IMF Recommends Hong Kong Should Remain Fiscally Flexible

by Mary Swire, Tax-News.com, Hong Kong

22 January 2013

In the Staff Report following the conduct of its 2012 Article IV consultation discussions on Hong Kong, the International Monetary Fund (IMF) commended the government's supportive fiscal policy to counteract the global economic uncertainty, but stressed that the fiscal stimulus should be withdrawn when the economy recovers.

Real growth in Hong Kong’s gross domestic product (GDP) is projected to have slowed to 1.25% in 2012, pulled down by the weak external environment. However, the IMF reported that domestic demand has been resilient, buoyed by a healthy labor market and supportive fiscal policy, and growth should recover to around 3% in 2013.

Nonetheless, it was said, as a small and highly open economy, Hong Kong remains susceptible to external shocks and would strongly feel the effects of a worsening of the euro area crisis, further fiscal problems in the United States or a hard landing in Mainland China. In the absence of an independent monetary policy, fiscal policy is the main tool for demand management.

Fiscal measures already taken have included reductions of public housing rent, tax relief to households, reduction in fees and increases in social spending. The IMF said that: "Next year’s budget should continue to be supportive of demand and, in the event of an external shock, fiscal policy should be deployed to provide further stimulus and protect low-income and vulnerable households."

In the event of an external shock, the IMF noted that options include targeted tax relief and increased direct transfers to poor and vulnerable households, extended support for smaller enterprises (which are important for employment), and accelerated public infrastructure spending where possible.

However, to prevent an erosion of fiscal discipline, the IMF added that "it would be critical to ensure that policies are applied symmetrically through the business cycle, with stimulus being withdrawn as the economy recovers. Hong Kong’s history of fiscal prudence, which has built fiscal reserves to over 30% of GDP, provides an important backbone to the economy."

The IMF viewed the property sector as the main source of domestic economic risk. With housing prices have doubled from their trough of 2008, policies on a variety of fronts are considered to be needed to contain the risks from the housing market, and, while the government has taken appropriate macro-prudential and financial measures, they "should continue to be fine-tuned in line with evolving risks and, if needed, additional measures could be deployed."

In November 2010, Hong Kong began to impose Special Stamp Duty (SSD) of 15% for residential properties resold within six months of purchase, 10% for properties resold between six months and 12 months, and 5% for properties resold between 12 months and 24 months, imposed in November 2010. Then, in October 2012, it raised of all levels of the SSD by 5%, and introduced a 15% Buyer’s Stamp Duty for buyers of residential properties who are not Hong Kong permanent residents. As the impact of these measures is assessed over time, the IMF suggested that these stamp duties "could be adjusted further if needed."

The IMF pointed out that Hong Kong is benefiting from the ongoing financial integration with the Mainland, and should continue to build on its competitive advantage. However, as claims on Mainland borrowers have grown significantly and accounted for 28% of Hong Kong banks' total external claims as of end-June 2012, there have been warnings about the risks of rapid Mainland portfolio expansion by some banks, especially in an environment where non-resident banks may be effectively subordinated in the case of payment problems and where collateral enforcement procedures are largely untested.

To identify emerging risks, the IMF recommended that the Hong Kong Monetary Authority should continue to stress test and closely monitor banks' exposures, including through close cooperation with the Mainland authorities, and to ensure that banks maintain prudent underwriting standards and hold adequate buffers that reflect the specific risks from Mainland-related exposures.

The IMF also concluded that RMB internationalization continues to benefit Hong Kong, which remains the main offshore RMB center. After growing rapidly through late 2011, its share of RMB deposits has stabilized at around 9% of total system deposits. Looking ahead, the IMF considered that the ongoing opening of the Mainland's capital account and expanded international use of RMB should provide further opportunities for Hong Kong to strengthen its position.

Finally, following the extensive discussion in last year’s Article IV consultation, the IMF continues to believe that the arguments for maintaining the Linked Exchange Rate (LER) system are compelling, given that it has generated substantial benefits in terms of monetary and financial stability, built up a stock of credibility over the decades, and kept the real exchange rate of the Hong Kong dollar broadly in line with fundamentals.

"The requirements for sustaining the current system, including a flexible economy, a track record of fiscal discipline and robust financial sector regulation and supervision, are all in place," it wrote. "The LER system is superior to other exchange rate regime options in the case of Hong Kong."

Hong Kong’s Financial Secretary, John C Tsang, welcomed the IMF's endorsement of Hong Kong's economic and financial policies, noting that "as a small, open economy and an international financial center, Hong Kong is susceptible to external shocks and our policies are adopted with that in mind."

"We are firmly committed to the Linked Exchange Rate system, which has helped maintain Hong Kong's monetary and financial stability during cyclical changes. Against the immense uncertainties in the global environment, we will remain vigilant and deploy necessary measures to address potential risks to economic and financial stability," Tsang said.