Hong Kong: Watch Monetary Conditions and Inflation

Despite our team’s call for a soft landing in the Chinese economy and a US recession, we forecast another year of robust economic performance for Hong Kong in 2008, with growth sustaining at 5.5%, against 6% in 2007. Here we look at Hong Kong’s economic growth drivers in turn:

1) Exports of services – possibly slower, but structurally robust. Economic expansion has remained supported by China’s growing appetite for Hong Kong’s exports of services, which we have long identified as a structural growth driver for Hong Kong. Service exports grew 15% YoY in 3Q07, and the expanding surplus in invisible trade has been contributing more than 2 ppt to overall GDP growth consistently. We expect double-digit service export growth for the fifth straight year in 2008, despite a mild slowdown to a 12% gain, in line with weaker global demand and softer growth in China.

2) Fiscal policy – pro-cyclical tax cuts and infrastructure projects. The Chief Executive’s policy address in October revealed government plans for several new infrastructure projects, and to cut direct (salaries and profits) tax rates in the next fiscal year, lending support to domestic consumption and investment against the weaker global economy.

3) Liquidity – back in overflowing mode. We base our favorable economic outlook on our expectation that Hong Kong’s asset markets will continue to receive support from sizable capital inflows as China further gradually relaxes restrictions on outbound investment (QDII and QDRI), generating a substantial wealth effect that boosts consumption and investment in Hong Kong.

Following recent large capital inflows absorbed by the Hong Kong Monetary Authority, the aggregate clearing balance of Hong Kong banks within the HKMA (pool of interbank liquidity) has increased more than eight-fold over its ‘normal’ level to HK$10.7 bn. This represents a non-interest-bearing asset on the banks’ balance sheets, leaving market interest rates suppressed. Meanwhile, capital inflows that have been absorbed in the banking system ballooned to US$86 bn by the end of October, with inflows totaling US$42 bn in August-October. The associated sharp drop in the Hong Kong dollar loan-to-deposit ratio to 70% (October) has also contributed to the low market interest rates. Also, our team now forecasts the Federal Reserve will cut interest rates another 75 bp to 3.5% (Fed funds target rate) by mid-2008. We expect the Hong Kong authorities to remain committed to the fixed exchange rate, despite strong and persistent appreciation pressure, so Hong Kong will once again import monetary easing in 1H08. All in all, we see more downside to Hong Kong dollar interest rates in the next six months.

Factors aligned for accelerating inflation in Hong Kong, nevertheless. Inflation, though biased downwards by fiscal concessions in 2Q-3Q07, has shown signs of a significant pickup in recent months. Strong consumer demand has allowed considerable recovery in pricing power in discretionary consumer categories. On top of this, Hong Kong has imported significant food inflation from China in recent months. Food prices rose 12% YoY in October. Private housing rents (+5.8% YoY in October) have also contributed significantly to inflation.

Looking ahead, we see increasing inflationary pressure, both cost-push and demand-pull, stemming from a number of factors. On the cost-push side, first, continued appreciation of the Rmb is aggravating rising prices of Chinese imports, especially food, even though direct imports account for only 15% of Hong Kong’s CPI basket, we estimate. Second, the significant weakening of the US dollar against other major currencies has made European and Japanese imports more expensive in Hong Kong dollar terms. Our currency economists forecast the US dollar to regain strength only towards the end of 2008. Third, we expect increasing upward pressure on the general price level passing through from the sharp surge in property values. While housing rents enter the CPI basket directly, consumer goods and services are also being priced upwards to pass on the higher retail space rentals to customers. On the demand side, we see consumer demand remaining strong from the positive wealth effect from asset values, tightening labor market conditions, and rising wages. We expect these to bring CPI inflation up to 4% in 2008.

Negative real interest rates to further support asset markets: The combination of rate cuts and accelerating inflation in 2008 will bring real interest rates down to levels last seen in 1997, though still not as low as they were in the early 1990s. We believe low real rates will support asset prices, in turn reinforcing inflationary pressure.

Stay alert for volatility and shocks: Hong Kong’s fixed exchange rate, small size relative to asset markets, and cross-border trade and capital flows leave the economy vulnerable to exogenous shocks and considerable volatility. While we are optimistic on Hong Kong’s economic prospects over the medium term, believing the economy is well-positioned to leverage opportunities from China’s multi-decade development, Hong Kong’s economic cycles remain dominated by, and often exaggerated by, its passive stance on monetary conditions. Amid the increasing role played by mainland Chinese investment capital in Hong Kong and the negative real interest rate environment, investment capital flows could well be ever more speculative and destabilizing, exacerbating volatility in asset markets and real economic activity in the year ahead. This remains a key risk to the Hong Kong economy, in our view.

By Denise Yam and Qing Wang Hong Kong
Morgan Stanley
December 17, 2007