Hong Kong at a Glance: 2001-02

COUNTRY REPORT

Hong Kong At a glance: 2001-02

OVERVIEW Donald Tsang will take over as chief secretary for administration on May 1st; he will be succeeded as financial secretary by Antony Leung. The first term in office of the chief executive, Tung Chee-hwa, comes to an end in 2002. He is unpopular in Hong Kong, but trusted by China’s government, and so is likely to be appointed to a second term. After growing by 10.5% in 2000, real GDP is likely to expand by just 3% in 2001 as external demand weakens. Growth will pick up to 3.9% in 2002 on the back of improving export performance. Consumer prices are likely to be broadly stable this year, but inflation will return in 2002. The current account is likely to remain in modest surplus this year and next, despite an expanding merchandise trade deficit. Key changes from last month Political outlook • The government introduced legislation in mid-March that will enable the selection of the next chief executive to be made by the same 800-person election committee that was chosen in July 2000 for the purpose of selecting legislators in the Legco election the following September. This reinforces the EIU’s view that Tung Chee-hwa will be re-appointed to a new term. Economic policy outlook • Interest rates have continued to fall, in line with reductions by the US Federal Reserve. We expect US rates to fall by a further 100 basis points this year, compared with our previous forecast of reductions of 75 basis points. Economic forecast • Recent data confirm our forecast of real GDP growth of just 3% this year. Retail sales, industrial production and export data for the first two months of 2001 have all been weak, indicating that the slowdown that began in the fourth quarter of 2000 has continued into the new year.

April 2001

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Outlook for 2001-02

Political outlook

Domestic politics The financial secretary, Donald Tsang, will become chief secretary for administration on May 1st. He will replace Anson Chan, who announced in January this year that she would retire early. Mr Tsang’s position has, in turn, been filled by a banker, Antony Leung. The term of the chief executive, Tung Chee-hwa, expires in 2002 but it is highly likely that he will be selected for a second term of office. The big question now is whether Mr Tsang, who is deferential (in public at least) to Mr Tung, will defend Hong Kong’s present freedoms more or less effectively than Ms Chan. It is expected that Mr Tsang will take a less confrontational stance in private towards Mr Tung and the central government, but that he will continue to defend Hong Kong’s autonomy and the democratic values that he has always propounded.

Over the next two years, the new leadership will need to address several difficult issues in addition to the management of government finances. The economy is still in transition from one based on manufacturing, which began to wane in the 1980s when industries shifted wholesale to the Chinese mainland, to a knowledge-based economy. Managing this shift will require great changes in education and training.

During the forecast period Hong Kong will retain the autonomy guaranteed it under the Basic Law (the territory's post-handover mini-constitution), but that autonomy will continue to be challenged from without and within, leaving the rule of law dented, though largely intact. In January the government asked the Court of Final Appeal (CFA) to seek guidance from the Standing Committee of China’s National People's Congress (NPC) in deciding whether to uphold the decision of two lower courts to grant the right of abode in Hong Kong to a three-year old boy born in Hong Kong of mainland Chinese parents. This is the second time that the government has decided not to accept the CFA’s right of final adjudication: in 1999 it overturned a CFA right-of-abode ruling by requesting an interpretation of the Basic Law from the NPC. As was the case in 1999, the government is now claiming to represent popular fears of an influx of mainlanders, this time the children of other mainlanders coming to Hong Kong to give birth, of whom there is normally a manageably small number. At the end of March, the CFA announced that it would not decide on the case until after a number of similar cases had been heard in May. If, as is likely, the CFA upholds the decision to grant right of abode without requesting “clarification” from the NPC, the government will then be faced with the choice of accepting defeat or making yet another direct appeal to the NPC, which would further undermine the CFA and the rule of law in Hong Kong.

Hong Kong’s relationship with the central government in Beijing will also remain problematic. On the political front, China will continue to expect the Special Administrative Region (SAR) to rein in protests against the central government like those by the Falun Gong spiritual sect. This issue may well come to a head in May, when China’s president and general secretary, Jiang

EIU Country Report April 2001 © The Economist Intelligence Unit Limited 2001 4 Hong Kong

Zemin, is due to arrive in Hong Kong to participate in an economic conference. Mr Jiang has a great personal dislike of Falun Gong. Were he to be confronted by Falun Gong protesters he might well insist that the Hong Kong government take action against the organisation, prompting debate within the government about how to respond to such a call.

