Hong Kong and the Asian crisis
Growth Model Fails to Deliver

Let’s remind ourselves: a year ago the Hong Kong economy
was booming; the rise in real estate prices and the stock market seemed unstoppable,
the government was announcing budgetary surpluses that would be the envy of any
Western government, Chinese companies were storming the stock market to offer
their securities, which were invariably oversubscribed several hundred times.
In short, at the time of the handover, the Hong Kong economy wore its economic
“fundamentals” as proudly as an A student in front of a motherland whose
economy was certainly growing, but which was wrestling with the endless challenges
of modernisation, and had everything to learn from the territory’s economy.

This makes the contrast today all the more striking. Granted,
at the time of the handover some nay-sayers could be found to predict a downturn,
but few would have bet on such a rapid and profound reversal. After having held
unshakeably until May to projections of 3.5% growth for 1998, when all observers
already talked of a recession, the government of the Special Administative Region
(SAR) has at last openly recognised that that objective will not be reached. And
all the indications are that the Hong Kong economy is falling into severe and
perhaps lasting recession. The Hang Seng indicator of the Hong Kong stock market
has lost 50% of its value compared to last summer, falling from 16,000 to 8,000
points by mid June, and bringing with it the closing of three brokerage houses
caught up in financial corruption scandals, as well as the liquidation of Peregrine—Hong
Kong’s biggest investment group—part of which has since been acquired
by the French banker BNP. Real estate and tourism have fallen by 30 to 40%, while
retail sales have shrunk by 20% and industrial production is down by more than
10%. Chinese companies established in Hong Kong have seen share values collapse;
the famous “Red Chips” (subsidiaries of Chinese companies set up in
Hong Kong) have called a virtual halt to all expansion and capital raising; as
for the Chinese state companies (the “H” shares), their new issues are
being offered only sparingly on the Hong Kong stock market when they had accounted
for almost two thirds of issues in the second half of 1997, after a wave of speculation
which had seen their value double in a year. The financial crisis has spread rapidly
to the production sector with a worrying increase in unemployment, which according
to local analysts is probably greatly understated in the official figures (4.8%
in August 1998). While at the time of the handover it was Hong Kong which was
to help China, the SAR authorities are now trying to attract tourists from China
to compensate for the fall in Asian and even European tourism. Their eyes are
fixed on trends in the Chinese economy which alone seems to them capable of stopping
the recession. Some analysts have thus been able to avoid confronting certain
sizeable imbalances born of a major speculative boom which began in 1995 and increased
markedly from January 1997, and no doubt more fundamentally, having to solve the
equation of the territory in the next decade: how to go on benefiting from the
income from access to a market of 1.2 billion people after having test piloted
its market reforms, notably financially.

So what has happened in the last year? What factors explain
the present crisis? Is it a simple reversal of the economic situation or a deeper
crisis which may change the structure of the Hong Kong economy as well the behaviour
of its decision makers? What interaction with the new political situation—resulting
from the handover and the legislative elections on May 24th—can one anticipate
in the medium term? We will seek to answer these questions by trying to show that
if the Asia recession has played an important role in the development of Hong
Kong’s recession, it has also clearly revealed and exacerbated certain fundamental
flaws in the growth mechanism. Thus Hong Kong has long been presented as a mere
victim of the recession in Asia. However a closer analysis of the situation shows
that the recession in Asia has hastened the bursting of a speculative bubble in
real estate and toughened the challenges posed by the handover, which is to say
a number of problems which were already perceptible in Hong Kong when the Thai
currency was devalued on July 2nd 1997. Therefore, unlike those who think that
a return to sustained growth will be brought about rapidly and painlessly by the
mere flexible movement of the market, one can no doubt show to the contrary that
sound and lasting outcomes are unlikely to be found without deeper adjustments,
some of which go way beyond the economic sphere.

The direct consequences of the Asian recession

The financial virus

Hong Kong could not claim the status of second largest
financial marketplace in Asia while considering, as it did for several months,
that it would not be affected by the Asian recession. Moreover, on a purely internal
level, the Hong Kong financial system constitutes an integral part of the Asian
recession by virtue of a system of growth over the last ten years based entirely
on real estate, the stock market and their collaterals. The latter have made possible
the obtaining of rapidly increasing bank credit which has, as elsewhere, benefited
from negative real-term interest rates due to the positive inflation differential
with the US which has suddenly been reversed in a few months.

Hong Kong’s financial marketplace essentially fulfils
three functions:

– An offshore centre, number one worldwide, with US$121
billion in commitments from Western banks declaring to the Bank for International
Settlement (BIS), to which must be added commitments from the other, non-declaring
countries like the Cayman Islands or Singapore (35.4 billion at the end of 1997),
or other Asian countries like Korea (8 billion), Thailand or even Indonesia. Overall,
the commitments of foreign banks in March 1997 amounted to 66.6% of total deposits
in Hong Kong, as against 2.2% in China, 44% in Korea, and a record 262% in Singapore,
because of its privileged position as a regional currency market rather than as
a financial banking centre, as with Hong Kong.

