Brazil
Reserves − Noah’s Ark for a Rainy Day
February 28, 2008

By Marcelo Carvalho | Brazil

Brazil has built up reserves rapidly, from US$16 billion in 2002 to US$180 billion at the end of 2007. By doing so, Brazil builds insurance against a ‘sudden stop’ of capital inflows while also buying its way into investment grade status. The authorities now celebrate that Brazil has become a net creditor, as it has enough reserves to fully cover its external debt.

However, despite the many benefits, reserve accumulation has costs too. The fiscal cost from sterilized currency intervention is particularly high in Brazil, given large interest rate differentials. In all, Brazil’s reserves appear well above their optimal level, in our opinion, and it seems hard to justify an aggressive build-up from current levels. 

Accumulating Reserves: Benefits and Costs

Why should central banks accumulate foreign reserves in the first place?   There are two main conceptual reasons that stand out. The first is buying insurance, in order to avoid a ‘sudden stop’ of capital inflows or, at least, mitigate the dire consequences for the economy if a sudden stop does materialize. The idea here is to use reserves as a buffer to smooth out currency swings over the cycle.

The second conceptual motivation for reserve accumulation is to depress the currency (or, at least, lean against appreciation) for mercantilist purposes, hoping that a sufficiently competitive currency boosts export-led growth. For instance, massive reserve accumulation in Asia over the last decade has often raised suspicion that currency intervention has gone well beyond what would be justified for prudential reasons alone.

In the case of Brazil, the authorities strenuously argue that their interventions in the currency market are not aimed at altering exchange rate dynamics. Brazil has a floating exchange-rate regime, and the authorities have no target, ceiling or floor for the real − they insist. In fact, we suspect that currency intervention can often prove ironically counterproductive if the goal is to weaken the currency on a sustained basis, as intervention can end up luring more short-term capital flows into the country.

Saving for a rainy day thus seems like the Brazilian central bank’s strategy, as it opportunistically builds a war chest of foreign reserves. Good things do not last forever, the argument goes, and so in good times the central bank builds a buffer for tough times. By doing so, the authorities also seek to lower external borrowing costs for the public and private sectors. Intervention is not meant to add volatility to the currency market; indeed, the prospect is that it might dampen it.

But insurance policies have costs too. Interest rate differentials are the clearest quantifiable cost for currency intervention. When Brazil’s central bank buys dollars from the markets, it buys with local currency. The additional injection of liquidity, via local currency issuance, is then mopped up with government bonds. This is ‘sterilized intervention’, as economists love to babble in their inscrutable jargon. The trick is that foreign reserves are typically invested in conservative, low-yielding international assets, while domestic paper issued to sterilize the intervention typically faces a much higher cost.

The fiscal costs of currency intervention are particularly high in Brazil. Brazil’s interest rates have come down steadily in recent years to unprecedented low nominal levels in the country’s modern history, but still remain way above international standards. Last year, with average interest rate differentials of about 7% and an average reserves level of some US$130 billion, we estimate that the average fiscal cost of holding reserves during 2007 was about US$9 billion, or 0.7% of GDP.

Intervention costs do not show explicitly in the fiscal accounts, but they nonetheless bite. Fiscal costs will appear as a larger burden of interest payments on the public sector’s debt. As it means acquiring low-yielding assets by issuing high-yielding liabilities, sterilized currency intervention ends up increasing the implicit interest rate paid on the public sector debt. All else equal, the overall net debt may not change, but its effective average cost increases. Indeed, while the overnight policy interest rate has declined steadily over recent years, the implicit interest rate has failed to fall as quickly. In sum, opaque sterilization costs may make the central bank’s intervention job easier, but they nonetheless hurt the fiscal accounts. 

Enough Is Enough

Brazil’s reserves stand well above standard measures of the ‘optimal’ level of reserves. What is the optimal level of reserves for Brazil? Let us consider four benchmarks:

• The first is the old back-of-the envelope rule, which says that reserves should cover three months’ worth of imports. That would now mean US$30 billion.

