Hong Kong: Bracing for a double-dip?

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This post is a guest contribution by Denise Yam and Ernest Ho of Morgan Stanley.

Hong Kong’s economic growth fell short of expectations in 2Q11. The economy expanded by 5.1%Y in real terms versus our and market forecasts of 6%, down from 7.5% (revised) in 1Q11. On a quarter-on-quarter seasonally adjusted basis, the economy contracted by 0.5% (-2% annualized), the first sequential contraction since 3Q09, after 3.1% (revised) (+13% annualized) growth in 1Q. In nominal terms, growth actually accelerated to 9.9%Y from 8.7% (revised) in 1Q, as higher inflation compensated for the slower growth in real terms. The year-on-year change in the GDP deflator jumped to 4.6% from 1.2% (revised) in 1Q.

The disappointment in 2Q follows the positive surprise in 1Q that prompted us to lift our 2011 growth forecast in May to 6% (from 5%), while leaving our 2012 projection at a conservative (below-consensus) 4%, as we were conscious of the fragility of the recovery. Yet, coupled with the latest developments in the developed markets, there is distinct downside risk to our current forecasts. It affirms our view that the aggressive monetary easing and fiscal stimulus by the G3 since late 2008 helped to recharge the global economy only somewhat in 2H09-2010. The resolution of deep-rooted structural issues in the financial systems of the developed markets and the large fiscal burden are proving to be much more challenging than earlier expected, heightening the risk of a double-dip ahead. We, together with the global economics team, will review our forecasts shortly to take account of the latest developments.

External Weakness Surfaced in 2Q11…

Compared with 1Q11, the biggest shortfall in growth impetus was in external trade. External demand softened noticeably in 2Q11, with export growth dropping to 7.9%Y (from 24.6% in 1Q). Imports, on the other hand, still sustained double-digit growth (+10.3%Y versus +20.7% in 1Q), with retained imports gaining 16.8%Y, up from 9.6% in 1Q. The relative strength in domestic demand stretched the merchandise trade deficit by 30%Y to a record quarterly amount of HK$118 billion, or 27% of GDP. In real terms, this contributed a 4.6pp decline in real GDP, a sharp swing from the 3.8pp positive contribution in 1Q.

Meanwhile, the tamer growth in total trade also implied less vigor in trade-related service exports, all along a significant growth driver for the Hong Kong economy. From a 22.5%Y gain in total merchandise trade flows in 1Q, shipments rose only 9.1% in 2Q, the weakest level in six quarters. This cut the growth in merchanting and merchandising service exports from 19.9%Y in 1Q11 (contributing 5.3pp to overall service export growth) to 12.3% in 2Q (contributing 3.4pp), also the slowest in six quarters.

Nevertheless, overall service exports growth actually accelerated to 16.1%Y in nominal terms (+15.7% in 1Q), contrary to our forecast for a slowdown. This was led by the sharp surge in the exports of travel services (inbound visitor spending) (+27.9% / +5.7pp to overall service export growth versus +18.8% / +4.1pp in 1Q), while transportation (+13.1% / +4.2pp versus +8.2% / +2.3pp) and other (i.e., financial and business) services (+13.9% / +2.7pp versus +16.9% / +4.1pp) also sustained strength. Note that service exports, which we continuously advocate as the key growth driver for Hong Kong, have continued to grow faster than the overall economy, upping their share in GDP to 48.3% from 45.8% a year ago.

Needless to say, Hong Kong is also a significant consumer of service imports, which grew 11.9%Y in 2Q (+12.1% in 1Q). Yet, the relatively stronger exports growth led to an expansion of service trade surplus to 25.3% of GDP from 23.2% a year ago. In real terms, this contributed 2.7pp to 2Q11 real GDP growth (+2.8pp in 1Q).

