Hong Kong has sailed through several economic crises while undergoing economic adjustment in the past decade. Both George Leung and Edward Leung reckon that the crises were not caused by the handover. On the contrary, changes in China's policy towards Hong Kong after 2003 have had a positive impact on the SAR.

Edward Leung: Our dialogue today is on what changes the Hong Kong economy has undergone in the 10 years since the handover, including successes and failures, and where Hong Kong's advantages lie. What are the external and internal factors affecting Hong Kong and what changes have taken place in its economic system or structure? Where do we stand now? And where will we stand in 10 years' time? How is the economic path we are treading related to the handover?

On the surface, since the handover the per capita income of Hong Kong has not changed much from 1997 to 2007. In the last 10 years, the growth rate is about 2% (in US dollar terms). How do you look at the past decade?

George Leung: There is no strong correlation between this and the handover. The period since 1997 till now has been a milestone. I would say the Hong Kong economy has gone through a major downward adjustment and has subsequently recovered. The economic cycles of Hong Kong usually last two to three years, that's why many people had expected an economic recovery in 2000. But as it turned out, this round of economic adjustment has lasted nearly 10 years. As you have just mentioned, per capita income only edged up a little during the period. Economic recovery has only just begun.

Edward: Hong Kong was in a slumber in the last 10 years. As we know, the 1980s were the "lost decade" of Latin America, a total loss. Is it the same case with Hong Kong?

George: The 10-year adjustment was necessary for Hong Kong. In the 10 years prior to 1997, many issues had been building up. In the course of Hong Kong's economic transformation, the level of labour skill has not been able to catch up with the change because the bubble in the property market before 1997 had created a huge demand for employment, making it difficult even for the hiring a courier delivery person; labour skill was not required at all.

Edward: The unemployment rate then was below 2%.

George: It was an overheated economy that concealed many problems which remained unresolved. While the outbreak of the Asian financial crisis after the handover was just a coincidence, it marked the beginning of economic adjustment. Issues that had pent up behind the veil of prosperity during the 10 years preceding 1997 came to the fore during the 10 years after 1997. For instance, large-scale structural unemployment was an issue which has been resolved gradually in recent years. The past decade (from 1997 till now) is therefore very important to Hong Kong's future development. Certain issues have to be cleared up first to pave the way for future development. The coming five to seven years should see a relatively steady development against the recession in the last six years.

Edward: We have had this very painful experience as we went through a protracted deflation that lasted 68 months. It was even longer than the 45-month US recession in the 1930s.

George: I have also made comparisons between the two and found that Hong Kong was facing even greater challenges than those of the great depression in the 1930s in many aspects, such as property prices, deflation and unemployment. Thanks to its strong financial resources, Hong Kong has weathered the storm and the society as a whole has remained stable. Unlike the US which has a great bearing on the world economy, Hong Kong's recession did not impact on the whole world.

Edward: We had to tackle the problems with our own hands.

George: Exactly. And in fact, Hong Kong's situation was even more serious than the US.

Edward: An overheated economy prior to 1997 and the Asian financial crisis after 1997 had resulted in a massive adjustment after 1997. By 2000, many people thought the adjustment should be over soon. In fact, the economy should have rebounded in 2000 if the IT bubble had not burst. In 2001, (Hong Kong's) exports fell instead of rose, this was very rare. By 2002, the Hong Kong economy was on the verge of recovery, but unfortunately SARS broke out in 2003.

George: Two developments affected Hong Kong in the past 10 years. First, the cyclical nature of the economy. Issues that had been in the making in the 10 years prior to 1997 had to be addressed after the outbreak of the financial crisis, this is cyclical.

