In Love With Hong Kong Again?

Yes, Hong Kong's climate eases up in October, and the Kowloon neighbourhood where I was staying with friends is a fine place to live, West Kowloon is shaping up really well, and it was great to be back for the first time in a couple of years. But I lived in Hong Kong for a long time, and left with ambivalent feelings about it. So is this simply nostalgia working on me, or is the old excitement coming back – the joy of the economic chase which Hong Kong does so incomparably?

When moods like these overtake me, I reach for my analytical tools to straighten me out. How is Hong Kong really doing? And what's happening to its growth model? This delivers two contrasting conclusions:

1. On a short-term cyclical basis, Hong Kong is exposed (responding to: monetary slowdown; weaker labour markets; likely short-term reversion of private sector savings deficit)
2. On a longer-term structural basis, Hong Kong looks in good shape, with positive readings for growth of capital stock, return on capital, services prices, services terms of trade, monetary velocity and . . . . confidence.

Cyclical Vulnerabilities

Among the professionals I met (largely lawyers) the mood was downbeat, as the realization slowly dawns that the next global (and Chinese) growth cycle is unlikely to be much like what Hong Kong (and China) has enjoyed since the 1990s. And in the short term, there are several reasons to expect Hong Kong's cyclical downturn to intensify.

First, consider the evidence of the monthly data – and in particular the link one expects between changes in monetary conditions and changes in domestic demand momentum. The chart below tracks Hong Kong's monetary conditions (movements in monetary aggregates, currency, real bond yields and the yield curve) and domestic demand (retail sales, auto sales, employment, tourist arrivals, residential property deals). Broadly, the story is that Hong Kong's domestic demand is doing rather better than the decline in its monetary conditions would suggest: in August, employment was up 2.2% yoy, retail sales up 4.5%, vehicles, tourist arrivals 20.5% yoy, sales & purchase agreements up 51.4% yoy, and car sales down only 0.9% yoy. By contrast, monetary conditions have been deteriorating now for a year, and on a 6m basis are now at their least-friendly since early 2009.   

In Hong Kong, changes in monetary conditions and domestic demand tend to go hand in hand, so a further weakening in domestic demand is already about six months overdue.

And it is not difficult to spot the vulnerabilities which could bring this about. First, the decline in real labour productivity (real output per worker adjusted for changes in capital stock per worker), is now about as severe as in 2009, but this has only now begun to provoke a noticeable slackening in the number of people employed. Only in July did hiring fall below seasonal trends, although in August this became more pronounced: we are more likely at the start of the weakness than the end of it.

The second vulnerability is connected with a likely correction in savings and financial leverage.The buoyancy of Hong Kong's domestic economy since 2009 has been underwritten by a financial confidence which has allowed the private sector savings surplus to erode from a peak of 12% of GDP (in 12m to June 2009) to a savings deficit of 1.7% of GDP in the 12m to June 2012. This willingness to run down savings surpluses is not necessarily a bad thing – it shows confidence – and whilst it continues it bolsters demand. But the danger now is precisely that if confidence dwindles, the private sector will re-build its savings surplus, and in the process depress domestic consumption and investment.

Intimately linked with this are shifts in the leverage of Hong Kong's private sector, which we can track using the loan to deposit ratio of Hong Kong's banks. If the private sector decides to go into savings-surplus mode, we will see the banks' loan/deposit ratio fall. And this is already underway: in August, HK$ loans rose only 3.6% yoy, with sequential movements 0.2SDs below seasonal trends, whislt HK$ deposits rose 8% yoy, with the sequential movement 0.7 SDs above seasonal trends. On a 3m basis, the loan/deposit ratio peaked a year ago at 85.7%, but the latest data suggests a new down-wave is arriving right now.  

Structural Strengths

There are good reasons to expect the current cyclical slowdown to intensify from here. But when it comes to Hong Kong's structural fundamentals, its ability to make its way in the world, things look a lot brighter. Indeed, on several measures, Hong Kong looks in better shape now than at any stage since the 1990s.

First, its growth factors look in good shape: HK's stock of fixed capital is growing around 7.4% yoy currently – the fastest since the pre-handover bubble. Returns on that capital peaked out at the end of 2011 and are now falling (and will continue to fall as the cycle deteriorates). However, they are still at historically high rates for Hong Kong. Hong Kong's underlying investment proposition remains more attractive than it was throughout the 2000s.

Second, this indicator finds an echo in the stabilization of Hong Kong's monetary velocity (GDP/M2). Unlike most of the rest of the world , Hong Kong's monetary velocity is no longer falling – rather it has been stable since late 2009 and is now gently trending higher. This suggests that the allocation of savings by Hong Kong's banking system is no longer fundamentally deteriorating in terms of the amount of GDP growth generated by each deposit in the banking system. A banking sector which is not acting as a systemic drag on growth is rather a rarity in the world: the US, Europe, Japan and China - in each case monetary velocity is falling. (In the chart below, notice also the sustained high levels of liquidity preference (M1/M2), which suggests sustained retail and speculative confidence.)

Third, and probably most important: despite the slowdown, and unlike in 2008-2009, Hong Kong is still able to price its services internationally. Working from the GDP deflators, the price of Hong Kong's services exports rose 0.3% qoq and 4.7% yoy in 2Q, whilst the price of its services imports fell 0.1% yoy.

Consequently Hong Kong's services terms of trade are surviving: indeed, quite possibly they are improving for the first time since the 1990s.

Now this truly matters for Hong Kong's future, and, of course, for its property market (and thus the balance sheet confidence of the private sector, and the balance sheet of the banks). So long as Hong Kong can continue to price its services internationally, its future looks bright.