(This essay was published in Hong Kong Economic Journal on 5 October 2016.)
Since the mid-1980s, the difference between private residential property prices and building costs has risen dramatically. Over these past three decades, it has increased by 70% on average when compared to earlier periods. This increased gap is a measure of the regulation cost of land development and building construction and it explains why development has been slow, why fewer units have been supplied, and why they are fetching much higher prices relative to construction costs compared to historical figures.
How does the regulation of land development and building construction in Hong Kong delay housing supply?
Regulators do not aim to reduce supply and boost prices. Their higher purpose is to seek to minimize incompatible land uses and maximize compatible ones – to generate positive neighborhood effects and mitigate negative ones.
In economics, this is known as attempting to correct the effects of externalities. Land use produces externality effects when there are uncompensated spillover effects on neighbors. Markets alone sometimes fail to correct for these effects, which is why planning rules and building codes have been invented.
Rules invented in one period may become outdated as circumstances change, and may occasionally be amended to reflect the new circumstances. Unfortunately their effects on land and housing supply are not always foreseen.
A Transformed Regulatory Framework
Have planning and building regulations become more onerous in Hong Kong? Like most places in the world there has been more regulatory growth. But the regulatory delays of the past three decades are not so much due to regulatory growth, but the greater willingness and ease with which advocacy groups and interested parties with strong opinions and intense interests are able to contest every development decision.
Their stake in the outcome has grown because property values have risen. This situation is a consequence of rising economic prosperity that resulted from the opening of China in the 1980s. The stakes involved in every development, whether for or against, became that much larger for every advocacy group and interested party.
The government began to show interest in overhauling the planning system, streamlining the town planning process, and strengthening enforcement control against unauthorized developments in the New Territories after it lost the famous case, Attorney General v Melhado Investment Ltd.  HKLR 327. The process took almost two decades and achieved only some of its intended goals.
The first step was not taken until 1991, some eight years after the court case, when a major amendment was made to the old Town Planning Ordinance (1939) relating to planning enforcement in the New Territories of unauthorized use of land. Planning committees and the Town Planning Appeal Board were also set up.
This was followed by the introduction of a White Bill in 1996 to seek public views on a proposal to overhaul the planning system, and the submission of a Blue Bill to the Legislative Council in 2000. Due to the contentiousness of the issues involved, the Council was unable to complete the scrutiny of the Bill before the expiry of its term.
Based on the experience of the Blue Bill, the Government decided to submit only those amendment proposals with general consensus to the Legislative Council in May 2003. The Town Planning (Amendment) Bill 2003 was passed on 7 July 2004.
In principle,, this was intended to be a step towards improving the quality of decisions and to advance public interest. In practice, it merely formalized the contentious process for different advocacy groups and interested parties to defend their respective stakes whenever a development proposal was put forward. The problem of development delays that emerged starting in the late 1980s did not improve.
The newly amended ordinance effectively admitted many more different voices into the development discussion process, making it even more difficult to reconcile demands and interests. This also reflected the growing openness of public policy decision-making.
There is no generally accepted term to describe these many different voices. I call them rent-seeking voices because their role is to secure specific benefits through the development consultation and decision-making process that benefit some members in society. These could be landlords, tenants, squatters, developers, intermediaries, and politicians or social activists of all persuasions. Such rent-seeking voices have always portrayed themselves as representing public opinion and the public interest. Some are genuine, some are misguided, and some are frauds.
Rising Barriers to Development
The new Town Planning Ordinance did not lower the transaction costs involved in the consultation and decision-making process. Such costs had risen significantly in the wake of the opening of China and the rising value of property, and they became a barrier to development as the development environment became more risky. Only the largest and most experienced developers were able to undertake projects. This is still a phenomenon that is very poorly researched in Hong Kong.
The complexity of the development process is a deterrent to small developers to enter the industry. Chicago economics professor George Stigler was the first to warn that regulatory barriers could be a tool used by industry incumbents to deter entry and limit competition.
In Hong Kong, the coincidence of four factors has encouraged the belief among not a few that an oligopolistic property development industry is conspiring with corrupt government officials to raise property prices. These are (1) slow development and a tight housing market, (2) the belief that government has always had a high land price policy, (3) the failure of government both before and after 1997 to sufficiently increase the amount of land for development, which has eroded popular trust in government, and (4) the market dominance of a few large property developers. The popular view of “property development hegemony” emphasizes the last factor.
I have not found this narrative to be a sufficiently convincing explanation for rising property prices. First, it is true that while prices can rise in a competitive market, they can only rise faster than costs in a monopoly market. Rising hegemonic power in the property market would have to be reflected not just in rising property prices, but also in a rising gap between property prices and building costs. But this is only a necessary, not sufficient, condition.
While the relative ratio of private residential property prices to building costs has indeed been rising for three decades (see chart), providing prima facie evidence of the presence market power, the rising gap can also be a result of the higher regulatory cost of development.
