China / Hong Kong political & economic forecast 2005-2006

China: Now that China’s former president, Jiang Zemin, has retired from the last of his formal posts, the fourth-generation leadership under China’s president, Hu Jintao, will strengthen its hold on power in 2005-06.

Hong Kong: Hong Kong’s former chief secretary for administration, Donald Tsang, will lead the territory’s government from July 2005 until the next chief executive election, due in 2007. He is expected to be a more competent head of government than his predecessor, Tung Chee-hwa, and may thus be better placed to reach a consensus with the democratic parties.

China

Now that China’s former president, Jiang Zemin, has retired from the last of his formal posts, the fourth-generation leadership under China’s president, Hu Jintao, will strengthen its hold on power in 2005-06. Despite a weaker global economy, China’s exports are continuing to perform well. The Economist Intelligence Unit therefore expects net exports to underpin GDP growth, which will remain strong at 9.1% in 2005 and 8% in 2006. Foreign-exchange reserves will surge to a new high of US$742bn this year, rising to US$842bn in 2006.

Summary

Outlook for 2005-06

The March 2005 resignation of China’s former president, Jiang Zemin, from his final formal position gives the new leadership under the president, Hu Jintao, the opportunity to stamp its mark on the policies of the ruling Chinese Communist Party (CCP). Mr Hu is growing in authority and seems to be developing a creative, yet hardline, political style. GDP growth will remain firm this year, underpinned by net exports as exports continue to roar ahead. The government is likely to allow an appreciation of the renminbi later this year.

The political scene

Under Mr Hu, the CCP is developing a single-minded focus on the retention of political power. The party’s pursuit of a “harmonious society” therefore does not presage a political liberalisation, but is designed to strengthen one-party rule. In March China’s central government accepted the resignation of Hong Kong’s chief executive, Tung Chee-hwa, who was more closely associated with Mr Jiang. Anti-Japan demonstrations in April culminated in violence and were eventually brought to an end by the authorities. The visit of two Taiwan politicians demonstrated Mr Hu’s tactical ingenuity.

Economic policy

At the annual meeting of the National People’s Congress (the legislature) in March, the government unveiled a policy platform centred around the need to curb an investment-led economic boom. Tighter fiscal policy is being used to slow economic growth. The government has taken steps to rein in the property boom. Some hitherto non-tradeable shares will be sold on the stockmarket.

The domestic economy

GDP growth reached 9.4% year on year in the first quarter of 2005. However, there are signs that capital spending growth is easing. As overall GDP growth is now being supported by net exports, a sharp downturn in external trade would make a hard landing more likely. A bumper grain crop is expected. The German car manufacturer, Volkswagen, has lost market share recently in the face of South Korean and Japanese competition. Power shortfalls are returning, but may ease later in the forecast period. Foreign financial services companies are entering the banking and asset-management sectors.

Foreign trade and payments

The US and the EU have imposed limits on the increase in textile imports from China following a surge in the first four months of 2005. China’s exchange-rate policy is a deeper issue in trade relations. Increased manufacturing output has allowed imports to slow. Speculation over an impending appreciation of the renminbi lies behind China’s huge balance-of-payments surplus in 2004.

Outlook for 2005-06: Domestic politics

The resignation in March 2005 of China’s former president, Jiang Zemin, from his final formal position as chairman of the state Central Military Commission (the body that controls the armed forces) marked the completion of the handover to the new leadership under the president, Hu Jintao. Mr Hu’s authority has grown in recent months and he is beginning to stamp his mark on the policies and day-to-day governance of the ruling Chinese Communist Party (CCP). One major indication of this was the decision of the government in March to accept the resignation of Hong Kong’s unpopular chief executive, Tung Chee-hwa. Mr Hu seems able to cast a fresh eye on the policies of Mr Jiang’s administration and to draw up more creative responses to the political challenges facing the leadership. However, the government’s bottom line remains its goal of preserving CCP dominance. Under Mr Hu, the CCP has, if anything, been focusing more clearly on this all-important goal than under Mr Jiang.

To those who interpreted the departure of Mr Tung as the removal of an incompetent leader—the official explanation is that it was the voluntary resignation of an ageing one—recent events in Hong Kong have provided evidence that Mr Hu is adopting a different approach to government from that of the third-generation leadership. The government has cut its losses in Hong Kong, deciding to back the selection of the territory’s former leading civil servant, Donald Tsang, as Mr Tung’s replacement. However, China’s decision to rule out democratic reforms in Hong Kong and to limit the term of Mr Tung’s successor to just two years, which preserves maximum flexibility in the event of further political turmoil in Hong Kong, shows that a more open political approach can be combined with a policy that remains hardline. Mr Hu’s achievement in having the Chinese legislature enact in March a law mandating a military response in the event of a Taiwan declaration of independence, but following this up by inviting two of Taiwan’s opposition leaders to visit the mainland, is another demonstration of his tactical ingenuity.

Within mainland China, Mr Hu is well aware of the social challenges facing his government, and is seeking to head them off through a programme of political change. The president has proposed measures to strengthen internal checks and balances, introduce more democracy and transparency into decision-making processes and make leaders more accountable to the demands of ordinary people. However, such policies are designed to improve the party’s ability to hold on to power in the long run rather than to foster political liberalisation. Similarly, greater attention to the plight of China’s peasants, urban workers and others who have fallen behind during the years of economic reform is intended to lessen social tensions. Even so, unrest in rural areas and ethnic strife will remain key sources of instability throughout the forecast period.

Outlook for 2005-06: International relations

After several years of relatively good relations with the US, which has largely been owing to the US’s preoccupation with its “war on terror”, bilateral tensions have increased. This reflects China’s perception that Japan and the US are moving closer together militarily, and its ire at the US-Japanese stance, enunciated in early 2005, on the preservation of peace in the Taiwan Strait. The much larger question of how the global community will manage to incorporate a large and ambitious rising power such as China is also thrown into sharp relief by trade tensions that surround booming textile exports and, not least, US attempts to influence China’s exchange-rate policy. China is likely to adjust its exchange-rate mechanism over the forecast period, and major trade partners share an interest in limiting the fall-out from trade disputes. But the wider geopolitical questions surrounding China’s integration into the international community will remain unanswered. The visit of two Taiwan politicians to the mainland recently seemed to offer the hope of a breakthrough. However, the Taiwan government remains in the hands of the pro-independence Democratic Progressive Party. Progress in cross-Strait relations will be limited by the continued insistence of the mainland on the “One China” principle as a precondition for talks, and by its consistent rejection by Taiwan’s president, Chen Shui-bian.

