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The past year has witnessed a surge in capital inflows, in common with several other
countries in the region, which has been an important factor in boosting both equity and property
prices. In Hong Kong's case, the large impact on asset prices appears to reflect a reassessment
of the benefits to be derived from China's growth potential and recognition of the growing role that
Hong Kong plays as an international financial center. In the event, stock prices--relative to
underlying earnings-are not out of line with those in comparable markets, suggesting the absence
of a speculative bubble.
The outlook for a continuation of Hong Kong's favorable growth performance, in line with
official forecasts, is good. Aggregate demand is likely to be sustained by higher incomes and
wealth, the implementation of major public works projects, and continuing expansion of activity in
southern China. Productive potential will rise further given high investment rates, combined with a
growing and increasingly skilled labor force.
Of course, there are also uncertainties about future prospects, particularly regarding
external developments. These include shifts in financial policies in China, the outlook for recovery
in industrial countries, trage policy actions in partner countries, and the durability of capital inflows.
Many of these risks, though, appear manageable. Indeed, against a background of strong
domestic demand growth, changes in the external environment that eased overall demand
pressures--such as a moderation in China's growth-could be absorbed without a major impact on
activity. Even if the adjustments were abrupt, the resilience demonstrated by the Hong Kong
economy in the past is reassuring. Nevertheless, the exposure of Hong Kong to external shocks
underlines the need to be prepared for any downturn by preserving economic flexibility.
The factors underlying riong Kong's past success have been complemented by sound
economic policies. The exchange rate link has assured a transparent anchor for monetary policy,
and its credibility appears to be unquestioned in financial markets. Fiscal policies have allowed
the accumulation of sizable reserves as a buffer against unfavorable shocks. Finally, Improved
regulation of the financial sector has reduced the risks associated with sharp movements in asset
prices and capital flows.
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