• Despite emerging weaknesses in the US economy, strong domestic consumption and increasing import demand in Asian and European markets will help both Hong Kong and mainland China maintain good growth momentum in the second half of 2007.
  
  
• The biggest downside risk is weakness in the US housing market and its impact on the economy. There is now a good chance that the Fed will cut the Fed funds rate to mitigate the adverse effects on the economy.
  
  
• The subprime risk notwithstanding, prospects for global growth remain positive over the medium term. Growth outside the US, especially in Asia, is likely to remain robust and provide a substantial offset to weakness in the US.

Mainland China

• The Mainland posted GDP growth of 11.5% for the first half of the year, driven by the traditional growth engines of external trade and fixed-asset investment.
  
  
• The Mainland's monetary policy will continue to focus on draining excess liquidity from the banking system and curbing lending growth as well as maintaining a preemptive stance with respect to the potential escalation of inflation risks.
  
  
• Full-year GDP growth and annual inflation forecasts for the Mainland have been upwardly revised to 11.5% and 3.8% respectively.
  

Hong Kong

• Hong Kong recorded strong year-on-year growth of 6.3% in the first half. Domestic demand was a key factor, driving 94% of this growth.
  
  
• The potential subprime blowout and subsequent spillover effects continue to pose risk to the Hong Kong economy. Growing inflation pressure is another risk factor.
  
  
• For the rest of 2007, Hong Kong will sustain its strong growth momentum, with domestic demand remaining a major driving factor. The full-year GDP growth forecast has been increased from 5.6% to 6.1%.
  

• The subprime risk notwithstanding, prospects for global growth remain positive. However, the trend of strong global demand continues to place strain on many economies and increase inflation risks.

The global economy was resilient in the first half of 2007, with growth outside the US leading the charge. In the euro area and Japan, growth remained above-trend. Emerging market economies continued to expand solidly, led by surprisingly rapid growth in mainland China, India and Russia.

The trend of strong global demand continues to place strain on many economies and increase inflation risks. This has prompted a number of industrialised economies, including the EU, the UK, Australia, Canada and New Zealand, to raise interest rates. Inflationary pressures are also running strong in many emerging economies, especially those more affected by changes in prices of energy and food.

The biggest downside risk in the global outlook is clearly with the US economy. Weaknesses in the US housing market are unfolding again. The turmoil in the subprime mortgage market has had significant repercussions for stock prices, interest rates and exchange rates around the world. The first economic tremor, which hit in March, triggered a temporary reduction in risk appetite but did not significantly change US economic fundamentals. This time, however, the stresses in the system have spread beyond subprime to other grades of debt and beyond the US to hedge funds and financial institutions as far away as Europe and Australia. A drastic off-load of risky assets and a bout of hedge fund redemptions developed into tighter credit conditions, prompting central banks worldwide to inject liquidity into banking systems and the US Federal Reserve to reduce the discount rate by 0.5%.

More importantly, the intensifying problems in the subprime market could start having a broader impact on the housing market. Total originations of subprime mortgages have more than tripled in five years to reach USD665 billion in 2006. Their delinquency rate rose to 13.8% in the first quarter of this year, very close to the peak reached in the 2001-02 recession. There are risks that the fallout from the housing correction could be amplified, particularly if tightening lending standards in the subprime sector were to lead to a broader reappraisal of credit availability across the economy or weakening of household cash flows.

The negative impact on the economy is now a cause for concern since growth in the US is currently more dependent on debt than at any time in history. The debt-to-GDP ratio has risen rapidly over the past five years to reach a record high of over 180%. Such a development could result in a deeper and more prolonged slowdown or even a recession in the US. There is always particular concern about the potential for spillovers from the US, which is still the dominant global economy, accounting for 20% of imports worldwide, and has the world's deepest, most sophisticated financial markets. There is now a good chance that the Fed will cut the Fed funds rate to mitigate adverse effects on the economy. Two rate cuts are expected before the end of the year, with the first likely to take place immediately following the September FOMC meeting. The Fed will then monitor the situation before deciding its next move.

