Hong Kong, China WT/TPR/S/52
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I. ECONOMIC ENVIRONMENT
(1) INTRODUCTION
1. The period under review (1994-98) has been mark ed by two main events.  The first was Hong
Kong's reversion to the People's Republic of China, on 1 July 1997, and its designation as a Special
Administrative Region (SAR) with a high degree of autonomy with regard to economic (and most
other) policies under the "one country, two systems" framework established in accordance with theBasic Law.
1  This framework involves a 50-year commitment to allow the SAR to maintain its
existing free and open market system, which has l ong been the hallmark of the Hong Kong economy.
2. Hong Kong's reversion to China coincided with the second main event during the review
period, namely the outbreak of the economic crisis in Thailand in July 1997 and its spread to other
countries in (and beyond) South-East Asia.  The crisis, and the associated drop in demand throughoutthe region, has seriously impaired Hong Kong's economic performance since the third quarter of
1997, causing a dramatic slow-down in GDP.  Whereas  real GDP grew by 5.3% in 1997, a 4% drop is
forecast for 1998.  At the same time, the unemploymen t rate has more than doubled to reach 5%, the
highest level since 1983.  Furthermore, sharp currency depreciation by neighbouring countries has
eroded Hong Kong's international competitiveness and placed a great deal of pressure on the Hong
Kong dollar, whose value has been pegged (at 7.8 ) to the U.S. dollar since 1983.  Notwithstanding
domestic calls for the Government to take action in  order to alleviate, if not reverse, the recent
slow-down in economic growth and the conseque nt rise in unemployment, apart from the
implementation of a few "emergency" measures aimed at stabilizing land and stock market prices,
together with inter-bank interest rates, and thwarting alleged speculative attacks on the Hong Kong
dollar, the authorities have largely refrained from interfering with the normal functioning of the
free-market system.
3. Nor, it would appear, has the Government attempted to influence the long-run structural
evolution of Hong Kong's economy during the period under review.  This evolution has been
characterized by increasingly closer links with the fast-developing adjacent region of South China.
The strong growth in cross-border trade and investment, together with the relocation of the lower
value-added, assembly-type manufacturing operations to South China, has been accompanied by agrowing demand for service-oriented activities in Hong Kong.  The outcome has been a continuing
erosion of manufacturing's share of GDP, down to 7.3% in 1996 from 9.2% in 1994, while the share
of services rose from 83.4% to 84.4% in the same period.
2  This continuous shift from manufacturing
to services has been reflected in the composition of Hong Kong's imports and exports.
(2) RECENT ECONOMIC DEVELOPMENTS
(i) Macroeconomic performance
4. During the period 1994-97, Hong Kong maintained its average annual growth rate of real
GDP at around 5%.  Per capita GDP also grew, exceeding US$26,000 in 1997 (Table I.1).  However,
the economy has slowed down markedly since the last quarter of 1997, when GDP growth dropped to
2.7%.  In the first quarter of 1998, real GDP shrank by 2.8% compared to a year earlier and is forecastto contract by 4% during the year as a whole.  This sharp fall is due to the adverse effect of the Asian
                                                     
1The HKSAR also exercises executive, legislative and independent judicial power, including court of
final adjudication.
2Many of Hong Kong's service-oriented activities are actually manufacturing-related, including product
design and development, source of materials, transport and communications, and banking and finance.WT/TPR/S/52 Trade Policy Review
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crisis on Hong Kong's external trade and the fall in domestic demand owing to higher interest rates
and declines in property and stock prices.  The Government estimates that overall labour productivity
in terms of GDP per person engaged in all sectors rose by about 1% in 1997.  For manufacturing, labour
productivity increased 9% in the 12 months  ending June 1998 (up from 8% in 1998).3
Table I.1
Major features of Hong Kong's economy
Area 1,095 sq. km. GDP (1997) HK$1,339 billion
Population (mid-1997) 6.7 million Consumption (private, per cent of  GDP) 59.9
Population growth (1992-97) 2.3% Gross fixed capital formation (per cent of GDP) 34.9
Employment (1997): 3.2 million GDP per capita (1997) HK$205,948
Manufacturing (share) 9.8% (US$26,601)
Services (share) 79.3% Share in GDP (1996):
Manufacturing 7.3%
Labour force participation rate: 75.4% Services 84.4%
male 75.7% Wholesale & retail trade, restaurants, hotels 26.6%
female 48.0% Financing, insurance, real estate, business
services25.2%
Unemployment rate (1997) 2.2% Merchandise exports f.o.b. (1997) a (% of GDP) 108.7
                                  (mid-1998) 4.4%
Consumer price inflation (1997) 5.8% Merchandise imports c.i.f. (1997) (% of GDP) 120.9
Legislative Council 60 seats The currency:  monetary unit Hong Kong dollar
Currency units per US$ (pegged) 7.8
a Includes re-exports.
