This is the fourth of five articles on public sector housing. In this article I provide economic reasons for subsidizing housing based on macroeconomic considerations based on the Hong Kong context, but I believe it is also of relevance to MainlandChina.
In earlier articles I proposed to introduce a free market for public sector housing units. For Hong Kong, this is a critical question because we have a large and inefficient public sector housing program that has failed to meet the evolving demands of the population. 47% of residents live in public housing units, but the system does not allow for bona fide asset ownership. Even owners of Home Ownership Scheme flats cannot afford to sell up because they have to repay land premiums at today’s high prices – regardless of when they bought.
Fortunately this can be easily and painlessly remedied by providing a subsidy on land values for all households that are eligible for public sector housing and allowing them to become homeowners if they so choose. This arrangement would empower owners with the right to sell their units on the open market after 5 years and paying a land premium that they can afford. It would thus achieve a simple goal of creating a market for public housing units, benefiting present and future households in the program.
Providing such subsidies to large segments of the population is no more than what theHong Konggovernment is already doing. The only question is how to do it more effectively. One has to recognize that by providing shelter as we do now, but refusing to allow housing to become an asset that can be traded on the market, we make valuable land worthless. To deny the land value to the occupying household also denies it to the rest of society, including the government, because no one else can use the unit so long as it is occupied. Destroying value like this cannot be in the interest of society, especially given that housing is not merely a roof over people’s heads, but also an important form of savings and investment.
InHong Kong, as elsewhere, people want to become homeowners because they think property prices will rise in the long run and provide a cushion for their future. However, these aspirations have become unaffordable for a large segment of the city’s population by a large margin. Macro-economic factors have provided the backdrop to these circumstances, but it is not beyond the government’s ability to improve prospects for the aspiring homeowners.
In an international, open, urban city economy likeHong Kong, the value of land and property is not tied to supply and demand factors in the local economy alone, but also to global financial and economic conditions. Under the linked exchange rate regime, the business cycle in Hong Kong is affected by interest rates and price movements in theUSover which it has neither control nor influence.
Economists have long recognized that the ability of governments to fine tune monetary and fiscal policies to offset the effects of business cycle fluctuations is quite limited. First, it takes time for government to recognize the onset of a business cycle downturn; this is the recognition lag. Second, it takes time to devise a policy response; this is the decision lag. Third, it takes time to get the policy approved and to take action; this is the implementation lag. Fourth, it takes time for the effects of the policy to act on the economy; this is the impact lag. All these time lags are variable and not known with any certainty.
The decision and implementation lags for fiscal policy is quite long compared with monetary policy. For this reason, economic stabilization policy has mostly relied on monetary rather than fiscal policies. Moreover some economists like Milton Friedman and Robert Lucas have favored the use of a policy rule rather than have government exercise discretion. They fear that given the unpredictability of government stabilization policy and its effects on the economy, it may introduce more uncertainty and worsen economic fluctuations.
The ability of the government to fine tune monetary and fiscal policies to offset the effects of business cycle fluctuations is quite limited, given that policies announced today may only start to take effect after conditions have changed. For example, in an economic downturn, the various time lags may be so long that any stimulus takes effect only after the economy has bottomed out, and it can actually end up causing overheating. Instead of stabilizing the economy, the stimulus leads to instability.
Business Cycles and Bubbles
Such economic fluctuations affect property prices. Housing property is developed in periods of medium length lasting 3-5 years and financed by banks through construction loans to property developers and mortgage loans to households. All these features make housing hostage to economic fluctuations in the medium run and to economic growth in the long run. When an economic upturn leads to more demand for property and housing, prices and rents increase rapidly because supply cannot be increased in the short run. Although development and construction activity speeds up, new supply only appears a few years later.
These dynamics of the property and housing markets often lead to the appearance of a bubble-like phenomenon. As property and housing prices increase, existing property and housing owners experience capital value appreciation. This wealth effect fuels further demand for property and housing. The push to increase supply becomes more forceful. But the new supply often arrives when the economic upturn has reversed direction. All of a sudden it appears as if supply is in excess because demand slacks off. Prices then plummet and property wealth contracts further, exacerbating the collapse of demand. Everyone now draws the conclusion that there was a bubble earlier and it is now bursting.
