Hong Kong: Overcoming Financial Risks of Growing Real Estate Credit Yuming Fu Department of Real Estate and Urban Land Economics University of Wisconsin –Madison [Forthcoming in Koichi Mera and Bertrand Renaud (editors) Asia’s Financial Crisis and the Role of Real Estate, M. E. Sharpe, 2000]

Introduction The recent Asian financial crisis has raised the concern for financial fragility, which precipitated the onset and spread of the crisis. The financial fragility of the economies affected by the crisis can be attributed to four major sources: currency mismatch and maturity mismatch in funding domestic investment, asset price inflation, and poor credit allocation (see Lane 1999). In a typical case, an economy experiences rapid credit expansion associated with rapid growth, financial liberalization, and foreign capital inflow. Poor credit allocation eventually creates financial distress, triggering an outflow of shortterm capital. Due to the maturity mismatch in lending by domestic financial institutions— borrowing short and lending long, the reversal in short-term capital flow leads to insolvency among these institutions, triggering further capital outflow. The currency mismatch—borrowing in foreign currency to finance projects that generate incomes in domestic currency—makes the financial institutions vulnerable to domestic currency devaluation, which causes a loss of confidence in the domestic currency and further capital outflow. The inflated asset prices also contribute to the vulnerability of the financial system. A deflation of asset prices resulting from a domestic credit crunch severely impairs the credit quality of domestic borrowers and the asset quality of the financial institutions. These four factors combined cause a vicious cycle of credit deterioration and capital outflow—a feature of the latest Asian financial crisis. Central to the financial fragility is also the process of information flows essential for credit decision making. A financial system is fragile when information flows and hence the functioning of the system are vulnerable to the interference of shocks to the financial system (Mishkin 1999).

1

Real estate sector plays a central role in the financial fragility, particularly in these East Asian economies disrupted by the financial crisis. The real estate sector absorbs a major portion of domestic credit. Real estate loans are typically of long-term nature and thus contribute to the maturity mismatch of the lending institutions that rely on short-term funding. Since real estate produces local services and thus local-currency income, real estate loans also contribute to the currency mismatch when these loans are funded by foreign capital. Moreover, credit misallocation is likely manifested in overbuilding in the real estate sector (Wong 1998). Finally, real estate market is typically the center stage of asset price inflation, exposing the borrowers and their banks to high credit risks. Furthermore, in economies where the information process supporting credit decisions is inadequate, financial institutions tend to rely on real estate collateral for credit allocation, making credit channels vulnerable to the shocks that depress real estate value. In this article, we examine the characteristics of real estate market development and real estate credit provision in Hong Kong. We attempt to identify the strength as well as weakness of Hong Kong’s financial system in meeting the growing demand for real estate credit as real estate wealth in the economy rapidly rises. We show that the major weakness lies in the maturity mismatch and inefficiency in funding real estate credit, which exposed Hong Kong to the risks of currency attacks during the Asian financial crisis. The strength of Hong Kong’s financial system—strong banking supervision and ample foreign exchange reserve—enabled the financial system to withstand the shocks of the Asian financial crisis. Finally, we discuss the benefits of developing a private long-term debt market, to which the government is committed, and the role of land policies in Hong Kong’s financial stability. The debt market would solve the maturity mismatch problem and raise the efficiency in funding real estate credit, both essential to Hong Kong’s financial stability in a globalizing economy.

Rising Real Estate Wealth and Sources of Price Volatility

The robust growth of Hong Kong’s economy over the past several decades, and its transformation from an export economy of light manufacturing goods to a prominent international center for financial and business services in the nineties, propelled the rapid

2

growth in real estate demand and wealth. Demand for residential real estate rose with population and income. Between 1973 and 1998, per capita GDP tripled (in constant dollars) and the number of households in the territory more than doubled. Over that period, about 680 thousand residential flats were built in the private housing market, equal to 72 percent of total private housing stock at the end of 1998.1 Demand for non-residential real estate was driven by the expansion of various employment activities. The amount of office space, for example, increased sixfold between 1975 and 1998, from 1.4 million square meters to over 8.6 million square meters. During that period total office employment— employment in trade, finance, insurance, business services, and real estate—grew fivefold. The real estate sector played a prominent role in Hong Kong’s economy. It contributes about 20 percent of the GDP,2 forms about 49 percent of domestic fixed capital formation, 3 generates about 35 percent of government revenue,4 accounts for 30 to 45 percent of the capitalization of Hong Kong’s stock market, and absorbs 48 percent of the institutional lending. The significant expansion in real estate wealth was accompanied by substantial volatility in prices and rents. Figures 1a to 1d plot the price and rental indexes since the last quarter of 1979 in four real estate markets—residential, retail, office, and flatted factories markets.5 These indexes are deflated by consumer price index (CPI(A)), so that their fluctuations reflect the conditions in the real estate markets. Price fluctuation between trough and peak in all but factory markets exceeded 400 percent in real terms, whereas rent fluctuation was between 157 percent in the residential market and 266 percent in the office market.



