicates that these stamp duties have been effective in curbing house price increases and, consequently, helped contain household leverage and systemic risks.14

  • As NRSD is levied at a higher rate on non-residents than on first-time resident home buyers, it is assessed to be a capital flow management measure and a macroprudential measure (CFM/MPM) under the IMF’s Institutional View on capital flows. Staff continues to assess the NRSD as appropriate because: (i) it was introduced amid a surge of capital flows into the property market; (ii) it was not used to substitute for necessary macroeconomic adjustment; (iii) additional tightening of macroprudential policies would not apply to cash buyers; and (iv) systemic risks remain elevated given the highly overvalued house prices and continued inflows from non-residents. Going forward, staff recommends phasing out and replacing the stamp duties with alternative non-discriminatory macroprudential measures when systemic risks from the non-resident inflow dissipate.

28. The eligibility criteria of the mortgage insurance program (MIP) were adjusted. While the LTV limit without the MIP remains unchanged at 60 percent, the maximum property values eligible for higher LTV ratios with the MIP in respect of completed properties were raised from HKD 4 to 8 million (LTV ratio of 90 percent) for first-time home buyers and from HKD 6 to 10 million (LTV ratio of 80 percent) for all home buyers considering recent appreciation of property prices. While this could also help reduce mortgage financing by non-banks, given that a significant portion of new mortgages are financed with this insurance (about 9 percent for the first nine months of 2019), the authorities should carefully monitor and assess the overall impact of the policy changes on the housing market and household leverage, and stand ready to adjust the policy mix of macroprudential policies and the MIP.

Authorities’ Views

29. The authorities agreed that increasing land supply remained the key to fundamentally resolve the structural imbalance between housing demand and supply. They noted that various measures to boost land supply for residential housing, including the land resumption initiatives announced in the 2019 Policy Address, would significantly increase land supply within the next ten years. The authorities viewed the current macroprudential stance as appropriate and noted that they stood ready to make adjustment based on evolving financial stability risks. While mortgage lending by non-banks (e.g., property developers) remained small and was monitored closely, the authorities were studying international experiences with a view to strengthening regulation if necessary. The authorities noted that the recent MIP adjustment was meant to promote housing affordability for those with stable and sufficient income but without enough funds for down payments, and that the recent softening in the housing market provided an opportunity for the adjustment. They emphasized that this was a targeted scheme with the adjustment confined to completed units and subject to debt-to-income ratio caps.

House Prices at Risk

House Prices-at-Risk methodology quantifies downside risks to house price growth at various horizons. Similar to the growth-at-risk framework, house prices-at-risk uses a statistical technique known as quantile regression and assesses changes in real house prices in response to changes in conditions that affect housing prices over different horizons, including changes in macroprudential policies, funding costs, and capital flows.1

Downside risks to Hong Kong SAR’s house prices appear related to property price valuations, ease of funding, income growth and indebtedness. Based on a study from IMF (2019) comprising 22 advanced economies over the period 1990-2017, five main factors were identified that affect house prices: past price growth, economic growth, credit booms, overvaluation2, and financial conditions. The results suggest that in a scenario where financial conditions tighten, households are loaded up on debt, and house prices are stretched, very large declines in home prices become more likely.

uA01fig16

House Prices at Risk

(Probability density as of 2019Q2)

Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

Sources: Bloomberg, L.P., and IMF staff calculations

Staff analysis indicates that downside risks to house prices in Hong Kong SAR have increased over the past few quarters. Conditional on 2019Q2 economic conditions, the above model predicts that real house prices in Hong Kong SAR could fall by 6¼ percent over the next year with a 5 percent likelihood, which is around the historical average for this downside risk measure for the 22 advanced economies. Over a three-year horizon, house prices-at-risk (with a 5 percent likelihood) would be about 24 percent (cumulatively). As real house prices could fall even more substantially with worsening economic conditions in the second half of 2019, careful monitoring of house price risk is warranted.

uA01fig17

One- and Three-Year House Prices at Risk

Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

Source: IMF Staff calculations based on IMF (2019)
1 Prepared by Sally Chen and Andrea Deghi.2 International Monetary Fund (IMF). 2019. “Downside Risks to House Prices.” Global Financial Stability Report (April 2019), Washington, DC.
Figure 4.
Figure 4.