Source: HKSAR Government.
5. After remaining low for most of the period u nder review, the unemployment rate rose to 5%
in the three months ending August 1998.
6. Prices and wages have apparently reflected the effects of the crisis since mid-1997.  According
to the Composite Consumer Price Index, the rate of inflation fell considerably from 9.1% in 1995 to
5.8% in 1997, and is expected to fall even further to 3.8% in 1998.  On the supply side, generally tightlabour market conditions saw real wages continue to rise, by 1.7% in September 1997.  However, the
increase in real wages moderated distinctly to 0.1% (on an annual basis) in the second quarter of
1998.  With demand being severely curtailed by the downturn in the economy, liquidity tightening by
the banks and high interest rates, flat prices fell in August 1998 by around 45% from their peak in
October 1997, and were just below their previous low in October 1995.  Flat rentals also fell, but to a
lesser extent.  Meanwhile, office prices and rentals also declined sharply.  In June 1998, the
Government announced the suspension of its land sales up to March 1999 in an attempt to stabilizeproperty prices.
                                                     
3The sustained productivity improvement was largely attributed by the authorities to the on-going
industrial upgrading and the increasing application of comp uter-aided technologies in  production over the years.
Keen competition in the export markets also prompted local manufacturers to strive to cut costs and enhance
productivity, including through relocating the more labour-intensive production processes outside Hong Kong.Hong Kong, China WT/TPR/S/52
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Table I.2
Performance of Hong Kong's economy, 1990-98.
1990 1994 1995 1996 1997 1998
(forecast)
(Annual p ercentage change)
Real GDP 3.4 5.4 3.9 4.6 5.3 - 4
Real Domestic demand 6.8 11.8 7.1 2.5 8.7 - 5
Private consumption 5.7 6.7 1.6 4.7 6.7 - 4.5
Public consumption 5.5 3.9 3.2 4.0 2.4 2
Private investment 8.6 15.5  8.8 9.6 20.4 - 4
Public investment 5.0 17.1 22.0 17.1 -4.8 - 9
Exports of goods 9.6 10.4 12.0 4.8 6.1 - 2
Domestic exports of goods -0.5 -2.3 2.0 -8.4 2.1 - 3.5
Re-exports of goods 16.0 13.8 14.3 7.5 6.8 - 2
Exports of services 3.6 6.5 4.8 8.5 -0.6 - 4
Imports of goods 11.4 14.0 13.8 4.3 7.2 - 3.5
Imports of services 12.1 8.8 2.1 2.5 4.3 1
Real GDP per capita 3.1 3.1 1.9 2.0 2.2 …
(Index 1990 = 100)
Terms of tradea100.0 100.3  98.7 99.7 100.4 …
(Index November 1983 = 100)
Effective exchange rate (end of period)b108.3 123.5 122.7 125.3 137.9 …
(Per cent)
Unemployment rate 1.3 1.9 3.2 2.8 2.2 …
Interest rates (short-term)c8.7 4.8 6.2 5.5 7.1 …
(Year-on-year rate of change)
Monetary expansion (M 2) (end of period)22.4 12.9 14.6 10.9  8.4 …
Inflation  (consumer prices) 10.2 8.8 9.1 6.3 5.8 3.5
Food 10.0 6.8 7.1 3.9 3.6 …
Housing 11.4 12.6 13.1 10.1  9.1 …
(Per cent of GDP)
Saving-investment balance 8.4 1.2 -4.3 -1.4 -3.6 …
Gross domestic investment 28.4 31.9 34.8 32.1 35.1 …
Gross domestic savings 33.3 33.1 30.5 30.7 31.5 …
Public sector balance 0.7 1.1 -0.3  2.2 6.0 0.8
Revenue 17.3 16.7 17.5 20.6 18.3
Expenditure 16.2 17.0 15.3 14.5 17.6
Fiscal Reservesd (at 31 March) 14.9 13.7 14.6 19.0 18.8
Merchandise trade balance (US$ billion) -0.7 -10.9 -19.6 -18.4 -21.1 …
(% of GDP) -0.9 -8.4 -14.1 -11.9 -12.2 …
Merchandise and services trade balance (US$ billion) 6.3 1.6 -6.1 -2.2 -6.1 …
(% of GDP) 8.5 1.2 4.3 1.4 3.5 …
… Not available.
