One policy error away from fiscal disaster

(Next Magazine, 2017/7/13, A002, Second Opinion, Bill Stacey)

One policy error away from fiscal disaster

In the west, country after country, government budgets have spiraled out of control, creating persistent deficits and leading to rapidly rising debt. The United States is not known internationally for its extensive welfare state, although that is a misnomer, but government debt that was 30% of GDP in 1980 had risen to 60% by 2005 and now sits at 104%. By similar measures, China’s general government debt rose from 20% in 2000 to 46% in 2016.

Despite the natural prudence and caution of Hong Kong people, because the government has no net debt, we can be complacent about our capacity to increase government spending. To avoid the spiral, we need to understand what causes debt to get out of control and have a good understanding of where we are starting from.

Although Hong Kong is not a large issuer of debt, the government does have substantial liabilities. The largest of these is government pensions, which are not funded at all by a separate pool of investments to meet those obligations. Financial liabilities of the government are now 43% of GDP, up from 30% a decade ago. In the five years that Leung Chun-ying was Chief Executive, government pension liabilities grew at a compound average rate of 9.9%. Those liabilities are valued using a defensible 4% discount rate, but with 10-year US government bonds yielding just 2.4%, those liabilities could prove to be much higher. Indeed pension liabilities have been revised higher in 11 of the past 13 years.

We have become accustomed to thinking of the HKMA-managed investments in the exchange fund as a surplus just waiting for a rainy day or to be spent. Look at our government’s balance sheet, and you will find that the exchange fund investments of HK$853bn are not even enough to cover the HK$875bn value of the pension liabilities. There is no pot of gold at the end of the rainbow.

Former Financial Secretary John Tsang was often criticized for parsimony, but the accrual accounts of the government paint a different picture. During the five years to March 2016, operating expenses grew rapidly at a compound rate of 7.7% per year, more than the 7.1% growth in revenues and far more than the 5.7% growth in nominal GDP.

Where did the money go? Health spending grew at a compound average rate of 11.8% each year over five years and social welfare spending 9.4%. Those growth rates are under current policies. How much room for new policies is there when demographics are pushing those costs ever higher? With these costs rising and expenditure growth higher than revenue growth, we are already on a path that without changes will lead to budget deficits. We are just one policy error (say a universal pension commitment) away from a spiral toward real fiscal problems.

Policymakers inevitably confront the law of the golden goose. Operating revenue growth has been higher than GDP growth over the last 13 years. Non-operating revenues like land premiums and investment returns have also grown rapidly. Under our current low-rate tax system, revenues have grown faster than the economy. Raising tax rates to boost revenue is likely to kill the goose that lays that golden egg.

One of the key reasons that revenue grows faster than the economy, is that we attract businesses managing activities from other countries and increasingly those from China. Nothing can turn Hong Kong into “just another Chinese city” more forcefully than removing our taxation and rule-of-law edge over the mainland.

Surpluses from past fiscal prudence have been absorbed by rising civil servant pension liabilities. Contravening Article 107 of the Basic Law, spending is increasing faster than revenues or GDP. Public clamor and politicians’ promises are accelerating this trend. Though not known for keeping his policy pledges, the former Chief Executive did – to our detriment – deliver on his promise to increase the role of government and public spending. Time to check our spiral-down towards fiscal disaster.

Bill Stacey


The Lion Rock Institute