An International Monetary Fund (IMF) Staff Mission to Hong Kong supports the government's policy framework to deal with the challenges ahead, and expects a moderate recovery for Hong Kong in the near-term, depending on an upturn in external demand. It notes that the longer-term outlook depends on Hong Kong's success in capitalizing on the opportunities arising from growing integration with the Mainland.
The 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 with China in respect of Hong Kong, which involved a review of Hong Kong's exchange rate, fiscal and economic policies.
According to the Mission's forecasts, Hong Kong's real GDP growth will be around zero in 2001, which is in line with the government's projection. It also projects Hong Kong's GDP to rise by 1 % for 2002, based on a rebound in US growth in the second half of the year.
The Mission considers that Hong Kong is facing the twin challenge of a sharp cyclical downturn and structural changes from increasing integration with the Mainland. In this connection, the Mission supports the Government's approach in dealing with these challenges through maintaining the rules-based and transparent economic policy framework, focusing near-term policies on facilitating the adjustment process, and continuing reforms to support the economy's growing integration with the Mainland. The reforms seek to further develop the financial markets, upgrade the skills of the labour force and ensure the flexibility of goods and factor market in support of the linked exchange rate system.
Mr Markus Rodlauer, Assistant Director of Asia and Pacific Department of the IMF, who led the Mission, said, "The authorities have set out an appropriate framework for dealing with these challenges, and we are confident that these challenges will be met."
As in the past, the Mission strongly supports Hong Kong's linked exchange rate system. It notes that the link has been a centerpiece of Hong Kong's rules-based policy framework, and an important feature of the "one-country, two-systems" principle. The stability of the link has played a critical role in boosting confidence in Hong Kong as a financial centre. Underpinning the link have been prudent fiscal management, flexible markets, a robust financial system and large foreign exchange reserves.
The Mission noted that this year's widening in the fiscal deficit has been caused mainly by the sharp economic downturn, and that it would not be advisable to take measures with immediate large effect to counteract the cyclical shortfall in revenues in light of the weak and uncertain economic outlook. Nevertheless, the Mission expresses concern about a structural deterioration of the fiscal position in recent years, and recommends an early adoption of a comprehensive medium-term deficit reduction plan which should aim to reverse the rising trend of government expenditures as a share of GDP and fortify the revenue base.
The Financial Secretary, Mr Antony Leung, said, "We welcome the IMF Mission's assessment of the Hong Kong economy. We agree with the Mission that, to ensure the sustainability of our monetary and financial policy framework, we need to cope with the challenges posed by the cyclical and structural adjustments. This would include moving back to a balanced budget within a reasonable period of time."
The Chief Executive of the Hong Kong Monetary Authority, Mr Joseph Yam welcomed the Mission's support for the linked exchange rate system. He said, "In an unusually difficult year when Hong Kong suffers from a sharp downturn, the IMF's endorsement of Hong Kong's policy framework, including the Link, is important to bolster the international financial community's confidence in our system."
The IMF Mission was in Hong Kong from 11 January to 24 January for the Article IV Consultation visit on Hong Kong SAR. It held discussions with the private sector and government officials.
Following is the Mission's Concluding Statement of the Consultation:
INTERNATIONAL MONETARY FUND
Concluding Statement for the 2002 Article IV Consultation with the People's Republic of China in respect of HONG KONG S.A.R.
RECENT DEVELOPMENTS AND OUTLOOK
After a strong recovery from the Asian crisis, last year's global slowdown dealt another blow to the Hong Kong economy. Aided by favorable external conditions, a strong recovery started in 1999 and real GDP growth surged to 10.5 percent in 2000. However, the progressive weakening of the global economy last year caused Hong Kong's exports to slow sharply, and although domestic demand held up for a while, it subsequently weakened as well. As a result:
- Real GDP growth in 2001 is estimated to have dropped to around zero, while the unemployment rate rose to 6.1 percent in the last quarter;
- Consumer prices fell by about 1.5 percent, continuing their three-year decline; and
- Asset prices also fell, with the stock market declining by some 25 percent, mirroring global market developments.
The near term outlook is for a moderate recovery, depending on an upturn in external demand. In 2002, real GDP is projected to rise by about 1 percent for the year as a whole, based on a rebound in U.S. growth in the second half as well as a recovery in emerging financial markets. Although property and rental prices, as well as import prices, are still on a declining trend, deflationary pressures are projected to ease as activity rebounds (note 1).