a Ratio of the unit value index of total merchandise exports (including re-exports) to that of imports.
b Trade-weighted average of the nominal exchange rate of the H ong Kong dollar, based on a new series released since 1 April 199 5.
c Three-month Hong Kong dollar interbank-offered rates ( HIBOR).
d Includes Land Fund.
Source: HKSAR Government.WT/TPR/S/52 Trade Policy Review
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Box I.1:  Monetary institutions and arrangements
The framework of Hong Kong's monetary institutions a nd arrangements has remained essentially unchanged
since the transfer of sovereignty.  Hong Kong dollars are issued by three banks, the Bank of China, Hongkong
and Shanghai Banking Corporation and the Standard Chartered Bank.  They are required to surrender U.S.dollars as backing to the Exchange Fund, which holds mainly the foreign exchange reserves of the HKSAR as
well as its fiscal reserves, at the fixed rate of HK$7.8 per U.S. dollar.  The fund is managed by the MonetaryAuthority (MA), who is appointed by the Financial Secretary under the Exchange Fund Ordinance.  TheHKMA manages another separate account, the Land Fund, comprising the accumulated sum of half the net
revenue from land transactions since 1986.  Total asse ts of the Land Fund were HK$201.5 billion at the end
of June 1998.
The HKMA has the mandate to:
(i) maintain currency stability, with in the framework of the linked exchange rate system, through sound
management of the Exchange Fund, monetary policy operations and other means deemed necessary;
(ii) ensure the safety and stability of the banking sy stem by regulating authorized institutions comprising
banks and deposit-taking institutions (Chapter IV);  and
(iii) promote the efficiency, integr ity and development of the financia l system and, in particular, the
payment and settlement systems.
Hong Kong operates what is called the linked exchange rate system, which was established in 1983.  This is a
currency board system.  The monetary base (which includes bank notes and coins issued and the AggregateBalance of the clearing accounts of licensed banks maintained with the HKMA) and all outstanding ExchangeFund papers (issued by the HKMA for the account of Exchange Fund) are fully backed by foreign reserves.
When the three note-issuing banks issue banknotes in Hong Kong, they are required to submit U.S. dollars (at
HK$7.80 = US$1) to the HKMA for th e account of the Exchange Fund in return for Certificates of
Indebtedness required by law as backing for the bank notes issued by them.  The Hong Kong dollar banknotesare therefore fully backed by U.S. dollars.  Against su ch backing arrangements, the HKMA cannot provide an
overdraft facility for the Government and thereby monetize budget deficit.
The HKMA also provides an undertaking to licensed banks to convert Hong Kong dollars in their clearing
accounts into U.S. dollars at the fixed exchange rate of  HK$7.75 to US$1 (the Convertibility Undertaking).
The rate will move to 7.80 when market conditions permit.
Operating under the rule-based currency board system, the Aggregate Balance will vary in accordance with
the flow of funds into and out of the Hong Kong dolla r.  Only in exceptional circ umstances, such as Initial
Public Offerings of shares and other large-scale Hong Kong dollar transactions, will the HKMA consider
varying the clearing balance temporarily without the corresponding change in its U.S. dollar holdings.  These
operations are carried out for the benefit of promoting general market stability.  On the other hand, theHKMA, as the agency managing the fiscal reserves , would undertake certain activities in the foreign
exchange and money markets.  In all such activities, th e HKMA would ensure that there is no departure from
the discipline of the Currency Board arrangements.
For the purpose of facilitating the smooth functioning of the payment system, the HKMA provides intra-day
liquidity as well as overnight liquidity to licensed banks, through the Discount Window, by entering intorepurchase arrangements involving pr edominately Exchange Fund Bills and Notes.  For the purpose of
accessing the Discount Window, there is a schedule of discount rates applicable for different percentage
thresholds of holdings of Exchange Fund paper by licensed banks.  As Exchange Fund papers are fully
backed by the foreign exchange reserves, the provisi on of last resort liquidity against the Exchange Fund
papers does not compromise the currency board principle.