– A maturity mismatching centre for China with commitments
there which amount to US$33.8 billion in currency and to 17 billion in Hong Kong
dollars equivalent, and its privileged role in direct foreign investment (DFI)
into China (57% of 1997’s 45 billion) as well as from China (10 billion between
1985 to 1995 according to the CNUSED in 1997).

– A local financial centre of the first rank in the region
with a local stock capitalisation of US$595 billion at the peak in 1997, equivalent
to 341% of GNP—the highest in the world—(18% in China, 211% in Singapore),
and a mass of local credit estimated at US$288 billion last December, equivalent
to 169% of GNP, also the highest—along with Thailand—in Asia.

The Asian recession has caused a break in all three of
these areas:

1. There has been an overall contraction of international
financing in Asia (liquidity crisis) and a dizzying rise in risk ( solvency crisis).
Among the banks declaring to the BIS, offshore capital withdrawal reached US$35.8
billion during the second half of 1997 of which almost a third (10.3 billion)
from Hong Kong. Including those of non-declaring countries, total withdrawals
from Hong Kong are estimated at 24.3 billion. Japanese withrawals have predominated
at 11 billion, followed by the German banks (4.2 billion), the Italians (1.3 billion),
the Spanish (1.2), etc. Only the French banks in fact have increased their commitments
(up 4.2 billion).

2. The effects of the recession on the Chinese diaspora
in Asia and rising uncertainty about China’s capacity to resist regional
deflation are translating into collapses such as those of Peregrine or the Chinese-Thai
C.P. Pokphand group (quoted on the Hong Kong market). The latter was pressed by
its creditors to sell off its acquisitions in China in order to meet its banking
liabilities of over US$1 billion. This also concerns the viability of investments
made in China, notably in real estate, and those realised in Hong Kong, often
at the height of the stock and real estate markets. The fall in value of the Chinese
companies quoted in Hong Kong, their downgrading by international agencies such
as Moody’s, the pressure from foreign banks to reduce their credit lines
on groups which now seem overstretched in relation to assets (CITIC, China Everbright,
etc.) are part of this “credit crunch” movement which is also the expression
of the doubts of investors about the capacity of the local authorities to supervise
the quality of investments on the market. Moreover, the crisis on the stockmarket,
whose Han Seng index could fall to a low estimated at 6-7000 as against 16,673
at the peak of 1997, and above all the maintaining of interest rates above 10%,
have broken the resilience of the financial marketplace for its operations in
China. No sizeable investment has seen the light of day since the crash of October
23rd, the syndicated loans still agreed on are in fact remaining stuck in the
banking pools which set them up, and the Chinese groups are obliged to go on to
the international market (New York or London) to place their issues of convertible
bonds, the quid pro quo being a much greater demand for openness than has been
the case in Hong Kong in the last few years.

3. Finally, a crisis specific to the Hong Kong dollar
and to its internal financial system has appeared. Its outcome will depend largely
on the ability of the SAR authorities to manage the variables which concern them:
whether or not they adjust Assat values. The Standard & Chartered Bank has
thus just estimated at 2 million per household the loss of wealth due to the deflation
of the real estate and security bubbles. The collapse of several brokerage houses,
of which C.A. Pacific was the most resounding, was only a reminder of the size
of the pyramid of assets built on real estate and stock portfolios (see above).
Under these conditions, the Hong Kong financial system cannot but be hit by the
same credit crunch and rise in solvency risk, thus reducing its capacity to finance
China and the other countries in the region. Moreover this explains the withdrawal
of the international financial corporations, which are seriously reducing their
staff, after having waited several months to evaluate the severity of the financial
crisis in the region and in Hong Kong. Furthermore the credit crunch—already
very noticeable for medium-sized companies, of whom many have delocalised to China
as well as to Vietnam and elsewhere—is beginning to reach the big Hong Kong
groups including the largest like Cheung Kong, New World, etc. These groups were
the principal justification for the notion of “special doorway to China”.

The main variable which symbolises the pressure on the
Hong Kong financial system is now interest rates. These will average 10% over
the year ahead, as against inflation of 2%—a stunning reversal of real-term
rates to the detriment of debtors whose asset values, meanwhile, are collapsing.
Nonetheless, two factors could save the SAR from a major financial crisis:

– a greater liquidity of the big Hong Kong groups, but
also of the medium-size companies, of which those which produce for export are
rarely over-indebted;

– more rigorous management of the Hong Kong banks which
have also had their fingers burnt by the periodic recessions which have hit the
territory since the 1950s, and whose bad debt should not exceed 10-15% at the
worst, with 50% recoverable. Compared with a shareholders equity ratio of about14%,
the probability of a systemic crisis in the banking system remains very low, despite
a few inevitable banking collapses. But the adjustment of the financial system—which
should last at least two years and be more stringent than in 1974 or 1983 (see
below)—will notably reduce Hong Kong’s regional area in future years,
putting it in competition with the biggest world market places, but also with
Shanghai, which is to benefit from the desire of the Chinese authorities to modernise
their financial system and make more use of their savings resources in renminbi.
Thus the publication last March of a comparative study of offshore centres in
Asia by the Hong Kong Trade Development Council (HKTDC), includes a comparative
table with the financial reforms envisaged in Singapore which demonstrates the
challenge offered by this competitor market place for the whole of Saoutheast
Asia. To this must be added the structural withdrawal of the Japanese banks and
anxiety among Taiwanese investors who have emigrated in the last few years to
other fiscal havens like the Virgin Islands. The reduction of the regional financial
area is thus a real risk for Hong Kong.

