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Hong Kong Special Administrative Region Concluding Statement for the Article IV Consultation with the
People's Republic of China
in respect of the Hong Kong Special Administrative Region
October 30, 1998
1. Over the past year, the effects of the regional crisis have hit Hong Kong--despite its remarkably strong economic fundamentals--with full force. Given the openness of the Hong Kong economy, activity has inevitably been hard hit by falling demand in regional countries. The deterioration in regional sentiment, and concerns that the linked exchange rate system might not hold, resulted in higher domestic interest rates and a further weakening of domestic demand. The depreciation of trading partners' currencies resulted in a loss of competitiveness, requiring a corresponding adjustment in wages and asset prices. This was exacerbated by the additional need to correct the overvaluation resulting from the sharp run up in asset prices from late 1996 through mid-1997.
2. In the face of these shocks, Hong Kong's economy has been adjusting remarkably rapidly. Asset prices have fallen sharply, and--while firm data are not available--there are clear indications that labor costs are falling. The effects--together with falling import prices--are now being seen in declining consumer prices. These developments demonstrate the flexibility of Hong Kong's economy, and that adjustment under the linked exchange rate system is taking place as it is supposed to.
3. However, there have been substantial costs, both in terms of a recession and rising unemployment. Over the past months, some have argued that these costs could be reduced by abandoning the linked exchange rate. We are skeptical of such claims, including the proposition that a shift to an alternative regime would result in a decline in interest rates. We remain strongly of the view that the linked exchange rate system should be maintained, with the Government playing a fully supportive role in facilitating the necessary adjustment, while seeking to lessen the pain to the community to the full extent possible under the rules based approach.
4. Recent economic data confirm that the economy contracted significantly in the first half of 1998, due mainly to sharp declines in private expenditures and exports of goods and services. While any forecast remains subject to wide margins of error, we expect activity to continue to weaken in the second half of the year, albeit at a slower pace than in the first half; correspondingly, GDP would decline by about 5 percent for the year as a whole. As the effects of wage and asset price adjustment feed through, the CPI would continue to fall, with the 12 month rate declining to 1 percent or less by end year.
5. The outlook for 1999 remains subject to great uncertainty, illustrated--inter alia--by the wide variation in the forecasts of market analysts. Externally, the recent cuts in US interest rates and the appreciation of the yen will benefit Hong Kong, but major risks remain, including with respect to developments in global capital markets and in domestic demand in key industrial countries. Internally, while recent signs of an improvement in sentiment in stock and property markets are encouraging, market analysts continue to see significant downside risks. At the same time, despite the fall in interest rates, credit conditions remain very tight, partly reflecting banks' reluctance to lend.
6. Against this background, we expect GDP growth to remain weak during the first part of 1999, with the prospect of some recovery in the second half of the year once domestic demand has fully adjusted to lower asset prices. Correspondingly, it is probable that unemployment will increase further, even allowing for some slowdown in arrivals of foreign workers and returning emigrants. With domestic spending remaining subdued, the balance of trade and non factor services is likely to strengthen. However, there are downside risks to this growth projection, especially if asset prices decline further or external conditions worsen. The speed of recovery may also be slowed by relatively high real interest rates, which will likely be sustained for a period as domestic prices decline to restore external competitiveness.
II. Policy Issues
A. Maintaining the link
7. Over the past twelve months, the Hong Kong dollar has come under significant pressure on several occasions. During this period, we have been impressed by your strong commitment to and defense of the link. While the strategy employed to defend the link has varied with circumstances, interest rates--the fundamental and indispensable adjustment mechanism of the currency board system--were allowed to rise in each case. During our discussions, you have stressed that Hong Kong remains fully prepared to accept, and has the ability to bear, the interest rate consequences of defending the link.
8. The attack on the Hong Kong dollar in August 1998 was considerably more intensive than earlier episodes, and involved simultaneous pressures in both the foreign exchange and securities markets. Faced with a very volatile situation, and concerned that the markets were being manipulated, the authorities took the unprecedented step of intervening in the stock and futures markets with the aim of ensuring that market integrity and stability was maintained. This was followed by technical measures to improve the operation of the currency board and to tighten securities market regulation.
9. Aided by recent favorable developments in global financial markets, the authorities' actions in August/September have succeeded in calming market conditions. However, the strategy has also had costs: in particular, it has raised concern about the role of the government in the securities market, potential conflicts of interest, and what its exit strategy will be. Market participants also point to technical problems, including a reduction in the free float for many shares; greater difficulties in hedging, which has affected trading in certain derivatives markets; and a loss of competitiveness of certain financial products compared with offshore markets. It will be important to move rapidly to address these issues: in this context, the setting up of an independent company to manage the government's investments, and the disclosure of details of its holdings, are welcome steps. Early publication of monthly data on the Exchange Fund balance sheet (including assets in domestic currency) could also help dispel uncertainties among market participants concerning the financing of the Government's intervention in the market.
