Hong Kong, China
Growth, Structural Change, and Economic Stability During the Transition

I  Introduction and Overview

As Hong Kong, China, enters a new stage of development with the return to Chinese sovereignty, it can take confidence from its long-term evolution and its resilience to adverse developments over the past half-century. The ability of Hong Kong to prosper amidst change has intrigued economists for a long time. Nearly 40 years ago, a pioneering study of the economic growth of Hong Kong (Szczepanik (1958)) noted

On 30 August 1945, when Hong Kong was liberated after four years of occupation, its economy was in ruins. Ten years later, the Colony achieved the fame of being one of the most prosperous territories in the Far East. It is difficult to find a comparable example of economic growth. The question which immediately arises is how to explain this fascinating case of economic development (p. 3).

Yet, fascinating as it may have seemed, the progress made during the 1950s pales in comparison with what was realized during the subsequent decades, especially since the 1970s. As one observer (Smith (1997)) summed up the state of the economy at that time,

When I arrived in the territory in 1970, Hong Kong’s reputation was as a low-cost manufacturer of cheap clothing, wigs, plastic goods and toys. Although the Hongkong and Shanghai Bank, Standard Chartered, and Citibank were present in Hong Kong with a group of relatively weak local banks, Hong Kong was in no sense a financial centre, let alone an international financial centre. If a trading company were to have asked its bankers for a price for U.S. dollars two weeks hence, it would most likely be told: "If you want dollars in two weeks’ time, come back then—I’m sure we will have some" (pp. 1–2).

In 1997, Hong Kong belongs to a very different world. It has transformed itself into one of the world’s premier trade, business, and financial centers. Although relatively small in terms of population—about 6.4 million people, slightly smaller than Switzerland—and area—1,095 square kilometers, approximately a third larger than New York City—Hong Kong has grown into an economic powerhouse, with GDP equivalent to US$155 billion, total trade worth over US$440 billion, and bank assets valued at over one trillion U.S. dollars in 1996. With integration into the global service economy, by 1996 Hong Kong had become

These achievements have been realized within a stable, noninterventionist economic policy framework, where the government has performed the classical role of providing a legal and administrative framework and parts of the physical infrastructure, and the private sector has decided on its own how to allocate resources on the basis of clear market signals. Within this setting, private firms have adapted quickly to shifts in comparative advantage and have maintained competitiveness, while the economy as a whole has demonstrated remarkable strength and resilience in the face of economic and political shocks. Indeed, Hong Kong’s performance contains important messages for policymakers everywhere. First, it underscores that economic success in today’s world is less a question of relative resource endowments and more a question of the market perception of the orientation and predictability of economic policy. Second, more than any other economy in the world, Hong Kong has harnessed, rather than resisted, the forces of globalization and has thereby demonstrated the economic gains that can be achieved, with the right policies, as the integration of the world economy continues through trade, financial flows, and the exchange of technology and information.

This paper aims to explore some of the reasons for Hong Kong’s successful economic performance and assess future economic prospects in the context of existing institutions and arrangements for economic policymaking that are expected to be in place after July 1, 1997. A discussion of the post-1997 arrangements complements this review by highlighting the extent to which the existing institutions and economic policies are expected to be preserved under the "one country, two systems" approach envisaged for the Hong Kong Special Administrative Region (HKSAR) of the People’s Republic of China. The following is a summary of the main conclusions reached in the paper.

Longer-Term Trends

Since 1980, Hong Kong’s economy has expanded by 6½ percent annually and evolved through three business cycles. The growth pattern over these cycles has taken three distinct forms: export-led growth (from 1980 to 1989), domestic demand-driven growth (from 1990 through the first half of 1994), and consolidation (from the second half of 1994 through the first half of 1996). During each phase, growth rates of real GDP have become progressively lower and more stable, reflecting the maturing of the economy and a structural shift from manufacturing to services.

