Hong Kong's comparative advantage is a blend of ingredients that make it unique in the global economy and financial system. This blend cannot be replicated and has propelled its economy for decades. Now, however, these advantages are at risk of erosion. Rising policy uncertainty, fraying social cohesion, and greater competition from mainland China are making Hong Kong less special. S&P Global Ratings believes trend growth will more than halve through 2030 to about 1.1%.

The growth slowdown will add to the unavoidable downward pressures resulting from its place as one of the most rapidly aging societies in Asia. In the near term, we expect a cyclical recovery with growth of -4.7% in 2020 followed by a rebound of 4.9% in 2021. However, we expect the underlying trend growth rate to slow.

The balance of risks to Hong Kong's long-term economic prospects is tilted to the downside. Prominent among them is a further rapid deterioration in the U.S.-China relationship resulting in a decoupling of the U.S. dollar and Chinese renminbi financial systems. A second risk is an accelerated financial opening of the mainland that would lessen Hong Kong's role as a conduit.

A plausible downside scenario could see trend growth of zero in a decade. The main upside risk is that Hong Kong benefits from a slower pace of mainland opening and attracts an increasing share of China's offshore financing business.

Hong Kong's Specialness Is Being Eroded

Hong Kong is one of the world's most expensive cities for conducting business. According to a study by CBRE, a commercial property expert, Hong Kong's Central district had the costliest office rent in the world in 2019. [1] Across Victoria Harbour, Kowloon district was the third most expensive location, behind only Hong Kong Central and the West End in London. Both Kowloon and Central are more expensive than prime midtown Manhattan in New York.

Other Hong Kong operating expenses, such as staff costs, are high, and the city regularly features among the most expensive cities in the world for cost of living. [2, 3]

And yet, Hong Kong has remained highly competitive. In the World Economic Forum's 2019 ranking, Hong Kong came third after Singapore and the U.S., scoring higher than the high-income group average across the board. [4] Its biggest advantages were macroeconomic stability, a robust financial sector, healthcare, and infrastructure.

We should not downplay these achievements, which all economies should aspire to match. But they do not reveal fully the edge that has propelled Hong Kong to such economic success, and which is now at risk.

The advantage is a mix of traits that derive potency from how they blend together. At the highest level, geography, economic flexibility, social cohesion, and soft infrastructure have all combined to make Hong Kong special. However, world perception of the robustness of at least three of these traits may be changing.

First, businesses had already begun to express more pessimism about the effects of social unrest on their prospects. In a survey of foreign businesses last year, almost one in four respondents said that their investment plans were being adversely affected. [5] Second, the new National Security Law (NSL) may have introduced greater uncertainty into the policy outlook and business climate. [6, 7]

Hong Kong's geography, at least in an economic sense, is also changing. Hong Kong is still "offshore" from the mainland in a regulatory sense but close enough to act as an effective financial conduit. Now this gap between Hong Kong and its mainland competitors, especially in the Greater Bay Area—a proposed economic hub encompassing Macau, Hong Kong, Guangzhou, Shenzhen, and Zhuhai--is shrinking. While this provides opportunities for Hong Kong, we think the net effect will be negative as more mainland-related business migrates to cities such as Shenzhen.

Hong Kong's Advantages Allowed Trade And Finance To Flourish

Hong Kong's history and distinctiveness helped it become an entrepôt with thriving trade and financial industries. Together, these two industries combined account for just over one-third of value added in the economy.

The financial industry has been a cornerstone of the city's prosperity for a long time, and accounts for nearly one-fifth of the economy, almost double the level just before the 1997 handover. This share is disproportionately large compared with global averages. For comparison, Korea, which has a comparable level of income, has a financial sector that accounts for about 5.5% of the economy.

Import and export trade account for a further 16% share of value added, excluding the direct contribution from transport. This is about the same as just before the handover. Hong Kong has benefited significantly from its role as a trade gateway to the mainland. The city has efficient port facilities and, in 2018, it was the seventh busiest port in the world.

