• Following two years of painful economic adjustment, Hong Kong is still struggling with deflation due to the depressed housing sector.

• Property prices usually rise after the economy starts recovering, but the heavy debt load carried by Hong Kong residents relative to their savings is a hindrance.

• A genuine recovery in the property market can only occur when domestic income growth improves, under the conditions of lower interest rates and a reduction in excessive housing stock.

Hong Kong is undergoing a rare bout of deflation, brought on by the Asian financial crisis in 1997 and following a strong inflationary trend that lasted for decades in the territory. Economic contraction in Hong Kong has never previously resulted in inflation dipping below zero and recovery was invariably quick. The present deflationary situation is unique. On the one hand, the economic adjustment needed after the crisis was substantial; on the other, this adjustment could only be achieved through real cost reduction, as the linked exchange rate system prevents any nominal adjustment through currency depreciation. To restore external competitiveness, Hong Kong's property prices and wage costs had to fall and this inevitably led to serious deflation. In the more than two years since the outbreak of the crisis, Hong Kong property prices have roughly halved from their peak and wages have been slashed or frozen. Have they fallen enough to revive cost competitiveness and bring an end to this deflationary cycle?

Real cost adjustment is complete

A look at the extent of cost adjustment that has taken place will help to answer this question. Hong Kong's GDP has rebounded strongly since the second quarter of 1999, and soared by 14.3% in real terms during the first quarter of 2000. External trade was the main driver of this recovery, with rapid expansion in the trade of goods and export of services leading to significant improvement of the trade account. If the cost of doing business in Hong Kong were still expensive, trade activity would not be so robust.

In the labour market, the territory's unemployment rate remains high, currently at 5.1% in May 2000 compared with an average of 2.4% in 1997, while wage growth is sluggish. However, the situation has improved significantly in the past few months with the unemployment rate falling from 6.2% in October 1999. The number of employed is picking up strongly, which indicates that current labour costs are no longer too high for businesses to expand and take on more workers. On this basis, it would appear that the cost adjustment process, which began in early 1998, is complete.

However, if this were the case and cost adjustment was the cause of Hong Kong's deflation, then prices would stabilise. But the reality is that deflation is still with us. The inflation rate in May was -4.5%, not far off the average of -4% last year, and contradicts views that downward price pressure is dissipating in conjunction with a gradual revival in domestic demand.

An anatomy of inflation

A breakdown of Hong Kong's consumer price index (CPI) components gives us more insight into the deflationary situation (see Chart 1). Food prices account for roughly 30% of the CPI and are surprisingly the least deflationary item among the three largest components of the CPI. This is despite food prices having been on a declining trend, with import prices falling on the back of increased supply from mainland China. Food is a perishable necessity and there has been no need to clear excessive inventory; the drop in food prices over the past two years has not been as significant as the drop in other major CPI components. Although food prices are expected to fall further with declining import prices, they are unlikely to be a major drag on local prices.

Two other major components, consumer goods and services and housing, each account for 30% of the CPI and have experienced greater falls than the index. There has been a notable improvement in the consumer goods and services category as the domestic economy recovers, which supports the relationship drawn above between general price levels and economic adjustment. Price declines for consumer goods and services have moderated due to higher import prices and stronger internal demand, but lower rentals and wages have helped to prevent local prices from rising more than import prices.

Housing has had the greatest influence on the CPI, much stronger than its proportionate share of the index, and continues to be a drag on the overall price level. This suggests that a reversal of Hong Kong's deflationary condition will mainly depend on housing costs. If housing costs rise in the coming months, Hong Kong's deflation will improve, and vice versa. Thus, the question is whether property prices will rise in the foreseeable future.

Property outlook

The widely held view is that the excess supply of housing units will depress any rise in residential property prices this year. Indeed, there are some 60,000 vacant units and 25,000-30,000 new units will be made available in the second half of this year. Next year should see around 30,000 units of new supply in the market. Excess supply will not be absorbed so quickly, although pent-up demand from the past two years may help. Buyers are not likely to enter the market until there is some indication that the downward trend has bottomed out. Of more importance is the change in attitude towards property following the Asian financial crisis, whereby property is no longer treated as a major investment vehicle. This effectively reduces both speculative demand and the gearing for property investments.

A strong argument for a positive property market outlook is the greatly improved housing affordability ratio; housing prices have fallen substantially over the past two years, while household incomes have retreated to a much lesser extent. Despite some adverse interest rate movements over the period, the share of household incomes taken up by mortgage payments dropped markedly, which indicates that homes are more affordable today than they were in 1997. Using median household income as a measure, the affordability for a typical size unit has improved markedly in the two years since the end of 1997 (see Chart 2). This level is much better than the troughs of the previous two economic cycles, in 1994 and 1990, and suggests that current property prices are very attractive. If affordability were the only consideration for home buyers, with other factors at a constant, property prices could be assumed to have reached the bottom of the cycle.

However, at present the economy is not generating sufficient savings relative to its debt outstanding. The overall financial portfolio of Hong Kong residents has to improve before they will take on more debt. Under the current situation of wage freezes and high real interest rates, the tendency is to reduce rather than raise the burden of debt. Until a 'safe' level of debt has been reached in relation to savings, a larger mortgage would cause undue economic hardship. A sharp improvement in economic conditions is needed to improve prospects for wage and income growth, making it more acceptable to increase borrowings.

Many Hong Kong residents find it frustrating that savings are not growing fast enough to outpace borrowings, when comparing deposit savings with the total outstanding mortgage debt. This is despite the expansion in outstanding mortgage lending slowing in the past year. It is also in contrast to what happened after the 1994 slump, when the ratio (mortgage loans outstanding to deposit savings) fell sharply from a peak of 28% to below 24% (see Chart 3). The ratio did not start to climb again until the 1997 boom, surpassing 28% due to increased mortgage lending. The ratio has since remained at this peak, and indicates that aggregate debt remains too high for a revival of the property market to take place. This situation is also reflected by the dip in the economy's overall savings rate over the past two years, despite a strong rebound in economic activity.

There is no reason to invest in property with little hope of realising any capital gain and a disappointing rental yield. Compared with mortgage rates of 7.5-8.0% (prime less 1.5-2.0%), the residential property yield of 4-5% is obviously unattractive. Either rental rates have to rise significantly or interest rates have to drop close to the rental yield. Otherwise, a further drop in property prices to a level that makes property investment attractive (for rental return) is necessary. Since there is still a large number of vacant flats on the market, it is difficult to see rental rates rising markedly in the near term. Also, interest rates have yet to reach the peak of the present cycle, in view of current US interest rate movements. Under these circumstances, property prices have limited upside potential. A significant drop is not expected, however, given the magnitude of the downward correction in the last two years and the improved confidence following the change in the government's housing target.

As housing costs are still under pressure, deflationary conditions in Hong Kong have lasted longer than originally expected and are likely to see slow improvement given the current property price trend.

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Interest rates (as at 31 May 2000)