Dollars and Houses: Why Currency is the Main Driver Behind Hong Kong’s Housing Bubble

Home prices in Hong Kong are insane. Since the second quarter of 2003 residential real estate prices have surged 300%. Since 2009 they have increased 80%. Year after year it becomes increasingly difficult for Hong Kongers to afford housing and one only needs to read the local papers or talk with local residents to feel the popular discontent brewing. The predominant opinion is that blame should rest with the government, who has allowed too many Mainland Chinese investors to speculate on property in Hong Kong. This has led to many politicians promising to make certain Hong Kong real estate purchasable only by Hong Kong permanent residents. “Hong Kong Land for Hong Kong People.” While Mainland investors are part of the problem, this is an oversimplification that has become popular only because Hong Kongers are predisposed to blame Mainland China for all their problems. Hong Kong people and politicians should see that currency is primarily to blame for their housing woes.

HK Home Prices up 300% in 9 years.

First, to understand why so much money is coming from Mainland China to Hong Kong, one must comprehend Chinese currency controls. To prevent significant capital from flowing out of China, Chinese nationals are only allowed to convert the equivalent of $50,000 US in RMB to foreign currency every year. That means those Chinese who have savings either must hold RMB or invest in China. Holding too much cash in China is a bad idea because the government keeps the currency weak in order to increase the competiveness of their exports. Many people are also wary to invest their RMB back into China, as the risks of corruption, government-appointed monopolies, or nationalization are relatively high. So what are these rich Chinese to do?

The main exception to Chinese currency controls is Hong Kong. Chinese nationals are allowed to invest as much as they like in Hong Kong. But the Hong Kong stock market is boring, if not depressing. In the past five years the Hang Seng Index, which tracks the performance of Hong Kong-listed companies, is down 20%. This is compared to the FTSE (London-listed companies), which is down 10% and the Dow Jones Industrial Average (US-listed companies), which almost breaks even for the five-year period. The Chinese investors want their cash to get to work, so they go for the already-surging real-estate market, pushing prices even higher. As prices rise, more investors jump on the bandwagon, thus perpetuating the bubble. This also means a higher percentage of Hong Kong property-owners are fickle speculators who will sell at the first sign of trouble.

The Hang Seng Index’s Abysmal Relative Performance

Second, although Hong Kong is part of China, they have their own currency. The Hong Kong Dollar is pegged to the US Dollar at around 7.8 HKD to 1 USD. This was established to prevent speculation on the Hong Kong Dollar (few people want to challenge a central bank’s peg), to improve confidence in the currency, and to remove exchange rate risk for business operating in Hong Kong and the US. While these are noble pursuits, the peg has some critical flaws.

A peg essentially gives the US Federal Reserve control over the valuation of the Hong Kong Dollar and, as a result, Hong Kong’s interest rates. In a normal economy, interest rates are pushed down by a central bank in bad economic times. In 2008-2009, the US suffered quite a devastating recession and so interest rates are at an all time low. This has led to money being cheap in Hong Kong as well. The problem is that Hong Kong’s economy is fine. Unemployment is low and economic growth is satisfactory. Wanting to take advantage of this cheap money, investors have borrowed at low rates and pumped the money into the housing market, which was already inflated by Mainland speculators.

The question of when the bubble will burst is difficult to answer, but it is possible to speculate on what will cause the decline.  Right now, the average Hong Kong household spends around 43% of their income on housing. However, if the US economy starts to recover or US inflation starts to rise significantly, the Federal Reserve will raise interest rates. If the Fed raises rates just 1%, then the share of income spent on housing in Hong Kong will rise to 55%. It seems unlikely most households will be willing or even able to meet this increase in housing costs. Many people may sell their homes or cease their leases in order to downsize. As soon as the meteoric increase in home prices ceases, the speculators will jump ship. The market will flood with excess homes and apartments. The positive supply shock will lead to a dramatic and rapid decline in home prices. Those caught off guard will be rushing to the exits, selling at any price. Those who put their life savings in a home will be devastated.

This is the most likely scenario for how the bubble will burst. The other possibility is that prices will reach such exorbitant levels that new players in what is essentially a Ponzi Scheme will be barred from entry. Solutions to this problem are few and far between. Hong Kong is ramping up efforts to increase the supply of homes and developable land through construction and land reclamation, but increasing supply in an irrational bubble will do little to calm the price increases. The truth is that all bubbles must burst and it will always be painful when they do. Prudent Hong Kong banks and residents should minimize their exposure to housing in the coming years. Hopefully a large derivatives market hasn’t developed around Hong Kong housing. If one has, many banks could be infected with a new set of assets about to turn toxic. If the effects of a housing crash are for the most part only felt in the housing market, then the bursting of this bubble will be good for Hong Kong. More average people will be able to afford homes and those with no long-term interest in Hong Kong will abandon the city as quickly as they came. For those outside of Hong Kong, this case provides a great example of why sovereignty over national currency is essential and why excessive currency manipulation is a bad idea.

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