Source:       HKSAR Government.Hong Kong, China WT/TPR/S/52
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(ii) Macroeconomic policies
(a) Monetary and exchange rate policies
7. The independence of the HKSAR in formulating its monetary policy is stipulated by the Basic
Law.4  The Basic Law further stipulates that neither foreign exchange nor capital controls can be
used.5  The monetary policy objective of the Government is to ensure the stability of the Hong Kong
dollar in relation to the U.S. dollar.  Accordingly, the Basic Law (Article 111) requires that the Hong
Kong dollar be fully backed by foreign reserves, and the exchange rate is linked to the U.S. dollar
under a currency board type of arrangement (Box I.1).  Foreign reserves stood at US$92.1 billion
(more than eight times the Hong Kong dollar notes issued) at the end of August 1998 compared with
US$96.5 billion a month earlier.  The decline is reportedly due mainly to the Hong Kong Monetary
Authority's (HKMA) use of reserves to finance its stock market intervention in August 1998 (seebelow).
6
8. The pegging of Hong Kong dollar to the U.S. dollar has limited the authorities' scope for
controlling the money supply and therefore interest rates.  The peg has also resulted in an effective
appreciation of the Hong Kong dollar, particularly in relation to the devalued currencies of those
countries in the region much more heavily afflicted by the Asian financial crisis (Table I.2).  In theauthorities' view, however, any negative effects of the currency peg on Hong Kong's international
competitiveness are dwarfed by its long-run stabilizing influence on the financial sector and the
economy at large, and competitiveness will be maintained through flexibility in the price and wage
structure.  The peg is also viewed by the authorities as essential to the maintenance of Hong Kong's
role as a major international financial centre.  As the peg forms the cornerstone of Hong Kong's
financial and monetary system, the Government is committed to its maintenance.
9. Since the latter half of 1997, however, the Hong Kong dollar has come under increased
speculative pressure as a result of spillovers from the financial turmoil elsewhere in the region.  While
this pressure has hitherto been successfully resisted through the corresponding tightening of domestic
liquidity, the resulting higher interest rates have contributed to sharp falls in stock and property prices
and depressed domestic consumer and investment demand.  Consequently, in addition to the freeze on
sales of government land, new rules were introduced in June 1998 by the Hong Kong FuturesExchange (HKFE) to curb speculation against the Hong Kong dollar.
7  Subsequently, in October
1998, the HKMA revealed that it had spent around US$15 billion intervening on the Hong Kong
Stock Exchange to purchase the shares of several major companies.8  The purpose of this intervention
was to frustrate the "double play" strategy of speculators, who the authorities felt had sought to create
extreme conditions in the money market in order to benefit from huge short positions in the stock andfutures markets.
9  In the case of the 9% stake purchased by  the HKMA in HSBC, Hong Kong's largest
                                                     
4Article 110:  the HKSAR Government shall, "on its own, formulate monetary and financial policies".
5Article 112.
6South China Morning Post, Internet Edition, 22 September 1998.
7The new rules include the imposition by the HKFE of special margin and position reporting on large
open positions in Hang Seng Index Futures and Options, which the authorities believe will ensure a fair and
orderly operation of the market.  In addition, China's recent promise to help Hong Kong defend the peg against
speculators is perhaps a sign that it may be prepared, if necessary, to use some of its US$140 billion in foreign
exchange reserves in support of the Hong Kong dollar (Financial Times, 31 August 1998, "China offers to fight
HK market raids").
8Statement by Mr T. L. Yang, Chairman of Exchange Fund Investment Limited, 26 October 1998.
