Yves Nosbusch 




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Residential Real Estate and Global Financial Stability

Economic conditions continue to improve globally. Unemployment is gradually falling on both sides of the Atlantic which should lead to more robust wage growth and a gradual pickup in inflation. The main central banks have started preparing markets for a gradual scaling back of the exceptional monetary support they have provided over the last few years. The Federal Reserve has already raised its policy rates by a percentage point and current forecasts by its governors suggest an additional rise of one percent by the end of 2018. In all likelihood, the Fed will also start scaling down its asset purchases soon in order to reduce the size of its balance sheet over time. The European Central Bank no longer mentions the possibility of lowering policy rates further and if economic conditions continue to improve a reduction of the volume of its bond purchases would be plausible from the start of next year. In contrast to other central banks, the Bank of Japan has an official target for the level of the ten-year interest rate and this target may be raised in the months to come. Finally the Bank of England is facing accelerating inflation following the depreciation of the pound, which makes a tightening of monetary policy likely over coming months.



After a decade of unprecedented monetary support, we are at a key moment when all the major central banks are likely to gradually reduce their support. If economic conditions continue to improve, there could therefore be a gradual rise in interest rates globally over the months and years to come. Even if central banks will undoubtedly be very cautious in handling this transition, it is worth asking whether there are potential risks for global financial stability.



The last global financial crisis started in the US real estate market and in theory, real estate markets are a potential source of risk in a rising interest rate environment. Indeed interest rates represent a key factor in real estate investment decisions. Higher interest rates may influence the demand/supply imbalance in the market and hence property prices. Through their effect on property prices they may also influence the net equity of the home owner. This in turn may influence economic confidence and hence spending decisions.



In assessing potential risks to global financial stability, a natural place to start is to look at current valuation ratios in housing markets globally and to put them into historical perspective. The present article is based on a recent analysis of residential real estate markets around the world[1]. The analysis is based on the ratio of residential real estate prices to household disposable incomes (henceforth price-to-income ratio)[2]. This ratio is a macroeconomic valuation indicator. The data used in the analysis covers 21 countries from around the world for the period from 1975 to 2016. The idea of the analysis is to construct indices which compare the current valuation ratio of the housing market in a given country to a country's history since 1975, thereby putting current valuation ratios into historical context.


Recent evolution v. historical perspective





The horizontal axis on the figure shows in which decile of the historical distribution the price-to-income ratio was in 2016. For example, a decile of 10 indicates that the value for the ratio in 2016 was in the top 10 percent of the values since 1975, a decile of 5 or 6 means that the ratio in 2016 was close to the historical average, and so on. For a number of countries, current valuation ratios are at or close to historical highs. These include the United Kingdom, Australia, Canada, New Zealand, Norway, Sweden and Luxembourg. Valuations also seem rather high (eighth or ninth decile) in France, Belgium, Denmark and South Africa. In terms of potential spillover effects and their implications for global financial stability, the more reassuring feature is that for the three largest economies in the sample, valuation levels seem moderate: in the fourth decile for the United States, the first decile for Japan and the third decile for Germany. In Italy and Spain, valuation ratios are also moderate. Thus while there are signs of high valuation ratios in some markets, this is not a global phenomenon.


In addition to valuation levels, their evolution over the recent period is of interest. Indeed, a country may have been expensive for a long time already, so a high percentile rank would be less of a source of concern. The vertical axis of the graph shows the evolution of the price-to-income ratio over the last five years. Among the countries with high current valuations, many have seen significant growth in valuation over the last five years, notably New Zealand, Australia, Luxembourg and Canada and, to a lesser extent, the United Kingdom and Sweden. As can be seen from the figure, this stands in contrast to France where valuations have declined significantly over the last five years even though they remain relatively high in historical comparison. In Belgium, Denmark, Norway and South Africa, valuation ratios have not moved much over the last five years.


An interesting case is Germany. The run-up in German house prices over recent years still only places the valuation ratio in the third decile of the historical distribution. This is simply due to the fact that the recent run-up started from historically low valuation ratios: the price-to-income ratio in Germany had been declining steadily from the early 1980s to around 2012.


In the United States as well, house prices have risen by around 10% over the last five years but the price-to-income ratio is still only in the fourth decile of the historical distribution. In the case of the United States, this is explained by the fact that the price-to-income ratio fell by close to 30% in the aftermath of the 2007-08 financial crisis. In Italy and Spain the continued fall in valuation ratios over the last five years has simply brought these ratios back roughly to their historical averages (fourth and fifth decile, respectively).


To conclude, while housing valuations currently seem high in a number of countries, this is not a global phenomenon. In particular, valuation ratios in the three largest economies in the sample seem moderate in historical comparison. In the United States in particular, there seem to be bigger questions hanging over the corporate rather than the household sector. In contrast to households, US corporates are highly indebted and the International Monetary Fund has recently highlighted the vulnerability of US corporates in the face of rising interest rates.



Yves Nosbusch

Chief Economist

BGL BNP Paribas

Published in the Letzebuerger Land on 14 July 2017


[1] The complete analysis is available at the following address: www.bgl.lu/chief-economist-en.

[2] The original data series are from the Federal Reserve Bank of Dallas. They are described in Mack, Adrienne and Enrique Martínez-García (2011), A Cross-Country Quarterly Database of Real House Prices: A Methodological Note.