In recent years, fiscal deficits have emerged as a significant new challenge for the Hong Kong government. The impact of the COVID-19 pandemic, the slowdown in global economic growth, and heightened uncertainties have led to a substantial decline in Hong Kong’s fiscal revenues. To address this issue, the government has implemented large-scale counter-cyclical fiscal stimulus measures. At the same time, government expenditures in areas such as infrastructure development, social welfare, healthcare, and education have continued to rise. While investments in these sectors are crucial for stimulating the economy, improving people’s well-being, and promoting the long-term development of Hong Kong, they challenge the city’s ability to maintain fiscal balance.

This article will analyze Hong Kong’s fiscal deficit in recent years, exploring the relationship between fiscal deficits and economic cycles, along with the impact of land revenues, to assess the city’s fiscal sustainability. Moreover, it will look ahead to future fiscal conditions and explore the feasibility of using fiscal reserves and debt instruments to address deficits.

1. The Size of Fiscal Deficits

Hong Kong has long adhered to the principle of keeping expenditures within the limit of revenues, maintaining prudent fiscal management and even running budget surpluses for more than ten years. However, Hong Kong’s significant fiscal deficits in recent years have attracted widespread attention. In the 2022 and 2023 fiscal years, Hong Kong’s consolidated account recorded deficits of HKD 188.3 billion and HKD 171.9 billion, accounting for 6.7% and 5.8% of the city’s GDP, respectively. To gain a deeper understanding of the scale of these fiscal deficits, we will compare them from both a historical perspective and a cross-regional perspective.

From a historical perspective, as shown in Figure 1, the deficit levels of the past four years have reached highs not seen in 25 years, even surpassing those of several major economic downturns including the Asian Financial Crisis and the Global Financial Crisis. These deficits have persisted even as the economy began to recover from the pandemic in the last two years, raising concerns about Hong Kong’s medium- to long-term fiscal outlook.

From a cross-regional perspective, the conclusions are equally alarming. Figure 2A presents the fiscal balances of 36 developed economies worldwide for the fiscal years of 2022 and 2023. The cyclical and structural balances, marked in the figure, will be analyzed in detail later; their sum constitutes the total fiscal balance. Hong Kong’s deficit ranks second highest globally, behind Italy and followed by the much larger economies of the United States, the United Kingdom, and France. Compared to Hong Kong, these economies have more tools at their disposal to handle financial pressures and external shocks. Meanwhile, Singapore, whose economic features are closest to Hong Kong’s, boasts a high fiscal surplus, ranking fourth. Financial centers such as Switzerland and Luxembourg are also in strong financial shape, in stark contrast to Hong Kong’s situation.

Looking further back to the height of the COVID-19 pandemic in 2020 and 2021 (Figure 2B), Hong Kong actually managed its finances better than most, with its fiscal balance ranking above the median. Therefore, the pandemic is not the primary cause of Hong Kong’s current deficit woes – other structural and policy factors are at play.

When compared to the fiscal conditions of local governments in mainland China, Hong Kong’s situation looks somewhat better. Multiple factors including economic transformation, the real estate downturn, and local government debt have contributed to generally high levels of fiscal deficit across regions[1] (see Figure 3). Nevertheless, economically developed regions such as Beijing, Guangdong, and the Yangtze River Delta (Shanghai, Jiangsu, Zhejiang, etc.) are in better fiscal condition, with deficit levels similar to Hong Kong’s.

To summarize, Hong Kong’s current deficit level is relatively favorable within the national context, but remains high when compared to its own historical record and other developed economies.

2. Cyclical and Structural Fiscal Balance

Economic cycles play a critical role in shaping government fiscal conditions. Government fiscal balances can be divided into two major categories: cyclical and structural balances. Cyclical balances are primarily driven by economic cycles. During a recession, government revenues fall while spending on economic stimulus and unemployment benefits rises, creating fiscal deficits. As the economy recovers, these gaps gradually shrink and eventually disappear. Structural balances, however, are less tied to economic cycles. They typically reflect imbalances in the government’s revenue and expenditure structure. Even when the economy is operating at its potential output level and growing steadily, government expenditures may still exceed revenues due to structural factors. These deficits often result from investments in areas like social welfare, public services, and infrastructure development. While cyclical deficits follow the rhythm of economic cycles, structural deficits can be brief or prolonged, depending on the intensity of policy actions.

Although economic theory draws a clear distinction between cyclical and structural fiscal balances, they do not have directly observable data in practical analysis and typically require model-based estimations. This article uses various methods to estimate both types of fiscal balances to ensure robust conclusions. The results below are primarily based on estimates by the International Monetary Fund.

