Hong Kong has seen a massive swing in sentiment in 2003, from extreme pessimism amid the SARS outbreak in 1H, to euphoric stock market gains in 2H.  Beyond the cyclical recovery that should persist well into 1H04, the medium-term roadmap for the Hong Kong economy continues to be shaped by further economic integration with China, and how it strikes a delicate balance between costs and benefits of such integration.  Interestingly, over the past few years, the market rallies, sometimes disproportionately, on the back of “goodies” from integration in periods of positive sentiment, and exaggerates concerns over the structural costs of integration when the mood is gloomy.  Looking into 2004, events and trends should further illustrate the opportunities and challenges associated with the disappearing border and increasing mobility of labor and capital.  We will try to identify the linkages among all the economic issues and analyze developments under this framework.
        Hong Kong ’s economic roadmap is essentially the balance between positives and negatives of its integration with under the circumstances of a fixed exchange rate.  Its “wish list,” which rests with the central Beijing government, encompasses measures that secure and progressively extend Hong Kong ’s first-mover advantage in the promising Chinese market.  The opportunity to front-run other WTO members in market access, derived from its preferential relationship with , was formally endorsed in the Closer Economic Partnership Arrangement launched mid-year.  The deliberate naming of CEPA as an “Arrangement” rather than an “Agreement” signals Beijing’s ongoing support for Hong Kong, and implicitly promises the gradual realization of other items on the wish list.  Aside from the relaxation in Mainlanders’ tourist visits to Hong Kong that has brought about a quick fix to the SARS-battered economy since mid-2003, the first step toward introducing Renminbi financial services in Hong Kong represents the most promising development in enhancing its status as an international financial center, and paves the way for immense opportunities as China progressively relaxes its restrictions on cross-border financial transactions.
        Hong Kong ’s structural pests, namely deflation, unemployment, and fiscal deficit, are not new to anyone.  While many still insist that they have resulted from the 1997 crisis and should ease upon a cyclical recovery, we are convinced that their persistence has a close association with Greater China integration, but that they only presented themselves as the 1997 crisis triggered the collapse of the asset bubble.  The CPI has fallen 16% from the peak in 1998, and the GDP deflator 23%, but the narrowing of the price gap could only continue amid increasing flows of labor and capital across the disappearing border.  Hong Kong university graduates are now competing with their Mainland counterparts for jobs in the Pearl River Delta.  The fiscal deficit has resulted in the erosion of the revenue base by deflation and the northward shift in consumption and productive economic activity, and the downward inflexibility of the public sector’s cost base.  Although the cyclical recovery appears looks promising to ease deflation and unemployment, we should not underestimate the pressure from millions waiting to be employed and hectares of land waiting to be developed, which is set to linger for many years to come.
        Looking into 2004, real economic growth for Hong Kong amid the realization of Chinese “goodies” could well surprise on the upside, exacerbated by the low base effect from SARS.  The unemployment rate is easing as opportunities in the Mainland help absorb job seekers.  We currently forecast real GDP growth of 4.5% for 2004, and a 1.5-2 percentage point ease in the jobless rate.   The fiscal deficit could narrow by HK$25 bn (2% of GDP) in FY2005 amid the cyclical upturn as the government collects more taxes from the improved economy, but will still be far from being eliminated until we see radical fiscal reform measures.  Nevertheless, we still stand out from the crowd in reiterating that any surprise to inflation will likely be on the downside (current forecast is -1% for 2004), as it is simply too naïve to ignore the deflationary pressure from Hong Kong merging into an economy with 186 times its population but only 5% of its per capita income.
        Hong Kong places immense trust in the leaders in Beijing in their support for the economy, independent of any displeasure with the local government.  We share the optimism that there are enormous opportunities that could offer to sustain Hong Kong ’s economic growth.  Nevertheless, effective implementation is vital in maximizing the benefits from these valuable opportunities, against the structural costs of integration.  Eventual success in reviving the economy still depends on coordinated measures on the domestic front.  Otherwise, valuable opportunities could well be wasted rather than constructively and profitably leveraged.