Ryan Lam, CFA

Senior Economist

ryancwlam@hangseng.com

January 2015

• While lower crude prices may provide a

welcome tailwind for economic growth, our

analysis suggests it is unlikely to be a game

changer for the Hong Kong economy. We

estimate that, all other things being equal, the

USD50 decline in oil prices over the past six

months will boost the city’s GDP growth by

about 0.2 percentage points over 2015.

• Hong Kong domestic households are estimated

to have spent HKD52.7 billion on oil-related

products last year, implying that lower energy

prices have resulted in a hefty windfall for

households.

• But there are more important yet often ignored

factors to consider when assessing the impact

of oil prices on growth. First, electricity in Hong

Kong is mainly generated from coal. Second,

the pass-through of changes in crude oil prices

to retail fuel prices is generally less than

perfect. Finally, consumers may save some or

all of the windfall rather than spend it.

• After taking necessary adjustments and second-

round confidence effects into consideration, our

view is that the sharp decline in oil prices will

boost GDP by about 0.2% via expanding

domestic demand.

• Our analysis suggests that the Hong Kong

economy will receive minor support from the

trade channel since the city’s export markets

are diversified to oil exporters, which are

suffering terms-of-trade losses.

• The dip in global crude oil prices that has

occurred over recent months, by itself, would

reduce 2015 full-year inflation by a percentage

point. We continue to expect headline inflation

to ease notably this year, declining from an

estimated 4.4% in 2014 to 3.5% in 2015.

Sliding Oil Prices andIts Implications

2January 2015

Living with cheaper oil

Policymakers in many Asian countries may be feeling a sense of relief over the

current downtrend in crude oil product prices. Falls in the oil price on the scale

experienced over the past six months are rare. From a high point in June last

year, the price of both West Texas Intermediate (WTI) and Brent crude oil

plunged more than 50%. Crude oil is currently trading at around USD50 per

barrel, a level not seen since 2009 in the aftermath of the global financial crisis

(Exhibit 1).

Source: Markit, HSBC, Hang Seng Bank

Exhibit 2: Purchasing Managers’ Indices(Quarterly average)

Source: CEIC, Hang Seng Bank

Exhibit 1: Crude Oil Price (USD per barrel)

However, unlike previous episodes of oil price weakness, which were generally

associated with adverse demand conditions, the primary catalyst for the current

sell-off has been developments on the supply side. There is no doubt that global

growth remained lacklustre in 2014, but the world’s economy appeared to be

stabilising in the second half of the year (Exhibit 2). Crude oil prices peaked in

mid-June 2014, a week after ISIS militants captured Mosul and were threatening

key Iraqi oil infrastructure. The decline gained speed after OPEC, which has

historically cut production to arrest sliding prices, chose to maintain its quota level

in November. This decision signals a continuation of a supply-demand imbalance

into 2015 and possibly beyond. So, if we are facing a supply-side shock that

would send oil prices down further than is warranted by a mild global slowdown,

what are the potential implications for the Hong Kong economy?

3January 2015

How concerned should we be?

The traditional rule of thumb for assessing the impact of crude oil shocks is that

for each 10% decline in oil prices, growth increases by 0.1 to 0.2 percentage

points. However, these estimates are largely the result of model-based

simulations and should be treated with caution. One limitation of these model

simulations is that they heavily rely on historical average elasticity. In practice,

the economic factors involved vary considerably over time. With reduced oil

intensity and improved energy efficiency, the evidence supporting an adverse

shock on oil supply today is less compelling than in the past.

We believe the decline in commodity prices is unlikely to be a game changer for

the Hong Kong economy. Though lower crude oil prices would provide a

welcome tailwind for growth, our analysis suggests its impact on the Hong Kong

economy should not be overestimated. The USD50 decline in oil prices

experienced over the past six months will boost the city’s GDP growth by about

0.2 percentage points, according to our estimates. As we explain below, the

positive effect on consumer spending probably represents the most important

boost to the economy from lower energy prices. Its estimated effect on exports,

on a net basis, is supportive but negligible.

Consumers to enjoy disposable income windfall

An oil price shock affects macroeconomic performance via various channels. For

domestic demand, we see the correction in oil prices as having two main effects:

1) a positive effect on private consumption, and 2) an adverse impact on oil-

related investment. Given Hong Kong’s relative scarcity of economically

significant natural resources, oil-related capital outlays are of almost negligible

importance for the economy. Our primary area of interest, therefore, is the likely

impact on private consumption.

