Barnett said bank lending and domestic economic activity would face headwinds because of a sharp fall in property prices.

He said policies such as increasing land sales and ramping up construction of public housing for sale to the middle class were the keys to tackling the red-hot property market in Hong Kong, where gross domestic product is expected to expand 1.25 per cent this year, with an inflation rate of 3.75 per cent. The IMF projects GDP will expand 3 per cent next year.

Despite lukewarm economic conditions, Hong Kong's home prices have surged to become the world's most expensive, surpassing the heights of the property bubble in 1997 - which burst that year and put thousands of homeowners in negative equity.

"The price increase in the mass market has been particularly pronounced of late, which is exacerbating affordability concerns," the IMF said in a report on the city released yesterday. "A combination of limited supply of new housing, strong demand from local and non-local purchasers, and low interest rates imported from the United States has been driving up prices."

Asked about leading indicators for Hong Kong's property market, Barnett said the fund looked at a wide range of statistics, such as the ratio of price to disposable income, demand-supply models and interest rate conditions.

"A sharp price correction would lead to falling collateral values and negative wealth effects, which could trigger an adverse feedback loop between economic activity, bank lending and the property market," the IMF report said.

The Washington-based fund said: "While the probability of a correction large enough to generate major macroeconomic and financial consequences is fairly low in the near term, the property sector is the main source of domestic economic risk."

Monetary Authority chief executive Norman Chan Tak-lam said he was pleased because the IMF agreed with the authority's prudent anti-cyclical measures for property mortgages.