HK: The story of 1 peg, 2 monetary policies and 3 housing markets

Hong Kong’s (HK) economy is influenced by three residential property markets — its own, China’s and the US. Each appears to be going in a different direction.

HK residential prices are firming, China’s have stalled seemingly mid-way, while the US property market after some steep falls, still has not found bottom. One of the policy ironies for HK is that all three economies by nature or by design have the same monetary policy.

The Fed’s FOMC decisions dictate the operations of the HK peg and to varying degrees how China’s interest rate and exchange rate move. Although purists will argue that China’s monetary cycle is independent from the US, the fact that policymakers decided to re-peg themselves to the US dollar during the 2008 financial crisis is perhaps an indication of the hidden ties China still has to US interest rate policy.

An inconvenient truth
“The US is at the doorstep of deflation. Falling price levels have been rare in post-war history and, therefore, present new challenges for investors and policymakers.

Historical episodes of deflation were associated with a wide range of economic outcomes, but overall these experiences suggest a persistent decline in prices would damage growth. Moreover, deflation greatly complicates monetary policy, and could weaken the Fed’s credibility.

While we forecast that core inflation will continue to fall, we think the economy will narrowly avoid outright deflation. In the face of heightened deflation risks, the Bernanke Fed will likely act aggressively and pre-emptively — as it has throughout the financial crisis.
Indeed, recent comments from Fed officials suggest that the debate about more quantitative easing is already under way. As a first step in any
additional easing, the Fed would likely reintroduce the Treasury purchase programme. However, the Fed has many more tools at its disposal, especially if it cooperates with Fiscal authorities,” Deflation — causes, consequences and cures, Zach Pandl, July 8, 2010

“In November 1923, when the Levy family cashed in their 20-year insurance policy for a piece of bread, there was truly what Walter Levy, historian Louis Snyder and others call a ‘a fever dance’.

In Berlin, a woman hopefully entered a butcher’s shop, bearing a basketful of million- and billion-mark notes. She left it on the ground at the entrance to queue up for whatever meat might be available.

She turned to find the load of marks dumped into the gutter and the empty basket stolen. Streetcar conductors would accept fares only at the end of a passenger’s ride because the value of mark would sink during the few minutes of the trip”, Currency Wars, John K Cooley

“The economic outlook remains unusually uncertain… if the economic recovery seems to be faltering, we need to at least review our options”, Fed Chairman Ben Bernanke, congressional testimony, July 2010

“Hong Kong slipped into deflation in 1998 and prices continued to fall for five years. The peak-to-trough decline in CPI was 16%. The sharp decline in property prices had a large direct effect on measured prices — house prices have a 29% weight in Hong Kong’s CPI — as well as indirect effects through weaker consumption and investment”, Deflation: causes, consequences and cures, Zach Pandl, July 8, 2010.

Deflation nothing new in the US
The US flirtation with deflationary pressures is nothing new. After the technology bubble burst in 2000-01, the economy had a wide output gap. Global pricing turned sharply negative and the Fed cut interest rates at that time to post-war lows.

At the same time, the economy was also receiving a secondary shock from the drop in equity values following the sharp falls on Nasdaq as the technology bubble burst.

In some respects there are similarities between 2000-01 monetary easing and the 2008 financial crisis. The economy became heavily leveraged to household spending following the technology bust and this came through not just in private consumption, but also through rising home ownership.

The latter was also accompanied by rising house prices encouraging wealth effects, which accelerated consumption even further. The positive feedback loops alongside low nominal interest rates encouraged further credit extension particularly as credit standards were relaxed.

Of course, the US economy suffered negative feedback loops as credit was curtailed and asset prices fell, leading to the extraordinary accommodative monetary policy of 2009 and the affirmative QE programmes that followed.

Although there are differences between Japan’s deflationary shock and the US financial crisis, there are similarities in that there was a double shock for each economy from both falling asset prices (housing and stock prices) as well as curtailed production. The deflationary effect came from the fact that balance sheets needed to be rebuilt at the same time as both asset and tradable good prices were falling.

The economy remained in a vicious feedback loop in which a price fall in the economy induced prices of assets also to fall. Central banks with rates at zero have no conventional policy left to use.

Deflation may not necessarily be bad for economies if it is associated with productivity gains, lower unit labour costs due to technological shifts, open trade or deregulation which results in lower domestic prices.

This type of deflation is termed disinflation. It is also possible to experience deflationary pressures through an appreciating exchange rate.

Insidious variety of inflation
However, the insidious variety of deflation may become more problematic if real debt burdens rise and interest rates reach zero at lower levels of targeted inflation. At this level, the central bank’s ability to stimulate the economy with conventional tools becomes difficult and if lower prices become embedded in the economy, real interest rates may rise further, prolonging the downturn.

In the recently published book by Reinhart and Rogoff, This time is different — Eight centuries of financial folly, the authors point out that Hong Kong experienced one of the sharpest drops in property prices in the shortest period of time from the peak in 1997.

The deflation was accentuated by Hong Kong’s rigid exchange rate system. By pegging itself to the US dollar, Hong Kong’s adjustment came through the asset markets rather than through changes in the exchange rate.

Although Japan’s decline in property prices was far greater (on most data a decline of over 70% from the peak), it was experienced over 18 years.

Hong Kong residents during the new century had little to celebrate with so many households experiencing negative equity (where the value of the outstanding mortgage is greater than the value of the home).

Unlike their peers in the US, Hong Kong households do not have the ability to walk away from mortgages with such impunity.

HK best placed in renminbi convertibility
Hong Kong is enjoying a benevolent period for financial markets. The US dollar is weakening on a trade-weighted basis. HIBOR remains well behaved and after a short clip has begun to recede again, while the renminbi firmed against the greenback recently.

More importantly, across the border, China’s exchange rate has commenced a modest appreciation against the greenback and re-export trends are also firm, leading to a surplus balance of payments on the mainland. HK assets tend to perform their best when China’s FX reserves are growing and HK real interest rates are negative.

We believe HK financials are the best placed to take advantage of the relaxation in renminbi convertibility and the natural monopoly afforded to HK after recent comments suggesting that Shanghai will only engage in onshore renminbi trading.

We believe HK financials are trading at inexpensive valuations and will benefit from the increasing turnover and disintermediation of renminbi in the economy and internationally.


by Nomura International (HK) Ltd
This article appeared in The Edge Financial Daily, August 6, 2010.