In Figure 4, the economic cycle is quantified as the percentage gap between current local GDP and potential output. For instance, in 2018, economic activity boomed and exceeded potential output by about 4%. In contrast, during the 2009 global financial crisis and the COVID-19 pandemic in 2020, economic activity fell about 4% below potential. The cyclical fiscal balance, represented by the bars in the figure, moves in clear synchrony with these economic cycles. Given the recent global economic slowdown, Hong Kong’s cyclical fiscal position has faced considerable pressure, with cyclical deficits reaching high levels from 2000 to 2023.

While structural balances are not directly linked to economic cycles, structural deficits remained elevated from 2000 to 2023, emerging as the primary driver of the past two years’ deficit. This suggests Hong Kong’s current fiscal challenges won’t simply be resolved through natural economic recovery.

Revisiting the international comparison in Figure 2, many countries in 2020-2021 experienced high cyclical deficits due to recessions, often exceeding even their structural deficits. Hong Kong’s total deficit ranked in the middle, but if we consider only its structural deficit, Hong Kong’s position would be stronger. As economies rebounded in 2022-2023, cyclical deficits diminished globally, with structural balances having a bigger impact on fiscal positions. Although Hong Kong ranks second in total deficits, its structural deficit ranks sixth, comparable to many other developed economies – a somewhat reassuring finding.

The cyclical-structural analysis outlined above is an effective method for assessing fiscal sustainability. We can also use another approach to dissect the sources of change in fiscal balances. Comparing the cyclical and structural balances shown in Figure 4 shows that cyclical balances are highly volatile. Cyclical balances can persist at around 5% for several consecutive years at their peak and drop to -5% at their lowest. In contrast, structural balances maintain steadier movements, generally within a 2% range. Hong Kong’s overall fiscal position shows limited cyclical fluctuations, indicating that its balances over the years were largely driven by structural policy adjustments and reforms.

Using the statistical method of variance decomposition, we can quantify that structural surplus fluctuations account for 80% of Hong Kong’s total fiscal surplus. This puts Hong Kong in ninth place globally, which is considered moderately high. This high structural volatility in Hong Kong is partly due to the government’s policy evolution in long-term projects related to livelihood, healthcare, pension, and housing. Since most structural deficits are closely related to policy choices, if the government is willing to scale down certain policies, it can quickly restore a structural surplus. Conversely, if an economy’s deficit is mainly cyclical, changes in government policy will have little substantive effect.

We can draw the following conclusions by analyzing the cyclical and structural nature of deficits. First, Hong Kong cannot rely solely on accelerated economic growth to resolve its fiscal deficits. Second, Hong Kong has considerable control over fluctuations in its deficits. Lastly, in the post-pandemic era, global fiscal policies have undergone structural changes, with structural deficits becoming a common challenge around the world. Hong Kong’s structural deficit is at a moderately high level.

3. Land-Based Fiscal Revenue

This section further explores the roots of structural deficits. Land income is a significant revenue stream in Hong Kong’s fiscal structure. Land-related income primarily comes from land premium, stamp duties, rates, government rent, and other forms. As the real estate market cooled in recent years, inactivity in land auctions and property transactions has led to a decline in land income. On average, over the last 25 years, stamp duties and land premium accounted for 19.0% of total revenue, while general rates, properties and investments (mainly government rents), and property taxes accounted for 8.3%, bringing their combined total to 27.3%. However, this figure dropped to 16.3% in 2023. The decline does not indicate falling reliance on land, but rather highlights the city’s vulnerability to fiscal shocks when the real estate market declines.

When analyzing fiscal stability, it is essential to consider not only revenue proportions but also risk attributes. Land income, though a small part of total revenue, is highly volatile. We can decompose the changes in government revenue into variations in land and non-land income. As illustrated in Figure 5, fluctuations in stamp duties and land income are the most critical drivers of revenue volatility. Revenue share fell by -2.0% and -3.7% in 2021 and 2022, respectively, with stamp duties and land income contributing -3.1% and -2.0% to this decline. Notably, non-land income actually increased in 2022.

Extending the timeframe to the past 25 years, variance decomposition analysis shows stamp duties and land income contributing 60% of revenue volatility. Other land-related income, namely general rates, properties and investments, and property taxes, are relatively stable, contributing just 2% of revenue volatility. Other non-land income accounts for the remaining 38%.

