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An Empirical Analysis of Malaysian Housing Market: Switching and Non-Switching Models A thesis submitted in partial fulfilment of the requirements for the Degree of Doctoral of Philospohy in Finance at Lincoln University by Zaemah Zainuddin Lincoln University 2010 Abstract of a thesis submitted in partial fulfilment of the requirements for the Degree of PhD in Finance.ct AN EMPIRICAL ANALYSIS OF MALAYSIAN HOUSING MARKET: SWITCHING AND NON-SWITCHING MODELS by Zaemah Zainuddin Increasing inflows of foreign investment particularly in the real estate sector in the early 1990s, has contributed to the building up of “bubble” in the economies of several Asian countries. In 2004, house prices increased rapidly in several countries such as South Korea, Hong Kong and Singapore (World Report, 2004). The rapid increase in prices has led economists to believe that a ‘bubble’ has form in the housing market. A housing market bubble occurs when house price increases are not justified by macroeconomic fundamentals and other underlying factors (Xia and Tan 2006). The effect of housing bubble bursts is seen in the loss of value to owners of capital, increase unemployment, slowing down of the economy particularly in housing-related sector. This study empirically test whether a bubble exist in the Malaysian Housing Market for the period 1990 to 2004. Using a general to specific approach from a simple multivariate liner regression model (OLS) to more sophisticated models such as Vector Error Correction Model (VECM), Vector AutoRegression (VAR), regime-switching (Markov-Switching),GARCH model and MS-GARCH, our result suggests that a semi-rational bubble does exist in the Malaysian housing market in 1997:Q1 to 1998:Q2. The deviations or fluctuations of the Malaysian House Price Index cannot be explained by the macroeconomic fundamental variables such as income, interest rate and inflation. Furthermore, the result also implies that Malaysian housing market is inefficient market due to the slow adjustment process towards its long run equilibrium price. The mean and variance of the MHPI is significantly different in the two states (boom and burst) which suggest that the Malaysian housing market had experienced a boom and bust of house price bubble prior to the occurrence of the 1997 Asian financial crisis. The results of switching model approach support the changing behaviour of MHPI in different economic states, implying possible existence of bubbles in the Malaysian housing market. Keywords: house price bubbles, regimes switching, GARCH, VECM ii Acknowledgements With the help and guidence by Allah, I was able to complete this thesis. I received a great deal of help and assistance in completing and putting this study together. It is a pleasure to express my appreciation to those who have inspired and motivated me throughout my Phd journey. Above all, I would like to express my deepest appreciation to my supervisor Assoc. Prof Dr Christopher Gan for his constructive comments, guidance, patience and valuable time in helping and editing this study. My sincere gratitude also goes to my associate supervisor, Mr Bert Ward who motivated me in learning and understanding econometric and statistical issues in this study. I would also like to thank my lovely and precious friends Yao, Pat, Lisa, Satit, Suriani, Athiah, Juhaida, Wan, Sabrina, Suraya, and Wan Munirah for all their supports, love and friendship throughout my studies at Lincoln University, New Zealand. I am also indebted to all the staffs at Student Learning Centre and the Faculty of Commerce for their guidance and help. It is my greatest pleasure to have such a wonderful experience studying at Lincoln University. Lastly, I would like to express my greatest appreciation to my parent, Zainuddin and Fatimah, my sisters, Zuhaida, Zahirah and Zuliana, for which I love and care so much. Thank you for your endless love and guidance without whom I would not be what I am today. I do owe a huge debt to my precious and lovely daughter Nur Atilia and my husband Muhamad Nizam. Your love and patience brought joy and happiness to my busy life as a student. Thank you Zaemah Zainuddin iii Table of Contents Acknowledgements .............................................................................................................iii Table of Contents................................................................................................................iv List of Tables......................................................................................................................vii List of Figures ...................................................................................................................viii Chapter 1 Overview of the study......................................................................................... 1 1.0 Introduction .................................................................................................................. 1 1.1 Background of the Study............................................................................................... 5 1.2 Problem Statement...................................................................................................... 12 1.3 Research Objectives.................................................................................................... 15 1.4 Significance of the Study ............................................................................................ 15 1.5 Organization of Thesis................................................................................................ 16 Chapter 2 An Overview of the Housing Market in Malaysia........................................... 18 2.0 Introduction ................................................................................................................ 18 2.1 Background of Malaysia ............................................................................................. 18 2.2 Overview of the Malaysian Property Market............................................................... 21 2.2.1 The Characteristic of Malaysian Housing Market ............................................ 23 2.2.2 Malaysian House Price Structure..................................................................... 26 2.2.3 Property Cycles in Malaysia ............................................................................ 29 2.3 The Mortgage Market in Malaysia.................................................................................. 38 2.4 Malaysian Housing Policy.............................................................................................. 41 2.5 Capital Control in Malaysia............................................................................................ 42 2.6 New Policies and Guidelines by Malaysian Government to Restructure the Real Estate Market after the 1997 Asian Financial Crisis............................................................... 44 2.7 Summary........................................................................................................................ 46 Chapter 3 Theories of Housing Bubbles ........................................................................... 47 3.0 Introduction ................................................................................................................ 47 3.1 The Concept of Bubble in the Housing Market............................................................ 47 3.1.1 Definition of Bubbles ......................................................................................... 48 3.2 Theories of Housing Bubbles...................................................................................... 52 3.2.1 Supply Side Economics Theory.......................................................................... 53 3.2.2 Keynesians and Shiller Theory........................................................................... 54 3.2.3 The Austrian School of Thoughts ....................................................................... 55 3.3 Price Expectation Theories.......................................................................................... 55 3.3.1 Rational Expectation Hypothesis (REH)............................................................. 57 3.3.2 Adaptive Expectation Hypothesis (AEH) ........................................................... 60 3.3.3 Exogenous Expectation Hypothesis (EEH)......................................................... 63 3.4 Signs and indication of bubbles in the housing market ................................................ 63 3.4.1 Phases of Bubbles in the Housing Market........................................................... 64 3.5 Review on Housing Bubbles Studies .............................................................................. 71 3.6 Conclusions.................................................................................................................... 79 Chapter 4 Housing Bubble Model....................................................................................