Hong Kong does not simply ship products from point A to point B. As far back as 2001, research has shown that re-exports of Chinese goods are much more expensive when they leave Hong Kong than when they entered, indicating that valuable tasks have been outsourced to the city. [6]

Hong Kong's Productivity Has Propelled Its Prosperity

Unique comparative advantages allowed Hong Kong's economy to grow much faster than one might expect. More jobs have helped but the real driver of growth has been labor productivity. From the 1997 handover to China, to 2018, before social unrest intensified, Hong Kong's real GDP grew by almost 3% a year of which labor productivity and employment have contributed 2.1 and 0.8 percentage points (ppts), respectively.

Usually, the poorer an economy is, the faster it should grow as its productivity levels catch up with the richest economies. We tested this theory by estimating the relationship between labor productivity and growth for 123 economies over the period 1963 to 2018. We measure labor productivity as real GDP (or value added) divided by the number of employees, a relatively crude measure but one that allows us to compare Hong Kong with a wide range of other economies that do not report output per hour. We also allowed for country-specific factors (so-called "fixed effects") that might also determine growth.

Chart 1, below, shows how an economy of Hong Kong's income level would have grown if it had qualities that placed it in the top 25% or top 10% of all economies. In 1997, Hong Kong's labor productivity was three-quarters that of U.S. levels. Our model suggests that its labor productivity would have grown by about 2% to 3% per year (the dark blue and yellow lines, respectively). In fact, Hong Kong grew faster, at 3% to 4%. As Hong Kong became richer, its labor productivity growth slowed, as expected, but it still did better than almost every other economy when we account for differences in income levels. In short, Hong Kong's performance placed it in the top 8% of all economies across the world. Where did this productivity growth come from?

Chart 1

Finance And Trade Account For 90% Of Labor Productivity Growth

The financial and trade industries are Hong Kong's productivity powerhouses. Together they account for about 90% of labor productivity growth since the global financial crisis (GFC). More sophisticated measures, such as output per hour worked, provide similar results. In practical terms, what does an exceptionally high level of labor productivity mean?

For the financial sector, high productivity reflects the decisions of firms to hire and attract workers that complete tasks generating outsized revenues in Hong Kong. Examples include teams that manage equity capital raising or debt syndication. A decade ago, workers in this sector generated more than three times the value added of those in the average sector. Not only was this gap wide but it has widened since then, aided by China's financial opening, with financial services output per employee growing by 2.2% per year compared with 1.8% for the whole economy. If these workers and their tasks move elsewhere, the level and growth of productivity would fall with substantial economic effects.

For the import-export sector, which is more capital intensive, it means that firms have invested heavily in advanced machinery, equipment, and software, allowing a smaller number of workers to generate substantial value added. The role that technology has played in this sector is shown by the fact that, over the past decade, real value added has grown about 3% in annualized terms, while employment has shrunk by almost 4% on average every year. In other words, labor productivity has surged by an annualized 7%.

So this is really a tale of two sectors, financial services and import-export trade. The prospects for both will depend on the extent to which firms that invest in Hong Kong perceive that it retains its comparative advantages (see chart 2).

Chart 2

Perceptions Matter For Comparative Advantage

Measuring perceptions about how uncertain the political, social, and business climate has become is hard. Some recent surveys suggest business confidence has eroded due to social unrest. The American Chamber of Commerce (AmCham) in Hong Kong polled 180 members in June 2020 and found that 80% were either "very concerned" or "moderately concerned." Moreover, 60% of respondents felt that the NSL (which at the time had not been made public) would harm their business operations in Hong Kong. [9]

Three types of uncertainty are rising. First, perceptions of Hong Kong's relationship with the mainland appear to be changing. Opinion surveys of the Hong Kong population point to diminishing confidence in the "One Country, Two Systems" framework. [11] How fast and how deep changes will be this side of 2047, when the framework expires, remain unknown.

Second, how the new relationship, based on what has been released publically to date, will work in practice is also unknown (indeed, ambiguity in the scope and enforcement of the new law was the top concern in the AmCham survey).

Third, how governments in other parts of the world will treat Hong Kong as a result of these changes has been thrown into doubt (the removal of Hong Kong's special status by the U.S. government may not be the last word).

