Hong Kong SAR Preliminary Conclusions of the IMF Mission
October 24, 2006
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 24, 2006
I. Economic Developments and Outlook
After three years of rapid economic growth, the pace of activity is now moderating. External demand has softened somewhat, while domestic demand has increasingly supported the economy, reflecting strong household and corporate balance sheets. Significantly, job creation has continued to improve across all sectors and skill levels, bringing the unemployment rate to its lowest level in five years. While a strong external environment provided considerable support, skillful macroeconomic management, continued strengthening of financial market infrastructure, and the underlying flexibility of Hong Kong SAR's markets were also key in the remarkable turnaround from the situation three years ago.
Looking ahead, the mission expects growth of 5½-6 percent this year, and around 5 percent next year and over the medium term. The main near-term risks to this outlook are a sharper slowdown in global demand (particularly in the United States) and a rise in protectionist sentiments against the Mainland. Over the medium term, much will depend on how well the evolving financial integration with China is managed and expanded, and competitive pressures from other regional financial centers withstood. Fundraising by Chinese entities is expected to reach new heights this year, with the gradual liberalization of China's capital account providing increased opportunities for Hong Kong wealth-management firms and banks, and the Closer Economic Partnership Arrangement with the Mainland beginning to make contributions in the financial sector. These areas of integration need to be further expanded, while safeguarding the economy against risks that may emerge.II. Fiscal and Exchange Rate Policies
Appropriately, this year's budget continues to take advantage of the strong economy to further strengthen the fiscal position. Last year, strong growth and expenditure restraint helped achieve the first budget surplus since the Asian crisis. The current economic outlook and spending trends suggest this year's outturn could be above ½ percent of GDP.
While there is little risk to fiscal sustainability, over the medium-term the budget will likely face rising aging-related spending pressures, and continued revenue volatility will have to be managed. Hong Kong SAR's fully-funded and privately-managed Mandatory Provident Fund (MPF) limits pension-related risks, but as previous missions have noted, healthcare costs could rise substantially going forward. Thus, the authorities have appropriately focused on reforming the healthcare-delivery and healthcare-financing systems. The mission supports greater involvement of the private sector in healthcare, including increased reliance on private health insurance. Nonetheless, international experience suggests that relying overly on private insurance could leave vulnerable sections of the population uninsured, exposing the government to contingent fiscal risks. Considering other financing options, including compulsory insurance, premium-based catastrophe coverage or contributory schemes could help mitigate some of these risks.
The mission also welcomes the public discussion on ways to broaden the tax base. Hong Kong SAR's fiscal revenue is the most volatile in the region reflecting the heavy dependence on investment and land income. The mission's analysis suggests that under the current revenue structure, significant fiscal reserves, possibly even higher than those already held, may be necessary to provide a sufficient buffer against the type of economic shocks seen over the last decade. A broader and more stable revenue base would lower the amount of reserves needed for such purposes. As before, the mission considers a low-rated and broad-based Goods and Services Tax to be an efficient way to broaden the tax base. This will become increasingly important as the aging of the population means a consumption-tax base should expand more than the salaries-tax base. The resulting burden on low-income households—a legitimate concern raised by many groups—could be alleviated through targeted compensation. The government should also explore ways to stabilize investment income through arrangements with the Exchange Fund.
The mission maintains its support for the authorities' commitment to the Linked Exchange Rate System (LERS). The May 2005 refinements have strengthened the credibility of the LERS, and the spot rate has moved well inside the trading band. However, the HIBOR has moved below comparable U.S. dollar interest rates. Consistent with this, the forward rate seems to be pricing an appreciation over and above the strong-side convertibility rate six months ahead and beyond. In discussions with the mission, most market analysts and bankers attributed this to high liquidity in the banking system related to several factors, including large prospective IPOs. While this is not necessarily a matter of immediate policy concern, a risk is that the HIBOR-LIBOR interest rate gap could close suddenly, putting pressure on some banks' interest margins.III. Competitiveness Issues
Hong Kong's traditional strengths—flexible markets and strong institutions—have been key to the economy's competitiveness. These features underpinned the recovery in competitiveness since the Asian crisis, and remain essential in adapting to future shocks and structural changes. In particular, the long deflation after the Asian crisis significantly improved Hong Kong SAR's price competitiveness.
Going forward, the authorities need to strike a balance between labor market flexibility and worker protection. The government is now encouraging employers to protect worker incomes in two specific low-wage sectors. As previous missions have argued, legislating a minimum wage to protect labor incomes is a social compact and, when properly designed, should not unduly affect employment. However, given institutional constraints on monetary and fiscal policies, much of the burden of economic adjustment is borne by the flexibility of nominal wages and other prices, particularly in the downward direction. For this reason, any minimum wage legislation would have to be designed in such a way as to maintain the overall flexibility of the economy and its competitiveness. That said, programs that help low-income individuals such as training and placement assistance, in-work welfare payments, supplementary MPF contributions, and education and child-care support, have been demonstrated elsewhere to be effective in improving the condition of the working poor. In addition, to address problems of poverty of households that do not participate in the labor market, measures other than minimum wage legislation could be considered.
In coming years, financial integration with the Mainland will be a major driver of Hong Kong SAR's competitiveness. In this regard, the mission commends the government's efforts to coordinate with the Mainland authorities on ways Hong Kong SAR's advanced financial infrastructure can be used to improve China's financial intermediation, thereby benefiting both economies. While much will depend on the pace of China's financial liberalization, the recent proposal to have Mainland firms issue renminbi denominated bonds in Hong Kong SAR is a good example of such coordination.
Reinforcing its reputation for strong market infrastructure and supervision is key to Hong Kong SAR's future as a financial center. The mission welcomes progress made by the authorities on cross-border cooperation and preparations for Basel II, while the introduction of the deposit insurance scheme should further strengthen the already sound banking system. The Securities and Futures Commission has also been proactive in assessing potential sources of stress in equity markets, including in the fast growing derivatives market, while corporate governance has been strengthened. Ensuring AML/CFT compliance is essential to preserving Hong Kong SAR's reputation as a financial center. In this regard, the authorities are enforcing guidelines for those institutions governed by existing regulatory agencies, and the mission supports plans to broaden enforcement by adopting a comprehensive legislative framework.
Separately, in discussions with the mission, concerns were raised over the adverse impact of increased pollution on competitiveness, especially reflected in difficulties faced in attracting and retaining high-skilled workers. While there was broad support for the government's growing recognition of these concerns and recent efforts to address them, many felt that initiatives to reduce cross-border pollution were urgently needed and that greater emphasis could be placed on market-based mechanisms.
Lastly, Hong Kong SAR's reputation for good governance also supports its competitiveness. Thus, the mission welcomes the government's decision to open consultations into the introduction of a general competition law, an initiative we have long supported.
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.