Worsened Housing Affordability Amid Tight Supply

Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

Sources: CEIC, and IMF staff calculations.Sources: R&VD, C&SD.Note: 1) Public Housing includes both rental and subsidized sale flats completed under Hong Kong Housing Authority (HKHA) and Hong Kong Housing Society (HKHS), and does not include the 322 subsidised sale flats provided by the Urban Renewal Authority on a one-off basis in 2015/16, 2) Private flats from 2003 onwards exclude village houses; 2004 figures include subsidized flats converted to private during the year; 2015 figures include flats completed and designated as subsidised sale flats in the year but sold to the public in the open market at prevailing market prices in 2017.Source: IMF Staff calculations.Sources: Haver Analytics, and IMF staffSources: CEIC, and IMF staff calculations.Sources: IMF staff calculations.

Safeguarding Financial Stability

30. Unanticipated tightening of global financial conditions could pose a risk to the economy due to the elevated level of private sector credit. During the prolonged low interest rate period after the GFC, private non-financial sector debt (both households and non-financial corporates) increased from 184 percent of GDP in 2009 to 295 percent in 2019Q1, increasing vulnerability of the economy and the financial system. However, strong regulatory and supervisory frameworks have helped build large buffers, which should help mitigate the impact of potential negative shocks.

  • Households. Household debt has steadily increased from about 50 percent of GDP in 2007 to 79 percent in 2019Q3, a level higher than the average of advanced economies. While two-thirds of household debt are mortgages, the average LTV ratio and debt services-to-income ratio were low at 46 and 35 percent on new mortgages in July 2019, respectively, due to increasingly tight macroprudential policies. Households also have relatively high gross savings (26 percent of GDP in 2018) and the ratio of deposits to liabilities was 3.2 times in 2018, providing another buffer for household balance sheets.15 However, international experience suggests that rapidly rising household debt could threaten macroeconomic and financial stability in the medium term.16

  • Corporates. Debt-to-GDP ratio of non-financial corporates peaked at 235 percent of GDP in 2018Q1 and has declined to about 222 percent in 2019Q1. However, it remains substantially higher than the average of other advance economies and key financial centers. Less than half of that borrowing was intended for use in Hong Kong SAR, with the remainder being cross-border credit, mostly to Mainland China’s firms. Staff’s analysis suggests that the overall debt-at-risk for listed firms was below 10 percent at end-2018 and it would remain relatively low even with adverse shocks compared to levels registered during the AFC or in other major economies (Annex 6). However, pockets of vulnerability exist in certain corporate sectors, and higher interest rates could increase financing costs, reduce investment and potentially weigh on bank balance sheet growth. Sectoral macroprudential measures (e.g., caps on total sectoral exposures or sectoral risk weights) could be considered to limit concentration risk of financial institutions.

    uA01fig18

    Non-Financial Corporates: Debt at Risk

    (Debt with interest coverage ratio<1 in percent of total debt)

    Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

    Sources: Bloomberg, L.P.; and IMF staff calculations.

31. Financial linkages with Mainland China have deepened in recent years. Thus, a significant growth slowdown or disorderly adjustment of financial system in Mainland China could have large impact on Hong Kong SAR.

  • Hong Kong SAR’s gross claims on onshore Chinese banks have fallen by HKD0.6 trillion from end-2018 to HKD1.7 trillion in August 2019 (59 percent of GDP). The decline reflected weaker loan demand from slowing economic activity in Mainland China as well as reduction in trade financing due to lower trade flows.

  • Total exposure to Mainland non-banks has further increased from HKD 5.6 trillion at end-2018 to HKD 6.1 trillion in June 2019 (210 percent of GDP or 23 percent of total bank assets). But NPL exposures to non-bank Mainland corporates remained low with the NPL ratio of 0.7 percent, lower than that of onshore Chinese banks (1.8 percent).

    uA01fig19

    Banking Sector’s Mainland Non-bank Exposures

    (Percent of total assets)

    Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

    Note: The breakdown is only available from 2013Q4.Source: HKMA, CEIC, and IMF staff calculations.