Commercial contagion

Hong Kong is a commercial dwarf in terms of exports (US$27.4
billion in December 1997, about equivalent to Poland at number 23 in world exports),
but a world giant in terms of the trade that passes through its port and airport
infrastructure (188.1 billion, number 5 worldwide, ahead of Singapore). To these
trade flows must be added the service flows, in particular tourism which multiplies
the number of local consumers by 2.5.

The considerable dependence towards Asia is far from being
limited to Chinese re-exports, as is often believed. Of HK$443.9 billion in re-exports
in 1997, mainland China accounted for 35.7%, the US 20%, and the rest of Asia
almost 25%. If we look at total exports, Asia’s share—including China—amounts
to 76.7%, the highest dependence in the whole region. The impact of the crisis
in this field is twofold:

– In the short term, deflation in Asia and the reduction
in intra-Asian trade, of which Hong Kong was an essential centre, translate into
a major loss of earnings on two counts: the fall in Asian imports, particularly
in countries like Korea ( down 40%), translates into a sizeable downturn in regional
re-export trade, while the small rise in exports to the rest of the world, due
to the difficulties connected with the financial crisis in these countries, does
not compensate for this fall in intra-regional trade. Chinese exports which had
boomed in the years following the 1994 devaluation (and were still up 25.8% in
1997) are expected, according to all the experts, to slow down seriously to about
5%, or even less in the most pessimistic estimates (they were down by 1.5% in
May 1998). Taking into account a squeeze on margins linked to an abundance of
exportable products which are often fairly similar, pressure on transport costs
will be very strong, while many local Asian hauliers have capacity which has been
freed up by the reduction in export volumes (Korean hauliers in particular). Hong
Kong’s unit freight costs are by far the highest in the region, which means
that it is likely to be hit harder by the effects of a slowdown.

– In the medium term, regional competition is going to
be strengthened, in particular with the Chinese ports where Hongkongers themselves
have often invested (Mr Li Ka-shing in particular). This concerns all the coastal
ports of China as well as those of the South, in particular those of Shenzhen
whose traffic doubles every year, while Hong Kong’s has gone from a yearly
growth of 15% to 4% last year, and is expected to go into negative growth this
year. The process was already clear in 1997 with major growth in “direct
shipment” traffic which no longer registers as re-exports from Hong Kong.
The same is true of trade with Taiwan, which now has a direct link open between
Kaohsiung and the Xiamen region. Another example is the mushrooming of airports
of international class, not only in the South (which now has five), but all over
China, at the very moment of the opening of the huge Chep Lap Kok airport.

The maintenance of parity at any cost

When the “peg” system and the currency board
were set up in Hong Kong in 1984, the idea was that in a small-scale economy like
Hong Kong’s, the establishment of a stable currency would encourage the expansion
of finance-based activities, while also making possible rapid wage and price adjustments
in the event of external crises. This system has worked well, enabling Hong Kong,
in the space of 15 years, to become Asia’s number two financial marketplace
and to overcome several external crises without too many problems, in particular
the Wall Street crash in 1987, and the crises of confidence linked to the negotiations
between Britain and China over Hong Kong’s status. In the framework of a
fixed parity, as soon as local or foreign investors express doubts—whether
justified or not—about the Hong Kong economy, interest rates rise in order
to ward off attacks and predictions of a fall in the Hong Kong dollar. The system
works fairly well in case of short-term crises because interest rates soon return
to previous levels. But it also has two drawbacks.

On the one hand, it does not make it possible to compensate
by devaluation for a rapid rise in prices in certain sectors which lead to a loss
of competitivity in the medium term. The skyrocketing prices in real estate dating
from the end of the 1980s—when office rents soared by 300 to 400%, depending
on area, between 1987 and 1997—helped make Hong Kong, in the space of ten
years, into the most expensive city in the world after Tokyo. A devaluation by
the British authorities before the handover, or by the SAR just before October
1997, would have made it possible to curtail the loss of the Territory’s
competitive edge.

On the other hand, if an external crisis drags on, as it
has since the summer of 1997, the rise in interest rates has time to affect the
real sphere of the economy and accentuates the slowdown in activity just when
the economy needs activity most. Already, several months before the recession,
real interest rates were higher than those prevailing in the US. But, since the
summer of 1997, they are at levels which are slowly strangling the economy of
the Territory, that is to say three or four points higher than the American rates
for long term rates, when in normal times the difference does not exceed one fourth
of a point. The first consequences are financial, with a fall in stock values
which brings in its wake a destruction of wealth and a fall in the value of the
collaterals which are used to guarantee investments. The financial situation of
companies is also hit by the rising cost of credit, while that of households also
suffers from the rise in interest rates with a noticeable rise in mortgage interest
payments and a loss in the value of their mortgage.

