The fallout from the SARS¹ epidemic of 2003 has fueled the debate over the causes of Hong Kong's long-term economic problems. While one popular view largely blames low-cost competition from China, our new study finds that the roots of the city's ills lie at home, as do the potential remedies.

SARS certainly further weakened Hong Kong's economy, reducing GDP growth in 2003 by an estimated 1.4 percent as consumer spending and tourism declined. But the economy had been battered already. Since 1998, property prices in Hong Kong have fallen by more than 70 percent, and in 2003 unemployment jumped to more than 8 percent, from 2 percent before the SARS outbreak.

Such grim statistics, many fear, mean that Hong Kong's position as the leading intermediary for trade and investment between China and the rest of the world is being undermined by China's emerging metropolitan areas, particularly Shanghai. The prevalent view seems to be that Hong Kong's high-cost operating environment is driving economic activity away and unemployment up and that this trend will continue until prices fall into line with those in China. Our study, however, found evidence to the contrary.

Is Hong Kong's recent unemployment a result of a shifting of work to China? The city once did have many thousands of low-skill manufacturing jobs, but it had lost most of them to China and other countries with low-cost labor by the mid-1990s. An expanding service sector, however, generated enough jobs in construction and property development to keep the unemployment rate at about 2 percent until 1998. Estimates by the International Monetary Fund, as well as our own calculations, show that 60 percent of the unemployment before the SARS epidemic was caused by structural shifts—most recently, the fact that companies are moving their call centers, data-processing facilities, and other low-end activities abroad. The remaining 40 percent was cyclical, which suggests that the lion's share of jobs will likely return when macroeconomic conditions improve (Exhibit 1).

Hong Kong's economy continues to create jobs, particularly in logistics, but so far that hasn't been enough to compensate for the jobs lost through structural change and the economic slowdown or to counteract the workforce growth caused by the arrival of 150 legal migrants from China each day. Like New York City and London, Hong Kong has become too expensive for many back-office services, which will continue to migrate offshore. Globally, the offshoring phenomenon has more to do with India, where the outsourcing market for business-process services is projected to rise to $16 billion by 2005, than with China, where it is estimated at $4 billion (see Vivek Agrawal, Diana Farrell, and Jaana K. Remes, "Offshoring and beyond," The McKinsey Quarterly, 2003 Number 4 Global directions, pp. 24–35, and Vivek Agrawal and Diana Farrell, "Who wins in offshoring," The McKinsey Quarterly, 2003 Number 4 Global directions, pp. 36–41). We believe that in Hong Kong the areas most likely to be further affected by this trend are corporate centers, banking, and telecommunications (Exhibit 2).

Moreover, the facts regarding Hong Kong's intermediary role are not as bad as much of the press coverage suggests. Hong Kong's overall trade volume,² for example, increased by 7 percent from 1995 to 2001 while the contribution of net exports (exports minus imports) to GDP actually rose to 26 percent, from 24 percent. And although the offshore flows of Chinese goods through Hong Kong to North America and Europe declined by 10 percent from 1998 to 2001 as companies on the mainland began to use other Chinese ports, trade flows to China by way of Hong Kong increased by 12 percent.

Another sign of the strength of Hong Kong's intermediary role in the region is the continuing willingness of multinational companies to maintain a presence in the city. Although some of the companies have moved to Shanghai to benefit from its rents, which are 50 percent lower than Hong Kong's, and its wages, which are 60 percent lower, the number of multinationals that have regional headquarters in Hong Kong actually rose by 11 percent from 2001 to 2003. The executives and business leaders polled in our study cited low and simple taxes, political stability, and the free flow of information as reasons to keep their businesses in Hong Kong.

For the future, Hong Kong must focus on high-value activities rather than on trying to bring its costs into line with those in China. A competitive advantage based on low costs is now unrealistic: in 2002, Hong Kong's GDP per employed person was $50,000, compared with $44,000 in Singapore and $10,000 in Shanghai. In the apparel industry, for instance, 75 to 90 percent of all design activities depend on skills higher than those needed to manufacture clothing (Exhibit 3). To succeed, Hong Kong must leverage its distinctiveness in legal services, financial services, and trade infrastructure as well as develop essential skills by improving its education and retraining programs. Our study noted, for example, that only 19 percent of Hong Kong's adults are college graduates, compared with an average of 32 percent of all adults in the reference cities (London, New York, Shanghai, and Singapore).

Whatever sector Hong Kong chooses to focus on—entertainment, fashion, financial services, logistics, tourism—closer economic cooperation and physical integration with China are inevitable. But the success of China's large cities is not incompatible with the continued success of Hong Kong. If it can attract higher-value activities associated with China's development—as it does in financial and trade services—it can only benefit from the country's boom. Hong Kong should recognize that its economic troubles result not from the growth of its next-door neighbor but from structural changes in its own and the global economy. It holds the keys to solving those problems itself.