Let's assume, for now, that we could attach meaningful probabilities to different outcomes for Hong Kong's relationship with the mainland and the resulting business climate. This distribution would surely have widened but also have become much more skewed. In other words, the probability of closer alignment with the mainland, rather than more independence for Hong Kong, has surely risen.

One does not need to take a position on recent developments, whether they are "good" or "bad," to conclude that policy uncertainty has risen and the probability of Hong Kong fully retaining its comparative advantages has decreased. Perceptions that comparative advantages could be eroded will likely affect investment and hiring decisions. But how, in practical terms, might their diminishment affect productivity and growth?

Some Financial Activities May Take Place Elsewhere

We do not need to come up with fanciful scenarios to believe that growth might be less exceptional in the future. Clearly, financial institutions with substantial operations in Hong Kong are not likely to close shop and move elsewhere. But this is not really the point. The point is that some activities could move elsewhere and with it would move the value added, which includes the wage paid to the resident employee and the taxes paid on those wages, and the profit. The challenge facing Hong Kong is that there are few barriers to many high-value activities moving elsewhere. Compared with complicated physical supply chains, service sector activities incur lower adjustment costs.

The pressure to move activities could be push and pull. The push could be firms locating activities in lower cost locations, including the mainland, as Hong Kong's unique advantages such as a monopoly in certain mainland-related financial activities erode. The pull factor could be employees who wish to work in other locations due to uncertainty about the new legal framework (over 40% of respondents to the AmCham survey were concerned about talent drain and staffing issues.)

Even prosaic issues such as taxes could lessen incentives to work in Hong Kong--news that the mainland is clarifying its rules on global taxation could mean more of its citizens relocate from Hong Kong to lower cost Shenzhen. Either way, the more that high value-added tasks relocate (or new tasks are undertaken elsewhere), the greater the downward pressure on productivity and growth.

As a simple thought experiment, if the growth in real financial sector value added halves from the near 5% per year over the past decade to a still-respectable 2.5% this would directly shave 0.5 percentage points off annual growth. Of course, there would be broader implications as the industry's employees earn and spend less in the domestic economy, affecting the real estate, transport, and services sectors.

One counterargument to this view is that Hong Kong will remain the super-connector for a rapidly growing China. This may be true but as China opens and develops its own capacity, one might also wonder if the world still needs an expensive middleman.

Hong Kong Will Face Stiff Competition From The Greater Bay Area

China's government has unveiled an ambitious plan to integrate the cities of Hong Kong, Macau, Guangzhou, Shenzhen, Zhuhai, Foshan, Zhongshan, Dongguan, Huizhou, Jiangmen, and Zhaoqing into an economic and business hub. This is the "Greater Bay Area" (GBA). The GBA brings opportunities but also competitive pressures for Hong Kong. Hong Kong may become more like other Chinese cities but other Chinese cities will also, from a financial perspective, become more like Hong Kong.

Specifically, the GBA may threaten Hong Kong's quasi-monopoly in some financial services as regulatory and capacity gaps narrow. First, integration over time will likely mean more harmonization of rules and regulations. Cross-border financial activities which, until now, have only been permitted in Hong Kong may increasingly be allowed within the broader GBA.

Second, mainland financial institutions will learn-by-doing and develop their own capacity to offer the more complex cross-border services now provided in Hong Kong, most likely at a much lower price.

The logistics industry is already dispersing across the GBA. Shenzhen and Guangzhou have overtaken Hong Kong to become the world's third and fifth busiest container ports, respectively. The growth in container handling in Shenzhen and Guangzhou has been brisk at a compound annual growth rate of 2.6% and 7.1%, respectively, over the post-GFC period. In contrast, Hong Kong now handles about 4.6 million fewer containers annually compared with right before the GFC (see chart 3).

Chart 3

Hong Kong's competitive advantages will not disappear overnight. Still, many businesses will repeatedly revisit the question of whether these advantages offset the higher costs involved in operating from Hong Kong.

Hong Kong Is Getting Old, Quickly, Adding To Growth Strains

Hong Kong is aging quicker than almost any other economy in Asia-Pacific. The working age population--which we define as individuals aged between 15 and 65 years--grew by about 1% a year through the decade ending 2010. In part, this was helped by migration inflows. However, this population started shrinking in 2015.