Second, a noticeable structural change in the past decade has resulted in longer economic adjustments than before. As we all remember, China announced its WTO accession prior to the IT bubble. This development had far-reaching implications for Hong Kong and the world. At that point, Hong Kong suddenly realised that its middleman role was gradually fading. As foreign firms can enter the China market direct, we can see that FDI rose sharply in China after 2000 whereas in Hong Kong it dropped to a point where a net outflow of capital was registered in 2003. Hong Kong has experienced a tremendous structural change. In the past, it was a middleman and provider of funds. But in 2001 as China opened up to the whole world, Hong Kong had to handle cyclical recovery on the one hand and structural change on the other. The adjustment period has therefore taken longer than anticipated.

Edward: Factors leading to cyclical adjustments originate from external challenges and our internal situation, including the adjustment of the property market. However, is the pegged exchange rate forcing the pressure for adjustment to be internalised? The reason is, as we are not able to alleviate external challenges through the peg, all that can be done is to suppress internal consumption, which has further increased the breadth and depth of the adjustment. Do you agree with this view?

George: Absolutely. Hong Kong is one of the few economies in the world that can use this means to make adjustment. Compared to the US in the 1930s where many people committed suicide, the flexibility of Hong Kong's economy is simply incredible.

Prior to 1997, the Hong Kong dollar was undervalued due to the peg. As a result, investment swamped the property sector. Rises in property prices were an indicator of the demand for Hong Kong services and assets, which subsequently created the asset bubble. When other Asian currencies depreciated in value during the Asian financial crisis, ours did not. That doesn't mean our economy did not undergo any adjustment, only that the adjustment took place by means of assets. In other words, under the pegged exchange rate system, Hong Kong's adjustment mechanism is regulated by asset price which is quite unique. Many countries shy away from using asset price as a means of adjustment because of the large impact it may have on society. Many people will go bankrupt if property prices drop 50%-60%. In the past 10 years after the handover, there was an immense pressure in this regard. Many social events were related to the plunge in property prices.

Despite the immense pressure, Hong Kong has demonstrated its great tenacity. For instance, its ability in making money and saving is incredible. We can see that the levels of savings at Hong Kong banks in the last few years have still been rising. (People) have still managed to save despite falling wages and property prices. The frugality and perseverance of Hong Kong people have helped cushion off the impact of the economy downturn. From this perspective, assets are used as a means of adjustment under the Hong Kong system.

It is worth noting that some people reckon that using internal mechanisms as a means of adjustment has a significant impact on society and they have suggested that the pegged exchange rate should be scrapped when the pressure gets too great. But I want to emphasise that the peg has for years proved to be an effective mechanism, and the (Hong Kong economic) system has been able to adjust automatically to the pegged rate system in terms of reaction to risks and allocation of assets. If changes are made to this system hastily when the social and economic systems are not ready, the impact will be even greater. For instance, many people called for the scrapping of the pegged exchange rate during the Asian financial crisis. But at the time Hong Kong had a large foreign debt. If its currency were depreciated all of a sudden, many Hong Kong companies would have been hard hit. Even the banking system might suffer. As a financial centre, it is of utmost importance for Hong Kong to maintain a stable financial system. Hong Kong people are also well aware of this. So it is imperative that any change to the existing system must take into account the dependence of the economy on it.

It is really fortunate that Hong Kong has successfully pulled through the economic adjustment in the past decade. As we can see now, the Hong Kong dollar is undervalued and interest rates are low, indicating that the Hong Kong economy has recovered. Otherwise, there wouldn't be any capital inflow. Compared to 1997, Hong Kong's position today is much stronger in terms of external debt, household debt and the debt of the banking sector. The negative balance in the past has reverted to positive now. Other indicators such as property prices and people's income, or any other (indicators), are also much healthier than those in 1997.

Edward: As mentioned earlier, the adjustment is partly cyclical in nature and partly structural which is closely related to the economic development of the mainland. According to statistics, the share of mainland origin goods re-exported via Hong Kong in China's total exports had dropped from 50% in 1997 to less than 20% in 2006. But in absolute terms, our exports did not drop. Rather, China's direct exports have increased dramatically and the percentage of re-exports through Hong Kong has gone down from 50% to 20%. On the other hand, Hong Kong accounted for 46% of the FDI in China before the handover in 1997. But at present, the share is about 30%. So, in a way, the importance of Hong Kong to the mainland economy has diminished.

