How Asia property becomes vulnerable when Fed tightens
EMERGING markets (EMs) have benefited tremendously from the sizeable liquidity injections by developed market (DM) central banks following the Lehman failure.
Among the major beneficiaries of this liquidity bonanza have been Asia's housing markets. According to the Bank for International Settlements (BIS), growth in nominal house prices ranged from 17 per cent to 130 per cent between 2008 and 2013, with an average increase of 52 per cent for the region.
However, the chapter of quantitative easing in the US has now closed, with the Fed widely expected to embark on interest rate tightening this year. Such a policy reversal could present a challenge for Asia's housing markets, particularly those facing stretched valuations fuelled by foreign credit infusion.
While the region as a whole has experienced a house price boom, valuations have risen by different amounts across countries. Some of this variation can be explained by genuine economic fundamentals, such as differences in growth rates and valuation, while others are driven more by speculation, which could be reversed in light of less abundant global liquidity.
To help investors identify areas of vulnerability, we develop a fundamental-based valuation model to assess fair values of house prices for eight Emerging Asian countries excluding China. Our model examines real house prices as a function of real economic growth and real borrowing costs.
Once the fair values are estimated, they are compared to current house prices to derive price misalignments.
Our model shows that five of the eight markets are currently over-valued, with Hong Kong leading the pack on a 20 per cent over-valuation. It is followed by Philippines and Malaysia, whose house prices are 16 per cent and 11 per cent above their respective fair values. India and Indonesia are moderately over-valued at around 5 per cent.
In contrast, house prices in Korea, Thailand and Singapore are currently under-valued by between 4.5 per cent and 7.5 per cent.
Over-valuation in house prices is one factor that makes a housing market vulnerable to monetary policy tightening. But it is not the only factor. Recent research suggests that economic fundamentals, such as the level of household debt, rates of inflation and economic growth, also matter for determining the impact of the Fed's policy on EMs. Taking cues from this work, we decided to supplement the measure of house price misalignment with the level of household leverage and the pace of credit growth to gain a more complete picture of housing market vulnerability in Emerging Asia.
We construct an overall vulnerability score for Asian housing markets, based on the degree of house price misalignment, the level of housing debt, and the size of capital inflows, proxies by the change in foreign exchange reserves.
The higher the score, the larger the vulnerability of the market to monetary policy normalisation by the Fed. Our calculation, which is standardised across countries, shows Hong Kong and Malaysia are the two most vulnerable markets to a global liquidity tightening.
In Hong Kong's case, this vulnerability comes from a large house price over-valuation, combined with a strong foreign credit infusion, while Malaysia is at risk because of its fast leverage increase. The Philippines and India's vulnerability comes from house price misalignments, while Singapore's risk stems mostly from capital inflows and leverage build-ups.
Note that housing markets in Singapore, Thailand and Korea are currently under-valued according to our model and hence are the least vulnerable from the perspective of house price misalignment. However, should the Fed's policy exit cause turmoil in Emerging Asia similar to that during the taper tantrum in mid-2013, housing markets in the region could all take a hit regardless of their initial valuation.
Should the turn of the US monetary cycle trigger a correction in Asia's housing markets, the economic impact could be severe for some countries. Unsurprisingly, Hong Kong faces the largest potential GDP decline, to the tune of 3 per cent, if house prices go back to their fair value. The Philippines will experience a similar adjustment if the 16 per cent price misalignment is fully unwound.
There are three main caveats regarding our analysis that readers should keep in mind: First, our analysis assesses the vulnerability of Asia's housing markets given the degree of house price misalignment, the level of housing leverage and the size of capital flows. It is not a prediction that a correction will occur, even in the most exposed markets, when the Fed embarks on policy tightening.
Second, our analysis makes no allowance for offsetting domestic policy changes that could counteract the impact of an external monetary shock.
Finally, our study examines house prices in real terms. Adjustments in real prices could come from falling nominal prices and/or a faster rise in inflation.
Furthermore, our calculation on the impact of a housing market correction assumes a full adjustment in the price misalignment. Yet, the correction may be a long and gradual process. Hence, its economic impact could be spread over time, reducing the impact at any given point.
The writers are economists at AXA Investment Managers. The above is an excerpt from a Feb 2 report.
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