Public Information Notice No. 00/15

Public Information Notice: IMF Concludes Article IV Consultation with People's Republic of China in Respect of the Hong Kong Special Administrative Region

March 6, 2000

On February 18, 2000, the Executive Board concluded the Article IV consultation with People's Republic of China in Respect of the Hong Kong Special Administrative Region.¹

Background

The Asian crisis hit the Hong Kong SAR economy hard in 1998, despite its generally strong fundamentals. External demand fell sharply, and the depreciation of the yen and the crisis country currencies led to a sharp real appreciation in the Hong Kong dollar. Driven by rising risk premia, real interest rates rose markedly, and asset prices dropped by 40-50 percent. As confidence ebbed, market pressures intensified, culminating in a major speculative attack in August 1998. Fearing erosion of domestic confidence in the economy, and concerned that markets were being manipulated, the authorities intervened in the stock markets. Aided by an improvement in the external environment, the intervention succeeded in calming markets.

In response to the crisis, the authorities eased fiscal policy—within the framework of a medium plan to restore budget balance, and significantly strengthened job creation and retraining efforts. Adjustment under the linked exchange rate system has proceeded generally rapidly, reflected in the sharp falls in asset prices and—from late 1998—the emergence of consumer price deflation. As a result, and aided by the appreciation of the yen and crisis-country currencies, by late 1999 the real effective exchange rate of the Hong Kong dollar had returned to its pre-crisis level. In the labor market, adjustment in larger enterprises has taken place primarily through employment shedding; while nominal payroll per employee has slowed sharply, it has continued to rise in real terms.

GDP continued to fall (in seasonally adjusted terms) through the end of 1998. Clear signs of recovery emerged in the first half of 1999, helped by the fast pace of economic growth in the Mainland of China and the sharp rebound in the earlier crisis-hit economies in the region. Financial and asset markets rose as external confidence returned, and from the second quarter, real GDP picked up sharply, driven by a rebound in consumption in response to rising wealth and consumer confidence; rising reexport trade with the Mainland; and latterly higher public investment in housing and infrastructure projects. As yet, however, private investment—and domestic credit demand—remains weak, reflecting corporates' efforts to reduce gearing ratios; continued caution by banks, and still high but declining short-term real interest rates.

Despite the inevitable pressures arising from declining output and the regional crisis, the financial position of the banking system remains generally strong. Non performing loans stabilized at about 10 percent of assets in the third quarter of 1999, while the capital adequacy ratio of the banking system increased to 20 percent of risk weighted capital. In late November, the authorities successfully launched the Tracker Fund, a listed investment vehicle linked to the Hang Seng Index, as a first step towards substantially reducing the equities they had bought in the August 1998 intervention.

Executive Board Assessment

Executive Directors observed that, despite its very strong fundamentals, Hong Kong SAR had undergone a painful period of recession and adjustment during the Asian crisis, including periods of intense pressure on the Hong Kong dollar. In the face of these difficulties, the authorities successfully defended and even strengthened the linked exchange rate. A supportive and timely fiscal policy, combined with job creation and retraining programs helped mitigate the impact on the domestic economy—although, given Hong Kong SAR's small size and openness, this was inevitably substantial. Directors attributed this successful turnaround of the economy to the authorities' skillful economic management, the credibility of policy-making in Hong Kong SAR, and the economy's flexibility and resilience.

Directors observed that the adjustment in prices necessitated under the linked exchange rate system was generally well under way, and—following a significant appreciation in the early part of the Asian crisis—the real effective exchange rate had returned to its pre-crisis level. However, some Directors expressed some concern that adjustment in labor costs was lagging, especially in the face of rising unemployment. Aided by the pickup in the regional economy, Hong Kong SAR was now experiencing a solid economic recovery. While the recovery was not yet broadly based, and much would depend on external developments, as well as the speed with which the remaining domestic price adjustment was completed and corporate profitability improved, Directors believed that the outlook for 2000 and beyond was generally positive.

Directors continued to strongly support the linked exchange rate system, which was underpinned by Hong Kong SAR's strong fundamentals, flexible economy, and resilient banking system, and was the lynchpin of the rules-based approach to economic policymaking. In this respect, they noted that the seven technical measures introduced in the fall of 1998 had worked well to date and the gradual shift of the convertibility undertaking rate to the linked rate was proceeding smoothly.

Given that the recovery was not yet broadly based, Directors considered that for the fiscal year 2000 a structural tightening of the fiscal position should be avoided. Allowing for the cyclical improvement in revenues, and the privatization of the Mass Transit Railway Corporation, the target of a small deficit set out in last year's medium-term forecast should nonetheless be achievable. Over the medium term, rising social expenditures would likely require increases in fees and charges; in light of the structural changes in the economy, which could alter the existing tax base, there was also a case to review the revenue structure to determine if further revenue diversification was required.

Directors observed that, while unemployment had stabilized, it remained high and might decline only gradually during 2000. They therefore strongly supported the authorities' efforts to further strengthen employment and training programs, especially for the youth unemployed.

Directors observed that the banking system had demonstrated its strength and resilience to external shocks over the past year, aided by the high quality of the regulatory and supervisory framework. Directors welcomed the upcoming reforms of the banking system, noting that these would improve efficiency and competitiveness. However, along with the anticipated technological changes, these reforms could exert increased pressures on a number of smaller banks. In this respect, they noted that the recent publication of a clear reform timetable by the authorities provided an important window of opportunity for the necessary consolidation in the banking sector to take place.

Directors noted that the intervention in the stock market in August 1998, aided by the improvement in the external situation, had stabilized financial markets, and that the adverse effects from this action had been less than anticipated. In this connection, they welcomed the successful launch of the Tracker Fund, which was a very good start toward divesting the equity holdings acquired during the intervention. They encouraged the authorities to continue this process in an orderly and transparent fashion. They also welcomed the authorities' initiatives to strengthen securities markets and legislation, which would be central to help ensure that Hong Kong SAR remained a world class financial center in an increasingly competitive global environment.

Directors observed that the Hong Kong SAR economy would likely undergo major structural changes in coming years, due both to technological advances in key service industries and the evolving relationship with the Mainland, including as a result of WTO entry. Hong Kong SAR had in the past adapted to such changes swiftly and flexibly, aided by its well-deserved reputation as one of the most transparent, well-governed, and least interventionist places in the world to do business. Preserving Hong Kong SAR's economic performance in an increasingly competitive external environment will require a continuing effort to strengthen the regulatory framework, upgrade skills, and foster technological innovation. In this connection, Directors believed that the policy of positive nonintervention supported by government efforts to strengthen infrastructure, education, and the environment remained appropriate. They underscored, however, that domestic competition issues continued to merit close attention, particularly as the economy became more oriented toward services and because there were no substantive penalties in certain unregulated sectors, if firms engaged in anti-competitive behavior. In this regard, several Directors urged the authorities to consider the establishment of a formal Competition Law.