Thomas Shik Acting Chief Economist [email protected]

Risks to Hong Kong Economy

May/June 2016

• The slowing mainland China economy, the US Federal Reserve’s policy tightening, and the strength of the Hong Kong dollar are all currently posing downside risks to the performance of the Hong Kong economy. • We have revised our full-year growth projection down to 1.5% from 1.8%, following the weak first-quarter gross domestic product (GDP) growth report.

China growth slowing Slowing economic growth in mainland China has increased the downside risk to the Hong Kong economy as the city’s economic cycles have become more closely aligned with those of the Mainland (Exhibit 1). The correlation coefficient between the two economies rose from 0.52 in the period from 1998 to 2006 to 0.62 in the years since 2007.1

There are also other indications. The Mainland’s share of Hong Kong’s total trade has increased to currently over 50% from 38% in 1998. Mainland tourists now account for 78% of total visitor arrivals, up from around 25% in 1998 (Exhibit 2). In addition, turnover on the Hang Seng China Enterprises Index is now equivalent to about 74% of that on the Hang Seng Index (HSI), up from 61% just three years ago.

Exhibit 1: GDP Growth (year-on-year %)

Exhibit 2: Hong Kong Tourist Arrivals (annually)

Source: Macrobond, Hang Seng Bank

Source: Macrobond, Hang Seng Bank

Fed tightening Hong Kong should keep monetary policy loose in response to the increased downside risks to growth. However, the city’s linked exchange rate system means that it must follow the US Federal Reserve (Fed) and tighten monetary policy.

1

The higher the correlation coefficient, the stronger the economic relationship.

May/Jun 2016

2

The Fed lifted interest rates for the first time since 2006 in December last year. Fed officials expect two rate rises this year and further hikes in 2017 and 2018 (Exhibit 3).

Although the currently large amount of aggregate balance in Hong Kong’s

banking system – a measure of interbank liquidity in the city – means that there is little chance for Hong Kong banks to raise interest rates in 2016, the continuation of the Fed‘s policy tightening implies that Hong Kong banks may have to start lifting rates at some point in the next couple of years (Exhibit 4).

Exhibit 3: US Fed’s Interest Rate Forecast

Exhibit 4: Hong Kong’s Aggregate Balance

Source: Macrobond, Hang Seng Bank

Source: Macrobond, Hang Seng Bank

Hong Kong dollar strength Even though Hong Kong interest rates have remained steady, the linked exchange rate system means that the Hong Kong dollar (HKD) tracks the US dollar (USD) closely and has therefore already appreciated considerably over the past few years.

The Bank for International Settlements (BIS) HKD index – a weighted average of the foreign exchange values of the HKD against a basket of currencies – rose by about 13% between mid-2014 and early 2016 (Exhibit 5). While it has recently declined from its peak, markets expect the prospect of Fed tightening to lead to further strengthening of the USD and, hence, the HKD.

A new phase of

strengthening for the HKD may add to the list of the negative factors weighing on the Hong Kong economy, particularly with respect to investment and trade.

May/Jun 2016

3

Exhibit 5: HKD & USD Index

Exhibit 6: Hong Kong GDP Growth (year-on-year %)

Source: Macrobond, Hang Seng Bank

Source: Macrobond, Hang Seng Bank

Economic outlook Hong Kong’s first-quarter economic data surprised the markets, with gross domestic product (GDP) growing by just 0.8% on an annual basis, the lowest rate in four years (Exhibit 6). On a quarter-on-quarter basis, GDP shrank by 0.4%, the first contraction since the second quarter of 2014.

The weakness was widespread across sectors.

Tourist spending declined,

contributing to a 4.9% annual decrease in exports of services, the biggest drop in seven years. Domestic spending slowed, with private consumption expenditure easing to 1.1% on an annual basis, a low not seen since the third quarter of 2009.

Trade activity also declined, with a weakening outlook for the global economy. Real exports of goods fell by 3.6% on an annual basis, marking a fourth consecutive quarter of contraction, and imports were down 5.4%, the largest decline since the global financial crisis in 2009. Although net trade boosted GDP annual growth by 1.1 percentage points, this was mainly because of a larger decline in imports than exports.

