A. Introduction

1. Hong Kong SAR's revenue flows are characterized by relatively volatile non-tax items. Foremost among these are investment income from the government's accumulated fiscal surpluses and the land premium on the sales and conversions of government-owned land. Over the past two decades these items have contributed, on average, about one-half of non-tax revenue and one-fifth of total revenue, although their volatility has been markedly higher than for tax revenue.

2. The extent to which these items are incorporated into various fiscal balance measures has important implications for assessing the fiscal position. The motivation for this note is to provide input into an underlying fiscal balance measure that seeks to gauge medium- to long-term sustainability. This concept should be distinguished from the structural fiscal balance approach used, for example, in recent staff documents on Hong Kong SAR, which strives to measure the effect of fiscal policy on aggregate demand. The latter approach has typically excluded the so-called volatile revenue items. It should be underscored that these two fiscal balance approaches are complementary.

3. This note concludes that Hong Kong SAR's volatile non-tax revenue items have made a stable contribution to revenue of about 3½ percent of GDP. Investment income (covered in Section B) contributes about 1 percentage point to this finding, while the land premium (covered in Section C) contributes about 2½ percentage points. The results are based on a simple trend analysis framework using data since the early 1980s. The conclusions are shown to be robust across a number of alternative metrics.²

B. Investment Income

4. Reflecting a tradition of budgetary prudence, Hong Kong SAR has built-up a considerable stock of fiscal reserves over the years, which gives rise to sizeable public investment income. Under current policies, fiscal reserves are placed with the Exchange Fund managed by the HKMA. (Fiscal deficits in the last few years were largely financed by drawing down existing reserves.) Investment income is the return the government receives at the end of each fiscal year and is linked to the return achieved by the Exchange Fund.³ Moreover, the presence of sizeable fiscal reserves in the Exchange Fund provides additional confidence for the currency board arrangement as the foreign currency equivalent of the surpluses provides potential backing to banking system liabilities beyond the monetary base.

5. Investment income represents an important, though volatile, non-tax revenue component (Table III.1 and Charts). The government's accumulated fiscal reserves rose from 10 percent of GDP in the mid-1980s to reach 35 percent of GDP in 1999/2000 before falling back to 22 percent at present owing to sizeable deficits in the early 2000s.⁴ Since 1983/84, the contribution of investment income to non-tax revenue has averaged 15 percent, but has ranged from 2 percent in 2001/02 to 39 percent in 1998/99. In terms of GDP, investment income has ranged from zero percent to 3½ percent. This volatility, particularly at the high end, reflects the performance of the relatively small equity component of the Exchange Fund. The correlation of investment income with GDP has been erratic, owing to the volatility of the investment markets.

6. Despite the volatility of the investment income to GDP ratio, its trend has been stable. A simple trend regression shows that this ratio rose by a statistically significant 0.07 percent of GDP per annum over the sample period. However, owing to serial correlation in the error terms, the test statistics for this simple regression are not valid. Correcting for this error persistence by quasi-differencing the data—see the Annex III.1 for details—shows that there is no statistically significant trend in the investment income to GDP ratio.⁵

7. Two alternatives to using a simple long-term average to assess the sustainability of the investment income to GDP ratio are the trimmed mean and “synthetic” returns using a constant real interest rate.

• Given a number of spikes in the series since the late 1990s—reflecting in part returns from equities following the stock market intervention by the Exchange Fund in August 1998—a case can be made for constructing a trimmed mean to extract the extreme observed values. Omitting the highest and lowest 10 percent of the observations does not materially change the results. The ratio of investment income to GDP falls by 15 basis points (to 1.05 percent); similarly, the ratio of investment income to non-tax revenue falls by 1 percentage point (to 17.4 percent).

• Some of the volatility in the investment income to GDP series also derives from swings in nominal and real U.S. interest rates, which are exogenous to Hong Kong. Over the sample period, the yield on the 1-year U.S. Treasury bill (which is used as a proxy in the present exercise⁶) averaged 2.6 percent, but moved in a range from around minus 1 percent in recent years to over 6 percent early in the sample period. Using the long-term average constant real yield on U.S. paper to impute a nominal rate of return on Exchange Fund assets also has minimal effect on the results, as it lowers the investment income to GDP ratio by 15 basis points to 1 percent.

8. Given the change in policy in 1998 regarding the interest rate paid on fiscal reserves in the Exchange Fund , examining a shorter time series has merit. Looking at the truncated series for the investment income to GDP ratio yields a slightly higher mean of 1.4 percent of GDP, with a statistically insignificant coefficient on the trend variable (with no serial correlation in the error term). This again suggests a stable investment income to GDP ratio.

