Housing Markets, Financial Stability and the EconomyBy Min Zhu
Deputy Managing Director, International Monetary Fund
June 5, 2014
As Prepared for Delivery
1. Let me begin by thanking the Bundesbank and the German Research Foundation for organizing this conference with us.
2. I will make three points in my remarks:
- First, housing is an essential sector of the economy but also one that has been the source of vulnerabilities and crises. Hence, while the recent recovery in global housing markets is a welcome development, we need to guard against another unsustainable boom.
- Second, detecting over-valuation in housing markets is still more of an art than a science. Broad measures, such as house price to rent ratios, provide a first pass. But detailed analysis and judgment are needed to make a call about overvaluation.
- Third, the policy toolkit to manage housing booms is still under construction. A variety of tools have been used and the evidence suggests some short-run success. But more analysis and sharing of experience are needed on what works and what doesn’t. Conferences of this kind are useful in adding to our stock of knowledge.
Role of the housing sector
3. Let me elaborate on these three points, beginning with the role of the housing sector. Food, clothing, shelter: these are traditionally thought of as basic needs of mankind; so the housing sector satisfies an essential need. Housing is also of course an important component of investment. And in many countries housing makes up the largest component of wealth. For instance, in the United States, real estate account for roughly a third of the total assets held by the nonfinancial private sector. The majority of households tend to hold wealth in the form of their homes rather than in financial assets: in France, for example, less than a quarter of households own stocks but nearly 60 percent are homeowners.
4. Housing also plays other key roles; for instance, mortgage markets are important in the transmission of monetary policy. Adequate housing can also facilitate labor mobility within an economy and help economies adjust to adverse shocks. In short, a well-functioning housing sector is critical to the overall health of the economy. And as economies develop, we expect a corresponding deepening and growth of housing markets.
5. Despite its importance, however, the housing sector has not received adequate attention from macroeconomists. As Ed Leamer once noted, leading textbooks in the field often did not have any mention of the housing sector. Of course, all that has changed since the Great Recession. The bursting of the real estate bubble in the United States was followed by the deepest global downturn since the Great Depression. It reminded people of the collateral damage that can be triggered by housing collapses.
6. Indeed, all through history, housing booms and busts have quite often been detrimental to both financial stability and the real economy. Many major episodes of banking distress have been associated with boom-bust cycles in property prices. IMF research shows that of the nearly 50 systemic banking crises in recent decades, more than two thirds were preceded by boom-bust patterns in house prices. The cost of resolving housing crises can be very high—in the case of Ireland, for instance, government bailouts of banks from the housing collapse ate up 40 percent of the country’s GDP. In contrast to housing cycles, boom-bust cycles in stock prices are much less likely to trigger systemic banking crises.
7. Even when housing busts do not have a large financial stability impact, they can affect the real economy. Research shows that recessions in OECD countries are more likely given a house price bust. Such recessions also tend to be much deeper and generate more unemployment than normal recessions. In short, there is abundant evidence that housing cycles can be a threat to financial and macroeconomic stability. Hence it is crucial to keep an eye on current housing market developments to keep them from going through another boom-bust cycle.
Detecting overvaluation in housing markets
8. So where do housing markets stand today? House prices and residential investment declined in many countries at the onset of the Great Recession. Since then, there has been a rebound. Overall, house prices are inching up again: the IMF’s Global House Price Index has increased for the last seven quarters in a row. Over the past year, 33 out of 51 countries in our index showed increases in house prices. In some cases house prices are recovering from a sharp correction during the Great Recession. In other cases, house prices have continued an upward march with only a bit of moderation during the Great Recession.
9. Have these developments moved house prices closer to or further away from economic fundamentals? One common first pass attempt to answer this question is by looking at long-run valuation ratios. Theory asserts that house prices, rents, and incomes should move in tandem over the long run. If house prices and rents get way out of line, people would switch between buying and renting, eventually bringing the two in alignment. Similarly, in the long run, the price of houses cannot stray too far from people’s ability to afford them––that is, from their income. The ratios of house prices to rents and incomes can thus provide an initial check on whether house prices are out of line with economic fundamentals.