The risks to these projections center mainly on the timing and strength of the expected U.S. recovery. A delayed or weaker-than-expected U.S. recovery would have a direct impact on Hong Kong S.A.R.'s external trade sector, reduce demand for business and financial services, and further weaken asset prices. This risk should be buffered by the expected continuing rapid growth on the Mainland. Although Hong Kong S.A.R., as an international financial center, is exposed to global and regional financial market disturbances, its standard vulnerability indicators remain robust (including a sizable current account surplus, a strong reserve position, zero public debt, and a strong banking system).
The longer-term outlook depends on Hong Kong S.A.R.'s success in capitalizing on the opportunities arising from growing integration with the Mainland, which itself is becoming increasingly open to the global economy. While the benefits are expected to outweigh the costs (especially in the next few years as trade creation exceeds trade diversion), the gains will depend on successful restructuring to preserve and upgrade Hong Kong S.A.R.'s competitive edge as an intermediating economy.
The Hong Kong economy thus faces the twin challenge of a sharp cyclical downturn and structural changes from increasing integration with the Mainland. In the mission's view, the authorities have set out an appropriate framework for dealing with these challenges, centering around the following elements:
- Maintain the rules-based and transparent economic policy framework that has served the economy so well over the past two decades;
- Focus near-term policies on facilitating the adjustment process and helping those most affected, while preserving and strengthening the economy's market orientation;
- Continue reforms to support the economy's growing integration with the Mainland, including by further developing financial markets, upgrading the skills of the labor force, and ensuring the flexibility of goods and factor markets in support of the linked exchange rate system.
While this year's widening in the fiscal deficit has been caused mainly by the sharp economic downturn, recent years have also seen a structural deterioration of the fiscal position that needs fundamental remedy. The substantial increase of the fiscal deficit from 0.6 percent of GDP in FY2000 to an expected 4.5-5 percent of GDP in FY2001 reflects mainly revenue shortfalls from the unexpectedly sharp slowdown. Given the weak and uncertain economic outlook, the mission agrees that it would not have been advisable to take measures with immediate large effect to counteract the cyclical shortfall in revenues - indeed, the strong fiscal track record of the past several decades has provided the necessary reserves cushion to absorb temporary deficits. However, the continuous drift over the past several years into a sizable "operational" deficit position (recurrent revenues minus recurrent expenditures) points to an underlying structural weakening of the fiscal position that needs to be corrected to ensure healthy public finances over the longer term (when additional pressures from structural change and demographic trends will come to bear).
The mission therefore recommends early adoption of a comprehensive medium-term deficit reduction plan. We welcome the authorities' proactive and transparent approach in addressing these issues, and look forward to the results of the two government commissions which are due shortly to report on them. In addressing the long-term fiscal issue, it will be necessary both to reverse the rising trend of expenditures as a share of GDP, and to fortify the revenue base which is being eroded by the forces of structural change.
- On expenditures, the projected rise in demand for education and health services over the longer term presents significant challenges for finding offsetting savings, and calls for higher user fees - with safeguards for the needy - and greater private-sector participation in the provision and financing of services. We support the authorities' initiative to carry out a comprehensive review of public expenditures, including the civil service, to identify the scope for savings.
- On the revenue side, a long-term solution to the budget problem will have to include, in our judgment, some form of a low-rate, broad-based consumption tax. While now is not the time to apply such a tax, given the weak demand conditions, preparations for it should start as soon as possible given the substantial lead time required.
- For FY2002, we would advise to avoid any further deterioration in the budget deficit, and where possible start implementing the necessary reforms to return the budget toward medium-term balance.
THE LINKED EXCHANGE RATE SYSTEM
As in the past, the mission strongly supports Hong Kong S.A.R.'s commitment to the linked exchange rate system. The link has been a centerpiece of Hong Kong S.A.R.'s rules-based policy framework, and an important feature of the "one-country, two-systems" principle. The stability of the link has also played a critical role in boosting confidence in Hong Kong S.A.R. as a financial center. Notwithstanding the difficult period following the burst of the property bubble and the Asian crisis, the economy has generally adjusted well to past cyclical shocks and structural changes. Underpinning the smooth functioning of the linked exchange rate system have been prudent fiscal management, flexible goods and factor markets, a robust financial system, and large foreign exchange reserves.
