The Government Budget for 2002-2003 offers interesting - and reassuring - material for the continuing debate about fiscal deficit and monetary stability.
In the run up to the 2002-2003 budget I deliberately drew attention, in this column and in other HKMA publications, to the risk that structural, as against cyclical, budget deficits, if left unchecked, may eventually endanger monetary stability. I also made the observation that the state of the public finances was at the top of the list of risks and vulnerabilities that we faced on the monetary front, ahead of the crisis in Argentina and the weakness of the Japanese yen. Many echoed my comments, but in varying degrees of intensity, ranging from merely noting the risk and dismissing it, to magnifying it and predicting doom for our currency link. Others simply interpreted my comments as crying wolf, in an attempt to prepare the way for the passage of the budget of the Financial Secretary.
Whatever the reaction, I wish just to add here that, as Monetary Authority, I have a duty to identify and, to the extent possible, manage any risks to monetary stability. Drawing attention to the risks and encouraging rational discussion of them is often an effective strategy in risk management, particularly where financial markets are involved. The trick is to minimise the likelihood of shocks, for they can be very destabilising to financial markets. It is not so much the shock-induced, short-term market volatility that I am concerned with, for markets do go up and down, and the regulators ought to ensure that the markets are robust enough to cope. It is the possibility that, in the absence of informed opinions on the understandably technical and controversial issues, the market volatility generated by the shocks may be so irrational and therefore so great as to exceed the reasonable threshold beyond which systemic damage will result.
I am pleased to notice that the discussion on the budget deficit is going well. There is calm realisation that we are facing a structural as well as a cyclical problem in the public finances; there is prudent acceptance that this may, if left unchecked, present risks to monetary stability; and consequently there is a highly credible strategy for tackling it decisively. The reaction in financial markets generally to the extensive discussion, more recently in the context of the 2002-2003 budget and the budgetary strategy for the medium term, is an encouraging indication that the government, with the necessary public support, will deliver what is needed. Specifically, the stability in the exchange rate, in both the spot and forward markets, is a demonstration of market confidence that the structural problem will not be allowed to get out of hand and endanger monetary stability.
While debate and deliberation on the 2002-2003 budget continue, let me contribute further to the interesting discussion. I am glad that the Financial Secretary is confident enough about the effectiveness of our monetary management to determine that it is no longer necessary for the fiscal reserves directly to contribute to monetary stability by earmarking part of it by reference to a measure of the money supply. I am also glad that this view has received the endorsement of the market. I agree with him that the indirect contribution through the depositing of fiscal reserves with the Exchange Fund should continue.
I am relieved that he did not express any intention to draw upon the HK$300 billion odd accumulated surplus of the Exchange Fund to meet budget deficits. In saying so I am aware of the possible challenge from monetary purists that a strict adherence to currency board rules does not require resorting to the assets representing the accumulated surplus so that we do not really need to hang on to it for the maintenance of monetary stability. My answer is simply that experience in the past 20 years in monetary management in Hong Kong has taught me the need to be conservative, which should not in any way cast doubt on our determination to adhere strictly and transparently to currency board rules.
But let us consider this also in the context of the budget deficit. In my opinion it is vitally important that there is not even the slightest impression given to anybody that monetary financing is involved. I am not suggesting that any transfer from the accumulated surplus of the Exchange Fund to the general revenue, in accordance with the provision in section 8 of the Exchange Fund Ordinance, amounts to monetary financing. Indeed, the process does not involve any creation of money. But if we were to go down this route, the question as to what next would certainly be raised in financial markets. Once again, performing my duty as Monetary Authority to identify and manage risks to monetary stability, I would suggest that interested parties should carefully consider whether this is a risk that we can afford to take.
Joseph Yam
21 March 2002
Related Viewpoint article:
The IMF Article IV Consultation, 7 February 2002
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