In addition, gross domestic fixed capital formation, a proxy of investment, dropped by 10.1% on an annual basis after a 9.4% drop in the fourth quarter last year. This reduced first-quarter 2016 GDP annual growth by 2.3 percentage points.

May/Jun 2016

4

Given the weak first-quarter GDP growth rate, we have revised our GDP forecast for the whole of 2016 down from 1.8% to 1.5% (Exhibit 7). Incoming data continued to show annual declines in retail sales and exports in April, albeit at a slower pace than the first quarter.

In any event, with the Mainland economy slowing, the Fed tightening monetary policy and the strength of the HKD, Hong Kong’s economic growth is now trending down. The negative factors weighing on growth may persist for some quarters to come, serving to prolong this downward trend.

Exhibit 7: Hong Kong Annual GDP Growth

Source: Macrobond, Hang Seng Bank

May/Jun 2016

5

Hong Kong Economic Monitor Statistics

GDP

June 2016 Foreign trade

Retail sales Exports

Imports

Trade balance

Unemployment rate (s.a.)

Inflation

Nominal

Real

Value

Volume

HKD bn

yoy (%)

yoy (%)

yoy (%)

HKD bn

yoy (%)

HKD bn

yoy (%)

HKD bn

(%)

yoy (%)

2011

1,934

4.8

24.9

18.4

3,341

10.2

3,768

11.9

-426.4

3.5

5.3

2012

2,037

1.7

9.8

7.2

3,437

2.9

3,915

3.9

-477.7

3.3

4.1

2013

2,138

3.1

11.0

10.6

3,562

3.6

4,065

3.8

-502.9

3.4

4.3

2014

2,258

2.7

-0.2

0.6

3,675

3.2

4,225

3.9

-550.0

3.2

4.4

2015

2,397

2.4

-3.7

-0.2

3,609

-1.8

4,051

-4.1

-442.5

3.3

3.0

Q3 2014

581

3.2

1.6

1.4

985

5.9

1,109

5.7

-124.0

3.2

4.8

Q4

615

2.5

0.2

3.1

971

1.2

1,133

3.3

-161.3

3.2

5.1

Q1 2015

573

2.4

-2.3

0.0

836

2.3

955

1.4

-119.1

3.3

4.4

Q2

566

3.1

-0.9

3.9

883

-2.0

1,008

-3.2

-125.1

3.3

3.0

Q3

614

2.3

-4.8

-0.4

945

-4.1

1,035

-6.7

-89.9

3.3

2.3

Q4

645

1.9

-6.6

-3.9

944

-2.8

1,053

-7.1

-108.4

3.3

2.3

Q1 2016

590

0.8

-12.5

-11.3

780

-6.8

877

-8.2

-97.7

3.3

2.8

Dec 2015

NA

NA

-8.5

-6.1

309

-1.1

355

-4.6

-45.7

3.3

2.4

Jan 2016

NA

NA

-6.6

-5.2

300

-3.8

317

-9.0

-17.5

3.3

2.5

Feb

NA

NA

-20.6

-19.5

204

-10.4

238

-10.1

-33.1

3.3

3.0

Mar

NA

NA

-9.8

-8.8

275

-7.0

322

-5.8

-47.0

3.4

2.9

Apr

NA

NA

-7.5

-7.6

285

-2.3

316

-4.5

-31.0

3.4

2.7

YTD

590

0.8

-11.3

-10.5

1,065

-5.6

1,194

-7.2

-128.7

3.4

2.8

Total deposit

RMB deposit

Money supply (M3)

Total loan

Residential property price

Tourist arrivals

HKD bn

yoy (%)

RMB bn

yoy (%)

HKD bn

yoy (%)

yoy (%)

Index

ytd (%)

'000

yoy (%)

