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Can Hong Kong Rekindle the Fire?

The city has defied the odds by adapting—and thriving. Now, it faces its biggest challenge yet, as an aging population and growing competition threaten growth.

In its evolution from sleepy fishing village to British-ruled port to mainland China gateway, Hong Kong's future has always been shrouded in uncertainty.

Ever attuned to the shifting tides of regional politics, East-meets-West culture, and global business, this resilient city has defied predictions of its decline by adapting—and thriving. Its business-friendly ethos, strong infrastructure, regulatory transparency, low taxes, and a savvy, urbane population of can-do entrepreneurs has become a model of success throughout Asia and beyond.

Now the city is facing its biggest challenge, as an aging population and growing competition threaten its growth and relevance as a regional and global financial hub. Moreover, Hong Kong's looming demographic and strategic struggles reflect similar issues ahead for many of Asia's economies, including Japan, Singapore, South Korea, Taiwan and, eventually, China itself. How Hong Kong copes with these challenges may become a blueprint—or a cautionary tale—for others.

Three Growth Scenarios

“The very successes that Hong Kong has experienced in the past have also prompted considerable debate about its future growth path and whether Hong Kong will be able to remain the regional business and financial hub," says Derrick Kam, Hong Kong Economist at Morgan Stanley and lead author of the report, "Hong Kong 2020: Sprinting Ahead, Sustaining Growth, or Sharing the Stage?"

The report examines the city's history of development and change, and lays out three possible scenarios for economic growth over the next five years:

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To be sure, even in the best-case scenario, annual growth will have slowed from an average 3.9% over the past decade.

Graying Population

Hong Kong is a veteran of change. When its manufacturing sector was squeezed by cheaper competitors in the 1980s, it transformed itself into a service and financial hub for Asia in general, and China in particular. Amid various regional political and financial crises, Hong Kong has kept calm and offered safe harbor: clean and efficient bureaucracy, a transparent legal system, and an educated competitive workforce. As of 2013, its services sector made up 93% of GDP.

Yet, its service-centric approach may also be its Achilles heel. Hong Kong's working population, which has averaged 0.9% annual growth over the past decade, is set to flatline in 2015, then begin declining in 2017, according to Census and Statistics Department projections. Concurrently, the number of retirees will rise. By 2020, the ratio of nonworking to working population is expected hit 42%, up from today's 35%.

Fewer young workers translate into a tighter labor market, higher wages and less competitiveness. Companies that have made Hong Kong their Asia headquarters won't flee overnight, but they could start looking elsewhere. The city government is mulling various ways to counter this, including raising the retirement age (60 years old for civil servants, setting the bar relatively low), improving the quality of its talent pool, and attracting outside talent.

The problem is that other Asian markets are also aging and facing similar demographic trajectories, intensifying overall competition for a shrinking pool of talent.

Competition in Pillar Sectors

The competition is always nipping at its heels. In recent years, Hong Kong has further consolidated its growth engines in a few “pillar" sectors: financial services, tourism, trading and logistics, and professional services, which together account for 57.9% of GDP. These are also the sectors facing the strongest headwinds.

TRACKING HONG KONG'S ECONOMIC STRUCTURE

Source: *CEIC, Morgan Stanley Research, as of 2013; Morgan Stanley Research Estimates. Note: Other sectors include construction, accommodation & food services, information & communications, electricity, gas, water supply, and waste management, manufacturing, and agriculture, fishing, mining & quarrying.

For example, Singapore, a perennial rival, has seen a sharp uptick in its share of the financial services market; Seoul also has been climbing the ranks in these same sectors.

Hong Kong's biggest challengers, however, are in mainland China. Shanghai in particular is casting a longer shadow, as China continues to liberalize its capital and currency markets and open up trade.

Case in point: Hong Kong's container port was the busiest in the world in 2004, before losing its lead to Singapore in 2005, then slipping to No. 3 behind Shanghai. In 2013, it fell further, as Shenzhen, across the mainland border, took over as the world's third busiest port.

Reinventing the Future

Tourism has also suffered recently. Last year's pro-democracy demonstrations put a dent in visitor numbers and retail sales, some 40% of which comes from tourists. Both visitor growth and per capital spending by tourists declined in 2014. The protests are over, but tourism and retail may still be hurting. Meanwhile, the stronger US dollar, to which Hong Kong has pegged its currency, has made South Korea, Japan and Europe more attractive to bargain-hunting mainland Chinese tourists.

To reduce reliance on these sectors, Hong Kong's government is targeting a handful of emerging sectors for development. These include cultural and creative industries, medical services, environmental industries, education, and innovation and technology.

It may take a while.

Meanwhile, none of its rivals should get complacent. The aging demographic is endemic in most of Asia, an artifact of the post-WWII baby boom and the now well-documented drop in fertility rates for most industrialized, urban societies. It will not be long before Hong Kong's rivals face similar challenges. By then, Hong Kong may have already transformed itself into yet another model of economic and cultural survival.

For more Morgan Stanley Research on the future of Hong Kong, ask your Morgan Stanley representative or a Financial Advisor for the full report, “Hong Kong 2020: Sprinting Ahead, Sustaining Growth, or Sharing the Stage?" (Mar 10, 2015), and more continuing coverage.

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