Too early to celebrate HK's economic recovery

Hooray! The recession is over.

On Friday the government announced that Hong Kong's economy grew by 3.3 per cent in the second quarter compared to the previous three months, the first period of growth since the first quarter of last year.

Forgive me if I manage to contain my excitement.

The uptick in output in the second quarter is certainly good news. But alas, it's hardly a compelling reason to celebrate.

For a start, whether you think the downturn is over depends on your definition of the word 'recession'.

If you take one widely accepted definition - at least two successive quarters of year-on-year contraction in gross domestic product - then Hong Kong is still in the depths of a slump.

That's because, although GDP in the second quarter was up from the first three months of the year, it was still 3.8 per cent down from output in the second quarter of last year. That's the third quarter in a row of year-on-year contraction.

And if you prefer the definition which says you are in a recession if your unemployment rate has risen by 1.5 percentage points over the last 12 months, then Hong Kong is definitely still in recession.

The unemployment rate over the three months from April to June stood at 5.4 per cent, up more than 2 percentage points from a year earlier.

Still, it would be silly to quibble over definitions.

The year-on-year measure is not much help when economic conditions are volatile as they have been over the last year. And unemployment is always a lagging indicator of economic health anyway.

After all, Hong Kong's output did grow in the second quarter, and that clearly represents a promising turnaround in activity.

Even so, celebration would be premature.

To see why, we need to take a closer look at what drove the second quarter's upturn versus the first quarter.

With global demand still depressed, by far the biggest contribution to the pick-up in Hong Kong's economy was domestic demand, and specifically private consumption, which jumped by 4 per cent compared with the previous quarter.

That's the strongest increase since consumer demand bounced after the Sars scare of 2003 and, according to Denise Yam at Morgan Stanley, it contributed more than three-quarters of the economy's 3.3 per cent quarter-on-quarter growth.

With visitor arrivals at their lowest level for two years, you can't credit cashed-up mainland tourists for the demand surge. It's locally propelled, and the driver is no great mystery.

As the first chart below shows, there is a powerful connection between the performance of Hong Kong's equity market and private consumption growth. (You can see a similar link between property prices and consumption, but to keep things simple let's stick with the stock market.)

As share prices slumped from their October 2007 peak, so consumer demand slowed and went into reverse. Now, with the Hang Seng index up 73 per cent since early March, private consumption is bouncing back.

That's great news, of course, especially for the retail sector. But you have to question whether the stock market rally is sustainable, which means you also have to wonder whether the consumption pick-up has got legs.

The stock market rally of recent months has been propelled largely by the torrent of liquidity that has flooded into Hong Kong's economy since central banks around the world embarked on a policy of quantitative easing. As the second chart below shows, the effect has been dramatic, with Hong Kong's monetary base more than doubling in size over the last year.

But quantitative easing isn't going to last forever. With the global economy stabilising, central banks are already talking about strategies to exit the policy. Just last week, Hong Kong Monetary Authority chief Joseph Yam Chi-kwong alerted investors to the possible impact of an end to quantitative easing, warning 'whether the rapid rise in... the prices of financial assets is sustainable is a matter of conjecture'.

The danger for Hong Kong over the coming months is that a withdrawal of global liquidity will leave the stock and property markets looking over-inflated, triggering a decline in prices. That would hit local consumers with a negative wealth effect, which would prompt them to rein in their spending.

With little else supporting the nascent rebound in economic activity, overall growth could well falter just as it appears to be regaining its stride.

That wouldn't necessarily mean a plunge back into recession. But it does mean it is way too early to celebrate Hong Kong's economic recovery.