The way this world works - like it or not

South China Morning Post  |  Sep 30, 2002

By Sin-ming Shaw

IT IS OFFICIAL. Chief Executive Tung Chee-hwa and Financial Secretary Antony Leung Kam-chung have both said the government will do "something" to support the property market to reduce deflation in Hong Kong. Mr Tung even promised to push the market "up a bit".

If higher property prices mean a better Hong Kong, all the government has to do is announce that for the next 10 years it will sell no land by auction or by private treaty, build no subsidised flats, and reinstitute a height limit on buildings on the Kowloon peninsula. There can be no doubt prices will go up and property stocks will rebound sharply. The only uncertainty is by how much.

But then what? How long will these prices remain high? Will the economy recover? Hong Kong is in deflation for two principal reasons. First, the world is finding the mainland an increasingly profitable alternative.

In technical terms preferred by Morgan Stanley economist Andy Xie Guozhong, investors are arbitraging between Hong Kong and China, especially Guangdong.

If two areas are producing the same goods or services, the prices, over time, should be the same in both societies save for transaction costs (transport, exchange risks) or country risks (legal, political, social and the like). There are fewer and fewer such barriers separating Hong Kong and Guangdong, except in the financial business. Hong Kong has a convertible currency and a financial infrastructure that is part of global finance. China does not - at least not officially.

Much of anything else Hong Kong can do - logistics, tourism, even education - Guangdong, Shanghai or Beijing can do as well. In arbitrage, the end result is straightforward: prices (including wages) in these two separate economic domains will converge. This means Hong Kong prices have some way to fall.

The Hong Kong dollar is over-valued. As long as the nominal rate of 7.8 to the US dollar remains unchanged, then the real rate of exchange must adjust. The adjustment process is better known as deflation. The decline of the property market is just one manifestation of that process.

Pro-peg diehards argue real estate is a "non-traded" good and hence irrelevant to the over-valuation calculus. It is true the Robinson Road flat cannot be moved to Shenzhen or Shanghai, but the "services" that flat provides can be relocated. The most important service a flat provides, other than shelter, is proximity to gainful employment and future income prospects. If a flat in Shanghai costs a small fraction of one in Hong Kong, and if the occupant can do a similar job up north, then there is no point in keeping that person in Hong Kong. The immovable flat is, indeed, irrelevant to the argument about non-traded goods.

Hence the demand for Hong Kong real estate falls relative to its competition. Today it may be Shanghai, tomorrow it could be somewhere else. Human capital, like financial capital, is highly mobile. As the world moves away from a hardware-centred world to one dominated by software, or brain power, it is increasingly important to look at the content of services provided instead of focusing on real estate that seems non-traded but in fact has substitutions.

Contrary to popular perception, the fixed nominal rate of 7.8 has brought only superficial stability. Hong Kong's core growth has declined over the past 20 years to a low single digit while bringing huge swings in the property market. A flexible exchange rate would not have resulted in years of negative real rates of interest and would have choked off speculative capital inflow into the property market because the nominal exchange rate would have appreciated.

Now Hong Kong has an over-valued exchange rate that is fixed, and that demands deflation as a price for its nominal stability.

The second reason for declining property prices has to do with the nature of bubbles. Just about every bubble in the history of bubbles declined by at least 80 per cent from its peak. The most recent exhibit is PCCW. Its share price on Friday of HK$1.14 is down by more than 96 per cent from its high. That is not totally abnormal in historical context.

The ever-changing official SAR attitude about land prices reflects a fundamental misconception about what makes an economy grow, as well as the government's own role in that process. Growth means profits, reinvestments, jobs and the confidence that job prospects are secure. Sound growth comes from businesses making a profit by doing things on a recurrent basis, by reinvesting, creating jobs, but not by trading assets which are considered non-recurrent.

Boosting property prices by administrative measures can only have a short-term, one-off impact, without a lasting consequence on economic activities. Hong Kong should have learned by now the bitter lesson of asset inflation mis-labelled as growth. Growth in Hong Kong has to come from productivity. Productivity has to do with what you can create in goods or services at a competitive price. Globalisation means competitors who have a winning idea can eat your next lunch at a speed unimaginable only 10 years ago. For Hong Kong, there is a competitor an hour away and whose currency, the yuan, is grossly undervalued against the Hong Kong dollar, and hence, against the US dollar.

That under-valuation is the principal reason for its phenomenal export growth. The export growth in hard goods has translated into re-export margins, read profits, for Hong Kong manufacturers and investors who have wisely poured their overvalued Hong Kong money into undervalued yuan assets. For the past two decades or so, Hong Kong has been living off the returns on investments in China. The Hong Kong government can try once again to fiddle with its land policy to support the market. Unfortunately this government will not be able to change the deflationary forces demanded by a fixed nominal exchange rate that is overvalued. The best thing it can do is to institute a clear, transparent, rules-based, land supply policy, the way the US Federal Reserve Bank prints money.

It should announce a quantitative target and then live within the allowable margins of error. That target could be 50 hectares, zero or 200 hectares a year. But announce it and then get out of the real-estate business totally. There are no free lunches. If you want a stable nominal exchange rate, you can have it. The price of that is that prices of the entire economy will fluctuate up and down as they have done in Hong Kong.

The more overvalued it is, the more domestic prices need to fall. Further, the more efficient China becomes, the more its nominal exchange rate, now fixed, becomes undervalued, which will prolong Hong Kong's deflation.

While the economics strongly favours a much lower Hong Kong dollar, the institutional prerequisites do not exist to support a change.

Hong Kong has a credibility problem in its economic management and it lacks a properly staffed potential central bank - both necessary for a successful regime change.

Property prices in Hong Kong are down 60-65 per cent from their peak. If an 80-85 per cent decline is what defines a bubble bursting, then another 30-40 per cent decline from today's level should not be considered extraordinary. You may not like it, but that's the way the world works.

The government can stop that decline by a zero-growth land policy. The price of that policy would be to drive Hong Kong further down the path taken by Japan. There are no free lunches in this world.

The government leaders should be honest with its citizens about the dilemma and not promise more than they can deliver.

Sin-ming Shaw is a visiting fellow at St Antony's College, Oxford University

 Back to home page