Hong Kong's residential property market has experienced significant changes since late-1997. Prices fell by about 50% between Q3 1997 and Q4 1998, and have since moved largely sideways during the past 15 months. Property prices have become a lot more affordable to many families.

Latest forecasts show that supply is ample and demand for home purchase has become much weaker as the perceived investment value of property has reduced significantly.

Hong Kong's public housing policy was set at a time when prices were rising and when demand exceeded supply. With market conditions now entirely different, the supply of public sector flats, particularly the HOS (Home Ownership Scheme) flats, is competing with the private sector for customers and is threatening the stability of the property market. There is an urgent need to review the government's housing strategy.

Because of geographic limitations (the lack of land) and economic prosperity in the past few decades, residential property prices in Hong Kong have been high by international standards. But as a result of the Asian financial crisis, prices of residential property adjusted downwards significantly (Exhibit 1).

While the existing level of property prices in Hong Kong remains high in comparison with other major cities around the world, the drastic fall in prices has made residential property a lot more affordable for many families in Hong Kong. Measuring the price of a medium-sized flat (the median size of a private sector flat in Hong Kong is about 50 sq m) by the number of years of the median household income, affordability of housing is now the highest since 1991 (Exhibit 2). Alternatively, affordability measured by the ratio of mortgage payments to median household income also shows a similar picture (Exhibit 3).

Providing shelter with basic facilities to those in need was the main purpose of the government's public housing policy during the two decades after the 1954 Shek Kip Mei fire.

As Hong Kong's economy took off in the 1970s, more and more families in Hong Kong aspire to own their own home. The desire to improve living conditions also rose gradually. In response to this, the emphasis of the government's public housing policy shifted gradually to assisting those families, which could not afford to buy a flat in the private sector, to buy their own home at an affordable price.

Since 1976, the government runs the "Home Ownership Scheme" (HOS) under which the government identifies land, designs the estates, builds the flats, sells the flats to qualified applicants, and manages these flats after they are occupied. These HOS flats are of better quality than the public rental flats. The aim of the HOS scheme is to encourage those tenants of the public rental flats, whose financial situation has improved over the years, to move out of the public rental flats by buying a HOS flat. This way, the public rental flat could be re-allocated to other families in need.

Part of the HOS flats will be sold to middle to lower income families who are not qualified to live in public rental housing because their income exceeds the threshold set by the government.

Soon after the HOS was introduced, the government also introduced a "Private Sector Participation Scheme" (PSPS) under which private sector developers bid for the right to build these HOS estates according to government design. The finished flats will be purchased by the Housing Authority at a pre-agreed price, for onward sale to buyers who are selected by the Housing Authority.

In subsequent years, other forms of subsidized home ownership schemes have been introduced. These include schemes run by the Hong Kong Housing Society (HS), such as the "Flat for Sale Scheme" and the "Sandwich Class Housing Scheme".

In the early-1980s, the government planned to build a total of 45,000 HOS flats in the following decade. By the late-1980s, the government's production target of HOS flats was raised to 15,000 - 17,000 per year.

In October 1994, the then Governor promised to provide 150,000 HOS flats in the six years from April 1995 to March 2001 (or an average of 25,000 per year).

In February 1999, the Long Term Housing Strategy White Paper set out plans to build 50,000 public sector flats in the following decade. While there is no mention as to how much of this 50,000 flats would be HOS flats, the White Paper re-affirmed the government's housing priorities established over the years. In particular, a 70% target by 2007 was set for Hong Kong's home ownership rate. This means that HOS will remain an important component of public housing policy.

By the end of 1999, the HOS, together with other variations of the scheme, have provided a total of about 285,000 flats (Exhibit 4).

Based on building work in progress, the government's forecast of public housing production is as given in Exhibit 5. These numbers show that there will be a substantial increase in the output of HOS flats in the years 2000 to 2004.

As prices of HOS flats are set at a discount to the prevailing market price, the demand for HOS flats has always exceeded supply during the 1980s and 1990s. This excess demand is also a strong reason for the government to keep increasing the amount of HOS flats to be built.

The number of qualified applicants for HOS scheme flats is affected by the qualifications set by government. Over the years, these qualifications have been altered to reflect changes in the government's housing priorities. The income limits have also changed as wage and income levels change.

A noteworthy change in the household size requirement was introduced in late-1999. This reduces the household size requirement from 2 to 1. The intention of the change as put forward by the Hong Kong Housing Authority is that it would enable non-elderly single-person families to enjoy the benefits of the HOS scheme, now that the supply of HOS flats has become more abundant.

But effectively, the reduction of the household size requirement from 2 to 1 has changed fundamentally the concept of the HOS which is to help families which are unable to buy their own homes from the private sector market. Any young person in Hong Kong, including university graduates, would find it to his/her interest that, apart from searching for a job, the first thing they should do when they leave school, is to apply for a HOS flat. They will be disqualified once their income exceeds the threshold set under the HOS. This change in requirement will not only increase substantially the number of qualified applicants for HOS benefits, but will also undermine the scope the private sector could play in the provision of housing in Hong Kong.

The surge in supply of HOS flats in the next few years is therefore worrying. The need to sell these HOS flats is likely to tempt the relevant authorities to relax gradually the qualifications of the potential buyers. The latest relaxation on household size is a clear example.

The glut of HOS flats happens at a time when the private sector market is also suffering from insufficient demand. Latest figures released by the Rating and Valuation Department show that supply in recent years has risen (due to a higher level of production when prices were high in 1996/1997). But demand has not recovered so that the vacancy rate has risen in the past two years (Exhibit 6).

Given the projected high level of supply in 2000 and 2001, and the prospects that interest rates are likely to rise in the coming year, it looks likely that supply will continue to exceed demand in the private sector market in the coming 15 months or so.

Latest indications are that prices of residential property in the market have been softening. Confidence in the prospects of the property market is fading gradually.

To minimize the disruptions of a large supply of public sector flats in the coming years on the functioning of the private sector market, one possible solution is to turn as much as possible the HOS flats into public rental flats. This move will also help to reduce the waiting time for those families who are in need of public rental housing.

Turning HOS flats into public rental flats is not a new thinking. In 1998, the Housing Authority turned 11,000 Harmony flats, which were destined to be sold under the HOS, into public rental flats.

Given the significant changes in the conditions of the residential property market in Hong Kong in the past 2-1/2 years, a fundamental review of some aspects of the government's housing policy are also called for. While providing more and better housing will remain a long-term target, there is a need to address the issues facing the property market in the next two years or so.

The role of the public sector in the provision of housing in Hong Kong should also be looked at. The production target of 85,000 units, of which 50,000 units are to be provided by the public sector, means that the public sector plays a dominant role in the provision of housing in Hong Kong. This is not necessarily in Hong Kong's long term interest.

The series of problems regarding the quality of some public housing estates are a reflection of some of the problems of having the public sector playing such a dominant role in the allocation of building contracts for the construction industry.

More and more people are likely to live across the border in the future. The impact of this on Hong Kong's housing policy has yet to be debated in the community.

The government has already introduced some interim changes to its long-term housing strategy, such as the reduction in the production of 21,000 HOS flats in the four years beginning with 2003.

But a more systematic review will prove to be fruitful.