• Hong Kong's total exports, up 9% in the first half of this year, are now expected to attain an 8% growth for the whole of 2006, against 9% forecast previously.
• Given a projected slower global economy, overseas demand is expected to moderate somewhat, although the world trade environment will remain largely stable.
• Meanwhile, certain risks and challenges exist, including persistently high oil prices, looming inflation pressures and the associated monetary uncertainties.
• On the supply side, Hong Kong exporters are faced with continued revaluation of the RMB, rising raw material prices and increasing labour costs in the PRD.

Following years of double-digit expansion, Hong Kong exports have moderated since the beginning of this year. This moderation, albeit widely expected, has been characterised by a surprising slowdown in recent months. Taken together, however, Hong Kong's total exports, which increased by 9% during the January to June period, were still in good shape, thanks to a continued sanguine external environment.

Electronics, the largest export item with a 48% share, play a big role in affecting sales performance. Despite relatively steady demand for electronics products, overseas buyers, especially European buyers, have shown great concerns over EU's mid-2006 RoHS Directive. To avoid any teething implementation problems, many of them advanced their orders to the early part of the year, and have lately postponed orders until all hitches are resolved.

As the problems of RoHS implementation fade out and the inventories of electronics products bottom out, resurgent electronics exports should help bring Hong Kong's total export performance to the trend level. But given a moderation of the world economy, overseas demand for electronics and other products will likely slow. For the whole of 2006, Hong Kong's total exports are now forecast at an 8% increase, vis-à-vis the 9% growth expected previously.

Although the world trade environment will remain largely stable over the medium term, certain risks and challenges exist. In particular, the direction of global monetary policies presents a considerable uncertainty. While it is widely anticipated that US interest rates will peak soon, a longer-than-expected upward trend is still possible, if US inflation continues to rise. There is also much room for further tightening in the EU and Japan. Other downside factors include high crude oil prices, which have a marked impact on global interest rates, as well as protectionism in overseas markets, especially the US and EU.

Further on the supply side, while a stronger RMB, which has appreciated by 3.5% against the US dollar since July 2005, appears to have only marginal impact on production costs, any faster and larger appreciation will likely hurt the price competitiveness of Hong Kong exports originated from the mainland. Rising raw material prices create another problem. Although oil and other commodity prices are expected to stabilise over the medium term, price volatility of raw materials will pose a treat to our exporters.

More importantly, industry sources indicate that labour wages in the PRD have increased by 15% - 30% since the beginning of this year, following a 20% rise in 2005. But despite considerable increases in wages as well as related fringe benefits, labour shortages remain critical. Over the medium term, higher wages and labour shortages will likely remain irreversible, and these issues should be taken seriously by Hong Kong manufacturers.

Overview and Outlook

Recent Developments

After years of double-digit growth, Hong Kong exports have slowed to a more modest pace in 2006. This slowdown in export growth, though largely anticipated, has been characterised by an unexpected downturn in recent months. While the strong expansion was maintained in the early part of the year, exports then showed an unexpected decline, albeit marginal, in May, followed by another lacklustre performance in June. In all, Hong Kong's total exports, which grew by 9% in the first six months of 2006, were still in good shape. Yet bucking the trend of past years, domestic exports, which leaped by 29%, outshone re-exports, which increased by a mere 7%.

Summary of Hong Kong's External Trade

Source: Hong Kong Trade Statistics, HKSAR Census and Statistics Department

Electronics, the biggest export item with a 48% share, played a decisive role in affecting Hong Kong's export performance. Notwithstanding a slight moderation, global demand for electronics products generally remained strong on entering 2006, thereby boosting sales of electronic parts and components to the Chinese mainland, as well as finished electronic products to overseas markets. But overseas buyers, particular European buyers, have shown enormous concerns over the EU's mid-2006 Directive on Restriction of Hazardous Substances (RoHS). To avoid the teething problems of implementing this pervasive environmental legislation, many of them brought forward their orders to the early part of the year, and have lately held back orders to wait for the dust to settle. Not surprisingly, Hong Kong's electronics exports have slowed dramatically in recent months.

Meanwhile, sales of clothing, accounting for another 9% of Hong Kong's total exports, have also slowed, amid the abolition of the world textile quota system in January 2005 and the subsequent re-imposition of quantitative restrictions on certain mainland-origin textile and clothing products by the EU and the US. For one thing, Hong Kong's clothing exports have been depressed by a high comparison base in the first half of 2005, as Hong Kong manufacturers shifted their production to the mainland to take advantage of the largely quota-free environment. For another, some US and EU buyers, for fear of a shortage of the re-imposed quotas, have diverted their orders to other production bases, such as India, Bangladesh and Indonesia. Many Hong Kong manufacturers, for their part, have relocated their production back to Hong Kong, in a bid to sidestep the import restrictions applicable to mainland-origin products. This relocation of production has helped boost Hong Kong's domestic exports, while suppressing re-exports.