To understand the sources of real estate price volatility it is useful to decompose changes in prices into changes in rents and in capitalization rate (or rental yield). Underlying this decomposition is a distinction between the market for real estate space and that for real estate assets. In the space market rents adjust according to vacancy rates that reflect the supply and demand conditions; in the assets market prices adjust according to asset valuation (capitalization rates) and rents.6 Accordingly, the causes of real estate price

3

volatility can be divided into two sources: 1) real economic activities affecting the supply and demand for real estate space and 2) financial conditions affecting asset valuation. Figures 1a to 1d show two major rent cycles in these four space markets. The first boom started in the late seventies followed by a depression in the early eighties. The second boom occurred in the late eighties and the early nineties followed by somewhat different patterns of consolidation across the four markets before the latest depression brought by the Asian financial crisis. The valuation cycles display a different pattern. Figure 2 shows that the capitalization rates peaked around 1984 near the bottom of the first rent cycle and followed a general downward trend since then until the onset of the Asian financial crisis in 1997.7 The valuation cycle tended to exacerbate the price volatility originated from rental adjustment in the space market.



The cycles in these space markets coincided with the major phases in Hong Kong’s economic development during the past two decades.8 The first phase, through most part of the eighties, is an export-led growth. This period is characterized by robust growth in domestic export and rapid rise in re-export business following the opening up of Chinese mainland to foreign trade and investment in the late seventies. GDP growth was very high and volatile in this period (see figure 3a). The growth was interrupted by the economic recession in Western countries in the early eighties following the second oil crisis, which depressed the demand for Hong Kong’s exports. Domestic demand was also weakened by the political uncertainty surrounding Sino-British talks at that time over Hong Kong’s sovereignty transition. The growth in office employment (see figure 3b), largely associated with expanding trade and shipping business, was also sensitive to export fluctuations. In this phase of Hong Kong’s economic development, the shocks in demand for real estate space in the four markets appear highly correlated, as indicated by the relatively more synchronized fluctuations in rental indexes across these markets. The second phase, beginning in the late eighties, is marked by reduced but steady GDP growth led by consolidation in the manufacturing sector and rapid expansion in international finance and business services. Domestic export in goods leveled off after

4

1989 but re-exports soared,9 as Hong Kong firms expedited relocation of their manufacturing operations to Chinese mainland and rapidly expanded production activities there. The rapid expansion of foreign direct investment in export-oriented manufacturing in Chinese mainland generated strong demand for Hong Kong based international finance and business services. Between 1988 and 1997, The share of GDP by finance, insurance, real estate, and business services rose from 18 percent to 25 percent, whereas manufacturing share of GDP dropped from about 20 percent to 6 percent. In terms of employment, the former’s share rose from 7 percent to 13 percent between 1989 and 1998, where the latter’s share dropped from 30 percent to 12 percent. In this second phase, demand shocks for real estate space appear more differentiated across the four markets. Falling factory rents correspond to the consolidation in manufacturing activities in Hong Kong, whereas high office rents reflect the robust growth in office employment. The steady rise in retail rents and relatively stable residential rents are indicative of a steady income growth that generates a rising retail sales turnover and a steady growth in housing demand.



The cycles in real estate rents reflect mismatches in timing between demand shocks and new supply in the space market. Figure 3a and 3b illustrate the demand and supply changes in the residential and office markets, where vacancy rates correlate negatively with demand shocks driven respectively by GDP growth and office employment growth. Such pattern reflects the long production cycle of real estate development, which entails an inelastic supply and reliance on vacancy and rental adjustments for market clearance in the short run. In both markets, supply responds to vacancy rates—completion tends to rise following a period of low vacancy rates. Wide swings in vacancies and rents occur when surges in completion following a low-vacancy period coincide with a reversal in demand growth, as happened around 1983 in both markets. The risk of mismatch in timing between new supply and demand change is inherent in real estate markets, given the volatility of demand and long lead-time in property development. The wider swings in office vacancy rates and rents indicate that the risk is greater in the office property market than in the residential property market. There are three potential explanations. First demand for office

5

is more volatile, since it is very sensitive to short-run changes in office employment, whereas new household formation, influenced by longer-term income growth, tends to be steadier. Second, the lead-time for new office development tends to be longer, given more constraints for office sites. Third, office-building starts tend to react to high demand more loosely, resulting in more volatile office completion. In residential market, where new supply is increasingly concentrated among a few dominant developers,10 the supply response to demand shocks tends to be more controlled. Contrary to the popular believe that the scarcity of land in Hong Kong would entail rising cost of real estate space as demand grows, we observe no apparent positive trend in the real cost of real estate space during the past two decades, even though the growth in the demand was very strong. In other words, the supply of real estate space is highly elastic in the long run, although short-run imbalances between new supply and demand shock appear inevitable.11 Turning to the examination of real estate valuation cycles, we observe in figure 2 that fluctuations in capitalization rates in both residential and office markets are closely related to the fluctuations in real interest rate, as investment theory would predict.12 The real interest rate is computed as the mortgage interest rate, which reflects the opportunity cost of long-term lending by depository institutions, minus expected inflation rate.13 It is clear that sizable reduction in real estate capitalization rate, driven by the falling real interest rate in the early nineties, is responsible for the phenomenal real estate price inflation during the period. At the peak of the real estate market boom in 1997, an entry-level low-cost flat would cost HK$2.25 million (500 square feet at a cost of HK$4,500/sq.ft.), about 5 times the annual income of a household at the top 20 percentile of income distribution. At the capitalization rate of 5% in 1997, the total market value of private residential properties would be about twice the GDP.14 Following the Asian financial crisis in 1997, residential prices dropped 42 percent on average in nominal terms between the third quarter of 1997 and the fourth quarter of 1998.15 This drop is accounted for by a 27 percent decline in rents and 25 percent rise in capitalization rates. The upward adjustment in capitalization rates, however, is very modest compared with the increase in real interest rates. In fact, the narrowing of the spread between the real estate capitalization rates and the real interest

