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An International Monetary Fund (IMF) Staff Mission to Hong Kong expects the Hong Kong economy to grow by 3 percent in 2003, up from 2 percent in 2002. The faster growth in 2003 is based on strengthening external demand, supported by robust growth in the Mainland.
Deflation could begin to ease, but weak property prices, high unemployment, and other structural factors are likely to continue to dampen both domestic demand and the overall level of prices. In the medium term, the outlook for Hong Kong will depend on how it meets the challenges of integration with the Mainland and rising regional competition.
This assessment was made by the IMF Mission in their Concluding Statement at the end of their visit to Hong Kong for the annual Article IV Consultation, which involves a review of Hong Kong's macroeconomic policies, including fiscal and exchange rate issues.
Noting that the continued deterioration of the fiscal position in Hong Kong has made it the main source of potential macroeconomic vulnerabilities, the Mission calls for a credible fiscal consolidation to begin in fiscal year 2003-04.
This will require the implementation of sizeable structural deficit reduction measures in fiscal year 2003-04, and a commitment to more substantial consolidation, supported by concrete measures, in the next three years.
Mr Eswar Prasad, Assistant to the Director of the IMF's Asia and Pacific Department, who led the Mission, said, "The Mission welcomes the authorities' objective of achieving a balanced budget by fiscal year 2006-7. However, a well-specified deficit reduction plan will be essential to bolster market confidence in Hong Kong's macroeconomic policies."
In response to the IMF Mission's call, the Financial Secretary, Mr Antony Leung, said, "We agree with the Mission that fiscal prudence is important to financial and monetary stability. The government has made fiscal deficit reduction a top priority, and will take concrete measures, with a view to achieving a balanced budget in fiscal year 2006-07."
As in the past, the Mission strongly supports the linked exchange rate system, which remains robust. The key challenge will be to ensure the continuation of the supporting conditions that enable the economy to fully derive the benefits of the linked exchange rate.
The Mission welcomes Hong Kong's participation in the Financial Sector Assessment Programme (FSAP) conducted by the IMF. Drawing on the FSAP's preliminary assessments, the Mission is of the view that Hong Kong's financial system is resilient and fundamentally sound.
The Mission supports the authorities' efforts to continuously develop Hong Kong's financial infrastructure and legal environment which will help maintain its competitiveness as a regional financial centre.
The Chief Executive of the Hong Kong Monetary Authority, Mr Joseph Yam, also welcomed the Mission's support for the linked exchange rate system and the positive assessment on the Hong Kong financial sector.
"It is encouraging to note the IMF's continued support for the Link, and the confirmation that the Hong Kong banking sector remains robust," Mr Yam said.
"The Hong Kong Monetary Authority will continue to enhance the regulatory framework and upgrade the banking sector infrastructure to maintain Hong Kong's competitiveness as an international financial centre," he added.
The IMF Mission was in Hong Kong from 4 to 14 February for the Article IV Consultation visit on Hong Kong SAR. It held discussions with the private sector, government officials and members of civil society, including academics and civil service unions.
Following is the Concluding Statement of the Consultation:
International Monetary Fund
Concluding Statement for the 2003 Article IV Consultation
with the People's Republic of China
in respect of Hong Kong SAR
February 2003
Recent Developments and Outlook
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Hong Kong SAR faces a challenging macroeconomic environment. The economy strengthened in the latter half of 2002, driven by robust export growth. However, domestic demand has remained weak -- private consumption and investment contracted in the first three quarters of 2002. Overall, real GDP is expected to have grown by about 2 percent in 2002. Despite the pick-up in growth, deflation has persisted for a fourth consecutive year and the unemployment rate, which rose to record levels in mid-2002, is still above 7 percent. Asset prices have remained weak--property prices continued to drift downwards and the Hang Seng index fell by 18 percent during 2002.
