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Concluding Statement for the Article IV Consultation Discussions with the People's Republic of China in respect of the Hong Kong Special Administrative Region

November 4, 1997

1. Economic prospects and the policy environment in Hong Kong SAR have been overshadowed recently by the disruptions in many of the Southeast Asian economies, as well as by volatility within local financial markets. Despite these events, we continue to be of the view that the underlying fundamentals in Hong Kong SAR are sound. Moreover, the resumption of sovereignty by the People? Republic of China was accomplished smoothly, and we have been impressed by the confidence that market participants place in the continued commitment to the existing economic policy framework and the rule of law.

2. Looking ahead, the key policy challenge will be to ensure that financial and other policies remain supportive of the economy? historical resilience and flexibility, so that the adverse impact of the present financial market volatility is relatively modest and short-lived. While this may require some adjustment of factor prices -- including in property markets -- in order to maintain competitiveness, the willingness in Hong Kong to let this process work is impressive. Indeed, with the recent tightening of liquidity, the policy framework has responded as envisaged to pressures on the Hong Kong dollar, and has provided a welcome element of stability domestically and within the region.


3. Recent data provide evidence that the economy continues to recover from the growth slowdown of 1994-95. Real GDP growth accelerated further to an annual rate of 6.25 percent during the first six months of 1997, from 5 percent in 1996. This reflected a pickup in consumption, which seems to have been boosted by strengthened confidence, as well as higher investment spending. While inflation remains broadly unchanged from its level last year, in large part because of low import prices, pressures on resource utilization appeared to emerge and the unemployment rate has dipped to 2.25 percent.

4. We expect that activity will slow to a more sustainable pace during the second half of the year. Household consumption appears to have been strong in the third quarter, but is likely to decelerate thereafter due to the volatility in domestic financial markets, and investment growth also should moderate in late 1997. Nonetheless, given the strength in the first half, growth is expected to average 5.25-5.5 percent for the year as a whole. This would leave output at close to capacity, which we estimate to be growing at an annual rate of about 5 percent.

5. The unsettled state of financial markets makes it unusually difficult to assess prospects for 1998. However -- even on the assumption of a relatively early firming of market sentiment -- a persistence of somewhat higher interest rates, the drop in stock prices, and turbulence within the region could slow growth to about 4.25 percent in 1998. Household consumption and private investment are likely to be adversely affected by the rise in lending rates and the wealth effect of stock price declines. The significant slowdown that is expected among many of the Southeast Asian economies, as well as the devaluations within the region, also would negatively affect Hong Kong? external trade. However, the impact should be moderate, since these countries represent a relatively small share of Hong Kong? trade, and the product composition of their exports means that their direct competition in third markets is relatively limited. Thus, we project a moderate improvement in Hong Kong? overall trade position, partly owing to an expected pickup in imports by the mainland.


6. The authorities?commitment to a rules-based and noninterventionist approach should enhance the economy? ability to withstand the recent regional and financial market turmoil. In our view, the existing policy framework -- which includes the linked exchange rate system, a prudent fiscal policy, the careful supervision of the financial sector, and a noninterventionist approach to factor markets -- has been extremely successful in fostering strong and sustainable growth in the past. We are encouraged by the authorities?steadfast adherence to this framework, which provides an environment that facilitates the flexible adjustment of costs and prices to external shocks, and which should reassure markets that the impact of recent events on Hong Kong will be relatively short lived.

7. As in the past, the mission strongly endorses the authorities?continued commitment to the linked exchange rate system. The system has proven its ability as an anchor for economic stability since 1983. Looking ahead, the fundamentals indicate that the link can continue to successfully play this role. Foreign exchange reserves are large and the fiscal situation is sound. Moreover, there is little or no pressure on the current account of the balance of payments, since the goods and services trade deficit is largely offset by net factor income inflows. The link also plays a critical role in maintaining confidence in Hong Kong? role as an international financial center, to a significant degree because it demonstrates the continued commitment to free-market policies and monetary autonomy under the ?ne country, two systems?approach.

8. Nonetheless, recent events have illustrated that the openness of the domestic financial market means that Hong Kong can be subject to external pressures arising from sudden shifts in market sentiment. Appropriately, the authorities have taken forceful action during the past two weeks to tighten significantly monetary conditions, and have successfully demonstrated their ability and commitment to defend the link. It is important to recognize that allowing interest rates to rise in response to exchange market pressures is an essential element of the currency board mechanism that lies at the heart of Hong Kong? monetary arrangements. Recent events demonstrate that the system is working exactly as intended, and there are encouraging signs that speculative pressures are easing. However, confidence could still be easily buffeted by events within the region that are beyond the authorities?control. We are confident that the authorities will be cautious and avoid a premature loosening of monetary conditions, despite the short-term pain that high interest rates bring. Indeed, a period of tighter monetary conditions may help facilitate a desirable unwinding of the asset price inflation, rapid credit growth, and labor market tightness that emerged during the past year.