6

rates appears to be a trend since the beginning of the nineties and became especially pronounced in the past 5 years.

Funding Real Estate Boom in the Nineties

The enormous increase in the quantity and value of real estate assets absorbs huge amount of savings. The way the savings are allocated to the real estate sector affects not only the long-term elasticity of supply of real estate space, but also the financial stability of the economy. Savings are allocated to the real estate sector in two forms: equity and debt. The equity is largely provided by homeowners for residential properties and by real estate firms for non-residential properties and for real estate development. Debt plays an important but moderate role in the real estate sector. Until recently, depository institutions are almost the only source of residential mortgage loans and of loans for real estate development and investment. In private housing sector, 72 percent of households are homeowners and majority of them live in condominium apartment flats of small to medium sizes. Residential investment properties are concentrated in the luxury housing segment catering to expatriate tenants and the majority of these properties are held by real estate firms. Residential sector absorbs 26.3 percent of total loans advanced for use in Hong Kong by the depository institutions in 1998.16 The overall financial leverage in the residential sector is relatively low. The average loan-to-value ratio in banks’ mortgage portfolio in September 1997 was 52 percent.17 The balance of mortgage loans was less than 20 percent of the total value of private residential properties before the Asian financial crisis.18 Further insights to the role of mortgage credit in Hong Kong’s residential market are provided by figures 4a and 4b. Figure 4a plots the number of assignments of building units and the number of mortgage instruments registered with Land Registries each month between 1984 and 1998, whereas figure 4b plots the dollar value of these transactions. On the one hand, the number of assignments and that of mortgage instruments matched very closely during that period. On the other hand, the value of the new mortgage instrument fluctuated around a stable level during the nineties but the value of assignments soared. The contrast between these two plots suggests that a large number of property transactions,

7

especially those of luxury properties, rely very little on mortgage financing. The low financial leverage for property transactions reflects, in part, banks’ prudent lending policies, which maintained maximum loan-to-value ratio at about 60 percent for luxury properties since 1993. But more importantly, the high value of property transactions relative to that of the new mortgage loans reflects the inflow of speculative real estate equity capital. In 1994, 97 percent of the mortgages in banks’ portfolio financed owneroccupied flats; in 1997, 93 percent did.



Real estate development and investment represent the other major use of domestic loans in Hong Kong, absorbing 21.3 percent of total domestic lending in 1998 (about 44 percent of total bank credit to the real estate sector). Some real estate firms specialize in development and others in property investment. In the past decade, major developers also retained substantial amount of investment properties in their portfolios to smooth out their earnings. Prime office and commercial properties are controlled by a few major real estate firms. Hongkong Land,19 for example, owns 4.5 million square feet of office properties in Central business district, amount to almost 10 percent of total grade A office stock in 1998.20 Yet debt-to-equity ratio in the property sector as a whole is very low. The overall debt-to-equity ratio of 16 major developers and real estate holding companies was about 31 percent in 1998; the short-term debt among them was only 6 percent of total equity. 21

Real Estate Credit and Financial Risks

Although the equity of homeowners and real estate firms provided the main source of capital for the real estate market boom in the nineties, the depository institutions’ exposure to the real estate sector rose rapidly since the end of the eighties (see figure 5). Nevertheless, the low financial leverage in the real estate sector, both for homeowners and real estate firms, greatly reduces the credit risk of real estate loans. Mortgage loan delinquency ratio, defined as loans overdue for more than 90 days as a percentage of total loan balance outstanding, was generally below 0.2 percent before the Asian financial