On the one hand, more investment and more companies enter the China market direct, and more mainland products are exported to overseas markets direct. On the other, closer ties have developed between Hong Kong and the mainland, facilitating the flow of various inputs. As a result, business activities which can be conducted both in Hong Kong and the mainland have been relocated to the mainland due to lower cost. During this process, unskilled workers in Hong Kong have seen hardly any increase in salary in the past 10 years. While we say that there is a 20% increase in wages in general, unskilled workers are finding it more difficult to make ends meet.

A quick recap of what you've just said. Based on past experience, Hong Kong's advantages lie in its sound banking system and strong economic system including the pegged exchange rate. The strength of these systems is built on Hong Kong's highly flexible economic system and its highly tolerant society. Otherwise, intense social unrest would have already erupted.

George: The further liberalisation of the mainland market since 2000 has made an immense impact on Hong Kong. As the statistics you just mentioned indicate, Hong Kong's share of China trade has continued to decline and it appears that economic ties have sagged. But this change is inevitable. When the vast China market first started to open up, Hong Kong was its only "walking stick". Now that China's eyes are wide open, its reliance on Hong Kong is bound to diminish. As the pie grows bigger, Hong Kong's share in terms of trade and investment will inevitably decrease. It also means that the vast Chinese economy can accommodate more financial hubs in addition to Hong Kong. That's also why we always emphasise that China is a market with 1.3 billion population and one should not worry too much about competition between Hong Kong and Shanghai.

Edward: A few more cosmopolitan cities are certainly no problem.

George: In fact, the changes in China after 2003 have benefited Hong Kong. The Individual Travel Scheme was a milestone. It is the consensus of many economists that the scheme does not bring much real benefits to the Hong Kong economy. But it certainly helped boost consumer confidence (in Hong Kong in 2003) when no one in Hong Kong would even buy a pineapple bun but (the mainlanders) came to buy cakes.

The scheme was a significant move in that it signified the outflow of China's capital. As the country got richer, funds began to flow in the reverse direction (back to Hong Kong). Hong Kong and foreign investors certainly saw this as an opportunity. Hong Kong as a financial centre definitely has a role to play when China allows capital outflow. Measures such as the Qualified Domestic Institutional Investor (QDII) scheme that were subsequently launched further affirmed China's green light for mainland investment overseas.

Edward: There is hope!

George: Hong Kong's role as capital provider is gone. The banks have been under a lot of pressure after the handover in 1997 because loans dropped to the level of the 1980s instead of going up. Think about it, the loan business is the lifeblood of banks, when it contracts, what else can be done?

Hong Kong's role as lender has disappeared after China's WTO accession. As Renminbi loans are gradually becoming popular, the demand for loans has shifted northwards in a big way. The situation was dire in 2002 and 2003 as it could be seen that not only manufacturing was moving north, financial services were also moving north. What could Hong Kong do? The launch of the Individual Travel Scheme in 2003 brought not only consumption power but also hope, that is, China has already accumulated (a certain level of) wealth that it has started to spend and invest offshore. Hong Kong, with its role as a gateway offering world-class financial services and management talent, has once again re-defined its role in this respect.

The surge in demand for financial services triggered by stock issuance and fund raising has reaffirmed the views developed after the outbreak of SARS in 2003. The conclusion is that this is a structural change. With (Hong Kong's) role as lender prior to 1997 now gone, today Hong Kong companies (with the demand for capital) are mostly looking to borrow Renminbi on the mainland to set up factories and few would borrow money from Hong Kong (banks). Meanwhile, debt levels in Hong Kong have dropped drastically in the last 10 years of adjustment. Banks are often flooded with cash (because there is simply too much capital around) and there are basically not enough channels for capital outflow. So, it can be seen that we no longer play the role of lender but that of a (wealth) manager. This also marks a major structural change in the financial sector. We are now positioned as a "financial supermarket" offering a comprehensive range of services including insurance, credit card, bank loans, private banking, and financial analysis.

