It should come as no surprise that Hong Kong fell into recession in the first half of the year, nor that the third quarter is likely to be sufficiently strong to pull us back out of the red once again.

In nominal terms, GDP fell 6 percent in Q2 and 3.1 percent in the first half of the year. The April-June figure was the sharpest drop since Q1 1999. Divide one by the other and the second quarter GDP deflator -- the broadest measure of price changes in an economy -- shed 5.5 percent, the steepest drop in three years. The first graph also illustrates how deeper deflation can boost real GDP growth.

What is unusual about the just-passed recession is that it was internally generated (no surprises there: remember face masks?). As noted last month, it is contracting trade that triggers recessions in Hong Kong. Yet, this year, physical trade in goods has remained positive and it was trade in services that sealed our fate, as any hotelier will tell you. See graph II.

Domestic demand fell for the seventh straight quarter in April-June, dropping 2.8 percent in real terms and 5.4 percent in nominal. Private consumption expenditure (PCE) fell a real 2.2 percent from April-June 2002 (nominally it was
-5.1 percent), a surprisingly mild figure given the collapse of tourism. What is different this year is the larger share of services than durable goods in determining the drop in PCE. The 10.9 percent drop in retail sales in Q2 and 19.7 percent drop in restaurant receipts support this interpretation.

Government consumption, the only major indicator to have expanded every quarter in the past two and a half years, rose 0.6 percent in real terms, just half the Q1 figure despite spending on the battle against SARS and various economic relief and recovery programs. Capital investment fell 5.3 percent after a surprising (and rare) spark of growth in January-March.

On the international side, exports rose a real 9 percent in the second quarter, barely half the pace of the first quarter, on the strength of merchandise alone (up 14.3 percent, from 19.1 percent in Q1). As usual, re-exports (up 19.5 percent in the first half) overwhelmed domestic exports (-12.3 percent). Services exports contracted by a shocking 14.7 percent. It was the first drop in services sales since the Asian financial crisis five years ago. The main culprit was travel-related services (down 26.3 percent in the first half).

On the import side, goods rose 10.9 percent (down from 18.9 percent in the earlier period) while services fell 19.6 percent, for an overall goods and services rise of 7.9 percent. Again, travel services (off 19 percent in January-June) played the key role.

On the whole, two-way merchandise trade rose 12.5 percent in Q1 -- the fourth straight quarter of double-digit growth -- and 15.5 percent in the first six months. Services, however, dropped 16.4 percent (and 5 percent in January-June), the first contraction in four years.