Yes, the HK$ peg is to blame, but the alternatives are worse

Cheap money is behind high property prices but any moves to fully float or manage the currency like Singapore do have their pitfalls

PUBLISHED : Thursday, 18 October, 2012, 12:00am
UPDATED : Thursday, 18 October, 2012, 4:47am

Property prices are an eternal obsession with Hong Kong's inhabitants.

Even so, Monday's Monitor column examining some of the reasons why we can expect the home prices to continue setting new records broke new ground.

Among the responses it elicited from readers was one tightly reasoned e-mail from a prominent local financier which ran to more than twice the word count of the original article.

In a nutshell, our reader argues that increasing the supply of housing will do nothing to bring down prices. With mortgage rates as low as 2 to 3 per cent, building more flats will simply encourage more buyers to invest in the property market.

The real problem, he insists, is Hong Kong's currency peg to the US dollar, which forces the city to import US interest rates, whether the local economy is in step with the US business cycle or not.

Right now that means Hong Kong is replicating the Federal Reserve's ultra-low interest rates, even though our economy is relatively strong and our property market is booming.

"With the peg, I think everyone would agree that the negative effects are crystal clear and causing many social and economic problems," our reader writes. "Can our Hong Kong property market withstand three more years of low interest rates and double-digit price increases annually?"

The answer, he argues, is for Hong Kong to ditch its 29-year-old exchange rate peg to the US dollar in favour of a currency regime that would allow the city to run higher interest rates, so constraining the property market.

There is nothing new about calls to get rid of the peg. The problem is deciding what to replace it with. The most common suggestion is that Hong Kong should simply peg its currency to the yuan instead of the US dollar.

But there are difficulties. Even though the Chinese currency is not fully convertible, the Hong Kong Monetary Authority would have no problem maintaining the Hong Kong dollar in a set trading band against the yuan.

The trouble would be interest rates. The lack of arbitrage opportunities would prevent Hong Kong from simply adopting mainland interest rates. And the offshore yuan market is too small and illiquid to provide a reliable benchmark yield curve for the much bigger Hong Kong dollar market (see the first chart).

Then there's the Singapore solution: a managed float under which the monetary authority steers the local currency higher or lower in an attempt to keep local inflation, asset prices and interest rates at moderate levels.

It sounds great. The problem is that property prices in Singapore have shot up almost as much as in Hong Kong over the past three years (see the second chart), despite a steady appreciation in the Singapore dollar.

In fact, the appreciation of the currency may have exacerbated Singapore's property boom by encouraging capital inflows.

"The policy has failed," says one Singapore-based economist, "but don't quote me on that."

Finally there is the option our reader would prefer: a full free float of the Hong Kong dollar, which would allow the HKMA to set interest rates appropriate for the city's domestic economic conditions.

That might rein in the property market. But Hong Kong's government and businesses would hardly welcome the inevitable exchange rate volatility that would follow.

Initially, the Hong Kong dollar would shoot up in value, reflecting both its current perceived undervaluation and the higher interest rates that would be on offer. But before long the appreciation would erode the city's competitiveness as a service centre, leading to a slowdown in the economy, widespread job losses - and very likely a collapse in the property market.

There's no way the government is going to risk that. So for the time being, like our reader, we'll just have to go on complaining about how expensive Hong Kong property prices are.