I Overview
Hong Liang and Eswar Prasad
Hong Kong, Special Administrative Region (Hong Kong SAR) enjoyed impressive
economic growth, high levels of income, and close-to-full employment
for years until the Asian crisis of 1997 brought about the most severe
recession in a generation. Following this, the economy rebounded in 1999
and 2000. Before sustained growth could take hold, however, the global
slowdown in 2001 brought on another recession. After four quarters of
negative or near-zero growth, the economy of Hong Kong SAR began to show
signs of a pickup in the second half of 2002, although domestic demand
remained weak. The outbreak of Severe Acute Respiratory Syndrome (SARS)
disrupted economic activity once again in the second quarter of 2003.
With the rapid containment of SARS, however, there are good prospects
of a rebound in activity, supported by strengthening domestic demand
and rising exports.
Hong Kong SAR's efforts to cope with the cyclical shocks to its economy
have complicated its efforts to undertake the structural adjustments
necessitated by its growing integration with the mainland of the People's
Republic of China (hereinafter referred to as the mainland). As a small,
open economy, Hong Kong SAR's economic performance has been closely tied
to changes in the world economy and especially in neighboring countries.
By successfully seizing the opportunities provided by the opening up
of the mainland, Hong Kong SAR was able to establish itself as the bridge
between the mainland and the rest of the world. Since the 1980s, the
economic links between Hong Kong SAR and the mainland have expanded rapidly,
with Hong Kong SAR becoming the most important trade and international
fund-raising center for the mainland. At the same time, Hong Kong SAR
has successfully transformed itself into a service-oriented economy as
its manufacturing sector has largely relocated to the mainland. Looking
forward, rapid economic growth and increased trade between the mainland
and the rest of the world should benefit Hong Kong SAR and support the
vibrancy of its financial services, logistics, and tourism sectors.
Increasing integration with the mainland has, however, proven to be
a double-edged sword, since it has promoted price convergence, exerting
downward pressures on goods and factor prices in Hong Kong SAR under
the linked exchange rate system. Moreover, the rapid improvement in its
neighbors' competitiveness has posed increasing challenges to Hong Kong
SAR's traditional advantages and position: its role as a traditional
trade intermediary is likely to diminish further as the mainland's trade
restrictions are lifted; direct trade relations are established between
Taiwan Province of China and the mainland; and more foreign businesses
are set up directly on the mainland. Section II, "Economic Integration
Between Hong Kong SAR and Mainland China," provides an overview of various
dimensions of the economic and financial integration between Hong Kong
SAR and the mainland, and the outlook for the further integration of
these economies. The analysis points to the significant challenges associated
with the process of structural adjustment and the policy implications
for Hong Kong SAR. To meet these challenges, Hong Kong SAR's traditional
strengths—flexible markets and strong legal and institutional frameworks—will
need to be complemented by sound macroeconomic and structural policies.
The recent economic downturn has exposed significant weaknesses in the
fiscal structure of Hong Kong SAR. Its revenue system has a narrow base,
with a heavy reliance on asset-related revenues, derived mainly from
proceeds of land sales and investment incomes. The bursting of the property-price
bubble after 1997, coupled with a set of reductions in various fees and
charges intended to cushion the impact of the economic slowdown, has
driven down the ratio of government revenue to GDP from around 21 percent
in fiscal year (FY) 1997 to 14 percent in FY 2002. Meanwhile, government
expenditure has grown rapidly in real terms, in part because major spending
components, such as civil service salaries and welfare benefits, have
not been adjusted for recent deflation. As a result, the consolidated
fiscal position has deteriorated gradually since 1998 and substantial
structural deficits have emerged. Section III, "Fiscal Outlook and Policy
Options," examines how revenues and expenditures might evolve in the
medium term in Hong Kong SAR under different policy scenarios and discusses
alternative policy options to restore fiscal balance. It argues that
the medium-term fiscal consolidation program under way in Hong Kong SAR
has to strike a balance between the need to provide comprehensive social
services to its citizens and its tradition of limiting the size and role
of the government in economic and social affairs.
Developments in the property sector have important implications for
the overall economy in Hong Kong SAR. Property prices have been declining
steadily since 1997—the peak of the property-price bubble—owing
to the weak performance of Hong Kong SAR's economy; overbuilding; and,
probably, increased integration with the mainland. Section IV, "Determinants
of, and Prospects for, Property Prices," discusses recent developments
in the real estate sector and their macroeconomic impact on the economy,
and presents estimates and forecasts of fundamental prices in the housing
sector. It argues that although property prices now appear to be at levels
consistent with demand-side fundamentals, further weakness in housing
prices cannot be ruled out if the economy remains weak.
Significant price differentials between Hong Kong SAR and neighboring
mainland cities such as Shenzhen and Guangdong, along with the bursting
of the property bubble, have been gradually translated into downward
pressures on Hong Kong SAR's domestic price level. Deflation has now
entered into its fifth successive year. Section V, "Deflation Dynamics," presents
a comprehensive econometric analysis of deflation in Hong Kong SAR. It
decomposes the aggregate price level into transitory and permanent components,
and identifies the nature and origin of the shocks that affect these
two components. The analysis shows that although cyclical factors may
have triggered the process of deflation, their effects have been perpetuated
by the negative wealth and balance-sheet effects in the corporate and
household sectors. In addition, price convergence with the mainland has
become more important over time in explaining the deflationary process.
Another major challenge posed by increasing integration with the mainland
relates to the sectoral reallocation of labor and its impact on income
distribution. Until the mid-1990s, Hong Kong SAR's economy was often
at or near full employment. This supported strong wage growth, with pay
for skilled workers rising particularly quickly. A shift toward higher-value-added
services, driven by increased outsourcing of manufacturing and low-end
services to the mainland, has contributed to rising structural unemployment.
Section VI, "Trends in Wage Inequality, 1981-2001," examines the
evolution of cross-sectional wage inequality in Hong Kong SAR and the
impact of structural shifts on wage inequality. The analysis suggests
that the most effective policy for addressing rising unemployment and
income inequality would be to upgrade the skill level of the labor force.
Over the past two decades, Hong Kong SAR has developed into an important
global financial center, spurring the growth of the domestic economy.
Financial markets—in particular, the banking system—are well
developed, liquid, and efficient. The regulatory infrastructure and supervisory
framework have been upgraded continuously to maintain international competitiveness.
Section VII, "Financial Market Developments," presents an overview of
recent developments in Hong Kong SAR, highlighting new initiatives, such
as the introduction of the Securities and Futures Ordinance and a deposit-protection
scheme, that are intended to further strengthen the stability of the
financial system.
All of the policy issues discussed in this paper are set against the
background of the linked exchange rate system (LERS). The LERS, which
has been in place since 1983, has served Hong Kong SAR well over the
years and remains robust. It has, however, limited the macroeconomic
tools available to the government to counter the effects of cyclical
shocks and structural shifts. As integration with the mainland deepens
and regional competitive pressures continue to intensify, further adjustments
in domestic goods and factor prices may be needed. Therefore, prudent
fiscal policies, a sound financial system, and improved flexibility of
goods and factor markets will be crucial to ensuring the long-term sustainability
of the LERS and to enhancing its contributions to economic growth.
Hong Kong SAR has already faced and overcome many challenges. By turning
hardship into opportunity, it has built a world-class economy and remains
a prominent international financial center. Looking ahead, economic restructuring
will—even though it may be painful in the short run—create
plenty of new opportunities and a broader scope for development. If it
continues to implement a disciplined approach to policymaking that harnesses
its fundamental strengths, Hong Kong SAR has a bright and promising future. |
