Hong Kong was hit particularly hard by the Asian financial crisis. BNP Asset Management (Asia) looks at how the economy is getting back on its feet
Like other Asian countries, the Asian economic crisis immersed the Hong Kong economy into a severe recession, generating doubts about the country’s future economic prospects. Over the past year or two, international investors have been overwhelmed with a barrage of issues impacting the local economy and stock market – the fixed exchange rate policy, sluggish economic growth, high property prices, possible devaluation of the Chinese currency and the government’s intervention in the Hong Kong stockmarket.
Notwithstanding, we took the opportunity to individually address the significance of these issues to Hong Kong’s economy. Some of our findings were rather interesting:
1. Is the Hong Kong dollar peg going to change?
Historically, the Hong Kong dollar/US dollar peg policy, inaugurated in 1982, has not hampered the economic prosperity of Hong Kong over the last 25 years, despite the peg rate being tested several times. While the fixed exchange rate policy, which pegged the Hong Kong dollar to the US dollar at 7.8, was able to stabilise the
immediate capital outflow, it was challenged by the investment community that Hong Kong would lose the autonomy on interest rates policy. The pitfall of a fixed exchange rate policy happened in 1997 when Thailand surrendered the peg policy and adopted a free float instead. However, our central forecast does not anticipate
an imminent change in the currency peg policy for Hong Kong in the following respects:
a) The Hong Kong dollar is supported by adequate foreign exchange reserves, which now stand at US$961bn and are ranked fifth in the world.
b) Hong Kong has a resilient banking
system.
c) Investors have a high degree of freedom on foreign exchange transactions.
d) This is a likely higher cost associated with the policy change and the subsequent uncertainties to the financial market.
We should not underestimate the willingness of the Hong Kong Monetary Authority to keep the peg policy unchanged, but another testing date may be drawing near. Hong Kong faced its worst economic slump in the last 12 months and GDP growth has been slowing down. The latest economic figures indicated a tentative rebound in the domestic economy but a false start would likely put the blame on the fixed exchange rate in an environment of rising US interest rates.
2. Why does the Hong Kong economic cycle lag behind other Asian countries?
The asset markets, the major driving forces of Hong Kong’s economy, are heavily influenced by foreign capital inflow wanting to capture higher interest rates under the fixed exchange rate system. The magnitude of these inflows is reflected in a lower loan deposit ratio and when this happens, real interest rates fall accordingly. As such, under normal circumstances, the stock market reacts positively to the surplus liquidity and the real economy is boosted by the lower rates.
However, recently, despite rising liquidity, real interest rates have escalated, holding back economic growth. The real prime lending rate is now over 12%, calling for the economy to grow at a double-digit rate.
In order for Hong Kong to catch up with its Asian neighbours, the following developments are necessary:
a) Deflationary adjustment to achieve a full-scale cyclical recovery
Deflationary adjustment is unfolding, to some extent, and there are signs that a gradual recovery is now taking place; for example, retail sales have bottomed, tourist arrivals rose by 10% and second quarter GDP rebounded by 0.7% year-on-year after five consecutive quarters of decline.
b) Restructuring the economy away from reliance on the property market
Both the government and private sectors are taking initiatives on economic restructuring.
The private sector in Hong Kong appears to be restructuring relatively quickly as a number of companies are endeavoring to be involved in e-commerce.
In addition, the government is also attempting to adopt an industrial policy for the first time through its sponsorship of a cyber port and a Chinese medicine research park.
3. Are high property prices a stumbling block for the Hong Kong economy?
During the 1990s, companies focused on the property market in response to a low real interest rates environment. Between 1985 and 1997, property prices had increased by almost 8.8 times, while the Hang Seng Index advanced by 11 times. However, if
we include the rental returns, investments
in the property market yielded 240%
more than equity investments during this period.
During the Asian financial crisis, property prices fell by almost 40%. Subsequently, the government cushioned the decline by reducing the land supply for property development and intervening in the stock market, leading to an indirect injection of liquidity into the market.
The key problem in Hong Kong is the land policy – the government controls the land supply released for property development. The result is that the land is sold off at high premiums in the land auctions and the property developers transfer the costs directly to the buyers. The mismatch is that the government does not redirect the revenue from the land auctions to the economy through increasing public expenditure.
The government, in its promise to supply 85,000 residential units per annum, is currently addressing this issue. Furthermore, a property sales tax can also be considered to maintain price stability in the property
market.
4. Will Hong Kong be undermined
by the devaluation of the Renminbi (Chinese currency)?
We believe that there is no imminent risk of a devaluation of the Renminbi (RMB). Devaluation can boost China’s export competitiveness, but the benefits of devaluation may not outweigh the costs. A weaker currency will penalise existing foreign investors and will increase the debt burden for the Chinese companies, thereby adding uncertainties to Asia.
Although some of the businesses in the service industry in Hong Kong will lose their competitiveness to China, a RMB devaluation is, in the main, a positive move for Hong Kong as a result of rising volumes in Chinese exports. This helps to boost the profits of Hong Kong exporters who use China as their manufacturing base.
In last 16 years, the RMB has devalued six times by an average of 16%, none of which incurred a downturn in economic activity in Hong Kong. Should another round of devaluation appear, the likely risk to Hong Kong is a speculative move by Hong Kong dollar deposits into foreign currency deposits, causing an increase in interest rates.
Our central forecast does not indicate that such a speculative attack will be
accomplished easily, because of the huge Hong Kong dollar deposits base of over $23.3bn. Moreover, the liquidity mechanism that the Hong Kong Monetary Authority laid down in 1998 provides a high degree of transparency and will make any speculative attacks on the Hong Kong dollar difficult.
5. What are the monetary implications of the government’s stock disposal?
The stockmarket intervention by the Hong Kong government in August 1998 gave an unintentional boost to liquidity. However, this implies that the impact on liquidity will also be great when the government disposes the shares in the future. Recently, the
government announced that the stock disposal will be conducted by means of an index fund but this represents only a small portion of the total portfolio. Other disposal options include private placements and share buybacks from listed companies.
At present, the government is closely monitoring the impact of the following three factors on the monetary system:
1) Stock level and total portfolio value;
2) The demand for Hong Kong dollar and foreign currencies, which may affect the foreign exchange reserves when the stocks are disposed; and
3) The Hong Kong dollar interest rates.
We believe that the government prefers to dispose of the majority of the shares to Hong Kong residents and the rest to international investors. Whatever the stock disposal methods the government takes, the primary objective is to maintain stockmarket stability.
In the case of selling shares to local investors, the Hong Kong dollar deposits base may be undermined when investors withdraw their deposits from the banking system, causingliquidity to be tightened accordingly. To alleviate this, the government could consider using the sale proceeds to finance the fiscal deficit and convert its excess Hong Kong dollar holdings into foreign currencies. Otherwise, we may expect a temporary imbalance on money supply and interest rates.
Going forward, we believe that the Hong Kong economy has bottomed as there is growing evidence of a cyclical recovery. In the second quarter of 99, annual GDP growth was 0.7% (as compared with 3.2% in the first quarter); year-on-year retail sales growth of –0.3% in June (versus –1.2% in May); retained month-on-month import growth of 4.7% in July (compared with –4.2% year-on-year); and the unemployment rate has been steady at around 6% over the last five months.
Significant structural changes are also taking place in the economy, particularly in the IT and telecommunications industries, as Hong Kong rapidly adjusts to low inflation and companies are changing their business focus, moving away from property. Overall, we expect the economy to move toward a path of slower growth with a lower underlying potential growth rate compared to its historical figures.
This article is contributed by BNP Asset Management (Asia) in Hong Kong

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