Public Information Notice No. 98/5

Press Information Notice: IMF Article IV Consultation Discussions held in 1997 with the People's Republic of China in Respect of the Hong Kong Special Administrative Region

February 16, 1998

The IMF Executive Board on January 26, 1998 considered a report on the Article IV consultation¹ discussions with People's Republic of China--Hong Kong Special Administrative Region, which were held in late 1997.

Background

The return of Hong Kong to the People's Republic of China took place on July 1, 1997. The terms of the transfer, which are embodied in the Basic Law, included the establishment of the Hong Kong Special Administrative Region (SAR). The Basic Law also provides the SAR a considerable degree of autonomy over economic and other policies, and includes a commitment to the continuation of the existing free-market system for 50 years.

The Basic Law's requirements in the area of fiscal policy include the avoidance of fiscal deficits and the principle of keeping the budget commensurate with the growth rate of GDP. In FY 1997, a surge in land-related revenues is expected to cause the fiscal surplus to exceed the budget target of 2 1/4 percent of GDP by a substantial margin. As a result, fiscal reserves (including the balance of the Land Fund) are expected to rise to over 30 percent of GDP.

The Basic Law also requires that Hong Kong SAR's currency be fully backed by foreign reserves, and the exchange rate is linked to the U.S. dollar under a currency board-type arrangement. As of end-December 1997, foreign currency assets totaled US$92.8 billion.

Real sector developments were generally favorable in 1996 and the first half of 1997, but activity showed signs of slowing during the latter half of 1997, owing to the impact of the regional crisis. Real GDP growth accelerated to 5 percent in 1996, following below-trend growth of 3.9 percent in 1995, reflecting strength in private investment and consumption, as well as the impact of a significant narrowing of the deficit in goods and nonfactor services trade. During the first half of 1997, GDP growth reached 6.4 percent, owing to strength in domestic demand that offset a widening of the trade deficit. Growth is expected to have slowed in the second half of 1997--for an average of 5 1/4 percent for the year as a whole--as a result of the effect of the regional crisis on external trade, as well as the impact on domestic demand of higher interest rates and declines in stock and property prices.

As a result of the pickup in activity to mid-1997, the economic slack that emerged in 1994-95 appeared to have been virtually eliminated. Output at mid-1997 is estimated to have exceeded potential and the unemployment rate dipped to 2.2 percent in the third quarter of 1997, compared with 2.6 percent a year earlier. Reflecting labor market tightness, real wage growth accelerated to 1.7 percent during the four quarters ending in September 1997. However, price pressures were contained--composite CPI inflation was 5.2 percent in December, down from 6.4 percent in July.

The regional crisis contributed to substantial financial market volatility. Stock and property prices rose strongly during the first half of 1997--by mid-1997, property prices were a third higher than their trough in the second quarter of 1994, and the Hang Seng stock price index reached an historical peak in early August, having risen by around 50 percent during the previous 12 months.

However, spillovers from the regional turmoil caused the Hong Kong dollar to come under speculative pressure in the latter half of 1997. Pressures on the exchange rate were successfully resisted by means of intervention in the foreign exchange market and a corresponding tightening of domestic liquidity. Nonetheless, higher interest rates, which resulted from spillovers from the financial turmoil in the region and the resultant pressures on the exchange rate, as well as weaker sentiment contributed to a substantial correction in stock and property markets. By end-January 1998, the Hang Seng index was roughly 45 percent below its 1997 peak, and property prices appear to have fallen by 15-20 percent on average since mid-1997. Although spreads between rates on short-term Hong Kong dollar deposits and U.S. dollar deposits have narrowed, they remain well above the historical average, and major Hong Kong SAR banks responded by hiking their prime interest rate in early January 1998 by 75 basis points.

Executive Board Assessment

Executive Directors observed that, notwithstanding the recent turmoil within the region, developments in Hong Kong SAR during the past year had been satisfactory in many respects. The handover had been achieved smoothly, and confidence in a continuation of the existing economic and legal framework had been maintained under the "one country, two systems" framework. In addition, the economy continued to recover during 1997 from the slowdown of 1994-95, consumer inflation had been contained, the fiscal position strengthened markedly, and foreign exchange reserves increased significantly. Directors observed that, more recently, Hong Kong SAR's solid fundamentals and decisive policy actions had helped it withstand the regional financial crisis and the bouts of speculative attack. In particular, they welcomed that the Hong Kong SAR Government (SARG) had allowed a prompt tightening of domestic monetary conditions under the linked exchange rate system to counter the pressures in the foreign exchange market.

Nonetheless, Directors agreed that the regional crisis significantly clouds the short-term prospects for Hong Kong SAR and exposes it to some vulnerability. In these circumstances, Directors stressed the importance of preserving confidence in the SARG's commitment to a rules-based and noninterventionist policy framework, and ensuring that policies remain supportive of the economy's historical flexibility. They also emphasized the need to maintain strong regulatory oversight over the financial system, especially given the burden on the banking sector of high interest rates and the decline in real estate prices. These policies would help limit the impact of the regional crisis and, as in the past, provide the foundation for Hong Kong SAR's continued economic success in the period ahead.

