Hong Kong SAR -- Preliminary Conclusions of the 2004 IMF Article IV Consultation Mission
November 2, 2004
November 2, 2004
Economic performance in Hong Kong SAR has improved markedly since mid-2003 on account of both cyclical and structural developments. While the near-term outlook is positive, formidable policy challenges remain, including those stemming from ongoing integration with the Mainland. Fiscal performance has improved significantly and provides a good basis for further necessary strengthening of the public finances. The mission urges the authorities to take advantage of the current favorable macroeconomic environment to address Hong Kong SAR's policy challenges in order to ensure robust and sustainable growth over the medium term.
I. Recent Developments and the Outlook
Hong Kong SAR's economic performance, which underwent a remarkable turnaround in the second half of 2003, has strengthened and become more broad-based in 2004.
· The recovery was spurred by a surge in Mainland tourism and a pick-up in global growth. Real GDP grew by 9½ percent (year-on-year) in the first half of 2004, reflecting strong domestic demand and exports. Deflation appears to have ended. The unemployment rate has fallen by almost 2 percentage points from its peak last year, but remains relatively high at 6.8 percent at end-September 2004.
· Strong growth and the resurgence of business and consumer confidence have led to a rebound in asset prices. Since last year's trough, property prices have risen by about 30 percent (but are still nearly 60 percent below their 1997 peak), while the Hang Seng index has risen by 55 percent.
· Hong Kong SAR's external position remains strong. The current account surplus is estimated at about 10 percent of GDP and the international investment position stands at 2½ times GDP.
Growth is expected to moderate to potential in 2005, with the risks broadly balanced around this central scenario.
· The mission projects that GDP growth will decline from 7½ percent in 2004 to 4 percent next year, reflecting a slowing in global growth and some easing of activity on the Mainland. The CPI, which is expected to remain flat on average over 2004, is projected to increase by 1 percent in 2005. The unemployment rate should fall below 6 percent in 2005, with employment growth in the range of 2 to 2½ percent.
· The risks to this outlook are largely external. The downside risks are related to the durability of the global expansion, including the possible negative effects of persistently high oil prices. On the upside, there is some potential for stronger inbound tourism and more robust intra-regional trade.
Sustained robust growth over the medium term will depend in large part on the extent to which Hong Kong SAR meets the challenges of integration with the Mainland.
· CEPA is expected to foster deeper trade and investment linkages between the two economies. In addition, the ongoing integration of the Mainland into the global economy will benefit Hong Kong SAR, given its position as a gateway for foreign investors into the Mainland as well as for Mainland corporates venturing abroad.
· Competition from regions within the Mainland as well as from other financial centers in Asia implies that Hong Kong SAR will need to continue to bolster its competitiveness by complementing its traditional strengths-flexible product and factor markets, and strong institutions-with sound macroeconomic policies and productivity-enhancing reforms.
· Assuming that these efforts are successful, the mission projects medium-term GDP growth in Hong Kong SAR to average about 4 percent. Inflation should remain low and stable over the medium term, in part reflecting ongoing, modest deflationary pressures stemming from continued integration with the Mainland.
II. Macroeconomic Policies
Fiscal performance in Hong Kong SAR has improved markedly over the past year, reflecting the strong recovery and implementation of deficit reduction measures.
· The outturn for FY2003/04 was a deficit of 3.3 percent of GDP, two percentage points lower than in the budget despite additional temporary SARS-related measures. This was due to revenue overperformance stemming from higher-than-expected investment returns as well as expenditure restraint.
· While the deficit target for FY2004/05 (before bond issuance) was set at 4.9 percent of GDP in March 2004, indications are that a significant overperformance is again likely, owing to robust revenue collection (resulting from strong growth and large proceeds from land sales) and a commitment to holding the line on expenditures.
The mission urges continued expenditure restraint to ensure a credible and lasting fiscal consolidation.
· The mission commends the authorities for their expenditure restraint in the current upturn, and advises locking in these gains in order to more rapidly reduce the expenditure-to-GDP ratio, which would be consistent with Hong Kong SAR's model of small government.
· This will require careful monitoring of the civil service wage bill and adequate control of social expenditures. The mission supports the maintenance of a strong and well-targeted social safety net, with rules-based adjustments to benefits.