Outlook for 2005-06: Policy trends

Since 2003-04 economic policy in China has seemed contradictory. Fiscal policy is being tightened overall, but the government is at the same time increasing public spending on the rural economy and social welfare. Benchmark interest rates have been increased, but in December 2003 and again in March 2005 interest rates on excess reserves deposited with the People’s Bank of China (PBC, the central bank) were cut. Similarly, although the China Banking Regulatory Commission (CBRC) has sought to clamp down on lending to industries such as steel and cement, it has encouraged banks to offer more credit to agricultural areas, small and medium-sized enterprises and the energy sector. Officials believe that a soft landing is possible partly because the rapid growth of the past couple of years has not been broad-based. Consequently, as much as it is necessary to slow growth in some sectors, there is also considerable potential to raise it in others. But the contradictory outcome of recent economic policy developments reflects the government’s medium- and long-term reform objectives as well as the more immediate one of slowing the economy. Cutting interest rates on excess reserves, for example, is an essential step towards giving market forces a greater role in determining the cost of capital in China.

Outlook for 2005-06: Fiscal policy

In 2003-04 government attempts to slow the economy focused on tightening monetary policy. This will be complemented in 2005-06 by a more restrictive fiscal policy. The government has announced that in 2005 the value of Treasury bonds issued to finance long-term construction projects—the most visible component of the proactive fiscal policy first adopted in 1998—will be cut to Rmb80bn (US$9.7bn), down from Rmb110bn in 2004 and Rmb140bn in 2003. In addition, the central government’s fiscal deficit has been budgeted to fall to Rmb300bn (2% of GDP) in 2005, down from Rmb320bn (2.5% of GDP) in 2004. However, the government cannot rely merely on increased revenue to achieve this goal as the rapidity of revenue increases in recent years has made achieving further rises more difficult. The government has room to squeeze expenditure, which in recent years has also increased rapidly. But restraining spending on a sustained basis will also prove difficult, given the pressing infrastructure and welfare needs of the economy. As a result, after narrowing as a percentage of GDP in 2005-06, the Economist Intelligence Unit expects the fiscal deficit to begin widening once again from 2007.

Outlook for 2005-06: Monetary policy

Monetary policy in China will remain restrictive during the forecast period. Efforts made by the authorities to tighten monetary conditions will not, however, be implemented using any one tool alone. The immature nature of China’s capital markets gives the government an unusually wide range of monetary policy options. Since 2003 the PBC has altered reserve requirements, and along with the CBRC has used administrative measures to influence bank lending behaviour directly. In October 2004 the PBC raised benchmark interest rates for loans and deposits of various maturities, and in March 2005 increased mortgage rates, which are fixed on a different schedule. Since mid-2003 lending growth in China has dropped from almost 25% year on year to nearer 10%, and the drop-off in consumer and producer price inflation in recent months has given much greater potency in real terms to the 27 basis point increase in benchmark nominal interest rates implemented in October 2004.

The political scene: Jiang Zemin is eased out of his last position

The assumption of formal positions of power by the Chinese president and general secretary of the Chinese Communist Party (CCP), Hu Jintao, was completed in March 2005 with the resignation of his predecessor, Jiang Zemin, from the state Central Military Commission (CMC, the body that heads the armed forces). In the first successfully choreographed handover of power since the People’s Republic of China was established in 1949, Mr Hu was appointed CCP general secretary in November 2002, state president in March 2003 and chairman of the party CMC, which oversees the armed forces, in September 2004. Finally, Mr Jiang’s resignation as chairman of the state CMC was accepted by the National People’s Congress (NPC, China’s legislature) on March 8th, paving the way for Mr Hu’s elevation to the same post on March 13th.

Mr Jiang and his supporters within the ruling party—five of the nine members of the politburo standing committee, the CCP’s top policymaking body, including the vice-president, Zeng Qinghong, owe their positions to Mr Jiang—remain a force to be reckoned with. Clear ideological differences do not divide the Chinese leadership, but policy failures—such as the recent deterioration in relations with Japan—give ammunition to Mr Hu’s rivals in the so-called Shanghai Faction grouped around Mr Jiang. Nevertheless, the concentration of formal titles in Mr Hu’s hands increases his authority. Mr Hu has emerged from Mr Jiang’s shadow since becoming head of the party CMC last autumn, and has increasingly stamped his mark on the policies and propaganda of the CCP.

Whereas Mr Jiang was noted for his “important thought of the Three Represents”, a theoretical contribution to the ruling party’s ideology aimed at consolidating CCP rule by co-opting members of the new private-sector entrepreneurial class into the party, Mr Hu has focused on the need to address the grievances of peasants, laid-off workers and others who are shut out from China’s new-found prosperity. In 2004 the CCP’s policies were summed up in the slogan of “scientific development”, which aimed for a more sustainable pattern of economic growth, paying more attention to less-developed regions, the vast countryside and quality-of-life issues. In recent months party leaders have continued to talk of the need for scientific development, but have also pushed a new slogan, that of creating a “harmonious society”, characterised by socialist democracy (a measure of democracy within the CCP and greater recourse to consultation among the general population), the rule of law, justice and social stability.

The political scene: The slogan of a harmonious society conceals a harder edge

According to Deng Weizhi, a sociologist and member of the Chinese People’s Political Consultative Conference (CPPCC, an advisory body that met in March alongside the NPC), “a harmonious society is not one without conflicts, but one where all conflicts and disputes can be solved through normal and legal means, and therefore will not escalate into hostility or massive clashes”. At the NPC much was made of policy measures designed to reduce social tensions, such as the elimination of agricultural taxes, a reduction in school fees in rural areas and greater assistance for laid-off workers seeking employment. New regulations came into force on May 1st this year, forbidding the punishment of “petitioners”, citizens with grievances who besiege local and central government offices. Although such regulations are more likely to be honoured in the breach, slogans such as “scientific development” and “the creation of a harmonious society” serve to differentiate Mr Hu’s leadership from that of his predecessor, and contain an implied criticism of unbalanced economic growth and the development of a more unstable society during Mr Jiang’s rule.

Nevertheless, the slogan of creating a harmonious society conceals a harder edge. More popular consultation, the rule of law and greater respect for petitioners’ rights are intended to allow the CCP to remain in power. Under Mr Hu, the ruling party is adopting a single-minded focus on the maintenance of power; greater openness is not intended to presage a genuine political liberalisation. For example, the April 22nd arrest in the southern city of Guangzhou of Ching Cheong, a Hong Kong-based journalist for the Singaporean newspaper, The Straits Times, marked the second arrest of a journalist for a foreign newspaper in a year. (Zhao Yan, a journalist for a US newspaper, the New York Times, was arrested in September 2004 and has been held without trial since then.) Mr Ching had reportedly been seeking a transcript of the politically sensitive memoirs of the recently deceased former leader of the CCP, Zhao Ziyang, who was dismissed from his position in disgrace in 1989 for opposing the Tiananmen Square massacre. Under China’s fourth-generation leadership, fluffy slogans and a show of concern for the welfare of the people do not detract from, but complement, an oft-repeated hardline determination to preserve the ruling party’s hold on power.