  • Capital market exposures. Total equity raised by Mainland China’s firms in Hong Kong SAR reached USD 60 billion in 2018, equivalent to 86 percent of total equity fund raised through the stock exchanges. USD bonds issuance amounted to USD 94 billion in 2018 or around % of total offshore issuance by Mainland China’s firms. Net equity fund flows under the Stock Connect Schemes have remained stable, and foreign purchases of onshore renminbi bonds through Bond Connect, China Interbank Bond Market Direct, Qualified Foreign Institutional Investor and RMB Qualified Foreign Institutional Investor continued to expand. The number of mutually recognized funds also continue to increase with cumulative net investment flows of RMB 13 billion.

  • Offshore RMB business. Hong Kong SAR remained the largest offshore renminbi center, with stable renminbi deposit pool at around RMB 644 billion in August 2019. Active trading in renminbi reflected the role of Hong Kong SAR as a platform for raising and investing renminbi funds, and as an intermediary channeling renminbi funds between offshore and onshore markets.

32. Strong regulatory framework and prudential supervision should help maintain financial sector’s resilience and safeguard financial stability. Key recommendations from the 2014 FSAP have been implemented (Annex 7).

  • Key Basel III standards, including minimum capital and liquidity requirements (liquidity coverage ratio and net stable funding ratio requirements for category 1 institutions), capital buffers, disclosure requirements, and leverage ratio requirements have been implemented.

  • The countercyclical capital buffer (CCyB), which had been raised to its maximum rate of 2.5 percent during the credit cycle upswing, was lowered to 2.0 percent in October 2019 to support bank lending. Staff view this as appropriate given that credit growth has declined sharply since the second half of 2018 and remains subdued, but recommend that the authorities stand ready to adjust the CCyB, if needed, as the credit-to-GDP gap and private leverage remain high.

  • Hong Kong SAR has established a resolution regime for financial institutions which is in line with international standards and made a good start on its implementation. The resolution authorities should maintain close coordination with home country authorities of Hong Kong SAR-based subsidiaries or branches of global banks, including in the areas of resolution planning and the roll-out of loss-absorbing capacity requirements.

    uA01fig20

    Primary Gap Indicators for CCyB

    (Percent)

    Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

    Sources: HKMA, and IMF staff calculations.

  • The HKMA updated both its business-as-usual and emergency liquidity facilities, including those for banks in resolution, in August 2019. These revisions aim to reduce stigma and provide more flexibility for banks accessing business-as-usual facilities. A new resolution facility was also introduced.

  • The Securities and Futures Commission (SFC) issued guidelines, including capping total margin lending to clients by brokers for stock purchases at five times of the brokers’ capital since October 2019. Staff view this as a positive move in managing margin lending risk, which is important for safeguarding financial stability, as high margin lending could amplify stock price declines and hence losses for ordinary shareholders when facing adverse shocks. The current regulatory and supervisory framework for securities market and trading systems has also been strengthened.

    uA01fig21

    Margin Lending and the Market

    (Billions of HKD; Index)

    Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

    Sources: Haver Analytics, and IMF staff calculations.

  • The Insurance Authority is on track to implement a risk-based capital regime for insurance companies. Detailed rules for quantitative requirements are expected to be drafted after the third quantitative impact study, which was launched in August 2019.

33. Anti-money laundering/combating the financing of terrorism (AML/CFT). The recently-concluded assessment of the Financial Action Task Force found that Hong Kong SAR has a solid AML/CFT system that is delivering good results. Hong Kong SAR has a strong legal and institutional framework. The authorities generally have a good understanding of the money laundering and terrorist financing risks they are exposed and actively prosecute money laundering from domestic offences. They should enhance prosecution of money laundering involving crimes committed abroad and strengthen supervision of certain non-financial businesses. Implementation of the priority actions identified in the Mutual Evaluation Report on AML/CFT, including with respect to transparency of corporates and trusts, would be crucial in helping to sustain Hong Kong SAR’s reputation as a leading global financial center.

