Dora M. Iakova

The past two decades have been a period of significant structural changes and rapid growth for the Hong Kong Special Administrative Region (HKSAR), driven by increasing economic integration with mainland China. The integration process has accelerated since the economy returned to Chinese sovereignty on July 1, 1997. HKSAR was hit hard by contagion and underwent a painful economic adjustment during the Asian crisis. Before sustained growth could take hold, the global slowdown in 2001 plunged the highly open economy into another recession. This article provides an overview of IMF staff research addressing both the cyclical and structural adjustment challenges facing HKSAR.

Hong Kong SAR follows rules-based macroeconomic policies, the centerpiece of which is a currency board system. The link has underpinned confidence in HKSAR as a stable financial center, and, historically, the economy has adjusted well to external shocks. Deepening economic linkages with mainland China have recently prompted some observers to ask whether a link to the U.S. dollar remains appropriate, and whether HKSAR and mainland China may constitute an optimal currency area (OCA). Liang (1999) bases her study of this question on Robert Mundell’s argument that with limited factor mobility and short-run rigidities in wages and prices, regions constitute an OCA if they experience common real disturbances.¹ Liang argues that HKSAR and mainland China do not satisfy the conditions for currency integration because their real exchange rates have been evolving on divergent time paths, at least until now. Wei and others (2000) simulate the potential effect of a devaluation of the Chinese renminbi on the stability of the Hong Kong dollar.² They find that trade balance effects will be negligible because the benefit from increased re-exports will offset the loss from a decline in direct exports, but the initial market reaction could be negative. Ma, Meredith, and Yiu (2002) construct a model of the currency board to study its stochastic properties under different shocks.³

A sound fiscal policy has been another pillar of the rules-based system. Conservative fiscal management in the past has resulted in the accumulation of large fiscal reserves. However, since the Asian crisis, there has been a sharp deterioration in the fiscal balances, which is partly structural in nature. Gobat (2001) studies the long-term prospects for public finances and finds that, with unchanged policies, there may be a sustained long-run deterioration in the fiscal position stemming from demographic pressures and a narrowing of the tax base.⁴ Therefore, an early start on consolidation would be advisable.

The constraints of the currency board require rapid adjustment of goods and factor prices in response to economic shocks. Lai, Ha, and Leung (2002) find that prices and labor costs adjust more readily in HKSAR than in Argentina.⁵ Starting from the hypothesis that more competitive markets facilitate price adjustment, Zitzewitz (2000) compares profit margins in different sectors, and finds that HKSAR is as competitive as a typical OECD economy.⁶ However, possible imperfect competition in some sectors does not prevent efficient price adjustment—he estimates that markups in HKSAR tend to be more procyclical than in other advanced economies.

HKSAR’s labor market is considered among the most flexible in the world. The last two decades witnessed rapid structural changes as manufacturing was gradually outsourced to mainland China, and the share of the service sector increased substantially. Strum (2000) attributes the efficient adjustment of the labor market to these shifts to lack of government intervention, limited means-tested social support for the unemployed, and low unionization.⁷ However, the rapid labor-market adjustment has not been costless. Iakova (2002) finds that labor earnings inequality has risen sharply over the past two decades and is among the highest in the world.⁸ While real wages increased for most workers during this period, the biggest “winners” have been those with higher education, suggesting that policies to address the growing income disparity should be targeted at increasing the skill levels of the labor force.

Property price developments greatly influence investment and consumption decisions in HKSAR—value added in the property sector accounts for a quarter of the economy’s GDP. The mid-1990s witnessed a rapid increase in property prices, fueled by sustained economic growth and low real interest rates. Kalra, Mihaljek, and Duenwald (2000) find evidence that a property-price bubble had developed by 1997.⁹ Indeed, property prices declined sharply in the wake of the Asian crisis and have drifted downward since then.

The collapse of the property-price bubble, and the need to adjust product and factor prices in response to the cyclical downturns, have led to a persistent deflation, which is now in its fourth year. Schellekens (2002) finds that variations in unemployment and credit growth explain the major part of deflation, while a narrowing price differential with mainland China accounts for only a small fraction of the pressure on prices.¹⁰ Schellekens argues that the persistence of deflation is partly explained by the amplification of the initial price adjustment through large balance-sheet and wealth effects.

In 1998, the domestic currency came under several waves of intense speculative pressure while, at the same time, the stock market plummeted. The authorities reacted by intervening in the stock market, arguing that the markets had been manipulated. Breuer (2001) uses currency-option prices to extract market expectations of future exchange rate movements around the periods of heavy speculation in August 1998.¹¹ He estimates that market participants attached a very high probability to an imminent collapse of the link, and the controversial government intervention was very successful in allaying devaluation concerns.

The Asian crisis brought major speculative attacks, interest rate hikes, large capital outflows, a sudden burst of the property-price bubble, and sharp output contraction. However, HKSAR banks remained sound and the deterioration of their portfolios was much less pronounced than in other crisis countries. Iakova (2001) finds that the stability of the banking system is supported by prudent bank management, low corporate leverage, a strong legal system, strong banking regulations, competent supervision, a lack of government intervention in lending decisions, good macroeconomic policies, and the stable exchange rate.¹²

Given the importance of continuous development of the financial sector for maintaining HKSAR’s competitive advantage, IMF research has examined different aspects of financial market evolution. Lee (2001) and Mendis (2002) find that the most important source of corporate financing is bank credit, followed by equity issuance.¹³ Jiang (2001, 2002) and Lee establish that a small domestic investor base, cumbersome listing procedures, and tax distortions are among the reasons for the relative underdevelopment of the bond market and discuss policy changes that could make the bond market more attractive.¹⁴

The long-term growth outlook for the economy depends on how it meets the challenges of further integration with mainland China. Breuer (2000) evaluates the likely impact on HKSAR of China’s membership in the World Trade Organization. He finds that trade creation will likely exceed trade diversion in the medium term.¹⁵ Wang (2002) emphasizes that in the long term, HKSAR’s role as a trade entrepôt is likely to diminish, and substantial restructuring will be required to maintain HKSAR’s competitiveness.¹⁶