Chief executive watch Mr Tung will almost certainly be appointed for a second five-year term of office in 2002, as there appears to be no alternative candidate with such a strong track record of obeisance to the wishes of the central government. Although unpopular with the Hong Kong public, he is trusted by the Politburo Standing Committee of the Chinese Communist Party (CCP) in Beijing, which is the real electorate. To ensure minimum democratic interference with this smooth transition, the government in mid-March introduced legislation that will enable the selection of the next chief executive to be made by the same 800-person election committee that was chosen in July 2000 for the purpose of selecting legislators in the Legco election the following September. Article 45 of the Basic Law stipulates that the method for selecting the chief executive shall be specified in the light of the actual situation in the Hong Kong SAR and in accordance with the principle of gradual and orderly progress towards the ultimate aim of selecting the chief executive by universal suffrage. Except in so far as members of political parties can now retain their party membership until they are elected (in the last selection process, they had to resign before nomination), such progress is not in evidence.

Economic policy outlook

Policy trends Mr Tsang’s swansong, the 2001/02 budget, eschewed any large extra fiscal stimulus, despite the certainty that growth will slow this year. The economic agenda of the new financial secretary, Mr Leung, has not yet been set out but tax reform will inevitably be at or near the top, as he indicated in his opening statement in which he promised to attach great importance to the prudent management of public finances. With the Hong Kong dollar remaining fixed to the US dollar throughout the forecast period, monetary policy will remain inoperative in 2001-02. Local nominal interest rates have been declining, in line with those in the US, and this pattern will continue.

Fiscal policy The 2001/02 budget was presented by Mr Tsang on March 7th. The real increase in spending in 2001/02 is forecast to be just 2.5%, rather below the 4% GDP growth officially forecast for 2001. This modest rate of increase is owing, in part, to fears that growth will undershoot the official target in 2001. But there are also worries that budget deficits may now be structural rather than cyclical, something which the Basic Law does not permit. The operating deficit for 2000/01 is estimated at HK$19.2bn (US$2.5bn), and while this deficit will be steadily reduced in the coming years, a surplus is not forecast until 2004/05. In the longer term, the government wants to introduce some form of consumption tax, to diversify revenue sources away from the highly volatile property sector.

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Monetary policy The government has no control over interest rates, as one of the main mechanisms by which the fixed exchange rate of the Hong Kong dollar against the US dollar is sustained is the close relationship between Hong Kong and US interest rates. The Hong Kong dollar risk premium—the differential between the London interbank offered rate (Libor) and its Hong Kong equivalent (Hibor) for three-month funds—shot up in 1997-98, returned to zero at the end of 1999, and stayed there during 2000. Provided there are no major shocks to the economy, Hong Kong rates should be no higher than those in the US. In early April, the Hong Kong Monetary Authority said it would proceed with plans to lift remaining regulations on interest rates on July 3rd. Following broader financial market reforms introduced in 1999, the new deregulatory measures will promote market liberalisation and competition in the banking sector.

Economic forecast

International assumptions The EIU’s forecast for the global economy has deteriorated markedly during the last few months, owing largely to a significant downgrade in our forecast for the US. We now expect economic growth in the US—Hong Kong’s largest export market—to grow by just 1.4% in 2001 (down from a previous forecast for growth of 2.5%) and by 2.9% in 2002. Growth in world trade will also slow substantially, from 12.6% last year to just 5.3% in 2001. As China is also a major exporter to the US, export growth will slow there as well. We are, however, still forecasting GDP growth of around 7% in China in 2001, where, as the slowdown becomes more apparent, the government will seek to stimulate the economy by other means. Owing to political influences, China’s economic data must, in any case, be considered unreliable. World oil prices will also decline this year owing to reduced demand.