In the decade ending 2030, the United Nations projects that this population will shrink by about 1% a year and more if net migration is lower than expected. With zero net migration--that is, the number of leavers balances out those arriving in Hong Kong--its working age population will shrink at rates comparable with Japan.

Hong Kong's aging is reflected in it old-age dependency ratios. In 2015, there were five persons of working age for every person aged 65 years or above. By 2035, the United Nations projects that this will drop to just two persons per senior. This demographic headwind means that employment will likely stagnate, at best, for some years and then fall slowly.

Chart 4

Chart 5

In Our Baseline, Hong Kong's Trend Growth Will Fall To 1.1% By 2030

We assume Hong Kong's trend growth will fall all through the next decade and reach 1.1% by 2030, more than halving from the estimated 2.7% in 2018. Incorporating a post-COVID cyclical recovery, this would mean the cumulative, annualized growth rate for the decade through 2030 would be 2%, down from a 10-year growth rate of about 3.5% in 2015. We arrive at this figure by making assumptions about employment and labor productivity which, in turn, reflect how quickly we think Hong Kong's specialness erodes over time.

Employment will stagnate, at best. Indeed, our forecasts assume a greater proportion of the working age population make themselves available for work (the so-called participation rate) and this may offset some of the population decline. Still, the participation rate is already high at 76% and it is hard to see it rising much further. The current level is comparable with participation rates in Korea or the eurozone, and higher than the U.S. where it is around 63%.

We expect Hong Kong's labor productivity growth to fall to 1.2% in 2030 as perceptions of its unique comparative advantages are eroded over time and some high-value tasks in the financial and import-export sectors are relocated or diverted to other locations, including mainland China. At the same time, the share of less productive sectors in the economy--such as tourism--will rise.

Chart 6 summarizes our projections in decade-long growth rates. Each part of the bar shows the contribution to changes in the number of employees, how long they work, and how productive we expect them to be. In the decade through 2030, we expect growth to be driven entirely by labor productivity as both the total number of jobs and average hours worked remain unchanged.

Chart 6

A downside scenario could be an acute or chronic deterioration in macroeconomic stability and prospects. In turn, we see the most likely catalysts for each of these scenarios being financial decoupling from the U.S. and a gradual, persistent rise in domestic policy uncertainty, respectively.

Financial decoupling is a continuum, ranging from "sand in the wheels" that raises the cost of some activities, to sanctions that freeze Hong Kong out of the U.S. dollar financial system. Of course, the U.S. economy would also incur costs in restricting access to its financial system. These costs are increasing, in a nonlinear way, along this continuum. As a result, it seems reasonable to assume that the probability of a dramatic decoupling is low.

The probability of increasing financial friction is not zero, however, and has surely risen. The U.S. is reviewing Hong Kong's special status and efforts to weaken Hong Kong's role as a financial center would tighten financial conditions globally, as well as in Hong Kong. While the economic impact of such efforts could be very large, at this point we see this as an extreme tail risk rather than a plausible downside for the Hong Kong economy.

A plausible downside for the economy would be a steady but persistent rise in perceptions of domestic policy uncertainty. Perceptions of uncertainty may be broad-based and would encompass more than macroeconomic and financial policies, including Hong Kong's soft infrastructure.

To put some flesh on the bones, we have assumed that in this downside, Hong Kong's labor productivity would grow in line with the most technology-advanced large economy (which we take to be the U.S.) which means about 0.9% per year. So Hong Kong's productivity growth is still good but no longer exceptional. We also assume that fewer people come to Hong Kong to work and some may leave for opportunities elsewhere--specifically, we use the United Nations' zero net migration population projections but kept assumptions about the participation rate unchanged. By 2030 in this moderate downside, Hong Kong's trend growth rate would be zero as labor productivity growth is entirely offset by declining employment.

Exchange Rate Implications Of Slowing Trend Growth

Given the Hong Kong dollar peg's contribution to economic and financial stability, it is natural to wonder what slowing productivity and growth will mean for the exchange rate. We think they will lead to depreciation pressure on the real exchange rate when measured against all its trading partners.