Moderate economic growth is likely to continue in the near term, but this is predicated on external demand conditions. A strengthening of external demand, supported by robust growth in the Mainland, should lead to a modest recovery of domestic demand, resulting in real GDP growth of about 3 percent in 2003. Deflation could begin to ease as the effects of administrative factors dissipate, but weak property prices, high unemployment, and other structural factors are likely to continue to dampen both domestic demand and the overall level of prices. The external current account is expected to record further sizable surpluses in 2002 and 2003. This outlook is subject to substantial downside risks relating to geopolitical uncertainties and the prospects for recovery in the U.S. and other advanced countries.
The medium-term outlook depends on how Hong Kong SAR meets the challenges of integration with the Mainland and rising regional competition. In the near term, 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. However, increasing competition from other regional financial centers and rising direct trade linkages between the Mainland and other economies could reduce the need for Hong Kong-based intermediation services. To meet these challenges, Hong Kong SAR's traditional strengths -- flexible markets and strong legal and institutional frameworks -- will need to be bolstered by sound macroeconomic and structural policies.
Fiscal Policy and the Linked Exchange Rate System
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The continued deterioration of the fiscal position has made it the main source of potential macroeconomic vulnerabilities. The FY2002 fiscal deficit is likely to rise to about 6 percent of GDP, representing a substantial slippage relative to the budget target for a second consecutive year, though this is largely due to deferred asset sales. The structural budget balance has also deteriorated significantly in recent years, owing to rising expenditures and a narrowing revenue base. Such large and persistent fiscal deficits could undermine the long-term sustainability of the public finances and the stability of the linked exchange rate system.
The mission welcomes the authorities' objective of achieving a balanced budget by FY2006. However, in light of the substantial deviations from the fiscal targets in the past two years, this objective needs to be underpinned by a well-specified deficit reduction plan to bolster market confidence. Despite the uncertain macroeconomic outlook, credible fiscal consolidation has to begin in FY2003. This will require the implementation of sizeable structural deficit reduction measures in FY2003 and a commitment to more substantial consolidation, supported by concrete measures, in the next three years.
Successful fiscal consolidation that is consistent with the objective of maintaining a small size of government will require significant cuts in expenditures. This will pose difficult challenges, particularly since expenditures on education, health, and social services will come under increasing pressure from demographic trends and the need to upgrade the education system to remain competitive.
* Reducing the public sector wage bill, which accounts for a substantial share of current expenditures, will have to constitute a key component of deficit reduction. The mission welcomes the authorities' proposal to reduce civil service establishment by 10 percent by FY2006. Rationalizing civil servants' compensation, including adjustments of salaries for recent deflation, should be a key priority. Completing the Pay Level Review expeditiously will facilitate this process. De-linking the pay scales for employees in government-funded organizations from those of the civil service would help reduce wage rigidities in the subvented sector.
* The mission supports the authorities' initiatives to address the financing needs of rising demand for health and education services by increasing user fees (with appropriate safeguards to protect the needy) and promoting greater private sector participation in the provision and financing of these services.
* The proposed changes to the Comprehensive Social Security Assistance program are to be commended since they will enhance the affordability and effectiveness of the safety net. These include adjustments of welfare benefit levels to account for recent deflation and programs to facilitate re-employment of able-bodied individuals. Additional welfare reforms, including outsourcing of direct services to the private sector, are also welcome.
Substantive measures will be required to broaden the tax base and stabilize revenues in the medium term. Traditional revenue sources are coming under increasing pressure -- in particular, revenues from land leases are likely to remain low due to weaknesses in the property market. Measures such as reductions in exemptions and limited increases in tax rates on personal and corporate income would be essential to complement expenditure measures and achieve the required short-term fiscal consolidation. However, their revenue effects are likely to be rather modest. Hence, the authorities will need to develop additional revenue sources that are broad-based and stable in order to make progress toward the medium-term fiscal objective. In our view, a low rate goods and services tax would be the best option and, given the long lead time required for its implementation, preparation for its introduction would need to start soon. Since Hong Kong SAR has very low effective tax rates, these revenue measures are unlikely to significantly affect its status as a low-tax jurisdiction that has enhanced its attractiveness as an international business center.