The political scene: Mr Hu moves to lance the Hong Kong boil

Mr Hu’s creative yet steely leadership style was also seen in his decision to replace Tung Chee-hwa as chief executive of the Hong Kong Special Administrative Region (SAR), but cut the length of his successor’s term to two years. Despite his unpopularity among Hong Kong residents, Mr Tung had been re-elected as head of the SAR government by an 800-strong committee in 2002, and had been due to serve until 2007. Originally from Shanghai, Mr Tung was closely associated with the Shanghai Faction and had for years received the strong backing of the Chinese government to persevere in office in the face of mass demonstrations in 2003-04.

Although the Chinese government was no doubt reluctant to appear to be bowing to popular pressure, factional politics on the mainland eventually cleared a policy logjam with respect to Hong Kong. Mr Hu was not personally associated with Mr Tung. The Chinese government was therefore able, with Mr Jiang due to resign from the last of his official positions, to cut its losses in Hong Kong and ditch the hapless Mr Tung. On March 12th Mr Tung’s resignation “for health reasons” was accepted by the State Council (China’s cabinet), and Mr Tung was rewarded for his loyalty by being elected as one of the more than 20 vice-chairmen of the CPPCC.

That Mr Tung’s departure does not represent a new willingness to respect Hong Kong’s autonomy is clear from the April 27th decision of the NPC’s standing committee, which has the power to interpret Hong Kong’s Basic Law, or mini-constitution, to limit the term of Mr Tung’s successor to two years only. Most legal scholars in the territory had believed that the Basic Law gave Mr Tung’s successor a fresh five-year term. The Chinese government’s clear support for the territory’s former chief secretary for administration, Donald Tsang, as Mr Tung’s successor, allowed him to win the position of chief executive unopposed in mid-June.

The political scene: Anti-Japan demonstrations go further than intended

Relations with Japan represent a much thornier problem for the Chinese leadership, not just in terms of international relations, but in domestic politics too. Having assumed control of China’s hawkish armed forces, Mr Hu needs to be seen to be standing up to Japan, but without damaging one of China’s most important economic relationships. The US-Japan joint declaration of February 19th this year rankled China by formally describing the peaceful resolution of the Taiwan issue as a “common strategic objective”. The US and Japan also used China’s passage in March of a law mandating military force in the event of a Taiwan declaration of independence to persuade the EU to delay lifting its ban on arms sales to China. Further disputes include the disagreement over Japan’s bid for a permanent seat on the UN Security Council and a number of hardy perennial issues, such as the reporting of the second world war in Japanese textbooks; visits by the Japanese prime minister, Junichiro Koizumi, to the Yasukuni shrine honouring Japan’s war dead (which includes Japanese war criminals); and overlapping claims of sovereignty over islands in the East China Sea. However, it seems likely that at least initially the government did not intend to allow relations with Japan to plummet as far as they later did. China’s foreign minister, Li Zhaoxing, in a speech delivered at the NPC plenum in March, had spoken encouragingly of the development of Sino-Japanese ties.

Boycotts of Japanese goods and online petitions against Japan’s bid for permanent membership of the UN Security Council quickly escalated in early April with three weekends of increasingly militant anti-Japanese demonstrations in cities across China. The April 9th demonstration in Beijing culminated in the vandalisation of Japanese-owned restaurants and the throwing of rocks into the Japanese embassy; the Chinese authorities did little to prevent the violence. Although the April 9th demonstration was attended by only around 10,000 people, it was the largest legally authorised protest in the capital since the 1999 demonstrations that followed the NATO bombing of the Chinese embassy in the Serbian capital, Belgrade.

By late April the government was quickly backpedalling as relations with Japan entered free-fall. The Ministry of Public Security began advising citizens not to attend unauthorised demonstrations, and the government began to explain to citizens that boycotts of Japanese goods were not conducive to China’s economic development. Tensions began to subside after an April 23rd meeting between Mr Hu and Mr Koizumi in Jakarta, Indonesia. On May 23rd, however, the meeting between China’s vice-premier, Wu Yi, and Mr Koizumi in Japan’s capital, Tokyo, was cancelled at the last minute as Ms Wu flew back to China on rather non-urgent business following further disagreements over the Yasukuni shrine issue. The tacit encouragement of militant nationalist demonstrations is clearly a double-edged sword for the Chinese authorities. Not only is there the possibility that protests will go too far, escalating the dispute between China and Japan, but the Chinese government is also not able to demonstrate to the Chinese people an ability to make much progress on these bilateral issues.

The political scene: Mr Hu shows tactical ingenuity with Taiwan

In March relations with Taiwan appeared to be going the same way as relations with Japan, but Mr Hu’s creative leadership style was once again evident in Taiwan policy, producing a turnaround by end-May. The passage on March 14th of the anti-secession law was far from popular in Taiwan. Under Chinese law, the government is now required to use military force if Taiwan declares independence. Even more controversially, an indefinite stalling by Taiwan on reunification with the mainland is also laid down in law as a pretext for military force, although the law does state that in the event of war “the state shall exert its utmost to protect the lives, property and other legitimate rights and interests of Taiwan civilians and foreign nationals in Taiwan, and to minimise losses”. The law taps into a rich vein of nationalist sentiment on the mainland and reflects the bellicose views of the armed forces, but also encapsulates China’s fears that the US and Japan are moving closer on the Taiwan issue just as independence sentiment on the island is gaining ground.

The anti-secession law clearly added fuel to the flames of the bilateral dispute with Japan and threatened a deterioration in cross-Strait relations too. However, in April the leader of Taiwan’s opposition Kuomintang (KMT, Chinese Nationalist Party), Lien Chan, accepted an invitation to visit mainland China in late April and early May. His visit, the first by the leader of a Taiwan political party since the Chinese civil war ended in 1949, included a return to his birthplace of Xi’an in western China as well as a meeting with Mr Hu, which produced an agreement to seek an end to hostilities across the Taiwan Strait. Not only did the visit undermine the position of the Taiwan president, Chen Shui-bian, a member of the pro-independence Democratic Progressive Party, it also gave the CCP a platform to appeal directly to the Taiwan people. Mr Lien’s visit was followed later in May by another week-long trip by James Soong, leader of Taiwan’s People First Party. Mr Soong also visited his birthplace, in Hunan province, and held a meeting with Mr Hu in Beijing. The visits of the Taiwan politicians were an undoubted success for Mr Hu, allowing him to neutralise the perception that he had allowed a number of important overseas relationships to deteriorate without achieving any of China’s nationalistic goals.