However, beginning at a certain point, these effects combine,
feed on each other, and wind up having devastating effects on the real economy:
increasing bankruptcies, rising unemployment (the official rate may reach 6 to
7% at the end of the year), increasing precautionary saving by households and
falling consumption. Moreover the withdrawal of the Japanese and European banks
in company credit operations and in refinancing on the Hong Kong banking market
has not helped. In a context which threatens a rapid increase in payment default
with the fall in the stock market (and the loss of wealth which traditionally
accompanies it), and the rise in household real estate mortgage repayments, local
banks are being more and more cautious. They are seeking to reduce their loans
and are demanding (as they are entitled to under Hong Kong law) repayment before
due date of loans given to companies in order to reduce their exposure to risk.
The result is that the Hong Kong economy is today trapped in a vicious circle,
and nobody, in the present conditions of economic turbulence in Asia, seems able
to predict when it will be broken.

By making the present parity of the Hong Kong dollar a
political issue, the SAR authorities have themselves discarded an important ace
from their hand: the possibility of using a devaluation as tool of economic policy.
In an interview on the BBC on June 25th last, Sir Donald Tsang, the Financial
Secretary, reiterated that he would resign if the parity was changed. The handover
did indeed focus the attention of the Chinese authorities, but also the British,
on the existing parity as one of the most important indicators of Hong Kong’s
wealth and of the superiority of its institutions. This contributed to linking
the present parity with the future of the peg system itself and of its institutions
like the currency board, which—until evidence to the contrary is found—could
perfectly well continue to exist after a readjustment of parity. Before the handover,
neither the British nor the Chinese authorities were willing to consider the possibility
of using a devaluation to compensate for the effects of skyrocketing real estate
prices. Each would have accused the other of wanting to harm the superiority of
Hong Kong’s institutions.

Furthermore, since the beginning of the Asian recession,
the SAR authorities (with the approval or on the instructions of Peking) have
betted that the outside impact from the Asian recession, would be short-lived.
“The crisis will be over at Christmas” was the message in in circles
close to the government last autumn. This made it possible to play on the flexibility
of the markets without too much social disruption using a rise in interest rates
coupled with wage and price reductions, in the hope that after a few difficult
months, everything would get back to normal. However the SAR authorities have
greatly underestimated both the extent and duration of external impacts as well
as their explosive combination with the internal problems of the Hong Kong economy.

In fact as things stand, the SAR authorities are condemned
to fall from Charybdis to Scylla. For if the authorities were to decide now to
change the parity, or even worse, to put an end to the institutions which sustain
the peg system in the Asian monetary turbulence, that decision could have consequences
for the Hong Kong economy that would be difficult to predict. After having repeated
on every possible occasion that parity would be maintained whatever the cost,
a devaluation would an extremely negative signal to the market. Given the politicisation
of parity, a devaluation could translate for Hong Kong residents into a loss of
confidence in the government’s ability to maintain the value of their currency.
Even though a general payment crisis of the Korean or Indonesian kind is highly
unlikely because of the currency reserves—which cover almost twice the money
supply in HK$—and the banks’ low debt levels, residents could massively
convert their Hong Kong dollars assets into foreign currencies (principally US
dollars). The authorities would then likely be obliged to use a sizeable part
of the reserves and maintain interest rates at a high level in order to defend
the Hong Kong dollar. Moreover, at this stage of the recession, and taking into
account the monetary instability in Asia, the SAR authorities seem condemned to
maintain the present parity. Obviously it is difficult to rewrite history and
know if a devaluation before the handover, or just before the market crash of
last October, would have diminished the effects of the Asian recession and curtailed
its spreading into the economy of the Territory as the experience of Taiwan might
indicate. In any case, in choosing the maintenance of parity, the SAR authorities
knew full well that if the external impacts were prolonged, Hong Kong would be
exposed to a drastic adjustment of stock values, prices and wages with unpredictable
economic consequences.

The burst of the real estate bubble

Hong Kong is often wrongly portrayed as the city where
trade and finance predominate. But a more finely tuned analysis of the statistics
brings out a different picture. Real estate is in fact by far the largest sector
in the Hong Kong economy. If we add up the two categories connected to real estate
which appear in the annual economic census i.e. that which is called “real
estate activities” (development, rental, property management) which amounts
to 12.4% of GNP and the—often overlooked—activity of private individual
rentals (under the category “ownership premises”) which represents 12.7%
of GNP, we get over a quarter of GNP linked to real estate activities in 1995.
Trade which comes in second, amounted to only 17.1% on GNP and finance 10.6% in
the same year. Even more significantly, real estate has been, since the middle
of the1980s, the activity which contributes the most to GNP and income growth:
its contribution was on the level of 22.2% between 1985 and 1990, rising to 31.5%
between 1990 and 1995 (with peaks of 43% in 1994), far ahead of trade with 17.5%
and 19.6% and finance with 7.5% and 15.7% over the same periods (1). These figures
are enough to show that real estate is far from being just another sphere of activity
in the Hong Kong economy. In fact it has been the main engine of growth since
the middle of the 1980s. The importance of real estate in the growth of the financial
markets, tax revenues, banking profits and household income is so great, that
the collapse of the market since last summer cannot continue without having profound
effects on the economy of the territory.

