By Sandra Sugawara
Washington Post Foreign Service
Friday, April 9, 1999; Page E01

HONG KONG—Real estate agent Scipio Ki is feeling better these days. Hong Kong's property prices have stopped dropping. Three-bedroom condominiums are again going for more than $1 million U.S.

"It's encouraging," he said. Good news indeed for real estate agents, stockbrokers and bankers. But not such good news, perhaps, for the future of Hong Kong.

"This is the basic contradiction in the Hong Kong economy. To keep the domestic economy healthy, you have to have a sound property market," said Ian Perkin, chief economist with the Hong Kong General Chamber of Commerce. But if property costs rise, prices for a whole range of goods and services here soar.

Hong Kong's high costs mean "it will not enjoy significant growth, even when the region recovers," said Andy Xie, a Hong Kong-based economist for Morgan Stanley Dean Witter & Co. He warned that Hong Kong could be headed for Japanese-style economic stagnation.

When the financial crisis swept through Asia in the summer of 1997, many Hong Kong residents expected to be spared. The culprits blamed for much of the rest of Asia's economic woes -- weak banks, rampant corruption, inept regulators, closed markets and meager foreign currency reserves -- were not problems here. The former British colony boasted some of the strongest banks in the region, sophisticated financial markets, Western-style regulators and business laws, a stable currency that was allowed to flow freely across the border, and hefty foreign currency reserves.

The biggest fear then was that China, which took control of Hong Kong on July 1, 1997, would attempt to seize Hong Kong's reserves, raise its taxes or influence its financial markets. China did none of those things.

But Hong Kong did get hit. Interest rates soared, and property prices plummeted. The economy contracted by 5.1 percent last year, after growing 5.3 percent in 1997, and unemployment jumped from 2.1 percent to 6 percent. The problems behind Hong Kong's fall are different from those elsewhere in the region and in some ways may be more daunting to solve.

Thus, while many economies in Asia are expected to begin growing this year, economists warn that Hong Kong's economy could continue to shrink this year.

Hong Kong's economy is built on three major pillars: a stable currency, property and business with China. All three now have major problems.

For years, Hong Kong has lured foreign companies here by promising to maintain an exchange rate of 7.8 Hong Kong dollars to the U.S. dollar, eliminating foreign currency risk.

But after speculators forced Thailand and other countries to devalue their currencies in 1997, they began aggressively attacking the Hong Kong dollar. Hong Kong fought off speculators -- but at a cost. The government pushed interest rates way up, a fatal blow to many struggling companies and to the country's property market. Unemployment rose, consumers and businesses cut back on spending and the economy contracted.

Meanwhile, the currency devaluations in South Korea and Thailand meant that their exports became much cheaper on world markets, helping fuel a rebound. But Hong Kong's stable currency kept its export prices from falling to competitive levels.

These problems illustrate that rigid exchange rates do not necessarily shield a nation from financial turmoil. Many world leaders have advocated currency trading bands to prevent wide exchange-rate fluctuations. But in a recent Merrill Lynch & Co. survey, more than half of Asian fund managers said that Hong Kong's outlook would improve if its currency was allowed to float.

But Hong Kong's biggest problem, economists agree, is its property market. Real estate sales, development and related activities account for about 40 percent of Hong Kong's economy. Many of the major companies traded on the Hong Kong stock exchange are property developers. The upper and middle class alike have their wealth tied up in property. The government, which owns all the land in Hong Kong, gets a big chunk of its revenue from auctioning off leases to big developers.

Thus, when Hong Kong's property market boomed earlier this decade -- with individual parcels sometimes changing hands three times in one day -- almost everyone felt richer. "You'd ask owners what price they wanted for their property and they'd say, "I don't know. It will be different in 20 minutes,' " said Jane Garnett, general manager of L.J. Hooker, a real estate company here.

Soaring property prices boosted the stock market and the general economy, but it also meant that companies had to charge high prices for everything, including sandwiches, clothing and consulting fees. Hong Kong lost its image as a shopper's paradise, hurting tourism. High property prices made it hard for retailers to make a profit, said Keith Cahoon, Far East managing director of Tower Records, which has two stores in Hong Kong.

