Residential property prices are near record highs as the tiny island has been squeezed between Chinese money looking to escape the mainland and the ultra-loose monetary policies of the US Federal Reserve.

For local banks facing the risks of a bubble bursting, the great saving grace is that there are quite strict limits on the loan-to-value ratios allowed for mortgage lending. Even with a heavy drop in prices – some are predicting up to 30 per cent falls this year – losses should be limited. However, in combination with rising interest rates and the ebbing of both the Chinese economy and US liquidity, small property price declines will be painful for the island’s most sophisticated banks.

The money flooding into Hong Kong, much of it from China, has been eye-popping in the past couple of years. Home prices are 20 per cent higher than the previous record set in 1997, just ahead of the Asian financial crisis, according to the Centaline Index, from the city’s largest estate agency.

Most apartments in Hong Kong cost between HK$10,000 (US$1,300) per sq ft and more than HK$30,000 – which in London, for example, is barely matched by the most exclusive inner-west areas of Kensington, Chelsea or Marylebone.

The flood of cash has come in other ways too. Sales of watches, jewellery and luxury gifts remain fabulous in spite of the crackdown on corruption in China. Almost one dollar out of every four spent in the city’s shops last year went on such things, hitting a total of $15.2bn, which was 25 per cent higher than the year before, according to government statistics.

Even the most ardent proponent of the “trickle down effect” would struggle to show how normal people had benefited in any way from this kind of spending, but it is unarguable that Chinese money has driven Hong Kong in many ways. On the flip side, though, the correlation between property price rises and the expansion of the Fed’s asset base shows the influence of US monetary policy – which is beginning to change course.

Hong Kong faces similar issues to other small Asian economies. Rising interest rates and the slowing of the biggest economy in Asia spell an end to special conditions enjoyed over the past few years, which have pushed down default rates and losses to lenders to negligible levels. For southeast Asia, the rising cost of money and the growing scarcity of foreign money in capital markets is coming at the same time as current accounts have deteriorated and local banks have seen deposit funding shrivel. Companies and people have spent more and saved less. The risk is a whiplash effect on the cost and availability of credit, the ability of locals to service their loans and the losses banks will suffer as a result. The influence of Fed policy has pushed local interest rates lower than theyshould have been given economic fundamentals (the BIS reckons 1.5 percentage points lower on average across emerging markets), so the unwinding looks likely to send them much higher than they ought to be for local conditions.

In Hong Kong, these problems are familiar. The HK Monetary Authority has reported that local deposits were shrinking and loan to deposit ratios rising in both local and foreign currencies. The authority has warned on the sharp increase in US dollar loans, especially to offshore, mostly Chinese borrowers. This borrower behaviour, predicated on higher interest rates inside China and an always appreciating renminbi, has been exposed now that the currency is changing direction.

For Hong Kong’s most sophisticated banks, however, there is an extra sting in the tail. Coinciding perfectly with the special conditions unleashed by US Fed policy, the HKMA allowed HSBC, its subsidiary Hang Seng Bank and Standard Chartered, to introduce advanced internal ratings-based capital measures in 2008.

These let the banks hold less capital when asset values are high (particularly property) and credit performance is good. This is highly pro-cyclical. Analysts at Morgan Stanley believe it has allowed those three banks to lower dramatically risk-weighted assets as a proportion of total assets even as overall lending has accelerated. What is worse is that the authorities have allowed the banks to ascribe similar risks to corporate borrowers outside Hong Kong as to those inside. Offshore loans have gone from 10 per cent of total lending to more than 30 per cent since 2006.

Morgan Stanley’s analysts do not believe Hong Kong’s big beasts will need to raise capital to cope, but more capital will be needed to cover existing loans and so will not be available to back new lending or to fund dividends. Just like interest rates in Asia, growth and payouts for Hong Kong’s big banks look likely to whiplash too.