The regulatory issues affecting Hong Kong exports aside, the external trade environment has remained largely sanguine, thanks to the solid world economy, as well as surging intra-regional trade, with the mainland again as the major impetus to growth. According to the IMF, world economic growth is projected to reach 4.9% in 2006, following the 4.8% last year. As the year opened, the US economy was on a sustained upswing, the mainland economy remained strong, whereas the EU and Japan continued to witness their economic recovery. In particular, sales to the mainland, sharing 47% of Hong Kong's total exports, have been underpinned by its hearty appetite for industrial inputs for export production. In the meantime, the renewed weakness of the US dollar, which has depreciated by 5% and 1% against the euro and the yen respectively since the beginning of the year, has also facilitated sales to the EU and Japan.

Yet the global trade environment has remained formidable, as Hong Kong exporters have faced rising production costs stemming from sustained RMB appreciation and, more importantly, rising costs of raw materials and labour wages and fringe benefits. Given intensified competition and further consolidation of foreign retailers, however, most Hong Kong exporters have not been able to fully transfer the increased costs to their customers. They have instead absorbed the higher production costs, and accepted lower profit margins. Even with the decent economic landscape, soaring oil prices have made overseas consumers more cautious. Such consumer cautiousness has further exerted downward price pressures on Hong Kong exports. Indicative of such downward price pressures, the unit value of Hong Kong's total exports was stagnant during January-May 2006, following its 1.3% increase in 2005.

Medium-Term Prospects

Total Exports by Main Destination

Source: Hong Kong Trade Statistics, HKSAR Census and Statistics Department

Over the medium term, the world economy will continue to expand at a steady pace. Seemingly, economic activity is slowing. But the outlook for the rest of 2006 and 2007 remains decent, although spiralling oil prices and higher interest rates will take their toll. According to the IMF, world economic growth is expected to be 4.7% in 2007, just a tad lower than the projected 4.9% for the whole of 2006. While global growth is cooling, major economies will continue to show resilience. In the industrial world, the US will still be the hot spot, and the recovery in the EU and Japan appears sustainable. In the developing world, the mainland economy will remain buoyant, thus maintaining the country's role as the key growth driver of intra-Asia trade. By all indications, Hong Kong looks set to further benefit from the steady world economy and sustaining intra-regional trade.

In the US, economic growth, after its fast expansion in the early part of 2006, has eased back into a lower gear. Evidently, successive interest rate hikes have started to make an impact on the housing market. Softer house prices, coupled with soaring oil prices, will increasingly affect sentiment and consumption. But such developments, buffered by solid business investment and low joblessness, are unlikely to throw the US economy off course. As inflation expectations remain contained, interest rate rises will probably peak soon, and economic growth in the second half of 2006 and in 2007, albeit slowing, should remain fairly robust. On the back of the still-strong economy, many consumers are inclined to clamour for value-for-money luxury items at department stores and specialty stores, although lower-income consumers will become more timid spenders, mainly looking for competitively priced products at mass merchandisers and discounters.

Sustained US growth, though expected to moderate marginally, will continue to help fuel economic growth in the EU, Japan and other Asian economies. In Europe, a gradual recovery is finally underway. The EU revival will gather pace in the rest of this year, and falling unemployment should bode well for consumer spending. But faster EU growth, along with higher crude prices, leads to rising inflationary pressures, and in turn a continued tightening of monetary policies. In 2007, growth in the euro zone will be further constrained by the scheduled VAT increase in Germany, although the prevailing recovery is expected to remain on track, and EU consumers will continue to look for quality products at competitive prices. Exchange rate movement, for its part, will likely enhance the price competitiveness of Hong Kong exports, as narrower interest rate differentials across the Atlantic should result in a weaker US dollar against European currencies.

Likewise in Japan, there are signs that the economy is heading for a steady and sustainable recovery in the rest of 2006 and in 2007. The good showing of the external sector, facilitated by a hearty appetite of the US and the mainland, has ultimately fed through to the domestic front, with the revival of business investment driving employment and consumption. But buoyant economic activity, combined with growing inflationary pressures amid higher oil prices, has prompted an end to Japan's zero-interest-rate policy, and softer overseas demand will further put a drag on Japanese exports. These headwinds notwithstanding, the prevailing recovery of the Japanese economy will continue to benefit Hong Kong's quality exports, especially value-for-money items sought after by Japanese consumers. In addition, a more stable yen, on account of a slow monetary tightening in Japan and the peaking of interest rates in the US, will also help.

Elsewhere in the region, the Chinese mainland will continue to be the axis of growth. Growth of the mainland economy has remained dramatic so far, fuelled mainly by a surge in fixed asset investment. This astonishing expansion has triggered concerns about a possible overheating. In this regard, the mainland has been taking measures to cool down investment, including increases in key lending rates and bank reserve requirements, as well as curbs on real estate, while rebalancing and sustaining growth of its economy, which are in fact major directions of China's 11th Five-Year programme for 2006-2010. Despite the possibility of further tightening measures, the mainland economy will largely maintain a robust pace of grow