8

crisis—it was 0.13 percent in September 1994 and 0.10 percent in September 1997.22 The sharp real estate price correction and economic recession following the Asian financial crisis did push the delinquency ratio to its peaked of 1.16 percent at the end of May 1999. The delinquency ratio began to decline as unemployment rate stabilized in June 1999. The mortgage delinquency ratio, however, was considerably lower than the delinquency ratio for all loans, which reached 6.01 percent at the end of June 1999.23 The lower credit risks in mortgage lending encouraged banks to continue to expand their mortgage loan portfolio during 1998 and 1999 even though the overall domestic lending shrank. Clearly, the generally stable credit quality of real estate loans contributed importantly to the confidence and liquidity in the banking sector as Hong Kong suffered the aftershocks of the Asian financial crisis. In addition to the low financial leverage in the real estate sector, relatively stable mortgage interest rates and more stable revenue cash flows for developers also contributed to the low credit risk of real estate loans during the latest real estate market downturn. The high mortgage default rates during the market downturn in the early eighties, which triggered a bank run in 1983, were mainly caused by high mortgage interest rates of nearly 20% per annum. Since almost all mortgage loans charged a floating interest rate, many borrowers were unable to meet their debt obligation when interest rates rose to extremely high levels. During the recent Asian financial crisis, although Hong Kong inter-bank offered rates fluctuated sharply, mortgage interest rates increased modestly and returned to below 10% level in 1999. The substantial increase in real interest rate in the last two years, which contributed to the sharp correction in real estate prices, is mainly due to decreased inflation rate. During earlier real estate cycles, developers were also more vulnerable since their revenue cash flow depended heavily on sales of new building units and was very susceptible to market downturns. In the past decade, developers expanded their portfolio of investment properties so that their financial position became less vulnerable to sales slowdown. After the recent sharp correction in real estate prices, the major source of credit risk for real estate loans today is perhaps the fluctuation in interest rates. The high exposure of the real estate sector to interest rate risks is due to the reliance on depository institutions for real estate credit. The long maturity of banks’ mortgage loan portfolio is mismatched with

9

the short maturity of banks’ funding sources. Banks have avoided the interest-rate risk arising from such maturity mismatch by underwriting only floating-rate loans, including mortgage loans that have a contractual life of 15 to 30 years. Mortgage interest rates are typically linked to the best lending rate, with a positive spread of between 0 to 200 basis points as determined by the conditions in the inter-bank market. The shift of the interestrate risk to homeowners, however, raises the credit risk in the real estate sector, as the experience in the early eighties proves. The credit risk arising from potential interest-rate shocks was heightened during the period of rapid housing price inflation. Findings from survey of residential mortgage lending by Hong Kong Monetary Authority show that the average outstanding balance of the loans in banks’ mortgage portfolio increased from HK$0.8 million in 1994 to HK$1.3 million in 1997. At the same time, the average contractual life of these mortgage loans increased from 183 months to 221 months. The increase in the contractual life suggests that borrowers have sought slower principal repayment to make the mortgage obligations affordable24 and, therefore, have become less tolerant to interest rate shocks.25



The maturity mismatch for the depository institutions is worsened as real estate loans continue to expand at a fast pace. Figure 5 exhibit the growth of real estate and non-real estate credit over the past two decades. Total real estate loans rose from 20 to 30 percent of GDP during most of the eighties to about 70 percent at present, whereas non-real-estate loans rose more modestly from 60 to 70 percent to about 80 percent. Real estate loans accounted for 24 percent of total bank loans for use in Hong Kong in 1979; this share rose to 48 percent in 1998. Within the real estate sector, loans for purchasing private residential properties rose steadily from about 8 percent of GDP at the beginning of the eighties to 40 percent in 1998. Loans for real estate development and investment peaked at 26 percent of GDP in 1982 and then again rose steadily from a low level of 10 percent since 1987. In the absence of a private debt market until recently, rising demand for real estate credit became the main source of rapid money supply expansion in Hong Kong, especially during the

10

nineties—HK$M2 rose from 80 percent of annual GDP at the beginning of the nineties to 138 percent of GDP at the end of 1998.26 Since October 1983, Hong Kong has maintained a linked exchange rate between Hong Kong dollar and US dollar under a currency board system. The currency board system allows the quantity of money supplied to be dictated by credit demand at externally determined interest rates; foreign capital inflow adjusts to make up the short fall in the funding of domestic lending. The currency board system also requires that money supply be backed by a foreign exchange reserve. Thus, the amount of foreign exchange reserve increases with money supply. The worsening maturity mismatch for the depository institutions demands a greater foreign exchange reserve backing for money supply. Total amount of foreign exchange reserve in Hong Kong at the end of 1997, including foreign exchange assets in both Exchange Fund and Land Fund,27 amounted to 43.8 percent of HK$M3. Between 1993 and 1997, the amount of foreign exchange assets in Exchange Fund rose at about the same pace as the domestic credit to the private sector.28 Funding real estate credit with money supply is unnecessarily costly. The demand for foreign exchange reserve makes a growing portion of domestic savings unavailable for domestic investment. Funding provided by the depository institutions is costly, since the institutions bear the risk of intermediation and require compensation. This cost is reflected by a typical interest margin of 2.5% between the borrowing cost to customers and the funding cost of the lenders. The margin is even greater for mortgage loans. The growing demand for broad money (and hence foreign exchange reserve) and the high interest margin for intermediation can be avoided by more direct funding of long-term real estate credit through a private debt market. Funding real estate credit with money supply also contributes to asset price inflation and volatility. Absent a long-term private debt market where households can invest their savings, the opportunity cost of equity capital, especially that of homeowners, would be determined by the return on savings deposit, which is low due to short maturity and high intermediation cost. The required return on assets would be determined by the cost of funding, which is a weighted average of the cost of equity and that of debt. The increase in equity financing in the real estate sector—partly due to the high cost of bank loans relative to that of equity, as reflected by the lending interest margin—contributes to a lower

11

opportunity cost of funding. The narrowing spread between real estate capitalization rates and the real cost of loans, especially in the residential market (shown in figure 2), is indicative of the increasing influence of the lower opportunity cost of equity of speculative investors.29 Furthermore, the components of real estate funding cost—the cost of credit, linked to the best lending rate, and the opportunity cost of equity, determined by savings interest rates— are closely linked to short-term interest rates and are thus volatile. Consequently, real estate valuation tends to be volatile.