9According to the Financia l Secretary, Donald Tsang, unprecedented levels of selling of Hong Kong
dollars took place in external markets starting in late July 1998, the regular patterns of which suggested to the
authorities that there was a "coordinated manipulative play" involving very large hedge funds and not normalWT/TPR/S/52 Trade Policy Review
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bank, a conflict of interest may arise because the regulator is now the main shareholder in one of the
banks it regulates.  To address the concerns on the potential conflict of interest, the Government
announced in September 1998 that a new company called "Exchange Fund Investment Limited" will
be set up to manage the substantial stock portfolio acquired by the Exchange Fund in the recent stock
market operation.10  Furthermore, in order to make the currency board arrangements less susceptible
to manipulation by speculators, the HKMA intr oduced several technical measures in early
September.11
(b) Fiscal policy
10. The Basic Law (Chapter II) also requires the Government to strive to achieve a fiscal
balance12, which accords with Hong Kong's prudent fiscal policies.  Following a small deficit in 1995,
substantial surpluses were recorded in 1996 and 1997.  These surpluses were attributable to increasedrevenues associated with strong economic growth and the proceeds from sales of government land.
Prior to 30 June 1997, half of the net proceeds of land transactions was set aside in a Land Fund for
the benefit of the HKSAR.  When this Land Fund was passed to the HKSAR on 1 July 1997 it
resulted in a doubling of the fiscal reserves, which amounted to US$58.7 billion at 31 March 1998.
However, in an attempt to ameliorate the slow-down in economic gr owth and the rise in
unemployment, the Government introduced a package of relief measures in June 1998
13, including the
suspension of government land sales in order to stabilize property prices.  As a consequence of these
measures a budget deficit of 1.5% of GDP is forecast for 1998, notwithstanding the requirement of the
Basic Law to strive to achieve a fiscal balance.
(iii) Structural/industrial policies
11. Although the Government characterizes its industrial policy as "proactive", by and large, this
has not entailed industry/firm-specific intervention or other attempts aimed at "picking winners".Instead, the authorities consider that the allocation of  resources among sectors, industries and firms is,
in most instances, best left to market forces.  A ccordingly, it provides little firm- or industry-specific
assistance, focusing instead on the provision of support for the development of human capital and
                                                                                                                                                                    
hedge fund activities.  More specifically, "the shorting of the Hong Kong dollar, which was aimed at sharply
driving up interest rates under our currency board linked exchange rate system, was accompanied by short
selling of stocks and futures with a view to reaping the profits of the nervous and sensitive securities markets
that were bound to dive further amidst another round of interest rate hikes.  Meanwhile, rumours began tocirculate in the media about the imminent devaluation of China's Renminbi and the de-linking of the Hong Kongdollar, and there were continued negative reports circulated about the impending collapse of Hong Kong's localproperty and stock markets.  These plays were designed to create panic conditions for the shorting positions tobe profitable".
10The new company will have its own board of directors, one third of whom have been drawn from the
Government.
11Inter alia , a Discount Window was set up to replace the Liquidity Adjustment Facility.  Overnight
liquidity is provided to licensed banks through repo transactions using Exchange Fund Bills and Notes fullybacked by foreign currency reserves.  These measures are designed to dampen excessive interest rate volatility
without departing from the currency board arrangement.  The schedule of the Discount Window is set in such a
way that the automatic interest rate adjustment mechanism operates fully when the exchange rate comes undersignificant pressure.
12Article 107:  the HKSAR shall "follow the principle of keeping expenditure within the limits of
revenues in drawing up its budget, and strive to achieve a fiscal balance, avoid deficits and keep the budgetcommensurate with the growth rate of its gross domestic product."
13The measures include exemption of interest income from profits tax, a 30% reduction of duty on
diesel and reduced declaration charges for imports and domestic exports.Hong Kong, China WT/TPR/S/52
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infrastructure, research and development, and the adoption of new technologies.  Nor does the
HKSAR provide much assistance by way of border protection;  applied tariffs are zero, and, with the
notable exception of import licensing for rice, non-tariff border measures are almost absent
(Chapter III).  Those non-tariff border measures that do exist either stem from Hong Kong's
obligations under various international undertakings or are applied for health, safety, security or
environmental reasons or to protect intellectual property rights.  Hong Kong's income tax system isremarkable for its simplicity and low corporate tax rate;  both features are partly the consequence of
the virtual absence of tax incentives other than accelerated depreciation allowances that are applied
across the board.  The outcome is a tax system that is largely neutral with respect to business
investment decisions.
14  This stance of minimum interference with market forces extends to
competition policy, with the authorities eschewing a comprehensive competition law, an approachthat has been questioned by the Consumer Council.
15
12. In the face of  the exceptional difficulties arising from the Asian financial crisis, however, the
Hong Kong Monetary Authority (HKMA) intervened in the Hong Kong stock market in August 1998.
