A Boom Built By Beijing

Hong Kong is coming back, thanks mainly to China's largesse

Franklin Lam has been through a rough patch in recent years. As regional property analyst for UBS (UBS ) in Hong Kong, he hasn't had much good news to report: From 1997 through last spring, property values fell by nearly 70% in the former British colony even as they surged in other financial capitals. "Home buying has been the topic of the town in London and the U.S., but in Hong Kong, it has been a conversation-killer," Lam says.

These days, though, Lam is a hit again on the cocktail-party circuit. Although residential real estate values remain less than two-fifths what they were at their 1997 peak, they're up more than 15% since May. Lam predicts they'll climb an additional 60% over the next two years. "Talk to anyone now, and they'll tell you how hot the market is," he says.

Lam isn't the only one who's hot on Hong Kong. The city is acting more like its old, confident self again. Investment bankers are lauding the virtues of China's roaring initial public offering market. Local punters are crowing about the 40% gain over the past 12 months in the Hang Seng index and the 150% surge in Hong Kong-listed China companies. Not even a recent dip in H shares has fazed them. Hotels, restaurants, and retailers are thriving, thanks to tourists flocking to the city. "We are at the center of the universe again," says Michael Spencer, chief economist at Deutsche Bank (DB ) in Hong Kong.

Look a little closer, though, and you'll see a Hong Kong that's much more dependent on largesse from Beijing -- and less certain of its place in the universe -- than it was 10 years ago. Of course, Hong Kong's great value has long been its status as the gateway to China -- the place where bankers, shippers, lawyers, and manufacturers could do deals and expand their businesses on the mainland. That's still the case, but while China hasn't skipped a beat in years, Hong Kong has floundered. So last summer Beijing decided to reignite the city's economy by letting residents of several mainland cities -- who once could only visit Hong Kong in tour groups -- travel there on their own.

The scheme is paying off for Hong Kong. It's expected to boost visits by mainlanders by 40% this year, to 11 million. And mainlanders, who last year made up 54% of visitors, appear to have pockets as deep as the Japanese tourists they're replacing. Credit Suisse First Boston (CSR ) estimates that mainland tourists could account for nearly half of this year's projected gross domestic product growth of 5.5%. That's the main reason why hotels expect an average 84% occupancy this year, compared with 16% last April at the height of the SARS crisis.

PREFERENTIAL TREATMENT. Trade and industry are as important as tourism, and Beijing is contributing there, too. China now accounts for more than 40% of Hong Kong trade, and its impact on the city's economy is likely to become even more profound due to an agreement that eliminates tariffs on 90% of Hong Kong's exports to China. Under the deal, which took effect on Jan. 1, Hong Kong companies get preferential access to key areas such as distribution and financial services. That should give businesses from the former colony a leg up in Chinese markets over foreign rivals, who, under China's World Trade Organization agreement, won't get full access to the country until 2008. Deutsche Bank estimates that by 2006, the pact could add 0.4% to the growth of Hong Kong's GDP each year and create up to 10,000 jobs.

Hong Kong isn't out of the woods, though. Deflation continues: Consumer prices have fallen for each of the past 61 months. Although unemployment is expected to drop to 6.4% by yearend from 7.3% today, it remains more than double the levels of the '90s, and payrolls have stagnated. Government spending has exceeded revenues for the last three years, and this year the deficit is expected to swell to $10 billion -- nearly 6% of GDP. The government has ruled out any tax increases, though, and with legislative elections scheduled for this fall, unpopular expenditure cuts are unlikely. Failure to get tough today could cause trouble down the road and might even endanger the city's U.S. dollar peg. Then there's SARS. With three confirmed cases in neighboring Guangdong, Hong Kong is starting to get the jitters. "If SARS comes back, the whole thing collapses," says Dong Tao, chief economist at Credit Suisse First Boston (CSFB ) in Hong Kong.

For now, the recovery is chugging along. The city's service economy, for instance, is "on an upward swing," says Connie Carnabuci, a partner at law firm Freshfields Bruckhaus Deringer. While Chinese firms are catching up, the city's dependable legal system, vigorous financial markets, and solid infrastructure mean it will serve as China's gateway for some time. "Hong Kong is going to have a big role going forward in high-end, value-added areas," says Guy Ellis, a tax partner at the local office of PricewaterhouseCoopers.

One challenge for the city is keeping its position as the world's busiest container port. The booming economy in Guangdong means that much of what might have been shipped from Hong Kong will leave from mainland ports, which offer cost savings of up to 50%. Last year, Hong Kong handled the equivalent of 20 million cargo containers -- up 1.5% from the year before -- while Shenzhen handled 10.65 million, up 40%. Nonetheless, China's global trade is expanding fast enough to "support growth in Hong Kong and Shenzhen even if Hong Kong's share of the pie is decreasing," says ING (ING ) analyst Cusson Leung.

PURCHASING POWER. The key to preserving the city's momentum is the Hong Kong consumer. And shoppers seem more upbeat than they did just eight months ago, when SARS appeared to be pushing the city into a prolonged decline. Oliver's The Delicatessen, an upmarket grocery store in the financial district, has seen business grow by double digits over the past six months. "People are more likely to pick up that second bottle of wine," says Nellie Ming Lee, a salesperson at Oliver's. They're dropping more on dining out, too. Cindy Won, marketing manager at Yung Kee, a top restaurant, says customers are spending about 20% more than they were a year ago on luxuries such as shark's fin soup.

Hong Kongers are flush with cash because they've been hoarding their savings for years. That means there's plenty of purchasing power in reserve, says Tim Condon, ING chief economist for Asia. Already, consumer spending accounts for 55% to 60% of Hong Kong's GDP, so if residents open their wallets even further, Condon says, "there are blue skies ahead." Hong Kong's problems? They're still there. But so is the city's legendary resilience.

By Frederik Balfour in Hong Kong

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