Foundation for Financial Stability

The globalizing economy today is characterized by high international capital mobility as well as exposure of domestic economy to external financial shocks. The high capital mobility makes the governance of domestic lending institutions crucial for financial stability. On the one hand, easy access to international capital increases the risk of moral hazard in domestic financial institutions. Lessons from Thailand and the other economies that suffered banking crisis amply demonstrate such risk. Financial liberalization and government protection allow domestic institutional lenders to fund their excessive lending with foreign capital. With a lax supervision, financial institutions lend excessively in speculative projects, which are likely found in real estate markets. An overbuilding follows. On the other hand, high capital mobility can trigger financial crisis when the problem of excessive lending becomes apparent. At the first sign that the government may not be able to protect the interest of investors, capital flees. A vicious cycle of capital outflow and credit deterioration ensues. Exposure to external financial shocks makes the maturity match between different uses of domestic credit and their funding crucial for financial stability. A severe mismatch in maturity between assets and liabilities of domestic financial institutions makes the economy vulnerable to external shocks that raise the cost of short-term funding. Hong Kong’s own experience during the latest Asian financial crisis demonstrates such risk. Hong Kong’s vulnerability to short-term liquidity difficulty due to the maturity mismatch among its domestic depository institutions invited speculative attacks on its currency peg with the US dollar. The strong foreign exchange reserve position enabled the government

12

successfully defend the currency peg. In Hong Kong’s situation, defending the peg is necessary to prevent the vicious cycle of capital outflow and credit deterioration from happening. Nevertheless, the short-run liquidity difficulty hurt Hong Kong’s economy and contributed to its economic contraction in the last quarter of 1997 and in 1998. Hong Kong’s strengths lie in its strong governance of the depository institutions and prudent fiscal policies. Hong Kong Monetary Authority (HKMA), which licenses and supervises the depository institutions in Hong Kong under the Banking Ordinance, has consistently sought to provide prudent guidelines for real estate lending and to monitor real estate exposure levels. The lending guidelines seek, for example, to keep the total real estate exposure under 40 percent of total loans of each bank 30 and keep the maximum loanto-value ratio at prudent levels. The maximum loan-to-value ratio used by the lending institutions was lowered from about 88 percent in 1989 to 70 percent in the nineties. During periods of excessive speculation in the residential property market (such as 1993 to 1994 and 1997), lenders reduced maximum loan-to-value ratio even further for luxurious properties to about 60 percent. Lenders also typically impose a prepayment penalty of about 2-3 percent of the original loan principal if the loan is fully repaid within 12 months to discourage borrowing for speculative real estate investment. The capital adequacy framework proposed by the Bank for International Settlement (BIS) has been applied in Hong Kong since the end of 1989. As of June 1999, the consolidated capital adequacy ratio for locally incorporated institutions as a whole was 19.5 percent, well exceeding the minimum international standard of 8 percent set by the BIS.31 Strong supervision by HKMA and market discipline in the absence of government bailing out for failing institutions contributed to a low moral hazard risk among the depository institutions in Hong Kong. The high standard of banking supervision and the government’s prudent fiscal policy, which generated a cumulative fiscal reserve of 14.5 percent of GDP at the end of fiscal year 1996, are central for maintaining the confidence in Hong Kong’s financial stability. The lack of a private debt market contributes to the weakness in Hong Kong’s financial stability. Without an adequate private debt market, money supply needs to expand more rapidly than GDP to support the growing demand for real estate credit. Funding of real estate credit with money supply is both costly and risky. It is costly because it requires

