Hong Kong Property: Looking Downward4 April, 2011, 14:46. Posted by Zarathustra
Tags: Hong Kong, Property, Real Estate
After reaching the bull case scenario of rising 11%, upside is getting limited for the rest of the year, and conditions are becoming less favourable. As companies in China are scrambling to Hong Kong to borrow and Hong Kong depositors favour Chinese Yuan (a.k.a. Renminbi) deposits over Hong Kong dollar, Hong Kong dollar liquidity is being tightened, thus funding costs are rising. Mortgage rates are at historical low because of ample liquidity in the system as well as the historically low spread between funding costs and lending rates. However, both are unsustainable and are changing. I maintain my base-case scenario for 2011 year-end for residential property prices, with the lower-bound of a 0% rise for the entire year of 2011 under such scenario. As property prices have risen roughly 11% (before the impact of Japan’s earthquake feeding into the market sentiment), a correction of as much as about 10% by the end of this year will be a real possibility.
The Beginning Of The End (Or The End Of The Beginning)
“This is not the end, though it is not even the beginning of the end. It is perhaps the end of the beginning”
– Winston Churchill, 1942
After rising 29% in 2009 and another 21% in 2010, home prices rose yet another 11% before the market felt the earthquake in Japan. Overall, residential housing prices rose some 73% from the bottom in late 2008 after the Great Financial Crisis. Residential property prices are now almost as expensive as in the previous peak in 1997, which, of course, was followed by an epic fall of home prices.
Time flies, particularly the happy one. As property prices are getting more and more expensive, I find less and less reasons why I should stay bullish. “Beginning of the end” or “end of beginning”, this is not the question. The thing is it is going to end, and now we are seeing signs of that ending.
It’s the liquidity, stupid.
It is important to understand what exactly drove property prices for the past 2 years or so, and in fact, the past 10 years.
The fundamentals for property market in Hong Kong is anything but strong. Median household income has not changed much since 10 years or so ago, and population growth in Hong Kong is falling. Despite the usual claim that the new supply of flats is lower than the long-term average for the past few years, low supply level has remarkably little to do with rising home prices. In a previous analysis (see Hong Kong property: the real supply situation), I have pointed out that there are roughly 1.4 million residential units in the private property sector, and there are roughly 1.2 million households living in private sector residential units. That implies that 200,000 units are in excess of the true demand, which should give the market enough buffer for a below-average supply level for a few years. I have also pointed out that to keep the current supply-demand balance stable, the new net supply required would be around 13,000 units a year for the next 5 years, which is less than what government has pledged to supply.
The only two things that drove property prices were monetary policy and monetary policy. First, it was the monetary policy of the United States (i.e. quantitative easing of course), which are causing some massive capital flow around and into Asia. Second, it was the monetary policy of China, which was overly loose due to the government’s desire to keep growth strong after the great financial crisis, leading to an overheating Chinese economy and increased number of Chinese buyers in the Hong Kong property market. Because of the linked-exchange rate system, capital flow into Hong Kong will not cause exchange rate to go up. Rather, it will cause money supply to increase as exchange rate is maintained. That means for the years after the financial crisis, liquidity is high in the banking sector of Hong Kong, causing the 3-month Hong Kong interbank offered rate (HIBOR) to drop to almost 0% for the past 2 years.
The following two charts show, once again, how money supply growth in Hong Kong has been driving home prices in Hong Kong. If you will, a quick expansion of money supply on an year-on-year basis has been almost invariably followed by a quick rise in property prices on an year-on-year basis with a 5 to 6-month lag.
Source: Hong Kong Monetary Authority, Centaline
Quarter averages of money supply is used to smooth out some extreme volatility
Liquidity Is Being Drained…
One thing is pretty clear from the charts: money supply growth has been slowing. That makes good sense of course, as the money supply became much higher after expanding in excessive rates in 2009, we are comparing the latest figure with a higher base. However, we have to face the reality: both Hong Kong dollar M1 and M2 peaked in October of 2010, and it has been dropping since then even though they are still higher now than a year ago. In short, liquidity has been tightened.