As explained, land income constitutes a small part of total revenue but serves as the main driver of revenue volatility. This dynamic mirrors investment theory: When investors allocate assets between high-risk stocks and risk-free bonds, even a small allocation to stocks can cause most of the portfolio’s volatility. Therefore, it is essential to not only consider allocation ratios but also understand how different assets contribute to overall risk. Land income, while accounting for 20% of the revenue, contributes 60% of fiscal risk. Drawing lessons from investment theory, we should focus on the risk factors of land income, conducting more scenario analyses and simulations to mitigate uncontrollable risks. This approach aims to prevent situations where land revenue amplifies overall deficit.

Similarly, local governments in mainland China are highly dependent on land income. Comparing 2013-2023 data (Figure 6), Hong Kong’s revenue share, at 31.9%, comes in tenth place. However, its volatility ranks among the highest in the nation, just behind provinces such as Jiangsu, Zhejiang, Anhui, and Guangdong. Notably, these provinces also have some of the lowest fiscal deficits in the country through relatively prudent fiscal management.

Land income volatility is closely related to housing prices. A rise in housing prices usually boosts the real estate market and land transactions, thereby increasing stamp duties and land income. Since 2021, Hong Kong’s housing prices have trended down significantly. To what extent can the decline in housing prices explain the decrease in land income? Indeed, analyzing data from the past 25 years shows a positive correlation between housing prices and land income in Hong Kong. For every 1% increase in housing prices, the land income-to-GDP ratio rises by 0.046%. A panel data regression analysis we conducted using data from local governments in mainland China from 2013 to 2023 reveals a coefficient of 0.03 between housing prices and their impact on land income. This is lower than the coefficient for Hong Kong, indicating that Hong Kong’s land income is more sensitive to changes in housing prices.

From 2021 to March 2024, housing prices fell 21%, corresponding to a roughly 1% drop in land income ratio, according to the Rating and Valuation Department’s Private Domestic Price Indices. However, the share of land income plunged from 6.1% in 2021 to 1.1% in 2023, which suggests that multiple factors, not only the drop in housing prices, are driving Hong Kong’s land-based revenue decline.

4. Fiscal Forecasting

According to its latest budget, the government has implemented fiscal consolidation measures aimed at increasing revenue and reducing expenditure. Its fiscal deficit is expected to gradually decrease over the next few years, with a return to surplus by 2027. While this projection suggests the current deficit is short-term and manageable, it’s common to see overly optimistic estimates globally due to the complexities of fiscal forecasting.

Analysis of historical budgets and the accuracy of forecasts shows a consistently prudent and conservative approach in Hong Kong’s fiscal management. Figure 7 depicts the discrepancies between Hong Kong’s fiscal budget and actual revenue and expenditure. Over the 15-year period from 2004 to 2019, the government generally underestimated revenue, showing instances of overestimation only in the past five years – though it still underestimated the pace of economic recovery in 2021. On the expenditure side, while the government significantly overestimated expenditure in 2020, its spending forecasts have generally proven more accurate than revenue predictions. This pattern of forecasting has led to long-term underestimation of fiscal surpluses, ultimately vindicating the government’s prudent fiscal strategy.

Long-term fiscal forecasting is challenging due to the many uncertainties surrounding future expenditures and revenues. But Hong Kong has shown remarkable consistency – its five-year forecast error margins closely track those of one year. This suggests a high degree of control over future fiscal conditions and demonstrates the government’s ability to execute planned strategies effectively, keeping long-term fiscal policy risks relatively contained.

5. Fiscal Reserves

Public concern over Hong Kong’s fiscal condition often focuses on the government’s reserves. The government maintains both an extremely low level of debt and substantial reserves, with the latter currently accounting for 25% of GDP – among the highest in developed economies worldwide (Figure 8).

Some commentators focus on how many months of government expenditure current fiscal reserves can support. Now at 12 months, this figure has fanned concerns about fiscal reserves running low. Such worries, however, are largely unfounded: this metric completely overlooks revenue streams that typically cover expenditures. Even if current high deficit levels persisted – which are historically rare and not likely to last – it would take five years to exhaust the reserves, well beyond the 12-month mark.

Still, the optimal level of fiscal reserves merits discussion. Ideally, the government should maintain a balanced budget, but this does not mean the fiscal situation should be balanced at all times. Considering economic fluctuations and structural factors, the government can build up reserves through fiscal surpluses during economic upswings and lower structural expenditures. These buffers serve multiple purposes: cushion potential economic downturns, alleviate public hardship, stabilize the economy, and address structural needs such as aging populations, social welfare, education, and infrastructure. The Hong Kong government has adopted this strategy over the past decade, causing fiscal reserves to grow from 22% in 2004 to 42% in 2019 (Figure 7). Hong Kong has been making full use of its accumulated reserves, which are enough to cover the deficits in recent years. While these deficits have drawn down resources, current reserves still exceed 2004 levels.

