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Saturday, February 26, 2011

The Hong Kong Budget 2011 and what it means for Inflation

When Hong Kong Financial Secretary John Tsang presented the 2011-2012 Budget on Wednesday, he announced that fighting inflation and inflation expectations was the Government’s main target.

However, a look at the ‘Combat Inflation’ section of the budget raises more questions than answers. The first point mentioned is that the government will waive property rates up to HK$1500 per tenement per quarter at a cost of HK$9.9 billion. The Budget then states that HK$4.7 billion will be spent in subsidies to every residential electricity account and that two months rent will be paid to public housing tenants at a cost of HK$1.9 billion. These endeavours are counter-intuitive as each measure will actually free up money that individuals would otherwise have spent on rates, electricity and rents. This money, instead of ending up in government coffers, will now be released into the market, inevitably contributing to demand-pull inflation. Indeed, the effect of this spending on aggregate demand will be greater than the amount of spending itself as the people who benefit from these waivers/raised benefit ceilings/lump sums are generally those with a high marginal propensity to consume. In other words, this spending by the government will have an amplified effect on inflation.

This said, the Budget does include significant supply-side policies that are bound to reduce underlying inflation in the long-run. Government capital works expenditure will be a record HK$58 billion this year – a figure that will rise to over HK$60 billion in the next few years, Tsang promises. Spending on education and health care will increase by 6% and 9% respectively, reflecting a total expenditure in these two areas of HK$94.4 billion this year. While, in the long-term, this spending will increase aggregate supply and reduce inflation, in the short-term this will only exacerbate inflation as aggregate demand will receive a boost. We always knew the government would have to bite the bullet someday and engage in supply-side policies to counter the largely cost-push inflation (apart from in the real estate market) but perhaps this year, given the high inflation, wasn’t the opportune time to do it.

Despite these unprecedented spending increases, the government plans to unveil HK$5 billion to HK$10 billion worth of HKD denominated ‘iBonds’ within the next six months. Investors will be paid an inflation-linked coupon twice every year. Superficially this appears promising as one would assume that the iBonds will reduce the money supply and increase savings. However, the advent of the iBonds is unlikely to increase savings as most of the money invested in the iBonds would otherwise have been saved somewhere else. Moreover, the relatively small scale of the bond issuance (less than 0.5% of total bank deposits in Hong Kong) will most likely mean that the iBonds don’t dent inflation.

Many people, myself included, have lambasted the Budget, however one cannot help but feel sorry for Mr. Tsang. Hong Kong’s dependence on foreign production for virtually everything means that most of the inflation that the city is experiencing is imported. Sadly, Mr. Tsang can do little about tensions in the Middle East, droughts in Russia and Argentina, or floods in Canada and Pakistan. In fact, the only thing that Hong Kong can do to control imported inflation is to raise the value of its currency which would mean dropping its peg to the weakening dollar.

Mr. Tsang’s approval ratings fell through the floor shortly after he announced the Budget as politicians and the people complained that the Budget would not lower inflation. They were right, in the short-term at least. However, these people also moaned about the fact that Mr. Tsang did not include any tax rebates in the 2011-2012 Budget. These two complaints are contradictory – lowering taxes will do nothing but increase inflation, especially if the rebates are for low-income earners who save little and tend to start strong multiplier effects. Indeed, if Mr. Tsang has to be lauded for one thing it is for preserving the HK$71.3 billion budget surplus. Spending away this surplus as politicians have suggested would only have increased inflation and I believe that the Financial Secretary is wise for holding out with his Keynesian counter-cyclical strategy and holding on to the surplus in expectation for what he calls ‘the perfect storm’ that may loom ahead.

Deep Vaze