By Ian K Perkin

Lower local interest rates and diminishing deflation have combined in the early weeks of this year to lower the real (deflation adjusted) cost of borrowing in the SAR and raised the prospect of a positive investment and economic stimulus in coming months.

Whether the two trends have the desired effect on local levels of economic activity, however, will depend on the latest round of U.S. interest rate cuts begun on Jan. 3 this year (and followed in Hong Kong five days later) being able to stave off a U.S. recession.

There is little doubt that the surprise move by the U.S. central bank, the Federal Reserve, to cut rates, is ostensibly positive for the local economy and for business and the property sector, especially with local deflation also easing.

Lower local nominal interest rates, together with the reduction in deflation, means that not only is the nominal cost of borrowing money coming down, but the "real" (or deflation adjusted) cost of that money is also coming down.

This is all to the good, as far as it goes, but it only remains true if the interest rate situation is viewed totally in isolation to other events.

The problem for Hong Kong is the rate cuts in the U.S. are really a reflection of the sudden deterioration in the pace of economic growth and domestic demand in the U.S. This evident slowdown is not at all good for Hong Kong, Mainland China, or the Asian region.

How the Hong Kong economy now does in the opening six months of this year will depend very much on how the U.S. economy reacts to interest rate cuts and whether domestic demand there will be enough to maintain imports out of the Asian region.

If the U.S. reaction is slow and its economy slips into recession, then it is likely that much of Asia, including Hong Kong and Mainland China, will feel the chill economic winds out of North America through both their export trade and foreign investment exposure.

For Hong Kong, the key economic factors looking ahead are the recent changes in the global economic outlook, the slow down in the American economy, the cuts in interest rates (both in the U.S. and here) and the fast changing exchange rate situation between the world's major currencies.

All will ultimately have an impact on the local and regional economies, for good or ill, and all will need to have been taken into account in planning the SAR Government's Budget for the 2001-2002 financial year to be delivered to the Legco on March 7.

The U.S. is especially important in the Hong Kong economic equation because of the SAR's direct exchange rate (and, therefore, monetary) link to the U.S. and the importance of U.S.-Hong Kong-Mainland China trade to the overall health of the local economy.

The best outcome for the SAR from the present situation would be a so-called "soft-landing" for the U.S. economy (meaning no recession) and further interest rate cuts to keep the U.S. economy ticking along at a sustainable pace.

Further cuts in interest rates in the U.S., followed by similar rate cuts locally, could be particularly important for the Hong Kong SAR's performance in the 2001-2002 Budget year and beyond.

One of the negatives in the local economy in the years since the Asian economic crisis hit in 1997 has been the real cost of money, with high nominal interest rates made even worse for business and personal investment by continuing local deflation.

For its part, the U.S. Federal Reserve has already indicated that it is prepared to cut rates further to help avoid recession in the U.S. and Hong Kong, because of the direct currency link with the U.S. dollar, would be expected to follow any further rate cuts.

In its statement announcing its initial 0.5 per cent rate cut to 6 per cent at the beginning of this year the U.S. central bank said that it would be monitoring the need for further cuts.

It said the initial rate cut was "taken in light of further weakening of sales and production, and in the context of lower consumer confidence, tight conditions in some segments of financial markets, and high energy prices sapping household and business purchasing power."

The central bank noted that inflation in the U.S. remained subdued and that, to date, there was little evidence to suggest that longer-term advances in technology and associated gains in productivity are abating.

The bank said it continued to believe that, against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future. B