Tuesday, March 15, 2016

Brian Gaynor: Bank pours fuel on the real estate fire


The Reserve Bank appears to have undergone a dramatic change in direction.

In recent years its elephant in the corner has been soaring residential property prices and the huge increase in household or personal debt. But Reserve Bank governor Graeme Wheeler downplayed the housing market this week when outlining the reasons for the reduction in the Official Cash Rate (OCR) from 2.5 to 2.25 per cent.

These reasons included dairy sector challenges, a higher-than-expected exchange rate, a decline in inflation expectations and weaker Chinese and emerging-market growth.

This looks like a clear change in direction as there is a proven relationship between lower interest rates, rising house prices and increases in household debt. In other words, lower interest rates usually stimulate the housing market and encourage individuals to borrow more and more.

The central bank seems to be comfortable with further house price rises as its accompanying Monetary Policy Statement noted: “Given continued pressure in the housing market, and price increases over the past year in regions outside Auckland, a plausible scenario is that house price inflation remains elevated for longer than assumed.”

The Reserve Bank is now looking much more like a cheerleader for the buoyant residential property market, instead of its harshest critic.

The accompanying table shows total New Zealand household or personal debt. The borrowings are divided into owner-occupied housing loans, rental property loans, consumer loans and student loans. The data is for each of the past six years and for 2006, 2002 and 1998.

The figures show that total household debt has soared from $65.9 billion at the end of 1998 to a massive $242.4 billion at the end of 2015. Total residential mortgages, which include housing loans and rental property loans, have skyrocketed from $56.2 billion to $211.8 billion in the same period.

New Zealand share prices would be much higher, and house prices much lower, if this money had been loaned to equity investors instead of residential property purchasers.

Financial deregulation, which has created a more competitive environment among financial institutions and allowed them to lend where they wish, has led to a dramatic increase in household debt, particularly residential mortgages. This has been a world-wide phenomenon, with a number of countries experiencing house price busts – notably the United States, Ireland, Spain and Britain – after sustained house price increases.

New Zealand has avoided the boom-and-bust scenario because of the large migration inflow and an extremely low level of new house construction.

For example, between 2007 and 2012 Auckland’s population increased by 86,000 yet only 19,740 consents for houses, apartments and townhouses were issued for the region. A reasonable number of these consents were probably never started.

There has been widespread concern about the $37.9 billion of dairy farmer debt and Fonterra’s $7.6 billion of borrowings, yet they pale into insignificance compared with the total $242.4 billion of household borrowings.

The New Zealand Government, which is often accused of having too much debt, has gross borrowings of $85.8 billion at present.

The International Monetary Fund has launched a new Global Housing Watch website covering the world’s housing markets. Its analysis reveals:

  • New Zealand ranked eighth of 64 countries in terms of house price appreciation over the past 12 months.
  • In terms of price-to-income, New Zealand residential property is the most expensive in the world.
  • New Zealand has the third most expensive residential property market in terms of the house price-to-rent ratios.

Last month the IMF released a 45-page report on New Zealand with a section headed “House prices, household debt, and financial stability risks in New Zealand”. The report projected our residential property to be overvalued by about 20 to 40 per cent based on price-to-income and price-to-rent ratios. It believes a meaningful fall in house prices would have an impact on the economy through wealth, investment, bank balance sheet and confidence effects.

The authors wrote that the financial liberalisation initiated by Sir Roger Douglas in the 1980s had facilitated easier access to credit and an OECD study found “that 30 per cent of house price increases in OECD countries can be attributed to financial deregulation”.

It also argued that “in New Zealand, housing is a tax-advantaged asset and owner-occupied housing is exempt from the capital gains tax and tax treatment of investment in rental property, and particularly from highly geared investment, also imply significant incentives for housing investment”.

The report stated that “the trends of lower interest rates, higher house prices and household debt are closely interrelated” but this “does not imply that it is sustainable in the long term”.

In light of this, it is surprising that the Reserve Bank decided to cut the OCR and risk rekindling the highly priced housing market, particularly as the non-dairy domestic economy remains reasonably buoyant.

An overheated housing market is a threat to the economy and has also created material inequalities between those who are already on the housing ladder and those who are not.

An October 2015 Reserve Bank study noted that “investor share of house purchases increased materially” after the implementation of the Loan-to-Value (LVR) restrictions in October 2013 and “the first-home buyer share dropped immediately”.

It also revealed that by mid-2015 investors represented 39 per cent of all Auckland market purchases, compared with 32 per cent before the LVR restrictions were introduced.

It is clear that existing owners find it much easier to obtain credit than first-home buyers and this has created a clear winner and loser scenario as far as housing is concerned. This winner and loser scenario is exacerbated by the large increase in student loans, which now stand at $14.8 billion, making it more difficult for these individuals to borrow for their first home.

A big positive for first-home buyers is the ability to use KiwiSaver funds to partially finance their purchases. This facility is being used more and more as KiwiSaver members withdrew $159 million for first-home purchases in the June 2014 year, $258 million in the June 2015 year and a massive $281 million in the first seven months of the June 2016 year.

Thus, the housing market is being stimulated by financial deregulation, aggressive bank lending, a favourable tax regime for residential property and the ability of KiwiSaver members to withdraw funds to purchase their first house.

Wheeler sprayed further fuel on the fire this week by cutting interest rates.

The Reserve Bank would argue that its LVR requirements are keeping a lid on the housing market. The problem with this argument is that if the value component of the equation is inflated, then the LVR requirements become relatively ineffective.

Dairy farmers have faced the harsh reality of this over the past year. Farmers who argued that they have a LVR of 67 per cent because they have borrowings of $2 million and their farm was worth $3 million are in a totally different situation when the value of their farm falls to $2 million. The situation is exacerbated when they have negative cash flow from farm operations and have additional interest cost outgoings.


There are no indications the New Zealand residential property market will soften, particularly following this week’s interest rate cut, but if the residential market does have a material downturn it will have enormous implications for household balance sheets and the economy.

Brian Gaynor is an investment analyst and the Executive Director of Milford Asset Management. 

1 comment:

Anonymous said...

I wouldn't take any claims by the IMF seriously. Their position that "deregulation" has resulted in higher house prices is a convenient one for supporting more government intervention in the market. House price increases and bubbles are a result of central banks setting low interest rates (lower than the market would) and government approved fractional reserve banking. Credit continues to expand more quickly than savings in this legalised Ponzi scheme.

The situation is of course more complex with other factors such as houses being bigger and more high spec than previously. Some of this is consumer choice and some is a result of building regulations. In NZ local Council taxes and land use restrictions, the RMA, and employment law also result in house prices being higher than they otherwise would be.