The best available proxy for consumer spending on oil-related products is

household expenditure on fuel and transport. According to the latest Household

Expenditure Survey, Hong Kong households spent HKD44.7 billion on oil-related

products including electricity and transport in 2009/10. Although no information is

4January 2015

Source: World Bank, Environmental Protection Department ofHKSAR, Hang Seng Bank

Exhibit 4: Electricity Production(by source, % of total electricity production)

Source: Census & Statistics Department of HKSAR, Hang Seng

Bank

Exhibit 3: Annual Household Expenditure(HKD million)

Xxxxxx

available from 2010 onwards, we have used sub-component CPI indices to

extrapolate oil-related spending through to 2014. The results are shown in Exhibit

3. Consumer spending on oil-related products is estimated to have reached

HKD52.7 billion in 2014. A simple calculation suggests the recent decline in oil

prices will provide a windfall of roughly HKD27 billion in discretionary income for

Hong Kong households. Taken alone, this windfall should contribute 1.2

percentage points to GDP growth.

Three crucial caveats need to be kept in mind with regard to this simple

framework, however. This estimation is likely to overstate the impact on

economic growth since 1) electricity generated in Hong Kong comes mainly from

coal (Exhibit 4), 2) the pass-through of changes in crude oil prices to retail fuel

prices is generally less than perfect, and 3) consumers may save some or all of

the windfall rather than spend it.

Given these realities, it is necessary to consider some factors that are ignored by

the above estimation. We have made the following adjustments in our analysis:

• A reduction of the impact on household expenditure related to electricity

usage, reflecting the fact that only 0.3% of electricity consumed in Hong Kong

is generated from oil sources.

5January 2015

Exhibit 5: Positive Impacts on Private Consumption

Adjusted household expenditure for oil-related products HKD42.3 billion

Change in oil prices -50%

Pass-through to retail fuel prices 30%

Short-run propensity to consume out of income 55%

Estimated impact on consumption↑HKD3.5 billion

(0.16% of GDP)

Source: Census & Statistics Department of HKSAR, Hang Seng Bank

Xxxxx

• We estimated the elasticity between Brent oil prices and domestic retail fuel

prices by conducting regression analysis. Based on our analysis and with all

other things remaining constant, a 1% drop in Brent oil prices depresses retail

fuel prices by 0.3%.

• Our consumption model presumes that about 55% of the windfall income will

be spent over the next four quarters.

We estimate the decline in oil prices that has occurred in recent months should

directly boost private consumption about HKD3.5 billion. However, there is one

other important point to take into consideration. A 2014 study by the IMF1 reveals

that the second-round confidence effects could be as large as the direct effect.

Using our in-house general equilibrium model, we estimated the impact of the

confidence effects by increasing long-term income growth by 0.15 percentage

points. After allowing for second-round effects, the fall in oil prices should boost

Hong Kong’s GDP growth by around 0.2 percentage points.

Negligible impact on exports

Another important transmission channel could be the impact on external trade. In

principle, a drop in the oil price should have little effect on the global economy. If

the same volume of oil is being produced and consumed, reduced oil prices

simply reflect a transfer of income from oil producers to oil consumers. It benefits

oil importers at the expense of oil exporters through the terms of trade effects on

1 Legacies, Clouds, Uncertainties, IMF World Economic Outlook, October 2014

6January 2015

Source: United Nations, Hang Seng Bank

Exhibit 7: Growth Impacts from Lower Oil Prices(% of GDP)

Source: United Nations, Hang Seng Bank

Exhibit 6: External Oil Balance (% of GDP)

2Standard Shocks in the OECD Interlink Model, OECD Economics Department Working Papers No. 306, September 2001

real incomes, but has negligible implications for global output. In reality, it is not

necessarily a zero-sum game. Oil-exporting countries tend to save a larger

proportion of their income than oil-importing countries. One of the implications of

this is that a transfer of income from oil producers to oil consumers should lead to

higher global demand.

Hong Kong is a net importer of oil. However, given that its exports head to a

broad sweep of countries – including both oil exporters and oil importers (Exhibit

6) – the impact of oil shocks are not unambiguously positive for the city. In fact,

lower oil prices are potentially a double-edged sword for international trading hubs

like Hong Kong. Typical macro models, however, fail to capture the

idiosyncracies of individual trading partners. We have chosen to approach this

issue by assuming that oil demand from our trading partners is unresponsive to

lower oil prices in the short run. As such, the change in the external oil balance in

percent of GDP is equal to the growth impact.

