(Reprinted from HKCER Letters, Vol. 71 July/August 2002)
Public Housing Reform and Its Effects
on the Private Housing Market
Y.C. Richard Wong
Ever since the onset of the Asian financial turmoil, Hong Kong's public housing policy has come under considerable criticism. At the heart of the matter is the depressed state of the private property market. Since 1997, property prices have corrected by as much as 65%. Accumulated consumer price deflation in the past four years has been 12%, of which some 57% is due to the decline in housing prices. With a public still languishing in negative net worth after the collapse of property prices, it is not surprising that there is widespread concern over the large supply of public housing units in the pipeline (see Table 1).
Table 1: Production of Public Sale Flats for Sale (Housing Authority and Housing Society)
By financial year
% of total
By source of land
Urban Areas - HK Island, Kowloon, Sha Tin, Tseung Kwan O and Tsuen Wan
New Territories - Fanling, Outer Islands, Tuen Mun and Yuen Long
Blame for the current state of affairs has been cast in many directions. First, the negative wealth effect from the collapse of property prices has continued to exercise a dampening effect and to sap confidence.1 Second, the slowdown of the global economy as a result of the recession in the United States has worsened deflation and unemployment in Hong Kong and further weakened property market sentiments, despite declining interest rates. Third, the perceived structural adjustments that would need to be made in the labor market to maintain Hong Kong's competitiveness in the global marketplace have added to fears of cyclical deflation and unemployment. Fourth, the Housing Authority's (HA's) success, since 1995, in building up land reserves to develop Home Ownership Scheme (HOS) units received fresh impetus from an official policy, announced in 1997, to provide 85,000 units each year. The large supply of HOS units is clearly crowding out private housing demand in a slow property market. Fifth, cheaper housing available across the border in Shenzhen may provide homeowners with another choice. Sixth, reforms within the public housing sector have been blamed for reducing demand for private housing units.
Today, homes in Hong Kong are far more affordable than they have been at any time during the past two decades, and it is cheaper to pay mortgage loans than to pay rent. Nevertheless market sentiments remain weak. Why has confidence in the property market evaporated so dramatically? I believe that a great deal of damage was done by a factor that has been largely neglected in most public discussions-the creation of the HOS secondary market in 1997.
The emergence of the HOS secondary market undermined the functioning of the private property market. The creation of two separate markets, one subsidized and the other unsubsidized, altered the foundations of the property market and resulted in negative long-term considerations that have depressed market sentiments in a most devastating way. The structural malaise in the property market today stems from decisions made by the HA with the best intentions but without fully appreciating their consequences.2
The Failures of Public Housing Policy
There are 645,000 rental units and 300,000 homeownership units in the Hong Kong's public sector. Together they constitute 50% of the entire housing stock. Some 60% of the total annual supply of new units in the past 10 years have been in the public sector. This massive public housing sector is the greatest source of economic inefficiency in the community. In previous studies, I estimated the annual efficiency loss to be between 0.5% and 1.0% of gross domestic product. I also found that the population would on average consume more housing services if the subsidies were in the form of cash rather than bricks and mortar.
Even worse, this massive redistribution of housing resources has not improved inequality in any significant way. Figures 1 and 2 compare the income distributions of households in the public and private sectors, respectively, for tenants and homeowners in 2001. These figures show that the income distributions of households in the public and private sectors are essentially similar, except for the extreme end of the upper tail. This is a serious indictment of our public sector housing policy for targeting scarce public resources at the lowest income segments of our society. These resources are apparently redistributed to broad segments of society resulting in seemingly random outcomes. One consequence of such distribution is that the differential demand for housing between households in the public sector and those in the private sector are likely to be minor.
Retreating from Bricks and Mortar
Recent public housing policy emphases have gradually shifted away from the direct provision of housing units as the only means by which to subsidize housing consumption. Various loan schemes and the partial easing of transfer restrictions on public sector housing units have been introduced to enhance efficiency and equity within the public housing sector. I emphasize the word within because this was the new measures' primary focus. These measures were undertaken with no consideration for or understanding of their possible effects on the wider market. They have given rise to unintended consequences and have significantly increased uncertainty in the property market. Let me now provide three concrete illustrations of these changes and explain how they have affected the private property market.
