According to my high school economics teacher, the price of a product is set at where the supply and demand curves intersect. Theoretically, if some force were to act on the supply or demand curve and shift it inwards or outwards, this will result in a new equilibrium price. This is how things are supposed to work.
As we noted last week, Hong Kong’s housing supply has increased by 31% over the past three years. Whether this was due to higher prices causing developers to increase supply (i.e. moving up the supply curve) or a more proactive government supplying land (i.e. an outward shift in supply curve) is up to debate. What is clear is that supply has definitely increased.
Ironically, Housing Demand is Driven by Money Supply
This week, we turn to the demand side of the equation. Ironically, in order to gauge housing demand, we will be looking at “Money Supply”.
M1, M2 and M3. No, not BMW’s but Money SupplyEmbed from Getty Images
Simply put, money supply is how much money there is in circulation or in existence in a country. Economist generally measures money supply using three terms – M1, M2 and M3.
- M1 is the narrowest definition. In Hong Kong, it would include all of the physical notes and coins in the hands of the public as well as demand deposits in the bank. As of Oct 2017, Hong Kong’s M1 money supply stood at HK$2,997bn.
- M2 includes all of M1 and adds all of the deposits with licensed banks (i.e. savings deposit, time deposit and negotiable certificate of deposit). As of Oct 2017, HK’s M2 money supply was HK$13,951bn, roughly 4.7x the size of M1.
- M3 includes all of M1 and M2 and further adds deposits with restricted licence banks and deposit taking companies. In HK, M3 is only slightly larger than M2 at HK$14,003bn.
M3 has increased 27% over the past three years
Over the past three years, Hong Kong’s M3 money supply has increased by 27% from HK$11trn to HK$14trn. Narrow money supply, M1 (i.e. the notes and coins in circulation as well as demand deposits) increased by 71% from HK$1.75trn to HK$3trn.
If one were to go back to the onset of the Global Financial Crisis back in October 2008, Hong Kong’s broad money supply, M3, has more than doubled, rising 131% from HK$6trn to HK$14trn.
Incidentally, home prices have risen 27% also
Incidentally, between October 2014 to October 2017, Hong Kong’s home price index has risen by 27%. And between October 2008 to October 2017, the Rating & Valuation Department’s home price index has increased by 196%.
That’s the past, what about the next three years?
Looking back, we can reason that with a larger pool of cash shifting out the demand curve, asset prices have increased. Now, the questions is what will happen to Hong Kong’s money supply in the next three years?
The way that I see it, there are three factors at play.
- Potential in/outflow of global liquidity
- Will HK banks increase their loan-to-deposit ratios?
- Change in reserve ratio and discount rate
Central Bank balance sheet expected to shrink sometime in 2018
Hong Kong being a small open economy has and will be subjected to change in global liquidity conditions. Over the past 10 years, a big driver of its money supply has been the expansion of the various Central banks’ balance sheets. Looking ahead, with the US Fed starting to allow its holdings to roll off and the ECB expected to taper its asset buying program, Central bank balance sheets are expected to start to shrink sometime in 2018.
Will HK banks increase their loan-to-deposit ratios?
Assuming that global liquidity flows are unchanged, another way to increase money supply would be for the banks to increase lending by raising their loan-to-deposit ratios. As of October 2017, Hong Kong banks’ loan-to-deposit ratio is only around 71%. Although this has risen by more than 10pp since 2008, one could argue that there is still scope for this figure to head higher and banks to lend more.
However, if one were to consider the rise in household debt, I have my doubts on how keen the banks are to further increase their lending to households.
According to the HKMA’s Half-Yearly Monetary and Financial Stability Report, Hong Kong’s household debt-to-GDP ratio has climbed to 68.3% in 1H 2017. Two things shout out at me when I look at the chart below. Firstly, 68.3% is the highest household-debt-to-GDP that Hong Kong has seen since 2000 when the data started. Secondly, look at the breakdown of this debt. Mortgage and credit cards have remained broadly stable but “Loans for other private purpose” has driven almost the entire increase in household debt.
I’m not sure what this is but judging by the commercials on prime time television, it is probably people consolidating their credit card debt or taking out high interest loans to fund their down payments to fill the gap from residential mortgage LTVs have been capped.
For now, as long as liquidity is plentiful and asset prices are rising, this number may yet rise. But my guess is that when the tide goes out, this would be one of the charts that people point to and say we should have seen it coming.
Change in reserve ratio and discount rate
Just like the first two questions, the reserve ratio question is debatable. Some would argue that although the discount rate has risen from its low of 0.50% to 1.50%, it is still very low and Central banks would surely come to the rescue and cut reserve ratios and discount rates on any sign of trouble.
This could happen but unlike 2007 when the discount window was reduced from 6.75% to 0.5% within a span of 18 months, there is a lot less ammo this time around. Furthermore, with the HKD pegged to the USD, for our base rate to be cut, it would require a synchronised downturn with the US.
Three key takeaways on demand
- Hong Kong’s money supply has increased by 27% and 131% since October 2014 and October 2008. This is coincidentally close to the 27% and 196% increase in local home prices over the same period.
- Will HK’s money supply continue to expand in the next three years? Well, we know that:
- the G4 Central bank balance sheet is expected to start shrinking sometime around Q2/Q3 2018.
- Although overall LDR at 71% is still low, HK’s household debt-to-GDP ratio at 68% is the highest that it’s ever been at. Furthermore, this increase has almost entirely been driven by “Loans for other private purpose”
For the die-hard property bulls, yes, it is possible that Central banks can put off shrinking their balance sheet and banks can increase their lending even more. But, with the Fed clearly spelling out their asset reduction program and household debt-to-GDP at the highest levels ever, to hope that Hong Kong’s monetary base will expand at the same pace would require one to turn a blind eye to some clear and present risks.