International assumptions summary (% unless otherwise indicated) 1999 2000 2001 2002 Real GDP growth World 3.5 4.8 3.0 3.9 OECD 3.0 4.0 1.8 2.6 EU 2.4 3.3 2.6 2.6 Exchange rates (av) ¥:US$ 113.9 107.8 122.5 122.0 US$:¤ 1.07 0.92 0.97 1.07 SDR:US$ 0.731 0.758 0.765 0.737 Financial indicators ¥ 2-month private bill rate 0.27 0.24 0.28 0.30 US$ 3-month commercial paper rate 5.18 6.32 4.89 5.39 Commodity prices Oil (Brent; US$/b) 17.9 28.4 23.9 23.0 Gold (US$/troy oz) 278.8 279.3 258.8 255.0 Food, feedstuffs & beverages (% change in US$ terms) –18.6 –6.1 8.0 14.8 Industrial raw materials (% change in US$ terms) –4.6 13.4 2.6 5.1

Note. Regional aggregate GDP growth rates weighted using purchasing power parity (PPP) exchange rates.

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Economic growth Full-year GDP data, released on March 7th, put GDP growth in 2000 at 10.5%. However, the sharp slowdown in the US—which accounts for the majority of Hong Kong’s exports—means that real GDP growth in 2001 is likely to slow to 3%, rising to 3.9% in 2002 as a gradual recovery in the US, together with lower interest rates, helps to boost exports and domestic demand.

The rapid rate of GDP growth achieved in 2000 resulted from a 16.7% rise in exports of goods and services (in real, national-accounts terms) as a result of rapid growth in US demand for most of the year, the continuing recovery of previously crisis-hit economies in Asia and faster growth in Chinese exports. As the fourth-quarter GDP figures make clear, growth was already beginning to flag slightly by the end of last year. Industrial production data for the fourth quarter, released in late March, confirmed this trend: the index fell by 0.2% year on year and by 2.1% quarter on quarter. The wider deceleration in the economy has continued into the new year, and has been reflected in retail sales, which for the first two months of 2001 combined fell by 1% year on year.

Gross domestic product by expenditure (HK$ m at constant 1990 prices; % change year on year in brackets unless otherwise indicated) 1999a 2000a 2001b 2002b Private consumption 467,027.0 492,461.0 507,234.8 530,567.6 (0.7) (5.4) (3.0) (4.6) Public consumption 64,203 65,534 67,172 68,852 (3.3) (2.1) (2.5) (2.5) Gross fixed investment 232,534 253,006 268,186 289,105 (–17.4) (8.8) (6.0) (7.8) Final domestic demand 763,764 811,001 842,594 888,524 (–5.4) (6.2) (3.9) (5.5) Stockbuilding –10,874 16,760 5,000 5,000 (0.5) (3.4) (–1.3) (0.0) Total domestic demand 752,890 827,761 847,594 893,524 (–5.0) (9.9) (2.4) (5.4) Exports of goods & services 1,623,316 1,894,572 1,993,090 2,134,599 (4.2) (16.7) (5.2) (7.1) Imports of goods & services –1,567,342 –1,828,683 –1,920,117 –2,071,806 (0.1) (16.7) (5.0) (7.9) Foreign balance 55,974 65,889 72,973 62,793 (8.1) (1.2) (0.8) (–1.1) GDP 808,864 893,650 920,566 956,317 (3.0) (10.5) (3.0) (3.9)

a Actual. b EIU forecasts. d Contribution to real GDP growth.

The slowdown in export growth in the last quarter of 2000, and particularly in December, corresponds neatly with the slowdown in US import demand. With the US entering recession in the first quarter of 2001 and only recovering to positive growth in the second half of the year, the outlook for Hong Kong is one of slower growth of exports and, therefore, also of private consumption— as exports of goods and services constitute around 150% of current-price GDP and provide employment for a high proportion of the workforce. Indeed, in the three-month period from December 2000 to February 2001 the unemployment rate rose slightly to 4.5%, from 4.3% in the November 2000 to

January 2001 period, indicating that recent improvements are over. With property prices unlikely to rise much in 2001 the property sector will remain weak, and consequently fixed investment will be sustained by further private investment in new technology and continuing government infrastructure investment. A further cut in US interest rates is likely during the year, and Hong Kong will almost certainly follow suit. As deflation ends, real interest rates will therefore fall faster than nominal rates, providing the basis for recovery in both domestic consumer markets and private capital investment in 2002, when external demand conditions will also improve. Consequently, after falling to 3% in 2001, GDP growth is expected to edge up to 3.9% in 2002.

