HKSAR - AFTER THE FIRST DECADE: ECONOMIC OUTLOOK

C O N F I D E N T I A L SECTION 01 OF 06 HONG KONG 001579 SIPDIS SIPDIS STATE FOR EAP, EAP/CM NSC FOR TONG/WILDER E.O. 12958: DECL: 06/12/2032 TAGS: ECON ETRD PGOV PHUM PINR PREL SOCI EWWT SENV KIPR, TBIO, CH, HK, MC SUBJECT: HKSAR - AFTER THE FIRST DECADE: ECONOMIC OUTLOOK REF: HONG KONG 1551 Classified By: Acting Deputy Principal Officer Laurent Charbonnet, Reasons 1.4 (b, d) ¶1. (U) SUMMARY: At the ten-year anniversary of its reversion to the PRC, Hong Kong's economy is strong, led by a potent services sectors and robust consumer demand. Over the past decade, Hong Kong has solidified its position as a regional transportation hub, an international interface for the mainland's Pearl River Delta (the manufacturing region that produces closes to 40% of China's exports) and a vibrant financial center where mainland enterprises can raise funds. Hong Kong trumpets its strengths as a free economy, built on fundamentals such as the rule of law, an independent judiciary, free flow of capital and information, and a labor pool that has extensive international experience suited to Hong Kong, mainland China and Asian markets. (In 2007, the Heritage Foundation ranked Hong Kong as the world's freest economy, an honor that Hong Kong has garnered 13 times.) After enduring a rather turbulent period from 1997 to 2003 (reftel),Hong Kong's economy is taking advantage of the global economic upturn as well as mainland China's continuing growth. Over the past three years, Hong Kong has registered GDP figures of US$166 billion, 177 billion and 189 billion, with growth rates of 8.4%, 7.5% and 6.8%. Unemployment rates also dropped from 7.9% in 2004 to 6.8% in 2005 and 5.6% in 2006 and is forecast to be 4.3% in 2007. ¶2. (C) July 1 will mark Hong Kong's reversion to the PRC and its transition from British colony to Special Administrative Region of the People's Republic of China. The key to the successful implementation of this transition has been the "one country, two systems" framework, which is established and elaborated through two legal documents: the Basic Law of the Hong Kong Special Administrative Region and the "Sino-British Joint Declaration on the Question of Hong Kong." The Basic Law was intended to ensure a continuation of Hong Kong's autonomy and prosperity; the existence of a free market economy; a commitment to democratic institutions, including a free press; preservation of Hong Kong's apolitical, independent civil service; respect for the rule of law that protects human rights and civil liberties; maintenance of Hong Kong's independence in fiscal and taxation matters and cooperation between Hong Kong and foreign states in economic, trade, financial, monetary, shipping and law enforcement activities. ¶3. (SBU) At the time of the handover, Milton Friedman, the U.S. Nobel Prize-winning economist, predicted that within two years Beijing would impose capital controls and abolish the Hong Kong dollar. Consistent with the Basic Law, however, Hong Kong continues to maintain its own currency; the Hong Kong Monetary Authority performs its functions without interference from the Mainland and the central government has not collected or attempted to collect taxes from Hong Kong for use on the Mainland. More generally, Beijing for the most part has respected Hong Kong's autonomy and the economic stipulations of the Basic Law, although instances of the Mainland meddling in Hong Kong's economic and trade affairs have occurred, particularly when it comes to key infrastructure industries and sensitive economic sectors, such as telecommunications, port operations, and intellectual property rights. ¶4. (SBU) Hong Kong has reaped enormous economic benefits from closer integration with the Mainland. Strengthening that integration to take advantage of the opportunities offered by the mainland's rapid economic growth remains a key priority for the HKSARG. The Closer Economic Partnership Arrangement (CEPA),the first free trade agreement for both Hong Kong and the Mainland, provides increased opportunities for trade in goods, trade in services and investment facilitation for Hong Kong and the Mainland. As a result of Hong Kong and mainland policies, Hong Kong's foreign trade, shipping, logistics, financial and tourism sectors are more closely linked to the Mainland. At the ten-year anniversary, Hong Kong-Mainland economic integration has clearly benefited the Hong Kong economy. As one analyst wrote, "Hong Kong has got on with the business of doing business and adapting to events as they have unfolded. Hong Kong foresees -- and indeed seeks to encourage -- deeper, broader and more rapid HONG KONG 00001579 002 OF 006 links with the Mainland." ¶5. (C) Not all economic developments since the handover have been positive. Recently Beijing intervened to prevent the sale of a Hong Kong telecommunications company to foreign interests. Similarly, Hong Kong declined to participate in the U.S.