The political scene: The anti-secession law justifies the crackdown in Xinjiang too

The anti-secession law was chiefly aimed at deterring a declaration of independence by Taiwan. However, the law has a broader application to all separatist-minded parts of what China considers to be its territory, especially the restive ethnic-minority region of Xinjiang in the far west of China: the CCP believes that it is entitled—indeed, morally obliged—to use military force to keep China intact. Thus the release in March of the Uighur businesswoman, Rebiya Kadeer, imprisoned on charges of “leaking state secrets”, in advance of the visit to China by the US Secretary of State, Condoleezza Rice, signifies no easing of the campaign against separatism (or activism of any kind) among the Muslim Uighur population who make up around half of Xinjiang’s population.

In addition to cracking down internally, the government is concerned to ensure that neighbouring countries in Central Asia do not harbour Islamist or separatist exiles from Xinjiang. The establishment of US military bases in Afghanistan, Kyrgyzstan, Tajikistan and Uzbekistan as part of the “war on terror” has left Chinese, US and Russian military forces cheek by jowl in a sensitive region of the world. Furthermore, the toppling of the government of the former Kyrgyz president, Askar Akayev, in April will also have alarmed the Chinese government. Consequently, it was no surprise in late May when China was one of the few countries in the world to welcome the military suppression on May 13th of a popular demonstration in the Uzbek town of Andijan, around 200 km from China. The spokesman for China’s Ministry of Foreign Affairs, Kong Quan, said on May 17th that China was “delighted to see the situation is under control”.

Economic policy: The government seeks to rebalance economic growth

The annual meeting in March 2005 of China’s legislature, the National People’s Congress (NPC), produced a bewilderingly long list of economic policies and targets for the year ahead. This is not unusual as the speeches of the premier and his leading officials at these events tend to be dominated by the many structural issues facing the economy. This time, however, this theme was accompanied by the need to cool the investment-led economic boom of 2003-04 while seeking to spur consumption to drive robust GDP growth in the immediate future. Thus, at the same time as setting out the need to control economic growth in the short term (reflected most clearly in relatively moderate targets for economic and investment growth in 2005), the premier, Wen Jiabao, also spoke of the need to raise employment growth.

The government’s focus on economic rebalancing is not new, having preoccupied many leading officials since the economic upturn gathered pace in 2003. The recent NPC plenary meeting did, however, add a new ingredient to the policy mix that the government has been using to control the economy: tighter fiscal policy. In March officials announced that the government was moving to a “prudent” fiscal stance from the “proactive” one first adopted in 1998. According to the minister of finance, Jin Renqing, this shift will be effected in two ways. First, the value of Treasury bonds issued to finance long-term construction projects—the most visible component of the proactive fiscal policy—will be cut to Rmb80bn (US$9.6bn) from Rmb110bn issued in 2004. Second, the central government’s fiscal deficit will be cut to Rmb300bn (2% of GDP) in 2005 from Rmb320bn (2.5% of GDP) in 2004.

Economic policy: The fiscal deficit improved on an underlying basis in 2004

This shift was well under way long before it was officially announced. The value of T-bonds issued in 2004 was below the Rmb140bn sold in 2003. The budget deficit also contracted in 2004 on an underlying basis (excluding export tax rebates), even if the headline figure announced was unchanged compared with the 2003 outturn, at Rmb320bn. Boosted by booming tax revenue, central government income surged by more than 25% in 2004 to Rmb1.6trn (US$193bn), whereas expenditure rose by just 13% to Rmb1.8trn. That this did not result in a sharp narrowing of the deficit was because the government used some of the revenue collected during the year to issue to companies overdue export tax rebate payments that had been built up in previous years.

The government’s deficit projections for 2005 are not based on the assumption that revenue will continue to grow at the same rapid pace as that recorded in 2004. Mr Jin has set a target for revenue growth of just 10.5% in 2005. This is sensible. Based on the IMF’s standard definition (which differs from the one used by China’s Ministry of Finance), central government revenue surged from 11.1% of GDP in 1995 to an estimated 20% in 2004, which has made achieving further rises more difficult. Cyclical factors will also depress revenue growth in 2005. Mr Jin explained that income from all of the major categories of revenue—value-added tax (VAT), import tax, corporate and personal income tax, domestic income tax and business tax—rose in 2004 by more than the budgeted figure. This was partly because GDP growth outpaced government projections last year. Mr Jin also pointed out that the government had enjoyed an exceptional Rmb80bn revenue gain in 2004 as a result of the ongoing move from a production-based system of VAT to a consumption-based one.

Tighter fiscal policy could play an important role in slowing economic growth. The significance of fiscal policy might not seem obvious at first glance: the Rmb110bn in special T-bonds issued in 2004 accounted for just 2.4% of total investment spending, and an even smaller proportion of GDP. But total government capital spending more than doubled from just 2.4% of GDP in 1996-97 to almost 5% in 2002-03. Moreover, projects launched with funds raised from the sale of Treasury bills have also been supported by lending from state-owned banks. As a result, government economists estimate that the proactive fiscal policy has boosted average annual rates of GDP growth by around 1.5 percentage points since it was launched in 1998. Even in an economy that is growing as rapidly as China’s, this is a significant amount.

Economic policy: A series of measures is taken to cool the property boom

The change of emphasis towards fiscal policy may be welcome, but it has not completely displaced the use of other policy tools in China. In recent months the authorities have been using instruments favoured in 2003-04—administrative measures, such as telling the banks not to lend to overheating sectors of the economy, and tighter monetary policy—in an attempt to engineer a more ordered rate of development on the property market. In mid-March the People’s Bank of China (PBC, the central bank) prohibited banks from offering interest rates on five-year home mortgages lower than 90% of the 6.12% base rate, in effect raising mortgage interest rates by 20 basis points to 5.51%. The PBC also gave commercial banks leeway to raise the ceiling on down payments to 30% from 20% in cities where property prices have risen quickly. In mid-May the PBC went further, announcing with six other government agencies a package of measures including the imposition on June 1st this year of a tax on properties sold within two years of purchase and restrictions on credit for property deals. Regulations requiring local governments to clarify prices and house sizes before granting land-use rights were also strengthened, and a cap was imposed on real estate developers’ profits. Last but not least, the seven agencies took action to tackle land hoarding. Developers will now face penalties if they fail to build within a year on purchased land, and will lose their rights to the land altogether if they fail to build within two years.

The broad-based nature of these measures is an indication of just how worried the authorities have become about the stability of the housing market. In Shanghai prices rose by an average of 19% year on year in the first quarter of 2005. Prices elsewhere in the country have started to show signs of catching up: property prices in China as a whole increased by 14.4% in 2004 and by 9.8% year on year in the first quarter of 2005. On the one hand, officials fear that rising prices will make housing too expensive for the vast majority of China’s population. On the other, they are worried that the sharp price rises indicate a bubble, the bursting of which would damage the banking sector.

