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February, 1999
Introduction
After many years of sizeable fiscal surpluses, the Hong Kong Government is experiencing a budget deficit. The immediate cause is the recession, which has reduced the revenue base. But the Administration is also preparing this year's budget in the face of a longer-term, structural challenge: how to wean itself off property-related revenues. It is an issue that has major implications for the whole economy.
For many years up to 1997, a combination of strong economic growth, an artificial scarcity of land, and negative real interest rates created significant increases in property prices. As the sole vendor of new land for development, the Hong Kong Government enjoyed a very healthy source of revenue, and, indeed, burgeoning fiscal reserves.
However, events in 1997 brought fundamental changes. First, the Handover marked the end of the tight restrictions on the amount of land that the Government could release, introducing the possibility of lower land prices as supply better matched demand. Second, the outbreak of the Asian financial crisis and the bursting of the asset bubble in the SAR touched off the worst recession since the oil crisis in 1975. With a slump in the property market, a severe economic contraction and a record high unemployment rate, the SAR Government is facing a growing budget deficit in this financial year and beyond.
On the surface, the situation may appear grim. However, we believe that the situation provides an opportunity for the SAR to reform its fiscal system. In the near-term, the Government can buy time, thanks to its healthy reserves and other assets. It can use that time to reform the tax system, making it less dependent on the property sector in the longer-term.
A Property Dependent Fiscal System
The Government budget has long been overly dependent on property-related incomes. Starting 1984, a Sino-British agreement restricted the supply of land for new development to 50 hectares a year. Rapid population and economic growth meant that demand for housing outstripped this limited supply. With negative real interest rates, speculative investment and trading in the property market became rampant. From 1990 to 1997, property-related incomes accounted for a growing and ultimately excessive share of the Government revenues (Chart 1).
However, the property-related revenues were a hidden form of compulsory consumption tax. Housing is a necessity, with no close substitute, so the public had to swallow the high housing costs and rentals. Indeed, some will be paying in the form of mortgages for many years, meaning that Government has been generating some of its revenues through private borrowing. Ultimately, high prices for commercial and residential accommodation have fed through into virtually all goods and services delivered in Hong Kong.
With the economy expanding and asset prices rising, many people paying this tax nonetheless felt steadily wealthier. Capital gains from property investment inflated business and individual earnings, and the wealth effect stimulated domestic demand and encouraged the bubble economy. Government profit and salary tax revenues, as well as revenues from the property sector, expanded significantly as a result.
However, the asset bubble damaged the Hong Kong economy by crowding non-property-related businesses out of Hong Kong. Over the years, important external economic sectors, such as external trade, tourism and manufacturing, became less able to compete for such resources as labour, land, and working capital. From 1990 to 1995, the average annual inflation rate of residential rents was 3.1 percentage points higher than that of other items of household expenditure. Rents grew from 20.6 percent of average household expenditure to 25.3 percent. Such pressures fuelled demand for higher salaries, raising overall operating costs. Thus wealth-creating, employment-generating economic activities have been made less viable in Hong Kong. This loss of cost competitiveness has far-reaching consequences for Government finances.
Short-term Implications of the Recession to Government Finances
The current economic downturn has severely undermined the Government's fiscal position in the 1998-99 fiscal year. With corporate earnings down and unemployment up, profit and salary taxes are likely to contract by around 30 to 40 percent. Also, the slump in property and equity markets has depressed stamp duties. Meanwhile, the Government has suspended land sales for nine months, further shrinking revenues. With operating costs still high by international standards, especially in comparison with other Asian economies, Hong Kong's externally driven businesses, such as tourism, are also suffering, further reducing indirect tax revenues.
However, Government expenditure is likely to increase during the economic downturn, notably as a result of increased welfare spending; no one doubts the need for a social safety net at this time. This, compounded by the shortfall in revenues, should swell the budget deficit to about HK$40 billion in 1998-1999 fiscal year.
We do not see a short-term budget deficit as a problem, even for a Government that places a high priority on a prudent and conservative fiscal philosophy. Given Hong Kong's abundant fiscal reserves, the projected fiscal deficits can be easily absorbed (Chart 2). What concerns us, however, are the long-term implications for Government finances.
