(This essay was published in Hong Kong Economic Journal on 22 March 2017.)


Home prices soared in late 2016 to the surprise of many, after falling by about 4 per cent between 2015 and 2016. Developers quickly pushed large numbers of pre-sale units onto the market at very high markups. The government responded quickly by slapping on an additional punitive stamp duty in a bid to cool down what was perceived as renewed speculative fervor.


This was a mistake. There are no speculators or short- or medium-term investors in the property market anymore, only final users and long-term investors with excess liquidity. Buyers today are more concerned about affordability than appreciation potential over the short or medium term.


The recent rise in property prices has been spurred by two factors.  One is the public’s perception of the economic future and the implication for their home purchase decisions. The other relates to why developers have rushed to push units onto the market with high markups: the pre-sale market is being crushed under a ton of regulations.


Perceptions of the Economic Future


Throughout most of 2016, interest rates were widely anticipated to rise and many forecasted home prices would finally correct after trending upwards since 2003. The Federal Reserve had expected to raise interest rates four times. But it gave up because of global frailties.


The past decade has been marked by false dawns, in which optimism about economic recovery at the start of each year was undone – whether by the euro crisis, wobbles in emerging markets, the collapse of the oil price or fears of a meltdown in China. The US economy kept growing through all this, but always into a headwind.


However, by the end of 2016, the signs were gathering that the vigor of American economic growth was being accompanied by growth everywhere else.


Fears about Chinese overcapacity, and of yuan devaluation, have receded. And from Japan to Europe, South Korea to Brazil and Russia, there are signs of a world economy finally stirring. This is vindication for Carmen Reinhart and Kenneth Rogoff, whose research into over a hundred banking crises suggests that on average, incomes get back to pre-crisis levels only after eight long years.


Closer to home, the broad public has probably gotten it right even if trained economists like myself have been reticent and cautious. Recent rises in interest rates have confirmed that the world economy is gradually and surely lifting itself out of the woods after a sustained eight years of cleaning up balance sheets, keeping monetary policy loose, and applying fiscal stimulus wherever prudently possible. To be sure, the pace of progress has not been even around the world, but economies are stirring nevertheless.


In Hong Kong, the key macroeconomic indicators for aspiring homeowners to look out for are straightforward – unemployment, China’s economic performance, and the future path of interest rates.


Unemployment affects whether a person’s ability to service his mortgage loan will be negatively disrupted. It has been low throughout the past eight years because of an unusually tight labor market due to a rapidly ageing population and a declining workforce. The public no longer fears they cannot find work.


Chinese economic performance affects Hong Kong directly. People understand that steady economic growth on the Mainland will be good for Hong Kong, the region and the world. The millions in Hong Kong who regularly visit the Mainland have had ample opportunities to observe what is happening across the border and made up their own minds.


Even if opinions differ on what they see there, a number of them will conclude that things are looking up. That conclusion will lead some in Hong Kong to enter the property market. Moreover, as more individuals and companies from the Mainland invest in properties and property development in Hong Kong, the people here also have less reason to become worried about the future of the property market.


The people here are less concerned about interest rates rising ahead of economic growth. Eight years of US quantitative easing has not led to price inflation. They have been told repeatedly that interest rate movements will only follow anticipated inflation and a robust economic record, but will not move ahead of economic recovery. As an economist, I thing they are wise to think this way. I would conjecture that small increases in the interest rate would be sufficient for preventing inflation, without threatening or dampening economic recovery.


In today’s property market, only final users and long term-investors with excess liquidity have any interest in entering. Buyers are more concerned about affordability than appreciation potential over the short or medium term. All three macroeconomic indicators – unemployment, China’s economic performance, and the future path of interest rates – have given aspiring homeowners in Hong Kong sufficient comfort in late 2016 to enter the property market.


There are many other households who also want to become homeowners in Hong Kong, if only they could afford it. The cumulative number of marriages in Hong Kong from 1986-2015 was 1,744,737. Of that figure, 704,890 (or 40.4%) were cross-border marriages and 301,850 (or 17.3%) were remarriages registered in Hong Kong. Among remarriages registered in Hong Kong 140,797 (or 50.3%) were cross-border marriages. In 2015 alone, there were 56,937 marriages, of which  24,255 were cross-border marriages and 17,546 were remarriages registered in Hong Kong.


