People’s Republic of China—Hong Kong Special Administrative Region Preliminary Conclusions of the 2009 Article IV Mission
November 2, 2009
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.
The 2009 Article IV consultation focused on the policies needed to manage the path of the economic recovery and the implications for Hong Kong SAR of the Mainland economy rebalancing from investment and exports toward private consumption. The mission would like to thank the Hong Kong authorities for their support, hospitality, and open and collaborative discussions.
1. Global context. Hong Kong SAR has been hit hard by the global financial crisis. The economy’s heavy reliance on trade and financial services made it doubly exposed when, in late 2008, global trade collapsed and extraordinary pressures built in the international financial system. The force of the shock was clearly seen in the severity of the contraction in the first quarter.
2. Economic recovery. The financial pressures experienced by Hong Kong SAR following the failure of Lehman Brothers began to recede in the latter part of 2008 due to the proactive and concerted policy efforts of the government and the improving situation in global capital markets. The recovery is now underway, fueled by growth in China, stimulative fiscal policies, the government’s efforts to support smaller enterprises and preserve employment, and highly accommodative monetary conditions imported from the United States. However, although Mainland growth is gathering strength, the world economy is still fragile and the global recovery is likely to be drawn-out and subject to downside risk.
3. Economic outlook. While 2009 has been a difficult year, recent monthly indicators have been quite positive and we now forecast a contraction of 2 percent for 2009, with growth steadily strengthening to 5 percent in 2010. We expect unemployment to decline in the coming months. Nevertheless, the protracted process of recovery in the main industrial economies is likely to mean that the contribution to growth from external demand will remain relatively weak for some time, despite a strong performance in the Mainland. Price pressures should remain muted and, given our current outlook for global commodity prices, consumer price inflation should end 2010 close to zero.
Liquidity And The Exchange Rate Regime
4. Monetary conditions. Over the past several months, nominal Hong Kong dollar interest rates, even at longer maturities, have remained close to zero. In addition, Hong Kong SAR has imported quantitative easing from the United States and the HKMA’s balance sheet has expanded alongside that of the Federal Reserve. It is likely that such accommodative monetary conditions will remain in place for an extended period, during which time the implications of the resulting high level of liquidity will have to be deftly managed. In addition, at some future point, the recent extraordinary expansion in the Aggregate Balance will be unwound. The working of Hong Kong SAR’s Linked Exchange Rate System will mean that, when the resulting outflows move the Hong Kong dollar to the weak side of the convertibility band, the Hong Kong Monetary Authority (HKMA) will need to intervene to sell foreign currency and reabsorb local currency liquidity. Clear communication with the public and financial markets during this period will be essential in order to prevent unnecessary turbulence in foreign currency or money markets.
5. Exchange rate regime. The Linked Exchange Rate System merits continued support. It has shown itself to be a simple, transparent exchange rate arrangement that has proven to be an anchor of monetary and financial stability. The Hong Kong dollar continues to be valued broadly in line with economic fundamentals and price flexibility—in goods, factor and asset markets—has acted as a vital mechanism for the real exchange rate to adjust to the recent large external shocks. Maintaining such flexibility going forward will be essential, particularly given the ongoing structural changes in the global economy and in Mainland China. A flexible labor market will be particularly important. The government, therefore, is right to be cautious and to adopt an evidence-based approach in setting the level of the statutory minimum wage.
The Financial System
6. Banking system. The Hong Kong banking system has proved to be resilient to the dramatic events in the global financial system over the past year. The system is healthy, liquid, and well capitalized. The level of nonperforming assets remains low, although the economic slowdown has led to some increase in nonperforming loans particularly in lending to manufacturing and trade-related sectors. The robustness of the banking system is the product of conscientious and prudent regulation and enforcement, as well as careful risk management by the banks themselves. Bank profits will likely fall in the coming months, a result of higher provisioning and tighter interest margins. Nevertheless, banks should be readily able to absorb this fall in profits.
7. Lender of last resort facilities. The mission fully agreed with the steps taken in September 2008 to put in place supplementary mechanisms for providing liquidity support to the financial system. Subsequently, as global financial volatility declined, it was appropriate for the HKMA to return its discount window to its previous status as an overnight facility collateralized by Exchange Fund Paper. However, to afford the HKMA greater flexibility, the mission supports the permanent inclusion of foreign exchange swaps and term repos collateralized by a broader range of instruments into the lender of last resort toolkit.
8. Deposit protection. The mission supported the temporary introduction of a blanket guarantee in October 2008 and it is clear that Hong Kong SAR is well advanced in planning its exit from this measure. The proposal to increase the deposit protection limit to a little over twice the level of per capita income is warranted and in line with the coverage in other jurisdictions. Consideration could also be given to, over time, moving away from the current system of netting deposit claims against performing liabilities to the bank. This would further strengthen the protection afforded to depositors. The mission welcomes the steps taken by Hong Kong SAR to coordinate with Singapore and Malaysia its exit from the blanket deposit guarantee.