The opening up of China to foreign trade and investment in the late 1970s has had a profound impact on Hong Kong’s economy. For much of its history, Hong Kong’s main economic function was as China’s entrepôt. That function, however, virtually ceased between 1949 and 1978. During that period, Hong Kong developed labor-intensive manufacturing industries and began exporting its products overseas. By the late 1970s, manufacturing matured to the point where Hong Kong entrepreneurs were ready to set up production facilities abroad. China had abundant land and labor resources, but still lacked well-functioning transportation, telecommunications, and financial sectors. These complementary factor endowments were the impetus for much closer economic integration and the main force behind Hong Kong’s remarkable structural transformation. Thus, between 1988 and 1995, the share of manufacturing in Hong Kong’s GDP fell by 12 percentage points, with an approximately corresponding rise in the share of trade, transportation, financing, real estate, and business services. By 1995, the share of manufacturing in Hong Kong had declined to less than 9 percent of GDP. In the process, Hong Kong’s traditional entrepôt role was resurrected, but this time within a much broader setting—Hong Kong firms no longer served just as intermediaries, but as initiators of international business activity. This role has allowed Hong Kong to play a small but important role in the enterprise reform in China, as economic integration with Hong Kong has provided additional flexibility for China selectively to open, develop, and deregulate its domestic markets. For Hong Kong, increasing integration with mainland China has meant that its business cycle has become more synchronized with that of China. Given the linked exchange rate system between the Hong Kong and U.S. dollars, this has implied, on occasion, that monetary conditions—determined essentially by those in the United States—have not been in line with Hong Kong’s economic cycle. However, owing to the flexibility of Hong Kong’s factor markets, the necessary adjustments have taken place through a rapid reallocation of resources.

Adjustment in the Mid-1990s

During the early 1990s, Hong Kong experienced a boom in personal consumption, reexports, and asset markets. Stock prices doubled during 1993, and residential property prices rose by a third during the first quarter of 1994 alone. Inflation approached double-digit levels and the external balance deteriorated sharply. Successive increases in U.S. interest rates in 1994 and the implementation of stabilization measures in China gradually cooled off demand in Hong Kong and led to a prolonged consolidation in its asset markets. Between early 1994 and early 1996, growth slowed from about 6 percent to 3½ percent a year. In 1995, as the unemployment rate rose above the 3 percent mark for the first time in more than a decade, consumer sentiment was profoundly affected. However, the underlying fundamentals were sound and investor confidence remained strong. Real wages and property prices fell rapidly between late 1994 and early 1996, while firms upgraded their office and production technology and cut costs, thus creating the necessary conditions for lower domestic inflation and resumption of growth. Without this adjustment, Hong Kong’s economy would have approached the transition with growing macroeconomic imbalances and uncertain prospects about stable growth after 1997.

Macroeconomic Policies

As frequently observed, one of the "secrets" of Hong Kong’s economic success lies in a clear division of roles between the private and public sectors. Within the public sector, institutional factors, such as a sound and transparent legal system, independent judiciary, neutrality of the civil service, free flow of information, and small and efficient administration, have contributed toward creating an atmosphere conducive to steady economic expansion. Equally important have been Hong Kong’s predominantly "rules-based" macroeconomic policies and a firm regulatory framework. Consistent with a noninterventionist approach, the authorities have maintained a coherent set of fiscal, monetary, and exchange policies that have helped limit the size of the public sector to under 20 percent of GDP, and have preserved the flexibility of factor and goods markets.

Fiscal policy has traditionally aimed at maintaining a simple and stable tax system with low tax rates, limiting current spending increases in line with GDP growth while providing adequate funding for infrastructure projects and keeping sufficient reserves to deal with contingencies. The authorities have refrained from the use of fiscal subsidies or preferential tax treatment to promote particular sectors or industries. In addition, social welfare benefits have been narrowly targeted and labor market policies have focused on providing assistance for retraining rather than for unemployment insurance. However, the authorities have also had a substantial involvement in sectors such as public housing and port and airport development, and through the release of land for development.

Monetary and exchange rate policies have been determined by currency board rules during most of Hong Kong’s history. Under the linked exchange rate system established in 1983, monetary policy has a single, transparent objective: to maintain a stable exchange rate between the Hong Kong and U.S. dollars. The link, together with the freedom from controls on capital flows, implies that Hong Kong’s interest rates are essentially determined by U.S. monetary conditions. While the Hong Kong Monetary Authority (HKMA) has some limited tools to influence interbank liquidity and thereby affect local short-term interest rates, these instruments have been used sparingly, mainly to smooth the occasional volatility in overnight interest rates. Such operations, however, have been very much a secondary objective to the primary goal of defending the exchange rate link, which has served Hong Kong well and has provided a firm anchor for financial policies.

In support of the exchange rate link, the financial regulatory framework has been overhauled since the banking crisis of the early 1980s and the authorities have placed priority on maintaining high standards of prudential supervision in line with best international practices. Their strategy in this area has been to promote a freer flow of information about the financial sector by enhancing banks’ disclosure requirements, to supplement on-site bank examinations with off-site review and analysis, and to ensure that banks’ internal risk management systems function well.

