Hong Kong's fiscal deficit this year is likely to exceed budget and this has attracted a lot of attention. While this is certainly a concern, one should put Hong Kong's fiscal position in a broader perspective. Hong Kong still possesses a lot fiscal reserves and has no public debt.

Talks of the fiscal deficit tend to shift the focus away from the need to pursue difficult but necessary public sector reform and reduce public spending. Public sector expenditure grew rapidly over the past 15 years in Hong Kong. As a percentage of GDP, it rose from 16% in 1986 to 23% in 2001.

Trying to reduce the deficit by raising more taxes at a time when most people are still suffering from the effects of a serious economic downturn, and when the public's money is not used as efficiently as it should be, is economically misguided, politically unpalatable, and ethically wrong.

The size of the fiscal deficit has been a focus of media attention in recent months. Talks of such deficits are also often tied to comments that rating agencies may downgrade Hong Kong's rating.

While the fiscal deficit is certainly something Hong Kong should be mindful about, I think the discussions about this subject have got out of proportion. In a sense, there is even an unhealthy obsession by some analysts about the fiscal deficit. Furthermore, there is also an important difference between addressing the fiscal deficit and addressing the need to control public sector expenditure and reforming the public sector.

Putting too much pressure on governments to address fiscal deficits when the economy is weak is simply wrong

In most countries, fiscal deficits are inevitable in an economic downturn. This situation is most vividly illustrated by recent experiences in the US. At the height of the NASDAQ bubble when the economy was growing strongly and talks of the productivity miracle were common place, projections of the fiscal balance show huge surpluses into the distant future. But when the economy turned downwards, projections of such fiscal surpluses suddenly became huge deficits.

The point illustrated by the US experience is that the fiscal balance is very sensitive to economic performance. When the economy is bad, the priority of the government is to focus on what is right for the economy, and not on the fiscal deficit. The situation is of course quite different in economies where fiscal deficits cumulated over the years have pushed the debt dynamics onto a dangerous path.

In the US, Bush's tax cuts and fiscal stimulation policies are widely supported and are seen by most economists and analysts to be the right things to do. Keynesian economics is certainly not as popular as it was 50 years ago. But basic macroeconomics tells us that it is unfair, and indeed wrong, to ask the Hong Kong government to tighten its belt simply for the sake of addressing the fiscal deficit when the economy is still recovering only very slowly after a serious economic downturn.

The experience of Japan during the mid-1990s is also very illustrative. The government raised taxes in 1997 in an effort to reduce the fiscal deficit when signs of economic recovery were emerging. The result: the economy fell back into recession again and the fiscal deficit worsened further.

Hong Kong is going through the most serious and protracted economic downturn in the past 30 years. Having a fiscal deficit is not unexpected. Indeed, compared with its regional neighbors, which also went through the agonies of the Asian financial crisis, Hong Kong fiscal deficit situation is not totally out of proportions. Hong Kong's aggregate fiscal deficit over a 4-year period 1998 - 2001 (during which the SAR went through a double dip recession) is 7.3% of 2001 GDP. This compares with 3.3% for South Korea and 20.3% for Taiwan. One should note that for technical reasons, the numbers for South Korea and Taiwan do not reflect the true costs to the government of the need to sort out the problems in the banking system. Hong Kong has a much stronger banking system and there is no need to make provisions for that.

The focus on Hong Kong's fiscal deficit is unfair and misguided

Over the long term, governments need to be mindful of their finances, in the same way as individuals need to be mindful of their own personal finances. Governments spending beyond their means for a long time, running persistent deficits and relying on borrowing to fund such deficits will ultimately lead the economy down a path to disaster. The crises in many developing economies lie with this very simple but fundamental concept.

But Hong Kong is in a totally different camp. Hong Kong's latest fiscal reserves (after the deficits in the past few years) stood at around HK$ 316bn, the equivalent of 14.5 months of total public expenditure. The Hong Kong government also has basically no public debt. At a time when the vast majority of countries around the world (including most OECD economies) are talking about how much debt their governments have, it is ridiculous to put Hong Kong's fiscal deficits under the microscope, as some commentators do.

Some analysts will point out that under certain pessimistic assumptions about the economy and about public finances, Hong Kong's surpluses could be run down in a number of years' time. This is true. But if this is the worry, then it is even more important to address the weakness of the economy rather than the fiscal deficit.

Hong Kong has kept a large fiscal reserve for many years. Indeed, before 1997, the then Financial Secretary, Donald Tsang, had to come up with an artificial formula to "justify" the high and continuously rising level of reserves. This may have helped to generate an expectation amongst some people that such reserves should keep on rising, and these people get worried when the level of reserves falls. But one should bear in mind that such reserves are kept for the rainy days. It is totally unfair to the citizens of Hong Kong if the government could not use up some of its reserves to help the economy when the economy is going through a thunderstorm.

