Looking Beyond the Retail Boom in Hong Kong

Ryan Lam Economist ryancwlam@hangseng.com Joanne Yim Chief Economist joanneyim@hangseng.com 19 August 2013 Looking Beyond the Retail Boom in Hong Kong Structure and performance of retail sector Riding on Asia s consumption boom, Hong Kong experienced rapid growth in retail sales. Between 2001 and 2012, retail sales value surged 141.6% in Hong Kong, growing nearly 8% per annum on average, twice the rate of overall nominal GDP growth. This rising tide has lifted all boats in the sector. The momentum was positive across a broad set of retail categories, with sales of higher-end products gaining particularly strong traction. Retailers have seen a secular rise of profit margins against this favourable backdrop. They are competing mostly by converting potential consumers to customers, rather than with one another. Roles of local consumers and inbound tourists Using tourists shopping expenditure as a proxy, we estimate the retail spending by visitors reached HKD158.1 billion in 2012, accounting for 35.5% of retail sales. That number also represents a more than sixfold increase since 2001. However, local residents remain the main source of demand for retail stores, reflecting rising income and wealth. Sales to local residents make up two-thirds of total retail sales even as the territory has experienced an exceptional growth in tourism receipts. Future prospect of the retail sector Hong Kong s tourism sector is still on the cusp of a high-growth phase. We expect the number of inbound travellers to rise 13% per annum for 2013-2017, bringing the total number of visitors to 90 million in 2017, from 48.6 million in 2012. Contribution to retail sales growth from local residents may diminish as income effects, the second key factor supporting growth, will however become less visible on the structural slowdown that Hong Kong is going through. While we believe Hong Kong s retail sector will manage to deliver stellar growth in the years ahead, the sector will see a transition from a period of spectacular growth to more sustainable expansion. By our estimates, annual retail sales would be running at around HKD806.6 billion by 2017, versus HKD445.5 billion in 2012.

Structure and performance of the retail sector Despite the latest pullback, the medium-term outlook for the Asian economy remains bright, mainly due to the consumption story. Analysts widely expect Asia s consumers to take the baton from their overextended counterparts in the advanced economies in coming decades. Riding on Asia s consumption boom, Hong Kong experienced rapid growth in retail sales. Between 2001 and 2012, retail sales value surged 141.6% in Hong Kong (Exhibit 1), growing nearly 8% per annum on average, twice the rate of overall nominal GDP growth. Even compared with other Asian industrialised economies, Hong Kong was a standout performer (Exhibit 2). This was followed by Taiwan and Singapore, which recorded retail sales growth rates of 55.0% and 44.7% respectively over the same period. Exhibit 1: Hong Kong Retail Sales Value and Volume (rebased to 2001 = 100) Exhibit 2: Retail Sales Value (rebased to 2001 = 100) 250 250 230 230 210 210 190 190 170 170 150 150 130 130 110 110 90 90 70 50 Retail sales value Retail sales volume 70 50 This rising tide has lifted all boats in the sector, helping Hong Kong to develop a more vibrant and diversified retail culture over time. Comparison of the 2011 figures with those from 2003 gives us a clearer picture about how the structure of Hong Kong retail industry has evolved over time. The momentum was positive across a broad set of retail categories, with sales of higher-end products gaining particularly strong traction (Exhibit 3). Since 2003, stores selling items favoured by tourists such as jewelleries, clothing and durable goods gained a larger foothold in the retail industry (Exhibit 4). In 2003,11.4% of retail sales were from outlets selling jewelleries, watches, clocks and valuable gifts. By 2012, its share had risen to 21.6%. It was followed by consumer durable goods with a 17.6% share, from 16.9% in 2003. 2

