The US$ Printing Press, Devaluation, Inflation, and Export of Defective Financial Products

Stephen Chung

Managing Director

Zeppelin Real Estate Analysis Limited

December 2007

An American friend recently told your humble author that while the USA accused China of exporting defective toys, the USA was also busily exporting defective financial products in the form of CDO (Collateral Debt Obligations) and securitization of questionable sub-prime mortgages. Up to the writing of this article, news of major financial institutions having to further write down their sub-prime investments and to have a change of guards, i.e. with CEOs, Chairpersons resigning, are still making headlines.  

The above is certainly no isolated event but is part and parcel of the US$ printing press because if the financial systems have not been flooded with money, sub-prime mortgages could not have been made available. Such macro concerns were also raised in a recent seminar held jointly by the Royal Institution of Chartered Surveyors and the Hong Kong Institute of Surveyors on asset management in which your humble author was also one of the invited speakers. Here are some of the salient points: 

A)     The US$ printing press started at the beginning of this century after the tech internet bubble burst = and was further entrenched by 911 with a view to prevent recessions. Essentially, lower interest rates do enable easier financing which helps push up asset prices, homes included, which in turn help sustain consumption, albeit at the expense of a weaker US$. This weakened US$ has recently raised concerns among foreign central banks whose (US$ dominated) reserves have been suffering as a result. Some are being enticed to take on more Euros as pouring their hard-earned Greenbacks (via exporting to the USA) back to Uncle Sam (via buying US Treasuries) makes less sense nowadays.

B)     Economies whose currency is pegged to the weaker (devalued) US$ can expect to see asset prices going up = to make up for the fall in the currency value, assuming all other aspects remaining the same. As such, it is not unreasonable to expect increases in Hong Kong real estate prices.

C)     Expect higher (actual) inflation in the USA and in US$ pegged economies = than what may be reported in public statistics as some of the calculation models may not be entirely reflective of current consumption patterns and behaviors. For instance, while sports shoes, clothing, toys etc may still be inexpensively priced thanks to low-cost production in China, India, or other emerging economies, these items occupy only a small fraction of a typical middle-class family budget. What matters may be services such as health care, vacation, quality entertainment, education, and so on. These are not and will not be inexpensive, and the challenge will likely become greater as the baby-boomers start retiring in huge numbers worldwide.

D)     Global asset price appreciation appears related to the US$ printing press = improved productivity, globalization, internet, and the like notwithstanding, the general global trend in asset price appreciation, real estate ones included, seems to have been a result of increased liquidity brought about by (artificially) low interest rates. The China economy is no exception and such liquidity also shows up in its asset price appreciation directly or indirectly, be these related to equities or real estate.

E)     Multiplying effect (and dividing effect too) = a significant portion of such increased (increasing?) liquidity takes the form of debt which in turn pumps up asset prices (equity) YET sustaining such increased equity requires further and continuous debt input. This increased liquidity also compresses the cap rates and yields i.e. successive investors need to take on increasingly higher risks in order to produce the same return obtained prior. In addition, a significant portion of the stated (global) capital may mask certain overlaps (or double-counting, triple counting etc). For instance, a pension fund may have $100B under management of which $50B are allocated to other funds who in turn allocate $30B to further fund companies and so on and so forth, thus creating eventually (an impression of) multiples of the original $100B even without financing. No major problems would arise while all these keep going on yet when the situation reverses itself, all hell will break loose with much of the created equity gone, dwarfing the Asian Financial Crisis and mimicking the Great Depression. 

Some widely held beliefs are also nonsense: 

1)     Nonsense No. 1: Interest rates down, real estate prices up, and vice versa = in the past 10 or so years, the markets appear to have believed that lower interest rates are good in that asset prices will go up owing to better affordability. However, this notion only has only held true since the mid 1990s where prior from 1950s to mid 1990s it was ‘the higher the interest rates, the higher the real estate prices’ based on the USA residential real estate price performance. Hence, is there a paradigm shift in the relation between interest rates and asset prices, or is it just a mathematical coincidence? Your humble author bets it is the latter. What drives asset prices is liquidity i.e. the higher the liquidity, the higher the asset price, and vice versa, regardless of what the interest rates are at the time.

2)     Nonsense No. 2: real estate is a good hedge against inflation = for most of the time it does ‘seem that way’ though there are certainly occasions when the return for real estate cannot even beat the CPI e.g. Hong Kong real estate prices from 1997 to 2003. However, ‘seeming that way’ may also be coincidental only or holds true only under certain circumstances. More rigorous research is required here.

3)     Nonsense No. 3: real estate beats other asset types in return performances = most of the data compilations which support this statement tend to involve the baby-boomers i.e. people born right after WWII up to around the early 1960s. This generation, to which your humble author belongs, is more numerous (and generally wealthier) than the earlier generation and as such was and still probably is a formidable economic force driving up asset prices for the past 30 years or so, including real estate, residential ones in particular. YET to conclude that real estate return beats all else just by observing the post-WWII years could be premature and illusionary.

4)     Nonsense No. 4: China real estate is different (or different this time) = we have heard this all before and several times too! To date, all such ‘different’ market phenomena proved no different to markets before them and China markets cannot defy gravity. If anything is to eventually prove different, it is the investors in China are collectively and comparatively less seasoned and greener than counterparts in more matured economies. Translation: easier to panic and higher volatility.

Notes: The article and/or content contained herein are for general reference only and are not meant to substitute for proper professional advice and/or due diligence. The author(s) and Zeppelin, including its staff, associates, consultants, executives and the like do not accept any responsibility or liability for losses, damages, claims and the like arising out of the use or reference to the content contained herein.                                

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