Edward: Developments in the past 10 years might not seem to be related to the handover but in fact they were. For example, there would be no Individual Travel Scheme or CEPA without the handover. Although these developments did not bring much direct benefit, they served to illustrate that, firstly, China has started to get rich. As it has just started, there is still much room for further growth. Secondly, people tend to share their good fortune among their peers. Hong Kong people will certainly find more business opportunities due to cultural affinity.

George: The past 10 years are very important. Both capital mobility and people mobility have become two-way. Mainlanders visiting Hong Kong have risen substantially because Hong Kong entry visas are easy to obtain and mainland capital is allowed to invest offshore. You can see that two-way flow is more in line with (the norms of) economic operations.

Edward: 2002 and 2003 were the darkest days. As we said, the government had to increase taxes or cut expenses, otherwise all the reserves would dry up in a few years. It was a structural fiscal deficit. When the unemployment rate reached 8.2% the problem was one of structural unemployment. At that time it was thought that the problem was all structural. But now that there is a fiscal surplus and unemployment rate has dropped to 4.2%, why is it that the structural problem at that time no longer exists now?

George: Perhaps I should explain it this way. I agree that the problem was structural at that time. But I would also agree that the problem was not structural. Taken separately, at that time we had structural unemployment and structural fiscal deficit. As we did not see any structural changes developing in Hong Kong in 2003, it was thought that there would be no way out if the situation persisted. At that time there was an outflow of Hong Kong capital but no inflow, the flow was one-way. Wasn't that structural haemorrhage?

Edward: Well, it was not over-pessimism at that time, it was just that (we) could not see any way out.

George: It was structural problem that brought about structural deficit and structural unemployment. If the structural problem of the economy could be resolved, structural deficit and structural unemployment could be resolved too. After 2003, structural changes began to emerge in Hong Kong. These changes, whether self-initiated or triggered by the mainland, have turned the table. (Hong Kong) found its new role and efforts were made to achieve transformation. The structural problem was gradually resolved over time. Once (the problem was) solved, it was like blood transfusion, the structural deficit was no longer structural in nature. So, it is correct to say at that time that the problem was structural in nature. However, today as some issues in Hong Kong have resolved the structural problem, the tricky part should not persist.

Edward: In other words, the situation we have today shouldn't be short-lived. Rather, we have undergone transformation and have been born anew. What is our new role in the 10 years to come? There have been marked changes in the financial sector, but what about other changes? For instance, logistics and shipping are lacklustre. We can see that shopping is facing intense competition and its growth will slow down. As for logistics, it is not easy for Hong Kong to compete. What other roles can we play?

George: Economic diversification was the saying in 1997, but it did not work out and we had to find another way. As long as the Hong Kong economy maintains its flexibility and vibrancy, it can make its own adjustments slowly in search of a way out. The most important issue is whether its system will remain sound and whether its infrastructure, talent exchange and free flow of information will continue. It is on this excellent foundation that transformation can be achieved should the need arise. Today, Hong Kong cannot rely solely on the development of the financial sector because the share of financial services (in Hong Kong's economy) is not that big.

To achieve sustainable growth, Hong Kong has been groping its way slowly. For instance, there has been an obvious shift to air freight in the past few years and the role played by Hong Kong as an air transport hub has been significant. Hong Kong is playing this role as the mainland (airfreight) system is not yet well developed. When the mainland catches up in three to five years' time, (Hong Kong) will then look for another role. Hong Kong people never look too far ahead, as long as there is something in the next few years, they would try their best and do it.