The authorities have played a limited, hands-off role in developing the financial sector, concentrating on providing a suitable institutional and regulatory framework and leaving the development of financial products to the market. In this context, recent initiatives have included the establishment of a longer-term benchmark yield curve, the introduction of a Mortgage Corporation, and bringing interbank clearing into the Monetary Authority through the introduction of a Real Time Gross Settlement system.

The existing macroeconomic policy framework has served Hong Kong extremely well. There has been no buildup of unsustainable macroeconomic pressures over the years. Occasional bouts of inflation and trade balance deterioration led to pressures to reduce costs and restore competitiveness. The absence of policy distortions has helped promote flexible markets and ensure that factors of production move smoothly across sectors in response to changes in market conditions. Prudent budgetary management has resulted in the accumulation of substantial fiscal reserves (equivalent to 14 percent of GDP at the end of FY1996), and, along with growing confidence in the Hong Kong dollar, has underpinned the strong growth of foreign exchange reserves, which reached US$64 billion at the end of 1996.

In the financial sector, the banking system has become profitable and the banks have become highly capitalized—the risk-weighted capital adequacy ratio for the entire banking system was almost 18 percent in 1996. The use of conservative loan-to-value ratios and variable loan rates has enabled the banks to withstand substantial asset market shocks. As banks’ assets and liabilities are repriced quickly, changes in interest rates have generally had a small and short-lived impact on lending and deposit interest rate spreads.

In the nontraded goods markets, a steady program of deregulation is under way. There is, however, a need for the authorities to take further steps to increase competition in certain service industries, which would further enhance Hong Kong’s position as an international business and financial center.


Concerns about the ability of Hong Kong’s service industries to keep pace with their competitors in the emerging regional centers, such as Singapore, Shanghai, and Kuala Lumpur, have been heightened in recent years by rising labor and property costs and uncertainties associated with the transfer of sovereignty. The issue of competitiveness has stimulated a wide-ranging debate and has emerged as a key public policy issue on the eve of Hong Kong’s transition in 1997. Many observers have argued that, with Hong Kong entering a new era, a fresh look should be taken at the government’s hands-off approach to industrial policy. The discussion has been hampered by the lack of sectoral data in constant prices, which has made it difficult to assess whether the services sector has a competitiveness problem.

To address some of these issues in an analytical framework, the study presented in Section V constructs estimates of competitiveness for Hong Kong’s manufacturing and services industries from highly disaggregated production-based GDP data for 1982–94. These estimates indicate that Hong Kong’s service industries, especially those producing tradable goods and services, are highly competitive, and that markets have performed well in channeling resources toward more efficient uses. Wholesale trade, import/export trade, transportation, communications, financial, and business services all expanded, on average, at double-digit annual rates in real terms and recorded high growth rates of labor productivity since the early 1980s. Responding to relative price changes and relative wage differentials, labor and other resources have moved in a clear, predictable pattern from manufacturing and certain declining service industries to the rapidly growing sectors, such as trade, transportation, financing, and business services.

There has been a marked difference in the performance of tradable and nontradable industries. Manufacturing and tradable services (import/export trade, most transportation industries, financing) expanded on average twice as fast as nontradable services (retail trade, restaurants and hotels, domestic passenger transportation, real estate, and social and personal services). At the same time, prices of nontradables increased twice as fast as prices of tradables. As employment growth in nontradable industries outpaced that of tradables by a huge margin, productivity growth in the tradable industries has been much faster than in nontradable industries. This productivity differential accounts for almost the entire inflation differential between Hong Kong and the United States, suggesting that the real exchange rate of the Hong Kong dollar did not become overvalued. These results confirm the view that inflation under Hong Kong’s linked exchange rate system has been an equilibrating response to the relatively strong productivity growth in tradable industries.

Transition and Future Prospects

Uncertainties over the implications of Hong Kong’s return to Chinese sovereignty have gradually narrowed with the approach of the transition. The institutional arrangements expected to be in place after 1997, which are summarized in Box 1, are described in detail in Section VI. Under the arrangements, policymakers will retain considerable independence and autonomy in economic management. The fundamental elements of the existing policy framework—openness, freedom from foreign exchange and trade controls, small government, and the avoidance of budget deficits—are embedded in the Joint Declaration and the Basic Law. Under the Basic Law, budgets are to be independently set by Hong Kong policymakers. In the monetary areas, China and Hong Kong will continue to have two separate monetary systems, two currencies, and two independent monetary authorities. Hong Kong will also continue to participate in international organizations and subscribe to international treaties.