13

growing foreign exchange reserve and capital reserve in the banking system. It also creates maturity mismatch and expose either lenders or borrowers to interest-rate risks. High land prices in Hong Kong also aggravate the weakness in financial stability, by raising the funding requirement for the real estate sector. Ownership of an entry-level lowcost home (of 500 square feet in size) today, after the sharp correction in housing prices, still requires six years’ median household income, about two thirds of which would be spent on land. Financing high land cost accounts for a major portion of real estate development cost. The high land price is largely a policy consequence. Virtually all land in Hong Kong is owned by the government and land is released for private use through “Crown leases”. These leases specify the land use conditions, through which the government controls the land use in Hong Kong. Prior to the seventies, the anticipated return of the New Territories to China upon its lease expiration in 1997 discouraged Hong Kong government to build infrastructure to the large amount of the territories north of Kowloon to create developable sites. The Sino-British Joint Declaration in1984 restricted land release for private development to 50 hectare a year prior to Hong Kong’s hand-over to China. High land prices enabled government to generate handsome revenue from its land disposal and therefore were instrumental for government fiscal surplus and large cumulative fiscal reserve. The government has a stake in keeping the land price high. High land prices, however, contribute to economic inefficiency. They increase the cost of funding real estate investment, raise credit constraints for private homeownership, and necessitate the maintenance of a huge public housing sector. Essentially, high land prices represent a high, arbitrary, and uncertain taxation on the private sector. Moreover, the incidence of such tax needs not be fair and may distort resource allocation in the economy. To strengthen the foundation of financial stability in Hong Kong requires the correction of these weaknesses. The Hong Kong government is committed to developing a strong debt market.32 Central to this commitment is the establishment of Hong Kong Mortgage Corporation (HKMC) in March 1997. Its mandate is to develop a secondary mortgage market to provide long-term funding for the real estate sector. It commenced operations in October 1997. By June 1999, it has purchased over HK$10 billion mortgage loans from its approved sellers. The primary funding source for HKMC has been debt

14

issuance; it was one of the most active corporate issuers in Hong Kong’s debt market in 1998. In October 1999, it issued its first mortgage-backed securities (MBS) of HK$1 billion. It also encouraged the introduction of fixed-rate mortgages by providing a ready secondary market for such loans for the approved sellers. The fixed-rate mortgage accounts for about 10 percent HKMC’s mortgage portfolio. An efficient secondary mortgage market will bring many benefits. It will play an important role in promoting banking and monetary stability in Hong Kong  by bringing long-term debt capital to the real estate sector and reducing the reliance on money supply for funding real estate credit. Depository institutions will be more resilient to external financial shocks due to reduced maturity mismatch in their financial intermediation activities. Credit risk of real estate loans will be reduced due to the lower volatility of longterm interest rates. Lower demand for money lowers the requirement for capital reserve and foreign exchange reserve in the banking system thus making more domestic savings available for domestic investment. The secondary mortgage market will also be instrumental to achieving the government’s goal of raising overall homeownership rate from 52 percent in 1997 to 70 percent by 2007. It lowers the cost of channeling savings to the real estate sector and thus lowers the cost of real estate credit. It also provides a high-yield investment opportunity for long-term savings. The rise in the rate of return on long-term savings will affect the real estate market by raising the required rate of return on real estate investment and thus lowering real estate prices. Real estate valuation would also be more stable, because the cost of funding becomes less sensitive to short-term interest rate fluctuations. There were also indications of shifts in land policies when the Hong Kong Special Administrative Region (SAR) government announced its long-term housing strategy in February in 1998 aiming for a homeownership rate of 70 percent by 2007. A housing production target of no less than 85,000 units a year was set up and measures were taken to provide more elastic land supply for housing development  including more spending on supporting infrastructure, shortening development procedures and publishing a long-term government land disposal program each year. The first five-year land disposal program lists a total land supply of 690 hectares for both public and private housing development. But the land disposal program was suspended in the middle of 1998 under the pressure

15

from real estate developers concerned about “destabilizing” housing price decline. Modest land disposal was resumed in April 1999. The hesitation in implementing the land disposal program reflects the government’s indetermination with its land policies. In particular, the government appears uncertain about how land prices should be regulated with its ability to control the land supply. On the one hand, a lower land price level is instrumental for achieving the homeownership rate of 70 percent. On the other hand, lower land prices would hurt existing homeowners in the private sector, hurt government revenue, and hurt major developers who benefited from the high market-entry barrier due to the high cost of financing development sites. The land policies also appear inconsistent. The long-term housing strategy still relies heavily on the public housing sector, which is given the mandate to produce 60 percent of the 85,000-unit housing production target in the years to come. The reliance on the public housing sector for improving homeownership rate indicates that the government is not prepared to see land prices to go down sufficiently to enable wider homeownership in an expanded private housing sector. Moreover, the government is yet to articulate its long-term fiscal strategies, of which land related revenue and spending are crucial components. The importance of the land market in Hong Kong’s economy warrants further studies on the issue of land price regulation. The impact of land supply program on land prices in the long run and the benefits of lower land prices—lower cost of real estate financing and more efficient resource allocation in the economy, both enhancing the financial stability— need to be more fully demonstrated. Such studies would be valuable for the government to articulate coherent land policies as an integral part of its long-term strategies to enhance Hong Kong’s financial stability and long-run economic growth.