For most of these countries, if oil prices remain at USD50 per barrel through

2015, growth rates will deviate -0.5 to 0.5 percentage points from the baseline

(Exhibit 7). These estimates are comparable to the simulation result generated

by the OECD’s Interlink Model2. We also calculated the aggregate impact on

Hong Kong export growth, in which contribution from each economy is weighted

according to its share of Hong Kong’s total exports.

7January 2015

On a trade-weighted basis, our estimate indicates that the Hong Kong economy

should receive a minor boost from the trade channel – a rise in GDP growth of

just less than 0.1 percentage point. One explanation for this is that the city’s

export markets are diversified to oil exporters as well. Another reason is that the

US ‘shale revolution’, which has greatly reduced its demand for imported oil, has

altered its GDP sensitivity to global oil price swings. All in all, we believe the

continued weakness in oil prices is not likely to provide a significant cushion to the

external trade.

Disinflationary pressure is building up

While the growth effect will still take time to play out, the sudden slide in oil prices

has already begun cutting into inflation rates in much of the world. Looking

individually at the components of the CPI, oil-related products account for 7.6% of

Hong Kong’s CPI basket (Exhibit 8). The key swing factor will be to what extent

oil price variation is passed through to consumers versus refiners and retail

market operators absorbing crude oil price changes into their profit margins.

Source: Census & Statistics Department of HKSAR,Hang Seng Bank

Exhibit 9: Price of Oil-related Products(% year on year)

Source: Census & Statistics Department of HKSAR, Hang Seng

Bank

Exhibit 8: CPI Weights of Oil-related Products (%)

With a diverse set of pricing mechanisms, a distinction must be made between

the relative sensitivity of different oil-related products within the CPI basket.

Prices of towngas, LPG and motor fuels are highly sensitive to oil price

movement, but public transport fares are far less sensitive (Exhibit 9).

8January 2015

Drawing lessons from the sharp sell-off in commodities during 2009, we have

assumed a 40% transmission in international oil price movements to Hong Kong’s

towngas, LPG and motor fuel prices, a 10% transmission to electricity tariffs, and

a 5% transmission to public transport fares. Under this setting, the dip in global

crude oil prices that has occurred over recent months would, by itself, reduce

2015 full-year inflation by a percentage point. Since the current weakness in

crude oil products was already factored into our baseline projections, we see no

need to revise our inflation forecast. We continue to expect headline inflation to

ease notably this year, declining from an estimated 4.4% in 2014 to 3.5% in 2015.

9January 2015

Hong Kong Economic Monthly Statistics January 2015

Note: (F) ForecastSource: Census and Statistics Department of HKSAR, Hong Kong Monetary Authority , Rating and ValuationDepartment, Hong Kong Tourism Board, CEIC, Hang Seng Bank

Real growth

yoy (%)

