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Up, down or Sideways?

The 2003 economy was strange, but 2004 looks promising,
writes DAVID O'REAR

When the final figures for Hong Kong's economy come in, 2003 will be shown to have been a year of conflicting signals, contradictions and anomalies. That makes life tough for economists and budget planners alike, and we're all been bruised.

If last year's October-December quarter produced something similar to Q-3, full year growth in nominal terms was -2 percent, deflation -5 percent and real growth +3 percent. For 2004, we expect nominal GDP to rise 2.3 percent and deflation to ease toward zero by year-end, averaging -1.5 percent. That will result in a +3.8 percent real growth rate. As the first graph shows [Hong Kong's GDP] the economy was probably worth HK$1,235 billion (US$158.8 billion) in 2003 and should rise to HK$1,265 billion (US$162.2 billion) this year. Keep your fingers crossed.

Some time back, there were efforts to calculate the cost of SARS to the economy. If the consensus forecast a year ago was for about 1 percent nominal growth in GDP, and the result was actually -2 percent, then the cost was the difference between the two. That's equal to HK$35-40 billion, give or take. Of course, that's assuming the consensus was right, and no other factors made much of a difference.

At this time last year, we were concerned about the Middle East war driving up oil prices, but otherwise expected a gentle recovery and steadily easing deflation. The global media panic over SARS ensured those forecasts were consigned to the circular metal file at about the time of the mid-March budget speech. Every one with an eye on Hong Kong's economy started subtracting as fast as their spreadsheets would recalculate. It isn't a pretty sight when economists stampede, particularly down hill, but woe to anyone who stands in the way.

In the first half of 2003, the nominal economy contracted 3.1 percent as prices fell 5 percent. That pushed real growth to +1.9 percent. While deflation was wholly responsible for the plus sign, strong growth in foreign trade helped off-set abysmal domestic demand. (Retail sales slumped 7.7 percent in volume and nearly 11 percent in value in April-June as tourist stayed away in droves.) The second graph [Nominal and Real GDP] shows the strong rise in late 2002 that led to the optimistic outlooks issued prior to SARS. The sharp downward dip is the stampede.

The economy contracted once again in July-September, falling 1.9 percent from a year earlier. If you recall the headline 4 percent third quarter growth rate, you might think I've got an Excel error somewhere, but I can assure you that isn't the case.

Nominal GDP -- the net sum of all demand in the economy, disregarding any change in prices -- contracted for the third quarter in a row. While the decline was not as bad as the -5.9 percent slump during the SARS (I mean 2nd) quarter, it did reduce our economy in the nine months to end-September by 2.7 percent, as compared to the first three quarters of 2002.

The third quarter 4 percent grow rate was wholly the product of deflation. Prices, according to the GDP deflator, fell 4.8 percent from July-September 2002, not quite as bad as the 5.2 percent drop in the first half, but worse than expected. Subtract the deflation  (i.e., subtract a minus) from the nominal contraction figure, and the result is +4 percent.

Guessing what the GDP deflator will be is the part of economics furthest away from science. As the third graph illustrates [Measuring Price Changes], the monthly Consumer Price Index (CPI) generally gives the right idea, but can also send conflicting signals. That's partly because of its narrower base: it only measures consumer goods and services, excluding things like foreign trade. Over the last three years, private consumption, which is roughly the same as the CPI, comprised only 59 percent of GDP.

The most important factors in the Q-3 contraction were capital investment (down 7.4 percent) and private consumption (off 1.9 percent), particularly services (down 2.9 percent). On the positive side were public sector spending on building and construction (up 9.1 percent), tourism spending (up 2.2 percent, albeit by a new calculation method) and a barely visible 0.2 percent rise in durable goods. Consumer prices continued to fall sharply, with services off 5.6 percent from a year earlier and durables down 5.2 percent.

What concerns me the most in contemplating the new year is the assumption that fiscal revenues will rise to meet expenses by the end of the decade. Over the past decade, revenues have typically increased or decreased by one-quarter of the change in nominal GDP. In other words, at current (and what appear to be planned) rates of spending we'll need nearly 5 percent nominal growth each year between now and 2008-09 to balance the budget.

David O'Rear is the Chamber's Chief Economist. He can be reached at david@chamber.org.hk