Experience Gain from 1997 home prices crash in Hong Kong

In 1997, home prices in Hong Kong were in its final run-up to the all-time high which were unmatched even today.

Then it crashed as the aftermath of the Asian Financial Crisis.
What can you learn from the experience in Hong Kong?

And what does it imply for the housing market in the United States?

Centa-city Leading Index, showing home prices from 1997 to 2004, Source: Centaline

Home Prices in Hong Kong dropped 60-70% over that 6-year period after the Asian Financial Crisis. Although there were some growth in some of the years within this period, overall Hong Kong people suffered. After the financial crisis, there were years of deflation, and overall economy was extremely weak. Even though there were some growth, surely Hong Kong people couldn’t feel any.

Why? Why did the financial crisis caused 6 years of protracted home prices decline in Hong Kong. Reinhart and Rogoff found that in history, a financial/banking crisis would cause the real estate bubble to burst and fall for, on average, 6 years.

We don’t need any sophisticated economic theories to explain why such real estate bubble and its subsequent burst is so toxic. Real estate bubbles are inevitably accompanied by high leverage, as there are usually not many people who can really pay off the whole home price without any borrowing. In the time of real estate boom, banks are happy to lend because value of the collateral, i.e. home, increase in value, giving a false sense of safety. As more and more people lend, and as value of homes increase, an over-leverage condition would happen.

There are no bubbles that will not burst. When real estate bubble burst, home prices decrease, thus what seemed to be a very comfortable gearing would now become dangerous as the value of collateral falls. What is worse, the burst of the bubble often directly or indirectly lead to economic recession, pushing unemployment up, etc. For people who find themselves unable to make their mortgage payments, they are in default. If this became a system-wide default, Banks will have to make massive provisions for loan losses, thus compromising the capital position, tightening the credit. For those who are still able to pay, and pay, and at the same time because of the fall in their homes’ value, they might be in negative equity, i.e. the mortgages outstanding are more than the market value of their homes. The wealth effect would naturally lead them to spend less to pay mortgages, and save more.

This in turn would depress the consumption because people are spending less. This will lead to slower recovery, and as the aggregate demand for consumption is low under such condition, the risk for deflation would be high.

That is what happened in Hong Kong after 1997, and it took 6 years for the economy to recover to full strength. This is lucky, because economies like Japan has never quite recovered.

So what can you make of the experience of Hong Kong?