Sat, Mar 23, 2002 page19

• Hong Kong sees deflation as the rightsizing of its bloated economy

  • By William Pesek Jr. / BLOOMBERG
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  It seems entirely fitting that Hong Kong's central bank is considering cutting salaries of its staff. More than three years of deflation are forcing pay cuts in the private sector. And since deflation tends to be a monetary-policy phenomenon, why not pay less to those in charge of it? Yet the most interesting thing about deflation in Hong Kong is the lack of panic about it. Over in Tokyo, officials are freaking out over falling prices, and they're not alone. White House economist Glenn Hubbard says deflation is a "cancer" eating at Japan. Rating agencies agree and are threatening to downgrade the world's second-biggest economy.

  One wonders if Hong Kong isn't being more pragmatic because it understands deflation sometimes can be a good thing. In Japan, deflation is sold as the cause of the nation's problems -- as evil incarnate. Here in Hong Kong, falling prices are seen as a symptom of trouble, not the cause of it.

  Too be sure, there's plenty of concern here about the perils of falling costs. It slams financial assets, boosting debt-servicing costs and undermining top-line corporate profits.

  Analysts also worry about its effect on business and consumer confidence. But in other respects, deflation may be a step in the right direction.

  "What's Hong Kong's real dilemma?" asks Simon Ogus, chief executive at DSG Asia Ltd. "It's that costs are too high, hurting its competitiveness in the global economy. Falling prices are the only thing correcting that." Think of it as the rightsizing of a bloated economy. Hong Kong is among the world's most expensive cities in which to live and do business. The deflation that's been chipping away at the economy here for over two years is doing two potentially positive things: Consumers are gaining greater purchasing power and the swollen economy is being deflated.

  In a place beset by gloomy economic news -- including unemployment hitting a record 6.8 percent in February -- falling retail prices are the only thing helping consumer confidence these days. Everything from food and clothing to house wares and electronics is costing less. Rents too. Home prices fell 9 percent last year after a 15 percent decline in 2000.

  "Prices have to fall -- it's that simple," explains Andy Xie, chief economist at Morgan Stanley Dean Witter & Co in Hong Kong. "Deflation is the only force helping that process." The integration of Hong Kong and the mainland is the most important structural factor behind deflation. The dynamic means that managing supply and demand is becoming far more difficult for policy makers. It used to be that Hong Kong's economy could be analyzed and calibrated in isolation. Now, the liberalization of labor, tourist and capital flows is joining the two areas, forming a new average price level.

  Given the size of the Pearl River Delta economy and its inconsistencies -- living standards in Hong Kong and mainland China are mighty different -- it's safe to assume this new price level will be substantially below current ones in Hong Kong. It's a necessary adjustment. If costs here don't adjust, consumers here will merely reach for the cheaper supply of goods and services offered by the mainland. That's already happening in a big way.

  Whether deflation is good or bad for Hong Kong, it's here to stay. The exploding of its property bubble in the late 1990s and Hong Kong's exchange-rate link to the strong US dollar will keep the trend in place. So will sluggish global growth.

  Globalization, the falling cost of capital, and technology are powerful deflationary forces that continue to rattle around the international economy. Even if global growth recovers, the upturn might not be sufficient to resist powerful deflationary influences at play.

  In such an environment, Xie says, the answer isn't monetary stimulus, which might only cause financial bubbles and eventually make matters worse. When Wal-Mart Stores Inc cuts prices to pass lower import costs to consumers, there's no need for the Fed to print dollars to maintain price stability. If the Fed did, it would create excess money supply and fuel an asset bubble, as in the past.

  The answer, Xie says, is to restructure high-cost economies away from manufacturing and cut excess capacity in the service sector. In other words, such deflation isn't a problem as long as higher-cost economies shift away from competing against low-cost producers. Consumers benefit from cheap imports, while resources vacated by exiting industries go into higher-value-added industries. It becomes a problem only if higher-cost producers engage in competitive devaluation to stay in business.

  Admittedly, deflation is rarely, if ever, good for the broader economy. It zaps corporate profits, cuts wages and eats into government tax revenues. But with unemployment at a record high and Hong Kong's economic fundamentals worsening, sliding prices are about the only thing propping up consumer confidence.

  It's akin to a stealth tax cut that's leaving consumers with greater spending power.

  More important, though, is the creative destruction that Hong Kong's cartel-ized economy needs. Hong Kong may be among the world's freest economies, but it's also a hotbed of anti-competitive behavior at the hands of monopolies. Even the International Monetary Fund has raised concerns about the "limited degree of domestic competition" here.

  If prices keep falling, the trend could root out some, or many, of Hong Kong's inefficiencies. Bloated, monopolistic companies might have to downsize or even shut down. That, in turn, could force companies to abandon uncompetitive industries. Or at least provide opportunities for new firms to compete.

  Things in Hong Kong never should've become as expensive as they are today. The 1997 Asian financial crisis sapped considerable life from the almighty property market, shoulder-checking confidence as well. If deflation lets out more air and lowers living costs to more reasonable levels, locals may be far better off in the years ahead.
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