• The second rule of thumb is the so-called Guidotti-Greenspan rule, which says that reserves should cover external debt maturing within a year. That would currently mean about US$65 billion.

• A third reference comes from an IMF study, which suggests an optimal level of reserves at about 10% of GDP, or about US$130 billion now.

• A fourth reference comes from a study conducted by the government-sponsored think tank IPEA, which estimates the optimal level of reserves for Brazil in late 2007 in the US$40-90 billion range, depending on the specific assumptions.

In sum, although estimates of the optimal level of reserves can vary significantly, Brazil’s actual current level of almost US$190 billion exceeds them all by a large margin. If Brazil is building for a rainy day, it seems to be building a Noah’s ark.

A simple cost-benefit analysis does not support much further increase in reserves.The marginal benefit of an additional billion dollars of reserves was surely much larger years back, when the total stock was a fraction of where it stands today. The marginal benefit of reserves is therefore declining. On the other hand, the marginal fiscal cost of sterilized intervention is now on the rise. While interest rate differentials are less than in years past, they are on the rise again today as Brazilian interest rates are on hold while the US Fed eases aggressively. With interest rate differentials currently at about 8%, we estimate that the fiscal cost of holding US$190 billion of reserves amounts to US$15 billion (or 1.2% of GDP) per year.

Buying its Way into Investment Grade

We suspect that a thinly disguised, additional reason for the reserve build-up is the desire to achieve investment grade status. Brazilis currently one notch below investment grade at all the three major rating agencies. Ideally, structural reforms would pave the way for a rating upgrade. But given the political and economic difficulties in moving fast on reforms, Brazil seems to be counting on buying its way into investment grade by accumulating reserves.

If true, this thinking would skew the reserve accumulation effort above what would be necessary for typical insurance purposes alone. In fact, most external solvency indicators now suggest that Brazil is already comparable to investment grade countries. And the authorities’ recent indications betray this thinking, as they loudly celebrate the fact that Brazil has become a net creditor, now that its international reserves more than fully cover its external debt.

Investment grade upgrade seems on its way and appears to be a matter of time, in our view. We think that S&P will be the first to move eventually, and the agency has recently indicated that an upgrade in 2008 is possible. If reserves have already risen to a level that the authorities consider sufficient to enter the promised land of investment grade, there would not be much justification for fast further reserve accumulation from here for rating upgrade purposes.

FX Implications

If the authorities decide to step back from intervention in the currency market, then the exchange rate would tend to appreciate,all else equal. True, we suspect that, in due course, a tougher global environment could eventually call into question the currency strengthening seen over the last several years. That said, if capital inflows instead prove strong, and in the absence of currency intervention, the currency would appreciate in the near term.

In turn, currency gains would further consolidate benign inflation expectations and reinforce the case for no monetary tightening. It would also be interesting to see whether currency gains rekindle concerns at the finance ministry about undesired side effects for exporters, and for import-competing producers. In such an environment, it would not surprise us to see renewed proposals for fiscal incentives for sectors hurt by currency appreciation.

Bottom Line

Brazil has come a long way from the reserves scarcity days of the past, as it has rapidly accumulated reserves in recent years, particularly in 2007. But it now risks having too much of a good thing. Brazil’s reserves are well above usual estimates of the optimal level. Buying reserves as a form of insurance is laudable, but over-insurance can be costly too. While the marginal benefit of further reserve build-up is declining, the marginal cost remains high, and right now it is actually rising.

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Euroland
Euroland Business Cycle Watch – The Slowdown Is Coming
February 28, 2008

By Carlos Caceres & Eric Chaney | London

Hidden behind the rebound of the headline Ifo index, February surveys (Ifo, Insee, Isae, etc) showed a downward correction with respect to business expectations.  European manufacturers are becoming more cautious, acknowledging that growth in the euro area is likely to slow significantly this year, because of the macro headwinds faced by the economy, i.e., the credit crisis and the overvaluation of the euro.  At this stage, however, companies’ assessments continue to suggest that an ‘orderly slowdown’ is the most likely outcome.

