Two schools of thought suggest changes to the economy if it is to keep pace with the rest of China Corporations plotting their Greater China strategy would do well to pay close attention to the debate over the cause of Hong Kong's economic woes. On one side are structuralists who believe Hong Kong is confronting a series of challenges to its role in Asia and must reinvent itself in order to survive. On the other side are those who view Hong Kong's problems as part of a slumping global business cycle that has taken its toll on the United States and other countries that are important drivers of Hong Kong's profits. Although most analysts see Hong Kong as suffering from both factors, the structuralist view tends to predominate. For corporate chieftains devising a regional growth plan, the issue is significant. A structural shift suggests Hong Kong is likely to become a bit player - or just 'another Chinese city' in the words of China scholar Michael Yahuda at the London School of Economics. If, on the other hand, the downturn is mainly cyclical, Hong Kong can sit tight and ride the rebound. The view on the debate could influence a choice of, say, Shanghai over Hong Kong for a Greater China headquarters. A new report from consultancy McKinsey & Co attempts to break down Hong Kong's unemployment rate according to systemic or cyclical factors. Of the city's 228,000 unemployed at the end of last year, the firm estimates that 137,000 - or 60 per cent - are 'structurally' unemployed, while the remaining 91,000 are victims of the business cycle. The structural losses stem from three factors: loss of 60,000 jobs overseas (mainly to Southeast Asia and to a lesser extent China); efficiencies in back-office operations; and the migration of Hong Kong's manufacturing industry, a process that began in the 1980s. Cyclical job losses include consolidation in the banking industry, such as the creation of Bank of China (Hong Kong) Holdings from a number of local banks. Surprisingly, McKinsey said China had 'piggy backed' on Hong Kong's outsourcing trend but has not been its cause - a view contrary to the popular perception that China is to blame for most job losses. 'There's a structural shift that reflects the maturing of the economy,' McKinsey consultant Emmanuel Pitsilis said. 'As with other mature economies, Hong Kong needs to focus on increasing value-added goods rather than cost competition against China.' The case for a fundamental change in Hong Kong's place in the global economy is made by Citibank economist Joe Lo. Clearly, Hong Kong is no longer a manufacturing centre; manufacturing's share of GDP has fallen to 5.1 per cent in 2001 from almost 24 per cent in 1980. The service sector's share jumped to 86.5 per cent from 67.3 per cent over the same period. Hong Kong's middleman status vis-a-vis China has also declined. As recently as 1993, Hong Kong firms accounted for two-thirds of China's exports - a figure now down to one-third. Similarly, for foreign direct investment, Hong Kong's share collapsing to one-third from two-thirds. Multinationals continue to set up headquarters in Hong Kong but their growth has slowed. The number of head offices nearly doubled from 588 in 1992 to 903 in 1997. Since then they have crept up to 948. But the decline in expatriates suggests multinationals in Hong Kong are employing fewer people. (Excluding the British and domestic helpers, the expat population has fallen by nearly half to 90,106 from 174,242 in 1997). Property is a significant contributor to Hong Kong's slump. Most analysts say the bursting of the property bubble in 1997 is a long-term structural problem. It usually takes 10 years to absorb a bubble of this size, notes Morgan Stanley economist Andy Xie. Mr Xie adds that property is but one source of Hong Kong's problems. More important is Hong Kong's relationship to China. 'Hong Kong had a window with China where it was able to collect a toll on trade,' he said. 'That window is gone. There is now tremendous pressure to cut costs.' To be sure, cyclical forces have battered Hong Kong's economy. The Asian financial crisis, the economic recession and Sars are cyclical, notes Goldman Sachs managing director Fred Hu. These factors have contributed to deflation, which has crippled corporate control over prices and thus profits. But Mr Hu said structural rigidities in Hong Kong's financial system make it difficult for the government to fight back. The fixed exchange rate prevents the government from stimulating the economy through an expansion of the money supply. And the budget deficit - which some analysts partly blame on the narrow tax base - prevents Keynesian fiscal stimulus. So what can Hong Kong do? McKinsey has three suggestions. First, select sectors where the city can compete and not try to be all things to all people; second, attract top talent; and third, make Hong Kong a 'world-class city' with improved environment, culture and education sufficient to encourage innovation and retain sophisticated executives. Better education is cited by many observers as a key to retaining Hong Kong's place as a centre for multinational headquarters in Asia. Only 13 per cent of Hong Kong's adults have a university education - too few to support a thriving high-tech economy Mr Lo at Citibank says Hong Kong has clear advantages in just two areas: air transportation and finance. Supporting these sectors is Hong Kong's pool of professionals, well developed regulations and large investor base. 'These advantages could vanish if other Chinese cities continue to narrow their gap with Hong Kong,' Mr Lo cautioned in a report.