References Lane, Timothy, “The Asian Financial Crisis, what have we learned?” Finance and Development 36:3, IMF, (September) 1999 Consumer Council, “How Competitive is the Private Residential Property Market?” Hong Kong, 1996

16

DiPasquale, Denise and William C. Wheaton, Urban Economics and Real Estate Markets, Englewood Cliffs, NJ: Prentice-Hall, 1996 Mishkin, Frederic S., “Global Financial Instability: Framework, Events, Issues,” Journal of Economic Perspective, 13:4, 1999, pp. 3-20 Wong, Kin Chee, “Boom-Bust Cycle and the Hong Kong Real Estate Market,” In N.T. Poon and H.W. Chan (ed.) Real Estate Development in Hong Kong, Hong Kong: PACE Publishing, 1998 Wong, Kar-Yiu, “Housing Market Bubbles and Currency Crisis: The Case of Thailand,” Working paper, Department of Economics, University of Washington, 1998

Footnotes 1. The private housing sector accommodates about half of the 6.7 million people in Hong Kong in 1998; the remaining population is accommodated by the public housing sector. 2. Including income from ownership of premises, building construction, and real estate development and services. 3. Based on 1998 figures, including the construction cost of new buildings, the transfer cost of land and buildings, and real estate developers’ margin. 4. Based on figures for 1997-1998, including revenues from land sales (23%), stamp duties from property sales and leases (6%), rates (2%), estate duty (1%) and property investment (2-3%). 5. These indexes are compiled by the Rating and Valuation Department of Hong Kong government based on market transaction data and reflect changes in prices and rents per square foot of the properties with comparable building and location qualities. 6. DiPasquale and Wheaton (1996) use a four-quadrant representation to capture the distinction as well as the interactions between the real estate supply and demand process and the valuation process. 7. Changes in residential rental yield are inferred according to relative changes in annual price and rental indexes. Changes in office rental yield are inferred according to the change in annual price index relative to that in the two-year moving average of rental index, to account for the longer-term nature of office leases (typically renegotiated in three years). 8. Wong (1998) provides a concise review of earlier real estate market cycles in Hong Kong as well as some major government initiatives that affected the land market. 9. Domestic merchandise export value was about 1.2 times the re-export around 1985; by 1998, it was only about 16 percent. 10. Developers in the residential market tend to specialize in different housing classes (by flat size). Within each housing class, the market concentration ratio for top three suppliers could be as high as 80 to 90 percent. See Consumer Council (1996). 11. The moderate upward trend in real rents for retail properties shown in figure 1b would be more an indication of improved efficiency in retail space utilization than a

17

consequence of long-term supply constraint. Over the past decade, retail sales become increasingly concentrated in large-scale shopping malls with high density of consumer traffic. 12. Expected investment return should cover the opportunity cost of funding plus a premium compensating for additional transaction costs and for the costs for bearing additional risks. The expected return from real estate investment can be calculated as rental yield plus an expected rate of price appreciation. Given an elastic supply of real estate space in the long run, the expected rate of price appreciation would equal to the expected inflation rate. Let the opportunity cost of funding be measured by borrowing cost. Then the rental yield would equal the interest rate minus the expected inflation rate plus a premium. 13. The expected inflation rate equals current inflation rate minus one-third of the deviation of the current inflation rate from a long-term expected inflation rate of 8%. 14. Income from owning premises is 13 percent of GDP in 1997. A typical public-housing household would spend about one fifth of what a typical private-housing household spends on rent (or imputed rent). Thus income due to private housing properties would be slightly more than 10 percent of GDP. At the capitalization rate of 5%, the private housing properties would be valued at 20 times the rental income, or more than twice the GDP. 15. Prices of luxury flats, which have a size over 1,000 square feet and account for about 7 percent of total private housing stock, dropped over 50 percent. 16. Loans for purchasing public sector housing represents another 3 percent of total domestic bank credit. 17. According to Survey of Residential Mortgages in Hong Kong, Hong Kong Monetary Authority, February 1998. Valuation refers to appraisal value at origination or refinancing. 18. Total mortgage loans outstanding in 1997 was 36.4 percent of GDP; in comparison, total value of private residential properties was about twice the GDP in 1997. 19. It specializes in prime office property investment and has a market capitalization of about 3 percent of the total market capitalization of top 35 real estate firms in Hong Kong. 20. According to Lehman Brothers Global Equity Research. 21. Figures are from Morgan Stanley Dean Witter Research. 22. Survey of Residential Mortgages in Hong Kong, Hong Kong Monetary Authority, February 1998. 23. Quarterly Bulletin, Hong Kong Monetary Authority, August 1999. 24. The maximum debt service to income ratio has been maintained at about 50 percent. 25. During this period, the homeownership rate in the private housing sector decreased from 74 percent to 72 percent. 26. According to Monetary Survey of Hong Kong 1993-1997 by Hong Kong Monetary Authority, Hong Kong dollar credit to the private sector accounted for 108 percent of M3 growth during the period. The government maintained an increasing fiscal reserve with the banking sector and thus contributed to a contraction in money demand. 27. Exchange Fund was created with the currency board system to provide foreign exchange backing of Hong Kong dollar money supply. Land Fund was set up by the Sino-British Joint Declaration in 1984 to manage land revenue on behalf of the future

18

Special Administrative Region (SAR) government. Under the Joint Declaration, the revenue from public land disposal between 1985 and 1997 was to be shared between the British colonial government and the future SAR government. It was merged with Exchange Fund in 1998. 28. Survey of Money Supply in Hong Kong 1993-1997, Hong Kong Monetary Authority. 29. The narrowing of the spread may also reflect an increased expected real price appreciation due to a higher expected real rental growth, which does not appear to be the case. 30. This guideline was withdrawn in July 1998 when real estate prices and transactions had dropped sharply. But HKMA continues to monitor the real estate lending activities closely. 31. Quarterly Bulletin, HKMA, August 1999. 32. Since 1990 the HKMA has taken a number of steps to develop the infrastructure for the growth of the debt market in Hong Kong. Debt market has grown substantially with the introduction of Exchange Fund Bills and Notes and issuance of debt instruments by government-owned corporations and multilateral agencies.