Current Production Easing Only Incrementally

The assessment on current production stood at 0.5 standard deviations (s.d.) above its long-term average in February, unchanged from the previous month.  Yet, current production is following a downward course that started more than a year ago, after it peaked at 1.4 s.d. in December 2006.  We expect this downward correction to continue in the future, with a risk that it could intensify, given that production was eventually softer than companies’ strong production plans had anticipated, three months earlier.

Demand Remains Stable and Robust

Demand has been recording a very robust performance in the recent past – growing by more than one s.d. above its long-term mean for almost two years – and remained unchanged from last month at 1.0 s.d.  The most buoyant sector is foreign demand for capital goods, especially those aimed at satisfying the infrastructure needs in emerging and catching up economies – a structural, not cyclical trend.  Yet, demand as reported in manufacturing surveys is a lagging indicator of actual production, because it includes demand for inputs (intermediate goods), which are highly sensitive to inventories.  In this regard, the good news is that companies continue to qualify their inventories as insufficient, which implies that, in the short term at least, an inventory overhang is unlikely.

Output Plans Revised Down Significantly

Production plans for the next three months, a key indicator in our models because it synthesises all the public and private information company managers have access to, recorded a significant downward correction this month.  It is now at 0.5 s.d. above its long-term mean, after it recorded a seven-month high in January (0.8 s.d.).  In fact, output expectations fell in all the surveyed countries included in our sample.  This correction suggests that company managers have now acknowledged the fact that this year’s economic outlook could be bleaker than they previously thought.

Our Surprise Gap Is Bordering on the Recession Zone

Our Surprise Gap moved downwards this month, still within the neutral zone, but it is now quite close to crossing the deceleration line.  The relatively upbeat production plans announced in the past few months are the cause of the downward move in our Surprise Gap index, as actual current production came in below manufacturers’ expectations.  This still leaves our Compass indicator in the ‘Grey Zone’ (i.e., trend growth).  This is the fourth month in a row that our Compass remains within the grey zone after it briefly signaled a ‘risk of recession’ in October 2007.  Yet, that episode could be repeated in the near future as our Compass seems to be moving progressively back towards the risk of recession zone.  Our Manufacturing Production indicator revised growth in 1Q down to 0.66%Q, compared with 0.84%Q last month.  It is now forecasting a quasi-standstill in 2Q, at 0.12%Q.

Our GDP Indicator Revised Growth Outlook Slightly Down

Our Early GDP Indicator – which depends on the trends in production and demand, past construction orders, business sentiment in services as well as on the spread between short and long term rates – is now predicting growth at 0.50%Q (2.0% annualised) for 1Q08, slightly down from 0.54%Q in January.  It is also predicting a deceleration next quarter, with GDP growth at 0.31%Q (1.2% annualised), still slightly higher than our 0.25% forecast.  Overall, we believe that the euro area economy is still on the ‘orderly slowdown’ path that we have been advocating since last summer (see Euroland Business Cycle Watch: Towards an Orderly Slowdown, July 27, 2007). 

GermanyBetter than its Peers; Italy Worse

Two cases, however, seem to stick out to some extent from the overall picture.  On one side, German manufacturers continue to benefit from stronger demand than their neighbours.  We believe that it is the product specialisation of the German industry – the most competitive in the world for machinery and equipment and related capital goods – that makes it so resilient.  As already mentioned, the demand for capital goods that originated in fast-growing emerging markets such as China is structural, not cyclical.  Since demand seems to grow faster than production capacity in this particular sector, companies benefit from more pricing power than others, which also explains their lack of sensitivity to the strength of the euro.  In Italy’s case, the story is quite different.  Output expectations have stood below their long-term mean for three consecutive months, while current production dropped below trend for the first time in 27 months.

Managers Are Preparing Themselves for the Slowdown

Looking forward, we still believe that the credit crisis, compounded by the stock market correction, is likely to hit corporate spending in the euro area this year.  In this regard, the downward revision of production plans is good news, as it reduces the risk of a hard landing.  However, we cannot exclude such an outcome: we think that production expectations are still too optimistic with regard to the slowdown of actual production already under way, and to the gravity of the credit crisis.  Watch our Surprise Gap index in the next round of business surveys!