1. The Emergence of the Home Ownership Scheme Secondary Market
The first example relates to the partial relaxation of the transfer restrictions on HOS units. In 1997, a secondary market for HOS units was introduced for units that had been occupied for three years. Eligible households, constituting some 50% to 60% of all households, could trade in this market. In this market, owners of HOS units could trade their units without having to return the subsidized portion of land premiums to the HA. A fairly active HOS secondary market was soon created. The size of this market will grow over time as more HOS units are built and existing units become eligible for transfer.
After five years, HOS units could be traded on the open market, but any gains from subsidized land premiums had to be returned to the HA. With this restriction in place, there was little incentive for owners of HOS units to sell their units on the open market, and they seldom did.3 The HOS secondary market, however, provided them with a previously unavailable opportunity to trade their units at a discounted price that they could easily afford. This increased the attractiveness of HOS units enormously for existing and prospective owners. The creation of the HOS secondary market made HOS and private housing units closer substitutes for one another and most likely has had a significant effect on the decline in demand for private housing units.
Recent attempts to tighten income and asset eligibility criteria for applicants of HOS units will only affect prospective owners; they will not affect existing owners. Since the latter are far more numerous than the former, the negative effect on the private market will remain substantial. The problem will be further exacerbated if old sites in the urban areas under the HA are redeveloped into new HOS estates. The locations of these estates are extremely attractive. The supply of new HOS units in desirable sites will further augment the quality of the units in the HOS secondary market, and these units will compete with private housing units for demand in the future.
The HOS secondary market was a well-intended policy to provide a means for a partial freeing up of "locked-in" landed resources among eligible households. These households were therefore provided with an alternative market in which to trade units at a discount. Units in the HOS secondary market and those in the private housing market may not be perfect substitutes for each other because of differences in quality and discounts on land premium. These differences, however, narrowed considerably after the collapse of the private property market and the improving quality of HOS units, overall.
2. The Introduction of the Tenant Purchase Scheme
The second example relates to the Tenant Purchase Scheme (TPS) introduced in 1998, which called for the sale of 250,000 public rental units over a 10-year period. The sale of public housing at highly discounted prices creates wealth and should increase the demand for housing, including for private housing. The TPS was therefore a potentially market-boosting policy. Unfortunately, however, it had the opposite effect, because other measures were introduced at the same time.
First, sitting tenants who acquired TPS units at a considerable discount were allowed to apply for HOS units within 10 years as White Form applicants. This meant that at least 250,000 households in public rental housing units were enticed to wait out the 10-year period to acquire, first, their TPS units, and then to apply for an HOS unit. The creation of the HOS secondary market in 1997 transformed HOS units into an attractive market commodity. These measures together killed off any incentive for prospective TPS beneficiaries to plan future home purchases in the private market. The TPS was clearly a success as judged by the high take-up rates, but it led to a serious negative knock-on effect on the private housing market. The real damage to the private housing market was not the immediate loss of buyers from among the ranks of prospective TPS households but the fact that these buyers were expected to leave the private housing market more or less permanently.
The behavior change is reflected in the dramatic drop in the number of successful Green Form applications for HOS units in the years following 1997. In 1997 about 74% of the new HOS units were sold to Green Form applicants, but in 2001 White Form applicants took ownership of some 78% of these units. Given the large supply of new HOS units coming onto the market, the HA was effectively competing with the private housing market for buyers.
Table 2: Statistics on Green Form and White Form Applicants for Home Ownership Scheme,
% of Green Form
to Total Units
Source : Hong Kong Housing Authority
The sale of public rental housing at a discount would not have resulted in the negative knock-on effect that was just described in the absence of two measures: (1) the option to allow TPS buyers to reapply for HOS units as White Form applicants within 10 years and (2) the creation of an HOS secondary market. The sale of public rental units would in fact have created a positive wealth effect.
TPS units can only be transferred on the open market after five years, but the owners must return to the HA any gains from the discounted land premium. As for HOS unit owners, there is really no incentive for TPS unit owners to sell their units on the open market. Had the HA sold all 250,000 units with immediate transferability on the open market, and had it not required owners to return the gains from the discounted land premium, it would have produced a hugely stimulating effect rather than a dampening effect on the private housing market.
It is not the sale of public rental units as such but rather the specific provisions of the TPS design and, crucially, the creation of the HOS secondary market that produced the negative knock-on effect. To make matters worse, the HOS building program was not reduced commensurately with the introduction of the TPS scheme and the creation of the HOS secondary market.