The mission reiterates its recommendation to broaden the tax base and stabilize revenues through the adoption of a goods and services tax (GST).
· Hong Kong SAR's tax base remains narrow by international standards. In addition, some important sources of revenue, including asset sales and investment income, tend to be quite volatile.
· The mission views a GST as the best option for improving the efficiency of the tax regime and reducing the reliance on volatile revenue sources. It could also enhance revenue buoyancy in a non-distortionary manner.
It is essential that Hong Kong SAR take advantage of the current favorable macroeconomic environment to forcefully address its long-standing structural deficit problem.
· Although a relatively early attainment of budget balance on a consolidated basis seems likely, the operating account is expected to remain in deficit for a longer period.
· Eliminating the structural deficit as soon as possible would help bolster fiscal reserves. This would facilitate adjustment to shocks that the economy might face and mitigate any future downward pressures on the linked exchange rate system (LERS).
· The mission recommends that the authorities develop an anchor to guide longer-term fiscal policy that takes into account fiscal pressures that are likely to arise from factors such as changing demographics.
The LERS has responded well to strong-side pressures on the Hong Kong dollar over the past year and remains robust. The mission continues to support the authorities' commitment to the LERS.
· Significant strong-side pressures on the Hong Kong dollar emerged in late September 2003, owing to the improved domestic outlook and expectations of an appreciation of the renminbi and other currencies in the Asian region.
· In response, the Hong Kong Monetary Authority (HKMA) utilized the absence of an explicit convertibility undertaking on the strong-side of the linked exchange rate under the currency board arrangement to let the spot rate temporarily appreciate slightly below the linked rate, thereby injecting a degree of constructive ambiguity into the regime. The HKMA's response to strong-side pressures has enhanced the resilience of the LERS.
III. Structural Policies
Hong Kong SAR will need to continue strengthening its financial infrastructure as well as its supervisory and regulatory systems in order to maintain its position as a leading international financial center.
· The mission notes that Hong Kong SAR has made substantial progress in implementing the recommendations of last year's Financial Sector Assessment Program, including the enhancement of regulatory and supervisory arrangements, improved transparency of institutional and policy frameworks, and further advances in corporate governance. Enhanced cross-industry supervisory coordination has become more important as banks and other financial institutions expand the scope of their businesses in response to intensifying competitive pressures. Sustained efforts in all of these areas will be necessary to deal with rising competition from aspiring financial centers in the region.
· The passage of legislation to introduce a deposit protection scheme is a positive development; its launch in 2006 will further strengthen the banking system. Preparations for adopting Basel II requirements are proceeding well, and the mission looks forward to the amendment of the relevant laws and regulations.
· Progress has been made in improving cooperation with Mainland supervisory counterparts in the banking and securities industries. Coordination of supervisory activities between the two economies will become increasingly important as their integration intensifies.
The property market has rebounded, reflecting the economic recovery; the government's continuing efforts to reduce its direct involvement in this market are welcome.
· The recovery in overall property prices appears to be broadly in line with improving fundamentals, including better prospects for income growth.
· The government has taken a number of steps in recent years to limit its active involvement in the property market. Indeed, beginning this year, land sales have been restricted to take place only through the Application List, which has resulted in a more market-based system. Continued provision of timely information about the government's plans concerning the supply of land would help reduce uncertainty and mitigate any associated instability in property prices.
Tackling the problem of high unemployment and the structural weaknesses in the labor market remains a key policy priority.
· Employment opportunities for low-skilled workers have diminished as manufacturing and low-end service sector jobs have been outsourced to the Mainland, generating significant skill mismatches in the labor market. This process is likely to continue as Mainland firms move up the value-added chain.
· The mission supports the government's proposed reforms to the education system and its ongoing retraining and skills-upgrading programs. The social safety net has an important role to play in facilitating the movement of displaced workers to growing industries, although it should also minimize disincentives to seek employment.
· The high degree of flexibility of Hong Kong SAR's labor market has traditionally delivered good outcomes. Maintaining this flexibility will be essential to facilitate adjustment to shifts in the structure of the economy.
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The IMF mission team would like to express its deep appreciation to the Hong Kong SAR authorities for their gracious hospitality and for the productive discussions.