Economic policy: The renminbi peg is driving protectionism in key markets

The shift in fiscal and real estate policy has not yet been accompanied by a change in attitudes towards the exchange rate. The renminbi remains fixed at Rmb8.3:US$1, the same rate that has been in place since the mid-1990s. At the NPC meeting the government continued to recite its now well-known mantra, namely, that reform of the exchange-rate regime was on the agenda, but that the aim was to keep the renminbi “basically stable at a proper and balanced level”. This is despite evidence that the extent of the undervaluation of the Chinese currency is actually growing. In 2004 the current-account surplus grew from an average of 3.2% of GDP to 4.1%, boosted by larger surpluses on the trade and current-transfers balances, and a narrowing of the deficit on the income account. The current-account surplus is likely to have widened even further in the first few months of 2005, led by the trade balance, which swung from a deficit of US$8.4bn in the first three months of 2004 to a surplus of US$16.6bn in the same period of 2005. (Some quarterly balance-of-payments figures are mentioned in the text of the PBC’s first-quarter monetary policy report, but a full breakdown is only released on an annual basis.)

Upward pressure on the exchange rate created by the rising current-account surplus was offset in the first quarter of the year by an easing of the pace of capital inflows. Capital inflows rose in April as financial-market speculation of an impending change in the renminbi reached fever pitch, but subsided once again when no change was forthcoming. Unfortunately for China’s government, there is not only economic pressure on the renminbi. There is also political pressure, as China’s rising trade surpluses with both the EU and US drives protectionist sentiment. To date neither has introduced broad-based measures to restrict Chinese imports, but they have moved to restrict shipments from China of particular goods, notably apparel. China's 2001 accession agreement to the World Trade Organisation (WTO) allows so-called safeguard quotas to be imposed if there is evidence that garment shipments from China are disrupting a country's domestic market.

Invoking this right, in November 2003 the US government introduced safeguard restrictions on three types of clothing, and on May 23rd and May 27th this year it moved to restrict imports of a further 13 categories of garment. The issuing of these formal requests triggered the immediate application of safeguard quotas, which will restrict growth in imports from China to 7.5% above the levels recorded in the first 12 months of the prior 14-month period. A similar dispute with the EU led to a bilateral agreement on June 11th restricting some of China’s textiles exports to the EU, but the increases permitted, between 8% and 12.5%, are only just above those that would have been permitted under safeguard quotas.

None of this has pleased China. The government in Beijing has long argued that rapid increases in shipments should not be surprising given that it was only at the end of 2004 that the US and EU completely lifted the restrictions on international trade in garments that had applied for the previous 30 years. Partly as a result, Chinese officials contend that sharp rises in imports from China are largely replacing shipments from other countries rather than putting US and EU workers out of jobs. Of course, given the long history of quotas in the global trade in garments, Chinese officials would probably privately concede that the imposition of some kind of new restrictions was inevitable. But China’s government appears to have been hoping that it could impose restrictions itself, with the result that some control over the pace of export growth would reside in Beijing. To this end, China’s government announced on May 20th that from June 1st it would raise export duties by to up 400% on 74 categories of garments. Realising that the US and EU would impose their own restrictions in any case, on May 30th China’s Ministry of Commerce angrily rescinded the higher duties.

Economic policy: A trial sale of hitherto non-tradeable shares is permitted

China’s authorities are making yet another attempt to tackle an issue that has dampened stockmarket sentiment for years: the more than 60% of shares that are currently non-tradeable. In May the securities market regulator, the China Securities Regulatory Commission (CSRC), issued guidelines to allow a trial sell-off of these shares. The CSRC seems serious in its intention, but is proceeding cautiously. Only four medium-sized listed firms will participate in the first round of the sell-off programme. Buyers of the freed-up shares will not be able to sell for one year, and thereafter will be able to cut their holdings only gradually. Moreover, both the CSRC and two-thirds of the public and minority shareholders will need to approve the conversion of non-tradeable into normal shares. To win over existing public shareholders, one of the companies selected for reform, Sany Heavy Industries, has proposed a compensation package. Initially, Sany, based in the central province of Hunan, said that existing holders of tradeable shares would receive three shares and Rmb8 (just under US$1) in cash for every ten shares.

It is as yet too early to judge how successful the programme will eventually be. Sany has been forced to raise the value of its compensation package, to offer 3.5 shares for every ten held. It is encouraging that the CSRC has at least managed to start the reform programme without causing a crash of the wider market, although the performance of the stockmarket has hardly been stellar—on June 13th the Shanghai Composite Index closed at 1,106, down from 1,168 at the end of April. But this short-term result is the direct consequence of the limited nature of the programme. That the CSRC is not bolder is understandable, but the caution suggests that the share overhang will continue to weigh on market sentiment for some time to come. The government has avoided a sharp downturn, but at the cost of a bounceback in share prices any time soon.

The domestic economy: A bumper grain crop is expected

From the perspective of both the government and farmers, China’s agricultural sector would appear to be in good shape. Officials are pleased that the rise in grain production that began in 2004 is continuing. According to a Ministry of Agriculture (MOA) report released at the end of May this year, initial indications are that the output of summer-harvested grain crops will increase in 2005. The MOA found that the area devoted to the winter wheat crop (which is harvested in the summer) had grown by 670,000 ha, the first increase in seven years. The area of land sown to high-yielding wheat varieties has risen even more quickly, increasing by 1.7m ha to 10.7m ha.

These figures are important for a government that sets great store by China’s ability to retain near self-sufficiency in food supply. The ongoing rise in grain supply has also cooled the sharp increases in food prices that contributed to an increase in overall consumer price inflation in 2004. The easing of food price inflation is bad news for farmers who sell the grain, but grain prices were still up by 8.7% year on year in the first quarter of 2005. In Heilongjiang province, part of the north-eastern grain belt, prices for maize, rice and wheat were respectively 4.2%, 47.1% and 5% higher in the first quarter of 2005 than in the year-earlier period. Moreover, according to provincial data, the slowdown in grain inflation has yet to feed through into rural incomes. Cash incomes per head in rural areas of Heilongjiang rose by 33.4% year on year in the first quarter of 2005. Rural incomes in other provinces, including Inner Mongolia in the north, Hubei in the centre and Sichuan in the west also rose by more than 20% year on year in the first three months of 2005.