-proposed Anti-Counterfeiting Trade Agreement (ACTA) due to concerns over Beijing's reaction. Hong Kong now faces sharp competition from the Mainland in areas where Hong Kong has traditionally excelled, namely transportation and logistics services, where its competitive advantages are being eroded. While Hong Kong's financial sector currently stands head and shoulders above mainland China's, Chinese companies increasingly look to raise money domestically, with the active direction of the PRC government to do so. Hong Kong residents' comparative advantages in standard of living over the "poor cousins" in the Mainland are dwindling. In addition, pollution from the Mainland has significantly degraded the environment in Hong Kong, despite Hong Kong's efforts to reach cross-border solutions. These challenges cause some Hong Kongers to question whether Hong Kong can sustain its current economic good fortune into the future. END SUMMARY. (U) Note: This is the second in a series of cables examining the state of the Hong Kong Special Administrative Region (HKSAR) as it approaches its tenth anniversary. The first report focused on Hong Kong's first ten years after the reversion (reftel). This report looked at Hong Kong's current and future economic development. A subsequent report will look at Hong Kong's likely future courses in the political arena. -------------- POSITIVE DEVELOPMENTS -------------- Services -------------- ¶6. (U) Hong Kong's economy is dominated by the services sectors, which account for 90% of GDP. Hong Kong's four pillar economic sectors are: trade and logistics (28.6% of GDP),financial services (12.7% of GDP),professional services (10.6%) and tourism (3.2% of GDP). According to the HKSARG, not only are domestic services industries in good shape but the outlook for the export of services is promising. Exports of finance, business and other services have been increasing at double digit rates over the past year, increasing from US$64 billion in 2005 to US$72 billion in 2006. As the pace of economic and financial integration with the Mainland continues to advance, prospects for continued growth of Hong Kong's services growth are good. Investment, Trade and Logistics -------------- ¶7. (U) Hong Kong industries have taken advantage of the opportunities offered by mainland China's economic growth. Hong Kong businesses have invested US$280 billion in the Mainland and it is estimated that Hong Kong funded enterprises have established over 80,000 manufacturing enterprises in the Pearl River Delta, employing some 10 million workers. At the end of 2006, 45% of all overseas-funded projects in the Mainland were tied to Hong Kong interests. Of Hong Kong's 2006 total merchandise exports of US$315 billion, US$298 billion originated in the Mainland and was re-exported through Hong Kong, while only US$17 billion originated in Hong Kong. Hong Kong's air and sea ports are major beneficiaries of mainland China's merchandise production and trade growth. Through 2006, Hong Kong's airport was ranked #1 in the world in cargo volume and its seaport was ranked #2 in the world behind Singapore, as the largest container shipping port in the world based on container through-put. However, 2007 may see Shanghai snatch second place from Hong Kong. Financial Center -------------- ¶8. (U) Hong Kong is one of the world's leading financial centers, with an extensive banking and services industry that HONG KONG 00001579 003 OF 006 is regulated non-intrusively and transparently. Seventy of the world's top 100 banks operate in Hong Kong and 180 insurers from around the globe serve Hong Kong. Hong Kong's stock market capitalization has quadrupled over the past decade to reach US$1.8 trillion, making it the second largest in Asia and eighth largest in the world. Hong Kong is a key offshore capital-raising center for Chinese enterprises; 375 mainland companies are now listed on the HKEx, with total market capitalization of more than US$900 billion. Over the past ten years, mainland companies have raised more than US$200 billion in Hong Kong. In 2006 alone, Hong Kong raised over US$42 billion through IPOs, the second largest fund raiser worldwide after London. Consumerism/Tourism -------------- ¶9. (U) Private consumption (tourist and domestic) is a main driver of Hong Kong's growth. Hong Kong's reputation as a world class tourist destination is well-known. A total of 25.3 million visitors, or 3.7 times the local population, came to Hong Kong in 2006, an 8% increase from 2005; 54% or 13.6 million came from the Mainland. Domestic demand with 3.3% growth in 2005 and 5.1% growth in 2006 is also playing an important role in the current economic upturn. Continued strong employment growth, tax rebates, greater access to public housing, and rising equity and property markets have resulted in greater demand for goods and services. The combination of tourist and domestic spending increases has driven retail sales up by 6.8% in 2005 and another 7.3% in ¶2006. Infectious Disease Preparation -------------- ¶10. (SBU) Hit hard by the SARS epidemic in 2003, Hong Kong has now emerged as an international leader in the monitoring of and preparing for pandemic outbreaks of emerging infectious diseases. Hong Kong's geographic location and its role as a shipping, transportation, and tourist center increase the territory's risk of an outbreak. Hong Kong recognizes the devastating impact that an epidemic would have on the local economy. GDP dropped and unemployment rose in 2003 as the SARS outbreak killed 299 people in Hong Kong alone and crippled the local aviation, tourism and restaurant industries. Hong Kong's Avian Influenza (AI) preparedness plan is on par -- if not better -- than that of Australia, New Zealand and the United States. Hong Kong will soon reach its target in stockpiling enough antivirals for