The skyrocketing of real estate prices is not only the
result of so-called objective facts which are traditionally presented—strong
demand ( the arrival of 150 emigrants from China daily, demand from foreign companies)
and low supply constrained by physical conditions (small area, low buildability).
In reality, the SAR authorities have a sizeable land and several analysts estimate
that at constant density, Hong Kong could double its population if the amount
of land sold yearly were to increase (2). The rise in real estate prices is above
all the result of a deliberate policy pursued by the British administration since
1985 with the approval of Peking. The signing of the Joint Declaration in 1984
set a ceiling on land sales of 50 hectares a year from 1985. By limiting the amount
of land sold, when economic and population growth continued to increase rapidly
(about 200,000 more people per year in the territory, an increase of 2 to 3%),
sale prices took off from 1987 on. Since then, real estate has become a means
of enrichment for all the actors in the economic life of the territory.

The primary beneficiary has been the government which,
thanks to the rise in land prices and the various property-related taxes, has
continued to derive an average of almost 30% of its tax revenue from property
and land (3). The second and certainly the major beneficiaries have been real
estate developers, with the big construction companies in their wake. Part of
real estate construction from 1988 was turned over to private developers (4).
The enormous sums that they needed to raise to acquire sites which were sold at
auction, quickly created financing entry thresholds and contributed to the creation
of an oligopoly: seven groups (Cheung Kong run by the billionaire Li Ka-shing,
Sun Hung Kai, Henderson, Sino Land, Swire, Wheelock & Co and New World) have
since divided most of the market between them. The limited quantity of apartments
put on the market has allowed these developers to reap phenomenal profits, with
returns on investment which have been able to reach almost 100% in some years.
The third category of beneficiaries is more difficult to define, but some households
with high savings capacity have also greatly benefited from this growth in property.
In a bullish property market, apartment purchases have become the investment most
highly prized by Hong Kong households. A rentier class, living on property has
grown up rapidly since the mid-1980s and though information is difficult to obtain
to better define this population, private rental income derived from property
amounted to 12.7% of GNP in 1995, more than finance (10.6%) or retailing (5%)
(5). Low—and sometimes negative—real interest rates encouraged households
to invest in property, rents being sometimes higher than mortgage repayments.
In a context where there is no pension system worthy of the name, households have
tended to think of property as a financial product similar to stocks and bonds
to provide for the future. So much so that the notion of home ownership is in
many cases a secondary motive in purchasing decisions, the dividing line between
speculator/investor and end-user being less and less clear. It is thus no accident
that in the Hong Kong asset structure in 1995, real estate and land were far in
front representing 302% of GNP, ahead of market-quoted stocks equal to 217% of
GNP, and a tiny bond market equivalent to 21% of GNP (6). The banks have also
benefited from real estate growth. A little over 40% (the official limit of 40%
was exceeded in 1997 to reach 50% according to the experts) of their credit business
is dominated by real estate loans which bring in considerable income. Finally
the last link in the system is the stock market. The high margins realised in
real estate have encouraged investors to invest heavily stocks linked to that
sector. This has allowed real estate developers to raise, in parallel with syndicated
bank loans, sizeable sums on the Hong Kong stock market for their financing needs.
Thus real estate is reckoned to largely dominate the Hong Kong stock market with
60% of stock capitalisation (7). In this context, all the principal players in
Hong Kong’s economic life have contributed by their actions to this “prosperity
pump”, leaving in subsidised public housing the almost 50% of the population
that did not have the means to get in on the action. Neither the British government,
wishing to leave behind an image of prudent management, nor Peking, anxious to
ensure a problem-free handover and to win the friendship of the business world,
wanted to face the problem of the dizzying rise in real estate prices, both preferring
to take up a position behind the so-called objective facts of supply and demand.

Of course, Hong Kong is far from having made the same mistakes
in real estate as the other Asian countries. The banks have been subjected to
stricter control of their credit business by the monetary authorities. They also
have much higher liquidity ratios than in Japan before the bubble burst (an average
of 17.8% in Hong Kong compared with 9% in Japan in 1990) and payment default is
at a very low level for the moment, less than 1%, even if it may rise rapidly
with increasing unemployment (8). The risk of a generalised liquidity crisis in
the interior banking system is thus very limited. However this frenzied activity
on the real estate market did indeed have some negative effects on the territory’s
economy long before the recession in Asia. A recent study estimated that, just
before the fall in real estate prices, the average shop rents in Hong Kong were
41% higher than in the most expensive areas of New York (9). Some hotels in Hong
Kong demanded from the retail tenants established inside their buildings prices
close to double what is charged in London or Tokyo (10). The cost of real estate
has been added to the price of goods, making Hong Kong one of the most expensive
shopping centres in the world. The cost of an expatriate or of skilled labour
is among the highest in the world, again just behind Tokyo: a university professor
makes US$250,000 a year and a mid-level manager US$65,000 (11). Moreover as soon
as there is an economic downturn or a loss of confidence in the territory’s
advantages, such costs quickly have negative effects on tourism, retailing and
foreign company expansion decisions, in an environment where devaluations have
again made the main Asian capitals a little less expensive. But these are not
the only negative effects on Hong Kong’s economy.

