Debunking 3 Myths Of HKD-USD Currency Peg And Its Relationship With Property Prices13 May, 2011, 11:09. Posted by Zarathustra
Tags: Currency Peg, Economy, Hong Kong, Real Estate
Despite having discussed for so many times about the common misconceptions regarding the underlying driving forces of Hong Kong property market, most people are still holding the same old misconceptions regarding the Hong Kong property market.
WAKE UP PEOPLE!
I am amazed by how little understanding many people have with respect of the Hong Kong dollar and US dollar linked exchange rate system even in simplified terms. I don’t want to go through all the technicality of the HK$-US$ linked exchange rate system as I am not someone working in the Hong Kong Monetary Authority who can give you the complete detail. However, I want you to understand deep enough to make some informed judgments and debunk those myths regarding the linked exchange rate system and the relationship with the property prices.
Myth 1: Interest Rates in Hong Kong always follow that in the United States
That is false.
I have discussed the fallacy of low interest rates in great detail previously, so I am only going to repeat the most important point.
Interest rates in Hong Kong are, most of the time, set by the Federal Reserve because of the linked-exchange rate system. In simplified terms, if the United States raise interest rate (Fed Funds rate), the Hong Kong Monetary Authority, most of the time, will follow that in order to maintain the exchange rate at HK$7.8 per US$.
The reality, however, is that interest rates are driven by the supply and demand for Hong Kong dollar, Hong Kong dollar denominated assets, as well as the peg, and the correlation of interest rates of Hong Kong and the United States is a mere coincidence which happens often enough to make you believe that they necessarily move together.
The reason is that interest rates in Hong Kong are part of the entire mechanism which keeps exchange rate stable. If the demand for HK$ is very strong, HK$ exchange rate will rise. In order to maintain the exchange rate stable, interest rate has to be reduced in hope to make HK$ less attractive. To achieve this, the Hong Kong Monetary Authority will buy US$ and sell HK$, increasing the monetary base, which will drive interest rates down. Conversely, if the demand for HK$ is weak, HK$ may depreciate against the US$. To counter that, the Hong Kong Monetary Authority will have to sell US$ and buy HK$, effectively decreasing the monetary base and drive interest rate up.
This mechanism works in the same way regardless the interest rates in the United States and the strength of the US$ against other currencies.
Myth 2: Raising interest rates in Hong Kong will attract money inflow, thus drive property prices higher
This concept is a manifestation of confusing between cause and effect.
Again, Hong Kong has no control over its own interest rates.
If interest rates in the United States remains unchanged (at any level, not limited to the current abnormally low level), the only thing that can drive interest rates in Hong Kong up is weaker HK$. The reason for a weaker HK$ is that the demand for HK$ decreases, that means people do not want HK$ or HK$ denominated assets: they are selling them for other currencies or assets denominated in other currencies. Many events can trigger a weaker demand for HK$. For example, as Chinese Yuan (RMB) deposits are getting more popular now, many Hong Kong people are now selling HK$ for RMB. Banks in Hong Kong are also lending more money to enterprises in China, yet these banks lend in HK$ and their borrowers need RMB, so that means these borrowers will need to sell HK$ and buy RMB when they transfer the money back into China. A more extreme example would be a speculator attack, in which HK$ is being dumped on the foreign exchange market in a massive scale. All of these examples drive HK$ weaker against the US$, and they are examples of so-called money outflow, or capital outflow.
The Hong Kong Monetary Authority’s major mandate is to maintain the currency peg. If HK$ demand is weakened amid money outflow, the Hong Kong Monetary Authority is obliged to buy HK$ to maintain the exchange rate of HK$. But that would mean tightened monetary base and higher short-term interest rates.
Here is the key:
Rising interest rates in Hong Kong in the absence of rising interest rates in the United States can happen when there is a money outflow or weaker demand for HK$ and HK$ denominated assets. The whole point of allowing interest rates to rise and shrinking monetary base is to stop money outflow in order to maintain the HK$-US$ exchange rate.
The whole point here is that when interest rates are increased in Hong Kong with that in the United States unchanged, that means there has been a money outflow, and the action of the Hong Kong Monetary Authority in maintaining exchange rate stability will decrease monetary base and increase interest rates, which are both bad for the property market, even if these are done in slow motion.
Unless the action of increasing interest is attractive enough to offset all the money outflow which happened prior to the interest rate hikes, there is no reason why increasing interest rate can be good for real estate. Also, if increasing interest rates can make HK$ so attractive that it can offset any money outflow (which caused interest rates to rise), interest rate will have to drop amid money inflow.
To put it in the simplest terms: all else being equal, rise in interest rates is a manifestation of money outflow; fall in interest rates is a manifestation of money inflow. Rising interest rates can be good for Hong Kong property prices only if it makes HK$ so attractive that the money inflow it attracts completely offset the previous outflow, but if that happens, interest rates will drop again, and that will of course be good for real estate.
So if one believe that raising interest rates can be good for the real estate market, think twice about why interest rates have to be raised in the first place before saying that.
Myth 3: Weaker US Dollar invariably means higher property prices in Hong Kong
This is not necessarily true.
Source: St. Louis Fed (the axis for dollar index has been reversed), Centaline
The US dollar started strengthening in 1995, yet it marked the start the last leg of the real estate bubble of 1997, which ended tragically as we all know. Again, the US dollar started weakening in 2002, but not until 2003 did the real estate market in Hong Kong started the recovery. And if you are eager to read more into the chart, the movements of the US dollar in the recent 2 years bear little correlation with property prices movements in the same period.
Again, back to the money/liquidity driven model of Hong Kong property prices, the key to understand this is that when the US$ is strong, HK$ can be even stronger. As long as there is strong demand for HK$ and HK$ denominated assets, the exchange rate of HK$ will be strong against the US$ regardless of the strength of the US$. In that situation, the Hong Kong Monetary Authority has to increase monetary base and interest rates will be reduced. In another scenario, you can have a weak US$, but HK$ can be even weaker. This can happen if there is a very weak demand for HK$ and HK$ denominated assets. If the demand for HK$ is weak regardless of the strength of US$, the Hong Kong Monetary Authority has to shrink the monetary base and interest rates will be increased.
So weak dollar is invariably good for real estate in Hong Kong? At best, it is only generally true, with many exceptions.