9. Our discussions with market participants have indicated a widely-held consensus that the prudential and regulatory oversight of the financial sector is strong, which has helped underpin confidence in the system. Conservative loan-to-value ratios and high levels of capital adequacy provide reassurance that the banking system will be able to withstand the effects of the recent financial market volatility. Nonetheless, further steps to enhance disclosure and transparency could help reduce market uncertainty, thereby limiting the risk of unwarranted contagion. Measures that could build on the considerable progress already achieved in this area include increasing the disclosure of individual banks?problem loans -- which on average are relatively low -- and adopting more specific guidelines for provisioning and income recognition. In addition, further improvements in financial disclosure by foreign and mainland-related banks and nonbanks would also be beneficial, particularly given the growing financial integration between Hong Kong and the mainland. Development of a market for mortgage-backed securities will allow banks to enhance their liquidity and risk management, but it will be important to ensure that the Mortgage Corporation does not create a significant contingent liability for the public sector.

10. The mission strongly endorses the commitment to prudent fiscal policies, including the commitment under the Basic Law to avoid fiscal deficits. We expect the FY 1997 fiscal surplus to be significantly higher than projected in the budget, mainly due to the unusual surge in land-related receipts during the first quarter of the fiscal year. As these receipts are expected to moderate, the surplus would narrow automatically in the coming fiscal year, but remain at a comfortable level. Despite the strong fiscal position, and the possibility of a growth slowdown next year, we would caution against the introduction of substantial expansionary measures in the FY 1998 budget. Particularly in view of the recent turmoil in financial markets, this would not be a propitious moment to signal a shift away from the traditional policy of significant surpluses. Moreover, a discretionary easing of fiscal policy could impede a desirable unwinding of demand pressures.

11. There remains the issue of the longer-term objective for fiscal policy, especially with regard to the appropriate size of the fiscal surplus and reserves. In our view, a number of factors argue in favor of maintaining a substantial level of fiscal reserves over the medium term. Large fiscal reserves will play an important role in ensuring that confidence in the authorities?policy framework -- including the exchange rate link -- is sustained. They would also appear to be prudent in view of the heavy dependence of the revenue system on relatively volatile land-related revenues. Demographic trends also argue in favor of maintaining a significant fiscal reserve. The expected rise in the old-age dependency ratio during the next 20 years could result in a substantial increase in the burden on the government for social welfare payments and medical care. While the Mandatory Provident Fund (MPF) will assist in providing for an aging society, there will still likely be significant fiscal costs associated with a rapid increase in the elderly population.

12. We support the government? effort to address the chronic undersupply of housing, especially the emphasis on rationalizing housing policy and streamlining its implementation. However, public sector intervention in the housing market is large -- roughly half the population lives in public housing or receives some form of housing assistance -- and there appears to be substantial scope for improved targeting of subsidies. In our view, therefore, the emphasis should be on reducing government intervention in the housing market, particularly by increasing the supply of land for private sector development and more strictly targeting subsidies to the truly needy.

13. While the near-term outlook is inevitably subject to risks, Hong Kong? medium-term economic prospects are favorable. Productivity is high, particularly within the tradable goods and services sectors, and Hong Kong is in a unique position to benefit from the growing demand by the mainland for financial, business, and trade-related services. Moreover, the continued flexibility of goods and labor markets gives confidence that the necessary adjustments will be made as needed to changing economic circumstances. Thus, we would support the intention to avoid an expansion of programs designed to promote specific industries. Rather, the emphasis should be on measures to increase the competitive environment in the nontraded services sector as a means of reducing business costs. The ongoing deregulation of the telecommunications sector is an important example of the potential benefits from such efforts. We also welcome the government? intentions to streamline administrative procedures, carefully assess the cost of compliance with new regulations, and transfer the provision of services out of the public sector.

14. Finally, the availability of timely and accurate economic data for Hong Kong SAR, including Hong Kong? subscription to the Fund? Special Data Dissemination Standard, is consistent with the authorities?commitment to open and transparent policy making. We would encourage continued improvement in this area, especially with regard to the timely provision of external current and capital account data.

Last revision date: 1 August 2011
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