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South Africa
Dead Cat Bounce in Economic Growth
February 28, 2008

By Michael Kafe, CFA & Andrea Masia | South Africa

Economic growth in the final quarter of 2007 surprised market participants (ourselves included) with a 5.3%Q rate that lifted GDP growth for the whole of 2007 at 5.1%. (All quarterly growth rates are seasonally adjusted and annualized, unless otherwise stated.) We expected the reading to come in at 4.5%Q, driven mainly by a strong, yet technical, resurgence in manufacturing production. While our expectations for this component were correct, upside surprises in the finance and personal services sectors lifted the final reading higher than even the most bullish had forecast. We do not view such growth numbers to be sustainable, particularly since a significant underpinning to its performance lies within the manufacturing and finance sectors, in our view the most compromised by tight monetary policy and international demand conditions. Although the weaker ZAR should provide some respite to manufacturing through 2008, an absence of monetary easing would be sufficient to ensure that industrial production registers another year of below-trend growth, with overall GDP following suit.

ManufacturingExits Recession Territory
At 8.2%Q, manufacturing bounced back strongly from the two consecutive quarters of negative growth in 2Q and 3Q. A particularly strong reading of 7.7%M in October (after the automotive industry strikes resulted in a 5.0%M contraction in output in September) explained most of the strong manufacturing performance in the final quarter of 2007, thus ensuring that manufacturing accounted for 1.2 percentage points of the 5.3%Q increase in GDP. Looking forward, however, we view this recovery with caution.

Previously, we provided estimates on the sensitivity of the manufacturing sector to currency developments and policy rates (see South Africa’s Manufacturing Sector: A Tug of War Between Real Interest Rates and the Exchange Rate, July 17, 2006). In an update to that note (see South Africa: Tight Squeeze in Monetary Conditions for Manufacturers, October 5, 2007), we reported that the long-run estimates of the elasticity of manufacturing production to the nominal effective exchange rate and the policy interest rate are approximately 0.44 and -0.31, respectively; that is, for every sustained 10% depreciation in the currency, manufacturing production, on average, would rise by 4.4%, while every 10% tightening in monetary policy portends a contraction of 3.1%. Although our year-end currency target of 7.60 assumes a 13% depreciation in $ZAR, this will only partially offset the impact of tighter monetary conditions, leading us to believe that, while manufacturing production could remain positive, it will not be the pillar of support to GDP growth that it has been in the past.

Further Signs of a Financial and Retail Slowdown
Finance and real estate decelerated to 8.5%Q from 12.3%Q, providing further evidence that tighter money is beginning to affect the financial sector: over the quarter, the Johannesburg Securities Exchange All Share Index declined by 17.4%Q, seasonally adjusted private sector credit extension was mostly unchanged at 20.4%Q, average house prices decelerated to 5.9%Q from 10.8%Q, and the strong private equity inflows seen in earlier parts of the year have dried up. As this sector is the largest contributor to GDP (20.6%), we attribute a large proportion of our slowing 2008 growth outlook to this component. Similarly, wholesale and retail trade and personal services showed signs of moderation, recording growth of no more than 2.1%Q and 4.3%Q, respectively, as the National Credit Act and tighter lending conditions set in.

Elsewhere, agricultural production rebounded significantly. Copious amounts of summer rain, and a greater tendency toward import parity pricing as international food prices rallied, ensured that the reward on agricultural produce helped lift output by 10.4%Q. However, despite the 17% and 13% rally in gold and platinum prices, respectively, mining production still contracted by 1.7%Q. After experiencing a protracted period of under-investment, miners have been unable to fully exploit the rally in global commodity prices in recent years. Outside of the well-documented structural bottlenecks, miners have also been faced with safety issues and regulatory burdens, contributing to sub-optimal levels of output.