C. Land Premium

9. The land premium is defined as the sum of land “sales” and fees paid to the government for the conversion of agricultural land to commercial use. Virtually all land in Hong Kong SAR is publicly owned. Firms and individuals can acquired the rights to use and/or develop land through an auction system whereby control—but not ownership—of the asset is conferred upon the highest bidder (in the case of land sales) or applicant (in the case of modification premium), usually for a period of up to 50 years.

10. The rationale for treating the land premium as revenue—and not a financing item—stems from the fact the underlying contracts are, in fact, leases. After the expiration of the lease period for both sales and conversions, control of the land reverts back to the government. Reflecting this fact, in Hong Kong SAR's government accounts the land premium has traditionally been included above the line as a capital revenue item. ⁷

11. Like investment income, the land premium has been a volatile non-tax revenue source over the past two decades (Table 1 and Charts). While the land premium has averaged 2.4 percent of GDP, it has varied from a low of 0.4 percent of GDP in 2003/04 to 5.2. percent of GDP in 1997/98. The low reflect the government's suspension of land sales following the over-supply created in the late 1990s while the high reflects the property market boom of the mid-1990s. The correlation with GDP has averaged about a 0.7 over the period, although on a rolling basis this has fluctuated sharply.

12. Despite numerous changes in land supply policy and the volatility of the series, the land premium as a percentage of GDP shows no statistically significant time trend. Using the same approach as above, the time coefficient for the land premium as a percentage of GDP is only .003; moreover, this coefficient is not statistically significant. However, as with investment income, there is serial correlation in the error term and quasi-differencing is adopted to correct for this (see Annex III.1). In the modified regression, the coefficient of the time variable becomes fractionally negative, but remains statistically insignificant.

13. Finally, on a related issue, the land premium has also been stable over the longer term in relation to capital expenditure. At issue is the extent to which the land premium should form a sizeable and stable counterpart for capital expenditure, which arguably should not be financed in large part from current revenues. The data show a long-run average land premium to capital expenditure ratio of 65 percent, with a somewhat higher ratio since 1997. Moreover, a simple regression shows that this ratio has been rising by about ¼ percent of GDP per annum, although the time coefficient is statistically insignificant.

Table III.1:

Hong Kong SAR: Volatile Revenue Items, Descriptive Statistics

Source: CEIC, Hong Kong SAR Government; and author's calculations.

^1/The trimmed mean excludes the lowest and highest 10 percent of the observations.

^2/Principle equals accumulated fiscal surpluses. The nominal yield uses the average real yield of the 1-year U.S. Treasury bill.

^3/Principle equals Exchange Fund balance. The nominal yield uses the average real yield of the 1-year U.S. Treasury bill.

Table III.1:

Hong Kong SAR: Volatile Revenue Items, Descriptive Statistics

		1983/84 – 2004/05					1996/97 – 2004/05
					Trimmed	Std.				Trimmed	Std.
		Average	Maximum	Minimum	Mean 1/	Dev.	Average	Maximum	Minimum	Mean 1/	Dev.
Investment Income
	As percentage of non-tax revenue	18.3	41.7	5.1	17.3	9.8	24.5	41.7	5.1	24.8	12.0
	As percentage of total revenue	7.0	19.5	1.5	6.3	4.9	10.4	19.5	1.5	10.4	6.1
	As percentage of GDP	1.2	3.5	0.2	1.0	0.9	1.8	3.5	0.2	1.8	1.1
Implied investment income A 2/
	As percentage of GDP	1.0	2.0	0.5	1.0	0.4	1.4	2.0	0.8	1.4	0.4
	Less actual investment income (as % of GDP)	−0.2	1.4	−1.9	−0.1	0.7	−0.4	1.4	−1.9	−0.5	1.0
Implied investment income B 3/
	As percentage of GDP	2.6	4.7	1.3	2.5	1.0	3.5	4.7	2.3	3.6	0.9
	Less actual investment income (as % of GDP)	1.6	3.2	0.7	1.5	0.7	2.2	3.2	0.7	2.2	0.8
Land premium
	As percentage of non-tax revenue	40.6	84.6	6.8	39.0	22.5	32.6	84.6	6.8	28.9	24.0
	As percentage of total revenue	14.3	27.8	2.6	14.0	7.2	13.0	27.8	2.6	12.4	8.6
	As percentage of GDP	2.4	5.2	0.4	2.3	1.3	2.3	5.2	0.4	2.2	1.7
	Land sales as a percentage of land premium	56.9	100.0	36.6				83.5	41.2
	As percentage of capital expenditure	65.4	211.2	12.2	59.6	43.8	70.7	211.2	12.2	59.0	62.6
Memorandum items:
Tax revenue (as a percentage of total revenue)		63.5	71.9	47.9	64.1	6.4	59.5	71.2	47.9	59.4	7.2
Tax revenue (as a percentage of GDP)		10.4	12.3	8.5	10.4	1.1	10.1	11.7	8.8	10.1	1.2
Fiscal reserves (as percentage of GDP)		18.6	35.1	9.3	17.9	8.8	27.4	35.1	14.1	28.2	7.1
Actual rate of return on fiscal reserves		6.2	10.1	0.7	6.3	2.5	6.5	9.9	0.7	6.9	3.0
Real yield on 1-year US Treasury bill		2.6	6.3	−1.0	2.6	1.9	1.6	3.4	−1.0	1.6	1.7
US 1-year yield using LT average real yield		5.8	8.1	4.2	5.7	1.0	5.1	6.0	4.2	5.0	0.6