Unfortunately, the rosy general picture masks some underlying worries. The government is far from satisfied with the amount of grain being produced in China. In the words of Hui Liangyu, one of China’s vice-premiers, “at present the foundation of China's grain production is still relatively weak, and this situation can hardly be turned around in a short time. Looking at the long term, the trend of increasing grain demand will not change, the trend of reduction of the farmland area will not change, and the trend of the serious shortage of water resources will not change.” After falling deeply into deficit in the middle of last year, by April 2005 China’s net volume trade in cereals and cereal flour had returned to rough balance. But in the first four months of 2005 China imported 600,000 tonnes more grain than it exported, whereas in the same period of 2004 China had been a net exporter.

The domestic economy: Rural incomes present a policy dilemma

The government is also worried that despite the sharp rise in rural incomes recorded in 2004, the agricultural economy continues to fall behind its urban counterpart. In 2004 rural incomes grew by 12.8%, but this was equivalent in absolute terms to a rise of just Rmb457 (US$55) per household. At 11.8%, the relative rise in urban incomes was more moderate, but this translated into a much more significant Rmb1,067 absolute increase. The rise in gross rural incomes that has occurred has also been offset by sharp rises in the prices of agricultural inputs. According to an official at the National Bureau of Statistics (NBS), Xian Zude, between January and February this year prices for farm materials increased by 10.6%, and fertiliser prices increased by 13.9%. The rise in fertiliser prices, attributed by the government to rising coal and electricity prices, bottlenecks in China’s rail transport system and higher international prices, is causing particular concern.

By wanting to increase both grain production and rural incomes, the government is caught in a dilemma. Since China is richer in labour than land, farmers in much of the country can earn better returns through the cultivation of labour-intensive crops such as fruit and vegetables rather than land-intensive grains. Therefore, to increase both grain production and rural incomes, the government needs to raise the relative returns from the cultivation of crops like wheat, maize, rice and barley. To do this, officials on the one hand are seeking to popularise the use of higher-yielding grains, investing in the laboratories needed to develop them and then using subsidies to ensure that the new varieties are affordable for farmers. On the other hand, the government is offering direct subsidies, both to grain basket areas and to grain farmers themselves. According to a vice finance minister, Zhu Zhigang, the government will offer a total of Rmb5.5bn (US$665m) in “rewards” to major grain-producing counties in 2005. Mr Zhu said that local governments could spend the money on any aspect of the rural economy, and that any area found using the funds “on vanity projects, such as office buildings for the local governments” would receive no more payments in the future. Mr Zhu also said that the value of direct farmer subsidies, which were granted for the first time in 2004, would rise by up to 10% in 2005. According to local media, the provincial government of Hebei in northern China will earmark Rmb650m (US$79m) for direct grain subsidies in 2005, up from Rmb47m in 2004.

It is not just grain-producing areas that are benefiting from the government’s largesse. Local governments are also cutting agricultural taxes across the country. According to the Agricultural Tax Bureau of the State Administration of Taxation, reductions this year will squeeze revenue from agricultural and animal husbandry tax by 93%, from Rmb23.2bn in 2004 to just Rmb1.5bn. The government is also continuing to raise expenditure on rural infrastructure. According to the Ministry of Agriculture, 352,000 km of rural roads were built in 2003-04, more than in the previous 53 years combined. Investment in rural roads will total a further Rmb100bn over the next five years, although this forms only one element of the six-part programme of rural infrastructure improvements being promoted by the government (the other components are water-efficient irrigation, potable water, rural marsh gas, rural hydroelectricity and pasture fencing).

The domestic economy: Inequalities will be eased by industrialisation

Still, as much as the government is trying to raise returns from agriculture, there is an official recognition that ultimately the gap between rural and urban areas will only be closed through industrialisation. According to Mr Hui, the government is seeking to raise the industrialisation of the rural economy by speeding up the development of township and town enterprises (TTEs). The government is also to industrialise rural workers by allowing them to move to urban areas. Officials in China are not about to allow unrestricted migration, but they are increasingly moving away from the hukou (household registration) system that historically limited labour mobility in China. In February Mr Hui said that governments must “speed up the work of taking stock of and abolishing discriminatory regulations, unreasonable restrictions, and indiscriminate fees and charges aimed at peasants entering towns for employment”. Also highlighted in the vice-premier’s speech was the need to improve educational standards to improve the ability of rural workers to find urban jobs. This is a message that some provincial governments appear to have taken on board already. According to local media, of the 2.2m labourers “exported” from the northern province of Shaanxi in the first quarter, 452,000 received training before they left.

The domestic economy: Manufacturing continues to roar ahead

Figures for industrial value added suggest that there has been no slowdown in the pace of industrial output growth in China. Excess capacity that cannot be absorbed within China is simply being exported. In the third quarter of 2004 industrial value added was growing at 15% a year. This pace moderated to an average of 14.5% in the first quarter of 2005, but by April the rate of growth of industrial value added was up by 16% year on year. Volume production of inputs such as steel is continuing to surge: output of steel and rolled steel rose by 23.8% and 22.4% year on year to 77.8m tonnes and 82.5m tonnes, respectively. Customs figures show a 676% year-on-year increase in the volume of exports of semi-finished steel products in January-April to 3.7m tonnes, with exports of steel products rising by 196% to 7.3m tonnes. Similarly, production of personal computers rose by 57.5% year on year in January-March to 14.6m units; exports rose by 100% year on year to 15.9m in the first four months of the year.



HONG KONG

Hong Kong’s former chief secretary for administration, Donald Tsang, will lead the territory’s government from July 2005 until the next chief executive election, due in 2007. He is expected to be a more competent head of government than his predecessor, Tung Chee-hwa, and may thus be better placed to reach a consensus with the democratic parties. Political tensions will ease, but the fundamental flaws of Hong Kong’s political system remain to be addressed. GDP growth will slow from 8.1% in 2004 to 4.6% in 2005 and 3.6% in 2006, in line with global trends.

Short-term risk event

An escalation of the trade dispute between China on the one hand and the US and the EU on the other—particularly if the dispute broadened to products other than textiles—could reduce re-exports from Hong Kong and pull down overall GDP growth.

Political risk

The former chief secretary for administration, Donald Tsang, resigned on May 25th from his temporary job as acting chief executive to run for the chief executive position proper. Political tensions are expected to ease in the territory, but Mr Tsang will face an early challenge in reaching a consensus on constitutional reforms to be adopted by the legislature for implementation in 2007-08.

Economic outlook

GDP growth will slow from the rapid pace of 8.1% achieved last year to an annual average of 4.1% in 2005-06, in line with trends in both the global and the Chinese economies. Interest rates have begun to rise, but consumer price inflation will remain positive, keeping real interest rates down.

Financing outlook

Hong Kong’s financing balance will remain in surplus in 2005-06. The current-account surplus will remain broadly steady as a percentage of GDP. The external debt stock will climb, but the debt-service ratio will remain low.

