The weakest HK dollar in decades As Interest Rates Soar, But Why?

Finance 101 tells you that higher interest rates are bad for real estate prices. Since property is a very debt-dependent asset, when interest rates go up, the cost of financing debt used to acquire a property (i.e., mortgages) increases. That’s bad for the demand for real estate – and thus, real estate prices.

What’s more, when you look at property as an investment using the yield it generates (calculated as the total annual rental income as a percentage of the total property value), if a property yields say 3 percent, and interest rates rise, then the yield investors need when buying a property will also increase.

That means either rental income needs to increase – or the price of the property needs to come down (the same rental income on a lower property price equals a higher yield).

The Hong Kong property market is one of the most widely watched in Asia. Year after year, the headlines have tracked its relentless rise to become one of the most expensive real estate markets in the world.

As U.S. central bank, the Federal Reserve, raised interest rates on Wednesday in another 25 basis point (0.25 percent) hike, the era of low interest rates in Hong Kong is also coming to an end.

You’d think that might mean an end to the endless Hong Kong real estate bull market.

You’d be wrong.

The weakest HK dollar in decades

Since 1983, the Hong Kong Monetary Authority (HKMA), the de facto Hong Kong central bank, has pegged the Hong Kong dollar to the U.S. dollar, and implemented a permissible trading band in 1983 of 7.75 to 7.85 Hong Kong dollars to the greenback.

The Hong Kong dollar just hit its weakest level against the USD in over three decades, nearing the 7.85 band that has constrained the currency since the early 1980s.

The Hong Kong economy, however, is booming, growing at 3.4 percent annually in real GDP terms as of Q4 2017. Private consumption was up 6.3 percent year-on-year, the latest data show. Inflation is now showing a healthy 3.1 percent annual rise in prices (although below my personal estimates of inflation). The government is flush with cash, with a budget surplus of 7.5 percent of GDP and a public debt ratio of just 44 percent of GDP.

So why is the Hong Kong dollar weakening?

The first thing to point out is this: The Hong Kong dollar isn’t going to weaken much further. The HKMA will defend the peg by buying up Hong Kong dollars at 7.85 for USD.

Norman Chan, the head of the HKMA made that explicitly clear saying “HKMA will promise that the Hong Kong dollar will not weaken past 7.8500. This is the design and operation of the peg”.

But the reason for the weakening is straightforward – there’s simply too much liquidity sloshing around the Hong Kong financial system. As a result of this, the interbank lending rate (a measure of the rate of interest banks charge one another for Hong Kong dollar loans) remains very low.

And by “low,” I mean – specifically – compared to equivalent U.S. dollar interest rates.

Because the Hong Kong dollar is pegged to the U.S. dollar, Hong Kong “imports” U.S. monetary policy when it comes to interest rates – regardless of what Hong Kong’s economy needs.

(For example: If Hong Kong rates were to go substantially above U.S. rates and remain there, then investors would simply borrow U.S. dollars (paying a relatively low rate of interest), and buy HKD with its higher interest rates.

The currency peg promises that you don’t run any exchange rate risk when it comes to selling back your Hong Kong dollar to buy U.S. dollars and repay the loan (pocketing the spread between the two interest rate levels).

Because of the peg, we should expect U.S. and Hong Kong rates to remain roughly in lockstep. But take a look at the following charts for the past five years.

In the upper chart we see the historical U.S. one-month Libor (interbank offered rate) and one-month Hibor (Hong Kong interbank offered rate). The lower chart shows the spread between the two.

As the Federal Reserve has raised rates, U.S. interbank rates have risen. Likewise, Hong Kong rates have too, but not to the same extent. As a result, we are seeing the biggest spread between the two rates we’ve seen in a decade.

This in turn has led to a sell off in Hong Kong dollars. However, this has not been enough to force interbank rates higher.

Yet.

Abundant liquidity in the Hong Kong financial system is what is pinning down Hibor. And abundance of cash means the cost of borrowing it remains low. That should start to change soon. When the HKMA starts buying up Hong Kong dollars, it mops up excess liquidity from the financial system, which in turn should start pushing Hibor higher.

What higher rates mean

Higher Hong Kong interest rates do two things: firstly, they raise the cost of mortgages, 90 percent of which are linked to Hibor.

And secondly, as mentioned earlier, they realign investor return expectations on all financial assets at higher levels.

In the case of property, mid- to high-end residential property yields (i.e., the annual rental income as a percentage of the total property price) and commercial property yields are anywhere from 1.5 to 2.5 percent.

If Hibor goes to where Libor is now (1.85 percent), then real estate from an investment perspective really starts to lose attractiveness (both the cost of borrowing is higher, and the yield looks less enticing).

That, along with the fact that Hong Kong residential real estate has been in a 15-year bull market (see chart below) might make you think it’s time for the market to correct.

This is unlikely. Peter recently outlined why he thinks this to be the case. But in my opinion he omitted one key factor….

China

Official statistics suggest that around 5 percent of residential property transactions are done by mainlanders (people from mainland China). Stamp duties on non-residents or companies buying residential property are extremely high (15 percent and higher), and these types of buyers remain proportionally small.

But just because a Hong Kong resident is buying a property doesn’t mean the money is not Chinese money.

Nearly every real estate agent I speak to says that up to 30 percent of their sales business is coming through mainlanders. Many are residents of Hong Kong, and as they reach the seven-year residency requirement needed to get a permanent identity card, the first thing they do is buy property.

Others have family ties here who can buy property on their behalf (in their own name) to circumvent the high stamp duties.

Wealthy Chinese have, for years, been moving their money offshore. I wrote last year how Chinese were buying tens of billions of dollars’ worth of U.S. real estate.

I hear similar stories from bankers covering China. The sums of personal wealth are astronomical. And the Chinese love real estate. Hong Kong, with it’s British legal system, adjacent and ever-more connected to the mainland, will remain a haven for that money.

Higher interest rates or not, property prices aren’t likely to shift down substantially any time soon whilst the money keeps pouring in from the north.

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