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Tuesday, October 14, 2003

Asia's Property Boom and Deflation

I think Andy Xie is getting his mind round an extremely important issue in this piece. The role of rising property prices in some economic development models, where the restrictions on land use and the favourable demography (lots of young, first-time buyers) create a positive feedback dynamic of tremendous importance. However when the demography turns, and the grwoth slows, this can turn itself into an equal vicious negative feedback process. I fear that this is precisely the outlook that Spain may have right in front of it.

Surplus savings in East Asia resulted from high savings rates in the economies that had fast export-driven growth but have now lost export competitiveness. Their savings rates are no longer compatible with their low-growth reality. Increasing currency values could force down their savings rates through income destruction via deflation. I believe this is a terrible strategy for them and the global economy. The right solution is to go through structural reforms.

The most important reform is to decrease the home value-to-income ratio. High property prices have kept savings rates high in these economies, as new households must save a higher proportion of their income to purchase a home in the future. Keeping property prices high is an effective strategy to keep taxes down and savings rates up. It is a necessary policy tool to maintain an investment/export-driven and high-growth model. It is essentially a leveraging strategy that forces households to subsidize production.

However, the savings rates in such economies become deflationary when they have to stop export-led growth, as they lose export competitiveness. There are two elements to this savings surplus story. First, capital in existing factories must go somewhere as they depreciate over time. Second, household net savings may be right for the property price but are too high for capital formation in industry. Decreasing property prices helps solve both issues. As property prices decline, new households need to save less to purchase homes in future. Lower property prices incentivize households to buy bigger houses. The combination could absorb the surplus savings............However, decreasing the property price has short-term wealth distribution implications, shifting wealth from older to younger households. Politicians are usually motivated to increase property prices in most East Asian economies. Political imperatives appear to conflict with a rational economic solution. Thus, East Asia must continue to buy dollars to keep deflation at bay. They effectively turn their factories into US treasuries.

East Asia is well known for its high savings rates. Cultural factors and demographics are usually cited as the main reasons. However, with the benefit of the hindsight, high property prices are an equally important factor. The Tiger economies experienced a jump in savings rate in the 1980s, accompanied by rapidly rising property prices.

China is now going through what the Tiger economies did in the 1980s. As public housing has been phased out, household savings behavior appears to have dramatically changed. China’s household savings rate has jumped significantly with the introduction of private housing to about 18% of GDP (or 24% of household disposable income) this year from 13% in 1997 -- the last year when public housing was assumed to be available. It appears that the trend of a rising savings rate in China is easing but has not stopped. It is not surprising that investment, exports, and the housing and auto industries have become strong in China, similar to the trends in the 1980s in the Tiger economies.

The politics of property in East Asia require rapid economic growth, which could keep property prices rising in line with or faster than per capita income, to make everyone happy. But high economic growth is possible only when an economy is competitive and has sufficient capital and labor. In the 1980s, for example, a rapidly appreciating yen made the Tiger economies more competitive, which allowed them to have rapid economic growth, high savings rates and rapidly rising property prices. The same phenomenon took place in the 1960s and 1970s in Japan.

Property-induced benefits for economic development are a form of leverage. It induces households to subsidize production during the high-growth period. Unfortunately, when high growth is no longer possible (for example, when an economy runs out of labor surplus and faces diminishing returns on capital accumulation as the capital stock rises), property prices must fall dramatically for the savings rates to be compatible with the low-growth reality. But it would redistribute wealth from older to new households. As most households are old in a mature economy, politics are not in favor of an active adjustment in property prices.

Instead, politicians may fight the inevitable property price decline to curry favor with property owners. That would push the economy into prolonged deflation, as its savings rate remains too high for its growth needs. Turning the surplus savings into foreign exchange reserves is an easy option to alleviate the pain. But, it forces other economies, mainly the United States, to borrow and spend. As the imbalance accumulates over time, it may cause instabilities in the currency market, casting doubts on the sustainability of such a policy.

Japan first slumped into this type of deflation induced by high savings and declining competitiveness. The Tiger economies appear to have followed in its footsteps. Japan’s deflationary adjustment has gone further than any other economy. Its savings rate has declined substantially. However, judging from the norms in other OECD countries, Japan’s adjustment is only halfway through. If its government does not pursue any active policy to adjust its property prices relative to its per capita income, it could face another decade of deflation. While this scenario is not a happy one, it is probably the most likely outcome.

Taiwan was the first Tiger economy to follow Japan. The IT boom covered up its deflation for a few years. Its land prices have declined by one fifth since 1995. There is much talk about stabilization in its property market. I am quite doubtful that Taiwan’s deflationary adjustment is over. Instead, the likely factor for less deflation is its aggressive policy to increase its current account surplus to 10% of GDP in 2002 from 3.8% in 1999. The temporary easing in deflation could only last if Taiwan continues to increase its current account surplus. The question is if its trading partners can tolerate this.

The most bizarre case is that Hong Kong, which has 8.5% unemployment and one-third of the mortgage borrowers in negative equity, is facing appreciating pressure on its currency. Its current account reached 12% of GDP last year from an average of -1.7% during 1995-97. While part of its current account surplus could be China’s capital flight, the trend is unmistakable.

South Korea is the only Tiger economy that has not seen deflation. Its property prices are still surging, as the surplus capital from weak capex tries to get into housing via low-cost mortgages. Korea could avoid the fate of other Tiger economies by expanding land supply dramatically to absorb its surplus savings, while keeping property prices low. Politics in Korea are in favor of stable property prices due to the country’s egalitarian culture. The country is fighting the rapid increase in property prices with discriminatory measures rather than with increasing supply. Korea may well follow other Tiger economies down the path of rising property prices followed by deflation.
Source: Morgan Stanley Global Economic Forum

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