2006 1,503 7.0 7.2 5.7 2,461 9.4 2,600 11.6 -138.8 4.8 2.0

2007 1,651 6.5 12.8 10.1 2,688 9.2 2,868 10.3 -180.5 4.0 2.0

2008 1,707 2.1 10.6 5.0 2,824 5.1 3,025 5.5 -201.1 3.5 4.3

2009 1,659 -2.5 0.6 -0.8 2,469 -12.6 2,692 -11.0 -223.3 5.2 0.5

2010 1,776 6.8 18.3 15.5 3,031 22.8 3,365 25.0 -333.8 4.3 2.4

2011 1,934 4.8 24.8 18.4 3,341 10.1 3,767 11.9 -426.4 3.4 5.3

2012 2,037 1.5 9.8 7.2 3,434 2.9 3,912 3.9 -477.8 3.3 4.1

2013 2,125 2.9 11.0 10.8 3,562 3.6 4,065 3.8 -502.9 3.3 4.3

2014F 2,227 2.1 1.0 1.0 3,704 4.0 4,248 4.5 -543.4 3.3 4.4

2015F 2,345 2.6 6.0 5.0 3,890 5.0 4,503 6.0 -613.1 3.5 3.5

Q1 2013 507 2.9 13.9 14.1 813 3.9 923 4.9 -110.6 3.5 3.7

Q2 491 3.0 16.1 15.0 859 2.4 996 3.5 -136.6 3.3 4.0

Q3 548 3.0 7.5 6.9 931 3.3 1,049 2.7 -118.7 3.3 5.3

Q4 580 2.9 6.8 7.0 960 4.8 1,097 4.4 -137.0 3.2 4.3

Q1 2014 531 2.6 4.2 4.0 818 0.7 942 2.1 -124.0 3.1 4.1

Q2 517 1.8 -7.0 -7.2 901 4.8 1,042 4.6 -140.7 3.2 3.7

Q3 576 2.7 1.6 1.6 985 5.9 1,109 5.7 -124.0 3.3 4.8

Jan 2013 N/A N/A 10.5 10.4 305 17.6 332 23.9 -27.5 3.4 3.0

Feb N/A N/A 22.7 21.9 216 -16.9 250 -18.3 -34.0 3.4 4.4

Mar N/A N/A 9.8 10.1 292 11.2 341 11.3 -49.2 3.5 3.6

Apr N/A N/A 20.7 19.4 290 9.0 333 7.7 -42.7 3.5 4.0

May N/A N/A 12.9 12.2 292 -1.0 336 1.7 -44.3 3.4 3.9

Jun N/A N/A 14.7 13.3 278 -0.2 327 1.4 -49.7 3.3 4.1

Jul N/A N/A 9.3 8.7 305 10.6 343 8.3 -37.2 3.3 6.9

Aug N/A N/A 8.1 7.2 307 -1.3 347 -0.2 -39.6 3.3 4.5

Sep N/A N/A 5.0 4.9 318 1.5 360 0.4 -42.0 3.3 4.6

Oct N/A N/A 6.3 5.8 323 8.8 361 6.3 -38.1 3.3 4.3

Nov N/A N/A 8.5 9.1 326 5.8 370 5.2 -44.6 3.3 4.3

Dec N/A N/A 5.7 6.1 311 0.0 365 1.8 -54.4 3.2 4.3

Jan 2014 N/A N/A 14.4 16.7 303 -0.4 323 -2.7 -20.0 3.1 4.6

Feb N/A N/A -2.2 -2.2 213 -1.3 267 6.8 -53.7 3.1 3.9

Mar N/A N/A -1.5 -2.5 302 3.4 352 3.2 -50.4 3.1 3.9

Apr N/A N/A -9.9 -9.6 286 -1.6 341 2.4 -55.3 3.1 3.7

May N/A N/A -3.9 -4.6 306 4.9 348 3.7 -42.4 3.1 3.7

Jun N/A N/A -6.9 -7.5 309 11.4 352 7.6 -43.1 3.2 3.6

Jul N/A N/A -3.2 -4.6 326 6.8 368 7.5 -42.1 3.3 4.0

Aug N/A N/A 3.5 2.8 327 6.4 359 3.4 -31.5 3.3 3.9

Sep N/A N/A 4.8 6.6 332 4.5 382 6.3 -50.4 3.3 6.6

Oct N/A N/A 1.4 4.3 332 2.7 382 5.6 -49.8 3.3 5.2

Nov N/A N/A 4.1 7.5 327 0.4 379 2.4 -52.2 3.3 5.1

YTD 1,625 2.4 0.2 0.8 3,363 3.4 3,853 4.2 -490.8 3.3 4.4

HKD bn yoy (%) RMB bn yoy (%) HKD bn yoy (%) yoy (%) ytd (%) ytd (%) '000 yoy (%)

2006 4,757 17.0 23 3.6 2,468 6.7 15.5 4.1 15.0 25,251 8.1

2007 5,869 23.4 33 42.7 2,962 20.0 20.6 25.7 14.6 28,169 11.6

2008 6,060 3.2 56 67.8 3,284 10.9 2.6 -11.1 9.2 29,500 4.7

2009 6,381 5.3 63 11.9 3,289 0.1 5.2 28.5 -9.8 29,590 0.3

2010 6,862 7.5 315 402.2 4,227 28.6 8.0 21.0 12.5 36,030 21.8

2011 7,591 10.6 589 86.9 5,081 20.2 12.9 11.1 15.5 41,921 16.4

2012 8,297 9.3 603 2.5 5,569 9.6 11.0 25.7 7.7 48,615 16.0

2013 9,180 10.7 860 42.7 6,457 16.0 12.4 7.7 7.1 54,299 11.7

2014F 10,189 10.0 N/A N/A 7,168 11.0 12.5 0.0 0.0 61,358 13.0

2015F 11,364 11.0 N/A N/A 8,033 12.0 12.0 -4.0 -4.0 66,880 9.0Q1 2013 8,353 8.9 668 20.5 5,738 10.4 9.6 5.4 3.0 12,742 13.5

Q2 8,481 10.1 698 25.1 6,096 14.6 10.9 6.9 6.0 12,624 13.7Q3 8,906 12.2 730 33.8 6,399 18.1 13.4 7.9 7.5 14,499 11.1Q4 9,180 10.7 860 42.7 6,457 16.0 12.3 7.7 7.6 14,434 9.0

