What Hong Kong must do to prepare for years of weaker growth in mainland China

At the start of this year, the conventional wisdom among analysts studying China was that the economy would come roaring back to life and easily beat the government's modest growth forecast. The US economy, meanwhile, was tipped to face a recession amid repeated interest-rate increases to bring down inflation that was running at close to 40-year highs.

The reality has turned out to be quite the opposite. 2023 will be remembered as the year that the Chinese economy struggled to deal with falling prices and wages - reflecting weak domestic demand - as firms and households cut spending to pay debts, and amid continued declines in the prices of property and other financial assets.

While China's economy is likely to meet the government's growth forecast for 2023 of 5 per cent, this hardly constitutes a strong recovery as the economy grew at just 3 per cent last year. The country's significantly lower interest rates have also led to capital flight, putting pressure on the renminbi, which has depreciated by around 5 per cent against the US dollar since the start of the year.

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By contrast, the US economy has surprised on the upside. Not only did third-quarter growth come in at a sizzling 4.9 per cent (which, coincidentally, was also how much the Chinese economy grew in the same period), but inflation fell to 3.2 per cent in October - raising expectations that the cycle of interest rate hikes was over.

The point of highlighting the US and China's contrasting economic fortunes this year is not to argue that they represent a longer-term trend. Rather, it is to suggest that the conventional view of China's economy as an unstoppable juggernaut - that would, inevitably, become the largest in the world by 2035 - could well be wrong.

If so, it is incumbent on the Hong Kong government to prepare for the possibility that the Chinese economy does not grow at the projected 5-6 per cent over the next decade or so, but at a more realistic rate of, say, 3 per cent.

The longer-term implications for Hong Kong of mainland China's slower growth are profound. A failure to anticipate and prepare for this scenario would mean that Hong Kong sleepwalks into stagnation, or worse, lurches from one crisis to another - not unlike how the city's authorities failed to anticipate and prepare for the likelihood of Covid becoming endemic.

A China that grows at an average of 3 per cent for the next 12 years would be very different from one that grows at 5-6 per cent. For starters, instead of doubling, the economy would only be 40 per cent larger by 2035. And though China as a whole would (barely) escape the middle-income trap, significant parts of the country would resemble middle-income economies like Malaysia or Thailand, rather than high-income economies such as South Korea.

The crucial question for Hong Kong's economic policymakers is whether this year's slowdown on the mainland is just a cyclical blip - requiring no significant changes to the city's growth model - or it represents a longer-term shift that necessitates profound changes to economic policies to avoid stagnation. Already, mainland China's weak post-Covid rebound has meant that Hong Kong's growth this year will barely top 3 per cent; this coming after a 3.5 per cent fall in output in 2022 thanks to the city's disastrous handling of the pandemic.

The first, and most obvious, implication of mainland China's slower growth is that the Hong Kong economy has to become a lot more diversified. The days of relying on an abundance of capital, talent and tourists from the mainland are over.

Responding to weaker Chinese growth would also require capabilities in government that have been significantly eroded over the years. While the Hong Kong government's efforts at re-industrialisation are laudable, the resources set aside for this are hardly adequate considering the scale of the problem - not least because the city has experienced deindustrialisation for nearly 40 years.

Worse, not only is Hong Kong too expensive for most parts of the manufacturing value-chain, but not having done this before, its government lacks the capacity or know-how to undertake industrial policy intelligently. By contrast, regional competitors such as South Korea, Singapore - and of course many provincial governments in the mainland - have been pursuing industrial policies for decades now.

The global context is also hardly conducive for re-industrialisation. Not only might US-China decoupling complicate the city's efforts to attract Western multinationals to set up headquarters, but foreign direct investment has also stagnated since the global financial crisis 15 years ago.

All this isn't to say that Hong Kong shouldn't try to re-industrialise; the city clearly needs more real engineering and less financial engineering. Rather, the point is that re-industrialisation is challenging and that relative to the scale of the challenge, the capacity of the Hong Kong government needs an overhaul.

A second example of how the Hong Kong government's good intentions do not always translate into sound policies is the effort to develop stronger economic links with Southeast Asia and the Middle East.

As multinationals (and some large Chinese firms) contemplate a China+1 strategy, Southeast Asia and India are the most likely contenders to be the plus-one. That Hong Kong should reposition itself from just being a gateway and super-connector to mainland China to also being a gateway to Southeast Asia is obviously a good idea. The problem is one of execution.

Ever since the 1997 Asian financial crisis, the Hong Kong economy has become increasingly integrated with, and dependent on, the mainland's. This is the result of "natural" economic gravity. It does not require deliberate planning or a capable government for the city to be the gateway to China. But deepening linkages with Southeast Asia - and more so, the Middle East - requires an active government with a far more international outlook.

To begin with, there is hardly any deep expertise on these regions in either Hong Kong's public or private sectors. Neither has government policy promoted these regions as being essential to the city's future. Whereas Hong Kong's focus on integrating with the Chinese economy over the last three decades did not really hurt, its failure to develop links and expertise on regions other than Greater China is now a serious handicap.

Finally, it is becoming quite obvious that although Hong Kong has prospered through market-friendly, pro-business policies and practices, its economic future is going to require a more active and adaptive government. Not only is this necessary for re-industrialisation and developing stronger linkages with other regions, but also for dealing with the effects of climate change, future epidemics, and in navigating geopolitical contests and the risks of decoupling.

Recent evidence - not least the authorities' refusal to have an independent inquiry into the city's handling of Covid - suggests that this government lacks the capacity to learn.

There also seems to be an instinctive aversion to being more activist. When the Heritage Foundation, a conservative, right-wing think tank in the US dropped Hong Kong from its Economic Freedom Index two years ago, the city's government bristled at the decision. Financial Secretary Paul Chan Mo-po criticised it as being motivated by "ideological inclination and political bias". More recently, when Hong Kong dropped to number two in the Fraser Institute's annual Economic Freedom of the World report, the city's government issued a strongly worded response.

It is rather surprising that government leaders here would care so much about rankings based on an outdated ideology worshipping free, unfettered markets. At a time when governments of most advanced economies are de-risking and pursuing industrial policies to bolster their resilience, the priority of the Hong Kong government must be to strengthen its capacity, diversify and internationalise the economy, and lead efforts to adapt to slower growth on the mainland.

Donald Low is senior lecturer and professor of practice in public policy, and the director of the Institute for Emerging Market Studies, at the Hong Kong University of Science and Technology.

This article originally appeared on the South China Morning Post (SCMP).

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