Since the handover from Britain in July 1997, Hong Kong has been a Special Administrative Region[SAR] of China. According to the Basic Law, it will keep its own economic and political system and enjoy far reaching autonomy in all internal affairs until 2047, including an independent legal, fiscal and monetary system. Externally, the Hong Kong administration holds authority over issues related to trade only, while foreign affairs, defence and national security are controlled by China. Under Chinas auspices, Hong Kong is governed by the Chief Executive, an Executive Council and an elected Legislative Council, which has limited powers.
Hong Kongs political agenda has been dominated by the issue of further democratic reforms. According to the Basic Law, universal suffrage is the ultimate goal in Hong Kong, but no target date has yet been set. Pro-democratic parties continue to demand free elections, but the Chinese authorities have until recently been reluctant to approve further political reforms, fearing that a full-fledged democracy in Hong Kong might potentially lead to disloyalty to Beijing and, in the long term, pose a threat to Chinas autocratic system.
However, last year the Chinese government surprisingly granted some democratic reforms to Hong Kong. The Legislative Council will be expanded by 10 seats - to 70 - for 2012. As the 10 new seats will all be elected by popular vote, the majority of legislators  will then be directly elected. At the same time, the electoral committee which elects the Chief Executive was expanded from 800 to 1,200 seats. Chinas rationale behind these reforms is to reduce the risk of protest by the democratic movement in Hong Kong before and in the wake of the 2012 elections.
Hong Kongs economy profits from a Closer Economic Partnership Agreement [CEPA] with China, a free-trade agreement granting Hong Kongs firms preferential access to the mainland market. Hong Kong is the largest foreign investor in China. Any political and economical development on the mainland therefore directly affects Hong Kong.
In 2010 Hong Kong recorded strong economic growth of 6.8% after a contraction of 2.7% in 2009. This year GDP growth will be 5.2%, supported mainly by private consumption and exports. In particular, exports to China and other emerging markets will be strong and will compensate for the weak demand from developed countries. Unemployment stood at 3.4% in March 2011, its lowest percentage for the past two years.
Inflation is increasing [4.6% year-on-year in March 2011], due in the main to higher food prices [food accounts for 26.9% of the overall Consumer Price Index Basket - CPI]. Hong Kong is one of the worlds top net food importers. Additional inflationary pressures are triggered by expected rent/housing increases, transport costs, and a loose monetary policy.
As the economy has become increasingly aligned with that of the mainland, inflationary pressures are similarly becoming progressively more synchronized, with China's CPI appearing to be a reliable lead indicator of the situation in Hong Kong over recent years. With China's inflation accelerating to 5.4% year-on-year in March, and new bank lending remaining strong, inflationary pressures on the mainland - and thus in Hong Kong [45.5% of total imports were supplied by the mainland in 2010] - should persist in the near term. Overall inflation is expected to increase to 4.2% this year from 2.4% in 2010.
There are concerns about asset price bubbles, as a loose monetary policy, tight housing supply and an influx of Chinese buyers have led to property prices rises of more than 60% since 2009. To discourage speculation, strong measures such as a property transaction tax increase have been taken by the administration in November 2010 - and the number of property transactions fell 26.2% month-on-month in December, while the value of transactions declined by 27.8% during the same period. Given the enormous consequences of a potential property market crash, it is expected that the government will introduce further cooling measures in the event that property prices resume their upward trend.
The financial sector is strong, as banks are well capitalised, liquid and profitable. The non-performing loans ratio is very low, as is the rate of corporate bankruptcy, and payment behaviour is generally good.
Hong Kongs government revenues are highly dependent on income from land sales and investment of accumulated surpluses - and therefore vulnerable to economic cycles. The tax base is still too narrow but, due to increased land sales, fiscal surpluses have increased to 3.5% of GDP. Central government debt is low, with high overseas assets.
In 1983 the Hong Kong dollar was pegged at 7.80 to the US$. Early in 2005 the currency board was changed to a trading band for the HK dollar, set between 7.75 and 7.85 to the US$. This has led to a current mismatch in monetary policy: Hong Kong has followed the US Federal Reserves interest rate policy of substantial cuts, despite the fact that the economic cycles of Hong Kong and the US are not at present synchronous. In contrast to the US economic situation, low interest rates are not desirable because of the strong economic rebound and rising inflation. However, no changes are expected.
Hong Kong, as a small open economy, remains highly susceptible to external shocks. Growth rates will be lower in 2011 and 2012 than last year, at 5.2% and 4.2% respectively, and in line with slower growth in mainland China. Crédito y Caución expects further monetary tightening measures in China and see inflation abating in the second half of 2011 as property market weakness induces a slowdown in the economy. This should also alleviate price pressures in Hong Kong in the latter part of the year, in view of the deepening integration of Hong Kong's economy with the mainland. After an increase to 4.2% this year, Crédito y Caución expects inflation to slow down to 3.3% in 2012. However, we would stress that further strength in the Chinese Yuan [CNY] presents upside risks to our Hong Kong consumer price index expectations. If Chinese authorities tolerate a CNY appreciation to ease imported inflation on the mainland, this in turn could worsen Hong Kong's inflation problems, given the Hong Kong dollars peg to the weak US$.
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