Long-term Implications for Government Finances
Being prudent, the Government should approach this budget with conservative assumptions about the next five years.
Revenue
Any rebound of revenue from property-related sources is likely to be moderate. The SAR Government will certainly not want to return to the damaging high-land-price policy, so it is likely to take advantage of its freedom to sell larger quantities of land when necessary. With supply more in line with demand, and real interest rates at higher levels than in the early 1990s, Hong Kong's property market is likely to be healthily calm. Although this is good news for the economy, it will be difficult for the Government to increase its revenues from either land sales or other property-related sources to the levels of the mid-1990s.
Nor can it expect the salaries tax base to increase fast enough to compensate. Lower inflation, slower economic growth and steady immigration may all encourage more modest wage increases and possibly slower growth of total employment in the years ahead. The profits tax base will similarly feel the effects of slower growth following the bursting of the bubble economy and the contraction of the over-expanded domestic sector. Even though Hong Kong's externally driven sectors will be able to enjoy some improvement in cost competitiveness, it will take time before they can fill in the gap created by the contraction of domestic demand.
Expenditure
The Government does not have the option of reducing expenditure in line with these lower revenue streams. For the foreseeable future, the economic slowdown will increase demand for unemployment, retraining and other welfare programmes. Indeed, it will take a longer period of time before we can again achieve full employment, especially with continuous levels of immigration. In the meantime, demand for health services, provisions for the elderly and other social services are likely to remain firm. Even if politically difficult social welfare reform is successful, we believe that welfare spending will take a growing share of Government expenditure (Chart 3).
Other major areas of Government expenditure offer few opportunities for meaningful cuts. The Government is committed to improving education standards, expanding transportation infrastructure and cleaning up the environment. It also has plans to use money to encourage the establishment of information technology and other high-tech activities. All in all, we foresee Government spending outpacing the income available from the existing revenue base.
New Policies Are Needed
The days when the property sector provided the Hong Kong Government with 35 percent of its income are over, and the Administration must find ways to make up the shortfall. In the short-term, it has enormous fiscal reserves on which it can draw. In the longer-term, it must do more. We believe that the following measures are worth considering.
Lower-cost Government
Few doubt that the SAR Government can be made leaner and more efficient. For example, review the pay structures of the Civil Service would certainly offer the possibility of lower recurrent costs.
The same may well apply to organizational structure and working practices, and with this in mind, the Government should also consider letting some public services, such as housing, postal services and water supplies, be managed by private companies. Indeed, the Government could raise significant one-off sums by privatizing or securitising publicly owned transportation infrastructure.
The Government could also relocate much of the space it currently occupies in prime office areas, releasing valuable real estate for sale to the private sector.
New Sources of Revenue
In the long-term, the Government needs to explore new tax sources, particularly to compensate for what will surely be a permanent reduction in the proportion of revenues coming from property-related sources. We believe the Government should consider another transparent and more equitable alternative to revenues, such as consumption tax.
A Consumption Tax
Already, Hong Kong has a consumption tax on fuel, alcohol and tobacco. And, as we have argued, it has been levying an invisible but compulsory consumption tax on the whole community by gathering proceeds from high land prices. A reduction of that burden would make room for the introduction of a consumption tax on a far wider range of goods. A rate of five percent on consumer goods would produce a relatively steady stream HK$25-30 billion per year, equivalent to 11 to 13 percent of the Government revenues in 1997-1998 fiscal year.
Such a tax would offer various advantages. Unlike the high-property-price approach which had crowded out the external sectors, this tax would not put any burden on our external economy. One could even argue that the overall economy would benefit from stabler operating cost as the tax would tend to stabilize domestic demand. This would help to enhance our overall competitiveness. Also, the tax would not distort markets, nor would revenue levels be subject to volatility. It would be perfectly transparent.
Is such a tax fair? Critics say that a consumption tax is regressive - the poorer you are, the more you pay (as a percentage of your wealth). This is true if the tax is levied on essentials such as food. Conversely, a tax weighted towards non-necessity consumer goods can be very fair: by choosing to save rather than spend, citizens do not even have to pay it. We believe a transparent consumption tax can be made much fairer than the "invisible consumption tax" currently drawn from property.