The puzzle in the figure is that the rise started in 1985 and by 1995 had increased by 200%. The Asian Financial Crisis of 1997 punctured the rise in the relative price gap for over a decade and did not recover to its previous peak level, until around 2011. The relative price gap has since continued to surge forward. At present the gap is 300% higher than in 1985.
If hegemonic power were the correct explanation for this, then the unexplained puzzle would be why monopoly power started to rise as early as 1985, and why it rose most rapidly during 1985-95. Furthermore, why has monopoly power continued to increase since 2012 when government policy has focused on curbing the pricing powers of developers with punitive measures?
The market dominance of the developers in fact experienced a boost after 1997. For many years before 1997, the Chinese authorities had been urging the British Colonial government to redeem the outstanding issues of the land exchange entitlements (Letters A/B) so that they would not become a claim against the future Special Administrative Government.
The New Territories Land Exchange Entitlements (Redemption) Bill (1996) committed the government to provide sufficient land in the 1996-97 Land Disposal Programme to cover the outstanding land exchange entitlements held by the four major developers. The consequence was to further expand the share of the four developers’ total supply of housing in the ensuing years. Smaller developers came under even greater competition pressure.
Historical circumstances surrounding the development of satellite towns in the New Territories, the good acumen (or fortune) of the four developers to have accumulated land exchange entitlements, and the redemption of these entitlements before the restoration of sovereignty had supported their rise to market dominance. But the rising gap between property prices and building costs had started to rise rapidly in the decade beginning in the mid-1980s before they achieved market dominance.
Similarly, the continued rise of this gap after 2012 cannot be attributed to greater monopoly power. A more convincing explanation is that the land formation machinery of the government largely halted under the administration of Tsang Yam Kuen, which further exacerbated the shortage of housing supply. Punitive measures aimed at suppressing demand can have little effect beyond the short run in the face of a continued shortage of land for development.
To me, the most consistent explanation of why housing supply has declined in the past three decades is the rising regulatory cost of development, which is reflected by the gap between private residential property prices and building costs. The pattern of the rise in the gap is at odds with a property developer hegemony narrative.
The rising value of land after China’s opening has increased the transactions cost of making land available for development. It has made landlords in rural areas less willing to surrender land at existing compensation levels. The planning system has tried to respond to the changes but has not been successful so far. The present urgency to make land in the New Territories available quickly will only provoke public outcry and calls of foul as government is seen to be cutting corners.
Regulations Have Consequences
The supply of housing has slowed down for more than two decades. But if plot ratios on many of the new developments in this period had been increased, then housing supply need not have declined by so much and housing prices in the city would not have increased by so much.
The plot ratio is an instrument for controlling development. Plot ratios can prevent the development of excessively high population densities that overburden the infrastructure provisions in neighborhoods, so as to protect the quality of the living environment. They can also be used to protect the value of existing properties by creating scarcity through denying further development.
So should the plot ratio be relaxed to facilitate development in the interest of those without property, or should they be maintained to protect the interests of those who are already owners? Whose rendition of the public interest should be served?
Refusing to increase the plot ratio contributes to higher housing prices. The benefits will be spread among all property owners and not only those in the neighborhood where development has been prevented. The costs are borne by all those who want better housing and are not yet property owners.
Wealth is redistributed from the “have-nots” to the “haves,” from the young to the old. Each successive generation of homeowners will have to pay ever-higher property prices, while earlier generations reap the windfall gains from higher prices. In a democracy, where the majority of the voters are property owners, then the winning coalition would tend to favor preventing development and will continue to redistribute wealth in this regressive way.
The plot ratio in principle is is not intended to increase property prices and redistribute wealth regressively, but it can be used for this purpose once its effect on retarding development is understood. The plot ratio is a very transparent rule and its effects are easy for all to see.
There are other rules whose aims are not to limit development, but to promote safety, health, leisure, conservation, and so on; but these too may have the same perverse effects on development. Every rule has consequences for development regardless of their original intentions. And every rule can be exploited to either facilitate or retard development.
Indeed the proliferation of rules creates more opportunities to retard development. Every rule is a hurdle that has to be straddled. And even if one succeeds in jumping over all of them, the time it takes to do so will have retarded development. Every rule has to be approved administratively and survive public consultation (and confrontation). All this takes time.
Looking back over the past three decades, one finds that the cost of developing rural land in the New Territories has become more difficult as different advocacy groups and interested parties are unable to agree among themselves and with government on proposed development plans. The attempt to revamp the planning system did not solve the problem. Plot ratios on approved developments could not be raised sufficiently to allow an increase in housing supply on the same plot of land. Negligence in preparing more land for development also slowed down housing supply. Underestimation of housing demand growth was also a policy mistake. The problem is serious but it does not have a quick solution. In a highly divided political environment, rushing things will not get us to the destination faster.