This intervention involved the purchase of substa ntial stakes in several major manufacturing and
service companies.  According to the authorities, the HKMA purchased all shares listed on the HangSeng Index on a pro rata  basis so as to obviate claims that it was supporting one share or company
more than another.  Such intervention, by raising th e price of these listed companies' shares above the
levels that would otherwise have prevailed, reduced their costs of new equity capital, thereby
providing them with a potential advantage over their competitors not listed on the Hang  Seng, insofar
as investment is financed by new share issues.  Moreover, in view of its substantial shareholdings in
these enterprises, the HKMA is now in a position to exert influence on their decisions.  As described
above, the authorities recently announced the establishment of a new company apparently to managethese shareholdings at "arms length" from the Government and regulators.
13. Rapid structural change in the Hong Kong economy has continued during the review period.
Manufacturing industry's share in GDP has come down, from 9.2% in 1994 to 7.3% in 1996.
Employment in the manufacturing sector declined from 444,600 persons in 1994 to 307,700 persons
in 1997.  The relative contraction of the manufacturing sector appears to have been accompanied bythe release of resources for innovative products or processes or for the services sector.  Growth of the
labour force, at an annual rate of 3.1% in 1996 and 3.9% in 1997, was thus absorbed without any
increase in unemployment before the outbreak of the Asian financial crisis. The labour force
participation rate (around 76% for men and around 48% for women) remained stable at 61.8% over
the period.  The declining share of manufacturing in GDP is the result of the movement of manylabour-intensive industries across the border to South China.
(3) D
EVELOPMENTS IN TRADE AND FOREIGN DIRECT INVESTMENTS (FDI)
(i) Overview of developments in trade
14. Hong Kong retained its position as the world's ninth largest exporter and sixth largest
importer of merchandise in 1997, and world's ninth largest exporter and fifteenth largest importer ofservices in 1997.  Mirroring the growing role of Hong  Kong as an entrepôt and the relative decline of
manufacturing, the share of re-exports in total merchandise exports has continued to increase, while
                                                     
14One notable departure from tax neutrality involves the corporate tax exemption granted to income
earned from the export of international shipping services (Chapter IV).
15Consumer Council (1996).  The Consumer Council is a statutory body set out by the Consumer
Council Ordinance to protect and promote the interests of consumers.WT/TPR/S/52 Trade Policy Review
Page 8
the share of services exports rose as a proportion of domestic merchandise and services exports
combined.
15. Whereas domestic merchandise exports stagnated between 1994 and 1997, re-exports
increased by over 30% during the period (Table I.3).  The share of re-exports in merchandise exports
and imports also increased:  of the total exports of Hong Kong, the share of domestic exports was
14.5% (down 4.5 percentage points from 1994), and of the total imports, 22.9% was retained imports(down 1.3 percentage points from 1994),  in 1997.
16
16. Reflecting Hong Kong's shift in production structure from manufacturing to services, the
share of services exports in the sum of domestic exports and services exports continued to increase
between 1994 to 1996, from 52.0% to 58.0%.   In 1997, however, the share increased by only 0.1
percentage point, reflecting stagnated services exports after 10.2% growth in 1996.  Services importsgrew in 1997 by 5.5%, following by 4.3% growth in 1996.
17. Throughout the period under review, Hong Kong has run a substantial and growing
merchandise trade deficit.  This has been offset to a large extent by a rising surplus in non-factor
services.  For merchandise and services combined, a deficit equivalent to 3.5% of GDP was recorded
in 1997, compared to 1.4% in 1996.  The rise in the overall deficit in 1997 is due mainly to theconstruction of the Airport Core Programme and the slow-down in exports of services as a
consequence of the fall in inbound tourism in the second half of the year.