Under ideal conditions, a consumption tax might even be implemented without anyone noticing: falling rents could enable retailers to divert the five percent from their landlords to the Government, leaving the price tags as they were. We would expect the Government in practice to adjust salaries and profit taxes as part of the process, in order to create a system that is both broad based and equitable.
Broader Repercussions
The asset bubble of the last decade gave Hong Kong people the illusion that profits are easy to come by, and that high property prices create wealth. Even today, some refer to "recovery" of the property market as if it will cause the recovery of the economy as a whole - rather than vice-versa.
The fact is that wealth creation in the future, as at all times, will come from good ideas and hard work. And, as always, the lower the business overheads, the greater the incentive to invest, and the greater the profits and jobs that are created.
While residential and business accommodation will never be cheap in a crowded place like Hong Kong, property does not need to account for such a large proportion of the costs incurred by business and individuals. By drawing revenue from a broader range of sources, the Government is less likely to distort the overall economy.
After the euphoria associated with the expanding bubble economy, Hong Kong is now in the depths of excessive pessimism. This is not the first time. In the early 1980s, uncertainty over Hong Kong's future led to a slump in the economy and three years of Government budget deficit. The adjustment faced today is certainly no more daunting than the one faced then. With its vast fiscal reserves, and the innate strengths of Hong Kong, there is no reason why the Government cannot put its finances on a sound footing for the long-term. This budget would be an ideal opportunity to begin the process.
Chart 1: Employment
The seasonally adjusted unemployment rate rose further from 5.5 percent in November to 5.8 percent in December 1998. Corporate downsizing and layoffs continued. The unemployment rate will surge even higher, as more companies are expected to close down before the Lunar New Year.
Chart 2: Inflation
Inflation measured by the Consumer Price Index (A) plunged further from -0.9 percent in November to -1.4 percent in December, hitting another new record low level. The downward trend is caused by contracting domestic and external demand, and is likely to continue in 1999.
Chart 3: Retail Sales
Retail sales dropped by an annual average of 19.7 percent and 17.2 percent respectively in value and volume terms during the period from January to November 1998. The momentum of decline in total value of sales exceeded that of the sales volume, indicating that cheap products are more preferred by consumers. It is anticipated that retail sales in volume will continue to improve moderately.
Chart 4: Orders-On-Hand
The value of manufacturers' orders-on-hand fell by a year-on-year 18.0 percent in November 1998. Economic downturn in Asia and negative effects of the strong HK Dollar adversely affected overseas demand for the Territory's products. In the months to come, the value of manufacturers' orders-on-hand should continue to decline.
Chart 5: External Trade
Total merchandise trade deficits for 1998 shrank to HKD81.4 billion from HKD159.1 billion in 1997. During this period, imports dipped by 11.5 percent due to flagging domestic demand, while total exports fell at a slower pace of 7.4 percent. The outlooks for both domestic exports and re-exports may become more negative, as the Territory's exports continue to lose competitiveness in value terms and exports in China also slide. The total merchandise trade deficits are expected to widen in the medium-term.
Chart 6: Deposits
HKD deposits continue to record solid growth. HKD deposits increased by 9.7 percent in December, compared to 8.9 percent in October. It indicates that measures introduced by the HKMA in last September had successfully boosted liquidity in the banking system. We believe that deposit growth would stay steady in 1999.
Chart 7: Loans and Advances
Falling trend of the total loans continues. Growth of total loans and advances slid further to -19.8 percent in December from -18.7 percent in October. The contraction of offshore loans is particularly acute as Japanese banks withdraw from the Territory. Growth of domestic loans also record sharp decline. As economic conditions continue to be difficult in the coming months, banks will remain cautious to their lending. And current contraction of loans and advances will continue.
Chart 8: Effective Exchange Rate Indices
The annual change on the trade-weighted effective exchange rate index fell to -5.0 percent in January from 1.6 percent in October. With the downward trend of US interest rates, the US Dollar and the Hong Kong Dollar would turn weaker in coming months. | 