34. In light of the growing role of fintech in the banking sector, the HKMA stepped up the supervision of technology risk management and operational resilience. The HKMA granted eight banking licenses to virtual banking operators, which are expected to become operational between late 2019 and the first half of 2020 (Box 2). At the same time, the HKMA requires virtual banks to meet the same set of supervisory requirements as conventional banks, and to establish appropriate risk management. Given that virtual banks may focus on lending to small borrowers, their underwriting standards and asset quality should be closely monitored by regulators. The authorities aim to achieve a balance between innovation and regulation, including by implementing the Cybersecurity Fortification Initiative. Close collaboration across regulatory agencies should help the Council of Financial Regulators and the Financial Stability Committee identify and close potential regulatory loopholes in a timely manner.

35. Development of green finance and the GBA offers opportunities to maintain Hong Kong SAR’s competitiveness as a global financial center. The three green finance initiatives launched in May 2019, including promoting Green and Sustainable Banking, aim to address the climate change-related risks facing the banking sector and achieve sustainable green financing. The Outline Development Plan for the GBA was released in February, with a plan to develop it into an innovation hub and a competitive industrial system with an enhanced infrastructural connectivity. In coordination with the Mainland, Hong Kong SAR’s authorities have announced new measures to improve cross-border cooperation. These include allowing city’s residents working in high-tech sectors and living in the GBA to pay Hong Kong SAR’s taxes, establishing start-up hubs in each of the Guangdong’s province cities to attract Hong Kong SAR’s entrepreneurs, new rules allowing Hong Kong SAR’s universities obtain funding from Guangdong government. To promote financial integration, the HKMA has worked with the Mainland authorities to allow the use of e-wallets in Hong Kong SAR for cross-border payments, and to streamline the process of opening Mainland bank accounts by Hong Kong SAR’s residents on a pilot basis.

Authorities’ Views

36. The authorities underlined the resilience of the financial sector and ample buffers in financial institutions. They noted that, despite the slowing economy, both the banking sector and capital markets had been functioning smoothly, and capital outflows had been limited. They added that regulatory agencies had strengthened market surveillance through enhanced collaboration to monitor financial sector developments closely and ensure that no regulatory gaps existed. The HKMA noted that it lowered the CCyB in October as a series of quantitative indicators and qualitative information, including the indicative buffer guide (credit-to-GDP gap and residential property price-to-rental gap), suggested that the economic environment had deteriorated significantly since 2019Q2 and there was a need to allow greater flexibility for banks to support businesses which were hit by the economic downturn.

Virtual Banking as a Catalyst to Promote Innovation and Financial Inclusion1

Virtual banking is a new initiative to promote inclusive banking and financial innovation in the banking sector. In 2019, the HKMA granted eight banking licenses to virtual banking operators, including joint-venture of traditional banks with fintech firms, or companies with proven experience and capacity in providing internet-based financial services.2 They are expected to become operational between late 2019 and the first half of 2020. Given their low overhead costs, such as staffing and maintaining bank branches, virtual banks are likely to attract new customers by offering higher deposit rates and innovative online banking services that improve customer experience. Provision of services via electronic channels would improve efficiency and reduce costs to customers like the travelling cost to go to a physical banking service point. This should in particular be beneficial to customers in remote areas. As virtual banks are required not to impose minimum account balance requirements and low balance fee, small depositors could receive basic banking services regardless of their financial background and location.

Traditional banks are already adjusting their business strategy in anticipation of increased competition. Major retail banks, including the three note-issuing banks, removed their minimum balance requirements and the related low-balance fees on banking accounts with small balances since the third quarter of 2019. In recent years, traditional banks have made good progress in expanding the scope of internet e-payments and transactions to provide one-stop online/mobile retail banking services to their customers. With the launch of the Faster Payment System (FPS) by the HKMA, customers can easily make real time P2P payments by entering the recipients’ mobile phone number and email address registered with FPS and linked with a bank or Stored Value Facility (SVF) account.