Exhibit 3: Retail Sales Value (cumulative growth, 2001-2012) Fuels 40.9% Exhibit 4: Retail Sales Value (by retail outlets, % of total retail sales) Food, alcoholic drinks and tobacco 57.2% Supermarkets 80.2% Other consumer goods 125.7% Consumer durable goods 141.9% Department stores 143.4% Clothing, footwear and allied products 147.8% Jewellery, watches and clocks, and valuable gifts 354.5% Total 141.6% Another trend that emerged is the rise in profit margins among retailers (Exhibit 5) despite the onset of financial crisis. This was no surprise given the scale of economic buoyance in the region. Retailers are competing mostly by converting potential consumers to customers, rather than with one other. Additionally, rising sales proportion of higher-margin luxury products have added extra premium to retailers. The economy also benefitted from the retail sales boom, in terms of employment and value added. The value added of the retail industry climbed from HKD29.5 billion in 2001 to HKD75.1 billion in 2011, or from 2.3% to 3.9% of nominal GDP (Exhibit 6). Retailers also took on 50,000 more workers over the past decade or so, with employment in retail industry expanding to 260,200 by the end of 2012 (Exhibit 7). Exhibit 5: Gross Profit Margin and Net Profit Margin for Retail Industry * 38% 12% Exhibit 6: Value Added of Retail Trade (Current Price) 80,000 4.5% 36% 34% 32% 30% 28% 26% 24% 2% 22% Gross profit margin (lhs) Net profit margin (rhs) 20% 0% 1990 1993 1996 1999 2002 2005 2008 2011 *Gross Profit Margin = (Sales - Cost of Goods Sold)/Sales Net Profit Margins = (Sales - All Costs)/Sales 10% 8% 6% 4% HKD Mn 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Value added of retail sector (HKD mn, lhs) Value added of retail sector (% of GDP, rhs) 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 3

Exhibit 7: Retail Employment 270,000 9.9% 9.8% 250,000 9.7% 230,000 9.6% 9.5% 210,000 9.4% 9.3% 190,000 9.2% 170,000 9.1% 9.0% 150,000 8.9% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Retail employment (lhs) Retail employment (% of total employment, rhs) Though hard to quantify, a thriving retail industry is crucial for more reasons than its direct economic contributions: Positive spillover effects: it ensures a smooth flow of goods from producers to the consumer and is thereby the primary route to market for other sectors; Foster human capital accumulation: it provides a path into employment for school leavers and the young unemployed; Encourage labor force participation: as an alternative work option to people who often want to work non-standard hours; Alleviate structural unemployment: for job seekers who have been made redundant or find themselves highly skilled in a struggling industry, retail industry offers an opportunity for retraining. Indeed, as we flagged in previous note, continued expansion of the labour intensity sector is a major factor explaining why the degree of adjustment seen in the domestic labour market in the last downcycle has been relatively muted as compared with previous downturns 1. Roles of local consumers and inbound tourists What are the driving forces for the retail boom? To answer this question, we have to decompose the retail sales number into spending by tourists and residents and conduct further analysis. Turning first to tourist spending, we can estimate its contribution to the retail sector by using tourists shopping expenditure as a proxy. Based on statistics provided by the Tourism Board, inbound tourists spend 66.3% of their budget on shopping. Total tourism 1 See Hang Seng Hong Kong Economic Monitor, Economic Outlook 2013: Steady but Slow Recovery, December 2012 4

receipts amounted to HKD238.4 billion in 2012. Simple calculation showed that the approximation of retail spending by visitors was at HKD158.1 billion in 2012, representing 35.5% of total retail sales. We assume the rest of retail sales were from local residents. Results of our exercises are presented in Exhibit 9. Exhibit 8: Spending Pattern of Inbound Visitors (% of total spending) Exhibit 9: Contribution to Retail Sales 70% 60% 50% 40% 30% 20% 10% 0% 66.3% 50.9% 15.9% 25.6% Shopping Hotel Bills Meals Outside Hotels 13.6% 9.5% 8.3% 9.9% Others 2012 2001 Source: Hong Kong Tourism Board, Hang Seng Bank HKD billion 500 450 400 158 350 134 300 110 250 70 82 62 200 22 22 28 39 42 49 150 32 272 287 100 165 162 149 141 153 162 170 185 203 193 215 50 0 2000 2002 2004 2006 2008 2010 2012 Visitor spending Resident spending Source: Census and Statistics Department of HKSAR, Hang Seng Bank What do the data actually show? As in other Asian countries, the importance of inbound tourism as a retail growth driver becomes more evident. In 2012, visitor spending accounted for over 60% of annual growth of the entire retail market. As a result, the difference between per capita retail sales in Hong Kong and other advanced economies is similar to the difference between GDP per capita (Exhibit 10 & 11), despite the fact that gross saving rate in Hong Kong is notably higher than its counterparts (Exhibit 12). Exhibit 10: Retail Sales Value Per Capita (USD, 2012) Exhibit 11: GDP Per Capita (USD, 2012) 5

