Why property is Hong Kong's national sport

Bernie Lo | @cnbcbernie | http://www.cnbc.com/id/101928585

"14 Years To Buy a Flat!" the newspaper headline screamed after the Chinese University of Hong Kong's housing affordability index hit an all-time low. In 2002, a household would need 5 years' savings to buy a modest 40 square meter flat, the survey showed; today they would need 14 years' savings. Hong Kong consistently ranks among the world's most expensive property markets. A series of policy decisions since the 1980s illustrates why Hong Kong was headed down this path from the start.

Pegged for trouble

The modern functioning real estate market only dates back to 1983, when the Government pressured banks into introducing long-term mortgage financing instruments. Before that no true mortgages existed, only short-term funding of 3-5 years. 1983 was also the year the Hong Kong dollar came under tremendous speculative attack and the administration opted to peg it to the U.S. dollar. The peg, which still exists, contributed to massive volatility over that period.

The peg has meant that Hong Kong has no independent monetary policy. It is hostage to the U.S. Federal Reserve; the Hong Kong Monetary Authority (HKMA) has no control over interest rates. At many times, the prevailing rates here have been at great odds with what is needed. For instance, while the U.S. economy may be soft and need low rates, Hong Kong could be bursting with economic activity and because of the peg, experiencing an inordinately low rate environment.

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In 1990 the U.S. entered a recession and interest rates were cut; this conversely boosted asset prices in Hong Kong whose economy was fine, and property prices began a multi-year climb. By the mid-90's, to make sure confidence was high ahead of the 1997 handover, money poured in from China and much of it found its way into real estate. By the time the handover arrived, Hong Kong's property market had skyrocketed; an average 115 percent of household income was paying for housing, clearly an unsustainable situation.

Then Thailand devalued its currency and the Asian Financial Crisis raged – currencies crashed, markets careened. Other countries could adjust and cut rates as needed, but Hong Kong, tethered by the peg, was choked. Interest rates could not be adjusted downward. Within a year and a half, property prices had crashed by 45 percent. Subsequent years brought some relief, but then SARS turned Hong Kong into a ghost town in 2003, and prices resumed their descent, now down 60 percent from their all-time highs in 1997.

Easy money boost

What goes down will come up though, and later, U.S. Fed Chairman Ben Bernanke's free and easy money policy was a booster injection for property. Mortgage rates hit lows well below 1 percent during the quantitative easing (QE) process, and even now are only at around 2.5 percent. Many blamed an influx of Chinese money for pumping up prices, but Chinese buyers have never accounted for more than around a tenth of total sales. Furthermore, they focused on the extreme luxury segment of the market.

The government, sensing creeping public outrage, resorted to draconian measures a couple years ago, including doubling the stamp duty (property transaction tax) on many buyers, mainly non-Permanent residents, in order to cool the market, and raised the down payment requirements, in some cases to 60 percent of the sales price. Transaction volumes fell by two-thirds. But prices have only eased about 5 percent.

Activity in recent months has picked up again, as developers learned that by discounting prices in order to compensate for higher down payments and stamp duties, there was plenty of pent-up demand. You now regularly see surveys and studies showing the property market frothier than it ever was even in the go-go days of the late 90's.

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There are many unknowns: when will the Fed actually begin raising rates again after shutting QE, and how will an expected slowdown in the Chinese economy impact HK?

There's also one overhang that cannot be overlooked that dates from the Shek Kip Mei fire of 1953 which destroyed massive shantytowns of mostly Chinese immigrants. The British governor at the time decided to embark on a massive construction program to rehouse those left homeless and marked the beginning of Hong Kong's public housing experiment. Since that time, government-provided rental and subsidized purchase property has come to comprise nearly 50 percent of total housing stock, meaning the government is landlord to half of Hong Kong, leaving the other half to fight it out in the private market. Simple economics tells you that a synthetically shrunken supply will only lead to higher prices.