From a broader economic angle, fiscal reserves are resources extracted from the private sector over the years and kept in the public purse. To the extent that private sector investment is curtailed and market efficiency is compromised because of this transfer of resources, the building up of fiscal reserves has a certain negative impact on the economy. From a longer term perspective, having an easy access to a pile of money will also tempt the government to have less fiscal discipline, and this is very well illustrated in the experiences of Hong Kong in the late 1980s and early 1990s. Having a high level of reserves certainly makes the government feel more comfortable, but this inflicts a cost on the economy and there is a balance to be struck. In Hong Kong's circumstances, I would argue that the government's surpluses is also partly a result of inadequate spending in the past on areas such as the environment, recreation & sports, arts and culture, and training & research.

Focusing on the fiscal deficit also distracts attention to the important issues and leads one to a wrong conclusion

Putting too much attention on the fiscal deficit also leads people to the wrong conclusion about what really should be done in Hong Kong. The problem in Hong Kong is the need to reform the public sector so as to enhance efficiency, and to cut public sector expenditure. This is a major task and needs a lot of attention. Focusing on the deficit alone often shifts the focus to other ideas like raising new taxes, broadening the tax base, etc., as many people have suggested from time to time. There is nothing wrong with these tax ideas. But this is not the right fiscal strategy at this point of the economic cycle.

Raising taxes actually will do more harm than good to the economy, both in the short term and in the long term. Hong Kong's tax burden is very low compared with most other economies around the world. Some would argue that there is room for taxes to be increased. But in the long term, having a low and simple tax regime is the very strength of the Hong Kong economy that must not be given up lightly. Indeed, maintaining a low tax regime is a requirement specified in the Basic Law, Hong Kong's Constitution. Asking the public to pay more to the government when most people are still suffering from the effects of a serious economic downturn, and when the public's money is not used as efficiently as they should be, is also economically misguided, politically unpalatable, and ethically wrong.

Hong Kong should focus on improving the efficiency of the public sector

First of all, it is important to point out that, despite all the criticisms launched at the government by the Hong Kong public in recent years, I think Hong Kong does have a generally clean and efficient civil service. However, in this day and age, being good is not good enough. The world moves on and Hong Kong needs to catch up, particularly if Hong Kong wants to stay at the forefront of global competition.

The size of the public sector in Hong Kong grew rapidly since the mid-1980s. When the economy was doing well and the government was facing the embarrassment of rising fiscal surpluses, increasing public spending was a piece of cake.

As a percentage of GDP, public sector expenditure rose from around 16% in the mid-1980s to 23% by 2001. Bearing in mind that Hong Kong does not have any military expenditure, the 23% number is too high.

Lots of examples appear in the media from time to time showing how inefficient some government departments or public-funded organizations are. Talk to senior government officials and many of them will be able to tell you the things that should be done but could not be done because of one reason or another.

Improving the efficiency and responsiveness of the public sector is not just a matter of ensuring a better use of public money. At a time when Hong Kong is facing a serious economic challenge, when the economy needs to be much more flexible in adapting to the rapid changes in the world around us, an inefficient bureaucracy does not only delay things and add costs, but also stops innovation by the private sector.

Hong Kong has had a good run of fortune in the last few decades of the 20th century. The government has developed over the years a good system to ensure that things are organized in an orderly and fair manner, and that changes are well considered in all aspects before they are implemented.

But as with all big organizations, inertia creeps in and bureaucracy builds up over time in Hong Kong's civil service. Major policy programme such as those in housing and education have also nurtured huge departments & institutions, and a lot of bureaucratic red tape. Many government agencies were set up and they all need to do what they were asked to do, even if such actions are no longer in the best interest of the community in the face of a new reality. When the needs of the community change, a considerable number of public servants and institutions have become obstacles to change. Attempts to change anything result in a lot of vested interests fighting aggressively to protect their own turf, consuming a lot of the government's and the community's energy in the process.

Most of our senior government officials are good managers and administrators. Under most circumstances, communities need continuity, stability and incremental change. And Hong Kong's civil servants have served Hong Kong well for a long time. But the world moves on. From time to time, new paradigms appear, new concepts are called for, and life has to change. These are occasions when a broader view has to be taken as to what the community should work towards. Under such circumstances, what communities need are leaders who have the vision and the skills to mobilize the community behind them.

Reforming the public sector in Hong Kong is an important but difficult challenge. This requires good political leadership and focus of attention by the Administration. There will be a lot of resistance and hard battles to fight. But as with most challenges, you will be damned if you do, you will be damned if you don't.

K. C. Kwok
Tel: 852 28211013

Mr. K. C. Kwok is the Chief Economist of NE Asia of Standard Chartered Bank.

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