17
Table I.3,
Hong Kong's external sector, 1990-97(HK$ million)
1990 1993 1994 1995 1996 1997
Merchandise exports (f.o.b.) 639,874 1,046,250 1,170,013 1,344,127 1,397,917 1,455,949
Domestic exports 225,875 223,027 222,092 231,657 212,160 211,410
Re-exports 413,999 823,224 947,921 1,112,470 1,185,758 1,244,539
Merchandise imports (c.i.f.) 642,530 1,072,597 1,250,709 1,491,121 1,535,582 1,615,090
Merchandise trade balance -2,656 -26,347 -80,695 -146,994 -137,664 -159,141
Services exports 142,321 215,577 240,668 265,635 292,757 293,373
Services imports 87,692 122,994 144,067 160,877 167,761 177,000
Services trade balance 54,629 92,583 96,601 104,758 124,996 116,373
Merchandise and services trade
balance51,973 66,236 15,906 -42,236 -12,668 -42,768
Foreign exchange reservesa192,323 335,499 381,233 428,547 493,802 585,475
  (In months of retained imports) … 10.1 9.9 9.1 10.7 14.7
… Not available.
a End of period.Source: HKSAR Government.
                                                     
16Retained imports are defined as the difference between imports and re-exports.
17The number of tourists visiting Hong Kong in the first quarter of 1998 dropped by roughly one
quarter compared to a year earlier.  The drop was most no table in the number of tourists from Japan, which fell
by about 60%.WT/TPR/S/52 Trade Policy Review
Page 10
(ii) Composition of merchandise trade
18. Hong Kong's industrial reorganization in recent years and the concurrent increase in
re-exports are related both to the Hong Kong dollar's appreciation and to the rapid development of
neighbouring South China, which affords access to low-cost land and labour.  Facing domestic cost
pressures and dwindling export returns, various manufacturing industries have relocated theirproduction bases to the region.  Against such a background, imports and re-exports of office machines
and telecommunications equipment, other electrical machines, and toys have continued to increase
since the previous Trade Policy Review, reflecting the Territory's shift from manufacturing to services
and its expanding role as a gateway to and from southern China.
19. Textiles and clothing, which are still largely covered by quota agreements in major markets,
have continued to be the largest category of domestic exports, accounting for 40.1% of domestic
merchandise exports in 1997 (Chart I.1).  Offi ce machines and telecommunications equipment
retained a share of 17-18%, and other electrical machines around 6-7%.  Since 1980s, reflecting
higher economic integration with South China, there has been a marked growth both in domestic
exports and re-exports of machinery and tr ansport equipment (Table AI.2 and AI.3).
18  D u r i n g  t h e
same period, other consumer goods in domestic exports declined while its share of total exports was
maintained.  The share of clothing declined rapidly in re-exports while its share in domestic exports
remained stable around 33%.
(iii) Direction of merchandise trade
20. In 1997, China (mainland) remained the largest market for Hong Kong, China's domestic
exports, accounting for 30.2% of domestic exports.  Hong Kong's other major export markets are the
United States, the European Union, and Japan (Chart I.2 and Table AI.5).  The share of domesticexports destined for the United States increased in 1997 after a continuous decline since 1994, while
the share destined for the EU declined slightly  in 1997.  Reflecting the growth of the Chinese
economy, China's shares in Hong Kong's total exports (domestic exports plus re-exports) continued to
increase, while the shares of the EU and the United States both decreased.  China (mainland), Japan,
the EU, the United States and Chinese Taipei ha ve remained Hong Kong's largest suppliers of
merchandise imports.  China's share remained stable, at 36.8% in 1997, while Japan's share was
13.5%, down 1.7 percentage points from 1994.
(iv) Foreign Direct Investment (FDI)
21. The overall stock of inward foreign direct investment at the end of 1996 increased by 14%, to
HK$609.3 billion.  About 92% of such FDI went to th e non-manufacturing sector, while the
remaining 8% went to manufacturing.  Banks and deposit-taking companies
19 accounted for the
largest share (39% of the total) of inward FDI in  the non-manufacturing sector.  This was followed by
holding companies (23%), and wholesale, retail, im port/export trades (17%).  The major sources of
accumulated FDI were the United Kingdom (27.7%), China (mainland) (18.7%), the United States
(18.2%) and Japan (15.5%) (Table I.4).
                                                     
18Among the exports of machinery and transport equipment, both the domestic exports of office
machines and telecommunication equipment, and the tota l exports of other electrical machines showed rapid
growth.
19The definition of deposit-taking companies is provided in Chapter IV.WT/TPR/S/52 Trade Policy Review
Page 12
22. Though no official statistics on outward direct investment have been compiled, the
Government estimates that China (mainland) is  the largest recipient of Hong Kong's direct
investment.  The cumulative value of Hong Kong's investment between 1979 and 1997 in China
(mainland) amounted to US$285 billion on a pledged basis, and US$121 billion on a realized basis.20
Each of these represent about 55% of the total pledged and realized foreign direct investment,
respectively, in the mainland.  About 40% of Hong  Kong's investment in the mainland are destined
for Guangdong area.   The Government estimates that Hong Kong's investment in other Asian
economies are much smaller.