Box 1. Institutional Arrangements for Hong Kong After 1997
The constitutional framework for the Hong Kong Special Administrative Region has been laid down in the Sino-British Joint Declaration (1984) and the Basic Law of the Hong Kong Special Administrative Region of the People’s Republic of China (1990). Under this framework, the Region is to remain autonomous in all but two areas—foreign affairs and defense—for 50 years after July 1, 1997.

Key provisions with respect to the economic and legal system of the Hong Kong Special Administrative Region are these.

  • The socialist system and policies shall not be practiced in the Region, and the previous capitalist system and way of life shall remain unchanged for 50 years.
  • The rights of private ownership of property and investments shall be protected by law.
  • The land and natural resources within the Region shall be state property and shall be managed by the Government of the Hong Kong Special Administrative Region.
  • The laws previously in force in Hong Kong—the common law, rules of equity, ordinances—shall be maintained, except for any that contravene the Basic Law.
On public finances, the Joint Declaration and the Basic Law guarantee:
  • Independent finances of the Region and use of its resources exclusively for its own purposes.
  • Freedom from taxation by the Central Government of China in the Region.
  • Independent tax system and own tax laws of the Region, taking the low tax policy as reference.
  • Prudent budgetary principles consisting of: (i) keeping expenditure within the limits of revenue in drawing up the budget; (ii) striving to achieve fiscal balance; (iii) avoiding deficits; and (iv) keeping the budget commensurate with the growth rate of GDP.
On the monetary and exchange rate system, the key provisions are the following.
  • Independence of the Region in monetary, financial, regulatory, and supervisory policies.
  • The Hong Kong dollar shall remain the legal tender and a freely convertible currency fully backed by foreign exchange.
  • Freedom from all foreign exchange controls in the Region.
  • Free movement of capital within, into, and out of the Region.
  • Management and control of the Exchange Fund by the Government of the Hong Kong Special Administrative Region primarily for regulating the exchange value of the Hong Kong dollar.
In addition, in September 1996, the Chinese authorities defined the monetary relationship between China and Hong Kong under the concept of "one country, two systems" as one country with two currencies, two monetary systems, and two monetary authorities that are mutually independent.

The Hong Kong Special Administrative Region shall also maintain autonomy in its external economic relations (including the status of a free port and a tariff-free zone, separate customs territory, and participation—in an appropriate capacity—in relevant international organizations), immigration controls on foreign persons (entry of people from the other parts of China will be controlled by the Central Government in consultation with the Government of the Hong Kong Special Administrative Region), and other policies (land leasing, shipping, civil aviation, social services).

Continuation of the institutions and the rules-based policy framework that have contributed to Hong Kong’s past success augurs well for maintaining confidence and stability in the coming years. In the area of fiscal policy, the authorities envisage budget surpluses to continue over the medium term. While some concerns have been expressed that the budget surpluses, along with a high level of fiscal reserves, will intensify political pressures for more interventionist policies, the tradition of small government appears well entrenched in Hong Kong, and continued moderate budget surpluses appear appropriate from the viewpoint of macroeconomic policy. Continuity of the current exchange rate arrangement will also be important for maintaining confidence, and policymakers are well placed to maintain the link between the U.S. and Hong Kong dollars. Past experience suggests that the adaptability of Hong Kong’s firms and the flexibility of factor and commodity prices—even during a period of massive structural change—are sufficiently high to preserve competitiveness and continued strong macroeconomic performance.

Within the context of a sound economic policy framework, Hong Kong’s medium-term prospects appear highly favorable. On the domestic side, recent public infrastructure investment and the related large imports of capital goods have raised the productive capacity of the economy. In addition, with many emigrants returning to Hong Kong, the labor supply has become more abundant after a decade of labor shortages. On the external side, the recent "soft landing" of the Chinese economy suggests that China will be able to sustain solid and more stable growth over the coming years, which will be highly beneficial for Hong Kong. In addition, Hong Kong has strong potential to develop further as an international trade, business, and financial center. As China liberalizes its controls on capital account transactions, Hong Kong will be able to play a central role in the subsequent rise in financial flows into and out of China. More generally, Hong Kong can benefit as an intermediary for saving and investment flows within Asia, as these are presently to a large extent intermediated outside the region. These opportunities are likely to develop further the ability of Hong Kong firms and financial institutions to initiate and manage commercial activity across international borders. Thus, while growth is unlikely to reach the levels of the 1980s, Hong Kong appears to be well positioned to mature further as a services-based economy with development of trading and financial links both to the rest of China and to the rest of the world.

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