A certain level of fiscal reserves provides benefits, but excessive reserves may also prove counterproductive. Economic theory suggests it’s more efficient for private citizens than the government to hold the same wealth, as it helps lower transaction, information, and agency costs. This concept also aligns with the traditional Chinese philosophy of “storing wealth among the people.” The government’s role is to make good use of its fiscal reserves. If the economy has not experienced a downturn in five years and reserves continue to reach new highs, the government could consider moderately reducing reserve levels by increasing spending, providing subsidies, and offering tax relief.

When discussing fiscal reserves, a clear distinction must be made between fiscal reserves and foreign exchange reserves. Traditional views hold that emerging market economies, due to their weaker borrowing capacity, may not be able to raise sufficient funds during a crisis and may need to rely on their fiscal reserves. However, foreign exchange reserves, rather than fiscal reserves, are often what’s needed to respond to international crises. An economy can maintain debt while holding significant foreign exchange reserves to manage balance of payments crises and exchange rate interventions. Given Hong Kong’s stage of development with ready access to low-cost financing, the case for maintaining high fiscal reserves is weaker. Meanwhile, Hong Kong’s Exchange Fund holds substantial assets and equities, providing ample support for its linked exchange rate system, as detailed in our economic policy green paper last year.

6. Issuing Debt

Unlike Hong Kong, other major economies do not hold substantial fiscal reserves. Before the COVID-19 pandemic, major developed countries were already burdened with high levels of debt. The United States’ frequent encounters with its statutory debt ceiling have resulted in “fiscal cliffs” and government shutdowns, while the Eurozone debt crisis is affecting half of its member states. Despite relative economic stability following the Eurozone crisis, many countries did not follow prudent fiscal principles to reduce deficits and debt levels, leaving them particularly vulnerable when a global crisis struck in 2020. Nevertheless, these countries introduced extensive stimulus measures, further increasing their debt burdens. By the end of 2023, the debt levels of many countries had reached historic highs, approaching 100% of their GDP.

This global response highlights the need for counter-cyclical fiscal stimulus, where expanding fiscal spending is imperative even when debt levels are high. While the Hong Kong government can tap ample reserves to address crises, other high-debt countries have also managed to secure sufficient funds to cover their deficits. The need for fiscal reserves to respond to crises is indeed debatable.

Traditional views advocate accumulating reserves through surpluses during economic booms and addressing deficits through borrowing during downturns, aiming for long-term balance. The optimal level of reserves or debt in theory warrants further study, but this balance point need not be zero. A debt level of 30% of GDP during normal periods –  rising to 50% during recessions or falling to 10% during booms – may be considered healthy and sustainable.

Hong Kong started issuing bonds under the Government Bond Programme in 2009, with the borrowing limit gradually increasing from the initial HKD 100 billion to the current HKD 300 billion. Subsequently, reflecting its support for sustainable development, Hong Kong introduced the Infrastructure Bond Programme and the Government Sustainable Bond Programme, raising the combined limit to HKD 500 billion. As of April 2024, government bonds accounted for approximately 14.7% of local GDP. This is lower than the fiscal reserves and significantly below the bond issuance levels seen in most developed economies.

Issuing bonds has multiple benefits. For the government, bonds can alleviate short-term fiscal pressure and provide a stable source of funding for long-term infrastructure projects. The debt servicing costs for the Hong Kong government are very low, even lower than that of U.S. Treasury bonds, which are considered global safe assets. For instance, the yield on a 20-year reopening bond issued on March 14, 2024, was 4.392%, while the yield on U.S. Treasury bonds of the same maturity on the same day was 4.492%. Similarly, the yield on a 3-year bond issued on October 23, 2024, was 2.952%, compared to 4.041% for the corresponding U.S. Treasury bond. These low interest rates are not only due to the Hong Kong government’s exceptional creditworthiness but also reflect the supply-demand imbalance in the bond market and other structural factors.

Government-issued risk-free bonds are a cornerstone of capital markets. An adequate supply meets investor demand for safe assets denominated in Hong Kong dollars, thereby enhancing market liquidity. A risk-free yield curve serves as a vital benchmark for pricing other risk assets. In economic theory, “incomplete markets” may lead to suboptimal resource allocation, unhedgeable risks, and societal welfare losses. Government bonds can address these gaps, contributing to market “completeness” and acting as a supplier of safe assets to tackle market failures, even when the government does not have financing needs.

