- 3.
The staff fully supports the thrust of these policies: indeed, continuing external uncertainties
reintorce their benefits In essence, our assessment of the macroeconomic situation is similar to
that offered last year. We believe that robust demand growth could well lead inflation to rise
somewhat over the near term following the recent moderation. Limitations on the scope for
pursuing a tighter monetary policy implied by the exchange rate link heighten the desirability of
maintaining a prudent fiscal stance. Because inflation remains the main macroeconomic issue in
Hong Kong, we first discuss its possible causes and effects, before turning to policy issues in
more detail.
In our view, domestic inflation in recent years has reflected a combination of factors: rapid
productivity growth in export-oriented industries, strong external demand for Hong Kong's financial
and trade-related services, in large part associated with rapid growth in China; and a relatively
inelastic supply of land and labor. More recently, buoyant domestic spending has also added to
demand pressures, which are likely to continue in light of the rise in asset prices and strong
confidence in economic prospects. Demand for domestic resources will also be increased by the
scaling-up of activity on the ACP and other major public works projects, even though a large
proportion of the resources will be imported. As a result, inflation is not likely to decline in the
immediate future, and, indeed, could rise somewhat, especially if the favorable impact of lower
import prices were to be reverscd.
A continuation of inflation rates well in excess of those in most trading partners, combined
with the maintenance of a fixed exchange rate, may well reduce the longer-term competitiveness of
Hong Kong's economy. When the current strength of domestic demand dissipates, a weakened
external position could lead to a cyclical slowdown in economic activity. Such an outcome would
be exacerbated if, at the same time, the U.S. dollar--and hence the Hong Kong dollar--were to
appreciate significantly against other currencies. Such a scenario underscores the importance of
avoiding an entrenchment of inflationary expectations or other economic rigidities.
Turning to monetary policy issues, the establishment of the HKMA is a welcome
development that has raised financial confidence in the lead-up to 1997. In addition, the
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