Given the importance of real estate in the incomes of the
economic players (government, households, banks, shareholders and companies) the
kind of price adjustment we are experiencing now, has devastating effects on the
economy, creating colossal destruction of wealth. A study published by the Standard
& Chartered Bank estimated that the fall in stock values and real estate prices
since the beginning of the recession may have caused losses equivalent to HK$4,300
billion, or over three times Hong Kong’s GNP (12). The effects on consumption
and banking are immediate, as is shown by all the indicators published in the
last few months. Finally, the speculative practices which have gone along with
the growth of real estate have created an income economy with resources being
recycled in non-productive activities, reinforcing Hong Kong’s dependence
on real estate.

This state of affairs has moreover been quickly realised
by the new administration of the SAR. Tung Chee-hwa’s general policy programme,
announced last October, was to break the speculative spiral by the building of
85,000 apartments a year, of which a good number would be in the public sector.
His idea was to slowly deflate the property bubble, to favour earned income and
direct the recycling of resources towards high value-added production, clearly
inspired by policy followed in Singapore (13). However, the new head of the Executive’s
plan had not anticipated the Asian recession, which has accelerated and amplified,
through the rise in interest rates, the effects of the deflation of the real estate
bubble. The government is now seeking to avoid an over-rapid fall in prices, while
being unable to act on interest rates, because of the Asian monetary situation.
Slow price deflation allows the consequent losses to be spread over several individuals
or institutions, to the extent that the owner can still sell off his real estate
assets. Moreover, real estate values, after a slight fall, are less likely to
be below the financing secured on them by the banks, which are thus less likely
to call in their loans. On the other hand, in the case of a rapid fall in prices,
potential buyers disappear (as is the case at the moment) and the cost is borne
by a single person. The value of the real estate asset often falls below the amount
of financing extended by the banks, which are moved to call in the loan, placing
individuals in a difficult financial situation, often leading to a renegotiation
of the agreements or simply to payment default.

In spite of the measures decided on the 23 June last by
the SAR government, aimed at stabilising prices by halting the sale of land until
the end of March 1999 (the end of the fiscal year), the odds are that we won’t
soon again see the likes of the real estate price explosion that happened between
1993 and 1995 and from the end of 1996 to the summer of 1997. Firstly, in the
short term, the monetary instability in Asia is likely to continue. Both the local
and foreign banks have already begun to adopt a policy of exposure reduction,
in particular in real estate. Where during July 1997 they had extended HK$3.85
billion in loans tied to real estate, they had only lent HK$1.32 billion in the
month of April last (14). Interest rates are also likely to remain high, keeping
mortgage costs above rent levels and the restraining the rise in stock prices.
In the longer term, however, unless there is a spectacular reversal of Tung Chee-wha’s
policy, the Hong Kong population knows now that the recent measures are only temporary
and that the new government’s long term objective remains to reduce real
estate prices and curb speculative practices in that sector. In any case, if the
parity of the Hong Kong dollar remains at this level, another rise in real estate
prices would be difficult to imagine, in an Asia where all the currencies have
been devalued. In this context, it does seem that this sector will no longer be
able to be the main engine of economic growth, as has been the case in the last
ten years, which could have profound consequences on the territory’s economy.

Structural evolution linked to the handover

At the time of the handover, a good many questions were
raised about the economic future of the Territory. Most of them remain more relevant
than ever, to the extent that the present recession could precipitate structural
changes linked to this change in Hong Kong’s political status. Among these
questions, the issue of the complementarity of the two economies remains central,
both from the point of view of the division of labour and of infrastructure, and
from the financial point of view.

From the point of view of financial complementarity, the
time of the handover was an occasion for big plans being drawn up for Hong Kong.
The SAR was in particular to play a crucial role in the financing of the restructuring
and privatisation of the Chinese state sector, as well as in the growth of certain
large companies with subsidiaries in Hong Kong—the Red Chips. The Chinese
companies were supposed to build on their performance in the early 1990s when
they experienced an exponential growth in their financing capability. A recent
analysis estimated that Chinese companies established in Honk Kong (the state
companies issuing “H shares”, the quoted or unquoted Red Chips) probably
raised on the stock market and from the local banking system between US$40 and
60 billion between the beginning of th 1980s and 1995, or about half of China’s
foreign debt over the period (15). From this point of view, the post-handover
period has got off to an inauspicious start. The Chinese companies quoted on the
Hong Kong market have seen their values collapse: the Chinese companies index
fell by 75% between July 1997 and June 1998—twice the decline in the Han
Seng general index. As we pointed out in the introduction, the new flotations
of state companies and the equity issues by Red Chips on the Hong Kong market
are being offered only sparingly since the beginning of the Asian recession.