Introduction of virtual banks may facilitate cross-border payments and money transfer. Virtual bank operators may introduce services to facilitate the cross-border transfer between banking accounts of Hong Kong SAR residents and their accounts opened with Mainland banks which are parents of virtual banks. They may also explore ways to facilitate local citizens to settle payments in Mainland China using their balances with virtual banks in Hong Kong SAR, offering an alternative option of cross-border payments with e-wallet. Given that capital control measures remain in place in Mainland China, cross-border payments and transactions at retail level could be limited to certain amounts or certain areas in Mainland China. Even with such restrictions, this bodes well for enhancing financial infrastructure and linkages within the GBA.

From the regulator’s perspective, cyber security and risk management are key to the success of virtual banking. The HKMA announced that virtual banks are subject to the same supervisory framework as traditional banks. This means virtual banks are required to meet the Basel standards on capital adequacy, liquidity coverage, and risk management. While virtual banks help promote inclusive banking and applications of fintech to serve a wider range of customers, they may also increase competition for deposits and exert downward pressure on overall net interest margins. Given that virtual banks may focus on lending to small borrowers, their underwriting standards and asset quality should be closely monitored by regulators.

1 Prepared by Kevin Chow.2 Virtual banking licenses have been granted to Livi VB Limited, SC Digital Solutions Limited, ZA Bank Limited, Welab Bank Limited, Ant Bank (Hong Kong) Limited, Fusion Bank Limited, Airstar Bank Limited, and Ping An OneConnect Bank (Hong Kong) Limited.
Figure 5.
Figure 5.

Credit Growth Slowing but Debt Remains High

Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

Sources: HKMA, and IMF staff calculations.1/ Non-financial corporatesSources: BIS, and IMF staff calculations.Sources: BIS, and IMF staff calculations.1/ Loans for domestic use include trade financing.Source: HKMA.Sources: BIS, and IMF staff calculation.Sources: BIS, and IMF staff calculation.
Figure 6.
Figure 6.

Financial Linkages with Mainland China

Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

1/ Non-Bank China exposure refers to the sum of Mainland-related lending and other non-bank exposure.Sources: HKMA, and IMF staff calculations.Sources: CEIC, and IMF staff calculations.1/ Investmentthrough Bond Connect, CIBM Direct and QFII/RQFII.Sources: WIND.Sources: Hong Kong SAR Authorities, and CEIC.Note: 2019 refer to January to October figures.Sources: HKEx, and WIND.Sources: HKEx, and Hong Kong SAR Authorities.

37. The authorities noted that fintech and GBA development would boost innovation in the Hong Kong SAR and help cement Hong Kong SAR’s status as a global financial hub. The recent introduction of virtual banks had already prompted its traditional banks to lower banking access barriers. Moreover, the introduction of lower-cost, innovative virtual banking platforms—as well as the recent granting of licenses to virtual insurers—was expected to broaden and enrich the fintech ecosystem, providing impetus for the introduction of other fintech products in the Hong Kong SAR. Meanwhile, the GBA developments would help reinforce the Hong Kong SAR’s global financing role as international investors increasingly make use of Hong Kong SAR to access the onshore capital markets, and businesses including high-tech firms in the area leverage the Hong Kong SAR’s funding platform for expansion.

Preserving an Anchor of Stability

38. The Linked Exchange Rate System anchors the stability of Hong Kong SAR’s highly-open economy with its large and globally integrated financial services industry. After its first introduction in 1983 and some refinements since then to adapt to changing economic environment, the LERS has anchored the city’s monetary and financial stability against external shocks, including the AFC and GFC. The U.S. dollar is still the most commonly used international currency in trade and financial transactions and Hong Kong SAR’s economic cycles and financial conditions are, to a large extent, influenced by the U.S. and the global economic/financial environment. The credibility of the currency board arrangement has been ensured by a transparent set of rules governing the arrangement, ample fiscal and FX reserves, strong financial regulation and supervision, the flexible economy, and a prudent fiscal framework. In this regard, the LERS remains the appropriate arrangement for Hong Kong SAR.

