Hong Kong's Special Administrative Region (SAR) government is under renewed pressure to cut its budget deficit. In the first four months of this financial year, from April to July, it racked up a shortfall of HK$40.1 bn ($5.15 billion). This amount is equivalent to 89% of its projected total deficit for the full year. Given the soft economy, this full-year budget deficit will certainly overshoot the official target of HK$45.2 bn ($5.8 billion) the Financial Secretary announced in his Budget in March.
The SAR's economic growth in the second quarter was only a tepid 0.5%. The outlook for the rest of the fiscal year, which runs through March 2003, and next year is murky, due to an uncertain global economy. Such an environment is hardly conducive for the Financial Secretary's effort to balance the budget in the next few years. Under such circumstances, the government is already under pressure to cut spending.
But progress is not encouraging. Notably, the savings from the cut in civil servants' pay will be only HK3.3 billion this year. This is about half of the HK$6 billion savings that the government was expecting; and it is only a drop in the bucket of the fiscal red ink.
There is not much hope to raise sufficient revenues to slow the growth of the deficit either. The weak economy makes income tax revenue intake almost impossible to grow. Feeble domestic demand and weak public confidence also tie the government's hands to raise any tax rates or to introduce any sales taxes in the short-term. The government is also unlikely to be able to realise the expected HK$15 billion proceeds from the planned sale of a second tranche of MTRC shares, due to poor market conditions and uncertainty about a merger with the KCRC.
The government has been funding its budget deficit by dipping into the territory's large fiscal reserves. As a result, the reserves were whittled down to HK$332.4 billion ($42.7 billion) in July from HK$430 billion ($55.26 billion) last year. At the heart of the fiscal problem has been a dependence on revenue derived from land sales. These land sale receipts have allowed the government, until recently, to keep Hong Kong a low tax haven and sales tax free, while maintaining a high level of public services.
With spending cuts and revenue sourcing being stuck in the short-term, the market's overriding concern is that the sharp rise in the fiscal deficit could prompt the government to accelerate land sales to make up the shortfall. This would depress real estate prices and worsen the territory's deflation spiral. The concerns are worth noting, given the importance of the property sector in affecting the local economic and financial markets movements. While such a move remains a possibility, there are no signs that the government would have to pursue it anytime soon.
First, the fiscal deficit partly reflects the counter-cyclical adjustment mechanism in the economy, where government spending rises to help soothe the economic pains during a down cycle. The SAR's huge fiscal reserves are meant for buffering cyclical downturns. They are not meant for eternal keeping. Investors should not be upset about the deficit provided that the government is committed to prudent fiscal practice over the long-term. Since the SAR government has no external debt, running a fiscal deficit with large fiscal reserves is not hazardous for the stability of the local economic system.
After all, Hong Kong's fiscal reserves have been kept far too high and created an opportunity loss to the economy. This is because the government has been investing the bulk of the reserves, on behalf of the Hong Kong people, in low-yielding US Treasury debt instruments. If some of the fiscal reserves were released back to the economy, private sector investment opportunities could well generate higher returns than the paltry US Treasury yields.
An economic low time, like this one, is an opportunity for the fiscal reserves to be put back into the economy to generate higher returns. From a macroeconomic perspective, these returns mean economic stability and public confidence in addition to the nominal investment returns. The point is that as long as the fiscal reserves are not whittled down to very low levels, there is no imminent need to replenish them. The fall in the reserves that we have seen is thus hardly a strong reason to expect the government to increase land sales to raise revenues.
Second, there is no evidence that the government has increased land sales to raise fiscal revenue intake in a soft economy. There were only two times when the government sharply raised land sales. One was in 1988 and the other was in 1995. Both periods happened to be times when the real estate market was booming. This suggests that the government was cautious in timing and deciding the amount of its land sales.
From a policy perspective, it seems that the government only increased land sales to cool an overheated market. From a fiscal perspective, maximising revenues seems to be the dominant factor in the land sales decision making process. Thus, the government is unlikely to flood the market with land sales when prices are soft, like in the current stage of the economic cycle.
While it is tough to argue that Hong Kong would enjoy another 1990s-like real estate boom, the macro conditions are ripe for a cyclical rebound in the next couple of years. It is crucial to note that property prices are generally 60% off their peak in 1998. Property rental yields are at a high 8% average relative to sub-2% money market rates.
Property affordability, as measured by the ratio of wages to housing prices, has risen dramatically since the Asian crisis. It is now standing at a 14-year high, implying pent-up buying power for property. The government is also trying to help by offering incentive schemes, such as second mortgage lending and interest-free loans of up to HK$530,000 per household, to ease the negative net-worth problem and to boost demand.
Interest rates are going to remain low for a much longer period of time than many people think, as the global, especially US, economy, will take longer to recover. The recent decline of the US dollar, which is expected to last for a while as the US finally adjusts its large current account deficit, will help ease the deflation pain for Hong Kong. Meanwhile, local narrow money growth, a leading liquidity indicator for demand growth, has continued to gain.
In a nutshell, the fears about a rising fiscal deficit crashing property prices are exaggerated. Given the heavy weight of property stocks in the local Hang Seng Index, this in turn means that the deficit's drag on the overall stock market would be limited. Hong Kong's property sector appears to be bottoming out. All it needs for a cyclical recovery to emerge is a return of confidence. The catalyst for this may have to come from an improvement in external demand, which will help boost Hong Kong's important trade sector (250% of GDP), and hence economic confidence.
Chi Lo, an independent economic strategist based in Hong Kong
