Shrinking Away in Hong Kong

Deflation wreaks havoc on its economy

When Britain handed Hong Kong back to Beijing in July, 1997, the colony was taking full advantage of its role as the gateway to China. Its economy was growing at nearly 8% a year, unemployment was down to 2.4%, and prices for everything from a tailor-made suit in Kowloon to a Repulse Bay flat were rising fast. Demand for housing was so hot that developments that had barely broken ground were sold out in a day.

Five years later, Hong Kong's mood could not be more different. On July 7, more than 30,000 people marched in Hong Kong's biggest protest since the 1989 Tiananmen Square crackdown. However, these weren't pro-democracy marchers taking to the streets but civil servants protesting the government's decision to cut their wages by as much as 4.4% this year. It was just the latest sign of how Hong Kong is grappling with a problem that its leaders never predicted but has battered its economy for nearly four years: chronic deflation.

Odd as it may be to a New Yorker or a Londoner conditioned to expect steadily rising prices, each and every month since October, 1998, prices in Hong Kong have fallen. While that may seem like good news for this notoriously expensive city, instead it has been a double blow. Prices haven't fallen enough to fully revive Hong Kong's competitiveness but they have dropped enough to help grind down the economy. Property prices have plunged 60%, leaving as many as 100,000 homeowners owing the banks more than their apartments are worth. The construction and real-estate sectors have seized up, adding to the jobless rolls: The 7.4% unemployment rate is the highest since the government began keeping records in 1981. That's helping to push down retail sales--they were off 4.1% in the first five months of the year, compared with the same period last year. "We have a very defensive consumer mindset," says HSBC Holdings PLC's chief economist for Greater China, George Leung.

What's more, short of breaking the Hong Kong dollar's peg to the U.S. dollar, there's nothing much the Hong Kong government can do about deflation except wait it out. The peg ties the government's hands when it comes to easing monetary policy to goose the economy. The Hong Kong Monetary Authority cannot lower interest rates dramatically and expand the money supply without causing huge capital outflows. So prices have had to adjust instead, as the architects of the peg envisioned. Hong Kong's price index has dropped nearly 11% since the deflation began, and wages have fallen by almost as much. The trouble is, other Asian currencies depreciated sharply with the 1997-98 financial turmoil. That means Hong Kong still looks expensive compared with the rest of the region. And the adjustment isn't over yet.

Nonetheless, Hong Kong Chief Executive Tung Chee Hwa reaffirmed this month that the government has no plans to change the 19-year-old 7.8-to-1 exchange rate between the Hong Kong and U.S. dollars. Although delinking would make deflation go away overnight by weakening the currency and driving up import prices, that would pose a huge risk to stability in a city with a big finance sector that depends on investors' confidence. "We've gone through so much pain already," says Ian Perkin, chief economist for the Hong Kong General Chamber of Commerce. "If we did away with the peg, it would be a very, very difficult situation."

Pump priming isn't much of an option, either. Hong Kong's budget deficit is already running at 3.3% of gross domestic product, very high for a city used to surpluses. "Hong Kong is an exceptionally open economy, so the cycle is dictated by what happens outside the city," says Deutsche Bank's chief economist for Asia, Michael Spencer. That means waiting until the global economy recovers and demand for Hong Kong's goods and services picks up. With both consumer and investment spending down sharply in the first quarter, the government forecasts that prices will fall 2.8% this year and that GDP will grow just 1%. True, the U.S. dollar's recent fall may help Hong Kong regain its balance, but the city probably faces at least 12 months more of falling prices. "It will be a slow grind back up," says Standard Chartered Bank economist Mike Moran.

The signs of suffering are easy to see. Banks, which once thrived on fat profits from mortgages, now face shrinking loan portfolios--lending was down 9.7% year-on-year during the first five months--while personal and corporate bankruptcies tripled during the same period. In March, banks wrote off an average of 9% of their credit-card loans, compared with 3.7% a year earlier.

Nowhere have falling prices hit harder than in the property sector. Consider Hong Kong developer Sino Land Co. Its high-flying chairman, Robert Ng, typified the excesses of the 1990s with his daring bids at government land auctions. In 1997, at the height of the property bubble, he made headlines by paying $1.53 billion for a 1.96-hectare plot on Hong Kong Island, the highest price ever for an undeveloped lot in Hong Kong. His timing could not have been worse: 25% of the apartments he built on the site remain unsold. Last year, Sino Land's revenues were less than half what they were in 1997.

Hotels are hurting, too. The average room rate is 35% lower than before the Asian turmoil. So profit margins are way down, though the occupancy rate is running at a healthy 81%. And these lower room rates can still look pricey to tourists who can go to Singapore or Thailand, where currencies trade well below their 1997 highs. "With Hong Kong pegged to the dollar, other markets in the region have great value," says Mark Letterbichler, chairman of the Hong Kong Hotels Assn. and general manager of the Ritz-Carlton Hotel. And Hong Kong remains Asia's most expensive port. Its handling charges range between $100 and $200 a ton, nearly double those in Singapore, while the ports of southern China charge as little as $35 a ton for some shipments.

Deflation has produced winners as well as losers. Relocation company Crown Worldwide International now rents three times as much space as it occupied five years ago but pays the same rent. Because of the high jobless rate, staff turnover is lower. That has also helped keep training costs down and improve efficiency, while the starting salary for new workers is 12% lower than a few years ago. "When unemployment was 2%, it was impossible to keep people," says Crown Chairman James E. Thompson. The result: Crown is still making money despite a 10% to 20% drop in moving charges.

Hong Kong retailer Giordano International Ltd. also has benefited from the deflationary environment. Starting salaries for salespeople have fallen 9% over five years, to $1,154 a month, and the company has shaved costs by buying more supplies from China. At the same time, it has managed to raise prices by improving quality. "Pre-1997, money was so easy that people might buy four or five shirts without thinking if they would wear them at all," says Giordano Chairman and CEO Peter K. K. Lau. "Now, people go for value for money."

But when you're sitting on a piece of negative equity, it's hard to think about shopping. Just ask Louie Lau. Back in 1997, he paid $307,000 for a 500-square-foot flat in Sheung Shui near the Chinese border. Today, his flat is worth 25% less than the $200,000 he still owes the bank. "It was a very silly purchase," laments the 35-year-old sales manager for a building-materials company. "But if you are stuck, you just have to dig yourself out." The same goes for Hong Kong: The city's only recourse seems to be to hunker down and wait for better times.

By Frederik Balfour in Hong Kong

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