39. The currency board arrangement continues to function well despite increased global financial market volatility. After trading close to the strong side of convertibility undertaking for a prolonged period following the GFC, the HK dollar began to depreciate against the U.S. dollar as ample liquidity in the domestic interbank market slowed the upward adjustment of the Hibor despite interest rate increases by the Federal Reserve. As the HK dollar further depreciated to the weak side of convertibility undertaking, the HKMA conducted FX operations as part of the currency board operations, selling USD2.8 billion in March 2019. As Hibor rates have gradually caught up with Libor rates since then, the spread has narrowed, and the HK dollar has traded within the convertibility undertaking range (Annex 8). The interbank rates have remained stable amid ample liquidity, and market expectations also remain well anchored. The authorities should continue to implement policies aimed at supporting smooth functioning of the LERS. In particular, maintaining the strong track record of public communication on the functioning of the arrangement and the corresponding HKMA’s FX operations as well as enhanced communication on overall FX and money market developments will help ensure credibility of the arrangement.

uA01fig22

HKD/USD Spot and Interest Rate Differentials

(HKD/USD, left scale; basis points, right scale)

Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

Sources: Bloomberg, and IMF staff calculations.

40. Staff assesses that the external position in 2018 was broadly in line with the level implied by medium-term fundamentals and desirable policies (Annex 9). The current account (CA) surplus declined to 4.3 percent of GDP in 2018 from 4.7 percent in 2017, mainly driven by a larger trade deficit in goods on the back of higher oil prices and robust domestic demand. The cyclically adjusted 2018 CA surplus of 4.5 percent is assessed to be in the midpoint of the range of the norm between 3.0 and 6.0 percent of GDP. The real effective exchange rate (REER) is also assessed to be broadly in line with fundamentals, with the estimated REER gap between -5 and 5 percent. The CA surplus is expected to widen to 5.5 percent of GDP in 2019, mainly driven by a large decline in imports amid weakened domestic demand and lower oil prices. Staff’s preliminary assessment for 2019 suggests that the estimated CA in 2019 remains broadly in line with the level implied by medium-term fundamentals and desirable policies, mainly due to larger cyclical adjustment and lower adjustment for measurement issues relative to 2018 (Annex 9).

Authorities’ Views

41. The authorities underscored that the LERS continued to function smoothly and remained the appropriate arrangement for the Hong Kong SAR. They noted that the HKD continued to trade within the convertibility undertaking range notwithstanding the HKMA’s latest FX operation in March, with a modest increase in Hibor rates and a narrowing Hibor-Libor spread. Banks have adapted well to the smaller Aggregate Balance, which gradually shrank during April 2018 to March 2019, and had become more efficient in managing their excess liquidity. Despite occasional increases in demand for HKD funding triggered by seasonal factors and initial public offerings, which caused Hibor to become more volatile than before, there had been no abrupt or major outflow of funds from the HKD or from the banking sector.

Figure 7.
Figure 7.

The Linked Exchange Rate System

Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

Sources: CEIC.Sources: Bloomberg, CEIC.Sources: CEIC.Sources: Bloomberg.Sources: HKMA, and CEIC.Sources: CEIC.

Staff Appraisal

42. Outlook. Economic activity weakened significantly in 2019 and the economy fell into a technical recession in Q3 as a result of trade tensions between the U.S and China, and the social unrest that started this summer. The economy is expected to start recovering next year but, with increased trade barriers and disruptions to global supply chains as a persistent drag on trade-related activities, the pace is expected to be gradual with a negative output gap over the medium term.

43. Risks. Risks are tilted to the downside. Risks arise from further escalation of trade tensions between the U.S. and China, potential restrictions by the U.S. against China in technology and the financial sectors, and a significant slowdown of Mainland China. A deterioration of the sociopolitical situation and delays in addressing structural challenges of insufficient housing supply and high income inequality could further weaken economic activity and negatively affect the city’s competitiveness in the long term. Conversely, an easing of trade tensions between the U.S. and China, and the development of the GBA would improve growth prospects.

44. Buffers. A history of sound macroeconomic and prudential policies has left Hong Kong SAR with significant buffers to address both cyclical and structural challenges. Sizable FX reserves and a large net international investment position provide a strong buffer against external shocks. Enhanced financial regulatory and supervisory frameworks have helped banks build up strong capital and liquidity buffers. Prudent fiscal management under the balanced budget principle has helped accumulate large fiscal reserves.

