If Greenspan could get things so wrong, then what about us?

PUBLISHED : Tuesday, 24 July, 2012, 12:00am
UPDATED : Tuesday, 24 July, 2012, 12:00am


For the last couple of years Monitor has argued doggedly that there is no bubble in Hong Kong's property market.

Despite a series of warnings from local officials and the International Monetary Fund that property prices were becoming dangerously over-inflated, this column maintained there were few signs of the sort of credit-fuelled speculative frenzy that Hong Kong saw in the run-up to the 1997 handover.

Sure prices were rising, but Monitor argued that buyers were reacting rationally to the prevailing economic circumstances - a limited supply of new homes, low mortgage rates, and negative real returns on bank deposits - and that the market was being driven by fundamentals. There was no bubble in the usual sense of the word.

So I was disconcerted this week to learn that former Federal Reserve chairman Alan Greenspan said much the same sort of thing about the American housing market back in 2005.

In a nutshell, Greenspan argued that the illiquidity of the property market, its high transaction costs and the need for sellers to find somewhere else to live all discouraged speculative trading in houses.

Of course, we know now how wrong he was. Even as Greenspan was denying its existence, an enormous speculative bubble was indeed inflating in the US market, fuelled by low interest rates, 100 per cent mortgages and easy credit for subprime borrowers.

By mid-2006 the bubble had burst, and prices have since fallen by more than a third, inflicting a grievous blow on the US economy.

If Greenspan, with all the resources at his disposal, could get things so catastrophically wrong, then I have to admit there is a possibility that Monitor could be wrong too.

Part of the problem, as researchers at the Federal Reserve Board of San Francisco pointed out in a recent research note, is that 'a common feature of all bubbles is the emergence of seemingly plausible fundamental arguments that attempt to justify the dramatic run-up in asset prices'.

Well, as the first chart shows, the run-up in Hong Kong property prices over the last three years has certainly been dramatic. So it's only right that I should reassess my reasoning and ask whether I'm guilty of making the same sort of seemingly plausible, but erroneous, argument as Greenspan.

One of the measures the San Francisco Fed's researchers use as a bubble detector is the ratio of home prices to rents. When this shoots suddenly higher, as it did in the US between 2002 and 2006, the bubble alarm should sound.

The ratio of price to rent is simply the inverse of the rental yield. So a sharp rise in the ratio will be reflected by a corresponding fall in rental yields.

Looking at the data for Hong Kong homes, we can clearly see that yields have indeed dropped steeply. In mid-2003 the rental yield on a typical 700 sq ft flat was 5.4 per cent. Today it is just 3.1 per cent, while yields on the biggest apartments have collapsed to just 2.2 per cent.

But that doesn't necessarily mean there is a bubble. After all, the yields on other assets have fallen lately as well.

So to get a clearer view, we need to look at how property yields compare with the yield on supposedly risk-free assets like exchange fund notes.

If property yields are significantly below the risk-free rate, then we should be worried about a bubble. If they are comfortably above the yield on exchange fund notes, then it is clear that homebuyers are wary of risk, and there is little danger of a bubble developing.

The second chart shows the spread between the rental yield on a 700 sq ft flat and the yield on a 10-year exchange fund note. As you can see, at the beginning of 1998, the property yield was fully 6 percentage points below the note yield: a clear sign of a market bubble.

Today, however, the property yield is 2 percentage points above the risk-free rate, which is high by historical standards.

In other words, there is no sign of a dangerous outbreak of irrational speculative behaviour among Hong Kong's homebuyers.

There is still no bubble.