Cross-border deflation myth must be laid to rest
Urban myths can amuse, horrify or confirm our worst fears. They are especially credible when articulated by apparently reliable sources. Hong Kong's great deflation offers a case in point, with government officials having consistently argued that more than four years of falling prices result from our integration with the low-cost mainland economy. The idea of so-called factor price equalisation has an hypnotic plausibility and has been enthusiastically embraced as a catch-all explanation for Hong Kong's economic woes by Chief Executive Tung Chee-hwa and Financial Secretary Antony Leung Kam-chung.
Like all good urban myths, this theory has an appealing simplicity and tells lots of people what they want to hear. Politicians, in particular, like the idea of falling prices being the inevitable result of some crushing economic re-alignment, since it absolves them of responsibility while providing an excuse to avoid doing something about it. Unfortunately, making policy on the basis of counter-factual speculation has never been a recipe for success and the International Monetary Fund (IMF) study into the causes of Hong Kong's deflation provides a reality check.
The IMF has previously argued that Hong Kong's deflation was the result of painful cyclical downturn rather than a major structural change. Yesterday it released a detailed study based on painstaking number-crunching. It found that only 2 per cent of general price falls in Hong Kong since 1998 was explained by the effect of cross-border shopping and home purchases. Instead it said Shenzhen was experiencing inflation as a result of its integration with Hong Kong.
The findings are of more than academic significance since Hong Kong's policy responses have been heavily influenced by the price equalisation theory. Failed housing policies and an ill-conceived lurch towards state-sponsored technology development were rooted in a belief that government action was needed to correct market failures resulting from Hong Kong being too expensive.
The IMF offers a simpler analysis. Hong Kong indeed suffered a property market bubble and its bust has destroyed household and corporate wealth, hitting household consumption and investment by small firms which rely on property holdings as collateral for loans.
Such an analysis does not mean Hong Kong can expect a quick bounce back once the Sars crisis stabilises. As an open economy, heavily dependent on trade, we are at the mercy of external forces. However, when leaders argue that prices are being inevitably driven towards mainland levels, it is not surprising that people defer consumption and save excessively. Before any of them again offer such pronouncements we would hope they read the IMF report. Urban myths are not easily killed, but this one has run its course.