There are a few factors that are contributing to the tightened liquidity, and none of them are immediately obvious as most people are fixated at the monetary policy in the United States. True, monetary policy will still be loose in the United States even if the second round of quantitative easing expires without any extension. However, we have to understand that interest rates in Hong Kong do not always follow the monetary policy in the United States (see The fallacy of low interest rates for more detailed discussion). Interest rates in Hong Kong are subject to shocks such as the tightening of liquidity in the banking system caused by withdrawal of funds. Pretty much in the same way as to why money supply increases when funds flow into Hong Kong, when funds are withdrawn from Hong Kong (e.g. when people owning Hong Kong dollar or Hong Kong dollar denominated assets are selling Hong Kong dollar for other currencies), the exchange rate of Hong Kong dollar cannot fall amid increasing selling pressure. Instead, liquidity will be tightened and interest rates will be driven upwards. This is demonstrated by the divergence of HIBOR and the Federal Funds Rate from time to time.
Source: Hong Kong Monetary Authority, St. Louis Fed
Two slowly developing factors are driving liquidity out. First of all, the monetary tightening in China is spilling over to Hong Kong (see The Impact of China’s Tightening and Hong Kong Banks: Three Updates). Chinese companies are now finding it difficult to borrow money from Chinese banks because of the monetary and credit tightening. Increasingly these companies are borrowing money from banks in Hong Kong. As mortgage rates are at record low (around HIBOR plus 90 – 120 basis points), lending to Chinese companies would be much more profitable (at least for now). As a result, banks increased mortgage rates.
The second development is a shrinking Hong Kong dollar deposits. Because of the expectation of appreciation of Chinese Yuan a.k.a. Renminbi, or RMB, depositors seem to favour RMB deposits over Hong Kong dollar deposits (see Hong Kong Banks: Three Updates). As a result, funding costs in Hong Kong dollar is on the rise, giving an upward pressure to mortgage rates.
We should also be aware of the possibility of tail events or black swans (as popularised by Nassim Nicholas Taleb), which have low probability of happening but large impacts. That can happen anywhere in the world, and anything that makes the world seems a scarier place will do the trick.
One of the biggest tail event that might happen is a recession in China. We understand the problems of the China’s economy as it is driven by debt-funded over-investments, though most people do not see a high probability of a crash in Chinese economy or a financial crisis in China. However, the ingredients for crisis are there (see 10 Reasons to short China). Even though you do not think that’s going to happen (although I think there is a real possibility for that), you will have to accept that the impact would be disastrous should that happen.
Long-Term, It’s Going To Be… Not OK
It is true that looking at history, you might make money in the long-run even you bought real estate at the top of the market (except if you bought it in 1997, perhaps). But we have no reason to believe that’s going to happen again.
One of the things that has not been properly understood is the long-term structural problem the city is facing in the years to come, and its implication to the property market. Pretty much the same as in China as well as the rest of the world, the city will have an ageing population, and that is going to be bad for equities and real assets, like property (see The World In 2030 for some more thorough treatment on this issue) in the long-run. Asset prices are more prone to over-pricing when you have the middle of your population pyramid bigger than the older and younger proportions. More specifically, people from age 35 to 54 are the main group of people within the population who are saving for retirement. If we have a large proportion of these people in the population, their huge saving will drive asset prices, leading to higher return in those years.
Both China and Hong Kong are at the turning points where this cohort of investors is shrinking relative to the total population. The turning point that we are facing is similar to what Japan faced in early 1990s, and what the United States faced in the early 2000s. In the case of Japan, it coincided with the burst of their real estate bubble and the subsequent lost decades. In the case of the United States, it coincided with the burst of the dot-com bubble and, if you will, the real estate bubble a few years later.
Both China and Hong Kong will be facing an ageing population. Demographic shift is a slow moving event, and the impact of that will not be immediately obvious (see Real Estate Prices and Demographics). The “demographic headwind” for real estate market in United States, for instance, is estimated to be -80 basis points per year. While I am not going to estimate the exact demographic headwind for Hong Kong real estate market, I believe that we would see a slow downtrend in the real estate market, and we should not be surprised if property prices 30 years from now are lower than today.