Source: CEIC, Hong Kong SAR Government; and author's calculations.

^1/The trimmed mean excludes the lowest and highest 10 percent of the observations.

^2/Principle equals accumulated fiscal surpluses. The nominal yield uses the average real yield of the 1-year U.S. Treasury bill.

^3/Principle equals Exchange Fund balance. The nominal yield uses the average real yield of the 1-year U.S. Treasury bill.

View Table

Table III.1:

Hong Kong SAR: Volatile Revenue Items, Descriptive Statistics

		1983/84 – 2004/05					1996/97 – 2004/05
					Trimmed	Std.				Trimmed	Std.
		Average	Maximum	Minimum	Mean 1/	Dev.	Average	Maximum	Minimum	Mean 1/	Dev.
Investment Income
	As percentage of non-tax revenue	18.3	41.7	5.1	17.3	9.8	24.5	41.7	5.1	24.8	12.0
	As percentage of total revenue	7.0	19.5	1.5	6.3	4.9	10.4	19.5	1.5	10.4	6.1
	As percentage of GDP	1.2	3.5	0.2	1.0	0.9	1.8	3.5	0.2	1.8	1.1
Implied investment income A 2/
	As percentage of GDP	1.0	2.0	0.5	1.0	0.4	1.4	2.0	0.8	1.4	0.4
	Less actual investment income (as % of GDP)	−0.2	1.4	−1.9	−0.1	0.7	−0.4	1.4	−1.9	−0.5	1.0
Implied investment income B 3/
	As percentage of GDP	2.6	4.7	1.3	2.5	1.0	3.5	4.7	2.3	3.6	0.9
	Less actual investment income (as % of GDP)	1.6	3.2	0.7	1.5	0.7	2.2	3.2	0.7	2.2	0.8
Land premium
	As percentage of non-tax revenue	40.6	84.6	6.8	39.0	22.5	32.6	84.6	6.8	28.9	24.0
	As percentage of total revenue	14.3	27.8	2.6	14.0	7.2	13.0	27.8	2.6	12.4	8.6
	As percentage of GDP	2.4	5.2	0.4	2.3	1.3	2.3	5.2	0.4	2.2	1.7
	Land sales as a percentage of land premium	56.9	100.0	36.6				83.5	41.2
	As percentage of capital expenditure	65.4	211.2	12.2	59.6	43.8	70.7	211.2	12.2	59.0	62.6
Memorandum items:
Tax revenue (as a percentage of total revenue)		63.5	71.9	47.9	64.1	6.4	59.5	71.2	47.9	59.4	7.2
Tax revenue (as a percentage of GDP)		10.4	12.3	8.5	10.4	1.1	10.1	11.7	8.8	10.1	1.2
Fiscal reserves (as percentage of GDP)		18.6	35.1	9.3	17.9	8.8	27.4	35.1	14.1	28.2	7.1
Actual rate of return on fiscal reserves		6.2	10.1	0.7	6.3	2.5	6.5	9.9	0.7	6.9	3.0
Real yield on 1-year US Treasury bill		2.6	6.3	−1.0	2.6	1.9	1.6	3.4	−1.0	1.6	1.7
US 1-year yield using LT average real yield		5.8	8.1	4.2	5.7	1.0	5.1	6.0	4.2	5.0	0.6

Source: CEIC, Hong Kong SAR Government; and author's calculations.

^1/The trimmed mean excludes the lowest and highest 10 percent of the observations.

^2/Principle equals accumulated fiscal surpluses. The nominal yield uses the average real yield of the 1-year U.S. Treasury bill.

^3/Principle equals Exchange Fund balance. The nominal yield uses the average real yield of the 1-year U.S. Treasury bill.