Tian-Cho Chu, Wai-Chan Chan, Lareina Yee
August 20, 2003

For some time now, there has been much wringing of hands over Hong Kong's future. It is losing its pre-eminence as Asia's commercial and financial entrepot, say the doom and gloom merchants; local and foreign companies are moving en masse to the mainland, attracted by low labour costs; and unemployment is startlingly high, particularly among young, low-skilled citizens. Coupled with the economic havoc wrought by the Sars crisis, all this must signal that Hong Kong's days are numbered.

Some of these negative views are based on valid observations, others are merely speculation, and so have led to several myths. These distract from the real challenges and the areas where government policy and private-sector action could make a real difference in turning around the economy.

The first myth is that Hong Kong's role as an intermediary for trade and investment between China and the rest of the world is shrinking. The reality is that this privileged position is for us to lose. While this function has become less critical as a result of the opening of China's economy, there has been no wholesale loss of its role. So while exports flowing from Guangdong through Hong Kong to North America and Europe fell 10 per cent between 1995 and 2001, trade flows in the other direction rose by 12 per cent. And while some multinational companies have relocated to Shanghai over the past two years, the total number with regional headquarters in Hong Kong rose by 11 per cent in that period.

Related to the feared loss of its role as an intermediary is the belief that unemployment has been caused by jobs shifting to the mainland. But estimates by the International Monetary Fund and our own calculations show that 60 per cent of unemployment in Hong Kong is driven by structural shifts in the economy - most of which can be attributed to its development into a mature, service-based economy.

This economic transformation, consistent with that in other developed metropolises such as New York and London, has brought the offloading of an increasing number of jobs to low-cost economies, and improvements in business practices that have reduced the number of workers. While the job losses are worrying, these trends have little to do with China. The relocating of jobs to other economies has mainly benefited countries such as Malaysia or India, whose outsourcing market is projected to continue to dwarf China's.

The second myth that continues to circulate is that Hong Kong cannot compete because its costs are too high, and thus it should do whatever it can to reduce costs. But Hong Kong can never compete with China on costs - nor should it. Instead, we should compete on value - Hong Kong's true source of distinctiveness. One measure is labour productivity - on the basis of gross domestic product per employed person, Hong Kong stands at US$50,000. This figure is substantially higher than that of regional competitors and has been growing at 8 per cent a year since 1998.

Hong Kong's advantage is well recognised by businesses whose locally based operations tend to focus on providing higher-value products and services (for example, cash management or credit scoring in banks). Based on our analysis of the value contribution of different activities within the apparel and mortgage industries, 75-90 per cent have a higher skill orientation. Hong Kong should focus on and further develop these types of activities to maintain its competitiveness and further distinguish itself from lower-cost alternatives.

The third myth is that the current trends are irreversible. In reality, Hong Kong can change its economic course - the challenges it faces are not unique, nor are they insurmountable. The way forward is to start with a radical change in mindset. From trying to do many things, Hong Kong should shift to doing a few things very well. Instead of integrating with the mainland at any price, Hong Kong should move to integrate, while differentiating itself by creating high-value services. Instead of attracting money, Hong Kong should attract talent. Turning these aspirations into action is not an impossible task.

We suggest steps in three key areas. First, Hong Kong needs to develop deep rather than broad clusters of economic growth. This means selecting areas in which it can create a competitive advantage, and then building critical mass around them. Hong Kong has already defined at least five areas it would like to develop, including financial services, trade and logistics, tourism, creative industries and in the hi-tech sector.

However, these opportunities need to be more narrowly defined for businesses to capture the opportunities. In the fashion industry, for example, Hong Kong could become the preferred sourcing centre in Asia for international fashion by focusing on higher-value activities such as product development and quality control.

Second, Hong Kong needs to focus on attracting talent. Developing talent will be the real growth engine that drives new jobs and wealth. Other cities, like Singapore, have been much quicker to realise this and have launched aggressive programmes with this aim in mind.
Hong Kong's admission schemes to attract financial services and IT professionals from the mainland were only able to recruit 338 people last year. This is clearly a lost opportunity as, by the government's own account, the import of one additional mainland professional helps create 2.7 new jobs and HK$2.3 million in additional corporate revenue by the second year of residency.

Third, to attract the talent it needs, Hong Kong must become a world-class city, going beyond simply stating the aspiration. We compared Hong Kong to four other international cities: London, New York, Singapore and Shanghai, assessing each against 30 different economic and social indicators. Our analysis shows that Hong Kong needs to make significant improvements in education, the environment and the arts. In addition, Hong Kong should continue to shore up its lead in critical areas such as economic freedom, transport infrastructure, the legal system and its financial and capital markets.

Achieving all this entails setting measurable targets against key priorities, and launching focused programmes to achieve them. To improve the environment, for example, Hong Kong should commit to reducing roadside air pollutants to the same levels as Singapore. Since achieving this will require co-operation with Guangdong, why not take recently renewed efforts between the two regions further?

The economic events of the last few months should be recognised for what they are: a wake-up call to rebuild Hong Kong's competitive advantage. Success will require determined action by a committed and well-supported leadership. How the political relationship between the Chinese government and the Hong Kong administration plays out will undoubtedly have a big impact on the economic future of the special administrative region. But this political uncertainty does not justify an unfocused approach on Hong Kong's part. It is time to get the economy back on track.Chu Tian-cho and Chan Wai-chan are partners in, and Lareina Yee is a consultant at, McKinsey & Company's Hong Kong office.

Tian-Cho Chu and Wai-Chan Chan are partners and Lareina Yee is a consultant in McKinsey & Company's Hong Kong office.

This article was originally published in the South China Morning Post .