The question which then arises is whether everything will
return to the status quo ante when the monetary unrest in Asia has settled
down. Those in charge of the Hong Kong stock market display an optimism which
is almost disconcerting in the present climate, announcing recently their desire
to propel the Hang Seng index to around 20,000 points in the space of five years
(today it fluctuates between 7,500 and 8,500 after hitting 16,673 last August)
with the quotation of some 150 further Chinese companies (in addition to the 100
presently quoted). Even though a complete reversal of the situation is always
possible, such a project seems more aimed at raising the morale of the troops
than providing an objective attainable in the medium term. There are several reasons
for this. The present crisis is likely to leave its mark on investors, both on
the local population which has in some cases seen its savings literally evaporate
by investing in these companies, as well as on institutional investors who are
likely in future to make much stricter demands in terms of transparency. The Red
Chips and H shares have been through crises of confidence before (16). In 1990
and again in 1995, investors felt that these companies were compromised by transaction
costs too excessive for them to be able to invest in them in complete confidence.
However, before the Asian recession, symptoms like the difficulty of obtaining
consolidated accounts, the diverted and speculative use of funds raised on the
stock market and originally earmarked for productive investment, seemed major
risks, but acceptable ones, bearing in mind the growth rate in the region. These
risks are much less acceptable to investors since the recent events in South Korea,
Japan and Southeast Asia. Investors ( in particular institutional ones) have set
their demands much higher in terms of openness, of assessment of the real value
of the Chinese assets of Chinese companies in Hong Kong since the beginning of
the recession and are likely to continue to do so in future. Some Red Chips like
Shanghai Industrial Investment (with a debt to capital ratio equivalent to 380%),
Guandong Enterprises Holding (237%), or Cosco (213%), have such a high level of
debt that some analysts have called their financial situations “Korean-style
balance sheets” (17). Moreover since the beginning of the recession there
has been a reversal of the situation in terms of the cost of raising capital between
Hong Kong and China. Where for several years the cost of credit was noticeably
lower in Hong Kong, the rise in interest rates in the SAR and the fall in rates
in China now make it more advantageous for Chinese companies to raise funds directly
in China. There again, the length of monetary instability in Asia, and the question
of the parity of the Hong Kong dollar will play a central role in this difference
in interest rates between Hong Kong and China. Finally, it must be pointed out
that the Chinese companies established in Hong Kong have been both the actors
and the most important beneficiaries of this growth in real estate. At the time
of real estate boom in 1994, they carried out a little over 30% of real estate
transactions (18). If, as we believe it will, the importance of this sector in
the Territory’s economy declines in the years to come, the consequent effects
on the financial health and investment strategies of the Chinese companies should
make themselves felt. Thus it is no accident that during last June the international
rating agency Moody’s Investors Service put under review the classification
of seven parent companies of Chinese companies established in Hong Kong, notably
the CITIC Beijing group, parent company of CITIC Pacific, one of the jewels among
the Red Chips in Hong Kong (19).

For all the reasons given above, we believe the Asian recession
is bringing about the exhaustion of a development model whichgradually established
itself between the first energy crisis in 1974 and the signing of the Joint Declaration
between China and Great Britain in 1984. More and more analyses take the recession
of 1974 as a reference point, rather than those of 1984, 1987, 1989 and 1995,
in oder to understand the present situation (20). The 1974 recession had initiated
the structural adjustments in th Hong Kong economy which took on a definitive
aspect only in the second half of the 1980s, with as their main features the gradual
reorientation of industry towards services, the transfer of industry to Guangdong
province and the development of a new real estate policy. A similar period may
be beginning now through adjustments and the search for new growth niches.

Assets and uncertainties in recession-beating policies

Hong Kong is far from lacking in assets to emerge transformed
from this recession. As well as the size of its reserves and the healthof its
banking system, the government could, in the medium and long term, continue by
certain measures to transform function structures of the economy. The question
of industry and technology policy, which unleashed heated debate in the territory,
was a little too concentrated on the construction of the famous technology park
which should be finished in 2013. Now even if competences and a territorial specialisation
cannot be reinvented in the space of a few years, Hong Kong would seem to have
everything to gain from policies which aim to encourage the territory’s companies
to offer higher value-added goods and services in a competitive environment: human
resource development, help in financing innovative small companies, and a competition
policy. All these policies could make it possible for local companies to rise
on the value-added ladder and better manage a specialisation complementary with
China, as is proved by numerous successes of Hong Kong companies in textiles and
electronics (21). The creation of a second market on the Hong Kong stock exchange
for these innovative small and medium size companies could not only help local
companies, but attract firms in the region, and reinforce Hong Kong’s financial
mediation role. Several small and medium size Taiwanese companies seem to have
already shown interest in this project (22). Moreover, anxious to stimulate activity
in the SAR, Peking could help Hong Kong investors by offering them special access
to the regions of the interior, and by speeding up a little more cooperation with
Guangdong province, in particular on the level of infrastructure and technology.

