(This essay was published in South China Morning Post on 17 May 2017.)
We often hear laments that ‘housing is for living, not for speculation’ whenever housing demand increases faster than supply and speculation becomes rife in the market place. Faced with populist political pressure, governments look for quick fixes. They often deal with the symptom of housing price increases by suppressing demand and limiting speculation.
Speculators are detested because most people simply reason that every housing unit they purchase and hoard removes its immediate availability to those in need of a place to live.
But such populist narratives fail to recognize that speculation is the outcome of housing shortages and not the cause.
Sometimes governments are also worried about the dangers runaway property prices will pose to banking and financial stability, so they try to tighten credit conditions by lowering the loan-to-value ratio. Purchasers have to put up a higher share of the property value as down payment towards a mortgage loan.
Hong Kong began doing this in 1991 and by 2011 the loan-to-value ratio had been lowered from 90 to 50 per cent. Other draconian measures were introduced in 2012 that for all practical purposes eliminated speculation from the market. Yet this did not prevent housing prices from soaring again in late 2016.
Two factors have been at play. First, the scale of the supply shortage is sufficiently large that it cannot be eliminated quickly through more construction unless housing prices correct downwards for some other reason.
Second, the market is still chasing yields as a result of the protracted, low interest rate environment that followed the 2008 financial crisis.
Low interest rates induce investors to seek alternative ways to generate returns. By chasing yields, investors assume higher risk that might be mispriced. This also provides an artificial stimulus to interest-sensitive sectors, such as housing.
The world economy is beginning to show encouraging signs of recovery after almost eight years of lethargic growth. This would conventionally mean interest rates should be increasing, so why are investors still chasing yield when real estate prices are already so high?
The significant fact to note is that market expectations of where the interest rate will be are consistently below the target forecasts of the US Federal Reserve governors (Hong Kong’s interest rate follows that of the US). Market expectations are derived from USD 1-month overnight-indexed-swap forward rates. As recently as March 2017, the difference was over 30 basis points for 2018 and 100 basis points for 2019.
I believe market expectations are so low because the market does not believe the Fed now follows any rules in determining its interest rate policy. This encourages the market to bet on what the Fed will do next and some in the market will continue to chase yields and seek alternative ways to generate returns. It is likely these investors will end up assuming higher risk, which might be mispriced.
Will this justify introducing more restrictions to limit market transactions and clamp down on speculation?
Whenever there are imbalances in the market, there is no simple way of limiting speculation without harming the market adjustment process.
Common measures such as transaction levies, capital gains taxes, and regulating loan-to-value ratios may help to eliminate short-term speculators, but the effect is not neutral in the long run for four reasons.
First, by thinning the number of transactions, liquidity is reduced.
Second, the secondary market is more affected than the primary market because developers often provide financing arrangements for buyers that are unavailable in the secondary market. This drives up the price of units in the primary market relative to the secondary market.
Third, the thinning of markets and the migration of transactions to the primary market creates a noisier price signal of the underlying supply and demand conditions in the market. In particular, the release of units onto the secondary market slows, further exacerbating price increases.
Fourth, regulating the loan-to-value ratio makes it more difficult for all buyers to enter the market because of higher down payments. Market opportunities thus shift from less capitalized buyers to more capitalized ones, equality of opportunity worsens and economic inequality increases.
Regulating the loan-to-value ratio is justified if the public is heavily leveraged in order to protect financial stability. But the effect is very marginal if leverage is not high. Curbing speculation and market regulation is therefore not always an improvement.
Hong Kong investors in the property market should worry that market expectations of future interest rate targets are not aligned with Fed targets. There is greater risk that markets may be surprised by Fed decisions to normalize, and wake up one morning to discover their bets were wrong. When this happens, it is important for markets to be able to adjust quickly to interest rate normalization—excessive regulations and restrictions are of no help.