The subprime risk notwithstanding, prospects for global growth remain positive over the medium term. The IMF has revised upward its forecast for global growth to 5.2% for both 2007 and 2008. Growth forecasts for the euro area and Japan have also been raised upward. Growth in the rest of the world, especially Asia, is likely to remain robust and provide a substantial offset to weakness in the US.

Mainland China: This Summer Hotter Than Usual

• Despite economic growth reacceleration, demand-supply imbalances are still not evident in the economy. Mainland China's monetary policy should focus on draining excess liquidity from the banking system and curbing lending growth as well as maintaining a preemptive stance with respect to the potential escalation of inflation risks.

The Mainland's economic growth again surprised on the upside in the first half of 2007. GDP growth was 11.5% year on year, up from 10.5% in the second half of 2006, with buoyant activity observable in almost every area of the economy. The traditional engines of external trade and fixed-asset investment continued to lead the charge, up 27.6% and 25.9% year on year respectively.

Consumer demand has strengthened on the back of stock market gains and a rapid increase in household income. Retail sales increased by 15.4%, compared to 14.1% in the second half of 2006. The Shanghai Composite Index has risen over 80% since the beginning of the year despite a series of policy measures aimed at reining in the stock market frenzy. Per capita disposable income in urban areas reached RMB7,052 in the first half, up a sharp 14.2% year on year in real terms, exceeding real GDP growth by 2.7 percentage points.

Reaccelerating vs Overheating

Although GDP growth edged up to 11.9% year on year in the second quarter, opinions are still divided as to whether the economy is overheating. However, the official assessment of the economic environment has recently changed from "guarding against the risk of growth acceleration transiting into economic overheating" to "the risk of growth acceleration transiting into economic overheating has become more obvious" according to the People's Bank of China (PBOC).

The Chinese authorities have been quick to back up this rhetoric. The PBOC has raised benchmark interest rates for both lending and deposits twice since the release of second-quarter GDP growth data, with the increases totaling 45 bps and 54 bps respectively. The required reserve ratio has also been increased by 50 bps to 12%. At the same time, following a State Council announcement, the 20% tax payable on personal bank account savings interest has been reduced to 5%. As a result, the effective one-year deposit rate has increased from 2.45% to 3.42%, a jump of nearly one percentage point.

However, taking into account the elevated inflation reading, the one-year deposit rate in real terms still stands at minus 2.18%. The one-year lending rate in real terms is currently 1.42%. These rates are not restrictive enough to encourage saving and deter borrowing given current levels of real GDP growth. In other words, despite a series of rates rises, the current monetary policy environment remains largely accommodative of growth.

On the surface, an 11.9% expansion of real GDP in the second quarter appears too high. But how high is 'too high' ? Policymakers do not formulate their macroeconomic policy based on whether growth is too high or not. Overheating exists when actual GDP, in growth terms, is running ahead of its potential rate. In reality, however, the determination of the potential GDP growth rate is subject to a considerable margin of error. There is no concrete answer to the question of whether the Mainland's potential growth rate should be higher or lower than 11.9%.

Perhaps a better way to determine overheating is through price pressures. When demand begins to exceed what an economy can produce, inflationary pressures will start to build. While headline CPI inflation has moved sharply upward since the beginning of the year (reaching 5.6% year on year in July), the pressure has not been pervasive and has been seen primarily in food prices. Most of this food price inflation has been caused by seasonal and cost-push factors such as a sudden rise in feed prices and last year's disruption to the supply chain of pigs and chickens. Non-food CPI has remained stable at 0.9%.

Further, there are no concrete signs of bottleneck problems in the economy. Back in 2004, when the economy was going through a period of cyclical overheating, industries suffered from widespread transportation overload, power blackouts and labour supply shortages. On this basis, demand-supply imbalances are still not evident in the economy.

Tightening Will Be Preemptive in Nature

There are currently no compelling reasons to impose heavy macro policies to rein in demand in the real economy. Monetary policy should be conducted in a way to address two major issues. First, it has to continue to drain excess liquidity in the banking system and curb lending growth. M2 growth is still running at 18.5% year on year as external surpluses continue to flow in and expand rapidly in the system. New loans for the first seven months of 2007 totalled RMB2,776 billion, an amount equivalent to 91% of total new loans in 2006. These two figures will continue to keep the PBOC on guard.