There remains nevertheless much uncertainty about the SAR’s
ability to break out of the recession quickly and to rebuild new bases of sustainable
growth. Unlike what happened after the 1974 recession where the rapid growth in
exports facilitated structural adjustments, government and private sector initiatives
will, in the next few years, come up against a more difficult environment given
the depressed regional economic context. Meanwhile, the Hong Kong economy will
certainly, in the short and medium term, have to continue undergoing the consequences
of the drastic adjustment in real estate prices which began in the autumn of 1997.
Apart from some dissenting voices issuing from the real estate developers, most
analyses agree in recognising, in the line of the programme announced by the leader
of the executive in October 1997, that the deflation of the real estate bubble
must continue. Only such a policy would make Hong Kong more competitive, and cut
back on speculation while redirecting resources towards productive investment.
But it would above all make it possible to stimulate consumption by reducing the
enormous hidden tax disguised as the exorbitant cost of housing (and by repercussion,
of goods and services) which weighs on household incomes.

However, having made this assessment, it remains true that
many Hong Kongers now doubt the government’s ability to impose the necessary
adjustments on certain classes who have greatly benefited from the high real estate
price policy—the developers and the landlords. For the reasons given above,
it is understandable why the government seeks to avoid too rapid a collapse in
real estate prices. However the recent decisions to halt land sales have been
widely interpreted as a sop to the developers who on several occasions had emerged
from their political neutrality to denounce the SAR government’s housing
policy (23), while at the same time, various categories of landlords continued
to refuse their retailing tenants any adjustment in rents. Several coalitions
of retail tenants have appeared in the last few months to petition both the government
and the developers for rent reductions. Some shopping centres have empty space
rates of 40 to 50% with the departure of retailers who, with sales falling, can
no longer pay their rents. However their demands are far from being satisfied,
with landlords offering reductions of 10 to 15% at most. Some retailers who signed
leases in 1996 have had their rents raised, with landlords reckoning that prices
on the market are now higher than they were in 1996, where the coalitions reckon
that there should be reductions of from 30 to 60%, to be able to survive in such
a difficult economic climate (24). Also the banks will have to accept the idea
of fixed-rate real estate loans which are still not available. Likewise, while
Hong Kong is one of the ports which charges the highest prices in the world, charges
for transshipment and infrastructure use have been increased by 20% for Asia-bound
trade, and 3.8% for that to North America, to the fury of the Hong Kong Exporters
Association (25).

On the fiscal level, many questions have been asked about
the government’s policy. On the one hand about the choices made in the face
of the possibility of a structural reduction in tax revenues connected to real
estate, which would produce a structural tax deficit. As proof of this, the recent
decision to freeze land sales translated automatically into the anouncement of
a possible tax deficit for 1998, when in the budget projections, Secretary of
Finance Donald Tsang had foreseen last February, surprisingly, a tax surplus of
HK$77 billion (26). The currency board system prevents the government from following
a policy of monetary creation unrelated to currency earnings: for each US dollar
held in Hong Kong the three issuing banks can create HK$7.7. Moreover the Basic
Law, which serves as a constitution in Hong Kong, outlaws a structural budget
deficit. The authorities seem to be following an ostrich policy for the moment,
and maintain that if there is a deficit, it will be temporary. But if the recession
continues for a relatively long period, a compromise will have to be made between
modifying the fundamental law or raising taxes, which would would call into question
Hong Kong’s tax haven status.

On the other hand, on the utilisation of the colossal HK$446
billion reserves. The democratic political parties, which made a strong comeback
in the new Legislative Council elections of May 24th, think that the time has
come for the government to keep its promises: that the reserves will be used,
as the Finance Secretary declared in 1997, ”when bad weather hits Hong Kong”.
Although the government reiterated last June that for reasons of fiscal prudence,
Hong Kong could not use its reserves to ease the consequences of the recession
(27), it intervened heavily at the end of August on the stock exchange, buying
an unprecedented—and unexpected—amount of US$15 billion of local blue-chip
shares (nearly one-fifth of currency reserves).

These questions highlight a set of problems linked to the
exercise of democracy in the resolution of economic and social dificulties caused
by the present recession. The longer the recession lasts, the more the lack of
democracy and openness which characterise the political institutions of the SAR
will be criticised by a population which has already repeatedly shown its democratic
aspirations during the elections. One can indeed wish that this recession will
be a favourable time to rethink, in a more democratic way than in the past, a
certain number of fundamental economic questions such as taxation, social insurance
and real estate. The SAR government still has a wide margin of manoeuvre: the
size of reserves, the quality of the infrastructure, and the immigrant mentality
which continues to prevail in the most disadvantaged classes, still determined
to succeed with few social demands in spite of a level of inequality which remains
among the world’s highest (28). Finally the agglomeration effects of economic
activities which are not easily suppressed and which continue to work in Hong
Kong’s favour. Nevertheless the government will have to react quickly, for
time is short and the challenges are mounting up. Above all, it will have to avoid
advocating as the only solution, the reversibility of economic trends by the workings
of market flexibility alone, for this flexibility exists only in the textbooks.

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