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Revised Budget Outlook Still Needs Work

With no significant reduction in government spending planned for the next five years, the Financial Secretary may need to pull a few rabbits out of his hat if the budget is to be controlled, writes DAVID O'REAR

Shortly after Financial Secretary Henry Tang Ying-yen's October 22 speech to the Legislative Council on the SAR's economy and fiscal situation, the government released first-half figures for the budget deficit. The April-September data show that revenues fell 5.6 percent from the same period in 2002, while spending rose 0.7 percent.

The first graph presents average monthly income, out-goings and deficit figures, on a 12-month rolling basis (to dampen seasonal fluctuations). What is immediately obvious is that revenues have fallen sharply, while spending continues apace.

In October, the Financial Secretary presented a more rosy outlook for the Hong Kong economy than that forecast by his predecessor seven months earlier. While the relatively rapid conquest of SARS and apparently strong Q3 growth figures might appear to be the reason for increased optimism, it must be remembered that Anthony Leung Kam-chung's budget speech was in the very earliest days of the crisis, before the full implications were known.

Mr Tang raised the real GDP growth figure for this year by half from the revised August prediction (to 3 percent) amid a rapid turn-around in tourist arrivals and improving retail sales figures. The Financial Secretary also added an extra half percent to medium-term growth, raising it to 3.5 percent per annum in 2004-05 to 2008-09. On this basis alone, one would expect the deficit to be conquered earlier than expected.

However, Mr Tang then predicted that the government's operating expenditure would be HK$7.7 billion higher than expected this year and revenues up by $5 billion. Although this will leave a deficit of about $78 billion -- a new record and equal to nearly 5 percent of GDP -- the sharp drop in business and extraordinary expenses associated with SARS make this seem reasonable.

The problems are further out. Over the medium term Mr Tang gave a rough forecast that operating expenditure would decline from this fiscal year's $218 billion to $200 billion in 2008-09. Since the previous forecast only went to 2007-08, the rest of this analysis will use that end-point as a basis for comparing the new plan with the old.

Under the new plan, nominal GDP will be $57.5 billion larger in 2007-08 than originally predicted. Based on the Financial Secretary's straight-line forecast, operating expenditures in 2003-04 to 2007-08 will rise $22.3 billion more than previously thought over five years, and revenues wil be $27.9 billion lower.

In other words, faster growth will yield less income, and under that lower income plan, spending will be higher. The second graph extends the first, showing the revenue, expenditure and deficit out to 2007-08.

What is obvious is that there is no significant reduction in spending, and that none is planned in the next five years. On a straight-line basis, spending will be $7.4 billion higher than Anthony Leung's projections in 2004-05, $7.2 billion more in 2005-06, $7.3 billion higher in 2006-07 and $500 million higher in the final year.

The problem gets worse when fiscal reserves are calculated by subtracting the deficit from existing reserves. The third graph shows the reserves in billions of dollars and as the number of months spending that they will accommodate. At various times, the government has suggested that one to two years spending is the appropriate level of reserves, and as the graph shows, the September level was equal to 12 months spending. Mr Tang pledged to ensure that fiscal reserves remain at a prudent level. That will be a challenge.

The two factors in the fiscal crisis -- the dramatic fall in revenues and the continued high level of spending -- cannot be solved with a single-sided solution. While it may be necessary for new or higher taxes to be imposed (one would hope only temporarily, so as not to violate the Basic Law), that will not suffice. Spending must be cut, and the only reasonable way to do so is by taking on the thorny issue of civil service redundancies. At the end of the day, it is better to cut one person's salary by 100 percent than to cut 10 people's salaries by 10 percent each.

It seems odd that a better economic outlook would increase revenues less than under a more pessimistic forecast, and that the renewed growth would not provide the context in which to sharply reduce spending. But, that's Hong Kong public finances.

David O'Rear is the Chamber's Chief Economist. He can be reached at david@chamber.org.hk