10. What does the evidence show? Among the OECD countries, these ratios remain well above the historical averages for a majority of countries. This is true for instance for Australia, Belgium, Canada, Norway and Sweden. This evidence provides a broad indication of housing market valuation. But one cannot assess overvaluation from this evidence alone. Whereas the long-run relationships do generally act as an anchor, house prices often drift away from them strongly and for long periods. Demand momentum leads to increases in house prices, particularly in situations where the supply of housing cannot be adjusted quickly due to geographical or other constraints. Judgments about housing valuation thus require supplementary information, such as credit growth, household indebtedness, lender characteristics, and the method of financing.
11. Of all these potential indicators of the risk of a boom-bust cycle, IMF research suggests it is particularly important to monitor credit growth. We find that there is a distinguishing feature of real estate booms that go ‘bad’: this feature is the coincidence between the housing boom and the rapid increase in leverage and exposure of households and financial intermediaries. During the global financial crisis, nearly all the countries with “twin booms” in real estate and credit markets—21 out of 23 countries that we analyzed—ended up suffering from either a financial crisis or a severe drop in GDP growth relative to the country’s pre-crisis performance. In contrast, of the seven countries that experienced a real estate boom but not a credit boom, only two went through a systemic crisis and these countries, on average, had relatively mild recessions.
12. IMF staff are thus increasingly paying attention to credit growth, along with several other country-specific features of the housing market. In recent months, IMF staff have provided detailed judgments about housing markets for Australia, Israel and Canada, which are all countries where the broad measures of valuation are high. We have also provided assessments for many emerging market economies in Asia and Latin America, where mortgage credit and house price growth remain strong, and house prices in metropolitan areas show signs of overheating. In some cases, this more detailed look suggests much more modest overvaluation than indicated by the house price to income and house price to rent ratios. One example of this is Belgium, where the IMF concluded that despite the high valuation ratios, risks of a sharp correction of real estate prices appear contained. These country-specific factors for housing cycles suggest that the policy response cannot be ‘one size fits all’.
Constructing a policy toolkit
13. With that, let me move to the third—and last—part of my remarks: the role of policies to contain housing booms. At the outset, let me note that this is part of a broader discussion of the appropriate role for monetary policy in the ‘new normal’. While many aspects of this role remain under active discussion, on thing is clear: monetary policy will have to be more concerned than it was before with financial stability and hence with housing markets. The era of ‘benign neglect’ of house price booms is over.
14. That said, regulation of the housing sector involves a complex set of policies. The noted economist Avinash Dixit suggested we use the acronyms “MiP, MaP, MoP” to remind ourselves of the set of policies. ‘MiP’ stands for microprudential policies, which of course aim to ensure the resilience of individual financial institutions. Such policies are necessary for a sound financial system but may not be sufficient. Sometimes, actions suitable at the level of individual institutions can destabilize the system as a whole. Hence we also need not just ‘MiP’ but ‘MaP’, that is, macroprudential policies aimed at increasing the resilience of the system as a whole.
15. The main macroprudential tools that have been used to contain housing booms are limits on loan-to-value (LTV) ratios and debt-to-income (DTI) ratios and sectoral capital requirements. Limits on LTV ratios cap the size of a mortgage loan relative to the value of a property, in essence imposing a minimum down payment. Limits on DTI ratios restrict the size of a mortgage loan to a fixed multiple of household income. The hope is to thereby contain unaffordable increases in household debt. Such limits have long been in use in some economies. For example, Hong Kong SAR has operated an LTV cap since the early 1990s and introduced a DTI cap in 1994. In Korea, LTV limits were introduced in 2002 and DTI limits in 2005. During and after the global financial crisis, over 20 advanced and emerging economies all over the globe have followed the example of Hong Kong SAR and Korea.
