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Sky-high Hong Kong property market could hit turbulence

Low debt ratios make crash unlikely, but capital outflows could hit prices

Hong Kong property prices have more than doubled since the 2008 global financial crisis, making the city Asia's most expensive market.   © Reuters

It is always difficult to predict when a bubble may burst, but the current level of prices in the Hong Kong residential property market suggests that there could be a correction in 2018, if not a U.S.-style crash.

Hong Kong property prices have more than doubled since the 2008 global financial crisis, according to government data. This has made the city Asia's most expensive market, according to a recent report by Swiss private bank Julius Baer. Data from the Land Registry this week confirmed that the market remains buoyant. Total property transactions last year rose 14.8% to 83,815 from a year earlier as buyers shrugged off multiple rounds of government efforts to rein in the sector.

But a decline in Hong Kong prices could be triggered by slowing Chinese economic growth or by shocks such as stronger-than-expected economic growth in the U.S., a development that could trigger large capital outflows from Hong Kong.

However, most Hong Kong homeowners have high levels of equity in their property, which cushions them from the financial distress faced by counterparts in other countries where high mortgage debt is often the norm.

In the U.S, for example, years of loose underwriting before the global financial crisis created a large number of highly leveraged homeowners, who were a key element in the 2007-10 subprime mortgage crisis. As the housing market slowed, these homeowners were forced to sell or default, creating a negative feedback loop that led to plunging prices.

The U.S. residential default rate peaked at 11.5% in early 2010, according to the U.S. Federal Reserve, as the ramifications of the crisis fed through the economy. By contrast, Hong Kong's default rate peaked at just 1.4% in 2000, according to the Hong Kong Monetary Authority's monthly residential mortgage survey.

The average homeowner in Hong Kong appears flush with equity, though hard figures are difficult to come by, and is likely to hold on through market downturns without resorting to panic selling or defaulting. In Hong Kong, borrowers typically finance about 70% of property costs. The average loan-to-value stands at around 50% after taking account of mortgage loans that have been partly paid down.

Although relatively high by comparison with conservative economies, this is well below the 95% borrowing level that has been common in the U.S. As a result of prudent underwriting and the fact that lenders can pursue other assets of defaulting mortgage borrowers, the city's default rate stood at just 0.02% at the end of October, according to the HKMA.

In 12 U.S. states, mortgage lenders cannot go after other assets of defaulters beyond the property secured by their loans. Such states, including California, Arizona, Texas and Florida, experienced large numbers of defaults during the recent housing crisis. Studies have shown that borrowers are 30% more likely to default in such states than in states where other assets of defaulters are at risk. In Hong Kong, mortgage borrowers similarly place their other assets at risk if they default.

Selling motives

While holding a large amount of equity limits distress in difficult times, it does not prevent homeowners from selling. In fact, high levels of equity encourage borrowers to sell to capture perceived gains. Delaying sales exposes borrowers to the risk that prices may fall, eroding potential gains.

The higher the equity level, the greater the incentive for owners to reduce asking prices to secure quick transactions. Borrowers with lower levels of equity are sometimes reluctant to reduce prices because that could entail a loss, leaving them with a shortfall that must be made up to repay the mortgage lender.

More broadly, the property market is affected by a wide range of factors, from macroeconomic considerations and movements in the capital markets to supply and demand. Generally, macroeconomic and supply and demand factors tend to change slowly over long cycles. Capital market conditions, on the other hand, can change quickly, driven by the flow of global capital and the actions of central banks.

Hong Kong, a small and open economy with a currency pegged to the U.S. dollar, is subject to large and potentially volatile capital flows. Typically, capital flows into Hong Kong when the economy is doing better than the U.S., and out when the reverse is true. Inflows can create abundant liquidity, lowering the cost of capital and raising property prices. When liquidity flows out and the economy slows, credit dries up and asset prices fall.

This phenomenon can lead to sharply different responses to major crises in Hong Kong and the U.S. For example, Hong Kong and its property market were deeply affected by the 1997 Asian financial crisis and the 2003 severe acute respiratory syndrome outbreak, while the U.S. economy was largely immune from both regional events. However, the capital flows and pegged exchange-rate regime prevents the HKMA from conducting monetary policy independently of the U.S. dollar, adding to local asset price volatility.

All this raises an interesting question about the significant U.S. cuts in corporate and personal taxes recently approved by the U.S. Congress. The impact is likely to include a faster rate of growth in the U.S. economy, which could trigger capital flows out of Hong Kong.

Would that be enough to pop the property bubble? It is hard to say, but the market remains precariously perched. At the least, a period of volatility is likely if there are any unexpected external shocks.

Phillip Zhong is a senior equity analyst for Morningstar Investment Management Asia in Hong Kong.

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