Has Hong Kong peaked? (Part I of III)

One of the highlights of any visit to Hong Kong is a trip up to “The Peak”. This is a steep sided hill that seems to threaten to tip the city into the sea harbour. (The Peak Cafe is also a great place for lunch or an early evening cocktail, in the tranquil garden area.)

Before air conditioning, having an address on the Peak was the ultimate sign of social status. Prices were at a premium, as the air was slightly cooler than at the lower levels during the hot and humid Hong Kong summers. To this day mansions on the Peak are some of the most expensive properties in Hong Kong.

Hong Kong is one of the key Asian centres for finance and trade. This is the colonial legacy left by the British, who created strong institutions, little bureaucracy, and a low tax regime. (If only the British could have achieved the same back at home…)

Of course it’s mainly the Chinese that built Hong Kong, and continue to build it today. The British administrators just created a good business environment.

Day to day you experience this business culture in the high service levels offered to customers. I lived in Hong Kong for three years, and was once buying a piece of furniture. Once I’d found what I wanted, the lady serving me looked a bit worried and informed me that there would be a delay in the delivery. Being used to European levels of service, I took this to mean I’d have to wait six to eight weeks. When she told me the delivery couldn’t happen until the following day (!), I struggled to keep a straight face…

Hong Kong was handed back to China in 1997, but little has changed in terms of the business environment. Hong Kong is the international face of China’s new capitalism, under the “one country, two systems” formula.

A number of factors combine to make Hong Kong’s real estate (property) market pretty volatile. This chart shows the Centa-City Leading Index, a monthly index of secondary (used) property prices, from 1994 to the current time.

Hong Kong’s Real Estate Market

Hong Kong’s real estate (property) market 1994-2013.
Hong Kong’s real estate (property) market 1994-2013.

You can clearly see the peak in 1997, towards the left, and the crash from late 1997 to late 1998, in the aftermath of the Asian crisis. Prices fell over 50% in the space of one year. That’s a huge crash in an asset class where prices usually move in slow cycles, in most parts of the world. Prices then continued to trend downwards until 2003, bottoming out around 70% below the 1997 top. Since 2003 prices have risen by a factor of nearly four, which is around 15% a year (with compounding).

(I was lucky enough to live in Hong Kong between 2002 and 2005, during the bottom of the market. By the time I left, friends were already downgrading to smaller and smaller apartments as things started to pick up again. My last visit to Hong Kong was in 2012, and it was clear that the cost of living was substantially higher than when I lived there.)

Hong Kong’s economy, and its stock market, are closely linked to real estate. Any serious fall in prices could have big knock on effects for investors in Hong Kong stocks.

Right now it looks like real estate could have reached another peak. Prices have just started to turn down and many analysts are expecting significant falls of 15-20% over the next year. Hong Kong’s economy, and its stock market, are closely linked to real estate. Any serious fall in prices could have big knock on effects for investors in Hong Kong stocks.

Let me explain the fundamental reasons why the real estate market can be so volatile in Hong Kong. The first reason is a simple geographical one. Most of Hong Kong island is made up of steep sided hills, covered in dense vegetation.

This naturally restricts the amount of land that is suitable for construction, leading to a dense concentration of high rise buildings around the narrow strip of land by the sea. This is particularly true in the most desirable areas close to the city centre. It also means land reclamation – pushing back the sea at vast expense – is a big deal in Hong Kong. Even the airport is built on reclaimed land.

The result is that stock of property, the supply, is relatively fixed. Certainly when compared with most other places in the world. This means that even small changes to demand can result in big price swings.

Secondly Hong Kong is a major trade and finance centre. When things are going well profits and bonuses rocket. Expat bankers, lawyers and accountants flood in, people are flush with cash, and demand soars.

Looking at the chart again you can clearly see a mini spike in late 2007, when markets were still booming. This was followed by a crash in 2008, as the global financial crisis took hold. Prices fell by a quarter in just over half a year as the profits at investment banks evaporated, trade dried up, and staff were laid off.

…Hong Kong’s interest rates are often completely inappropriate for local economic conditions.

The third big factor is that the currency, the Hong Kong dollar, is pegged to the US dollar. To cut a long story short this means that Hong Kong’s interest rates are often completely inappropriate for local economic conditions.

The US has ultra low interest rates at the moment as it tries to stimulate its debt laden economy back into growth. That means Hong Kong also has very low rates, despite the much stronger local and regional economy.

The knock on effect is that borrowing Hong Kong dollars is extremely cheap, including mortgages. If we have learnt one thing for sure in recent years it is that cheap and easily available mortgage lending leads to property bubbles – such as seen in the USA, UK, Spain, Ireland and Australia…to name just a few.

I’ll explain more about the current risks of the Hong Kong property market in part II, and then how that could hit the stock market in part III. It could be time to come down from the Peak.

Stay tuned OfWealthers…

Until next time,

Rob Marstrand,

Do you live in Hong Kong or have experience of living there? Let us know your thoughts on the current situation? Leave your comments below.

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.