Financial Times

A Test of Nerve

Events abroad will mainly determine how deep
and long the downturn will be

By Peter Montagnon

For much of last year Hong Kong seemed to have weathered the worst of the Asian economic storm: property prices turned softer after the July handover, there was evident weakness in the tourism and retail sector and there were even sporadic speculative attacks on the currency. But Hong Kong's strong banking system and its sound economic management record seemed sufficient to stand it in good stead.

Only after the government revealed last month that the economy shrank by 2 per cent in the first quarter of this year did the full extent of the damage sink in. Now the territory is bracing itself for a full-scale recession, and the questions are how deep will it be and how long will it last.

The answers are made all the harder because only some of Hong Kong's troubles are internally generated, and those that are - such as weakness in property prices and consumer spending - are mainly related to confidence. A large part of the problem relates to external factors over which the territory has no control.

Worries about Japan and the persistent slowdown in China's economy have put pressure on Hong Kong's currency peg, prompting the high real interest rates and the credit crunch from which the territory is now suffering.

The government's initial response was cautious. It offered only minor palliative measures such as extra training, limited spending on infrastructure and technical measures intended to support the property and the money markets.

But signs that the negative growth was lasting into the second quarter prompted a much more dramatic intervention last week with a temporary halt to land sales in a HK$432bn package which will lead to a budget deficit of HK$21bn.

Though the deficit is manageable the volte face raises serious questions about whether Hong Kong is moving away from its traditional laisser faire economic policy. The answer is probably not - despite its tradition of non-intervention the Hong Kong government has always interfered with the property market.

But the move has left doubts about whether government will become more interventionist, or whether its close connection to business led it to choose to favour property developers over the mass of the population for whom house purchase is still inaffordable despite the sharp fall in prices.

The danger, if the latter course is true, is that the government will have interfered with the adjustment process before the bubble is properly deflated.

Residential property prices fell by about a third between last June and May this year and have fallen further since.

Commercial property prices have also fallen by about 50 per cent from their peak, and though rents have lagged, these too will come down because several large developments - including the prestigious Cheung Kong Centre on the site of the old Hilton Hotel - are due to come on the market over the next 12 months.

Prices are still above their 1996 levels, but, according to C.Y.Leung, a surveyor who is a senior adviser to chief executive Tung Chee-hwa, there is good underlying demand for residential property and the government's land sales have satisfied demand.

"Demand for housing is still very strong," he says. "The reason behind the reduction in volume in the past few months is not so much lack of willingness to buy but the lack of mortgage finance which is in turn a result of reduced liquidity."

Others are less sure. Dong Tao, regional economist at Credit Suisse First Boston, believes Hong Kong is only at the beginning of what could be a protracted and deep recession. "This is a long night, and we are only at 10pm," he says.

There are three areas of concern, he argues. The first is excessively high real interest rates. As a result of the pressure on the peg, money market rates have been going up while inflation is falling. This will add to the interest pain in the second half when real rates could reach 7 to 9 per cent.

Second, he says, is a large contraction in credit which is looming as foreign banks pull out of the Hong Kong loan market in an attempt to reduce their exposure to Asia.

Finally, the territory is about to see a sharp increase in unemployment. Already nearly 4 per cent, and the rate could rise to about 7 per cent, its worst level since the mid-1970s.

These factors could combine to produce what Mr Tao refers to as "a structural crack" over the coming months.

So far it has tended to be smaller retailers who have faced cash flow problems. Large property developers are under-geared but the squeeze is spreading into middle ranking manufacturing companies and into some smaller property developers, bankers say.

As the credit crunch intensifies even well-known companies could experience trouble. "I would not be surprised to see one or two blue-chip companies get into cash flow problems," says Mr Tao.

Much depends, however, on the external environment. If Japan takes steps to revive its economy after the forthcoming upper house elections, some of the fear that is currently stalking the exchange markets could recede, and with that, the pressure on interest rates in Hong Kong.

Similarly, a revival of economic growth in mainland China would provide a tonic for Hong Kong, while a majority of economists expect Beijing to resist pressure for a currency devaluation.

China's current account remains in surplus and its reserves are large, while devaluation would not help China's depressed inland provinces.

"Our view is that the renminbi won't go," says Clive McDonnell of the SG Group. "China's real effective exchange rate, taking account of inflation elsewhere, has not risen nearly as far as the nominal rate against other Asian currencies."

If he is right, then Hong Kong's troubles may be reasonably short-lived. If he is wrong, then much worse is in store for the territory. A renminbi devaluation would almost certainly undermine the Hong Kong peg which would devastate the economy: according to Mr Tao, GDP would shrink by 10 per cent next year if that happened.

Hong Kong will have to live off its nerves for several months while it waits to see which way things go.

© Copyright the Financial Times Limited 1998
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