Electricity Production Disappointing
There has been much pessimism in South Africa regarding the electricity shortages and the associated losses – actual and potential – to economic output. Today’s GDP figure for the electricity, gas and water sector showed a 1.8%Q contraction. But, while we acknowledge the potential impact of a power shortage on growth, we are hesitant to materially scale back our growth outlook on the back of such concerns, particularly as there is a lack of firm evidence of the extent of power rationing that South Africa faces going forward. Furthermore, the 2008 National Budget presented by the Minister of Finance last week (see South Africa: Fiscal Mettle in Fine Fettle, February 22, 2008) outlined rather encouraging capital expenditure plans for power generation over the medium-to-long term, while short-term measures such as demand-side management, energy-efficiency awareness programs and de-mothballing of old power plants are already yielding positive results. As such, we stick to conservativeness, and maintain our long-held 4% GDP growth estimate for this year.

Looking Forward
On the whole, today’s growth reading brings to a close yet another firm year of economic growth in South Africa. In the year ahead, however, we expect growth to be compromised as monetary policy remains restrictive, and as the external environment exhibits signs of moderating demand growth. Morgan Stanley’s big bet this year is that the SARB will not cut rates in 4Q08 as the market thinks. We expect the first rate cut to come in no earlier than mid-2009. This obviously dims the prospects for 2009 and 2010 GDP growth.
Weak Currency Prospects
In such an environment of weaker growth, we hold even more conviction on our call for currency weakness as equity portfolio inflows dry up (see:EM Economist: South Africa: Show Me the Carry, June 8, 2007). We expect $ZAR to close the year at 7.60, but will not be surprised to see an overshoot to 8.00 in coming months.

 

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Japan
Chance to Repair Dialogue: Message for Next BoJ Governor
February 28, 2008

By Takehiro Sato | Japan

While politicians are still debating the choice for the next BoJ governor, market attention is likely to shift from the individual to policy shortly after the choice. We think that the new BoJ leadership might lower the policy rate, and we maintain this position regardless of the top pick. The current administration’s emphasis on growth as a core economic policy should support a rate-cut trend along with economic and market developments.

Profile of the New BoJ Governor Might Differ from the Consensus View

The ruling and opposition parties have not finalized a proposal for the new BoJ governor yet. We anticipate the promotion of Deputy Governor Toshiro Muto. While we previously explained the possibility of not reaching a decision during the current BoJ governor’s term (which lasts until March 19) and the position being left open due to political disruption in a worst-case scenario, setbacks in global stock markets and weaker economic conditions thus far have eliminated the leeway for political games by the opposition. Some members of the Democratic Party are reportedly against the Muto choice, but are mainly trying to attract attention and do not have a constructive alternative. Only a few members favor former Deputy Governor Yutaka Yamaguchi.

We think that the next leadership team is likely to offer a safe choice in line with general expectations, reflecting recent economic and market conditions. Mr. Muto has served as deputy governor for five years after his position as the top Ministry of Finance bureaucrat. Mr. Shirakawa was involved in planning and formulating monetary policy for many years. However, Mr. Muto would symbolize a restoration of Ministry of Finance authority. Yet Mr. Shirakawa played a key administrative role in the Bank’s adoption and subsequent dismantling of quantitative easing and the ZIRP reversal. These choices, hence, might be criticized for a lack of freshness, though such criticism would only be partially correct.

Opinion is split on whether Mr. Muto is simply a carbon copy of the current BoJ Governor Toshihiko Fukui. We see Mr. Muto respecting bottom-up decisions as a former head of a bureaucracy and possibly having a more flexible stance toward the economic outlook than Mr. Fukui. The latter has sustained a fundamental stance that the Japanese economy is enjoying a positive cycle of output, income and spending until the very end, in contrast to an earlier switch to a more cautious outlook from Mr. Muto.

For example, Mr. Muto commented at a Q&A session following a speech in Sapporo on January 10 this year that “uncertainty from instability in the US economy and global financial markets is increasing downside risk” and “we expect the Japanese economy to continue expanding at a moderate pace in the future as a standard, main-scenario view but it is also important to acknowledge risks”. While the current governor has continually voiced a bullish outlook that is deviating from market expectations and undermining dialogue, Mr. Muto’s stance is more reasonable and could repair dialogue.

