The government expects Hong Kong's economy will shrink by 2 to 3 percentage points this year. It's the first full-year contraction since the Asian financial crisis more than a decade ago, Financial Secretary John Tsang said in his second budget address.

"2009 will be a very difficult year. Both external trade and domestic demand are expected to remain subdued," Tsang said in the Legislative Council yesterday.

GDP growth in Hong Kong tumbled to minus 2.5 percent in the fourth quarter from 1.7 percent in the third quarter. The decline dragged down overall economic performance, so that the GDP showed only a small 2.5 percent increase in 2008.

Tsang also forecast that inflation in 2009 will ease to 1.6 percent. He cited weaker demand and a significant drop in global commodity prices commencing with the second half of last year.

The deficit for the current fiscal year was HK$4.9 billion. That's smaller than the original estimate of HK$7.5 billion. However, Tsang said the deficit may significantly deepen to HK$39.9 billion in 2009-10.

Fiscal reserves are estimated at HK$488 billion projected to the end of March 2009. A year from now reserves are expected to be about the same, equivalent to 18 months of government expenditures.

The credit rating firm, Standard & Poor's, said Hong Kong government's reliance on a narrow tax base is the key reason for a sharp deterioration in the fiscal balance.

"This longstanding weakness of the Hong Kong fiscal system subjects government revenue to large cyclical fluctuations," S&P said in its statement yesterday.

In an effort to reinforce Hong Kong's position as an international financial center, the territory will focus on developing its bond market and to create its own issue of government bonds.

Tsang said the government can provide more diversified investment instruments and broader avenues for financing, so as to attract more overseas capital and enhance the stability of the financial system.

A government source said the bonds will be managed by a separate account, while the government will invest derived income in low-risk instruments.

To increase co-operation with emerging markets, the government also plans to create a level playing field for Islamic financial products in Hong Kong. Consideration is to be given to making changes to the stamp duty, profits tax and property tax accordingly. Sarah McGrath, Taxation Committee Deputy Chairperson of CPA Australia Hong Kong China Division, said it will be more important for the government to implement enabling regulations, if Hong Kong is to evolve into an Islamic finance center.

(HK Edition 02/26/2009 page1)