People’s Republic of China—Hong Kong Special Administrative Region, 2008 Article IV Consultation Discussions: Preliminary Conclusions of the Mission

October 28, 2008

Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

October 28, 2008

The 2008 Article IV consultation discussions took place against the backdrop of a global financial crisis of exceptional proportions. Discussions focused on the implications of unfolding global events for Hong Kong SAR and on the appropriate policy response to these developments. The mission also had an opportunity for a productive dialogue on issues that have longer-term importance for the local economy, including the consequences of prospective reforms to the healthcare system, future minimum wage legislation, and the ongoing economic integration with the Pearl River Delta.

The mission would like to express its sincere appreciation to the Hong Kong SAR authorities for their gracious hospitality and for the frank and candid nature of the discussions.

1. Context. Hong Kong's economy has undergone a remarkable transformation over the past decades. Manufacturing operations have shifted to the Mainland and Hong Kong SAR has leveraged its strong institutional framework, flexible labor and product markets, and status as a global financial center to emerge as a dynamic, services-based economy with an enviable record of growth over the past several years. However, that transformation is a double-edged sword. Hong Kong SAR's high degree of integration with international goods and capital markets also means it is inextricably exposed to downturns in world trade and the global financial system. Both of these downside risks have now materialized. It is, therefore, no surprise that economic activity is slowing. Going forward, adroit economic management and the enduring innovativeness and diligence of the Hong Kong people will be needed to chart Hong Kong's safe course through this increasingly challenging environment.

2. Macroeconomic Outlook. Our assessment is that growth should fall noticeably in the coming months, to around 2 percent next year, with significant downside risks attached to this forecast. The slowdown will also be reflected in labor markets and we expect unemployment will rise across the course of the next year or more. The easing of domestic demand and declining food and fuel prices should mean that consumer price inflation will fall below 3 percent next year. Over the medium term, we continue to believe that an underlying growth rate of around 5 percent is feasible, although much will depend on the trajectory of economic and financial integration with the Mainland and how those interdependencies are managed.

3. Risks. Clearly, the foremost macroeconomic risk is the turbulence that is still unfolding in international financial markets. This risk is two-fold. First there is the possibility of direct contagion to local financial markets. While asset prices have adjusted downwards, the domestic financial system has proved itself resilient to the spillovers from events emanating from the industrial economies. Nevertheless, in the current environment, complacency would be a mistake and we are encouraged that the authorities are watching very closely for signs of contagion risk and are prepared to act expeditiously should global market volatility further disrupt the workings of the Hong Kong financial system. Second, the disruption in international financial markets could precipitate a more profound downturn in the global economy. This will have an important negative impact on Hong Kong's immediate growth prospects, given the reliance on trade and related services and the spillover effects for the rest of the economy.

Financial Sector

4. Banking sector. All indicators suggest that Hong Kong's banking system remains sound, very liquid and well capitalized. Risk premiums for many of Hong Kong's banks have risen with global risk aversion, as evidenced by higher credit default swap rates. Nonetheless, increases have been modest in comparison with other global financial institutions. While local entities have largely avoided the securitized products that have been at the epicenter of the global crisis, bank credit portfolios will probably worsen in the coming months and credit growth will slow sharply. Hong Kong's banks have, however, managed risk prudently, provisioned for losses, and they are well positioned to manage a worsening in credit quality. It is encouraging that the authorities are fully prepared to act decisively if necessary. In this regard, the announcement of a time-bound, blanket deposit guarantee and a contingent facility, that can be activated in the event there is a need to provide capital to Hong Kong banks, was fully warranted in the current extraordinary global circumstances.

5. Interbank markets. As elsewhere in the world, Hong Kong's interbank markets have faced heightened stress since late September when the global financial crisis entered a discernibly new phase. In large part, this reflects conditions in offshore, (particularly U.S.) markets, an increase in global risk aversion, and concern over counterparty risk. The HKMA's actions to increase the attractiveness and flexibility of its facilities to provide liquidity support under extraordinary circumstances were fully appropriate. Along with steps taken in other jurisdictions, these measures have begun to restore the workings of local interbank markets, although term lending has yet to normalize. Nevertheless, the scope for the authorities to affect Hong Kong dollar interest rates remains limited and interbank rates will continue to be largely determined by external conditions.