As a center for offshore RMB, Hong Kong can expand the currency’s investor base by issuing RMB-denominated government bonds – an effective way of promoting RMB internationalization. Currently, RMB assets account for only 8% of Hong Kong’s relatively small outstanding debt. Expanding RMB-denominated bond issuance can help build a more mature market and broaden the scope for global investment in RMB assets. As Hong Kong cultivates this market with more investable assets and better liquidity, global investors will be more willing to hold and use RMB in a wider range of investment, trade, and other scenarios.

In the current economic climate, many may be apprehensive about debt, especially given recent hikes in interest rates. However, it is important to recognize that these rate increases are primarily nominal, driven by global inflation. When adjusted for inflation, real interest rates are not high and have been trending down over the past few decades.

Furthermore, the ongoing issue of local government debt in mainland China has made debt resolution a shared priority from top to bottom. New debt issuance is now tightly controlled, driven by the economic downturn and debt risk management. Should Hong Kong go against the trend? Local debts have been accumulating for over a decade. The starting point is the mismatch between policy goals and financial resources, with economic downturns and debt risk management amplifying the challenge. Hong Kong shares a similar starting point to mainland China, but their underlying conditions are different. It’s difficult to achieve policy goals without the necessary resources.

The Hong Kong government currently has multiple expenditure projects aimed at benefiting public welfare and promoting long-term social development. Providing “big government” social services with a “small government” revenue model, characterized by low taxes, will inevitably lead to short-term fiscal imbalances. Hong Kong has ample fiscal reserves and no net debt concerns. Aligning policy goals with financial resources, strategically utilizing existing fiscal reserves, and issuing debt within the bond program limits can be wise moves.

It is essential to be bold yet cautious, conducting prudent risk assessments and management throughout the process to ensure debt risks are controllable. The market serves as a barometer for debt conditions. A significant rise in bond yields serves as a warning, signaling the need for increased preventive measures to nip any potential debt crisis in the bud.

7. Conclusion

In recent years, Hong Kong has faced relatively high deficit levels, ranking among the top in developed economies. A significant portion of this deficit stems from structural deficits, which cannot be passively alleviated by economic growth alone but require proactive fiscal policy adjustments. Land revenue contributes a substantial proportion of fiscal income, but its volatility also poses high risks, having driven most revenue fluctuations. Consequently, more prudent risk management is necessary. The decline in land revenue is influenced by factors beyond just falling property prices.

Looking ahead, the government must strike a balance between reducing deficits and implementing fiscal policies. The government has actively adjusted fiscal policies, with current forecasts suggesting a return to surplus within a few years. The government’s fiscal forecasting has historically been cautious and accurate, lending credibility to these projections.

Hong Kong has accumulated substantial fiscal reserves over the years. Despite a decline in recent years, these reserves remain among the highest globally, with limited downside risks. The government does not need to aim for continuous accumulation of reserves. The recent decline in reserves is not a cause for concern; rather, it can be seen as an example of the efficient utilization of fiscal reserves.

The Hong Kong government should make full use of the government bond program’s capacity to raise funds for infrastructure investment. This approach would not compromise long-term fiscal sustainability and would foster the development of capital markets and the internationalization of the renminbi.

Figure 1. Hong Kong Fiscal Balance, Revenue, and Expenditure

Source: Census and Statistics Department.

Figure 2A. Cyclical and Structural Balance of Advanced Economies (2022 and 2023 fiscal year)

Source: International Monetary Fund.

Figure 2B. Cyclical and Structural Balance of Advanced Economies (2020 and 2021 fiscal year)

Source: International Monetary Fund.

Figure 3. Fiscal Balance of Mainland Local Governments and Hong Kong

Source: National Bureau of Statistics, CSMAR.

Figure 4. Economic Cycle, Cyclical Balance, and Structural Balance

Source: International Monetary Fund.

Figure 5. Annual Change of Revenue/GDP by Sources

Source: Census and Statistics Department, Inland Revenue Department.

Figure 6. Land Revenue Share and Share of Variance of Mainland Local Governments and Hong Kong

Source: National Bureau of Statistics, CSMAR, Provincial Department of Finance.

Figure 7. Fiscal Forecasting

Source: Government budget.

Figure 8. Debt and Reserve of Advanced Economies

Source: International Monetary Fund.

[1] The fiscal balance includes the “four accounts,” namely the general public budget, the government fund budget, the state-owned capital operation budget, and the social insurance fund budget.