Directors endorsed the Hong Kong SARG's commitment to the linked exchange rate system, which was demonstrated by its firm adherence to the link in the face of recent speculative attacks. They agreed that the system had provided an important anchor for economic stability since 1983, and that it currently plays a vital role in demonstrating the commitment to an independent monetary and exchange rate policy in Hong Kong SAR, and in maintaining confidence in its status as an international financial center. They emphasized the importance for the exchange rate link of maintaining substantial foreign exchange reserves, a fiscal surplus, and flexible factor markets. While the costs associated with maintaining a linked exchange rate system were recognized, Directors agreed that these were outweighed by the benefits, in Hong Kong SAR's case. In this connection, Directors also welcomed the Chinese authorities' commitment not to devalue the Renminbi, which should further enhance confidence in the maintenance of Hong Kong SAR's linked exchange rate system.

Directors expressed confidence that the economy of Hong Kong SAR would respond flexibly to the impact of the regional crisis, as it had responded to adverse shocks in the past. However, they noted that the openness and liquidity of its financial markets meant that Hong Kong SAR remains vulnerable to shifts in investor sentiment. In these circumstances, and given the continued regional turmoil, Directors suggested that monetary conditions should remain tight in order to maintain confidence in the Hong Kong SARG's commitment to the exchange rate link.

Directors expected that higher interest rates and the effects of the regional crisis on trade would contribute to a noticeable slowdown in activity in Hong Kong SAR during 1998. Indeed, the continued uncertainties about the magnitude and duration of the regional slow down mean that a further reduction in growth cannot be discounted. The outlook for Hong Kong SAR also depends importantly on developments on the mainland of China, given the important linkages between the two economies, and growth on the mainland is expected to slow down somewhat in 1998. Nevertheless, the expected easing of demand was seen as desirable, in view of the signs of overheating that emerged during the past year, including asset price inflation, rapid credit growth, and labor market tightness. A reduction of these pressures would have the welcome effect of facilitating an improvement in Hong Kong SAR's competitiveness, which was adversely affected by currency depreciations within the region. While noting that the recent corrections in asset prices are already contributing in this regard, Directors stressed the importance of continued flexibility in goods and factor markets, especially with regard to wage developments. In this regard, a few Directors noted that the scope for further sharp gains in productivity may be more limited in the future.

Directors commended the Hong Kong SARG for the firm prudential and regulatory oversight of the financial sector and for the recent improvement in disclosure requirements. This commitment, and the strong capital position and profitability of the domestically incorporated banks, helped provide confidence that the system would weather the impact of the regional crisis. Nonetheless, Directors suggested that a further broadening of disclosure requirements could help reduce market uncertainty and limit the risk of unwarranted contagion. In this regard, they welcomed the Hong Kong SARG's willingness to allow weaker financial institutions to fail, in line with its overall noninterventionist approach to policies. They stressed the need to ensure that banks adhere more closely to existing guidelines on property lending, in order to reduce the financial sector's exposure to the real estate sector. Directors welcomed the intention to develop a market for mortgage-backed securities, which would enable banks to improve their liquidity and risk management. A few Directors questioned whether it is appropriate to set up a government-owned mortgage corporation, but noted the Hong Kong SARG's intention to eventually privatize the mortgage corporation. They stressed the importance of ensuring that the mortgage corporation's activities did not transfer risks related to mortgage lending to the public sector.

Directors endorsed the Hong Kong SARG's continued commitment to prudent fiscal policies under the Basic Law. They considered that maintaining a surplus during the coming fiscal year would help moderate aggregate demand pressures, and they urged the authorities to avoid including measures in the 1998 budget that would ease the underlying fiscal stance. Moreover, Directors noted that, particularly at this juncture, large fiscal reserves play an important role in signaling the authorities' continued commitment to the rules-based policy framework. Directors agreed that fiscal reserves also provide reassurance that resources would be available to cope with the longer-run pressures that will result from an aging population.

Directors endorsed the Hong Kong SARG's effort to rationalize housing policies, and encouraged efforts to reduce public sector intervention in the housing market. Directors also welcomed the Hong Kong SARG's continued commitment to a noninterventionist industrial policy framework. In their view, programs aimed at promoting specific industries or sectors risked impairing the flexibility of goods and labor markets. Indeed, they encouraged measures to improve the competitive environment within the nontraded services sector, including through further deregulation, as a means of reducing business costs.

Directors commended the Hong Kong SARG for its efforts to improve the timeliness and accuracy of economic data for Hong Kong SAR. However, they called for further early progress, particularly with regard to the timeliness of data on foreign reserves and the timeliness and availability of data on the capital account of the balance of payments, as well as data on short-term liabilities and banking and corporate sector data. Such improvements would help in monitoring Hong Kong SAR's external position.