Taper threatens Hong Kong property

You might not expect the Argentine peso to have much in common with Hong Kong property, but they both could be casualties of tightening by the U.S. Federal Reserve.

Last week’s plunge in the pesoUSDARS +0.84%  has been a sharp reminder of the risks of Fed tapering, and it has renewed fears that Hong Kong’s bubbly property market could soon be tipped over.

This means Hong Kong will be watching particularly closely when the Fed issues its latest policy statement later this week. A continuation of tapering (reduced bond buying) could jolt both local property and equity markets. Despite the influx of mainland Chinese listings in recent years, property stocks still represent a quarter of the Hong Kong equity market, as judged by the market value of the MSCI Investable Universe Hong Kong Index.

The reason Hong Kong property is singled out as a potential taper causality is due to the extent it has gained from quantitative easing in the U.S. The longstanding currency peg to the U.S. dollar means Hong Kong has had to import the ultra-loose U.S. monetary policy, which has left the territory awash with cheap money.

It was during this period of successive Fed QE that Hong Kong banks introduced rock-bottom mortgages based on interbank rates, which helped propel property prices to record highs. Since 2007, property price have increased over 100% despite a succession of measures by the Hong Kong government to tame the market, including heavy transaction taxes for non-residents.

Now analysts warn that a policy shift by the U.S. Fed can do what seemed beyond the power of Hong Kong’s government: it can reverse property prices.

According to new strategy note by Société Générale, Hong Kong property will soon be a casualty of U.S. tightening. It expects 2014 to mark the end of the uptrend in prices. Given how important QE was in pushing prices up, it will have a sting when it exits, they argue, making local property highly vulnerable to subsequent tightening of U.S. monetary policy.

Although bearish views on property are becoming increasingly common, prices have, at least so far, proved remarkably resilient. But despite this, there are some vulnerabilities in the property outlook emerging. One is a slowdown in transactions.

Since the government introduced successive stamp-duty increases, it appears to have had more success curbing sales activity, if not prices.

In 2013, property sales fell by more than a third to a 17-year low with 70,503 transactions, down 39% from 2012, according to figures from the Land Registry. One explanation for the drop in transactions is that traditionally very active mainland Chinese buyers are now looking elsewhere for real-estate investments due to Hong Kong’s high prices and transaction fees.

That seems understandable, as various surveys confirm that Hong Kong property prices are extremely high. According to estate agent Savills, Hong Kong remained the world’s most expensive city in terms of residential and office costs in the second half of 2013, with New York a close second. With a yearly business-accommodation cost of $1,625,000, Hong Kong was more than 50% more expensive than neighboring Asian capitals, such as Tokyo and Singapore.

Another red flag is the apparent disconnect between ever-higher property prices and the prices of developer stocks. Last year, property stocks were down on average 13% year-on-year, with Li ka-shing’s flagship Cheung Kong HK:1 -1.44%   CHEUY +0.20%  the only gainer.

The price of developer stocks could be a leading indicator for the physical market. SocGen warns that 2014 could yet be worse year than last year, and based on the housing-price trend line, prices could still be 30% overvalued.

Such a correction would be significant but still nothing like that of 1998, when prices fell in excess of 60%. Credit Suisse says in a report that they expect a mild correction rather than a collapse in property prices, citing increasing household income and a buoyant employment market.

What could be a swing factor to watch is whether changing monetary conditions in the U.S. filter through to mortgage rates in Hong Kong. There has been no credit-market reaction yet to the changing outlook for property.

Credit Suisse also says it sees no imminent reason for a change in mortgage rates in Hong Kong. We will have to watch if Fed tapering does subsequently have an impact.

Another consideration is the impact of a slowdown in mainland China. Not only have mainland buyers been very active in the market, but so too have Chinese banks lending to Hong Kong property over the past five years.

Tightening monetary conditions in China at the same time as tapering could present a double headwind to property. Then Hong Kong could face more than just a mild correction.