Good deficits and bad budgeting

Original version of what should have been published in the SCMP on November 4. What was actually published was a bowdlerized and ill-edited version of this

With Budget-making time upon us, it will be interesting and important to see whether Antony Leung Kam-chung can stamp a modicum of coherence on the government's economic policies. At present there is none. He also needs a vision of how much needs changing if Hongkong is not to follow the path of Japan, beholden to the past and to entrenched interests.

The Chief Executive, as ever muddled in his thinking, simultaneously stresses the dangers of deflation and of budget deficits while simultaneously stressing the inviolability of the dollar peg and the need to ramp up property prices. Meanwhile the representatives of vested interests far too close to his ministerial system continue to make a laughing stock of Hongkong's supposed free market principles, and to extract monopoly profits from essential public services from ports to stock exchange.

But first spare some sympathy for Mr Tung and others trying to achieve coherence when Standard & Poors downgrades Hongkong's currency rating and casts long term doubt over the long term sustainability of the peg. S&P delivered a homily about belt-tightening etc and suggesting dire consequences if Hongkong's deficit persisted.

Forget for a moment that on its record S&P should be regarded with utmost caution. It is representative of the same kind of received wisdom which has given us Mary Meeker, Henry Blodget, Abby Joseph Cohen and other "professional advisors" who have suckered foreign as well as domestic investors into Wall Street's scams and fads. It is no surprise either that S&P sometimes stands accused of failing to apply the same standards to US debt issuers as to foreign ones. (Just look at the easy ride S&P gives to Fannie Mae and Freddie Mac, two of the most over-leveraged institutions on earth).

Forget S&P. Look at some of today's facts about the relationship between budget deficits and currencies. Look at Europe. There the stability pact which limits government deficits is daily being accused of responsibility for weak domestic demand and hence for a relatively weak Euro! If government deficits were a major ingredient in currency valuations, where would the yen now be?

Of course, government deficits can cause huge currency problems - witness Argentina. But that is because much of the debt is foreign currency funded or is borrowed short term and at volatile rates. An economy with a private savings surplus can easily fund government deficits without any problem. Indeed, in times of recession that is what is needed. Hongkong is in just such a position.

Without the government deficit, now running at around 4% of GDP, the economy would be in a lot worse shape than it is. If private sector demand revives the deficit will automatically contract. Until then, a 3% or so deficit is desirable. Hongkong has an excess of savings, high bank liquidity, a huge current account surplus etc. What is lacks are good investment projects and consumer confidence.

For now, official reduction in government foreign exchange holdings to cover the budget deficit is roughly matched by private sector acquisition of foreign assets. To suggest that there is any significant link between the deficit and the sustainability of the peg runs contrary to the rationale on which the peg is based - the expansion or contraction of money supply. The only threat to the currency is an exodus caused by the perception that it needs to be abandoned for good economic reasons.

But instead of abandoning the peg, as I have long argued, the government now seems determined to make it even more of an albatross by cutting the budget deficit out of fear of S&P's parachute experts and an often irrational market. If the peg is to force us into a deflationary fiscal as well as monetary policy, that is all the more reason to dump it now.

That said, it is also true, as I have been writing in this column for years, there is a structural fiscal problem which has long been avoided but has to be addressed. Fiscal reform must proceed independently of the macro-economic considerations in framing the budget. Even at the macro level, there is an argument to be made that given Hongkong's savings excess, higher taxation would be less damaging than drastic spending cuts in bringing the deficit down to the 3% of GDP range.

Direct tax increases would be preferable to a sales tax from the points of view of equity, simplicity and impact on demand. That means slightly higher standard tax rate - on salaries as well as profits -- higher property rates and cuts in the very generous salaries tax allowances, particularly for upper middle income earners. Spending cuts need to be concentrated in two areas: infrastructure projects of unproven economic or social value, and pay and staffing levels in the upper echelons of the bureaucracy.

It is alarming to hear demands for cuts in social security, particularly from the well-heeled leaders of the Liberal. Most social security spending goes to the elderly, already Hongkong's underclass. Only a minority of unemployed people receive welfare and, contrary to the stories put about by fat cat officials, very few receive anything approximating the median wage. Welfare spending also has a direct and immediate impact on consumption while infrastructure spending goes either to imported equipment or labour.

The Budget is also the place to address issues of private exploitation of public assets. It could start with the industry with which Mr Henry Tang and Mr James Tien are familiar: textiles. Although the demise of the Multifibre Arrangement should, three years from now, consign textile quotas to history, the fact is that quotas, which are a scarce commodity which belong to Hongkong as a whole, are given out freely to select groups. This process has always lacked the degree of transparency it warrants. It is well known in the trade that some old established groups make a handsome living by selling quota. These rentier capitalists are not only living off the past, they are taking from the public purse. If Mr Leung is brave, he will announce that from now on all quotas will be auctioned.

He should also announce an inquiry into the pricing policies of the oligopoly that causes Hongkong container handling charges to be two to three times levels in most Asian ports. At the same time port charges, which are levied by the government, remain very low. The gigantic profits that Hutchison has made from Hongkong terminals has enabled it to become a global player. This may be fine for its shareholders, but can hardly be of benefit to Hongkong. If this government is serious about making Hongkong more competitive, and in showing that it is not beholden to Mr Tung's former business associates, it will go head to head with Hutchison, Wharf etc on the ports issue.

In the recent traffic rights negotiations with the US it finally showed willingness to put Hongkong's economic interests before those of Cathay Pacific. It must now do the same with other key transport, trading and utility concerns and introduce real competition into cosy, crony-run monopolies.

Likewise it must represent the public interest, not the interests of its friends and certain business and family groups over-represented in Legco, in addressing the issues of land supply and border opening. It is quite obvious that these interest groups, not the mainland, not technical issues, are frustrating cross-border movement.

Likewise it is obvious that lower land prices are of benefit to the majority of people and businesses in Hongkong. A government which refuses to spend money on old peoples' welfare or needed public transport because it refuses to sell land to help out its property pals is worthy of being compared with the latter years of the Suharto government in Indonesia.

Likewise, one which fails to recognize that entrenched anti-competitive structures must be broken up if Hongkong's overall vibrancy is to be restored will lead it down the path of Japan. Budgets are not just about balancing books or even about macro-economic policy. They help define a government's view of its responsibility to the society for whose interest it is supposed to govern. ends


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