45. Fiscal policy. Greater countercyclical fiscal support would help the economy navigate through negative shocks while maintaining long-term sustainability. A comprehensive medium-term fiscal package, including additional fiscal stimulus in the current fiscal year targeted to vulnerable households and SMEs, is needed to cope with the cyclical downturn and to address structural challenges of insufficient housing supply and high income inequality. Spending increases of around 1½ percent of GDP per year, relative to the projected baseline, in the areas of targeted transfers, housing/infrastructure, and education/training, would help close the negative output gap over the medium term. If growth falters more than expected, the authorities should provide more near-term fiscal support.

46. Medium-term fiscal challenges. The economy faces challenges of rapid population aging and the corresponding increase in social expenditures in the medium to long term. Thus, the authorities should consider structural measures to ensure fiscal sustainability and greater equity. International benchmarking with other global financial centers suggests that there is room to introduce a VAT, raise excise taxes, increase the top PIT rate and the tax rate under personal assessment. Regular comprehensive expenditure reviews would help ensure that long-term goals of increasing productivity, raising labor force participation, and tackling income inequality are addressed. Effectiveness of budget planning and execution should be improved by reducing reliance on property-related revenues and avoiding systematic under-execution of operating expenditures.

47. Housing policies. The three-pronged approach to containing housing market risks and increasing housing affordability remains appropriate and should continue. Increasing housing supply is critical to resolving the structural supply-demand imbalance and should be accelerated by increasing land allocation for residential housing. The macroprudential stance should stand ready to adjust to address financial stability risks. The NRSD is assessed to be a CFM/MPM under the IMF’s Institutional View on capital flows and should be phased out when systemic risks from the nonresident inflows dissipate. The authorities should carefully monitor the overall impact of the adjustment of the MIP and stand ready to adjust the policy mix of macroprudential policies and the MIP.

48. Financial sector policies. The authorities have strengthened the regulatory and supervisory framework, including the key Basel III standards. Continued efforts are necessary to maintain financial sector resilience and safeguard financial stability amid rising global financial volatility. As private non-financial sector debt remains high, with pockets of vulnerability in certain corporate sectors, sectoral macroprudential measures could be considered to limit concentration risk of financial institutions. In light of the growing role of fintech in the banking sector, the authorities stepped up the supervision of technology risk management and operational resilience. The development of green finance and the GBA offers opportunities to maintain Hong Kong SAR’s competitiveness as a global financial center, and efforts in this regard should continue.

49. Exchange rate regime and external position. The LERS anchors the stability of Hong Kong SAR’s highly-open economy with its large and globally integrated financial services industry. The credibility of the currency board arrangement has been bolstered by a set of transparent rules governing the arrangement, ample fiscal and FX reserves, strong financial regulation and supervision, the flexible economy, and a prudent fiscal framework. Thus, the LERS remains the appropriate arrangement for Hong Kong SAR. The external position remains broadly in line with medium-term fundamentals and desirable policy settings.

50. 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, 2015-24

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Sources: BIS,CEIC; HKSAR Census and Statistics Department; and IMF staff estimates.

Based on loans for use in Hong Kong SAR, including trade financing.

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

Table 2.

Hong Kong SAR: Balance of Payments, 2015-24

article image
Sources: CEIC and HKSAR Census and Statistics Department.

Sign convention as per BPM5: Negative = net lending (net outflow); Positive = net borrowing (net inflow).

Table 3.

Hong Kong SAR: Consolidated Government Account, 2015-2024 1/

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Sources: CEIC; and IMF staff estimates.

Using medium-range forecast as a starting point to make staff adjustments. Fiscal year begins April 1.

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

Balance excluding investment income and interest expenditure.

Change in structural primary balance adjusted for one-off factors, non-inflationary output and house price gaps. A positive value corresponds to an expansionary fiscal stance.

Bond Fund comprises of securities issued under the Government Bond Fund Programme

Negative sign indicates net assets.

Table 4.

Hong Kong SAR: Monetary Survey, 2015-20

article image
Sources: IMF, International Financial Statistics; Haver Analytics, and staff calculation.

Domestic credit measures loans for use in Hong Kong SAR (excluding trade financing).