Outlook for 2005-06: Domestic politics

According to the April 27th 2005 interpretation of Hong Kong’s Basic Law, or mini-constitution, by the standing committee of the National People’s Congress (NPC, China’s legislature), the chief executive of the Special Administrative Region (SAR) to be selected in July will serve for just two years before a fresh election is required in 2007. Donald Tsang, the former chief secretary for administration who served as Hong Kong’s acting chief executive following the resignation of the territory’s former head of government, Tung Chee-hwa, resigned on May 25th to run for formal selection as Mr Tung’s replacement. The selection, due on July 10th, will be by a committee of 800 people. Mr Tsang is certain to be selected. Not only have the other two declared candidates, Lee Wing-tat, the leader of the Democratic Party, and Chim Pui-ching, a member of the Legislative Council (Legco), so far failed to gain the required 100 nominations from members of the election committee, but Mr Tsang has received the clear backing of the Chinese government and is also a popular choice for the position among Hong Kong residents. If no other candidate receives 100 nominations by June 16th, the selection process will be dispensed with and Mr Tsang will be declared chief executive. During the run-up to the selection, the finance secretary, Henry Tang, is serving as acting chief executive, and the secretary for housing, planning and lands, Michael Suen, is serving as chief secretary for administration.

The transition to a new head of government in Hong Kong has been marred by the dispute over the length of the term of the new chief executive. Many legal experts in the territory argue that the new chief executive should serve for five years, pointing out that the Basic Law contains no provision for a two-year term. This prompted the Hong Kong government in early April to request an interpretation of the relevant section of the Basic Law from the NPC standing committee, which under Article 158 of the Basic Law has the power to hand down interpretations of Hong Kong’s constitution. The two-year term for the chief executive will give the Chinese government maximum flexibility in the event of further political tensions in Hong Kong. However, concern is growing at the overly frequent recourse to the NPC standing committee to solve political disputes in Hong Kong, which is promised a high degree of autonomy under the “one country, two systems” formula.

The departure of the unpopular Mr Tung has ushered in a quiet period in Hong Kong’s politics. Although most Hong Kong residents would like to see democratic reforms, there is also a desire to reach a modus vivendi with the sovereign power. China’s decision to back a long-time civil servant rather than another tycoon as chief executive also represents a determination to ease confrontational politics in the territory. However, tensions over the issue of constitutional reform are likely to bubble to the surface again. Mr Tsang will face an early challenge with the publication later this year of constitutional reform proposals. In the April 2004 interpretation of the Basic Law, China ruled that political reform in Hong Kong must fall short of introducing universal suffrage, leaving the Hong Kong government little room for manoeuvre in the search for a compromise formula for reform. Constitutional reforms that will determine how the chief executive is selected in 2007 and how Legco is elected from 2008 will need to be agreed by 40 of Legco’s 60 members.

Outlook for 2005-06: International relations

Under the Basic Law, defence and foreign affairs are the preserve of the central authorities in the mainland capital, Beijing, with the Hong Kong government having authority only over external issues that relate to trade (Hong Kong is, for example, a member in its own right of the World Trade Organisation). Until recently, Hong Kong officials remained quiet when other countries commented on non-trade-related developments in the territory, content to allow the central government in Beijing to make representations on Kong Kong’s behalf. This may now be changing. Thus, in October 2004 Hong Kong’s secretary for constitutional affairs, Stephen Lam, rejected a US congressional report that argued that Hong Kong’s autonomy was being undermined by central government intervention.

Outlook for 2005-06: Policy trends

The broad economic policy challenge facing the Hong Kong government in 2005-06 is to maximise the benefits accruing from the rapid economic development of China, while minimising the costs. This could be achieved by pursuing closer integration with the mainland in matters such as the flow of people and resources, while maintaining—and even widening—the differences with China in other areas, notably the rule of law and regulation. Most progress is likely to be made on the integration front. The weakness of Hong Kong’s government will prevent it from challenging vested interests in the domestic economy and undertaking the structural reforms that would strengthen the territory’s competitiveness vis-à-vis the mainland.

Outlook for 2005-06: Fiscal policy

Preliminary figures show a consolidated budget surplus in fiscal year 2004/05 (April-March) of HK$21.4bn (US$2.7bn). However, this figure includes HK$26bn in two separate bond issues in May and July 2004. The Economist Intelligence Unit does not count such sales as revenue. Nevertheless, even after excluding these inflows there was a sharp improvement in public finances last year: netting out bond revenue, the budget deficit was just HK$4.6bn, a much narrower gap than the HK$40.1bn recorded in the previous fiscal year. The major contribution to the narrowing of the fiscal deficit was the rise in land premiums to HK$31.3bn, up from HK$5.4bn in the previous year. An expected slowing of the world economy and higher interest rates in Hong Kong in 2005-06 will not end the recovery of Hong Kong’s property market or economic growth in the territory, but the recovery is likely to cool. Consequently, we expect a rise in the fiscal deficit in 2005/06, before a slight narrowing in 2006/07 as the government makes some headway in streamlining its expensive civil service. In his recent budget speech, Mr Tang said that public consultations on the introduction of a goods and services tax (GST) would be held, but that implementation of a GST would take at least three years from the time of making a decision to introduce it.

Outlook for 2005-06: Monetary policy

Owing to the fixed exchange rate between the Hong Kong and US dollars, local interest rates are largely determined by the Federal Reserve (the US central bank), rather than by the Hong Kong Monetary Authority (HKMA, which performs some of the functions of a central bank). However, local interest rates do not always rise and fall in line with changes in US rates, as the prime lending rates charged by local banks depend in the first instance on levels of liquidity in the local banking system, which influence interbank lending rates. The Federal Reserve has raised the US federal funds rate by 200 basis points since mid-2004. Local banks, by contrast, raised their prime lending rates in September 2004, but reversed the increase two months later as foreign capital flooded into the territory, fuelled by speculation over an impending revaluation of the renminbi, a change that some investors believe would force an upward movement in the value of the Hong Kong dollar. Expectations of a near-term revaluation of the renminbi weakened again in early 2005, leading Hong Kong banks to implement another round of increases in their prime lending rates in March-April.

In early May fresh speculation over a renminbi revaluation gathered pace, pushing local interbank rates down once again. The chief executive of the HKMA, Joseph Yam, warned that the HKMA was considering intervention to address persistently low interest rates, partly because the failure of local interest rates to reflect the increase in US rates risks a sudden catch-up at some point in the future. The HKMA subsequently announced a refinement of the exchange-rate mechanism designed to limit the use of the Hong Kong dollar to speculate against China’s renminbi and allow local interest rates to track US rates more closely. The move was followed by a reduction in liquidity, and a fresh round of increases in local banks’ lending rates, which have now risen by 75 basis points this year. Given the likelihood of a further 100 basis point increase in US interest rates before the end of 2005, retail interest rates in Hong Kong will be forced up further in 2005-06. This change will, however, have only a moderate impact on Hong Kong’s economy. For economic activity, it is real rather than nominal rates that matter, and these will be dampened in 2005-06 by an expected firming of producer and consumer prices.