10. The recent episode has revealed a number of areas for improvement in the regulatory framework for securities trading. In this context, we welcome your strong emphasis on transparency; your plans to review existing legislation and strengthen coordination and information flows among the various regulatory bodies; and the tightening of enforcement of existing rules on illegal trading. More generally, we also support your intention to strengthen the regulatory and supervisory framework for non bank financial institutions, and to improve monitoring of the financial position of the corporate sector.
11. While the recent technical reforms to the linked exchange rate system have only been in place for a short period, they have worked well to date in reducing interest rate volatility. As market conditions stabilize further, we see merit in greater formalization of the arrangements for calculating the Base Rate, while ensuring that interest rates continue to react quickly to changes in external conditions, and that use of the facility is appropriately costly for the banks.
B. Fiscal Policy
12. Hong Kong has built an almost unrivaled reputation for fiscal prudence, reflected in the maintenance of steady fiscal surpluses and the accumulation of substantial fiscal reserves. While questions have been raised in the past as to whether the accumulation of fiscal reserves has been excessive, recent economic developments confirm the wisdom of these policies. Hong Kong's high fiscal reserves have played an important role in sustaining confidence in financial markets; and they have also significantly increased the authorities' room for maneuver in the present economic situation.
13. The slowdown in the domestic economy and in the property market will have a substantial effect on the budgetary outlook for FY1998/99. While it is difficult to judge the outlook for revenues with precision this early in the year, a deficit of the order of 3 percent of GDP appears possible. For FY1999/00, as the full effect of declining corporate profitability is felt on profits taxes, revenues are likely to remain weak (although much will depend on land-related revenues). Based on recently announced expenditure targets, and assuming that land revenues remain relatively modest, this could imply a further significant budget deficit in the coming fiscal year.
14. In our view, given the outlook for growth and unemployment in 1999, it would be undesirable to tighten fiscal policy next year, and there is a good economic case for a modest fiscal stimulus. In view of Hong Kong's past record of fiscal surpluses, we would not see this as inconsistent with the provisions of the Basic Law. However, were land revenues to prove higher than expected, this should be used to reduce the deficit (being asset transactions, land revenues have limited impact on aggregate demand). In addition, such a deficit should be seen as temporary in nature, and set in a medium term framework which incorporates a return to budget balance, while maintaining fiscal reserves at prudent levels (along the lines described in the FY1998/99 Budget Speech).
15. With activity expected to remain weak in 1999, unemployment will remain a pressing issue. The expansion of major public infrastructural projects--particularly in the railway sector--will help to boost activity, and to offset the completion of the new airport. We also support your intention to accelerate other labor intensive investment projects, and to expand retraining and job placement schemes, which we understand have shown good results. The CSSA provides a safety net for people suffering from economic difficulties, while seeking to avoid reducing labor market flexibility, which remains central to the adjustment process in Hong Kong; these principles should continue to be maintained in the upcoming review of the scheme.
C. The Banking Sector
16. The financial position of Hong Kong's banks, and the quality of the regulatory and supervisory system, are very strong by international standards. As the impact of the regional crisis has deepened over the past year, pressures on the banking system have inevitably increased, reflected in declining profitability and rising non performing loans, although the latter remain low. These trends can be expected to continue for a period, as the full effects of the economic slowdown are felt on banks' balance sheets. While continued close monitoring will be required, the banking system's strong underlying fundamentals give confidence that the situation will remain manageable.
17. The regulatory and supervisory environment has been further improved over the past year, including through the issuance of a guideline on interest recognition, raising the minimum capital adequacy ratio to 10 percent, and by asking listed local banks to disclose their non performing loans. We welcome the authorities' intention to widen this disclosure to all other banks. The purchase of mortgages by the Hong Kong Mortgage Corporation (HKMC) has also helped banks to manage their property market exposure, although continued close watch will be needed to ensure that the HKMC's operations do not result in any contingent liabilities for the government. In this regard, it will be important to push ahead with the timetable for asset securitization and ultimate privatization. Over the longer term, it will be important--as pointed out in the Report on Financial Market Review--to consider how best to limit the danger of asset price bubbles recurring.
18. Hong Kong continues to disseminate a wide range of high quality economic and financial data on a timely basis, and is on track to meet the Special Data Dissemination Standard. In this context, we attach particular importance to developing and releasing data on the external current and capital accounts, and to publishing more timely and detailed data on fiscal developments (including the consolidated funds). In other statistical areas, there is scope for strengthening collection of data on wages (which come with a considerable lag), and on the household composition of the unemployed population.