• Fin Secretary Antony Leung appears to have achieved his near term goals
• But the long term objectives of a balanced budget by 2006/07 is not assured yet
• HK's fiscal stability is dependent upon widening the tax base and restructuring costs

Financial Secretary Antony Leung made tentative first steps towards balancing HK's books. The measures were broad in scope, touching on key areas such as cutting civil service expenditure to raising corporation and salaries tax. Even political 'hot potatoes' such as the Comprehensive Social Security Assistance (CSSA) were not spared. Although the measures proposed in the Budget are unlikely to be sufficient to address the fundamental deficiencies in HK's tax system in the long run, they were, at the very least, necessary given prevailing fiscal concerns. Mr. Leung appears to have appeased markets for now by showing he no longer wishes to drag his feet.

Immediate objectives satisfied

In essence, Mr. Leung had two priorities in this budget. First he needed to impress upon the public that the government was prepared to make tough decisions to narrow the deficit. He needed to signal intent. Second, he had to be careful not to deliver too contractionary a budget that would undermine HK's recovery. On both counts Mr. Leung seems to have done enough. Given the extent of uncertainties in the global context, too aggressive a budget may not have been the appropriate medicine at this stage. The reaction from the business community has broadly been supportive so far. The next litmus test will be the credit agencies, in particular S&P who unexpectedly cut HK's rating outlook to negative last October. An announcement is expected this week.

Indeed, against the regional as well as the global backdrop of expansionary fiscal trends, HK's budget could well be seen as aggressive. But the fact is the tinkering in marginal tax rates isn't likely to have a dramatic impact since the higher tax burden will fall only on a small proportion of the working population. This is perhaps one of the few upsides of having a narrow tax base.

The focus should be on the operating deficit

What is of particular concern is HK's recurrent operating deficit. This is the shortfall incurred from the day-to-day operation of government. It is here that the largest chunk of the current deficit resides and perhaps the more difficult to curtail. Central to the government's fiscal strategy are the following three policy targets/assumptions:

1. Cutting expenditure by HK$ 20bn;
2. Raising revenue by HK$ 20bn and;
3. Stimulating economic growth, raising revenue by HK$ 30bn;

On cutting expenditure, there is little argument. HK's government spending is currently around 23% of GDP. This needs to be reduced to 20% by 2006/07 and preferably lower. Its no secret that the government will need to seek ways to further downsize the civil service. Further cutbacks are likely but opposition from within the civil service remains staunch. Progress on this is and will be slow but is improving. The reality is that more and more civil servants are accepting the fact that the old "golden rice bowl" has become an anachronism in a world where the role of the private sector and the virtues of market efficiency are key global trends.

This also applies to HK's overly generous social and welfare provisions (housing, medical, education and social security). Again, wholesale reform will be slow as the politics will inevitably complicate matters. Nevertheless, the public mood is gradually responding to the need to trim public spending which remains critical to ongoing reform. This is where Mr. Leung's political savvy will be put to the test and, arguably, the area he needs to improve most. The government has often relied on sound bites to advocate policy: the "3R1M - reprioritise, reorganise, re-engineer and use the market" is the latest attempt to encapsulate government's desire to reform the public sector. But yet again, concrete proposals on these are lacking.

Revenue projections are ambitious

But the biggest grey area is the government's revenue projections and potentially where the fiscal targets could be compromised. The government's aim of raising revenue by HK$ 20bn should be achievable. This year's budget contains estimated additional revenue of HK$ 14bn. There remains HK$ 6bn that has not been accounted for but was acknowledged by the government. This suggests that further tax hikes to the tune of HK$ 6bn are assured. But most questionable is the government's assumption that HK$ 30bn will be raised through economic growth. This is ambitious and really deserved more explanation than the government chose to give. This leaves the distinct impression that the government may still be relying on the somewhat hopeful "fingers-crossed, a strong economy will fix the deficit" policy theme that prevailed in Leung's first budget. It would be a surprise if the credit agencies don't dwell on this point.

The government will need to cash-in past investments

While trimming the operating deficit is the priority, the government will need to cut the deficit in their capital account too. Last year, the capital deficit accounted for HK$ 17.1bn of the overall deficit. This number was exacerbated by the decision to delay the partial sale of MTRC shares that would have brought in some HK$ 15bn of revenue. Indeed, the accelerated sale of a number of government assets is one way of clearing up the current deficit quickly. The government plans to step up asset sales to HK$ 21bn in 2003/04, HK$ 30bn in 2004/05, HK$ 24bn in 2005/06 and HK$ 21bn in 2006/07. This should bring the capital financing account into balance by 2006/07 and leave only the operating deficit to be dealt with. This is not a bad idea. In effect, the government needs to cash-in past investments. This not only helps to narrow the current deficit but proceeds from such sales should be used to fund future investment in capital projects (infrastructure & logistical connections especially with the Pearl River Delta) that would promote growth. Privatisation of this sort greatly helped the UK government balance their books during the 1990's. It will also be instrumental in HK's hopes of eradicating their fiscal deficit.

But fundamental deficiencies have not been addressed

Intuitively, the sale of government assets cannot fund an operating deficit indefinitely. For long run fiscal stability, both the operating and capital accounts needs to balance themselves. This naturally leads us to the fundamental deficiency in HK's finances, an inhibitingly narrow tax base. It may surprise some outsiders that out of HK's 3.2m working population, 2m don't pay any tax at all. This budget did not address this underlying problem. Yet it's an issue that will need to be tackled soon. In its current form, HK's current tax regime is unsustainable.

The reason it has lasted this long is because HK was able to fund its recurring operating deficit from large windfalls from land sales during the property boom years. This golden goose may well have been lost for good. This means that self-sufficiency in the operating account is crucial to fiscal stability.

Broadening the tax base is essential for long term stability

It is common knowledge that HK needs to widen the tax base. Mr. Leung alluded to the possibility of a general sales tax (GST) in his budget. In our view, it is inevitable. A GST would instantly broaden the tax base by taxing people's spending rather than their earnings. Estimates from a local think tank project that a 3% GST could raise HK$ 18bn while a 6% GST could raise HK$ 36bn, greater than the government's total 2001/02 forecasted receipts from salaries tax.

This clearly leaves the door open for a major change in HK's tax policy. Indeed, the government is slowly coming around to this idea and consultations shouldn't be too far around the corner. Moreover, the additional revenue from a GST would allow the government to reverse some of the tax hikes announced this year. This would help restore part of the erosion in tax differentials with regional competitors like Singapore (who incidentally surprised many by NOT cutting corporate taxes this year). Together with the simplicity of HK's tax regime (for both domestic and foreign firms), HK's tax competitiveness won't be drastically undermined.

A start but not the end.....

The pressure to keep costs falling and revenues growing will remain the priority in budgets to come. Mr. Leung appears to have done enough this year. He has delivered a fiscal starter that appears to have appeased the sceptics at least for now. However, given a number of grey areas in the revenue projections, the underlying pressure to narrow the deficit has not dissipated. The government seems to have secured the support of the business community with this budget but how the credit agencies respond will be more important. Moody's highlighted again the risks of persistent deficits undermining confidence in the HKD peg. S&P's verdict has yet to be released but will be of particular interest following their downgrade of HK's rating outlook to negative last October. While we view the risk of an actual credit downgrade as limited at this stage, it remains to be seen how convinced S&P are. From the market's perspective, Mr. Leung may well afford to lose some of the public's confidence, but it is paramount that he doesn't lose the confidence of the credit agencies.

Mike Moran
NEA Economist
Standard Chartered Bank
(+852) 2821 1647