6. Exchange rate regime. The mission continues to support the Linked Exchange Rate System. It is a simple, transparent exchange rate arrangement that has, over the past 25 years, proved to be an anchor of monetary and financial stability in Hong Kong SAR.

7. Stock markets. Equities have been the most visible casualty of the global reassessment of risk and the repricing of assets. The Hang Seng index has lost over two-thirds of its value since the peak in October 2007 while Hong Kong listed shares of Mainland companies have fallen by even more. Equity prices are now back to levels reached in May 2004. This equity market decline will undoubtedly prove to be a drag on economic activity both as a result of the direct wealth effect and also a more generalized impact on household and business sentiment.

8. Property. Over the past few years, the property market has risen in line with the strong local economy, increasing disposable incomes, rising construction costs, and the availability of financing. However, indicators suggest that property prices have moved onto a downward track, in line with weakening fundamentals. This will add to the downdraft on economic growth and should be monitored carefully since a worsening property market may well feed back onto the financial system and the real economy.

9. Financial stability. Hong Kong SAR has experienced a difficult adjustment in asset prices. Nevertheless, the financial system has performed well, without significant market dislocation. The authorities have taken various steps to bolster stability and these have been carefully considered and calibrated to the situation at hand. The financial system's remarkable resilience is no accident. Investments have been steadily made over the past several years to establish a more robust system of financial supervision and regulation and a sophisticated financial infrastructure. The ability of the regulatory authorities to step up their supervisory activities in recent months has been impressive. In addition, the substantial attention to contingency planning and the authorities' continued willingness to look critically at their current system and explore areas for further improvement are now fully paying off. On a real-time basis, the regulatory authorities are proactively enhancing their supervisory mechanisms to assess liquidity and other risks and new lessons are being drawn from recent events in both Hong Kong and other jurisdictions.

Fiscal Policy

10. The 2008/09 Budget. Fiscal policy is the principal demand management tool available to the government. Given the clear downside risks and Hong Kong's healthy fiscal position, fiscal stimulus is warranted to guard against a more dramatic economic slowdown. In addition, there is an important role for public action to protect vulnerable groups from the consequences of high food and fuel prices and the effects of the coming downturn. The 2008/09 Budget and the supplementary package of measures introduced in July accomplish both of these goals. The emphasis on improving infrastructure to better integrate Hong Kong SAR with the Mainland economy will provide long-term benefits. Similarly, investing in human capital through free secondary school education and support to university level research will help meet the future demand for skills. Finally, the provision of timely and targeted social assistance to the elderly and lower income groups is welcome, particularly given the elevated costs of basic foodstuffs.

11. Fiscal policy going forward. Continued fiscal stimulus will be needed in the upcoming 2009/10 Budget and the government should target budget balance or a small fiscal deficit for the year as a whole. Our sense is the one-off measures of the past couple of years have run their course and they should be allowed to expire. Instead, the time has come for a more fundamental evaluation of the revenue needs of the government, the appropriate tax structure, and the likely fiscal outlays over the medium-term. Such a medium-term perspective would, we believe, lead to the conclusion that the stimulus in the next budget should be provided through an acceleration of the much needed infrastructure investments that are already being planned and by contemplating a permanent reduction in direct tax rates. Further adjustments to the tax structure would likely need to be considered in the coming years. The government will also have to make difficult social choices on how it will handle the fiscal implications of an aging population, notably in healthcare (see below). Finally, forecasting future fiscal outturns is a difficult exercise in Hong Kong SAR due to the volatile nature of budget revenues and uncertain speed of the execution of budget spending plans. As a result, and particularly in the current circumstances, the staff see merit in the government beginning to provide updated fiscal forecasts during the course of the year as a mechanism for guiding expectations, helping to increase the effectiveness of fiscal policy.

