Public Information Notice No. 02/53

Public Information Notice: IMF Concludes 2002 Article IV Consultation with People's Republic of China - Hong Kong Special Administrative Region

May 15, 2002

On May 1, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with People's Republic of China — Hong Kong Special Administrative Region.¹

Background

Over the last five years, the Hong Kong SAR economy has suffered two rounds of external shocks, while also adjusting to growing integration with the Mainland of China. Aided by favorable external conditions, a recovery from the Asian crisis started in 1999, and GDP growth surged to 10½ percent in 2000. However, before sustained growth could take hold, the global slowdown in 2001 dealt another blow to the economy, and real GDP growth dropped to almost zero. While the renewed downturn was led by falling exports, domestic demand also slowed. The unemployment rate reached 6.8 percent in early 2002, and deflation has continued for over three years, reflecting adjustment to the successive external shocks under the linked exchange rate system. The outlook for 2002 is for a moderate recovery, spurred by the expected rebound in global activity.

Despite the economic slowdown, market confidence has remained strong and contagion from the crisis in Argentina has been minimal. Interest rates have declined significantly following the successive cuts in the US rates; nevertheless, domestic credit growth has remained weak reflecting the uncertain business outlook and weak asset prices. The banking sector remains robust, thanks to the traditionally prudent banking practice and strong supervision. Bank capitalization remains well above Basle standards, and the ratio of non-performing loans to total loans has declined to below 7 percent, from a peak of 10⅓ percent in the aftermath of the Asian crisis.

The overall fiscal deficit widened to over 5 percent of GDP in FY2001 (from near balance in FY2000), mainly due to a cyclical decline in revenues. In late 2001, the government also introduced a set of measures (totaling about 1 percent of GDP over two years) to cushion the impact of the economic slowdown. However, the structural budget position has deteriorated significantly over the last four years. The FY2002 budget, while maintaining a mildly expansionary fiscal stance for this year, outlines a framework of medium-term fiscal targets toward eliminating both the overall and the structural deficits by FY2006. This is to be achieved largely by containing the growth of government expenditures, with revenue measures to be considered if necessary.

Growing economic integration with the Mainland is challenging Hong Kong SAR to continue its transformation to a high-value added, service-based economy. This process, while offering many new opportunities, has also raised income disparities and structural unemployment. To meet these challenges, the government has made strengthening the skills of the workforce through better education and training a policy priority, in addition to the continuing efforts to upgrade infrastructure and the regulatory environment (such as by the recently enacted new Securities and Futures Ordinance).

Executive Board Assessment

Executive Directors observed that the highly-open economy of Hong Kong SAR has been hit hard by successive cyclical shocks, while also facing structural changes from growing integration with the Mainland of China. Directors commended the authorities' skillful and pro-active economic management in dealing with those challenges, which centers on maintaining the rules-based policy framework that has served the economy well over the past two decades, while limiting the impact of the downturn; and continuing reforms to bolster competitiveness. Looking ahead, they expected the economy to recover as the global environment improves, and were confident that Hong Kong SAR would, as in the past, adapt successfully to the structural changes underway.

Directors noted that, while the widening of the fiscal deficit last year was mainly cyclical, recent years have seen a significant structural deterioration in the budget. While a sharp fiscal correction during the cyclical downturn may not be warranted, the recent drift into a sizable structural deficit will need to be reversed in order to ensure healthy public finances in the longer run. Directors therefore welcomed the authorities' commitment to restore budget balance over the next four years, as outlined in the fiscal-year 2002 budget. They emphasized the importance of supporting this goal with concrete measures to reverse the rising trend of expenditure as a share of GDP and to strengthen the revenue base, and urged the authorities to start preparing these measures as soon as possible. Directors supported the initiative to review all public expenditures for possible cost savings while protecting priority social spending and public expenditure programs contributing to long-term competitiveness. Many Directors considered that efforts to strengthen the revenue base would likely have to include the introduction of a low-rated, broad-based consumption tax, but the authorities were encouraged to carefully consider other revenue enhancing options as well, including in the income tax area.

Directors expressed their continued support for the linked exchange rate system and unanimously viewed the link as the best option for Hong Kong SAR. They noted that the economy has adjusted well to shocks under the link, which has also contributed to boosting confidence in Hong Kong SAR as a financial center. Directors emphasized that the smooth functioning of the link will continue to depend critically on prudent fiscal policies, flexible goods and factor markets, a robust financial system, and large foreign reserves. They also noted that the exchange rate regime and supporting conditions should be, as they have always been, subject to continuous review.

Directors noted that the banking sector remains well capitalized, notwithstanding the recent economic slowdown. While the search for new products and consolidation in an increasingly competitive banking environment is desirable, Directors cautioned that vigilance will be needed to ensure that the new activities and products offered by banks do not overtax their risk management capabilities. They supported the plan to introduce a deposit insurance scheme, with appropriate safeguards to minimize moral hazard, as well as the establishment of credit reference agencies covering commercial and individual borrowers.

Directors noted that growing competition from global financial markets as well as those emerging in the Mainland will require continuous upgrading of financial infrastructure and regulations. In this regard, they welcomed the recent enactment of the Securities and Futures Ordinance and the steps taken to provide investors with a highly secure and efficient operating environment. Directors commended the leadership role which Hong Kong SAR is playing in the international effort to combat money laundering and the financing of terrorism. They welcomed the authorities' agreement to participate in the Financial Sector Assessment Program.

Directors observed that economic integration with the Mainland offers many benefits for Hong Kong SAR, but also implies significant restructuring to direct economic activity to higher-value added sectors. To remain a center of trade-related and financial services, Hong Kong SAR will need to continue upgrading its infrastructure, human capital, and business environment. Directors supported the authorities' efforts to address pressures in the labor market and rising income disparities by improving the skills of the workforce through better education and training, and providing well-targeted social support to the needy. Directors commended the authorities' efforts to promote competition and lower costs in regulated sectors, and urged continued close attention to domestic competition issues especially in unregulated sectors, given the absence of a comprehensive competition law. They welcomed the ongoing review of housing policies and the envisaged move toward better targeted and more efficient subsidy schemes.

Directors commended Hong Kong SAR's compliance with the Fund's Special Data Dissemination Standard. They welcomed the authorities' intention to soon start publishing data on external debt and the international investment position, and encouraged them to make continued progress toward the presentation of fiscal accounts in the standard Government Finance Statistics format.