However, Mr. Muto has trodden lightly with comments regarding monetary policy. He repeated the Bank’s official line at the above-mentioned Q&A session, stating that “the Bank will continue gradually adjusting the interest rate level, which is currently at an extremely accommodative level, based on a careful analysis of economic and financial conditions and in accordance with the anticipated moderate expansion of the Japanese economy”. This view is even more orthodox than recent comments by Mr. Fukui at press conferences after the January and February policy meetings, as it did not mention rate hikes or adjustment of the interest rate level at all. Yet we expect Mr. Muto to tone down comments on interest-rate normalization, considering his more cautious economic outlook compared to Mr. Fukui.

What’s Next

The most important near-term event is the Outlook Report issued at the end of April under the new BoJ governor. We expect a downgrade of the Bank’s basic assertion that “the economy is likely to continue its sustained expansion” and that “a virtuous circle of growth in production, income, and spending is expected to remain in place” in light of the recent outlook for lower industrial production. The Bank’s Monthly Report for February already adds a hedge to the production outlook. More cases of these ‘hedge’ additions to core opinions can foreshadow important policy changes.

We think that these revisions are a natural outcome of adjustment pressure on production activity that has been the primary source of Japan’s positive cycle, and that preventing revisions interrupts dialogue with the market. The Bank might remove the “adjustment of the interest rate level” portion from the existing monetary policy stance that has called for “gradual adjustment of the interest-rate level at a pace that coincides with improvements in economic and price conditions”. We expect a removal in the next report since Mr. Fukui has already been intentionally avoiding this expression.

However, it is still two months until the next Outlook Report, and the new leadership team might present some type of message at the official appointment on March 20 or soon thereafter, depending on economic and market conditions. Mr. Fukui held an emergency meeting on March 25, 2003, after his appointment, to begin charting a new course. The Bank decided to raise the current account target, which was the main policy indicator at that point, for the technical purpose of accommodating the launch of Japan Post, and expressed a commitment to supplying even more surplus capital to stabilize markets. Mr. Fukui subsequently promoted a reflation agenda by steadily raising the current account target. We think that this policy reflected a strong push by the Koizumi administration and Seiwakai political group (Mori faction, now the Machimura faction), particularly former LDP Secretary General Hidenao Nakagawa (then head of the LDP Diet Affairs Committee), with their heavy emphasis on economic growth. Japan has seen two more prime ministers since then who are from the same group, putting a priority on economic-growth strategies and are generally relying on the same key players. The next BoJ governor could face similar political pressure in this environment and might need to offer monetary easing in exchange for being nominated.

Risks

The economy and markets might unexpectedly stabilize in April-June and deflate political pressure for a policy rate cut, in contrast to our outlook. In fact, there is currently no strong clamor from Nagatacho or Kasumigaseki (Japan’s political and bureaucratic world) for restoring rate cuts with the policy rate at just 0.5%. We visited London last week for Morgan Stanley’s conference on Japanese equities and met with local investors, many of whom questioned our outlook on the basis that a rate cut would lack meaning. We agree that our view is an overwhelming minority. However, we learned a valuable lesson last year about the insignificance of consensus opinions when it comes to monetary policy outlooks.

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Hong Kong
Fiscal Stimulus from a Generous Budget
February 28, 2008

By Denise Yam, CFA | Hong Kong

Financial Secretary (FS) Mr. John Tsang presented the F2008/09 Budget speech on February 27, 2008, his first since he assumed the post last July.  The government was again urged to “return wealth to the people” amid favorable results in the 2007/08 fiscal year, with a revised estimated budget surplus of HK$116 billion (7.2% of GDP).  The FS therefore unveiled significant one-off concessions as well as tax cuts for the next fiscal year, totaling close to HK$52 billion.