Second, it has to maintain a preemptive stance with respect to the potential escalation of inflation risks. Although price pressures outside food remain stable, food accounts for one-third of consumer spending and CPI weighting. Minimising the second-wave effects of rising food prices via other prices and wages is also necessary. Recent statistics show that the average wage for urban workers went up 18% year on year in the first quarter. Wage increases could become the impetus for the next round of inflation pressure.

As these two challenges are unlikely to fade in the near term, policy tightening is here to stay. At 7.02%, the one-year lending rate now stands very close to our year-end forecast of 7.11%. At least one more rate rise now appears likely, and we have revised our forecast to 7.29%. To complement this tightening campaign, further adjustments of the required reserve ratio are also on the cards. However, our forecast of 13% by the end of the year remains unchanged. For next year, the odds of further policy tightening are tilted to the upside.

Upgrading Our 2007 GDP Forecast

Globally, prospects for growth this year remain good. In terms of trade, slowing demand from the lacklustre US market has already been quickly made up by stronger growth elsewhere. The euro area and Asia now absorb 67% of the Mainland's exports. The robustness of European growth in particular has been reflected in the Mainland's recent trade figures. During the first half of this year, the euro area overtook the US to become the Mainland's biggest trading partner, picking up much of the slack generated by the slowdown in US imports.

Import growth reached 18.2% year on year in the first half, in line with our full-year forecast of 18%. Export growth came in at 27.6%, much stronger than our forecast of 22%. The external environment continues to support a positive Chinese export growth outlook. However, a new list of export tax rebate reductions, higher taxes on energy intensive products, and extended rules against the processing trade means that this outlook faces a considerable headwind.

In light of these developments, we have raised our full-year forecast for export growth to only 26% in the belief that growth of exports in the second half will slow slightly to 24%. Our forecast for import growth remains unchanged at 18%.

The domestic domain will provide strong economic growth momentum. Rising household income and ample liquidity conditions are favourable to consumer spending. We have increased our full-year forecast for retail sales growth from 14.5% to 15.8%. Fixed-asset investment has been gathering pace, running at 25.9% in the first half. Enterprises continue to benefit from a highly liquid economic environment. Industrial profits increased by 42.1% year on year for the first five months of 2007. The underlying business incentives for investment, including solid growth in demand, buoyant underlying profitability and strong cash flows, remain in place. The accumulated effects of policy tightening will have some impact on fixed-asset investment but this should only be moderate in nature. Accordingly, we have revised our full-year forecast to 25% from 21% previously.

Overall, we expect GDP to continue to run at above 11% in the remaining two quarters. In light of the latest economic data, we have upgraded our 2007 GDP growth forecast for the Mainland from 10.7% to 11.5%, and our annual inflation forecast from 3% to 3.8%.

Hong Kong: Domestic Strength Saves the Day

• Hong Kong will sustain its strong growth momentum. In particular, resilient domestic demand will be a major impetus for growth. A protracted period of high growth has nevertheless created pressure on production capacity and inflation.

Domestic Demand Still Centre Stage

First-half GDP figures illustrate our long-standing view that economic growth, driven by domestic demand, is now solidly entrenched in Hong Kong. Private consumption has trended higher while investment spending has staged an encouraging recovery. The external sector has been thus far unscathed by the ongoing weaknesses of the US economy. The result has been a very strong year-on-year growth record for the first half, at 6.3%. Domestic demand alone has contributed some 94% of this growth. This domestic story will continue to take hold and drive overall expansion in the near term.

Helped by improving job prospects and healthy wage increases, private consumption growth has stayed solidly above the 5% level in the past two quarters.

In the second quarter, a total of 27,400 new jobs were created, helping to push the unemployment rate down to a nine-year low of 4.1%. At the same time, both private and public sector employees are seeing more substantial adjustments to their wages. Wage growth in the private sector has reached a nine-year high. And after having had their salaries frozen for many years, civil servants have also been awarded pay rises of 4% to 5%.

Improvement in the labour market usually comes after overall economic recovery is in motion, often with a time lag of at least a year. As such, the market is still seeing very encouraging and broad-based improvement in the labour sector even though GDP has been running strong for a number of years.

