The first Budget by the Financial Secretary Mr. Antony Leung was prepared at a time when Hong Kong was facing economic hardships and fiscal stress. It should be helpful in resolving Hong Kong's short-term problems and fostering long-term development. Nevertheless, further efforts are necessary to restore fiscal health.

Fostering Recovery and Restructuring

The Budget speech used a substantial portion to identify Hong Kong's advantages and challenges. This was so written in light of the deteriorating public confidence on Hong Kong's economy. The Budget gave people a positive stimulating effect, reminding us of the various advantages Hong Kong still possesses, with the most important ones being its geographical location, institutional strengths, talents and strong business base. Notwithstanding the challenges posed by our relatively high costs, the need to upgrade manpower quality and increase the number of talented individuals, and to enhance economic ties with our neighbouring region, we still have bright prospects provided we collaborate and make use of our advantages.

The new Financial Secretary spelt out the government's role in the economy - to have a clear vision of the direction of economic development and be a proactive market enabler. Some people criticised this as discarding the positive non-interventionist policy. Nevertheless, management of the direction of economic development by the government is entirely necessary. In the past, although economic flexibility and freedom were preserved under the non-interventionist policy, Hong Kong has missed the opportunity to develop high technology industries since the late 1980s, resulting in its falling behind the three little dragons in this area and the inflated economic bubble before reunification. On the international front, with persisting economic globalisation and ever tightening competition for capital, technologies and talents, not to proactively create favourable conditions for development will bring Hong Kong to an adverse position. Practically speaking, amid the decline of the property sector, we can only rely on the government's direction and support in order to make better progress in economic restructuring.

Based on such a role, this year's Budget pointed out the direction of economic development: affirming financial services, logistics, tourism and business supporting services as the four major pillars of the economy, and proposing to foster domestic economic development. In recent years, Hong Kong has been desperately seeking new economic momentum. Now, with experiences accumulated over the years, the Budget spelt out for the first time a more concrete development direction, proposing major areas for development. These suggestions were able to capitalise fully on Hong Kong's advantages and foundations, while also meeting public consensus. Better chances for success can be anticipated. Actually, as the Budget proposed to increase liquidity as a measure to boost the development of financial services, the Hong Kong Exchanges and Clearing Limited has already planned to simplify procedures for the issuance of financial products and trim associated costs. The indication by the People's Bank of China of the possibility to allow qualified investors to invest their foreign exchange deposits in Hong Kong just happened to fit into the objective of attracting capital from the mainland. With the support from the mainland, Hong Kong's financial sector should have good prospects for development.

The fiscal allocations should help ease Hong Kong's economic difficulties and boost recovery. Recognising the structural fiscal problem and the huge deficit for the past year, some expenditure cuts and tax increments are expected. However, taking into consideration the current economic conditions, the Budget proposed a net reduction of $ 6 billion in tax revenue, allocating additional funding to policy areas affecting livelihood. Concessions on taxes and charges would benefit all households and different sectors, favourable for sustaining consumption. Total recurrent government expenditure in money terms for the new fiscal year will increase by 6.2%, compared to the revised expenditure for the previous year. This is much higher than the forecast nominal GDP growth. In addition, fiscal reserves have to be drawn upon to cover the consolidated deficit of $ 45.21 billion. All these signify that fiscal policy will be highly expansionary, favourable for economic recovery. In fact, the government forecast of a 4% real growth in government consumption expenditure in 2002, is the second fastest growth rate among GDP components, next to exports of services. Growth of public sector domestic demand is forecast at 1.7%, notably higher than the -2.1% forecast for the private sector. In light of the unanticipated rise in government expenditure, GDP growth may exceed slightly above 1% this year. Deflation, however, will worsen. The government forecasts that Composite CPI will fall by 2.8%, an increase of 1.2 percentage points compared to the previous year.

Restoration of Fiscal Health

Management of public finances is a significant issue in this year's Budget. This is not only due to the occurrence of deficits in three of the past four years and the remarkably high level of deficits, but also the conclusion drawn by the Task Force on Review of Public Finances that Hong Kong is confronted with structural problems in public finance, with fiscal reserves expected to be totally depleted by 2008/09 under current policies.

In such circumstances, the Budget expounded on the principles of management of public finances and proposed measures to restore fiscal balance. It stated that the share of public expenditure in the economy should be controlled at 20% or below, the Operating Account must balance, fiscal reserves have to be increased to accompany rises in expenditure, and that these should be met by 2005/06. Due to Hong Kong's externally-oriented nature and its linked exchange rate system, keeping public finances sustainable is of primary importance. Persistent deficits in Hong Kong have caught international attention, particularly in light of the collapse of the linked rate and social unrest triggered in Argentina brought about by huge deficits and high debt levels. The Budget affirmed to restore fiscal balance in five years' time. It re-emphasised the principle of fiscal prudence and employed quantitative targets, particularly the control of expenditure in money terms and the reference to GDP growth when drafting the Budget. These should help to strengthen people's confidence on Hong Kong's public finance.

The Budget redefined the appropriate level of fiscal reserves. This is another reasonable as well as positive measure. It is reasonable since the original standard has become impractical, not to speak of the fact that it lacks public consent. Favourable results can be expected by the redefinition. First, an amount of fiscal reserves equivalent to about 6 months' expenditure will become available, soothing the pain to be endured when restoring fiscal balance in the coming 5 years. Second, the new standard reaches public consensus. With this redefinition, fiscal reserves should no longer hinder the progress in restoring fiscal health.