Sustained strong economic growth (+6.3% in 2007 versus +7% in 2006) and favorable asset market conditions boosted tax revenues and gave Hong Kong a surplus in its operating fiscal account for the third straight year, of an estimated HK$63.7 billion (versus HK$7.2 billion originally budgeted).  Operating revenue excluding investment income is estimated at HK$248.3 billion (15.4% of GDP), HK$46.8 billion higher than budgeted originally.  The operating balance before investment income also enjoyed a surplus of HK$41.9 billion, 2.3 times that in F06/07, versus a budgeted deficit of HK$12.7 billion.

The significant fiscal concessions and tax cuts, however, result in a deficit budget for F08/09.  The government projects a 13% drop in total revenues (to HK$303 billion), a 34% increase in total expenditures (to HK$310 billion), and a consolidated deficit of HK$7.5 billion.  The operating budget balance before investment income is expected to see a deficit of HK$43.4 billion (2.5% of GDP), a turnaround of 5.1% of GDP from the preceding year’s surplus.  A fiscal injection into the economy of such magnitude is unprecedented.  Although the FS defends that the stimulating impact on the economy will come through only gradually and should not fuel excessive domestic demand growth and inflation in the immediate term, we cannot help but be slightly skeptical of the pro-cyclical fiscal policy stance.

Concessions That “Return Wealth to the People”

To “return wealth to the people”, the FS proposed tax cuts and one-off concessions totaling close to HK$52 billion (45% of the estimated surplus in F07/08, or 3.2% of GDP) in the latest budget speech.  One-off waivers and concessions totaling HK$43.1 billion include:

1)  75% reduction in salaries tax and tax under personal assessment for F07/08 with a cap of $25,000 – HK$12.4 billion;
2)  75% reduction in profits tax for F07/08 with a cap of $25,000 – HK$1.73 billion;
3)  75% reduction in property tax for F07/08 with a cap of $25,000 – HK$680 million;
4)  Waiver of all four quarters of property rates in F08/09 with a ceiling of $5,000 per property per quarter – HK$11.2 billion;
5)  Waiver of business registration fee in F08/09 – HK$1.6 billion;
6) Additional one month of allowance to be paid to CSSA and Disability Allowance recipients – HK$1.2 billion;
7) One-off grant of HK$3,000 to Old Age Allowance recipients – HK$1.5 billion;
8) Electricity charge subsidy of up to HK$1,800 per residential account – HK$4.3 billion;
9) Injection into MPF accounts – one-off injection of HK$6,000 to those earning less than HK$10,000 a month – HK$8.5 billion.

Tax cuts totaling HK$8.8 billion in F08/09 include:

1) Salaries tax – HK$3.3 billion (see details below);
2) Profits tax – tax rate lowered by 1 percentage point to 16.5% for corporations (as promised in the 2007/08 Policy Address in October 2007) – HK$4.4 billion;
3) Tax deduction on charitable donations – ceiling raised from 25% to 35% of assessable income / profits – HK$80 million;
4) Alcohol duty – Beer and wine tax abolished (from 20% and 40% respectively) – HK$560 million;
5) Hotel accommodation tax – waived – HK$470 million.

In salaries tax, as promised in the 2007/08 Policy Address, the standard tax rate was lowered by 1 percentage point to 15%, last seen in F02/03.  The basic allowance was lifted to HK$108,000 (from HK$100,000), also where it was in F02/03.  Marginal salaries tax bands were widened for the second straight year to HK$40,000, from HK$35,000 previously, although marginal tax rates remain unchanged.

Because of the cut in the standard tax rate, which becomes 2 percentage points below the top marginal tax rate (17%), the annual income level at which the standard rate kicks in falls to HK$1.52 million, from HK$2.75 million.  It follows that the largest drop in the effective tax rate applies to those who enjoy the full 1 percentage point cut in the standard rate, i.e., those earning more than HK$2.75 million a year.  In terms of the absolute decrease in the tax bill, just over half of the taxpayers (earning between HK$228,000-HK$1.52 million annually) see a flat reduction of HK$2,860.

Who Do the Concessions Benefit?