Outlook for 2005-06: International assumptions

Global economic growth is estimated to have reached 5.1% in 2004, the fastest rate of growth for 20 years. But growth is now decelerating in some major economies, and the outlook for 2005-06 is for a more modest pace of expansion. We forecast that world GDP growth (on a purchasing power parity basis) will slow to 4.3% in 2005 and 4% in 2006. The forecast slowdown does not represent a poor global economic performance in absolute terms: the rate of growth expected in 2005-06 is robust compared with those achieved during much of the 1990s. However, after several years during which the performance of the global economy has improved, 2005-06 is likely to be characterised by a gradual deceleration in output and demand growth.

Outlook for 2005-06: Economic growth

In the first quarter of 2005 Hong Kong’s GDP expanded by 6% year on year, following a 7.1% increase in the fourth quarter of 2004 and 8.1% in 2004 as a whole. GDP growth was supported by a good foreign trade performance and continued expansion in private consumption, in line with the recovery in the property market and a reduction in unemployment. Growth in 2005 is likely to be creditable, but nevertheless much more restrained than last year, as demand in the OECD countries and China weakens. High oil prices, rising interest rates, the recent partial recovery of the US dollar (to which Hong Kong’s unit is pegged) and a sharper than expected slowdown in regional trade all cloud the outlook for exports. However, signs of a recovery in the construction sector, the continued fall in unemployment and the bright outlook for the tourism sector all point to upside potential for domestic demand.

China’s GDP growth is expected to weaken both this year and next, but even this will not affect Hong Kong as severely as might be expected. If, as we forecast, consumer spending in mainland China does defy the overall slowdown in the mainland economy in 2005-06 and the government in Beijing further relaxes restrictions on visits to Hong Kong, spending by mainland tourists will remain a powerful engine of growth for the territory throughout the forecast period. Tourist arrivals should be strong in 2005, particularly after September, when Hong Kong’s Disneyland theme park is due to open. Consequently, we continue to expect GDP growth of 4.6% this year, easing to a still reasonable 3.6% in 2006 as the global economy slows further and interest rates rise.

Outlook for 2005-06: Inflation

Consumer price inflation remained muted at 0.5% year on year in April 2005, down from 0.9% in March and 0.8% in February, in line with trends in mainland China (the source of a large proportion of Hong Kong’s retained imports). The recovery of the property market is expected to feed through into higher rental values in the months ahead. Together with the relative weakness of the US dollar and strong domestic demand, this should ensure that the sustained deflation that characterised Hong Kong in 1999-2004 does not return. However, viewed on a month-on-month basis prices rose by just 0.2% in April. A sharp pick-up in inflation is therefore unlikely. We expect consumer prices to rise by an average of 0.5% in 2005 and by 1.2% in 2006.

Outlook for 2005-06: Exchange rates

No changes to the HK$7.8:US$1 currency peg are expected during the forecast period. The extent of the changes expected in 2005-06 to China’s exchange-rate mechanism, with which the future of the Hong Kong dollar peg is sometimes linked, is likely to be limited—we forecast that the renminbi will have firmed to Rmb8:US$1 by end-2006, compared with the current rate of Rmb8.28:US$1, as China only slightly adjusts the band within which the renminbi trades. On May 18th the HKMA announced a refinement of the exchange-rate mechanism designed to reduce the use of the Hong Kong dollar as a vehicle for speculation against the renminbi. The maintenance of the fixed link between the Hong Kong and US dollars is essentially a political decision. Hong Kong’s large foreign-exchange reserves, supplemented by substantial fiscal reserves, make it unlikely that Hong Kong could be forced to abandon its currency peg.

Outlook for 2005-06: In focus

The Hong Kong dollar exchange-rate mechanism is refined

On May 18th 2005 the Hong Kong Monetary Authority (HKMA, which performs some of the functions of a central bank) announced a change to the operation of the linked exchange-rate system that aims to keep the currency pegged against the US dollar at a rate of HK$7.8:US$1 to reduce the use of the Hong Kong dollar as a proxy for speculation over a revaluation of China’s renminbi. Previously, the HKMA was committed to selling US dollars to licensed banks at the pegged rate, but was not obliged to intervene when the Hong Kong dollar strengthened beyond this rate, as it did in late 2003 and once again in late 2004. Under the May 18th changes, the HKMA is now committed to buying US dollars from licensed banks at a rate of HK$7.75:US$1. The weak-side convertibility undertaking to sell US dollars at HK$7.80:US$1 is being shifted to a rate of HK$7.85:US$1 in stages over a five-week period ending June 20th, creating symmetrical convertibility undertakings around the linked rate of HK$7.80:US$1. The HKMA has reaffirmed its commitment to the Hong Kong dollar peg. The refined exchange-rate mechanism removes uncertainty over the extent to which the local unit will be allowed to appreciate and will allow the local authorities to deal better with financial inflows in the wake of an adjustment to China’s exchange-rate mechanism.

The move was prompted by the HKMA’s concern that speculation over a renminbi revaluation was keeping liquidity levels in the local banking system as measured by the aggregate balance (settlement accounts held by banks with the HKMA), artificially high, depressing local interbank interest rates and raising the risk of a sharp rise in interest rates on a sudden reversal of liquidity flows out of Hong Kong. Liquidity dropped back to normal levels several days after the change to Hong Kong’s exchange-rate mechanism and interbank rates in the territory have since moved upwards.

Outlook for 2005-06: External sector

External trade data for April 2005 showed a 7.8% year-on-year increase in exports and a 3.8% increase in imports. These figures are an improvement on the increases of 3.5% and 2.5% reported in March, but it is becoming clearer that Hong Kong’s trade performance will be positive, but much less impressive than the outturn in 2004. Export growth has so far held up more consistently than import growth, but in view of the risks to the outlook for external demand and the upside potential in domestic demand we forecast only a small improvement in the trade deficit this year, before a widening once again in 2006 as global demand eases further. The merchandise trade deficit will be offset by the large and increasing surplus on the services account. This reflects the boom in tourist arrivals from mainland China, which will be fuelled further by the September 2005 opening of a Disneyland theme park in Hong Kong. Overall, we expect the current-account surplus to rise from US$16bn (9.7% of GDP) in 2004 to US$17.4bn (9.9% of GDP) in 2005 and US$18bn (9.6% of GDP) in 2006.

(Information sourced from The Economist Intelligence Unit)