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The Government must act on inflation

A PROBLEM THAT MUST BE ADDRESSED
(Speech by Chan Ying-lun on 24 May 1991)

Sir,

In April inflation reached a level that has become alarming to the people of Hong Kong. The elderly and those on fixed and low incomes a particularly hard hit. Workers who are not able to keep up in the inflation race, including many in the manufacturing sector, also suffer. These people face hardship as prices rise faster than their incomes.

But it is not only the poorer members of our society that suffer through inflation. Business is also the loser. Our exporters have not been able to pass on cost increases to their customers and so lose profits. Foreign companies considering setting up in Hong Kong are deterred by the high wage and other costs. If not checked, inflation can erode the prosperity that we have enjoyed in Hong Kong for so many years.

What can be done about inflation? The Hong Kong Democratic Foundation believes that there are sensible, practical steps that the Government can take to address the problem. I shall outline these in a moment. But inflation is partly a psychological phenomenon. It is people’s expectations of higher prices that lead them to demand higher wages. The Government must take the lead in order to break this cycle of inflationary expectations. Only firm Government action will restore confidence.

WHAT THE GOVERNMENT CANNOT DO

Let me first acknowledge that there are limits on what the Government can do. One major cause of our present round of inflation is the labour shortage, which pushes up wages, particularly in the services sector. Little can be done about this in the short term. Massive importation of labour is not an answer.

The link with the US dollar is also a major constraint on the action that we can take. The Government cannot raise interest rates to rein in monetary demand because this would affect the linked rate. Allowing the Hong Kong dollar to rise against other currencies would be another source of relief from inflationary pressure. But our link system rulers this out.

Should we abandon the link system? The US dollar has been unstable in recent years, dragging our currency up and down with it. However the confidence in our currency that comes from this link has been good for Hong Kong. The Hong Kong Democratic Foundation believes that there is at present no acceptable alternative to the link with the US dollar.

WHAT THE GOVERNMENT CAN DO

However the Hong Kong Government is not impotent in the fight against inflation. There are important steps that it can and must take.

Firstly, we need a sensible fiscal policy. Further increases in indirect taxation should be avoided. I think all of us are conversant with the inflationary effects of the original proposal to increase tobacco taxes by 200%. While I am relieved at the Government's conversion, even if belatedly, to the cause of fiscal moderation, I must emphasise that in our current circumstances we cannot increase indirect taxes further. Whether or not we have the right balance now between direct and indirect taxation we have to pause for a while before shifting the balance again.

I would entreat my Honourable colleague the incoming Financial Secretary to drop his predecessor’s proposals for a sales tax. Such a tax would be inflationary. It would also hit the lower income groups hardest.

The Government should aim not to spend more than it raises through taxation and other revenue sources. A large Budget deficit at this stage would be inflationary.

Secondly, Government spending must be controlled. How can this be done when we are at the same time asking for more and better services? Clearly, there is no simple solution. However, as my Honourable Colleague noted in his Budget proposals, a firm line must be taken on staffing levels and rates of Civil Service pay.

Perhaps I could add some further recommendations here. Greater flexibility is needed in allocating staff between different departments to meet changing workloads. The system of setting Civil Service pay by reference to private sector pay of the previous year should be abolished. Where pay settlements are on a declining trend this has an inflationary effect on expectations.

The Audit Commission should be strengthened and a proper system of cost accounting introduced to ensure that value for money is being obtained. Finally, an independent Commission should be set up to consider where activities currently undertaken by the Government could be performed more efficiently by the private sector. This should not result in higher charges to the public but to better value for money being obtained.

The pricing of Government contracts with allowance for inflation should be reviewed. Fixed price contracts or some sharing of cost increases by the contractor should be considered. This is important in view of the heavy infrastructure spending planned for the l990s.

Thirdly, the pricing of utilities must be reviewed. The schemes of control under which our utility companies operate are inefficient. The! guarantee the company providing a certain rate of return after deduction of its costs. The company therefore has no incentive to control its costs as it knows that it may pass these costs on to the consumer. This system is both inflationary and inefficient.

A preferable system would be to fix the permitted price increase each year, say at the rate of inflation minus a certain factor. This is the system followed in the UK. Alternatively, the present rate of return regime could be maintained but with the rate of return being calculated before, rather than after, deduction of the utility's costs.

Both of these methods would result in lower prices for the consumer. The more efficient utility companies could also make higher profits, despite the lower prices.

Fourthly, public sector pricing policies must be coordinated. We seem to be undergoing a wave of sharp price rises in both the public and private sectors. Housing Authority rents have been increased by between 12 and 28%. Bus fares have risen by up to 17%. Taxi companies have put in a bid for a 25% fare increase.

It is vital that the individual bodies responsible for setting or approving these price increases bear in mind the effect they have on the macroeconomy. While our current inflationary conditions persist every effort should be made to moderate such increases.

Fifthly, the Government must encourage productivity improvements. I have mentioned the labour shortage as a problem about which we can do little. Ultimately, however, the only way we can increase the capacity of our labour force is by upgrading the skills and educational level of our workers. There is scope for the Government to do more to encourage employers to improve training programmer and to educate the working population as to opportunities available in growing sectors of the economy.

CONCLUSION

I have said that there is no magic solution to our inflation problem. The current high inflation rate derives in great part from factors outside the Government’s control.

However there are still important steps that the Government can take to limit inflation. The most important of these are the adoption of sensible fiscal measures, particularly the avoidance of further increases in indirect taxation, and the control of its own spending. These measures will give the private sector the lead and help break the spiral of inflationary expectations.