CY's well-intentioned housing supply policy likely to backfire

In his first policy speech yesterday, Hong Kong Chief Executive Leung Chun-ying announced plans to ramp up home building.

It's a well-intentioned move aimed at tackling the crippling supply shortage Leung blames for pushing housing prices and rents up to unaffordable levels.

Unfortunately, his new policy is likely to backfire spectacularly.

"Supply shortage lies at the heart of the prevailing housing problem," Leung declared yesterday.

At first this sounds like a reasonable deduction. As the chief executive pointed out, over recent years the number of new homes built in the city each year has tumbled to less than half that of a decade ago.

Over the last five years, developers have completed on average only around 10,000 private homes a year, while the government has added some 15,000 public rental flats, making a total of 25,000 new homes a year (see the first chart).

Over the same period, thanks largely to marriages, divorces and immigration, the number of households living in the city has grown at an average rate of around 28,500 a year.

The result of this under-supply, says Leung, is an acute housing shortage that has pushed the price of a new flat beyond the financial reach of many middle-class families and left more than 200,000 households on the waiting list for public rental flats.

Leung's solution is to bump up the supply of new homes. According to the plan he outlined yesterday, by 2017 the number of new public rental flats being completed should rise to 20,000 a year.

On top of that the government will build an additional 17,000 flats a year for sale to the public at subsidised prices. Meanwhile, the number of private sector completions is projected to double over the next few years to 20,000 a year.

In total then, over the next five years the supply of new homes should climb from 25,000 a year to more than 55,000. In the longer run, Leung pledged to increase the supply of building land to meet the city's future demand for housing.

This all sounds splendid, except there is a real danger that Leung's counter-cyclical attempt to make housing more affordable will end up providing enough pro-cyclical momentum to turn any coming property market correction into a full-blown slump.

At some time over the next few years the US unemployment rate will fall below 6.5 per cent, at which point the Federal Reserve will begin raising interest rates. Extrapolating the trend rate at which unemployment is currently falling, the first increase is likely to come early in 2015 (see the second chart).

At that point, the Fed might find itself forced to raise rates fairly aggressively, if it is to keep inflation in line with its 2 per cent target.

In other words, Hong Kong is likely to find itself facing sharply rising mortgage rates just as Leung's ramped-up supply of new homes reaches the market.

The effect would be devastating. At the moment, with interest rates at record lows, servicing a typical mortgage costs around half of median household income. As a result, any increase in interest rates will soon make paying a mortgage unaffordable for many homeowners, triggering a spate of sales and forcing down prices.

At the same time, the increased supply of public rental housing will reduce demand for rented accommodation in the private sector, pushing yields down and making property less attractive to investors.

The result is likely to be a nasty slide in property prices that could leave many recent buyers in negative equity.

Worse, it will erode the value of the only collateral that many local entrepreneurs have to offer against working capital loans for their companies, hammering business activity, job creation and economic growth.

At that point, no doubt, the government and developers will stop building. But the damage to Hong Kong's economy will already have been done.

tom.holland@scmp.com