OUR FINANCIAL SECRETARY, Antony Leung Kam-chung, is a man under pressure. He has targeted a reduced fiscal deficit of HK$45.6 billion for the year to March 31 and he cannot afford to miss it by much. His trouble is that the deficit is still running at an annual figure of HK$64.8 billion, more than 5 per cent of gross domestic product, while his colleagues in government show no signs of restraining their spending habits or willingness to raise taxes. There is also little sign yet of the economic recovery that could produce the revenues he needs without higher tax rates. As that March deadline approaches, Mr Leung may consequently find himself tempted to resort to a few tricks to make up the shortfall and here is one that we had best hope he does not find too tempting. The Hong Kong Monetary Authority has just reported that its Exchange Fund has recorded investment earnings of HK$22.8 billion for the first half of this year. Under an earlier agreed formula, HK$8.1 billion of this, more than Mr Leung might have expected so far, will go into a fiscal reserves account for him to draw down against the deficit if he so pleases. In theory there is nothing wrong with this. The bulk of the Exchange Fund represents government savings and why bother with having such savings at all if we cannot use some of the income for government revenues? The difficulty, however, lies in the nature of that HK$22.8 billion investment gain. It is not, as you might think, made up from dividend and interest income but mostly from unrealised exchange gains and capital appreciation. Now ask yourself a simple question. If you had bought a flat for HK$10 million and prices in the property market moved up so that it was worth about HK$12 million, would you treat that HK$2 million difference as a locked-in profit that could immediately be spent on cars, holidays and restaurants? Remember that you have not sold it. You also know full well that property prices can go down again and that if you wanted to move you might need that money because the price of your new home has also gone up. Treating that unrealised gain as free spending money would be hugely imprudent, would it not? But this is what we could be doing here. Take the HK$17.4 billion that the Exchange Fund 'earned' in an unrealised exchange gain in the first half. This mostly represents the recent decline of the US dollar against the euro. We are locked into the US dollar through our peg to it so that we lose or gain nothing on US dollar investments when the US dollar goes up or down. But some of the fund's holdings are in euro instruments and they are therefore worth more in US dollar (and HK dollar) terms than they were six months ago. Fine, but what if the US dollar rises again? These 'gains' are instantly wiped out. Similarly, the HK$20.9 billion booked on total return from bonds is heavily made up of higher bond prices. Think about it. If you hold a HK$100 bond paying 10 per cent and interest rates fall to 2 per cent you are not going to give that HK$8 a year difference to a stranger for free. You will demand more for the bond you hold. So the Exchange Fund's bond holdings are now worth more. Fine, but what happens if interest rates rise? They are more likely now to rise than fall further. And if it happens, and our government has meanwhile booked these unrealised gains as firm revenue, what will it do when gains turn to losses? We stop private corporations from booking unrealised gains as earnings. We should be all the more on guard for it in government. Let us hope Mr Leung does not succumb to temptation.