As noted, a major challenge facing Hong Kong S.A.R. is to manage the structural changes from its growing integration with the Mainland, which is itself transforming and becoming increasingly open to the global economy. Economic activity in Hong Kong S.A.R will shift increasingly toward higher-value added sectors, while low value-added services (such as back offices) will migrate to the Mainland. This transition offers major opportunities for the Hong Kong economy, but also challenges that will continually test the flexibility of economic agents, markets, and policies. Key policy issues include the following:
FINANCIAL SECTOR POLICIES. Hong Kong S.A.R.'s financial system, supported by well-developed legal and regulatory frameworks and a modern financial infrastructure, is among the most advanced in Asia, and indeed globally. The mission welcomes the imminent enactment of the Securities and Futures Bill, which will consolidate and modernize existing legislation, increase transparency, and improve investor protection. Looking ahead, increasing competition from global financial markets as well as those emerging on the Mainland will require continued upgrading of both the rules of the game and their enforcement. The authorities are rightly focused on keeping the Hong Kong markets "one step ahead" of its competition, and the mission encourages vigorous enforcement of existing laws, regulations, and industry guidelines to strengthen practices in corporate governance, financial disclosure, investor protection, and de-listing requirements. We also commend the authorities' efforts to continually upgrade the financial infrastructure to provide investors and intermediaries with the most efficient and secure operating environment. The mission welcomes Hong Kong S.A.R.'s agreement to participate in the IMF's Financial Sector Assessment Program (FSAP), which will provide a useful peer review and assessment of codes and standards, regulatory practices, and financial sector vulnerabilities.
The banking sector remains well capitalized, notwithstanding the Asian crisis and the recent downturn. An increasingly competitive banking environment is spurring a search for new products, increased efficiencies, and consolidation. While this is helpful and necessary to sustain industry profitability, increased vigilance is warranted to ensure that the new activities and products offered by banks do not overtax their risk management capabilities. The mission supports the plan to introduce a deposit insurance scheme, with appropriate features to minimize moral hazard (including a risk-differentiated premium structure), and recommends early establishment of full-fledged credit reference agencies covering relevant data for both commercial and individual borrowers.
HOUSING. The mission welcomes the ongoing review of all housing policies and encourages a move toward better targeted, more efficient, and market-based subsidy schemes. As a result of lower property prices and mortgage interest rates, the target group of subsidized home ownership (HOS) flats has increasingly overlapped with that of the private sector residential market. The ongoing review of the HOS scheme, following the moratorium on sales of HOS flats, is a welcome opportunity for reform, and we support the intention to gradually reduce the scale of the government's intervention in the housing area (with an increasing role for subsidized loans and rental allowances instead of government-produced housing units).
LABOR MARKET AND RELATED POLICIES. Structural change, accelerated by growing integration with the Mainland, has contributed to pressures in the labor market and rising income disparities. While a large part of the recent increase in unemployment is cyclical, a growing mismatch of skills in the labor force has caused higher structural unemployment and income disparities. Demand has outstripped supply of skilled labor in the expanding high-value added service sectors, while unemployment among low-skilled workers has risen, exacerbated by the downturn of activity and the inflow of Mainland immigrants to Hong Kong S.A.R. We support the Government's overall approach in dealing with these issues, which centers on (1) upgrading the skills of the workforce through better education and training; (2) facilitating job search and re-employment of the unemployed, and (3) providing well-targeted social support to those in need-while minimizing interference with the functioning of the labor market (such as through imposition of a minimum wage). In particular, we welcome the increasing emphasis on improving education. Given the results of our work on the causes of growing income disparities (note 2), better education and skills are also the key to improving income distribution by lifting the earning power of the lower income strata.
BUSINESS COSTS. Competitive business costs will remain crucial to the economy's future and its capacity to benefit from Mainland integration. Initiatives to promote competition and lower costs have been taken during the last year in a number of regulated sectors, notably broadcasting, telecommunications, transportation, and power utilities. The mission advises continued close attention to domestic competition issues in unregulated sectors, especially in the absence of a comprehensive competition law.
STATISTICS. Hong Kong S.A.R. produces and publishes a comprehensive set of reliable economic statistics. It provides data to the IMF on a timely basis for surveillance and publication in International Financial Statistics, and has subscribed to the Special Data Dissemination Standard. The mission welcomes the plans to publish international investment position statistics, external debt data, and quarterly constant-price production-based GDP estimates during 2002. We also look forward to the start of reporting Government Finance Statistics (GFS) data for publication in the GFS Yearbook, planned for next year following the adoption of accrual accounting standards.
Note 1 Preliminary work by the mission, though still in progress, suggests that cyclical factors explain a major part of deflation in recent years.
Note 2 The mission's analysis indicates that rising income disparity in recent years has reflected mainly the higher price for skilled labor and, in turn, the premium on better education, and not a decline in absolute incomes of the lower-paid segments of the workforce.
It remains for us to thank the authorities for the excellent cooperation and kind hospitality extended to us during this mission.
End/Tuesday, February 5, 2002