Exhibit 12: Gross Saving Rate (% of GDP) Another takeaway from this analysis is how important the local resident has been as a source of demand for retail sales. Spending by local residents came in at HKD287.4 billion last year, 77.4% higher than what it was in 2001. Contrary to what some might have expected, sales to local residents still make up two-thirds of total retail sales even as the territory has experienced an exceptional growth in tourism receipts in the past decade. If tourist arrivals can help explain the rapid growth in tourist spending, what are the factors supporting spending by local residents? Retail Sales = (Retail Sales/Labour Income) + (Labour Income/Employment) + Employment The purpose of growth accounting is to determine the relative importance of different components in explaining the ongoing consumer boom. From the above formula, we recognise that three factors: (1) changes in wage, (2) employment and (3) other factors affecting consumption decisions. Our findings indicate that labour market conditions were the most important. Employment gains (+13.9%) and wage growth (+24.5%) in total contributed 38.4 percentage points to the 77.4% increase in resident spending growth for 2001-2012 (Exhibit 13 & 14). 6

Exhibit 13: Total Employment Exhibit 14: Nominal Wage Index (rebased to 2001 Q4 = 100) Our analysis also shows that changes in other factors, such as housing and financial wealth, explain the remaining 50% of domestic retail sales gains. According to the latest study by Hong Kong Monetary Authority, net housing and financial wealth s elasticity of consumption is estimated to be around 0.18 and 0.12. On that premises, one may calculate that the advances in net housing and financial wealth contributed about 11.2 percentage points and 6.0 percentage points to resident spending growth during 2001-2012. All told, beyond the wealth effect, structural factors such as aging population, negative real interest rates, credit expansion and reduced unemployment volatility were also at play in supporting resident spending, albeit to a lesser degree. Exhibit 15: Net Financial and Housing Wealth * (HKD Billion) 7,000 6,000 5,000 HKD billion 4,000 3,000 2,000 1,000 0 Net housing wealth Net financial wealth *Net housing wealth is obtained with household s housing asset minus residential mortgage liabilities Net financial wealth is estimated by retail investors' holding of equity minus credit card advance and other personal loans Source: R&VD, HKMA, Hang Seng Bank estimates 7

Future prospect of the retail sector Two on-going developments are of essence underlying the sector s rapid expansion in the past decade. The first is that growing presence of inbound tourists. The second is the consistent expansion of labour force and improvement in wages. Since examining the trends related to these factors brings us to the heart of the question if current rate of retail sales growth could be sustained, we shall turn our focus to tourism prospect and economic outlook in the following section. Our view is that Hong Kong s tourism sector is still on the cusp of a high-growth phase. Since international tourism is generally regarded as a luxury product, the demand growth in related sectors is likely to be exponential, on rising incomes and a propensity to consume and risk taking. Future growth potential in Hong Kong s tourism sector is apparent, considering rising income levels in other Asian economies combined with increasing confidence about the future and falling saving rates. We expect the number of inbound travellers to rise 13% per annum for 2013-2017, bringing the total number of visitors to 90 million in 2017 (Exhibit 16). Exhibit 16: Total Visitor Arrivals (Million) Exhibit 17: Actual and Potential GDP Growth (% YoY) 20% 20% 15% 15% 10% 10% 5% 5% 0% 0% -5% Potential growth (HP filter) Actual growth -5% -10% -10% 1971 1976 1981 1986 1991 1996 2001 2006 2011 Source: CEIC, Hang Seng Bank Contributions from income effects, the other key factor to retail sales growth, will however become less visible on the structural slowdown that Hong Kong is going through. We have applied the Hodrick-Prescott (HP) filter, a technique that is widely adopted within academic and non-academic macroeconomic research, to estimate medium-to long-term growth rate of the Hong Kong economy. The HP filter decomposes the GDP data into a cyclical component and a trend component, and hence helping to estimate the potential growth rate. As exhibit 17 shows, the HP-based data highlight a downward trend in potential output growth since 2005. This probably reflects (1) an unfavourable demographic trend, (2) a slower pace of capital formation amid heightened macro uncertainty and (3) the rising share of employment in low value-added sector. These structural challenges will likely continue to pose headwinds to Hong Kong s overall growth for the years ahead, in our view. 8