Q1 2014 9,189 10.0 945 41.4 6,826 19.0 12.1 -0.6 0.9 14,698 15.3Q2 9,612 13.3 926 32.7 7,074 16.0 15.0 2.1 2.1 13,831 9.6Q3 9,920 11.4 944 29.4 7,210 12.7 12.2 8.6 3.7 16,130 11.2

Jan 2013 8,535 11.2 624 8.3 5,685 11.1 12.4 2.2 0.4 4,633 11.9

Feb 8,436 9.0 651 15.1 5,671 10.1 9.7 5.4 1.7 4,022 19.3

Mar 8,353 8.9 668 20.5 5,736 10.4 9.6 5.4 3.0 4,087 10.2

Apr 8,475 9.4 677 22.6 5,804 10.7 10.3 5.2 4.5 4,280 11.5

May 8,577 12.8 698 26.1 5,903 12.3 13.4 5.8 4.9 4,142 13.8

Jun 8,481 10.1 698 25.1 6,096 14.6 10.9 6.9 6.0 4,201 16.0

Jul 8,607 10.8 695 23.4 6,181 15.1 11.6 7.7 6.7 4,832 10.6

Aug 8,652 10.3 709 28.5 6,263 16.9 11.3 8.2 8.0 5,358 9.4

Sep 8,906 12.2 730 33.8 6,399 18.1 13.4 7.9 7.5 4,309 13.9

Oct 8,973 10.9 782 40.9 6,406 17.8 12.4 7.8 7.1 4,632 9.1

Nov 9,065 11.2 827 44.8 6,460 17.7 12.6 7.6 7.7 4,580 8.6

Dec 9,180 10.7 860 42.7 6,457 16.0 12.3 7.7 7.6 5,222 9.3

Jan 2014 9,184 7.6 893 43.2 6,697 17.8 9.6 -0.2 -0.2 5,455 17.8

Feb 9,330 10.6 920 41.2 6,908 21.8 12.8 -0.3 0.4 4,417 9.8

Mar 9,189 10.0 945 41.4 6,826 19.0 12.1 -0.6 1.0 4,825 18.1

Apr 9,392 10.8 960 41.8 6,852 18.1 12.5 0.0 1.3 4,748 10.9

May 9,522 11.0 956 36.8 6,966 18.0 12.6 0.9 1.9 4,591 10.8

Jun 9,612 13.3 926 32.7 7,074 16.0 15.0 2.1 2.2 4,493 6.9

Jul 9,848 14.4 937 34.8 7,141 15.5 15.9 4.6 3.0 5,374 11.2

Aug 9,855 13.9 937 32.0 7,142 14.0 15.2 6.6 3.4 6,010 12.2

Sep 9,920 11.4 944 29.4 7,210 12.7 12.2 8.6 3.7 4,747 10.2

Oct 10,037 11.9 944 20.7 7,282 13.7 12.1 10.2 3.7 5,214 12.6

Nov 10,075 11.1 974 17.8 7,287 12.8 11.2 N/A N/A 5,300 15.7

YTD 10,075 11.1 974 17.8 7,287 12.8 11.2 10.2 3.7 55,172 12.4Note: (F) Forecast

Source: Census and Statistics Department of HKSAR, Hong Kong Monetary Authority , Rating and Valuation Department, Hong Kong Tourism Board, CEIC, Hang Seng Bank

Total DepositsOffice Rental

Index

GDP

Total Loans

Trade

balance

Money

supply(Total M3)

yoy (%) HKD bn

Consumer

prices

yoy (%)

Foreign TradeRetail

sales(volume)

% yoy (%)HKD bn HKD bn

Tourist Arrivals

Imports

RMB Deposits

Unemployment

rate (s.a.)

yoy (%)

Exports

Retail

sales(value)

Residential

PropertyPrice Index

yoy (%)HKD bn

Source: CEIC, Hang Seng Bank Source: CEIC, Hang Seng Bank

Source: CEIC, Hang Seng Bank Source: CEIC, Hang Seng Bank

Source: CEIC, Hang Seng Bank Source: CEIC, Hang Seng Bank

January 2015 10

Hong Kong CPI Inflation Hong Kong Property Prices(overall index, 1999 = 100)

Hong Kong Total Loans and DepositsHong Kong Exports Volume

Hong Kong Unemployment RateHong Kong Retail Sales Volume

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January 2015 11