Other Titles in the Occasional Paper Series
People's Republic of China -- Hong Kong Special Administrative Region
Meeting the Challenges of Integration
with the Mainland
Edited by Eswar Prasad, with contributions from Jorge Chan-Lau, Dora Iakova, William Lee, Hong Liang, Ida Liu, Papa N’Diaye, and Tao Wang
©2004 International Monetary Fund
February 12, 2004
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Hong Liang and Eswar Prasad
Hong Kong, Special Administrative Region (Hong Kong SAR) enjoyed impressive economic growth, high levels of income, and close-to-full employment for years until the Asian crisis of 1997 brought about the most severe recession in a generation. Following this, the economy rebounded in 1999 and 2000. Before sustained growth could take hold, however, the global slowdown in 2001 brought on another recession. After four quarters of negative or near-zero growth, the economy of Hong Kong SAR began to show signs of a pickup in the second half of 2002, although domestic demand remained weak. The outbreak of Severe Acute Respiratory Syndrome (SARS) disrupted economic activity once again in the second quarter of 2003. With the rapid containment of SARS, however, there are good prospects of a rebound in activity, supported by strengthening domestic demand and rising exports.
Hong Kong SAR's efforts to cope with the cyclical shocks to its economy have complicated its efforts to undertake the structural adjustments necessitated by its growing integration with the mainland of the People's Republic of China (hereinafter referred to as the mainland). As a small, open economy, Hong Kong SAR's economic performance has been closely tied to changes in the world economy and especially in neighboring countries. By successfully seizing the opportunities provided by the opening up of the mainland, Hong Kong SAR was able to establish itself as the bridge between the mainland and the rest of the world. Since the 1980s, the economic links between Hong Kong SAR and the mainland have expanded rapidly, with Hong Kong SAR becoming the most important trade and international fund-raising center for the mainland. At the same time, Hong Kong SAR has successfully transformed itself into a service-oriented economy as its manufacturing sector has largely relocated to the mainland. Looking forward, rapid economic growth and increased trade between the mainland and the rest of the world should benefit Hong Kong SAR and support the vibrancy of its financial services, logistics, and tourism sectors.
Increasing integration with the mainland has, however, proven to be a double-edged sword, since it has promoted price convergence, exerting downward pressures on goods and factor prices in Hong Kong SAR under the linked exchange rate system. Moreover, the rapid improvement in its neighbors' competitiveness has posed increasing challenges to Hong Kong SAR's traditional advantages and position: its role as a traditional trade intermediary is likely to diminish further as the mainland's trade restrictions are lifted; direct trade relations are established between Taiwan Province of China and the mainland; and more foreign businesses are set up directly on the mainland. Section II, "Economic Integration Between Hong Kong SAR and Mainland China," provides an overview of various dimensions of the economic and financial integration between Hong Kong SAR and the mainland, and the outlook for the further integration of these economies. The analysis points to the significant challenges associated with the process of structural adjustment and the policy implications for Hong Kong SAR. To meet these challenges, Hong Kong SAR's traditional strengths—flexible markets and strong legal and institutional frameworks—will need to be complemented by sound macroeconomic and structural policies.
The recent economic downturn has exposed significant weaknesses in the fiscal structure of Hong Kong SAR. Its revenue system has a narrow base, with a heavy reliance on asset-related revenues, derived mainly from proceeds of land sales and investment incomes. The bursting of the property-price bubble after 1997, coupled with a set of reductions in various fees and charges intended to cushion the impact of the economic slowdown, has driven down the ratio of government revenue to GDP from around 21 percent in fiscal year (FY) 1997 to 14 percent in FY 2002. Meanwhile, government expenditure has grown rapidly in real terms, in part because major spending components, such as civil service salaries and welfare benefits, have not been adjusted for recent deflation. As a result, the consolidated fiscal position has deteriorated gradually since 1998 and substantial structural deficits have emerged. Section III, "Fiscal Outlook and Policy Options," examines how revenues and expenditures might evolve in the medium term in Hong Kong SAR under different policy scenarios and discusses alternative policy options to restore fiscal balance. It argues that the medium-term fiscal consolidation program under way in Hong Kong SAR has to strike a balance between the need to provide comprehensive social services to its citizens and its tradition of limiting the size and role of the government in economic and social affairs.