3. Applicability of the Home Purchase Loan Scheme
The third example relates to the HA's 1998 decision to permit the Home Purchase Loan Scheme (HPLS) to be applied to the purchase of units in the HOS secondary market. Before that decision was made, HPLS loans could be used only for the purchase of private housing units. The number of HPLS loans granted jumped from 2,979 in 1997/98 to 9,832 in 1998/99. The proportion of HPLS loans granted to Green Form applicants in the three years from 1995 to 1998 was two-thirds, but in the three and half years from 1998 to 2001 it was over four-fifths. Moreover, in the period from 1 August 1999 to 31 March 2001 some 55% of the HPLS loans among Green Form applicants were used to purchase units in the HOS secondary market.
Table 3: Use of Home Purchase Loan Scheme among Green Form and White Form Applicants,
No. of Loans and Subsidy Granted
No. of Public
#Figures are up to September 2001
Source : Hong Kong Housing Authority
Simple Economics of Two Housing Markets
Under the bricks and mortar approach, public sector housing units were nontransferable; therefore, a market for public housing sector units did not exist. Households in the public sector could not trade their units in any way. Every household in that sector was locked into its original unit. Only private sector housing units could be transferred, and the private housing market constituted the only housing market in the system. Without transferability, the effect of the public program on the private housing market was limited to the supply side (i.e., the annual flow supply of public sector units). With transferability, a huge stock of units in the public housing sector was liberated, and the result was an enormous impact on the private housing market. The scale of the effect is many times larger than that due to changes in the annual supply.
The HA reforms created a new secondary market that is distinct and separate from the existing private housing market. The introduction of various financial subsidies and the partial easing of transfer restrictions has meant that a large proportion of the entire stock of housing units in the public sector is now transferable in the new HOS secondary market among eligible households. The introduction of the TPS in 1998 will further increase the future supply of units on the HOS secondary market. Over time this secondary market will continue to grow as new HOS units are constructed, as more existing HOS units becomes transferable, and as more TPS units are sold and become transferable.
Table 4: Stock of Units in the Home Ownership Scheme Secondary Market
Stocks of Units in the HOS Secondary Market
Of which : HOS/PSPS/FFSS#
Of which : sold for 2 years but below 5 years
sold for over 5 years
# As at the end of 2000/01, the cumulative number of HOS/PSPS premium payment was 21722. The figures are adjusted for this number.
Assumptions: (1) TPS take-up rate = 70%; (2) HOS/PSPS/FFSS take-up rate = 100% from 2001 to 2004;
Source: Rating and Valuation Department, Hong Kong Property Review, various issues, Hong Kong Housing Authority
The distribution of household income of tenants and homeowners in the private housing sector is not significantly different from that of those in the public housing sector. This guarantees that the demand for private and public units will overlap almost totally. Economics tell us that when there are two markets-one subsidized and the other unsubsidized-that overlap considerably on either the demand or the supply side, the subsidized market will drive out most of the activity in the unsubsidized market.
The HOS secondary market has created awkward and perverse incentive effects. First, financial subsidies are provided on the demand side. Second, the market has a monopolist developer that collects sales revenues on the supply side to provide financial subsidies on the demand side. Moreover, this developer is an avowed nonprofit maximizer. How should this monopolist developer set prices and determine output? If it does not seek to set sales prices to maximize profits, how should prices be set? How should it set financial subsidies for loans and determine the quantity of loans? How should it set rents for public rental housing? I do not believe that anyone knows what sort of decisions will actually be made, except that they will be highly political and subject to the vicissitudes of every noise and squeak in the market. This means a great deal of uncertainty for the housing market. Clearly the decisions made by the HA with respect to the public sector will have consequences for the private housing market. The HOS/TPS market guarantees that the effects will be amplified many times. But where is the mechanism to ensure that the HA's decisions will be the right ones for the entire housing market? In the absence of such a mechanism, many decisions will lead to unintended outcomes that would not have been foreseen at the very beginning.
As the HOS secondary market continues to grow, HOS units will become increasingly attractive as an alternative to private housing units because of their transferability in the secondary market. This will create a powerful disincentive for households to exit the public sector and enter the private sector. The trading-up ladder that was previously present has now been largely eliminated. It is important at this point to recall that private-housing-sector tenants' and homeowner' income distribution is virtually identical to that of tenants and homeowners in the public housing sector. This similarity not only kills any incentive to move from the public sector to the private sector but also provides powerful incentives for those in the private sector to move to the public sector.