19

Figure 1a Residential Price and Rential Indexes

Figure 1b Retail Price and Rential Indexes

(CPI deflated. 1979 Q4 - 1998 Q4)

(CPI deflated. 1979 Q4 - 1998 Q4)

250

250

Price

Rent

Rent

150

100

100

50

50

-

1

4

20

Q

Q

4

1 Q

Q

79

150

8 Q 1 2 82 Q 3 8 Q 3 4 84 Q 1 86 Q 2 87 Q 3 8 Q 8 4 89 Q 1 9 Q 1 2 92 Q 3 93 Q 4 9 Q 4 1 96 Q 2 97 Q 3 98

200

79

200

8 Q 1 2 82 Q 3 8 Q 3 4 84 Q 1 86 Q 2 87 Q 3 8 Q 8 4 89 Q 1 9 Q 1 2 92 Q 3 93 Q 4 9 Q 4 1 96 Q 2 97 Q 3 98

Price

Figure 1c Office Price and Rential Indexes

Figure 1d Flatted Factory Price and Rential Indexes

(CPI deflated. 1979 Q4 - 1998 Q4)

(CPI deflated. 1979 Q4 - 1998 Q4)

250

250

Price

Rent

Rent

150

100

100

50

50

-

1

4

21

Q

Q

4

1 Q

Q

79

150

8 Q 1 2 82 Q 3 8 Q 3 4 84 Q 1 86 Q 2 87 Q 3 8 Q 8 4 89 Q 1 9 Q 1 2 92 Q 3 93 Q 4 9 Q 4 1 96 Q 2 97 Q 3 98

200

79

200

8 Q 1 2 82 Q 3 8 Q 3 4 84 Q 1 86 Q 2 87 Q 3 8 Q 8 4 89 Q 1 9 Q 1 2 92 Q 3 93 Q 4 9 Q 4 1 96 Q 2 97 Q 3 98

Price

Figure 2 Real Estate Valuation and Real Mortgage Interest Rate 15%

12%

9%

6%

3%

19 73

0%

-3% Office Capitalization Rate

Residential Capitalization Rate

-6%

22

Real Mortgage Rate

Figure 3a Residential Market Real Activities (1973 - 1998) 40,000

Figure 3b Office Market Real Activites (1975 - 1998)

20%

750,000

25%

600,000

20%

450,000

15%

300,000

10%

150,000

5%

0

0%

35,000

15%

15,000

10,000

5%

Square Meters Completed

10%

Vacancy & Growth Rates

20,000

0

197 5

5,000

0%

197 3

Units Completed

25,000

-150,000

-10,000

Residential Completion Real GDP Growth Residential Vacancy

-5% Office Completion Office Employment Growth Office Vacancy

-5,000

-5%

-300,000

23

-10%

Vacancy & Growth Rates

30,000

Figure 4a Property Transactions and Mortgage Loans

Figure 4b Property Transaction and Mortgage Loans

(Number of Instruments Registered, Jan 1984 - Mar 1998)

(Value of Instruments Registered, Jan 1984 - Mar 1998)

30,000

100,000

Assignment of Building Unit

90,000

Mortgage

Assignment of Building Unit Mortgage

25,000 80,000

70,000 20,000

HK$ million

60,000

15,000

50,000

40,000 10,000 30,000

20,000 5,000 10,000

19

19

84 19 .01 84 19 .12 85 19 .11 86 19 .10 87 19 .09 88 19 .08 89 19 .07 90 19 .06 91 19 .05 92 19 .04 93 19 .03 94 19 .02 95 19 .01 95 19 .12 96 19 .11 97 .1 0

-

84 19 .01 84 19 .11 85 19 .09 86 19 .07 87 19 .05 88 19 .03 89 19 .01 89 19 .11 90 19 .09 91 19 .07 92 19 .05 93 19 .03 94 19 .01 94 19 .11 95 19 .09 96 19 .07 97 19 .05 98 .0 3

-

24

Figure 5 Real Estate Loan Expansion 600,000

90.0%

80.0% 500,000

60.0%

50.0% 300,000 40.0%

200,000

30.0%

20.0% 100,000 10.0%

19 98

19 97

19 96

19 95

19 94

19 93

19 92

19 91

19 90

19 89

19 88

19 87

19 86

19 85

19 84

19 83

19 82

19 81

0.0% 19 80

0

Mortgage Loans for Purchasing Private Residential Properties

Loans for Property Development & Investment

Total Real Estate Loans (% of GDP)

Total Domestic Loans other than Real Estate Loans (% of GDP)

25

Percent of GDP

400,000

19 79

Loans Outstanding (HK$ millions)

70.0%