the entire population and conducts continual training for front-line responders, including health care workers, school employees and airline/airport staff. Hong Kong has also improved its communication with health officials in mainland China and continues to urge transparency in the Chinese public health sector as the most effective way to manage an epidemic. Two of the world's leading infectious disease researchers are based at Hong Kong University, while the city's other universities contain additional research centers. The city hosts a World Health Organization AI testing center. Hong Kong-native and former HKG official Margaret Chan, who spearheaded the HKSARG response to the 1997 AI outbreak and SARS, now serves as Director General of the World Health Organization. The HKSARG takes a more proactive and independent role regionally by offering technical expertise and advice to mainland China and southeast Asian countries. HKSARG hopes that its preparations will help mitigate infectious disease outbreaks and the associated problems. -------------- HONG KONG STILL FACES SERIOUS CHALLENGES -------------- ¶11. (C) Not all economic developments since 1997 have been positive. Prior to the handover, many observers predicted that mainland authorities would take an active role in the political, economic, and commercial affairs of Hong Kong. For the most part, however, mainland China has not interfered directly in Hong Kong and has allowed the HKSARG and Hong Kong businesses to function relatively independently. Recently, however, incidences have occurred that point to Beijing's meddling in Hong Kong's affairs. In 2006, PCCW, a local telecommunications provider, considered buyout bids HONG KONG 00001579 004 OF 006 from Australian and American suitors, but China Netcom, a mainland telecom giant and the second largest shareholder of the Hong Kong company, was opposed to the deal, in line with Beijing's opposition to the sale to foreigners of a key strategic infrastructure in Hong Kong. PCCW's primary shareholder, Richard Li, later accepted a rival bid from Francis Leung, an associate of Hong Kong tycoon Li Ka Shing (and Richard Li's father),for PCCW's telecom assets. This deal eventually fell apart due to regulator concerns over nepotism, lack of transparency and a high level of independent shareholder opposition. Consulate contacts have since confirmed that Beijing, through Li Ka Shing, helped block the sale to foreign investors. Local Hong Kong legislators and analysts have expressed concern over Mainland meddling in this commercial transaction and its repercussions for Hong Kong's reputation as transparent financial center with strict rule of law. ¶12. (C) Instances of indirect mainland influence over Hong Kong policy makers also have emerged. In January 2007, the Office of the United States Trade Representative (USTR) invited Hong Kong to join its new Anti-Counterfeiting Trade Agreement (ACTA). Hong Kong officials reviewed the proposal in detail and expressed satisfaction that USTR rated Hong Kong's intellectual property rights (IPR) regime high enough to participate as a global partner in the fight against IPR theft. After careful consideration, however, Hong Kong officials told us that they were not able to participate in ACTA out of concerns that Hong Kong would be held up as a model of IPR protection in contrast with mainland China. HKSARG officials also expressed concerns that Taiwan might at some point also be invited to participate in ACTA; and the possibility of both Hong Kong and Taiwan (but not the PRC) entering an international agreement could put Hong Kong in a difficult position with Beijing. In addition, HKSARG officials have deferred sponsoring joint IPR and law enforcement training programs with the USG out of concern over mainland sensitivities. They expressed concern in winter 2007 over the USG's impending WTO case against China for IPR violations. Beijing does not appear to be directing Hong Kong's decisions in these matters, but local authorities clearly are considering the repercussions their actions might have on Beijing before making final decisions. Environment -------------- ¶13. (SBU) Hong Kong air quality continues to deteriorate. Pollutants hang heavily over Hong Kong, often obscuring one of the world's most stunning vistas - Victoria Harbor, the Hong Kong cityscape and the mountains in the background. Air quality is so poor, that the HKSARG advised people with asthma or cardiovascular disease to stay indoors on 41 days in 2006. The HKSARG states that 80% of Hong Kong's pollution comes from mainland sources and is working with the government of Guangdong to create cross-border air quality monitoring schemes, joint emission reduction goals and a pilot emissions trading scheme. But, commentators have questioned these emissions reduction targets and trading schemes due to lack of transparency and enforcement in Guangdong and the high prevalence of corruption in the Mainland. Civil society groups remain critical of Hong Kong's environmental policies, claiming that the HKSARG uses the assumption that the majority of pollution comes from Guangdong to justify the lack of local action in addressing Hong Kong emissions from the transportation sector, the port, and electricity production. ¶14. (SBU) Hong Kong also struggles with high levels of water pollution. Though possessing its own reservoirs, Hong Kong has