Financial Stability and the Property Bubble

inSight

06 Oct 2005

Financial Stability and the Property Bubble

Low interest rates, the 70% loan-to-value ratio, two-income households, a high savings rate, the high capital adequacy ratio of banks, and the Hong Kong Mortgage Corporation all helped Hong Kong’s financial sector to remain resilient during the last property market downturn.

Readers may have noticed the heightening of concern about housing markets in a few developed economies, including the United States. This subject featured prominently in a number of international meetings on financial stability I attended recently. Given Hong Kong’s experience of a major downturn in the housing market between 1998 and 2003, when housing prices went down on average by over 60%, there was considerable interest in what lessons we could offer. While noting that circumstances differ in different markets, I have six observations on why financial stability, in particular banking stability, was maintained in Hong Kong through the property market downturn.

First, we were quite lucky that US interest rates were on a declining trend over that five-year period. On top of that, interest rate liberalisation in Hong Kong, through the stepped removal of the Interest Rate Rules of the Hong Kong Association of Banks, has produced a highly competitive environment in retail banking, leading to the fall of the mortgage rate, relative to the prime rate, by four percentage points. In total, the mortgage rate over the five-year period fell from 11.5% to 2.5%. Since the great majority of mortgages were on floating rather than fixed interest rates, this helped mortgagors tremendously.

Second, we have a 70% loan-to-value supervisory guidance that banks observe closely. Around the peak of the property boom, banks actually adopted an even lower loan-to-value ratio for the more risky end of the market. This supervisory guidance played a key role in cushioning the effect of much of the fall in housing prices before mortgages went into negative equity.

Third, our policy on the employment of domestic helpers from other countries means a relatively high female labour force participation rate, so that in a typical family there are two breadwinners instead of one. Even though the unemployment rate went up significantly during the five-year period, as long as someone in the family kept his or her job, the mortgages continued to be serviced. Home ownership is a valued tradition here, even if the mortgage is in negative equity.

Fourth, as in other economies in the region, our savings rate is fairly high, and households in Hong Kong have accumulated significant financial assets over the years. Thus, the staying power of mortgagors is probably considerably greater here than in an economy with a low savings rate.

Fifth, our banks are run conservatively with a capital adequacy ratio in the high teens. There is therefore a large cushion to absorb possible losses arising from mortgages in default, although, in the event, banks did not have to rely on this cushion since the industry remained profitable throughout the period.

Sixth, we established the Hong Kong Mortgage Corporation to which banks could sell their mortgages if they wished to reduce their exposure to the residential housing market to a comfortable level.

When describing our experience to others, I could not help wondering what the financial stability implications of a substantial downward adjustment in housing prices might be if circumstances were different. I am aware that in other jurisdictions, there are “interest-only” mortgages instead of 70% loan-to-value ratios, low savings rates, low capital adequacy for banks, predominantly single-breadwinner families, and rising interest rates. In other words, the necessary cushions are simply not there. Perhaps the housing market is less volatile in other jurisdictions than in Hong Kong and interest rates could be used in a discretionary manner to cushion the housing downturn when it comes and lessen its adverse impact, although this would not help those paying fixed-rate mortgages. Deposit insurance is also quite common now and so deterioration in the quality of the loan book of a bank with low capital adequacy is less likely to undermine the confidence of depositors and lead to a banking crisis.

Financial stability implications apart, falling housing prices have a debilitating effect on consumption. The feeling of your property going deeper and deeper into negative equity is painful, particularly when your home is your only asset. Those who have been financing consumption by borrowing against rising housing prices are particularly vulnerable. Thankfully the community of Hong Kong is quite conservative in this respect.

 

Joseph Yam

6 October 2005

 

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