Bloomberg recently had an interesting article (London and Hong Kong Facing Housing Bubble Risk, UBS Says) which ranked Hong Kong as the second most overvalued city in terms of property prices. Housing prices are up 60 percent since 2010 and UBS asserts that it is at the most risk of a housing bubble (along with London).

Hong Kong 1

It is interesting to note that the Hong Kong market serves as a playground for Chinese demand. There are three reasons for this. Firstly, taxes in Hong Kong are lower for luxury and consumer goods. Secondly, quality control in Hong Kong is stricter with little food safety lapses – baby formula, anyone? Lastly, the Hong Kong market is a medium for Mainland Chinese citizens to transfer money (both dirty and clean) out of China. Bloomberg’s China’s Money Exodus profiled the many ways Mainland Chinese citizens use to circumvent China’s capital controls on currency movements.

The Hong Kong market has essentially become a Chinese market, including properties. According to Midland Realty, Mainland Chinese accounted for 37 percent of new sales of luxury homes priced above HK$50 million in the first quarter of this year. This is not news for most people. Retailers in Hong Kong have already seen a slowdown in earnings due to a reduction in Chinese consumer spending. What is peculiar is that the Hong Kong property market has not seen a similar decline thus far. It could be that property prices are simply stickier due to their relatively inelastic nature. But I believe the real reason is far more sinister.

That is, Hong Kong property prices continue to be propped by Chinese demand, sustained by lowering interest rates. The Chinese central bank cut lending rates by 0.25% for the sixth time last October and further reduced the reserve requirement ratio by 0.5 points. There is going to be plenty of money flowing around and a portion of it will be going out of the country, as it always has been. It is anyone’s guess whether this has been anticipated or not – it is still fairly easy to transfer money out of the country through illegitimate means. It also explains why the Hong Kong government’s measure to curb property prices has been largely ineffective.

The bottom line of the situation is that Hong Kong’s property problem is likely to be a Chinese one instead. In such a scenario, the Chinese government is caught between a rock and a hard place to quell property prices in Hong Kong (or other regions) or to stimulate its own economy. Given the circumstances, it will not be surprising for the Hong Kong property market to see sustained demand from cheap Mainland money in the medium term. This bodes unnerving times for any investor vested in the Hong Kong property market, especially for REITs with their gearing covenants.