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

From 2016 onwards, data on net foreign assets adopted IFS new presentation.

Table 5.

Hong Kong SAR: Vulnerability Indicators, 2015-19

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Sources: CEIC; Hong Kong SAR authorities; Bank for International Settlements; Bloomberg; IFS; and IMF staff estimates.

Composition of liquid assets and short term liabilities changed in January 2015 after the implementation of a new liquidity regime in

accordance with the Basel III framework.

Broad Money refers to M2. ▯

Annex I. Impact of Trade Tensions on the Economy of Hong Kong SAR1

1. The economy of Hong Kong SAR is highly dependent on external trade and trade-related services. Hong Kong SAR is one of the most open economies in the world, with trade amounting to almost 360 percent of GDP (not including 167 percent of GDP in offshore trade). The city is a major trading and processing hub for Mainland China and other countries linked through the global value chains with more than 95 percent of goods passing through its ports produced elsewhere. Instead, domestic value added comes from the trade and logistics sectors that process re-exports and offshore trade. Trade-related services contribute around 20 percent to employment and GDP.

2. Mainland China and the U.S. are the city’s two largest trading partners, although their relative importance has changed over time. Accession of Mainland China into the WTO and its subsequent investment in various ports along the Mainland’s eastern seaboard has gradually led to a decline in share of re-exports between Mainland China and the U.S. routed through Hong Kong SAR. However, expansion of a high-tech manufacturing base in the Guangdong province of Mainland China that neighbors Hong Kong SAR contributed to closer trade links between the city and the Mainland. Hong Kong SAR’s exposure to Mainland China’s final demand is second only to Taiwan Province of China.2

3. Trade tensions between China and the U.S. have adversely impacted Hong Kong SAR. Since July 2018, the U.S. and the Mainland authorities have imposed several rounds of tariffs on each other’s exports. As a result, by 2020 the average tariffs are expected to raise from below 2 percent to around 21 percent on Mainland China’s exports to the U.S., and from around 3.5 percent to 15 percent on U.S. exports to Mainland China. Initially, re-exports through Hong Kong SAR held up, likely due to pre-orders by importers. However, as the trade conflict showed no signs of abating and global sentiment began to worsen, from November 2018, re-exports began to decline at around 4.9 percent (y/y) on average. While only about 7.5 percent of Hong Kong SAR’s re-exports was directly affected by the four rounds of tariffs implemented by September 2019, other re-exports were falling as well, likely because producers scaled back purchases of intermediate goods embedded in products covered by tariffs. If all goods re-exported between Mainland China and the U.S. were subject to tariffs as announced by the end of 2019, the share of Hong Kong SAR’s reexports directly affected by these tariffs would increase to around 9 percent. Staff analysis based on a gravity model confirms the negative impact of additional tariffs between the U.S. and China on export growth of Hong Kong SAR.

4. Trade-related industries have been hit hard by the trade tensions. Employment in the trade-related industries has declined by 14.2 percent (y/y) in 2019Q3 while business receipts in the import-export sector fell by 6 percent in Q2 2019 (y/y). The seasonally adjusted overall unemployment rate edged up, but remained low at 3.1 percent in August-October 2019, due to still-tight labor market conditions.

Figure 1.
Figure 1.

Economy Dependent on Trade

Citation: IMF Staff Country Reports 2019, 394; 10.5089/9781513524627.002.A001

Position on the vertical axis indicates share of domestic value added, size of the bubble indicates share in total exports. Green color denotes services. Sources: OECD TiVA database; and IMF staff calculationsSources: CEIC; and Fund staff calculations1/ Refers to U.S. tariffs on Mainland China’s goods announced on June 15, 2018, August 7, 2018, September 17, 2018, and August 23, 2019.Sources: C&SD; and IMF staff calculationsSources: CEIC; and Fund staff calculationsSources: OECD TiVA databas; WED; and IMF staff calculations.1/ Refers to Mainland China’s tariffs on U.S. goods announced on June 16, 2018, August 8, 2018, September 18, 2018, and August 23, 2019.Sources: C&SD; and IMF staff calculations

Annex II. Risk Assessment Matrix1

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