The IMF highlights the rule of law, a skilled labor force and an ideal location as Hong Kong's strengths but also cautions the rise of significant risks in a recent report
By Kenny Lau
Despite the prospect of persistent uncertainty and volatility, a softening of international trade and downturn in mainland Chinese tourist arrivals, Hong Kong’s economic and financial standing remains relatively strong, according to the latest assessment by the International Monetary Fund (IMF). The report says the city is well placed to withstand shocks from an unfavorable economic environment, although there are some challenges that are likely to darken the outlook for growth.
After annual growth of 1.5 percent, the IMF expects Hong Kong’s GDP to pick up to about 2 percent this year, driven mainly by private consumption in a steady market for labor. Hong Kong is also on a solid financial footing as a result of prudent fiscal policy and intensive supervision of the financial system, the IMF says. The current accounts surplus is just under 3 percent of GDP and is projected to increase to around 3.5 percent over the medium term.
Hong Kong has abundant savings, its fiscal reserves being the equivalent of 35 percent of GDP, or 23 months of expenditure, and its net international investment being 315 percent of GDP, more than that of any other developed economy. Banks in Hong Kong are capitalized well above the global standard of Basel III and the U.S. dollar peg continues to support a small yet open economy.
The outlook, however, is more challenging, as global economic growth has slowed considerably since 2015. Hong Kong achieved an average annual rate of growth in GDP of 4 percent between 2005 and 2013, largely due to unusually low interest rates and economic development in the mainland, the IMF argues. This is changing as U.S. interest rates see an upturn, global trade softens, the mainland economy slows and U.S. policy shifts.
Hong Kong has performed “below potential” in the past 18 months, the IMF says, blaming a poor global trade environment; soft spending in retail, private investment and exports since the mainland stock market crashes in 2015; and a downturn in mainland tourism. Measures of consumer confidence, expected retail sales and business activity remain subdued. Yet the labor market is steady and resilient to slower growth, the IMF says, owing to robust investment in public-sector construction.
Unemployment in the third quarter of last year was relatively low, at 3.4 percent, though job vacancies have decreased in recent months. Hong Kong's major industries - financial services, tourism, trading and logistics, and professional services - employ roughly half of the city’s labor force and account for more than half of GDP.
The Hong Kong stock market has climbed out of February 2016’s trough, equity prices ended last year 20 percent higher, amid concern about the mainland’s economic prospects, the implications of Brexit, the presidential election and U.S. interest rate increases. The outflow of capital stabilized and began to reverse in the middle of the year, though depreciation of the Chinese currency has sharply reduced offshore Renminbi liquidity, deposits having fallen 35 percent from their peak in 2014.
It was a year of poor credit growth, particularly the first six months, because of the weakening of demand for loans by mainland investors, a reduction in domestic lending for wholesaling, retailing and manufacturing, and a decline in mortgage lending and personal loans. But property prices were only 3.3 percent below their previous peak by the end of the third quarter, and have since climbed higher than ever before. The IMF estimates that at the end of the year prices overvalued housing by between 10 percent and 20 percent.
To blunt the spike in property speculation, the stamp duty on residential property transactions was raised in November to a flat rate of 15 percent from a rate that varied between 1.5 percent and 8.5 percent. This was a macroprudential measure targeting buyers that already own property. The IMF says the risk exposure of banks to the property boom has been contained through limits on loan-to-value ratios, debt service-to- income ratios, higher risk weight floors for property loans and interest rate buffers since 2009.
Outlook and risks
The IMF says that given the global environment of tepid international trade, the imminence of an upswing in U.S. interest rates and a rebalancing of Chinese economic policy, the quickening of growth in Hong Kong will likely be gradual and follow a bumpy road. Growing economic ties with mainland China, exposure to U.S. and global market volatility, and an over-stretched property market are the main sources of downside risk, the fund says.
In the short term, Hong Kong is expected to make a slow recovery as US interest rates increase gradually while the global economy improves. The IMF says Chinese GDP growth will be “steady” but will begin to soften in the coming years. In Hong Kong, the fund says credit growth will be “moderate” as property prices adjust; consumption may begin to recede, owing in part to the fall in housing prices; and private investment will be “subdued.”
Further out, an aging population will curb growth and weaken the structural fiscal position of the city, perhaps leading to structural fiscal deficits within a decade as demand for social spending increases exponentially. The fiscal reserves will drop to 33 percent of GDP in 2021 without fiscal impulses, or changes in expenditure and revenue.
In the unlikely event of heightened uncertainty about policy in the West being coupled with a hard landing for the Chinese economy, a contraction in external demand could trim the annual rate of growth in GDP by up to three percentage points. It may mean the economy contracts.
Such an external shock would badly buffet equities and households in Hong Kong because of a backdrop of already high household and corporate debt levels, the IMF says. A decline of 35 percent in stock and housing prices would cause considerable negative wealth effects and reduce by 2 percentage points or more the contribution to growth made by domestic demand. GDP growth could fall by between 3.5 percentage points and 5.5 percentage points in a global downturn.
Ample fiscal reserves and the sturdiness of the capitalization of the banks could offset adverse effects on the Hong Kong financial system in the event of economic distress. But the IMF says it is equally important to adapt to the mainland's rebalancing and move up the value-added chain by playing a bigger role as a global financial center, by reducing inequality and by supporting labor force participation.
The strength of the rule of law, its skilled labor force and ideal location put Hong Kong, as a leading center for offshore dealing in Renminbi, in a good position to seize the opportunities created by the mainland's economic expansion, its integration and liberalization of its capital account, the IMF says. But, it cautions, Hong Kong will remain a financial and business center relevant to global commerce only if it can preserve its strengths and fulfill its potential.