On the trade front, export performance has held up surprisingly well, expanding at 9.8% year on year in real terms in the first half, despite developments in the US. Exports to the US, Hong Kong's second-largest export market, only grew by 1.6% year on year in the first half. However, robust demand from Asia, particularly the Mainland, and Europe has made up for much of the slowdown in demand from the US. Asia now takes 65.8% of Hong Kong's exports while the EU area accounts for another 13.5%. In the first half, exports to Asia were up significantly by 12.9% while those to the euro area increased by 5.9%.

Inflation Becoming a Challenge

Inflation remained benign at 1.5% in the first half, but strong domestic factors now point to growing inflation pressure down the road. At present, the headline CPI reading remains low, but this is largely due to factors that are temporary in nature. The government's one-off waiver of public housing rent and property rates has kept the overall CPI at around 1% over the past few months. Housing is a heavily weighted component in the CPI's construction. If it is excluded, inflation should have moved up to about 2.4% in the first half.

Prices tend to move in tandem with changes in capacity utilisation. The Hong Kong economy has registered above-trend growth for 15 consecutive quarters. A protracted period of high growth has created pressure on output capacity, rental and other operational costs. In certain industries, companies are already reporting difficulties in hiring new staff and wages are on the rise.

RMB appreciation and surging food prices on the Mainland are providing additional pressure in this inflation drive. Hong Kong depends heavily on the Mainland for food imports. This situation has already driven the CPI for food up by about 3% in the first half. As the RMB continues to appreciate, there may be more inflationary pressure in the pipeline.

Inflation could also be squeezed higher as this risk begins to lodge itself in household and company expectations. Given this, we now see an upside risk to our 2% inflation forecast for the full year.

The imminent pressure on capacity utilisation has been mitigated by a rapid increase in labour productivity. The economy may yet run into an overheating zone. The strains from further rapid economic growth could become more apparent in the future. The government now sees higher inflationary pressure in the medium term, and is projecting 1.5% for 2007 and 3.5% for 2008-2011.

Near-term Outlook Still Favourable

The potential subprime blowout and its subsequent spillover effects remain the biggest wild card in our outlook for Hong Kong. The worst may not be over.

Hong Kong remains highly dependent on global liquidity conditions. The current global inflation challenges have triggered more interest rate rises by major central banks. Monetary conditions are being tightened again. This has set the stage for corrections in the global financial markets.

Tightening looks set to continue as inflation risk has now taken a front seat. There will be less liquidity available to chase risky assets, most notably equities. With the elevated degree of leverage taken by investors globally over the past few years, the unwinding of this process has become a much more problematic scenario. Any sudden turn in the global liquidity tide will therefore pose a major risk to Hong Kong's financial market performance.

The trade sector is expected to stay solid, and our global growth outlook remains positive. The US appears to be entering a weaker cycle, but the rest of the world should pick up most of the slack. In particular, Hong Kong will continue to benefit from the Mainland's strong domestic growth story leading up to the Olympic Games and beyond.

There are concerns over the potential negative impact of RMB appreciation on the Mainland's exports and thus Hong Kong's re-exports. Anecdotal evidence suggests that import price elasticities of most developed countries are low. Their demand for imports is less responsive to the changes in price of such goods. The adverse impact from RMB appreciation is therefore likely to be limited. On the other hand, income elasticities play a more important role in driving a country's import demand. In many cases, a country's demand for imports is dependent on its income level and the pace of GDP growth.

To reflect our positive global outlook, we have raised our forecast for trade in 2007. Exports are now expected to rise by 9.5% instead of 7.5%. Our forecast for import growth is now 10.5% compared with our original 7.9%.

For the rest of 2007, Hong Kong will sustain the strong growth momentum it enjoyed in the first half. In particular, resilient domestic demand will be a major impetus for growth. We have revised our forecast for private consumption growth up from 4.5% to 5.5%. Investment spending is expected to grow by 8.7%, with the interest rate environment remaining supportive. Overall, we have increased our 2007 GDP growth forecast to 6.1% from 5.6%. This will help drive the unemployment rate down to 4% by the end of the year.

MAJOR HONG KONG ECONOMIC INDICATORS