Hong Kong's recent economic woes have sent property prices falling by more than 50 percent, but that leaves them still too high for Hong Kong to be competitive, economists say. Housing prices are still so high that half the population lives in public housing.

"I think you'd be hard pressed to find any other economy where the gross domestic product per capita was about $25,000 -- which is high by world standards -- where half the population is unable to afford their own housing," said William S. Kaye, senior managing director of the Pacific Group, a Hong Kong-based investment company.

Meanwhile, Hong Kong's third major source of economic activity has been its role as a gateway to China. Foreigners doing business with China would often set up their headquarters in the more sophisticated, English-speaking Hong Kong, and then jet to China when needed at their factories or sales offices there. They often used Hong Kong ports to ship their goods in and out of China. Likewise, China used Hong Kong financial markets to raise money for its companies and infrastructure projects.

But traders are increasingly bypassing Hong Kong for cheaper ports in China, while foreign companies are slowly moving more personnel and office operations directly to China, to escape Hong Kong's high costs.

Investor fervor for China-related stocks -- which fueled the Hong Kong stock market a couple of years ago -- has also cooled. The collapse of Chinese investment trusts, such as Guangdong International Trust & Investment Corp. (GITIC), burned a lot of investors. The investment trusts were set up by regional Chinese governments to attract foreign capital to invest in companies or infrastructure projects in their regions. Many Hong Kong investors figured these businesses had the backing of the government and therefore were safe, despite shaky-looking finances.

The collapse of GITIC, however, dispelled that illusion. A top Guangdong official, Wang Qishan, chastised foreign investors for not following "accepted international practices in evaluating Chinese companies and projects in giving loans to them."

With its three economic pillars in trouble, Hong Kong is struggling to find a new act. "Hong Kong needs to find new sources of growth, now that property and China trade can no longer drive the economy," Xie said.

For now, the government has singled out two projects. It is negotiating with Walt Disney Co. to build a huge theme park in Hong Kong. The talks are still underway, with few details made public, but the government said a Disney theme park would stimulate tourism and bring thousands of jobs.

Critics, though, said the jobs would be low-paying. They also said it's unclear whether a Disney theme park would lure back the big-spending tourists from Japan, the United States and Europe, or would simply bring in more tourists from mainland China, who spend far less at hotels and restaurants.

The other project is a $1.7 billion high-technology industrial park and luxury apartment complex called Cyberport. The buildings will have high-speed communications connections and wiring to support computers. But the project has been criticized as mainly a property deal that will enrich Richard Li, the son of influential tycoon Li Ka-shing. Richard Li's Pacific Century Group was awarded the Cyberport deal without competitive bidding.

Furthermore, critics say neither of these projects addresses Hong Kong's fundamental problems, such as high costs. The government could sharply reduce the costs of operating in Hong Kong, by loosening its tight control over the property market and significantly boosting the supply of land auctioned off. But it's reluctant to do that because of the economy's dependence on the market.

"The government is inhibiting what would be a healthy adjustment for the community. It will be painful for a lot of people, especially if you're heavily invested in real estate and you have a lot of debts to repay," Kaye said. "But it would be healthy for the community as a whole. Hong Kong's long-term prosperity depends on it becoming a far more cost-competitive place in which businesses can operate."

South Korea and Thailand were forced to adopt painful reforms when their financial systems were facing meltdowns. Hong Kong's finances are strong enough so that it is not in danger of collapse, and it has sufficient resources to pump money into its economy to stabilize it. That means Hong Kong can avoid the fundamental restructuring that would mean both substantial pain but an eventual return to robust growth, much as Japan did for eight years.

"Sales in South Korea and Thailand are coming back. But I don't see any indication of that in Hong Kong," Cahoon said. "Hong Kong wasn't hit as severely as other countries. But unfortunately, I don't see Hong Kong making any strong comeback."