Justification given

The rescue package announced by the Government on 22 June 1998 is estimated to result in a HK$21.4 billion deficit. This was a dramatic and largely unacknowledged U-turn in policy. However the original high reserves policy expounded in the 1998/99 Budget was wrong.

To answer those critics, including the Foundation⁽¹⁾, who have challenged the high level of fiscal reserves, Donald Tsang provided justification in his Budget. Mr Tsang sees three purposes for the reserves:

Operating requirements, for which he believes an amount equivalent to three months expenditure is needed;

Contingency, for which he requires nine months expenditure-equivalent;

Monetary requirements, for which he requires the equivalent of money supply M1.

The total of these amounts in 1997 was about HK$400 billion, so Mr Tsang feels, HK$300 to 500 billion would be sufficient for the reserves at the present time.

Mr Tsang thus sought to confound his critics. Far from being too high, according to his analysis, the existing level of reserves, HK$446 billion at March 1998, is only adequate, and in future would even have to increase.

Justification not valid

But the argument is not valid. Firstly, it is an argument ex post facto: a surplus, having arisen, is given retrospective justification through the arbitrary assignment of relationships. There is no in principle argument: if the actual surplus was at a different level, it would have been equally easy to justify by assigning different relationships or percentages.

Secondly, no overseas experience is quoted. In fact, the experience of many developed countries is that they have substantial net accumulated deficits which they seek to keep within bounds; beyond that they aim to maintain a rough balance over the economic cycle. The Mastrich target for European Monetary Union, for example, is merely that each member country keep its government debt to 60% of GDP and its annual budget deficit to 3% of GDP. Hong Kong, in contrast has an accumulated surplus equivalent to 33% of GDP; last year, it budgeted for a surplus of 3% of GDP and achieved 6%.

Taking the supposed purposes of the reserves in turn, none is justified.

The operating requirements, i.e. the requirement for the Government to have cash in hand during the several months of the year when expenditure exceeds revenue, is met in other countries by short term borrowing. Such borrowing programme can be beneficial to financial market development, and is an economically efficient way of covering a temporary shortfall.

The contingency element at first glance appears more reasonable. But if a contingency should arise, it would not instantly wipe three quarters of the Government's annual tax revenues. There would be time to anticipate such a decline and to compensate for it by raising taxes or borrowing over a period of years.

The final purpose, to underpin the stability of the currency, is the most spurious of all. M1 is composed of notes and coins (HK$80 billion in 1997) and demand deposits (HK$122 billion). However, the notes are already required to be backed by US dollars deposited with the Hong Kong Monetary Authority. In addition to that the Monetary Authority had its own retained earnings of HK$190 billion at December 1997. Thus the Monetary Authority already more than covers M1, if coverage is necessary: a second layer of cover from the fiscal reserves is superfluous.

Not only are these three purposes unjustified individually, but they are even less valid collectively. It is highly unlikely that all three purposes would be triggered at the same time; therefore, even if it were appropriate to retain reserves in respect of each one should not have to do it three times over; a certain sum should be enough to cover all three purposes.

Optimal reserves level

If Donald Tsang's justification for the reserves is not supportable, what would an appropriate level of reserves be? The Foundation believes that the Government's fiscal position should be seen as a trade off between costs and benefits. The cost of a low or negative fiscal position is that ultimately the Government may be forced to default or to introduce drastic changes to improve its position. It is worth paying some price to avoid this outcome. However, the benefit of a low fiscal position is also large. Firstly, low reserves means that as much as possible of the economy's resources is left in the hands of its people and businesses. Secondly, the Government has an incentive to manage its money carefully. Thirdly, taxpayers and their representatives have an incentive to scrutinise Government spending carefully. These are large benefits, conducive to economic efficiency and social fulfillment, that Mr Tsang totally ignores.

Where is the optimal trade off point? The decision will depend on the weighting given to the costs and benefits outlined above. However, looking at the experience of the developed countries, one might say that an optimal point is probably an accumulated deficit large enough to focus minds, but small enough to be manageable. With its vast accumulated surplus, the Hong Kong Government is out of line with the international norms, is wasting taxpayers’ money and has effectively nationalised a portion of society's savings.

Policy Committee, HKDF

(1) What can be done with those reserves? HKDF Newsletter, Issue 2, August 1997