Hong Kong's Economy Is In The Calm Before The Storm

Like a cartoon character whose legs continue to pump even after he has run off a cliff, Hong Kong's house prices have remained buoyant even as purchasing activity in the real-estate sector has crashed to levels not seen since the slump at the start of the millennium. The situation cannot continue indefinitely: sooner or later prices will follow sales down.

Property prices more than doubled in Hong Kong between end-2008 and end-2012. Policymakers have taken several steps to try to cool the market, including tightening restrictions on mortgage loan/value ratios and increasing stamp duty in late 2012 and early 2013. However, according to the Hong Kong Rating and Valuation Department (RVD), property prices in September 2013 were still 7.8% higher than in December 2012.

Defying gravity

Nevertheless, the sector is not in rude health. Figures from the Land Registry show that there were only 3,426 residential units sold in October, a drop of 60.7% year on year and of 7.1% compared with September. On a rolling three-month basis, the number of all types of building units being sold is at its lowest level since March 2001. Over the last two decades, slumps in sales activity have usually been temporary, but the current downturn has been unusually long-lasting-and there are few signs that it will end in the near future. That is largely a reflection of the fact that prices continue to levitate, despite the sharp contraction in demand.

The strength of prices is partly a reflection of high levels of liquidity, a phenomenon that is linked both to rapid credit growth in China (a major source of demand for property in the territory) and to the extraordinarily loose monetary policy being adopted in the US. Hong Kong's interest rates are linked to those in the US through the exchange-rate peg. However, given that demand is slumping, liquidity no longer seems to be the primary driver of local property prices.

Sellers' boycott

Instead, the key factor behind recent trends appears to be the reluctance of homeowners and developers to put properties up for sale in such a weak market, which has resulted in a relatively tight supply of new properties. Similarly, sellers have, overall, been reluctant to slash prices in order to clear the market. They have been supported by developments in the rental market, where prices have remained buoyant. Nevertheless, pressures for a more substantial readjustment are beginning to build. Although private residential rents were still up by 5.6% year on year in September according to the RVD, this growth has slipped from a rate of 14.2% in February.

The coming months are likely to see some confusing data. Anecdotal reports suggest that demand in some parts of the market may be picking up again. Developers have sought to offset government policies by offering incentives, including stamp-duty rebates. This can result in a considerable reduction in the overall transaction price for higher-end properties-and one that does not filter through into property price indices, thus avoiding potential declines in "property prices" as reported by the media that might spook potential buyers. However, it is an expensive tactic that hits the margins of developers. Other buyers are reported to be trying to make purchases before higher interest rates make mortgage borrowing significantly more expensive.

Rate rises the trigger?

In the longer run, the current level of house prices is unlikely to be sustainable. Our current expectation is that local interest rates will rise in line with those in the US in 2015-16. Higher borrowing costs will increase the pressure on developers to clear inventory, even as they deter buyers, suggesting that they will be the trigger for a broader correction in the Hong Kong housing market. However, a shadow tightening could occur before 2015, as the US winds down its quantitative easing programme, pushing up market interest rates even as policy rates remain stable. It is also hard to determine how well confidence will hold up among property owners. A serious price decline could thus begin in 2014.

The drop in prices, whenever it comes, could be substantial. Although it is unlikely to match the 66.2% slump in residential house prices that occurred in Hong Kong between October 1997 and July 2003, it will almost certainly be in double digits, and could be as high as 30-40% for some types of property. Policymakers could reverse the recent curbs imposed to rein in house prices, but we do not believe that such a step would succeed in halting the slide in prices. Indeed, it is not clear that the chief executive, Leung Chun-ying, who campaigned on a platform of tackling the issue of housing affordability, would be keen to prop up prices, even if he could.

Riding out the crunch

Although a dramatic property crash will have negative effects on the economy, the risks to the financial sector are not as high as they would be if such a decline occurred in another developed economy. Loan/value ratios for home loans in Hong Kong are low, at around 56% in recent months, and negative equity is virtually non-existent. Consequently, the banking sector will face any price correction from a robust base. Its experience of handling the massive slump in house prices in 1997-2003 with few problems also suggests that it should be able to handle the downturn.

The biggest impact on the economy is thus likely to stem from negative wealth effects (as house prices fall) and the loss of employment that tends to accompany a downturn in the real estate sector. These will be significant, but given that the external trade sector is expected to be strengthening at the same time, the overall economy should continue to expand, even through the property downturn. If the effects on domestic demand are stronger than we expect, the government's fiscal position is more than strong enough to provide additional stimulus. This would probably be channelled through income supplements rather than public investment. The government already has an extensive programme of infrastructure "megaprojects", such as the Macau-Zhuhai-Hong Kong bridge, under way that would be hard to ramp up at short notice.

The real-estate sector's troubles will be unnerving, and will cause economic hardship for many individuals, but the territory is well prepared for the volatility that lies ahead. The looming clouds will also come with a silver lining. Hong Kong's sky-high housing and office costs are a notable weakness in the city's otherwise stellar business environment. A fall in rents could, in the longer run, serve to boost investment in the city.

Click here to subscribe to The Economist