Hong Kong's Economic Integration and Business Cycle Synchronisation with Mainland China and the US

While Hong Kong's monetary policy is effectively tied to the US, its real economy has been experiencing increased integration with the Mainland through trade, Foreign Direct Investment (FDI), tourism, and increasingly financial flows. Co-movements of business cycles in Hong Kong and the Mainland have increased steadily since the 1990s. Although its co-movements with the US dipped in the late 1990s, there has been a significant increase in the synchronisation of business cycles among these three economies since 2000. This finding naturally raises a question as to what factors drive the co-movements of business cycles among the three economies. Our structural vector auto-regression analysis suggests that over the medium to long run, about 60% and 45% of variations in output and prices in Hong Kong respectively can be explained by US shocks, while the impact of Mainland shocks mostly concentrates on Hong Kong's price movements. It is estimated that Mainland shocks explain over one-third of Hong Kong's price developments. Using a methodology to distinguish between the effects of common US shocks and idiosyncratic domestic shocks, we find little correlation between the business cycles in Hong Kong and the Mainland in the absence of the common US influences, whereas the influence of the US shocks on these two economies leads to a high degree of synchronisation. In other words, the business cycle co-movements of Hong Kong and the Mainland are largely due to the common influence of economic conditions in the Unites States and possibly their US dollar pegged exchange rate system. The lack of similarity of domestic shocks between Hong Kong and the Mainland can be mostly attributed to their continuing structural differences and stage of economic development. Since the similarity of shocks is the most important factor for the choice of exchange rate regime, it follows that the Linked Exchange Rate system based on the US dollar would continue to be desirable in the foreseeable future.