Actually the exaggerated boom and bust cycles in property and housing markets are part of the inevitable outcome of uncertain policy time lags, long construction cycles, and the exaggerated effects of capital gains and losses when property prices change. Property bubbles and their bursting are part of the adjustment dynamics driven by economic fluctuations. They are a natural outcome. These cycles are one of the macroeconomic factors affecting housing and property prices.
Another significant factor is the situation in the banking sector. Sometimes when property and housing prices plummet, the assets of the banking sector may be seriously impaired because banks often provide most of the financing for property development and mortgages. When this happens, there is the risk of a bank run and a contagion-induced financial crisis. For this reason, mortgage loans are vigilantly regulated inHong Kong, especially the proportion of the property value that must be paid as mortgage down payment. Over two decades bank regulations on down payments have risen from 10% to 40% for property purchases and 50% for luxury properties.
While these regulations may be necessary to maintain stability of the banking system, they also mean that property purchases have become prohibitively expensive for first-time purchasers. This situation has created a compelling reason for supporting home purchases for permanent residents who cannot reasonably afford to do so otherwise. If they are only provided with shelter and no ownership potential, they essentially become permanently enslaved to their housing units with little hope for upward mobility.
Middle Class Confidence Battered
Property prices have been a persistent barrier to wider home ownership inHong Kong; despite two dramatic collapses in real property prices over the past 30 years (see Figure 1). The first was during 1981-1985 (the Volcker Shock) and the second was during 1998-2003 (the Asian Financial Crisis). Each of these periods was followed by a sustained period of soaring growth in real property prices. As a result, despite the high volatility, real property prices have shown a continued increase over the past three decades.
The Volcker Shock raised US interest rates to double digit levels to break inflationary expectations. The effect onHong Kongwas to create a huge disinflation pressure as local interest rates also soared. Price increases, in terms of consumer prices and the GDP deflator, fell from an annual high of 15% to a low of 3-4% (see Figure 2). Real interest rates remained high at 4-5%. Real property prices fell by a cumulative 44% during this period. In the two years 1981-1983 real property prices fell by more than 22% a year. In 1983, the Government adopted the linked exchange rate regime to stabilize market sentiment as political uncertainty over the future ofHong Kongburst open amidst a period of considerable economic turmoil in global and local markets.
In the aftermath of this,Hong Kongsaw exuberant growth. Real property prices rose for a decade from the mid-1980s as the economy prospered and fortunes were made in the property market. A weakUScurrency and low interest rates fuelled domestic inflation. Tight labor markets lulled many men and women into over-confidence.
The exuberance ended with the onset of the Asian Financial Crisis. During 1998-2003, Hong Kong experienced the worst deflation since the Great Depression in theUnited States. Consumer prices fell by a cumulative 12.5% and the GDP deflator declined by a cumulative 18.2% over this period. In 1998 alone real property prices fell by 30% and for the next five years fell by about 10% a year. The real interest rate never fell below 4% and was as high as 12% at its peak. At its peak an estimated 20% of mortgage loans were under water as property values fell below their outstanding mortgage loan value. Young households who bought property a few short years before the property market crashed saw their future vanishing with each passing month, and then with each passing year. When the crisis finally ended, real property prices had fallen by a cumulative 57.3%.
Many Asian currencies devalued after the Asian Financial Crisis struck. The strength of theUScurrency also worsened deflationary pressure inHong Kong. Figure 3 plots the annual percentage change in the exchange rate of selected foreign currencies against the Hong Kong Dollar using 1995 as the base year. TheHong Kongdollar was not only appreciating against these currencies, but doing so at an increasing rate.
Price deflation inHong Kongwas the worst in the world since the Great Depression. The linked exchange rate regime made this inevitable. Deflation finally ended after 2003 when theUScurrency weakened and the Hong Kong Dollar fell with it. As consumer prices began to rise again, interest rates also began to fall. Finally, property prices began to recover. They would rebound remarkably in the years ahead but in the meantime,Hong Kong’s middle class had been half devastated by the property crisis. Those that survived lost precious time in the prime of their careers and their entrepreneurial and risk taking spirit was dulled.