Under this new situation, the public and private housing sectors are linked not only through annual supply flows but also on the supply and demand sides in terms of both annual flows and a large proportion of the total stocks. When such broad stock and flow linkages on both the demand and supply sides are permitted, it will no longer be possible to keep these two sectors separate.
On the Need to Restore a Single Housing Market
The creation of a separate market for public sector housing units made it possible for many public housing tenants and homeowners to address one of their most pressing housing aspirations-to change their residential location within the territory. The demand for private housing units was immediately negatively impacted as a consequence. While the creation of a market mechanism for facilitating the transfer of public housing units constitutes an improvement over the earlier situation, it has resulted in inevitable spillover effects. The current lack of activity in the private housing secondary market is primarily a reflection of the breakdown of the trading-up effect created by the HOS secondary market.
The public housing reforms should have been designed to create a single housing market rather than two separate markets. Unifying the two markets as soon as possible is a policy matter of the utmost importance and, moreover, would be very simple to achieve. The key issue is to enhance the incentive for owners of HOS and TPS units to trade on the open market. This can be accomplished by reducing the amount of subsidized land premium that has to be returned to government when a unit is sold. If half of the discounted land premium has to be returned, there will be a strong incentive for HOS households to pay back the land premium and the two markets will then become unified. Once such a measure is announced, prices in the HOS secondary market will immediately reflect the enhanced value of HOS units, as households will be unwilling to trade units at prices that fail to reflect the reduced land premium.
It is in the interest of all parties to offer such discounts to HOS and TPS homeowners. Doing so is a simple way to stimulate consumption and investment activity through an injection of property wealth. Moreover, the decision to unify the two housing markets would eliminate an important uncertainty in the marketplace. If public sector homeowners never sell their units on the open market, the government will never be able to collect this future income stream. Since the land has no alternative use under the present arrangement, the net loss to the government may be very limited and may even be reversed if the land can later be redeveloped through the private market for a more highly valued use.
The notion that such a measure would be unfair to other citizens is beside the point given that the benefits of using the units have already been transferred to the owners. The owners would merely have the freedom and opportunity to realize these benefits at a time and in a form they chose, rather than being compelled to consume its value in-kind and over a very long horizon. Moreover, such a measure would allow society to realize an estimated $150 billion in wealth, if not more. HOS and TPS homeowners would capture half of this wealth, and the other half would go to the government in the form of paid-up land premium. This would go a long way toward recapitalizing our economy at a time when sentiment is negative and the fiscal deficit is growing. The measure would cost society virtually nothing, given that the occupied land has little alternative use under present regulations.
The unification of the HOS secondary market with the private market should be undertaken in conjunction with measures to end the HOS program. We shall then have a consistent policy to restore a single private housing market. Public policy aimed at assisting qualified households to become homeowners can be achieved through a more cost-effective scheme of loan subsidies rather than via a bricks and mortar approach.
A public rental housing program may continue to exist to help society's truly needy; however, wherever possible a subsidized rental scheme should also be operated to provide qualified households with a choice. A thriving private rental market will provide the housing market with long-term stability. A properly functioning rental market will also need a better balance in tenancy contracts and their enforcement to protect not only the rights of tenants but also the rights of landlords against errant tenants.
Given that the HOS program will be terminated, all existing HOS units still under construction, and completed HOS units that have not been sold, should be redeployed for other purposes, for example, as rental units on the open market.
Land made available for the development of new HOS units should be transferred to the private domain. Revenue derived from these land sales would be adequate to provide loan subsidies to help the needy finance property purchases and rental subsidies. This is the best time to end the HOS program given the considerably deflated prices in the private housing market. Such a move would send a clear signal that the government is reducing its role in the property market.
1 A number of recent analyses have shown that over 50% of the deflation experienced in Hong Kong can be accounted for by the fall in housing prices. The negative wealth effect due to the decline in property prices on consumption expenditure has been strongly confirmed in a study titled "The Property Market and the Macro-Economy" published in the HKMA Quarterly Bulletin, May 2001.
2 It is interesting to note that the creation of two separate markets, one subsidized and the other unsubsidized was proposed by Ho Lok-Sang in "Towards an Optimal Public Housing Policy," Urban Studies (U.K.), Vol. 25, 1988, pp. 204-211. I believe that the HA's decision to create the HOS secondary market was made without considering the ideas presented in this paper.
3 In fact, over the entire 30-year-history of the HOS program, only 12% of the units have been sold and the subsidized land premium repaid.