How are the latest announced benefits distributed within the economy?  While the most disadvantaged groups receive extra social security assistance (HK$2.7 billion), the one-off salaries tax rebate (HK$12.4 billion) only benefits 38% of the employed population, and not the ‘poor’.  Around 75% of the salaried taxpayers (28% of the employed population) will get the full 75% waiver on F07/08 taxes.  The remaining 25% (10% of the employed), because they paid more than HK$33,333 in taxes, will not get a full 75% waiver as the rebate is capped at HK$25,000.  With regards to the salaries’ tax cuts in the next fiscal year, the biggest tax savings, as described in the previous section, go to the highest income earners.   The waiver on rates and the cut in indirect taxes (such as alcohol duty) reach a larger population, nevertheless.  The generous cap of HK$5,000 per property per quarter means that 99% of the domestic properties will have their rates completely waived in the next fiscal year.

Expenditures Planned to Secure and Enhance Hong Kong ’s Competitiveness

Aside from the high expectations for concessions and tax cuts, the market was also watching out for sensible and constructive expenditure plans consistent with Hong Kong’s strategic economic positioning.  The FS did provide more details on infrastructure plans, with expenditure in F08/09 projected at HK$21.8 billion.  Meanwhile, feasibility studies and preparation work will commence on developing Container Terminal 10 and a third runway at the airport, in efforts to secure Hong Kong’s strategic position as the region’s transport hub.

An Expansionary Budget for F08/09

The FS reminded that, given the unstable nature of the government’s sources of revenue, Hong Kong continues to see significant fluctuations in fiscal outturn.  Specifically, the exceptionally strong fiscal revenues over the past couple of years resulted mostly from buoyant asset markets in terms of both price gains and heavy turnover.  Therefore, recognizing that the large surpluses cannot be sustained, the FS opts for more one-off than recurrent measures to “return wealth to the people”.  Nevertheless, the sizeable concessions to be handed out in F08/09 suggest a rather expansionary budget. 

The government projects a HK$7.5 billion consolidated budget deficit in F08/09.  The operating balance before investment income will plunge into a deficit of HK$43.4 billion from the HK$41.9 billion surplus in F07/08, representing a turnaround of HK$85 billion, or 5.1% of GDP.  A fiscal injection into the economy of such magnitude is unprecedented.  Although the FS defends that the stimulating impact on the economy will come through only gradually and should not fuel excessive domestic demand growth and inflation in the immediate term, we cannot help but be slightly skeptical of the pro-cyclical fiscal policy stance.

Still Dependent on Asset-Based Revenues Over the Medium Term

The government’s medium-range forecasts show that Hong Kong will continue to derive significant fiscal revenues from asset-based sources.  Specifically, investment income on fiscal reserves contributes an average of 13% of operating revenue in the next five years, totaling HK$200 billion.  Land sales (and premium) revenues are to average HK$50 billion per year in the next five years.  Once again, we feel that the government is showing considerable complacency with its finances, as the large surpluses seem to have silenced all fiscal reform initiatives introduced earlier to stabilize revenues and broaden the tax base.

Maintaining Economic Forecasts

The Hong Kong economy grew by 6.3% in real terms in 2007 (+6.7% in 4Q07), beating our 6% forecast, as resilient trade growth, bullish asset markets and friendly liquidity conditions buoyed domestic consumption and investment.  We are maintaining our 5.5% growth forecast for 2008, factoring in a slowdown in trade growth amid weaker global demand and a soft landing in the Chinese economy.

On the inflation front, we have been following the opposing influences from imported inflation (upward) and fiscal measures (downward).  Headline inflation averaged 2% in 2007, the same as in 2006, but the figure was biased downwards by concessions on public housing rents as well as property rates, without which inflation would have reached 2.8% last year.  With a clearer idea of the fiscal measures in place this year (rates concessions for the full year), we are revising our CPI inflation forecast to 4.5%, from 4% previously, to take account of increased upward pressures from higher inflation imported from China.  Looking to 2009, assuming that all the property rates concessions will be removed in F09/10, inflation will remain elevated even with easing underlying inflationary pressure from imports (softer inflation in China and US$ recovery).  We forecast CPI inflation to average 4.5% also in 2009.

 

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