Hong Kong's Woes Aren't Over Yet

As stocks rose all across Asia in recent days, the financial markets seemed to be sending a signal: the worst is over. The market sentiment was especially strong in Hong Kong, where investors and residents alike were swept into the maelstrom that sucked in Thailand, Indonesia, and Korea. But this may be a false dawn. Even Hong Kong, once the economic jewel of the region, is facing stresses that will dampen growth for some time to come.

Unlike its neighbors, the city-state doesn't have a plummeting currency or shaky banks. Indeed, the irony is that a couple of unique structural elements that have served Hong Kong well for many years are now being exposed as flaws. The first is the nature of Hong Kong's wealth, which is heavily tied to real estate. For years, real estate prices were driven higher by the government and a cartel of developers, and now the high cost of doing business puts Hong Kong at a distinct disadvantage in the region.

The second flaw is the pegging of Hong Kong's currency to the dollar. Supporting that peg has forced monetary authorities to push interest rates way up, which slowed economic activity and dented real estate values. But dropping the peg at this point would prompt a wholesale capital flight--exacerbating a growing inclination by businesses to convert their holdings into other currencies.

Eventually, both of these structural flaws must be fixed. But precipitate action would only make the outlook worse. Hong Kong was supposed to be the beacon of economic prosperity for China after the handover. Now, it will be lucky to get through the next year without a cascade of failures. Already, falling real estate prices are affecting ordinary folk as well as developers, so spending will pull back. Despite what the markets seem to be saying, it's too soon to be optimistic.

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