Deflationary pressures on Hong Kong are a reflection of the current difficult environment. They should also be seen as part of a longer-term process of economic integration with the Mainland.
There continue to be deflationary pressures on the economy, taking deflation to mean slower increases or even falls in prices and output, and higher unemployment. Two factors stand out as the main causes.
The first factor is, of course, the weakness of the global economy. This is led by the slowdown of the US economy in recent months, which has been characterised by the inventory liquidation in the technology sector, which is the consequence of substantial over-investment in that sector previously. With the tragic and horrifying events of last week, further anxieties have now been added to economic weakness, and have dramatically intensified the uncertainties about the future. This is affecting everyone on a global scale. Hong Kong, being so externally oriented, is not spared. But, while our exports have been falling and the growth rate of the economy slowing sharply, we are fortunate that Hong Kong is less dependent on exports of technology-related products than are a few other economies in the region. Instead, our economy is more dependent on that of the Mainland of China, which is continuing to grow strongly. Compared with others in the region, therefore, we are faring a little better. But this is of no comfort to those affected by the deflationary pressures, particularly those rendered unemployed as part of this inevitable process of adjustment.
The second factor is specific to Hong Kong and, somewhat ironically, the result of the increasing integration of the Hong Kong economy with that of the Mainland. While the long-term prospects of such integration for Hong Kong are clearly good, particularly in the light of this week's formal agreement on terms for China's accession to the World Trade Organisation, in the short term there are deflationary pressures at work. The increasing integration, coupled to the starting point of huge discrepancies in prices and wages, consigns Hong Kong to deflation and the near Mainland to inflation over time. This will in theory go on until the differentials have been arbitraged away to equilibrium levels, although in view of the significant differences under "one country, two systems", and the limitations in the flow of labour and capital, this does not necessarily mean price equalisation. In fact, the arbitrage process has already been operative for over twenty years, as the Mainland embarked on the road of reform and liberalisation in earnest. It is just that the process has been accelerated in recent years.
As to when this process will be completed is difficult to tell. Its effects are certainly being felt in property prices, in the problem of finding jobs in Hong Kong for the unskilled, and in the pressures that the retail sector in Hong Kong has experienced. However, we can I suppose take some comfort from the fact that significant price and cost differentials exist between any metropolis and its hinterland, Further, in those cases there are no restrictions on the mobility of labour and capital, and "one country, two systems" is not operative. In other words, one can reasonably expect price and cost differentials between Hong Kong and near Mainland to be, in relative terms, greater than that between, for example, London and the north of England. I shall leave those who are closer to the relevant markets to judge whether we are near to, or still some way from, equilibrium. But I fear that an objective assessment will not be easy because we are talking about a very dynamic situation. Suitable actions are, of course, being taken to enhance the cross-border mobility of labour and capital, which is clearly in the long-term interest of Hong Kong.
I should add here that Hong Kong's monetary arrangements have not been contributing to deflation in Hong Kong, notwithstanding the sporadic and understandable claims to the contrary. Readers may not be aware of this, but the real effective exchange rate of Hong Kong has actually depreciated since the crisis period in 1998 by about 12%, although our nominal exchange rate against the US dollar has remained fixed. The linked exchange rate has therefore not, at least in recent years, undermined our competitiveness. Furthermore, recent weakness in the US dollar, together with interest rates being at historically low levels, represent a favourable monetary policy stance for Hong Kong. There is, of course, the residual and sensitive question of whether the exchange rate should be used to lessen the impact on the community of deflation arising from other causes. Looking at the performance of those economies with substantially depreciated currencies, the benefits of exchange rate adjustments are at best doubtful and clearly disproportionate when compared with the risks of tampering with a proven pillar of stability.
Joseph Yam
20 September 2001
More information on the Linked Exchange Rate System can be found here.
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