traditionally been dependent on the Mainland for drinking water. As river pollution increases in mainland China and the PRD population expands, Hong Kong will face future challenges to its water security. Furthermore, Hong Kong's Victoria Harbor remains extremely polluted. Despite its status as a developed global city, untreated waste water still flows into the Harbor from the western side of Hong Kong Island. The failure to address sewage and other forms of water pollution could impact Hong Kong's image as a holiday destination, since Hong Kong's waterways and beaches play an important role in its tourist industry. HONG KONG 00001579 005 OF 006 Trade and Logistics -------------- ¶15. (U) Greater China's trade and logistics sectors continue to develop and expand; however, Hong Kong's share of the market is not keeping up with mainland ports. During the first quarter of 2007, Shanghai's Port surpassed Hong Kong's Port to become the world's second busiest container port - Shanghai shipped 5.88 million containers while Hong Kong shipped 5.5 million containers, potentially putting Hong Kong's status as the second largest global port in jeopardy. Hong Kong Port's container throughput volume continues to grow, but the growth rate is both low and decreasing. Ports in Shanghai and Shenzhen are beating Hong Kong's Port on both port costs and associated land transportation costs. For example, trucking a 20-foot container from a factory in Guangdong and shipping it from Hong Kong costs US$333 more on average than moving it out of Shenzhen, according to a study commissioned by the HKSARG. Hong Kong's Port claims a competitive advantage in efficiency and customs clearance time, but in 2006 Hong Kong's container throughput grew only 4%, against 14% for competing ports in Shenzhen. Financial Center -------------- ¶16. (U) The Hong Kong stock exchange (HKEx) bills itself as a world class financial services platform offering a wide spectrum of financial services. It acts as a bridge between China and the international financial markets for raising capital for mainland enterprises and serves as a launch pad for outward-bound mainland investors. The two capital markets -- China's and Hong Kong's -- are at different stages of development, operate on separate structures, and also have dual listings. Hong Kong has been counting on the superiority of its financial markets to retain its leading position as a financial center within China and the region for decades to come. However, in April, 2007 the combined market capitalization of the Mainland's Shanghai and Shenzhen Exchanges surpassed that of the HKEx for the first time ever with mainland exchanges reporting a total market capitalization of US$1.765 trillion, marginally higher than the US$1.756 trillion recorded by the HKEx. Furthermore, on just one high-volume day (April 11),Shanghai and Shenzhen reported a record volume of transactions, worth US$29 billion, nearly four times greater than HKEx's US$7.5 billion. Increasing numbers of mainland firms are now choosing to list in Shanghai and Shenzhen, and China's Securities Regulatory Commission is directing mainland companies to list in the Mainland rather than on the HKEx. There is increasing concern among Hong Kong's financiers about Hong Hong's future financial role. Even a merger between the Mainland and Hong Kong stock exchanges, which seemed a very remote possibility prior to this year, has emerged as a topic of conversation. A former Hong Kong Financial Secretary and former HKEx President both opined in news articles in June 2007 that a merger of the Mainland and Hong Kong markets would be inevitable if the Mainland moved to a convertible currency. In the meantime, analysts warn that a burst of the mainland stock market bubble would have very serious negative impact on the HKEx. "Poor Cousins" -------------- ¶17. (U) Long-time Hong Kong residents note that during the 1960's and 1970's, Hong Kongers donated money and foodstuffs to support their "poor cousins" on the Mainland. In the 1980's, Mainlanders no longer needed donated foodstuffs, but Hong Kongers still kept up their generosity and donated money to their "poor cousins." In the 1990's, Hong Kong's donations to the "poor cousins" tapered off as Mainlanders began traveling to Hong Kong to spend some of their increasing incomes. Now the "poor cousins" have become key drivers of Hong Kong's tourism and retail sectors. In terms of currency, the Hong Kong dollar was highly sought after in the Mainland before 1997. At that time, Hong Kongers in the Mainland could pay in Hong Kong dollars and obtain more favorable exchange rates than the official rate. The RMB now has appreciated to match or exceed the value of the Hong Kong dollar. Mainland tourists in Hong Kong can pay their bills at the exchange rate of 1:1 and the Hong Kong dollar is no HONG KONG 00001579 006 OF 006 longer popular in the Mainland. The steady erosion of Hong Kongers' comparative advantages over their mainland counterparts has generated some uneasiness and dissatisfaction among local residents. Long accustomed to viewing Mainlanders with a mixture of disdain and pity, proud Hong Kongers now feel the pressures from a strong and rising China. It has become much more difficult now for local residents to look down upon the throngs of PRC nationals who pump cash into the city's shops, restaurants, and tourist attractions. Cunningham