Civil service pay cut was the single measure proposed for the control of expenditure. This is an appropriate and positive proposal. The structural problem of Hong Kong's public finances rests mainly on the expenditure side, demonstrated by the rapid rise in the share of public expenditure in GDP boosted by excessive staff expenses (69.53% in government operating expenses in 2000/01). In addition, the rigid staff remuneration system in the public sector, resulting in huge divergence between public and private sector pay, has affected social cohesion and harmony. The suggestion to trim public sector pay as an early step to restore fiscal health is appropriate and can bring about long-term effectiveness. Based on the assumptions made, savings of about $ 3 billion can be achieved in the new fiscal year, followed by annual savings of $ 6 billion thereafter. According to the medium range forecast, operating expenses can be trimmed by 2.5% while government expenditure will fall by 2.1% within 2001/07, bringing the share of public sector in the economy down by 0.4 percentage point. Public sector employees are expected to share the burden amid economic hardships. This can facilitate the implementation of other measures to reduce fiscal deficit.

The Budget made some adjustments in resources allocation. The most notable one is the increase in resources allocated to Economic and items related to sustainable development, while controlling the funding for Broad Social Welfare items. In the revised 2001/02 Budget, the relative proportion of expenditure among the three categories was 37.7 : 35.8 : 26.5. In the 2002/03 Budget, the relative proportion became 40.5 : 33.7 : 25.8. Nevertheless, movements in the sub-items were not in the same direction, particularly under Broad Social Welfare. Estimated Housing expenditure dropped by $ 4.33 billion, with its share in public expenditure falling from 12% to 10%. Health expenditure would rise, though its share dropped slightly. As for the estimated expenditure under Narrow Social Welfare, it rose in terms of both the absolute amount and in its share of public expenditure.

It is good to see Housing expenditure being curbed since it demonstrates that the government is going to gradually withdraw from the property market. In addition to sparing more opportunities for the private developers and stabilising the property market, it will bring about more efficient utilisation of resources and hence more revenues generated from land. Further increases in Health and Social Welfare expenditures should be understandable amid the current economic environment. Yet, the role of the government in these areas should be reviewed in the medium term. The current arrangement can by no means be sustainable, given Hong Kong's fiscal outlook. Reform is deemed necessary to adjust the role back to only helping those in need. In the near term, tighter screening is necessary to reduce flaws and wastage while frauds should be severely combated.

A step by step approach has been employed to restore fiscal balance amid adverse economic conditions. In light of the increase in expenditure in the new fiscal year, the pressure to contain spending and seek new sources of revenue will be greater for the subsequent four years. According to the medium range forecast, from 2003/04 to 2006/07, the average annual increases in government expenditure and public expenditure in money terms will only be 0.95% and 1% respectively, significantly lower than the forecast nominal GDP growth of 4.5%. Besides, other measures are necessary to restore fiscal balance, including the sale of MTRC shares and other assets which would bring about $ 35 billion in revenue, other expenditure cuts or new revenue items by public bodies in addition to pay cut. Moreover, fiscal status by 2006/07 will still be fragile: the forecast operating and consolidated balances will only amount to $ 2.79 billion and $ 50 million respectively, whereas the fiscal reserves will barely cover government expenditure for 12 months.

It should further be pointed out that the above fiscal forecasts were all based on relatively optimistic assumptions. For example, annual investment return for fiscal reserves was assumed to reach 4% in the new year and 5% in subsequent years, revenue from land premiums were assumed at 2% of GDP. Although these assumptions were made with reference to historical data since 1980s, the changing circumstances, particularly the ease of inflationary pressure and the resulted lower interest rates and property prices, would make it much harder for the assumptions to be realised.

The Budget gave very few comments on tax reform. It only proposed to introduce Boundary Facilities Improvement Tax and indicated that further study on the details of the "Goods and Services Tax" would be conducted to prepare for implementation when necessary. It seems that the government is just hoping or targeting to seek sufficient revenue to meet its expenses. Nevertheless, this is far from adequate since there has been no change at all in Hong Kong's narrow tax base and a punitive system taxing solely on income and properties. Given the same situation, restored fiscal balance through the sale of assets probably cannot sustain. Therefore, although a step-by-step approach to resolve the fiscal problem is desirable, people would expect the government to link it closely with the reform on the tax system to bring about a broader tax base, a more stable and fair system that encourages progress.

Composition of Public Expenditure
2001/02 (revised budget)
Governance 26.5%   Broad Social Welfare 35.8%   Economic and Sustainable Development 37.7%
Support 13.1%   Security 10.3%   Community and External Affairs 3.1%
Health 12.5%   Social Welfare 11.2%   Housing 12.1%   Education 19.3%
Infrastructure 9.1%   Economic 5.2%   Environment and Food 4.1%

2002/03 (budget)
Governance 25.8%   Broad Social Welfare 33.7%   Economic and Sustainable Development 40.5%
Support 12.7%   Security 10.0%   Community and External Affairs 3.1%
Health 12.0%   Social Welfare 11.7%   Housing 10.0%   Education 21.4%
Infrastructure 8.8%   Economic 6.0%   Environment and Food 4.3%