Developments in the property sector have important implications for the overall economy in Hong Kong SAR. Property prices have been declining steadily since 1997—the peak of the property-price bubble—owing to the weak performance of Hong Kong SAR's economy; overbuilding; and, probably, increased integration with the mainland. Section IV, "Determinants of, and Prospects for, Property Prices," discusses recent developments in the real estate sector and their macroeconomic impact on the economy, and presents estimates and forecasts of fundamental prices in the housing sector. It argues that although property prices now appear to be at levels consistent with demand-side fundamentals, further weakness in housing prices cannot be ruled out if the economy remains weak.
Significant price differentials between Hong Kong SAR and neighboring mainland cities such as Shenzhen and Guangdong, along with the bursting of the property bubble, have been gradually translated into downward pressures on Hong Kong SAR's domestic price level. Deflation has now entered into its fifth successive year. Section V, "Deflation Dynamics," presents a comprehensive econometric analysis of deflation in Hong Kong SAR. It decomposes the aggregate price level into transitory and permanent components, and identifies the nature and origin of the shocks that affect these two components. The analysis shows that although cyclical factors may have triggered the process of deflation, their effects have been perpetuated by the negative wealth and balance-sheet effects in the corporate and household sectors. In addition, price convergence with the mainland has become more important over time in explaining the deflationary process.
Another major challenge posed by increasing integration with the mainland relates to the sectoral reallocation of labor and its impact on income distribution. Until the mid-1990s, Hong Kong SAR's economy was often at or near full employment. This supported strong wage growth, with pay for skilled workers rising particularly quickly. A shift toward higher-value-added services, driven by increased outsourcing of manufacturing and low-end services to the mainland, has contributed to rising structural unemployment. Section VI, "Trends in Wage Inequality, 1981-2001," examines the evolution of cross-sectional wage inequality in Hong Kong SAR and the impact of structural shifts on wage inequality. The analysis suggests that the most effective policy for addressing rising unemployment and income inequality would be to upgrade the skill level of the labor force.
Over the past two decades, Hong Kong SAR has developed into an important global financial center, spurring the growth of the domestic economy. Financial markets—in particular, the banking system—are well developed, liquid, and efficient. The regulatory infrastructure and supervisory framework have been upgraded continuously to maintain international competitiveness. Section VII, "Financial Market Developments," presents an overview of recent developments in Hong Kong SAR, highlighting new initiatives, such as the introduction of the Securities and Futures Ordinance and a deposit-protection scheme, that are intended to further strengthen the stability of the financial system.
All of the policy issues discussed in this paper are set against the background of the linked exchange rate system (LERS). The LERS, which has been in place since 1983, has served Hong Kong SAR well over the years and remains robust. It has, however, limited the macroeconomic tools available to the government to counter the effects of cyclical shocks and structural shifts. As integration with the mainland deepens and regional competitive pressures continue to intensify, further adjustments in domestic goods and factor prices may be needed. Therefore, prudent fiscal policies, a sound financial system, and improved flexibility of goods and factor markets will be crucial to ensuring the long-term sustainability of the LERS and to enhancing its contributions to economic growth.
Hong Kong SAR has already faced and overcome many challenges. By turning hardship into opportunity, it has built a world-class economy and remains a prominent international financial center. Looking ahead, economic restructuring will—even though it may be painful in the short run—create plenty of new opportunities and a broader scope for development. If it continues to implement a disciplined approach to policymaking that harnesses its fundamental strengths, Hong Kong SAR has a bright and promising future.