A salient feature of Hong Kong's external trade is its intermediation role. As the entrepot for Mainland China, Hong Kong helps channel raw materials and semi-manufacturing products from the rest of the world to the Mainland for further processing and then helps re-export the processed goods and final products to the rest of the world. Economic theory suggests that the effect of a real exchange rate depreciation on trade balance can be ambiguous. However, if the Marshall-Lerner condition is satisfied, a depreciation of the real exchange rate would lead to an improvement in the trade balance under normal circumstances. Partly because of the complicated nature of re-exports, there has not been adequate study on whether the Marshall-Lerner condition holds for an entrepot economy such as Hong Kong. This paper applies an error-correction model to examine Hong Kong's long-run price and income elasticities as well as its short-run dynamics. Our empirical estimates indicate that the sum of the absolute values of the estimated price elasticities of Hong Kong's direct imports and exports is greater than one, thus implying that the Marshall-Lerner condition holds for Hong Kong. Moreover, changes in re-exports and the re-export earnings are found to be sensitive to changes in the real effective exchange rate of the renminbi and income growth of the Mainland's trading partners. The movement in the real exchange rate between the Hong Kong dollar and the renminbi is found to have a significant influence on merchandise trade flows between Hong Kong and the Mainland, thus indicating the processing trade activities are quite sensitive to changes in the real exchange rate.