2011

7,591

10.6

589

86.9

5,081

20.2

12.9

181.1

11.1

41,921

16.4

2012

8,296

9.3

603

2.5

5,567

9.6

11.0

227.6

25.7

48,615

16.0

2013

9,180

10.7

861

42.7

6,457

16.0

12.4

245.1

7.7

54,299

11.7

2014

10,073

9.7

1,004

16.6

7,276

12.7

9.6

278.3

13.5

60,839

12.0

2015

10,750

6.7

851

-15.2

7,535

3.5

5.5

285.0

2.4

59,913

-1.5

Q3 2014

9,920

11.4

945

29.4

7,210

12.7

12.3

266.3

8.6

16,130

11.2

Q4

10,073

9.7

1,004

16.6

7,276

12.7

9.6

278.3

13.5

16,180

12.1

Q1 2015

10,403

13.2

952

0.7

7,627

11.7

11.8

291.5

4.7

15,421

4.9

Q2

10,552

9.8

993

7.2

7,676

8.5

7.9

301.3

8.3

13,907

0.5

Q3

10,659

7.5

895

-5.2

7,560

4.9

4.9

306.1

10.0

15,097

-6.4

Q4

10,750

6.7

851

-15.2

7,535

3.5

5.5

285.0

2.4

15,489

-4.3

Q1 2016

10,971

5.5

759

-20.2

7,522

-1.4

3.5

271.2

-4.8

13,735

-10.9

Dec 2015

10,750

6.7

851

-15.2

7,535

3.5

5.5

285.0

2.4

5,666

-10.7

Jan 2016

10,926

7.3

852

-13.2

7,531

2.2

5.7

279.0

-2.1

5,226

-6.8

Feb

10,845

6.9

804

-17.4

7,470

1.4

4.8

273.8

-3.9

4,296

-20.5

Mar

10,971

5.5

759

-20.2

7,522

-1.4

3.5

271.2

-4.8

4,214

-4.3

Apr

11,009

4.8

723

-24.3

7,544

1.9

3.0

273.1

-4.2

4,789

-2.1

YTD

11,009

4.8

723

-24.3

7,544

1.9

3.0

273.1

-4.2

18,524

-8.3

NA: not available; yoy= year-on-year; ytd= year-to-date Source: Census & Statistics Dept., HKMA , Rating & Valuation Dept., Hong Kong Tourism Board, Macrobond, CEIC, Hang Seng Bank

May/Jun 2016

6

GDP Growth

Source: Macrobond, Hang Seng Bank

Unemployment Rate (s.a.)

Source: Macrobond, Hang Seng Bank

Exports & Imports

Source: Macrobond, Hang Seng Bank

May/Jun 2016

Consumer Price Inflation

Source: Macrobond, Hang Seng Bank

Retail Sales Value

Source: Macrobond, Hang Seng Bank

Residential Property Price Index

Source: Macrobond, Hang Seng Bank

7

Disclaimer This document has been issued by Hang Seng Bank Limited (“HASE”) and the information herein is based on sources believed to be reliable and the opinions contained herein are for reference only and may not necessarily represent the view of HASE. The research analyst(s) who prepared this report certifies(y) that the views expressed herein accurately reflect the research analyst’s(s’) personal views about the financial instrument or investments and that no part of his/her/their compensation was, is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report. Nothing herein shall constitute as offers or solicitation of offers to buy or sell foreign exchange contracts, securities, financial instruments or other investments. Re-distribution of any part of this document by any means is strictly prohibited.

The information contained in this document may be indicative only and has not been independently verified and no guarantee, representation, warranty or undertaking, expressed or implied is made as to the fairness, accuracy, completeness or correctness of any information, projections or opinions contained in this document or the basis upon which any such projections or opinions have been based and no responsibility or liability is accepted in relation to the use of or reliance on any information, projections or opinions whatsoever contained in this document. Investors must make their own assessment of the relevance, accuracy and adequacy of the information and opinions contained in this document and make such independent investigations as they may consider necessary or appropriate for the purpose of such assessment. All such information, projections and opinions are subject to change without notice.

HASE and its affiliates may trade for their own account in, may have underwritten, or may have a position in, all or any of the securities or investments mentioned in this document. Brokerage or fees may be earned by HASE or its affiliates in respect of any business transacted by them in all or any of the securities or investments referred to in this document.

The investments mentioned in this document may not be suitable for all investors. Investors must make investment decisions based on their own investment objectives, financial position and particular needs and consult their own professional advisers where necessary. This document is not intended to provide professional advice and should not be relied upon in that regard.

No consideration has been given to the particular investment objectives, financial situation or particular needs of any recipient. Investment involves risk. Investors should note that value of investments can go down as well as up and past performance is not necessarily indicative of future performance. This document does not purport to identify all the risks that may be involved in the securities or investments referred to in this document.

May/Jun 2016

8