Inflation After falling by 4% in 1999, consumer prices (composite index) fell by a further 3.7% in 2000, despite rapid real GDP growth. Producer prices in manufacturing started to increase in year-on-year terms in the second quarter of 2000 after having fallen steadily since the third quarter of 1997. Since bottoming out in August 1999, deflation has gradually eased, narrowing to 1% year on year in January 2001. Although prices subsequently fell by 2.1% in February, this resulted in part from timing issues related to the Lunar New Year. Prices are expected to start rising very gently in 2001, with consumer price inflation averaging just 0.1% for the whole of 2001 and 1.5% in 2002. Prices will be held down by the relatively depressed state of domestic demand, which will partially offset the expected recovery in consumer prices in China, the source of 40% of Hong Kong’s imports.

Forecast summary (% unless otherwise indicated) 1999a 2000a 2001b 2002b Real GDP growth 3.0 10.5 3.0 3.9 Industrial production growth –3.7 2.1 3.5 3.0 Gross fixed investment growth –17.4 8.8 6.0 7.8 Unemployment rate (av) 6.1 5.1 4.7 4.0 Consumer price inflation Average –4.0 –3.7 0.1 1.5 Year-end –2.9 –2.3 1.0 2.0 Short-term interbank rate 8.5 9.5 8.1 8.2 Government balance (% of GDP) –4.0 –0.3 –0.1 –0.2 Exports of goods fob (US$ bn) 174.7 202.7 214.0 234.8 Imports of goods fob (US$ bn) 177.9 210.9 225.3 248.0 Current-account balance (US$ bn) 10.5 8.8 5.7 5.6 % of GDP 6.6 5.4 3.5 3.2 External debt (year-end; US$ bn) 53.5 56.5 57.7 62.9 Exchange rates HK$:US$ (av) 7.76 7.79 7.80 7.80 HK$:¥100 (av) 6.81 7.23 6.37 6.39 HK$:¤ (year-end) 7.81 7.32 8.00 8.70 HK$:SDR (year-end) 10.67 10.16 10.40 10.77

a Actual. b EIU forecasts.

Exchange rates Although growth prospects are beginning to look more shaky, another regional financial crisis leading to renewed attacks on the Hong Kong dollar is not forecast. Even if such an onslaught were to recur, the authorities are now better prepared for it than they were in 1997-98 and would doubtless be able to fight it off successfully. With the need for stability in the business environment the main priority of the authorities, the pre-crisis discussion on optimal exchange rate regimes will continue to be shelved, along with proposals for alternatives such as dollarisation or pegging the Hong Kong dollar to a trade-weighted basket of currencies. The Hong Kong dollar will therefore remain linked to the US dollar at the rate of HK$7.8:US$1 in 2001-02 and well beyond.

External sector The slowdown in exports will not have a huge impact on the current-account balance, which is expected to maintain a small surplus over the next two years. If the current account does dip into deficit, it will only be to the tune of a few billion Hong Kong dollars, representing a negligible percentage of GDP. The reason is that a high proportion of exports are import-dependent, since re- exports of goods imported from elsewhere account for the overwhelming majority (88.5% by value in 2000) of Hong Kong’s exports. Therefore, a slowdown in exports necessarily entails a corresponding slowdown in imports of a similar magnitude. This effect is reinforced by the dependence of domestic incomes on exports. As income growth slows, so does growth in retail sales, and therefore imports, since practically all items in the shops are imported. Both exports and imports of merchandise will grow by only a third as fast in 2001 as in 2000. Indeed, the value of total exports of goods increased by just 4.2% in the first two months of 2001, with imports rising by a somewhat faster 6.7%. The recovery of total trade in 2002 will be gradual. Services imports will also grow more slowly as a result of slower merchandise trade growth, helping to keep the current account in small surplus.

Editors: Leo Abruzzese (editor); Graham Richardson (consulting editor) Editorial closing date: April 12th 2001 All queries: Tel: (44.20) 7830 1007 E-mail: [email protected] Next report: Full schedule on www.eiu.com/schedule