A potent channel

Recent evidence of a sharp slowdown in house construction in major markets poses downside risks to global growth

An important and potent channel of monetary policy transmission is the housing market. Weakness in housing demand triggered by higher interest rates is an important contributor to the intended slowdown in overall economic activity. 

This is particularly so in developed economies, where real estate is formalised, and mortgages are 30 per cent to 60 per cent of banking credit. There are several intuitive reasons for this. Not only is housing an important source of economic demand, accounting for 10 per cent to 24 per cent of gross domestic product (GDP), but it is also an important asset for most households (the share of financial assets is high only in the top decile or two in most economies). Most importantly, being a long-term asset, its value is highly sensitive to interest rates.

During the 1980s, too, when the then Fed Chair, Paul Volcker, raised interest rates sharply to control inflation, it was a 40 per cent fall in real estate investment between 1979 and 1982 that drove the recession. On the other hand, a large part of business capital is competitive in nature and relatively short-lived, so the cost of financing is a relatively small factor while making investment decisions.

In last month’s Tessellatum (“The Accidents Have Started”, March 14), we briefly discussed downside risks to real-estate markets in developed economies after the Covid-era low-interest rates, accumulated savings and the desire for bigger homes pushed the pace of price growth to 30- and 50-year highs. As house prices fall back to or below trend, two risks emerge: Slower growth (as discussed above), and financial market stress. In major markets, nearly a fifth of loans have loan-to-value ratios more than 80 per cent: A 20 per cent price drop would mean a distressed mortgage.

Nominal prices rarely fall so much, so at this stage, our primary concern is the impact on global growth rather than on financial system stability. A slowdown can though expose or deepen other fault lines, like in the corporate bond market. We estimated a 0.9 percentage point impact on global growth if housing construction in the US, China, Germany, Canada, and Australia were to fall back to trend: Most of it due to slower construction, and the rest due to weaker consumption caused by negative wealth effects as house prices fall.

Recent evidence of a sharp slowdown in activity in several of these markets suggests the drag on global growth may be worse than our earlier estimate.

In the US, the $2.7 trillion of mortgage-backed-securities that the Fed holds as a result of earlier quantitative easing (QE) should be seen as a direct infusion of funds into housing markets. The end of these purchases has pushed the gap between mortgage rates and government bond yields to the highest since 1985. Thus, unless QE starts again, mortgage rates are unlikely to fall to 2021 levels even if government bond yields do.

At this stage, there is low risk of mortgage delinquencies becoming a systemic risk, as borrower credit scores are far superior to those seen in 2007, debt service share of disposable income is low, and home-owner’s equity is at multi-decade highs.

However, housing starts are now 20 per cent below the October 2022 peak, and if patterns seen over the past five decades are a guide, should fall further. Given the seven months, on average, taken to build a house, the number of units under construction, which determine home-building’s contribution to GDP, are now correcting from a record high, and are likely to fall substantially. With sales volumes now the lowest in nearly a decade, home listings with price drops are at a 10-year high and rising.

In Germany, new building permits are now below the post-2008 trend-line, and the value of real estate construction orders in January 2023 was 28 per cent below the peak seen about a year before. Germany’s population has barely changed in the last two decades, with immigration only offsetting the natural decline in population. Real house prices in Germany (that is, house prices adjusted for inflation), moved in a relatively narrow range between 1970 and 2015. The sharp increase since then and the recent decline in nominal prices (the strongest in many decades), thus, could expose untested vulnerabilities in the system.

In Canada, despite falling 23 per cent from the peak, new building permits are still at the trend-line, and are likely to fall below it, in our view, to help digest the excess construction seen in the last two years. Affordability (price-to-income ratio) has been worsening for most of the last two decades and is now the worst in half a century.

In Australia, which has also seen a somewhat unbroken growth in real house prices for 25 years, and the weakest affordability in half a century, housing loan commitments have nearly halved from the 2021 peak. Given that they are now almost at 2014 levels, a further decline is unlikely, particularly given the tight rental markets, supported by a pickup in immigration. However, the sharply lower flow of mortgage funds into construction is likely to drive activity steadily lower in the coming months.

The trends in Australia also demonstrate the pro-cyclical characteristics of real-estate in developed markets when it comes to monetary policy. Tight rental markets can keep consumer-price inflation elevated, given how important rents are in the consumption basket. However, as high interest rates slow down sales volumes and then construction, the rental market could tighten further. This may only end once demand weakens.

It is important to look at nominal and real house price trends separately. High inflation, particularly in rents, means nominal house prices need to fall less. Though in the large, developed economies, rental yields are down 20 per cent to 30 per cent versus 2015 too, as interest rates were low: Higher interest rates warrant a reversal. 

The severity of macroeconomic impact hinges on the extent and pace of correction in housing prices. If they fall gradually, and most of the decline is in real terms and not nominal, financial stability should remain intact even as growth weakens. However, we estimate that if house prices fall more than 15 per cent in nominal terms, there could be financial stability concerns as well in some major markets.

These concerns are less relevant in India, where the market is recovering from a decade-long downturn, housing is not fully financialised, rental yields matter less, and mortgages are only a sixth of financial assets. However, India would not be immune to weaker global growth and the risk of financial instability.

The writer is co-head of APAC Strategy for Credit Suisse