Overall, while we believe Hong Kong s retail sector will manage to deliver stellar growth in coming years, the sector will see a transition from a period of spectacular (with an annual average of 18% growth since 2009) to more sustainable growth. Going forward, we expect low-teens growth, with scope for a slight positive surprise. If our forecasts materialise, annual retail sales would be close to HKD806.6 billion by 2017 (Exhibit 18), versus HKD445.5 billion in 2012. Exhibit 18: Retail Sales Value (HKD Billion) 900 800 700 HKD billion 600 500 400 300 200 100 110 70 62 82 42 49 162 170 185 203 193 215 134 158 272 287 186 318 223 264 351 379 311 409 367 440 0 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E 2017E Visitor spending Resident spending Source: Census and Statistics Department of HKSAR, Hang Seng Bank estimates What are the micro and macro implications? The emergence of the retail sector is likely to have a transcending impact on Hong Kong s economy. Some of the key micro and macro implications are summarised as follows: Challenges on promoting productivity growth: The low value added per worker in the retail sector reflects the high labour intensity as well as the comparatively low skill levels (Exhibit 19). A structural shift of employment from high-value added sector towards this low profitability, labour-reliant sector could cause a gradual slowdown in GDP growth. One of the key challenges ahead is how to improve productivity growth in the retail sector to offset this structural effect. It remains to be seen whether mounting competitive pressure will prompt players to produce customised products and move up the value-added ladder. 9

Exhibit 19: Value added Per Employed Persons (HKD Million, 2011) HKD million 2.0 1.5 1.0 0.5 0.0 0.25 0.25 0.28 0.29 Accommodation & Food Services Wholesale Manufacturing Retail 0.47 Real Estate,Prof &Business Services 0.67 0.73 Information & Communications Transport, Storage, Postal & Courier 0.81 Import & Export Trade 0.94 Construction 1.48 Financial & Insurance Exhibit 20: Retail Rental Rates and Its Sales Floor Area Index 150 140 130 120 110 100 90 80 1996 1998 2000 2002 2004 2006 2008 2010 Property Rental Index (Retail) (lhs) Floor Area occupied by retailers (rhs) 6,000,000 5,800,000 5,600,000 5,400,000 5,200,000 5,000,000 4,800,000 4,600,000 4,400,000 4,200,000 4,000,000 sq. m. Competition will become more sophisticated: Driven by the emergence of aspirational middle-class consumers in the region, consumption pattern will shift towards discretionary spending. In line with this transformation, competition among retailers will become more sophisticated as visitors seek more organized formats and greater exposure to global brands. It is also likely to observe higher degree of market concentration amid the changing retail landscape. Further demand for store space: Despite the increasing opportunities coming from the online space, presence of physical stores remains irreplaceable as a channel to reduce brand confusion and spread awareness about product capabilities. It is already evident that retailers seek to have larger footprint (Exhibit 20). With a promising business prospect, retailers appetite for the store space remains strong. We project an additional demand of 950,000 sq.m. of store space over the next five years. On the supply side, the Rating and Valuation Department estimates retail floor space completions of 58,000 sq.m. in 2013 and 60,000 sq.m in 2014 respectively, way below the 20-year average of approximately 137,200 sq.m. per year. The supply-demand imbalance would put upward pressure on retail rents. 10

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