In the period 1986-2015, the cumulative gross number of new domestic housing units built was 1,571,659 (before deducting the number of units that were demolished). The number of units built in 2015 was 22,753. The unmet cumulative housing demand in terms of the number of units is phenomenal. This is why the estimated number of sub-divided units in the private sector is over 200,000, and part of the reason why housing prices and rents have skyrocketed.


Effects of Regulation on Markets


When prices soar due to shortages in the market, the public is naturally unhappy and blames the government. Throughout history, governments everywhere have responded by blaming speculators for causing prices to escalate. Their favorite policy is to penalize transactions by imposing levies to suppress prices. This works in the short run because buying and selling activities slow down and price increases are delayed. But shortages remain and inevitably prices will rise again.


Many decades ago, Mr. Henry Fok created a forward market for pre-selling units before their completion to spread risk and provide liquidity. The pre-sold units were tradable and were in fact actively traded. At the beginning, stamp duty was exempted on transactions in the forward market, which led to active trading activity there.  In forward markets, it is not always easy to distinguish between speculators and final users, so trades were naturally viewed as speculative activities.


Developers, however, could use the price information revealed through speculative trades in the forward market to price the sale of new units that were released in batches over time. Speculation activity in the forward market helped developers, who have to sell large numbers of units in a single location within a limited period of time, to better diversify risk.


In a bid to prevent speculation, the stamp duties were extended to transactions in the forward market. High punitive stamp duties (including the special stamp duty and double stamp duty) have killed the incentive for speculators to trade units in the forward market. Furthermore, the government has also required developers to use lotteries to assign pre-sold units to prospective buyers, making it difficult to place the units with known speculators.


The elimination of the pre-sale forward market weakens the price discovery process. Prices are determined and, therefore, discovered through the buying and selling of units. Developers still pre-sell their new units before completion today, but trading activity in the forward market has disappeared. The elimination of speculative trades means developers now have less information to set prices correctly because there are fewer market transactions.


As a consequence, developers today are flooding the market with a lot of units at high mark-ups as soon as they detect some positive sign of buyer uptake. They are under intense competitive pressure, to sell their units to final buyers quickly, as they can no longer place units with speculators to hold them off the market. Mispricing has become more likely as markets have become highly regulated, contributing to greater price volatility.


Large developers could offer discounts and financing arrangements to cash-strapped buyers in the primary market, thereby inflating the nominal prices of units that they sell. Vendors in the secondary market typically are unable to match such offers and transactions there have dwindled (see Table). Between 2011 and 2016, annual secondary market transactions have decreased from 73,582 to 37,908 units. Meanwhile primary market transactions have increased from 10,880 to 16,793 units.


Table: Number of property transactions in the primary and secondary markets

  Primary market transactions Secondary market transactions
2011 10,880 73,582
2012 12,968 68,365
2013 11,046 39,630
2014 16,857 46,950
2015 16,826 39,156
2016 16,793 37,908


The combined effect of punitive stamp duties and high initial down payments has thus been to raise the nominal price of units in the primary market and depress transactions in the secondary market.


The net result for buyers has been to shift demand away from the secondary market to the primary market. The total supply of housing units on the market has been artificially reduced in the secondary market. Buyers now have less choice of units because of punitive stamp duties.


The regulation of property transactions can slow down price increases in the short run for politicians, who temporarily come out smelling like roses, but it is a futile means of holding down housing prices because the ultimate driver is excess demand.


When punitive stamp duties were imposed in late 2012 and early 2013, there were many who argued they would prevent a subsequent hard landing by dampening speculation.


Four and a half years down the road, we know speculation has been eliminated, but prices have not abated, and price collapses are not in sight.


The world economy is recovering, even if one may argue whether it will be a robust recovery. But it is certain that buyers have less choice as secondary market transactions have declined. And the forward market in pre-sale housing units – this great creation of Mr. Henry Fok – has been killed. I am puzzled why this has been celebrated as a huge policy success.


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