Hong Kong’s Economic Policy During COVID

Prior to the COVID pandemic, Hong Kong’s economy was among the best performing in the world, ranking 35 out of all the major economies. Driven by strong consumption, investment and exports, Hong Kong’s GDP had expanded steadily at an average rate of close to 3% from 2014 to 2019. Unemployment declined to 2.4% in 2018 from 3.6% in 2014.

At the same time, Hong Kong’s government finances were strong. In 2019, the Hong Kong government debt-to-GDP ratio was one of the lowest in all of Asia at around 42%. Unlike most other countries internationally, the Hong Kong government is a net creditor, with more financial resources than liabilities that it owes to the public. Its fiscal reserves stood at more than HK$1.2 trillion in 2019. In addition, Hong Kong was running a government budget surplus of 5.5% and 2.1% of GDP in 2018 and 2019, respectively, equivalent to roughly HK$50 billion in the 2018-2019 budget.

Then came COVID. The pandemic that began in early 2020 greatly affected the economies of most countries in the world, Hong Kong included. The demand shock put Hong Kong into a recession. The Government employed many different tools to try and lessen the negative impacts of a recession. Chief among them were fiscal and monetary policy.

As background, monetary policy consists of the actions of central banks to achieve certain economic objectives such as price stability, full employment, and stable economic growth. Fiscal policy refers to the tax and spending policies of the government. Governments can use both monetary and fiscal policy to meet their economic objectives.

During a recession, governments need to shift aggregate demand to the right. As can be seen in the graph, the economy during a recession is producing at price level 1 and real output 1, or below the long run equilibrium. Monetary and fiscal policies both aim to shift the demand curve back to long-run equilibrium (P2 and Y2).

In comparing the two policies, monetary policy tends to have a more general impact, while fiscal policy can target certain sectors or market participants to have a relatively greater impact on specific parts of the economy. For example, during COVID the Hong Kong Government allocated funding of approximately HK$21 billion to 16 specific sectors including travel industries, construction-related enterprises, education, school bus operators and the aviation industry. It also provided hand-outs to residents to directly boost consumption.

Other differences between monetary and fiscal policy include the time to enact the policy and the time for the policy to take effect. Since monetary policy is decided by central banks (the Hong Kong Monetary Authority, or the HKMA, in the case of Hong Kong) and not by the government directly, often in the form of rate changes or bond purchases or sales, it is usually enacted faster. In addition, the effects of the monetary policy can often be felt even before it is enacted because once the central bank signals its intentions, other banks make corresponding changes to the money they supply.

Fiscal policy that requires government decisions on budgets and spending can often take longer to implement and can be politically motivated. However, once implemented, the effects of fiscal policy can happen faster. For example, government hand-outs can be spent to lead to an immediate shift in demand. On the other hand, aside from the signaling effect, macro effects of monetary policy generally occur after some time has passed and can take months or even years to materialize.

During COVID, Hong Kong policymakers employed both fiscal and monetary measures to help alleviate some of the financial burden suffered by individuals and businesses and to assist the economy to recover. As noted, at the start of the pandemic, Hong Kong had very little debt and a large government surplus that could be deployed to boost the economy. Hong Kong spent heavily during 2020 and 2021, equal to about 5% of GDP. Included in the fiscal stimulus was HK$10,000 provided to each adult Hong Kong permanent resident, as well as certain income tax cuts and rent suspension for a portion of the population. The government also provided financial assistance to many business segments and offered wage subsidies to employers who agreed not to lay off workers. Fiscal spending led to Hong Kong running its first budget deficit in years, and Hong Kong is projected to continue to run this deficit for the coming five years at least.

Aside from fiscal policies, Hong Kong employed monetary policy to counter the effects of COVID. The HKMA lowered the capital buffer imposed on banks by 1.5% and reduced its base lending rate by 64 basis points to 0.86%. This provided additional liquidity to the banking sector to support borrowing and other economic activities.

It is important to note that one of the key objectives of the HKMA is to maintain currency stability within the framework of the Linked Exchange Rate System whereby the HK dollar is pegged to the US dollar. This is so Hong Kong can keep its status as an international financial center. As a result, during COVID Hong Kong could not cut its benchmark interest rate on its own without hurting its linked exchange rate system.

That is, since the Hong Kong dollar is pegged to the US dollar, Hong Kong must generally follow US monetary policy. The requirement to keep HK$ and US$ interest rates the same is a result of interest rate parity theory. Interest rate parity means that the difference in interest rates between two currencies needs to be equal to the difference between spot exchange rates (HK$/US$) and forward exchange rates based on a certain time period. If HK$ interest rates are much higher than US$ interest rates, investors could borrow US$, switch it to HK$, and deposit the HK$ to earn a higher HK$ interest rate (compared to a US$ interest rate). This means that if there was no peg, the HK$/US$ exchange rate would go up since demand for HK$ increases. The opposite is also true, so if HK$ interest rates are much lower than US$ interest rates, investors would sell HK$ and convert to US$ to make US$ deposits and benefit from a higher US$ interest rate. However, because of the monetary policy of a HK$/US$ peg, the exchange rate cannot change. Therefore, HK$ interest rates need to follow US$ interest rates, so investors are not incentivized to buy or sell HK$ against the US$.

In March of 2022, as the US was coming out of the pandemic, the US Federal Reserve increased interest rates 50 basis points to counter high inflation. Even though Hong Kong’s economy has not recovered from COVID, the HKMA had to follow the Fed by increasing interest rates in Hong Kong. The rate hike was the biggest for Hong Kong in 22 years. If the HKMA had not raised rates to match the Fed, investors would have greater incentive to move out of HK$ and into US$. Higher interest rates will squeeze anyone who has a mortgage linked to the Hong Kong interbank offered rate (HIBOR) and will hurt small and medium-sized businesses which need to borrow money. This will slow the economic recovery following the pandemic.

In summary, during COVID Hong Kong employed both fiscal and monetary policy. Without independent monetary policy, aggressive fiscal stimulus became even more necessary to react to the pandemic.

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