The mission strongly supports the authorities' commitment to the linked exchange rate system, which remains robust. The key challenge will be to ensure the supporting conditions that enable the economy to fully derive the benefits of the linked exchange rate. In addition to the fiscal consolidation measures discussed above, this will require attention to a number of structural policies.
Structural Policies
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The mission welcomes Hong Kong SAR's participation in the Financial Sector Assessment Program. The preliminary assessment confirms that the financial system is resilient, fundamentally sound, and supported by a strong financial stability framework. The banking system is well capitalized and profitable. Stress tests indicate that banks are well positioned to absorb the effects of a range of macroeconomic shocks and equity market distress without systemic consequences. However, with shrinking profit opportunities in traditional lending, a key challenge for banks will be to maintain their resilience to shocks in a more competitive environment that may lead to higher risk taking and further narrowing of profit margins. As banks and other financial institutions expand the scope of their businesses, there is a need for enhanced supervisory coordination among regulators of the banking, insurance, and securities industries.
Hong Kong SAR's efforts to continuously develop its financial sector infrastructure and legal environment will help maintain its competitiveness as a regional financial center. The new Securities and Futures Ordinance is a major achievement in modernizing the securities legislation and enhancing competition, investor protection, transparency, and regulatory oversight. The mission endorses the government's plan to introduce legislation to provide statutory powers for the oversight of important payment systems. Also welcome are recent initiatives to upgrade the regulatory framework in the area of corporate governance, as well as to enhance accounting and auditing standards. Priority should be given to an expeditious completion of the review of the three-tiered equity market regulatory system in order to clarify regulatory roles and strengthen enforcement (notably in the area of delisting). The planned introduction of a deposit insurance scheme and a credit reference agency would help enhance the stability of the banking system. The authorities have largely put in place a framework for Anti-Money Laundering and Combating Financing of Terrorism that is in accordance with the Financial Action Task Force recommendations.
The labor market is generally flexible but structural shifts have imposed significant adjustment costs and resulted in rising income disparities. Opportunities for low-skilled workers have diminished as manufacturing and some service sector jobs have been outsourced to the Mainland. Changes in the structure of production and the resulting inter-sectoral reallocation of labor have increased the level of structural unemployment. While social assistance programs serve a useful purpose in aiding unemployed workers and facilitating labor reallocation, some restructuring of these programs may be required to mitigate disincentive effects that dissuade able-bodied individuals from actively seeking re-employment and that may have contributed to rising long-term unemployment. To remain competitive and move successfully to a high-value added services economy, Hong Kong SAR will need to increase the relative supply of skilled labor. This will require more efficient investment in education (including support for private provision of education) and expansion of labor re-training programs. The authorities are already taking a number of steps in these areas and are also considering changes to immigration policies.
The mission welcomes recent reforms to land and housing policies. The decision to conduct future land sales only through the Application List will reduce direct government intervention in the land market. The cessation of the supply of residential units through the Home Ownership Scheme also represents a welcome move toward better-targeted and more efficient housing subsidy schemes. However, the mission cautions that frequent changes in policy, such as the temporary suspension of the Application List, could increase uncertainty about the nature of the government's future role in the property market and hinder the effective stabilization of property prices in the short run.
Hong Kong SAR produces and disseminates a comprehensive set of economic statistics. It provides data to the IMF on a timely basis for surveillance and publication and is fully compliant with the IMF's Special Data Dissemination Standards. The mission welcomes the publication, since June 2002, of data on the international investment position, gross external debt, and production-based quarterly real GDP estimates. The mission also notes that the authorities are on track to provide the IMF with accrual-based fiscal data in accordance with the Government Finance Statistics manual. The first set of accrual-based accounts, for FY2002, will be published in November 2003.
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We are grateful to the authorities for their gracious and unstinting hospitality and for the productive discussions.
End/Tuesday, February 25, 2003
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