From plastic flowers and wigs to sweaters and electronic components, and subsequently to services and financial services, Hong Kong has taken a path that was hardly envisaged by policy (makers). Even the business community has no idea what the next step is. Many opportunities are unleashed by mainland policies. For example, in 1997 it could be foreseen that the mainland would emerge. But what about its financial muscle to invest overseas? I think even the Chinese leaders might not have foreseen this development at that time. Hong Kong people are quick in adapting to changes. That's why it is crucial to make sure that Hong Kong's fundamental systems remain sound. Also, social stability, financial stability and talent supply... we have repeatedly mentioned these many times.

Edward: But these are all truths. (We) have to repeat them a hundred times if (we) need to.

George: Business people well understand the practice of "doing what one is familiar with". In terms of hardware technology, Hong Kong lags behind Japan, Korea, Taiwan, and even the Chinese mainland. What (Hong Kong) can do at the most is to take its own technology path.

Technology has made rapid advancement in the Chinese mainland. Its success is attributable to government support, training of talent, and the supply of scientists by universities. Technology development must also be backed by manufacturing. However, in Hong Kong, as manufacturing industries have been relocated, creativity finds no ground for application. All R&D activities can only be done on the mainland. Given the small size of the Hong Kong economy, there is no way that we can catch up.

On the other hand, Hong Kong offers world-class management expertise in software technology. A knowledge-based society does not necessarily have to possess the technology. In fact, creativity in business and enterprise management capability are also different forms of knowledge.

Hong Kong has transformed into a cosmopolitan economy, but it does not have all the features of a cosmopolitan economy because it is not a nation economy. Instead, specialisation is its niche. For example, no one will set up factories in New York's Manhattan. Hong Kong has reached a certain level of specialisation where its present development model will serve it well in the 10 years to come.

I think the present situation of Hong Kong is better than that of 1997. Prior to 1997, there were serious social imbalances and excessively high debt ratios. Unemployment was at an artificially low level of 2% due to an overheated economy. Compared to 1997, the social welfare system is better now, there is no external imbalance, the banking system remains sound, and the surplus has not dropped. Also, the economy is on track to full recovery, for example, consumption has rebounded and property prices are no longer soaring like before.

Edward: There is really no need to give development priority to any industry in the 10 years to come. As a service and business hub and a cosmopolitan economy, Hong Kong cannot operate on its own but has to rely on close ties with neighbouring regions in the foreseeable future. Prior to 1997, as a business centre Hong Kong benefited from China's reforms and the Asian miracle. Right now, China is the driver of the regional bloc ASEAN, as well as Hong Kong's economic recovery. I reckon that first, Hong Kong and the mainland will become more integrated; and second, Hong Kong will continue to grow after economic transformation. These views are based on the premises that Hong Kong will have a bright future as long as the prospects of China's economic development are promising.

George: Agree. Undoubtedly, Hong Kong's relations with the mainland would only grow closer and closer in the next 10 to 20 years. Due to geographic proximity and its status as a world-class financial city, Hong Kong is definitely the number one choice when China looks for a wealth management centre. Hong Kong has long anticipated the rise of a strong China.

Hong Kong is optimistic about the development prospects of China. Unlike the current A-share craze, this optimism is not unjustified. Industrialisation is China's present stage of economic (development). Many countries have gone through the same stage in their history, such as the Industrial Revolution in England and the Meiji Reformation in Japan. China is just following the same path trodden by many other economic powers before. Right now China has yet to reach the standard of superpowers, its path of development still has to take some more time. Thanks to massive FDI, today (the country) has turned into a world factory and its manufacturing industries account for a substantial share of the world total. The Chinese leaders are very clear about what the next step is - to develop the domestic consumer market, not to rely solely on foreign markets, not to propel growth solely by exports, and to create a buffer zone to absorb (external) shock.

Edward: There is no need to be too rich. The domestic market will suffice.

George: China absolutely has the ability to become a huge consumer market, following the footsteps of other superpowers such as the UK and US.

Edward: Based on history and experience, China is set to play a leading role in the world economy over the next 10 to 20 years.

*George SK Leung: Advisor, Strategy and Economics, Asia-Pacific, HSBC
**Edward Leung: Chief Economist, Hong Kong Trade Development Council