…Cushioned by Domestic Demand Strength amidst Resilient Asset Markets

The external weakness observed in 2Q11 was partly mitigated by sustained strength in domestic demand. Private consumption powered ahead amid stable labor market conditions, resilient asset prices and the low real interest rate environment. The year-on-year gain accelerated to 9.2% (+8% in 1Q), beating our aggressive estimate of 9%, the strongest level since 4Q07. This contributed 5.9pp to headline GDP growth. Private sector investment, which suffered a surprise contraction in 1Q (-7.9%Y in real terms, led by a 13.8% decline in expenditure on machinery and equipment, contributing a 1.3pp decline in real GDP), rebounded sharply in 2Q, gaining 8%, in line with our forecast. Overall domestic demand expanded by 7.3%Y in real terms, up from 0.9% in 1Q, contributing 7.1pp to overall growth.

Significant Risks on the Radar Screen

We identify the following key downside risks to Hong Kong’s economic performance in the next 12-18 months:

a) Deterioration in US and Europe sovereign and economic outlook

While the direct impact from the downgrade in the US sovereign credit rating by S&P on the Asian ratings is minimal, the ramifications from the weaker growth outlook – given higher funding costs and reduced capacity in monetary and fiscal stimulus compared to 2008-09 – are significant. While aggressive fiscal and monetary stimulus played a pivotal role in cushioning the downturn in late 2008, we cannot be optimistic that Hong Kong will enjoy the same magnitude of support from capital inflows this time around. Moreover, the volatility experienced in financial markets in the last fortnight is also expected to have already hurt consumer and investment sentiment in the region and especially Hong Kong, given the asset-driven nature of the economy.

b) Policy risk in the property market

In response to public concerns over housing affordability, the government has become more proactive in cooling the property market in the last several months. There had been a few rounds of tightening on mortgage lending, while the government has sold more land to developers to increase housing supply. There is now much anticipation that the government could revive the Home Ownership Scheme, the 24-year-old subsidized housing program that ceased in 2002, addressing housing demand from households with income above the threshold eligible for public rental housing. While we had long been advocates of boosting housing supply to upgrade general living standards in Hong Kong, we have also recommended investors to stay alert of the risk of these further supply measures coinciding with the downturn in external conditions that is already bringing about an adjustment in property prices. To elaborate, even if appropriate policies are formulated, their introduction and implementation at the wrong time (i.e., good policy at bad timing) or their misunderstanding/misinterpretation could cause a strong reaction from the private sector, exacerbating asset market volatility and hence the economy. And it is not news that Hong Kong can be prone to this sort of volatility, given the asset market-driven nature of the economy and high asset value to income ratio.

c) Social and political tension amid income and wealth inequality, exacerbated by inflation

Hong Kong’s impressive economic boom since 2H03 has been strongly associated with significant asset price appreciation, widening income and wealth inequality. We believe that this has contributed to the escalating social discontent and conflicts observed in the last few years. Higher inflation of late has served to exacerbate the situation through further redistributory effects. As the inflation is associated with (i) property market ascent, (ii) higher cost of imported goods, especially from China amid renminbi appreciation, and (iii) rising labor costs associated with the implementation of minimum wage legislation, the pressure is unlikely to be readily relieved by tamer global growth ahead. We are also concerned that the government’s recent efforts in providing an adequate response to satisfy near-term social demands through one-off giveaways and subsidies is diverting its focus, and directing limited resources, from initiatives and projects that are more conducive to Hong Kong’s longer-term economic benefit.

While we maintain our cautiously optimistic medium-term outlook for the Hong Kong economy, given its sustainable role as a service center for China and the region, we are wary of the risk factors we outline above. Moreover, it remains our concern that Hong Kong’s economic activity hinges heavily on asset market performance and prevailing easy monetary conditions, meaning considerable vulnerability to great volatility and painful corrections when capital flows reverse. The latest dataset as well as the developments in the US and Europe spell downside risk to our current 6% real GDP growth forecast for 2011. We, together with the global economics team, will review our forecasts shortly to take account of the latest developments.

Source: Denise Yam and Ernest Ho, Morgan Stanley, August 16, 2011.

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