The sub-prime mortgage crisis in 2007 and the subsequent global financial crisis and economic recession have leftHong Kong– and its property prices – relatively unscathed. Hong Kong’s economy has remained buoyant thanks to growth in the Asian economies, especially MainlandChina. The weak US Dollar and low interest rates are fuelling property price increases inHong Kong. Inflation is rising rapidly and the real interest rate has turned negative. It is now at the historical low of -4% and still falling. One of the macroeconomic consequences of the economic shocks in the past three decades has been to worsen the distribution of propertied wealth among households inHong Kong. Entering the property market at the wrong time often leaves a persistent difference between the haves and have-nots.
Housing Ladder Beyond Reach
I have described these big picture developments to show that property prices inHong Kongare subject to many unexpected and unknown influences from afar. Even eminent economists have difficulty foreseeing them. The Queen once asked professors at the London School of Economics why nobody had predicted the credit crunch in 2008. They replied through a letter that “the failure to foresee the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole.”
I quote the above passage not to apologize for the failures of a brilliant and arrogant profession. It is to show the complexities and difficulties of predicting what will happen next.
Similarly, inHong Kong, policy-makers have faced harsh questioning over their inability to have more foresight in their policies. In 1997, Mr. Tung Chee Hwa tried to increase the proportion of homeowners inHong Kongto 70% to help the population fulfill its homeownership dream. But he ended up pushing the supply of housing at a time whenHong Kongwas hit by the Asian Financial Crisis and faced rising real interest rates, deflating prices, and a strengthening currency. His successor, Mr. Tsang Yam Kuen, confronted with the memory of the Asian Financial Crisis and a global economy slipping into the worst global recession in 70 years, failed to increase the supply of housing when real interest rates turned negative, prices were inflating, and currencies were weakening. Both have been criticized for their error and failure. What were they thinking? What were their advisers thinking?
A bright economics student might suggestHong Kongshould leave the linked exchange rate arrangement and insulate itself from the unknown and unexpected influences from afar with a more refined policy instrument. But to whom should we entrust this decision? Delinking the exchange rate will not necessarily make the economy more stable. It can be an overwhelming task and politicians in theUSandEuropehave shown us most vividly its unpleasant side.
What, then, canHong Kongdo to meet people’s aspirations for homeownership? Despite the volatility of property prices over the past 30 years, they have surged to levels well beyond the reach of the have-nots. Even waiting for the next property cycle downturn may appear unreal or too far off. These people are not merely young men and women trying to form a household, but the 47% of people living in public sector housing, those on the waiting list, and those who are not qualified to be on the waiting list. Hope should not vanish for such a large segment of society.
Government has failed to address this growing long-term problem, but deployed short-term solutions to dampen the volatility of property price fluctuations, like increasing punitive transactions fees and mortgage down payments, or introducing ad hoc housing programs like the Private Sector Participation Scheme, Middle Income Housing Scheme, Sandwich Class Housing Scheme, Flat for Sale Scheme, and My Home Purchase Plan. None of these get at the heart of the issue – the need to provide a subsidy on land values. Policies to dampen property price increases, including calls to limit property purchases from foreign investors or any of the many ad hoc housing programs that have been introduced do not address this problem.
Deregulate Public Housing Market
I believe the best solution is to establish a market in public sector housing by (1) reactivating the Tenant Purchase Scheme (TPS) on the existing stock of public rental housing units; (2) reducing the unpaid land premium on existing TPS and Homeownership Scheme (HOS) units to the level prevailing when the units were first completed, so they can become affordable; (3) unifying all future supply of public sector housing units as available either for rent or purchase; and (4) setting the sales price of these new public units at an affordable price so that a substantial subsidy on land values is provided outright.
The subsidy on land values is not something that society loses to the household. The household already occupies the premises. The premises and the land it takes up cannot be used by anyone else and therefore there is no cost to society. Providing a larger subsidy to the occupant owners means they can then choose to sell those units on the open market and can therefore unlock the hidden value to be redeployed for a better use – a use that would not have been possible or permitted if the right to sell the units were infeasible. It is not a double benefit. It is merely completing the other half of the benefit that was not initially provided in the first place.
At present 16% of households live in HOS units and 31% live in Public Rental Housing (PRH) units. Accepting this proposal would transform these households into bona fide homeowners. Together with the 37% who are private sector owners, the total percentage of homeowners in Hong Kong could become as high as 84%. Half the population of have-nots would become haves. The have-nots would then own a piece of Hong Kong and have a stake in its future not as “house serfs” but as property owners. Society would regain the land value that had been evaporated by regulations disallowing bona fide ownership.
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