Over the long run, an economy's productivity should help determine the valuation of its real exchange rate. As an economy becomes less productive than its trading partners, its tradable goods and services will become less competitive and its external balance (that is, the current account) will deteriorate.

Its internal balance will also worsen as more workers and capital that produce these goods and services stand idle. All else equal, to restore both external and internal balance to the economy, its exchange rate versus its trading partners, including mainland China, will have to depreciate.

Of course, the Hong Kong dollar peg means that the nominal exchange rate is inflexible. The Hong Kong dollar can move against other currencies but only to the extent that the U.S. dollar is moving at the same time. If the peg remains in place, as we expect, this means the adjustment will have to happen through relative prices. With inflation very low in Hong Kong's trading partners, this probably means deflation in the domestic economy.

This is what happened to Hong Kong after the Asian financial crisis and SARS. Hong Kong's real exchange rate based on relative unit labor costs--a measure of competitiveness--depreciated by almost 60% between 1998 and 2008. Since bottoming out in 2012, this same exchange rate has appreciated by about 40%. If Hong Kong's productivity growth advantage versus its trading partners diminishes, then to maintain the same level of competitiveness, the exchange rate would have to depreciate more (or appreciate less) than otherwise. If the peg prevents the nominal exchange rate from adjusting much, then unit labor costs in Hong Kong have to decline compared with peers and relative wages will fall. In turn, this will weaken consumption and lower inflation.

Chart 7

Between 1998 and 2005, Hong Kong suffered sustained deflation or falling consumer prices. Hong Kong's economy is highly flexible with wages quick to adjust and this provides an important support for the pegged exchange rate regime. At the same time, though, it does mean higher real interest rates.

Hong Kong's real short-term interest rate was substantially above its U.S. equivalent between 1998 and 2005. Indeed, around 2000, Hong Kong's real interest rate reached 10% and was over 600 basis points higher than the U.S. equivalent. Higher real interest rates tighten financial conditions and would have adverse implications for interest rate-sensitive sectors of the economy (see chart 8).

Chart 8

End Notes

[1] CBRE, June 27 2019, Six of the World's 10 Most Expensive Office Markets are in Asia. https://www.cbre.com.sg/about/media-centre/six-of-the-worlds-top-10-most-expensive-office-markets-are-in-asia

[2] Mercer, 2020 Cost of Living Survey, https://www.mercer.com.sg/newsroom/mercer-2020-cost-of-living-survey-sg.html

[3] Economist Intelligence Unit, Worldwide Cost of Living 2020, https://www.eiu.com/n/campaigns/worldwide-cost-of-living-2020/

[4] World Economic Forum, 2019, "Global Competitiveness Report".

http://www3.weforum.org/docs/WEF_TheGlobalCompetitivenessReport2019.pdf

[5] American Chamber of Commerce in Hong Kong, "How is Hong Kong's unrest affecting business?" AmCham Temperature-Testing Survey, October, 2019.

[6] Financial Times, "Businesses in Hong Kong Fear Collateral Damage from Security Law," July 2, 2020 https://www.ft.com/content/b056cd9b-c3d3-42dc-a2e1-6a204ea25e85

[7] Wall Street Journal, "Big Tech's Stand on Hong Kong Law Reveals Wider Fears at Foreign Firms," July 7, 2020. https://www.wsj.com/articles/big-techs-stand-on-hong-kong-law-reveals-wider-fears-at-foreign-firms-11594139991

[8] Feenstra, Robert C. and Gordon Hanson, 2001, "Intermediaries in Entrepôt Trade: Hong Kong Re-Exports of Chinese Goods," NBER Working Paper 8088.

[9] American Chamber of Commerce in Hong Kong, "National Security Law and Hong Kong's Special Status," AmCham Temperature-Testing Survey, June, 2020.

[10] United Nations, World Population Prospects 2019.

[11] The Hong Kong Public Opinion Research Institute semi-annual survey conducted in February 2020 found that confidence in "One Country, Two Systems" dropped to a -27 (a balance out of 100 of those confident less those that were confident).