Hong Kong SAR -- Preliminary Conclusions of the IMF Mission
October 25, 2005
The economic expansion that began in mid-2003 has now been sustained for eight consecutive quarters. Growth remains robust, recently supported by strong Mainland-related exports. This rapid turnaround owes much to the favorable external environment, with judicious macroeconomic policies, continued structural reforms, and the confidence building effects of the Closer Economic Partnership Arrangement (CEPA) making significant contributions. Importantly, job creation has steadily gathered strength, which has brought down the unemployment rate quite significantly, although for low-skilled workers it remains relatively high. Reflecting the buoyant activity, inflation has picked up mildly, but remains well contained. Asset prices, which have rebounded sharply since mid-2003, now appear to be stabilizing.
Looking ahead, the mission expects activity to ease in the near term. While real GDP growth is likely to be around 6-6½ percent this year, next year it is expected to moderate to about 4½-5 percent, with lower export growth in the Mainland. Despite this moderation in activity, inflation should rise modestly as rents pick up and the labor market tightens.
The risks to this outlook are broadly balanced. Given the general openness of the economy and the strong linkages with the Mainland, Hong Kong SAR's growth prospects depend crucially on external conditions and developments in the Mainland. If global demand weakens significantly, Hong Kong SAR's current driver of growth-net exports-could be threatened. On the upside, the growth momentum in the Mainland remains strong although rising protectionist sentiments in the Mainland's main trading partners pose some risk. On the domestic front, consumption and investment growth could be higher, reflecting higher asset prices, stronger household balance sheets, and sizeable increases in corporate profits.
The authorities have continued to take advantage of high growth to further strengthen the fiscal position. The FY2005/06 budget targets a deficit of about ¾ percent of GDP. Based on current economic trends and reflecting the government's unstinted restraint on spending, the mission projects that the budget could return to balance this fiscal year, significantly ahead of schedule.
With the target of reaching a budget balance almost achieved, the mission believes that this is a good time to develop a longer-term fiscal strategy. Like other advanced economies, Hong Kong SAR is facing demographic challenges. As the population ages, substantial pressures would likely be exerted on the public finances. While progress has been made on pension reform through the Mandatory Provident Fund (MPF), health care costs could rise substantially. The mission welcomes the priority given to health care reform in the Policy Address and the discussions underway in the government and in the public arena on reform alternatives. Consideration should be given to greater private sector participation and alternative ways to finance rising health costs. Over the longer term, a shrinking of the working population because of aging could also lower the government's tax revenue. In formulating a longer-term fiscal strategy, consideration should also be given to the appropriate level of fiscal reserves. These reserves underpin confidence in the predictability of Hong Kong SAR's traditional low-tax environment by providing assurance that the government can meet the challenges of aging-related pressures, as well as large unanticipated shocks.
Separately, there remains a need to broaden the tax base to help stabilize revenue. Hong Kong SAR's tax base is narrow with more than half the working population outside the tax net. A substantial portion of non-tax revenue accrues from land sales and investment income that are very volatile. Thus, we welcome the government's intentions to begin public consultations on the feasibility of introducing a low-rate GST. We consider this an important tax reform and would encourage its implementation with few or no exemptions to prevent leakages and misuse. Given the long lead time required for its implementation, an early start would be useful. Meanwhile, we would caution against further tax concessions which, unless taken with great care, could permanently increase the budget's reliance on more volatile non-tax revenue.
Turning to exchange rate policies, the May refinements have significantly strengthened the Linked Exchange Rate System and we reiterate our support for the authorities' commitment to the currency board. The refinements have removed uncertainties about the extent to which the Hong Kong dollar can appreciate, and have successfully dampened speculative inflows related to market expectations of a renminbi appreciation. They have also helped to keep financial markets quiet in the aftermath of the changes in the renminbi regime in July. In addition, by capping the potential upside in the spot rate, the traditional tight link between Hong Kong and U.S. interest rates has been reestablished. Moreover, the two-sided flexibility afforded by the band now allows the nominal exchange rate to aid adjustment in the face of moderate temporary shocks. As before, adjustment to larger or more lasting shocks will rely on the considerable and demonstrated flexibility of Hong Kong SAR goods and factor markets.
III. Structural Policies
The economic transformation of Hong Kong SAR has been greatly facilitated by the continuous structural reforms implemented by the authorities.
The authorities rightfully emphasize the need to continue strengthening the market infrastructure and supervisory systems in order to maintain financial stability. Banks remain well capitalized and non-performing loans have declined following the economic expansion. The mission welcomes progress made on the introduction of a deposit protection scheme; its launch planned for the second half of 2006 will further strengthen the banking system. Preparations for adopting Basel II requirements are proceeding well with the amendment of the banking ordinance in July 2005 that provides statutory backing for it. Hong Kong financial markets have enjoyed rapid growth, fueled in part by increased listings by Mainland companies and increased popularity of the equity-derivatives products. As growth in the size and sophistication of these markets, particularly for equity derivatives, is likely to continue, close surveillance will be critical to ensure that Hong Kong financial markets remain efficient and orderly.
The continued success of Hong Kong as an international financial center hinges upon its ability to assist in the Mainland's financial intermediation. Hong Kong is well positioned to play a significant role in view of its sophisticated financial infrastructure, although progress in this area depends crucially upon the pace of financial liberalization in the Mainland. Cooperation and coordination with the Mainland's financial authorities, which have advanced well, will become increasingly important.
The property market plays a pivotal role in the economy and the general increase in prices has once again brought into the fore the appropriate role of the government in the market. As the sole supplier of new land, the government's land policy is a key influence on prices. In recent years, the government has taken various steps to reduce its influence in an attempt to become a passive player in the market. The current Application List system for sale of new land is more market based. Recent changes in the system appear to have induced greater market interest and the authorities should be prepared to make further changes if the need arises.
The mission supports the government's strategy to reduce unemployment among low-skilled workers through programs that upgrade skills, retrain, and assist in job placement. The recently announced public works program should help to boost employment in the construction industry, which has been the worst affected. Despite the improvement in the employment situation, the number of welfare recipients who are employed has continued to rise and points to a more generalized weakness in earnings among the low-skilled. Relatedly, we support the call for a public debate on the appropriateness of introducing a statutory minimum wage and standard working hours as noted in the Policy Address. However, as demonstrated in the last several years, the flexibility of Hong Kong SAR's labor market is a key factor behind the economy's resilience to external shocks.
Hong Kong SAR has one of the most open and flexible economies, but lowering business costs will remain crucial to the economy's future. Against this background, there have been calls over the years for promoting domestic competition in some sectors. The government has responded to these concerns and has continually reviewed its policies to ensure that anti-competitive behavior is minimized. In this regard, we welcome the setting up of an independent committee to look into the existing competition policy, including any need for a general competition law.
* * * * *
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.