10% Fall By The End Of 2011
Because of the tightening of liquidity from increasing lending to companies in China and the increasing interest in RMB deposits over HKD deposits, we shall see more upward pressure as far as mortgage rates are concerned, which will be hurting affordability. Based on that, the year-on-year change in money supply may hit zero within the next 3-6 months, and may turn negative towards the end of the year. That implies that property prices towards the end of this year will be flat comparing to the beginning of this year, consistent with the lower-bound of my base-case scenario in my 2011 forecast. As home prices has risen 11% (before earthquake), which was within the range of my bull-case forecast, correction of as much as about 10% should be a real possibility by the end of this year.
Source: Hong Kong Monetary Authority, Centaline. Anything to the right of the dashed line are my estimates
Should liquidity be tightened faster than expected, property prices by the end of this year may be 5-10% lower than the beginning of the year, thus as much as 15-20% correction from the current level will be possible. This is my bear case scenario.
More Correction Possible in 2012
Predicting home prices 1 year and 3 quarters ahead is difficult. While Andrew Lawrence of Barclays Capital (a.k.a. the Skyscraper Index guy) estimated a 25-30% drop in home prices till the end of 2012, I would like to consider a few more different scenarios.
This is what a 30% correction by the end of 2012 will look like
Let us first look at some of the major corrections in the last 30 years and their causes:
1. 1981 – 1984: Property prices dropped by 32% over 3 years (Source: Rating and Valuation Department) due to the confidence crisis surrounding the handover of Hong Kong from the United Kingdom to China
2. 1994 – 1995: Property prices dropped by 28% over 18 months (Source: Centaline) due to Hong Kong government’s curbing measures, macro-regulation in China, and the increase of interest rate by the Federal Reserve
3. 1997 – 2003: Property prices dropped by 69% over 5 years and 7 months (Source: Centaline) due to the Asian Financial Crisis in 1997 (and arguably the burst of dot-com bubble in early 2000s made things worse)
4. 2008: Property prices dropped by 23% in 6 months (Source: Centaline) due to the subprime crisis and the subsequent great financial crisis.
(See Hong Kong property market history in a chart for more detail)
The severity of the correction by the end of 2012 will depend on what is going to happen in the next. The key will be the liquidity condition in the banking system over the next 12 to 18 months. A slow but sustained “drain” of liquidity from the system would imply a slow and moderate correction, while a sudden withdrawal of funds (that may happen in a crisis) would cause a quick and dramatic fall. If any banking crisis happened around the same time, the correction will be severe, long, and painful, like the 1997 crisis (In their analysis, Carmen Reinhart and Kenneth Rogoff has pointed out that when a real estate bubble burst around the time of a banking crisis, historically, on average, the correction last for around 6 years).
Of course, the current situation cannot possibly be completely comparable to any of the above historical instances. If one has to pick the most similar one, one will say that it is the 1994-1995 correction, as the Hong Kong government at both instances have been trying to curb prices, and the Chinese government at both instances have been trying to curb inflation and real estate prices (see The forgotten real estate bubble in 1990s), although the United States were tightening in 1994 but not now. Thus a correction of 25-30% from the current level seems to be the most probable scenario.
However, the tightening in China in 1994-1995 somehow managed to curb real estate prices and inflation without slowing economic growth (soft-landing). We have no reason to believe that a soft-landing will happen again in 2011-2012. Also, the economic link between China and Hong Kong has been strengthened over the past decade, meaning that what happens in China will have a more significant impact now than in 1994-1995. Should a hard-landing with some sort of financial crisis occur (I actually find it quite probable, although most people would still expect the chance to be slim), the 1997 crash will be a more comparable scenario. That would imply a sudden crash in a short period of time and a prolonged correction after a dead cat bounce.
Another consideration is the unintended consequences of government intervention. The punitive Special stamp duty, in particular, has deterred speculators from entering the market. As the market correct, however, it may deter any buyers from entering the market, thus increasing the downside risk.
Read more about China Economy
Read more about Hong Kong Economy
Read more about Hong Kong Real Estate