(4) PROSPECTS
23. The recent marked decline in real GDP and the associated sharp increase in unemployment
are the consequences of the adverse effect of the collapse in regional demand on Hong Kong's
external trade and the fall in domestic demand.  The deterioration in Hong Kong's external trade
balance is probably to some extent due to its loss of international competiveness owing to the
maintenance of the currency peg in the face of large devaluations by some of its neighbours.  The fall
in domestic demand is attributable to higher interest rates, which are the result of speculative attacksagainst the Hong Kong currency.  Higher interest rates have increased the cost of borrowing to
consumers and businesses alike, and contributed to the recent decline in property and stock prices.
The consequent negative wealth effects of the declin e in such asset prices may have exacerbated the
fall in domestic demand.
24. It remains to be seen whether wages and other prices are sufficiently flexible downwards and
whether productivity can be improved rapidly enoug h to compensate for the loss in Hong Kong's
international competitiveness as a result of its currency being pegged to the U.S. dollar.  Althoughnominal and real wages reportedly rose 4.5% and 0.1% respectively, on an annual basis in the second
quarter of 1998 despite the economic recession
21, more recent newspaper reports indicate that some
firms may be starting to cut wages substantially.  Property prices and rents have already undergone
sharp declines during the past year.  While labour productivity in the economy as a whole has been
only 1%, in manufacturing it increased by 9% in  the 12 months ending June 1998 (up from 8% in
1997).  The fact that the trade deficit is expected to be considerably lower in 1998 suggests that
domestic product and factor markets may be adjusting so as to reverse Hong Kong's recent loss of
international competitiveness.  The recent decline in the value of the U.S. dollar, especially relative to
the Japanese yen, as well as cuts in U.S. interest  rates will also undoubtedly help to restore Hong
Kong's international competitiveness.  These developm ents together with its traditional adherence to a
free and open market system should facilitate Hong Kong's emergence from the current economic
crisis and a resumption of its strong economic performance.
                                                     
20 According to the data from the Almanac of China's Foreign Economic Relations and Trade, 1986-
1997/98.
21According to figures by the Census and Statistics Department as reported in Hong Kong Standard,
17 October 1998, "Pay rises despite recession".Hong Kong, China WT/TPR/S/52
Page 13
Table I.4
Stock of foreign direct investment in Hong Kong, China
Non-manufacturing
(Percentage share) Source 1994 1995 1996
United Kingdom 30.6 29.4 29.6
China (mainland) 20.1 21.5 19.9
United States 11.6 12.1 17.5
Japan 16.0 14.3 13.6
Netherlands 1.7 1.9 2.3
Singapore 1.9 1.9 1.7
Germany 1.9 2.2 1.5
Switzerland 2.3 3.2 1.4
France 2.1 1.7 1.2
Others 12.0 11.7 11.4
All countries (HK$ billion) 459.9 487.3 561.3
Manufacturing
(Percentage share) Source 1994 1995 1996
Japan 33.6 38.9 37.8
United States 28.6 28.4 26.8
China (mainland) 9.1 6.5 5.5
United Kingdom 6.7 5 5
Netherlands 3.8 3.9 4.6
Switzerland 3.4 2.4 2.6
Singapore 1.9 2.4 2.1
Germany 1.5 1.1 1.3
France 1 0.8 1.3
Others 10.4 10.6 13.1
All countries (HK$ billion) 39.6 45.3 48
Non-manufacturing and Manufacturing
(Percentage share) Source 1994 1995 1996
United Kingdom 28.7 27.3 27.7
China (mainland) 19.2 20.2 18.7
United States 12.9 13.5 18.2
Japan 17.4 16.4 15.5
Netherlands 1.8 2.1 2.5
Singapore 1.9 2 1.8
Germany 1.8 2.1 1.5
Switzerland 2.4 3.2 1.5
France 2 1.6 1.2
Others 11.8 11.6 11.5
All countries (HK$ billion) 499.6 532.6 609.3
Source: HKSAR Government.