12. Healthcare reform. The authorities have rightly recognized that continuing indefinitely with the current healthcare system is simply not sustainable. Doing so will result in a worsening quality of care that will be particularly incident on lower income groups and on the older members of Hong Kong's population. In addition, without change, healthcare will place an increasing burden on public finances, crowding out needed spending or necessitating a large increase in the tax burden. The government's consultative paper comprehensively lays out the various options that ought to be considered. The mission agrees that any reform would need to tackle three broad areas: to ensure cost containment and efficient provision of services; to discourage extraneous spending through some form of user fees or other price-based measures; and to revise the healthcare financing model such that a much larger share of expenditure, particularly for in-patient care, is picked up by the private sector. From a macroeconomic perspective, our belief is that some form of mandatory scheme will be required. Voluntary schemes run the risk of under-provision for future health costs and greater volatility in consumption, particularly for lower income groups. In addition, an integral part of any reform should be to maintain public support for those with chronic illnesses, with disabilities, or who have incomes that are insufficient to generate enough savings to cover their healthcare needs.

Structural Issues

13. Competitiveness. Staff's assessment, based upon both quantitative models and macroeconomic indicators, is that the Hong Kong dollar continues to be valued broadly in line with economic fundamentals. Although, on the face of it, the current account surplus (at 11½ percent of GDP) appears large, it is consistent with Hong Kong's position as an international financial center with a reliance on the service sector and a rapidly aging demographic profile. Our expectation is that the current account surplus will decline moderately in the coming years as infrastructure investments pick up and demographic trends lower the private saving rate. The level of the currency is not the only factor determining long-run competitiveness. Hong Kong SAR has continuously been able to innovate in various areas of the services industry, steadily raising productivity as a result. In addition, recent progress in moving towards the adoption of a new competition law that is in line with international best practice will help enhance competitiveness.

14. Minimum wage. Rising income inequality and a relatively high share of the population in lower wage occupations make it natural that society should consider the introduction of a minimum wage. At the same time, Hong Kong SAR is highly reliant on the flexibility of its labor and product markets. An overly binding minimum wage will lessen that flexibility, compromise the economy's ability to adapt to shocks, and potentially reduce employment opportunities for low income groups. However, if the social consensus determines that a minimum wage is the best available vehicle for lessening income inequality, the mission supports the government's intention to make the minimum wage legislation uniform across employment groupings. In addition, any minimum wage should be set at a level to protect lower income workers without unduly damaging their employment prospects. Achieving this balance will be greatly helped by the government's efforts to improve the data on low wage labor markets, in order to better understand the structure of the existing wage distribution. In addition, to provide greater employment stability, we would support a simple, automatic scheme to adjust the minimum wage over time, alongside changes in relevant indicators such as wages or unit labor costs. Consideration should also be given to complementing a basic level of the minimum wage with additional social assistance for the working poor, to better support lower income groups while mitigating some of the rigidities that may be associated with a minimum wage.

15. Developments in the Pearl River Delta. Hong Kong SAR is an integral part of the Pearl River Delta economy and its future will depend on successfully managing further integration with the Mainland. To date, much of the progress has been concentrated in the eastern region closest to Hong Kong SAR. A broader expansion of communications and infrastructure offers significant potential for further growth and development in the region. Recent announcements to improve transport linkages and allow Hong Kong companies to increase their activities in the Mainland will allow that potential to be realized. However, at the same time, obstacles such as congestion at some customs control points, border traffic, as well as rising pollution, threaten to undermine future prospects. Coordinated efforts are needed to minimize these risks and provide a stable and predictable policy environment. Further investments in tertiary education and in opening Hong Kong's universities to more Mainland students will help sustain the local skills base and build a pool of well-trained professionals with knowledge of both Hong Kong SAR and the Pearl River Delta.

16. Financial integration with the Mainland. Much headway has been made in recent years in attracting initial public offerings of Mainland companies, developing renminbi deposits and bond markets, expanding banking operations in Mainland China, and facilitating Mainland outward investment through the Qualified Domestic Institutional Investors scheme. Although conditions in international capital markets are difficult, we encourage the authorities to continue to find opportunities to move the process forward, to capitalize on Hong Kong SAR's first-mover advantage, and to allow it to play a catalytic role in the modernization of the Mainland's financial system and its integration with global capital markets.


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