Excess reserves

Next Magazine (Second opinion A004, 2012.9.06)

 

It feels good to be well endowed with reserves. It provides animpression of strength and the ability to handle future threats.Reserves offer the comforting stability of being well prepared for arainy day. All this seems consistent with Hong Kong’s values and wellreserved indeed is Hong Kong. The Hong Kong Monetary Authority (HKMA)controls US$296bn, the eighth highest level of reserves of any countryin the world and more than the Eurozone or the United States.
Yet all of this apparent strength does not come without risk, andholding such high reserves is not costless for the people of HongKong. Only US$139bn or 47% of reserves have the express purpose ofbacking the currency. Those reserves hold sufficient funds to supportthe conversion of the entire monetary base to USD at the linkedexchange rate. Those funds are ample and Hong Kong should not movefrom a strict currency board where the monetary base is fullybacked.However, the rest of the reserves represent the cumulativesurplus that arises from the government taking more money from thepeople of Hong Kong each year than it spends. It also has certainother funds that are reserved for special purposes. These fundsrepresent 5x the current annual budget of the HK government. They comewith many hazards.Firstly, there is the hazard of managing such alarge pool of funds. The people of Hong Kong carry substantial marketrisk on these funds. Managers carefully judge the mix of currencies,fixed income, equities and other assets, that will balanceconservative preservation of capital with some returns. However, thepool of funds is far too large to invest in Hong Kong and is largerelative even to global markets. Managing these funds getsincreasingly difficult as the size increases, with the 10-year bondaverage return of 4.9% dropping to 3.5% over the last 3 years.
Centralized management of the assets precludes some of the mostproductive potential uses of the money. It cannot be invested in newbusiness ideas, plant and equipment for real businesses or thedevelopment of individual’s human capital. It cannot capture thegenius of the people of Hong Kong at a local level, who have such asuperb track record of building their own capital. This opportunitycost is difficult to measure, but real. The exchange fund has returnedon average 3.2% over 5 years in the hands of the HKMA, which is lessthan the 3.9% rise of the CPI. Secondly, the high reserves providefuel for ever larger and expanding government. At a departmentallevel, incentives to economize on spending are eroded. It gives roomfor dreamers about unsustainable universal pension schemes, breathingspace to think that their plans can be afforded, because the reckoningwith the actuarial certainty that they cannot be is so far out.
Third, it is wrong to tax people beyond the prudent needs ofgovernment, just to build an ever-large buffer to absorb futurespending. Assuming that Hong Kong continues to build wealth as we allhope, we are taxing poorer people today, to provide a larger pool ofmoney for the richer people of tomorrow. Eventually that tension willlead to a movement to spend now what has been built over generations.How can we preserve the stability and ability to manage risks thatpeople in Hong Kong crave, without unlimited growth of financialreserves? The right answer is to focus on growing the capital of theindividual people of Hong Kong and the productivity of our businessesand government. Lean and efficient governments that do not over spenddo not get into systemic problems and do not need excessive reserves.
We should focus on keeping government spending small as a share of theincome of the people of Hong Kong. A highly productive people backedby a deep private capital base can better absorb the inevitable risksin a volatile world. We should commit to returning excess reserves tothe people of Hong Kong so that they can invest in the areas theybelieve will generate the highest returns. There are many options todo this. A “holiday” on existing taxes until reserves get back to moreprudent lower levels would leave money with people already using itproductively enough to generate a taxable income.
Bill Stacey is in his 10th year as a resident of Hong Kong and isChairman of the Lion Rock Institute.

It feels good to be well endowed with reserves. It provides an impression of strength and the ability to handle future threats. Reserves offer the comforting stability of being well prepared for a rainy day. All this seems consistent with Hong Kong’s values and well reserved indeed is Hong Kong. The Hong Kong Monetary Authority (HKMA) controls US$296bn, the eighth highest level of reserves of any country in the world and more than the Euro zone or the United States.

Yet all of this apparent strength does not come without risk, and holding such high reserves is not costless for the people of Hong Kong. Only US$139bn or 47% of reserves have the express purpose of backing the currency. Those reserves hold sufficient funds to support the conversion of the entire monetary base to USD at the linked exchange rate. Those funds are ample and Hong Kong should not move from a strict currency board where the monetary base is fully backed. However, the rest of the reserves represent the cumulative surplus that arises from the government taking more money from the people of Hong Kong each year than it spends. It also has certain other funds that are reserved for special purposes. These funds represent 5x the current annual budget of the HK government. They come with many hazards. Firstly, there is the hazard of managing such a large pool of funds. The people of Hong Kong carry substantial market risk on these funds. Managers carefully judge the mix of currencies, fixed income, equities and other assets, that will balance conservative preservation of capital with some returns. However, the pool of funds is far too large to invest in Hong Kong and is large relative even to global markets. Managing these funds gets increasingly difficult as the size increases, with the 10-year bond average return of 4.9% dropping to 3.5% over the last 3 years.

Centralized management of the assets precludes some of the most productive potential uses of the money. It cannot be invested in new business ideas, plant and equipment for real businesses or the development of individual’s human capital. It cannot capture the genius of the people of Hong Kong at a local level, who have such a superb track record of building their own capital. This opportunity cost is difficult to measure, but real. The exchange fund has returned on average 3.2% over 5 years in the hands of the HKMA, which is less than the 3.9% rise of the CPI. Secondly, the high reserves provide fuel for ever larger and expanding government. At a departmental level, incentives to economize on spending are eroded. It gives room for dreamers about unsustainable universal pension schemes, breathing space to think that their plans can be afforded, because the reckoning with the actuarial certainty that they cannot be is so far out.

Third, it is wrong to tax people beyond the prudent needs of government, just to build an ever-large buffer to absorb futurespending. Assuming that Hong Kong continues to build wealth as we all hope, we are taxing poorer people today, to provide a larger pool of money for the richer people of tomorrow. Eventually that tension will lead to a movement to spend now what has been built over generations.How can we preserve the stability and ability to manage risks that people in Hong Kong crave, without unlimited growth of financial reserves? The right answer is to focus on growing the capital of the individual people of Hong Kong and the productivity of our businesses and government. Lean and efficient governments that do not over spenddo not get into systemic problems and do not need excessive reserves.

We should focus on keeping government spending small as a share of the income of the people of Hong Kong. A highly productive people backedby a deep private capital base can better absorb the inevitable risks in a volatile world. We should commit to returning excess reserves to the people of Hong Kong so that they can invest in the areas they believe will generate the highest returns. There are many options to do this. A “holiday” on existing taxes until reserves get back to more prudent lower levels would leave money with people already using it productively enough to generate a taxable income.

 

Bill Stacey is in his 10th year as a resident of Hong Kong and is Chairman of the Lion Rock Institute.

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