16. Evidence thus far suggests that these measures are somewhat effective in cooling off both house prices and credit growth in the short run. They are able to break the financial accelerator mechanism that otherwise leads to a positive two-way feedback between credit booms and housing booms. But more fine tuning of these measures is needed. Macroprudential measures need to take into account the ability of market participants to circumvent some of the limits on leverage. In some countries, such as in Canada, LTV limits usefully distinguish between owner-occupied vs. investor mortgages.
17. Another macroprudential tool is to impose stricter capital requirements on loans to a specific sector such as real estate. This forces banks to hold more capital against these loans, discouraging heavy exposure to the sector. In many advanced economies such as Ireland and Norway, capital adequacy risk weights were increased on mortgage loans with high LTV ratios. Sectoral capital requirements have also been used in a number of emerging markets such as Estonia, Peru, and Thailand. Evidence suggests that while this tool increases resilience from additional buffers, its ability to curb credit growth is mixed. Some IMF work suggests that higher capital requirements on particular groups of mortgage loans have some success in curbing house price growth in countries like Bulgaria, Croatia, Estonia, and Ukraine.
18. There are a number of reasons why higher capital requirements may be less effective in containing credit growth. First, when banks hold capital well above the regulatory minimum, lenders may not need to make any change in response to increases in risk weights. This often happens during housing booms when policymakers hope the tool to be most effective. Second, when lenders compete intensely for market share, they may internalize the costs of higher capital requirements rather than impose higher lending rates.
19. Macroprudential tools may also not be effective to target housing booms that are driven by the shortage of housing or by increased housing demand from foreign cash inflows that bypass domestic credit intermediation. In such cases, other tools are needed. For instance, stamp duty has been imposed to cool down rising house prices in Hong Kong SAR and Singapore. Evidence shows that this fiscal tool did reduce demand from foreigners who were outside of the LTV and DTI regulatory perimeters. In other instances, high house prices could reflect supply bottlenecks, and hence the effectiveness of demand-focused instruments may be limited. In such cases, the mismatches should be fundamentally addressed by measures to increase the supply of housing.
20. Along with micro and macroprudential policies, we need ‘MoP’: monetary policy. It is often said using policy interest rates is a blunt tool for containing house price booms. But as I noted earlier, housing booms have often coincided with a generalized private credit boom. This suggests that monetary policy could be an important tool in many cases in support of macroprudential policies. It is true, however, that in many relevant cases at the moment, policy interest rates have to remain low to support economic recovery.
21. Let me conclude. Housing booms have different characteristics across countries and time periods. What is common is that when the bust comes, it very often damages financial stability and the real economy. The tools for containing housing booms are still being developed. The evidence on their effectiveness is only just starting to accumulate. The interactions of various policy tools can be complex. But all this should not be an excuse for inaction. The interlocking use of multiple tools might overcome the shortcomings of any single policy tool. We need to move from “benign neglect” to an “all of the above” approach when it comes to policy choices.
22. It is only by maintaining an open dialogue on these issues that we will gain a solid understanding of how policies can contain housing booms. International coordination is also essential, since housing booms in one country can be fed by credit market developments abroad. The IMF intends to do its part. As I mentioned, assessments of housing markets are becoming a regular feature of our country reports. We also report on housing markets through our flagship publications, the World Economic Outlook and the Global Financial Stability Report, as well as through other reports to our Executive Board. We are working with other agencies to improve housing statistics. Next week, we are launching a new webpage where all this work will be given a home. I encourage you to visit the new Global House Watch page on imf.org over the coming weeks and see what we have to offer and to tell us how to do better.
23. The IMF is also contributing to the sharing of cross-country experiences through regular consultations with policymakers and experts. We held a successful conference last November, co-organized with the Federal Reserve Bank of Dallas, on housing issues. And I have no doubt that this conference will be just as successful. Thank you.