Economic situation of Hong Kong

Description of the issue

Hong Kong has been ranked as the freest economy for the eighth consecutive year in its Index of Economic Freedom and China’s entry into the World Trade Orgainization (WTO), these may increase Hong Kong’s economic growth by at least 0.5 percentage points each year. However, people lose their confidence to the economy, so their consumption remains low. As a result, Hong Kong’s gross domestic production (GDP) drops to 0.5% in the second quarter. Chief Executive Tung Chee-hwa said that recession would last for few quarter because of the global economic slowdown.

Explanation of the issue

Business cycle refers to the recurrent fluctuation in GDP. Recession occurs when the GDP growth rate is falling and the unemployment is rising.

Having global economic recession, Hong Kong will have negative GDP growth for few quarters. During the recession, there is high unemployment all around the world, for example, Hong Kong has 5.8% unemployment rate, so the national income drops. As consumption and income are positively related, when income drops, the consumption also decreases. As a result, aggregate demand for goods decreases and hence the imports from other countries. At the same time, world demand for HK exports also decrease. This source of income is significant to Hong Kong economy. GDP is the sum of the consumption, government expenditure, investment and net exports. Since exports decrease in larger extent that reduction of import, there will be negative net exports, i.e. deficit trade.

Decrease in income caused by unemployment leads to consumption drop. Since consumption is lowered, there will be increase in inventory. To clear the accumulated stocks, producers will reduce output. Due to poor expectation of the future economic environment, they invest less, investment will fall. GDP falls in result of these changes.

The recession will last for few quarters, the public and business corporations have to overcome this hard period. Investors tend to reduce investment and keep part of their profits as retained earnings in order to have sufficient fund for investment in the later period of recession. For the household, they will save more to maintain their living standard in the recession. The household and corporation savings act as stabilizer to reduce the economy’s fluctuations.

According to Keynesian Theory, increase in savings also creates bad effect for the economy. As assumed in the theory, savings and interest rate are not related. When people increase their savings, their consumption decreases and hence the aggregate demand for goods. There will be increase in stocks which leads production drops. As a result, there will be unemployment and income decreases. Increase in savings is good for individuals but not the economy. This is called Paradox of Thrift.

People are not willing to spend or invest during recession because of the uncertainty about the future. This makes people feel insecure and causes high precautionary demand for money. People will keep money to “provide contingencies requiring sudden expenditures”. The money kept in case of unforeseen emergencies is called precautionary money. They save their money in accounts. Banks can make use of this money to create credit by lending out excess reserve and increase money supply. However, people are lack of confidence about the future, even the interest rate is lowest in record, the market demand for loanable fund is so low that the banks cannot lend out the money. Credit cannot be created and this affects the banks’ profitability.

Apart from viewing people’s behaviors according to uncertainty about the future, they hold money also may due to the low current interest rate. Assuming there are only 2 assets to be held: money and bonds. The current interest rate is believed to be lowest possible interest rate, people expect it will rise, so they hold their assets in money to avoid capital loss (since price of bonds =standard income/market interest rate). The speculative demand for money is so high that people hold all the assets in money, the demand for money is horizontal, and this is liquidity trap according to Keynes.

In theory, government can use expansionary monetary policy to increase money supply. When money supply is raised, it will be greater than money demand, excess money balance is resulted. People spend more on goods and services and this increase aggregate demand and income. In addition, when money supply increases, interest rate drops, people will increase demand for loans to consume and invest and in turn increase income. In reality, the current interest rate is low but this cannot stimulate the demand for loanable funds for consumption and investment, the use of monetary policy cannot solve the existing recession problem, we suggest the government to use fiscal policy.

Hong Kong is now suffering high unemployment and deflation. Existence of unemployment means the income level in equilibrium is smaller than the income level of full employment. The gap between the two income levels is called deflationary gap.

To cure these problems, government can use discretionary fiscal policy. Fiscal policy is the change of government expenditure and tax policies with the intention of achieving certain economic goals (attainment of full employment and price stability). The deficit budget of fiscal policy has the expansionary effect on income. A deficit budget can be either increase government expenditure or decrease taxes or both.

When government expenditure increases, the aggregate expenditure rises and hence the income.

When the taxation is reduced, people’s disposable income increases which can stimulate their consumption and hence the aggregate expenditure. The income increases in resulted.

We suggest that the government should reduce the taxes instead of raising government expenditure to improve the employment. Although it has smaller multiplier effect than that of government expenditure, it is more efficient. Increase government expenditure by construction of infrastructure takes longer time to be approved and completed. Besides, reduction of taxes provides stronger incentive effect on work and investment so that it can speed up the recovery.

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Carol Kwok & Virginia Ng