9. Credit conditions. As indicated above, the extremely expansionary monetary conditions are likely to persist for some time. The large increase in base money has been accompanied by a much more modest growth in credit. Nevertheless, it is possible that, over the next several months, the demand for loans could pick up and, with such a large liquidity overhang in the financial system, credit supply could expand quickly. More credit would fuel asset markets and, in turn, higher asset valuations would provide greater collateral to underpin further borrowing. Such a financial accelerator process has the potential to translate into macroeconomic volatility (in consumption, employment, and consumer prices), particularly given the unprecedented monetary policy easing in the United States, the scale of inflows coming into Hong Kong SAR, and the differential pace of the recovery in the United States and China.
10. Asset price inflation. Therefore, we share the authorities’ concerns that a credit-asset price cycle could take hold, leading to a sharp run-up in prices for certain real and financial assets. While such asset price movements are part of the natural equilibrating mechanism of the Hong Kong economy, there is a risk that prices could become driven more by short-term liquidity conditions, divorced from fundamental forces of supply and demand.
11. The policy response. The continued strict enforcement of the existing regulatory regime will certainly be essential in maintaining financial stability and limiting future macroeconomic volatility. In addition, there is a role for the introduction of countervailing prudential measures. Such measures should be simple and transparent and introduced at an early stage in order to make clear what the ground rules are and ensure that the banking industry continues to manage risks prudently. Finally, we welcome the consideration that is now being given to increasing the supply of land to the market as one of the possible means to help moderate potential property price surges.
12. Fiscal response. In the face of a strong economic downturn, the government announced an expansionary budget earlier this year and a further fiscal package in May. This supplemented the stimulus that was already in train from measures introduced in 2008. Fiscal measures have included a lowering of direct taxes, greater support to public housing tenants and recipients of government social security, and an increase in public works spending. These efforts were fully warranted given the weak economy. However, it is our expectation that the fiscal outturn for this year will be somewhat less expansionary than originally planned due to a stronger revenue performance linked to the upswing in local asset markets.
13. 2010 Budget. Given the downside risks to the global economy, the mission recommends maintaining a supportive fiscal stance in the upcoming 2010/11 Budget. In particular, the government could continue with the financial assistance it has introduced in the past two years to provide assistance for the elderly and low income groups. Consideration could also be given to extending the reduction in the income tax burden for those in the lower income brackets. Finally, we are encouraged by the government’s intention to press ahead with the major infrastructure projects that have been identified by the Chief Executive.
14. Fiscal management. In addition to short-term stimulus, the government could also consider further modernizing Hong Kong SAR’s systems for budgetary management. A greater focus on assessing social and economic outturns relative to policy goals would provide a useful complement to the extensive information already provided on compliance with the budget’s financial targets. In addition, the monthly reports on budgetary outturns could provide more detail in order to allow a more ready assessment of the fiscal position. The government could also begin producing an analytical, mid-year progress report on budget execution to present a broader narrative on the fiscal situation. Finally, the medium term expenditure framework could be strengthened in order to devolve greater authority to government agencies to set medium-term expenditure priorities, supported by measures to increase those agencies’ accountability for achieving the government’s policy goals.
15. Healthcare. Hong Kong SAR’s demographics imply that, under the current system, the share of public spending on health is likely to rise steadily in the coming years, putting pressure on the longer-term fiscal position and, ultimately, on the quality of care. An integral part of any reform should be to safeguard the existing public commitment to support those with chronic or catastrophic illnesses, with disabilities, and those at the lower end of the income distribution. Within that broad guiding principle, efforts should aim to ensure cost containment and increase efficiency. In this regard, many changes are already underway to improve service delivery. Consideration could also be given to the introduction of a broader range of user fees or price-based measures to ensure the efficient use of medical services. Supplementary sources of financing should be phased in at an early stage to ensure that, over time, private financing sources contribute to a larger share of healthcare expenditure. We continue to believe that some form of mandatory health care financing scheme will eventually be required. Given the high quality of the existing public system, a voluntary scheme may not be sufficient to reduce the pressure on the fiscal accounts, achieve adequate risk pooling, or prevent households from undersaving for future healthcare needs.
16. Mainland rebalancing. In the coming years, the Mainland government’s goal is to shift growth away from exports and high levels of investment toward a greater reliance on household consumption. If this objective is realized, Mainland companies will progressively orient themselves toward a domestic market while increasingly competing with Hong Kong SAR in providing financial, merchandising and logistical services. This provides an important policy challenge but also an opportunity for Hong Kong SAR to seek out new lines of business, particularly as the Mainland economy expands its demand for a range of services.
17. Future growth strategy. The suggestions of the High Level Taskforce provide useful new directions for upgrading the quality and expanding the range of services provided to the Mainland market. This strategic direction was more fully fleshed out in the Chief Executive’s October 14 policy address. As an important international financial center, Hong Kong SAR certainly has significant potential to provide a range of financial services to the Mainland. In addition, there are opportunities to retool existing trade services including through the provision of greater logistics, marketing and distribution services within the Mainland itself. Hong Kong SAR is also well placed to offer various other services—such as tourism and leisure, healthcare, and higher education—to both Mainland visitors and to the region more broadly. Finally, in line with the direction outlined in the Chief Executive’s policy address, the government should continue to seek out ways to develop Hong Kong SAR as an offshore renminbi business center.