Monday, June 5, 2017

David Skilling: House of Cards


The fifth series of House of Cards was released this week on Netflix, although it is not clear how we should distinguish between the fictional series and the non-fiction (perhaps science fiction?) occurring in the real-life White House.  But a house of cards remains an apt metaphor for housing markets around the world, and particularly in small advanced economies, which are deeply exposed to the process of interest rate normalisation.

In a previous edition of this note, I discussed the particular challenges that QE by large economy central banks has imposed on smaller economies, and particularly on the eight small advanced economies outside the Eurozone: Norway, Denmark, Sweden, Switzerland, Israel, Hong Kong, Singapore and New Zealand.  As price takers, each of these small economies has had to set monetary policy in a way that reflects the world interest rate (even more so for economies that are directly pegged to other currencies, Denmark to the euro and Hong Kong to the USD). 
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Central banks in small economies have marked down policy rates sharply to reduce sustained upward pressure on their exchange rates (although effective exchange rates have continued to appreciate in most of these countries) and to attempt to achieve inflation targets.  In Denmark, Sweden and Switzerland, this has involved cutting policy rates into negative territory.

Given the circumstances, this small economy central bank response has been useful.  But keeping interest rates low in what were often relatively healthy economies has generated significant pressures on asset pricing.  In particular, housing markets in small advanced economies have been under sustained upward pressure over the past several years.  My analysis shows that housing prices in small economies have consistently run ahead of large economies over the past couple of decades (for a variety of structural reasons), but that this difference has increased significantly in the QE world: small economy house prices have grown about twice as rapidly.

Since Q1 2011, real house prices in the non-Eurozone small advanced economy group are up by over 25%.  House price to income ratios are up 10% from their 2007 highs, and are up by 20% from 2011.  The appreciation in house prices in non-Eurozone small advanced economies during the QE period has been led by New Zealand (real prices up 52% to Q4 2016), Hong Kong (43%), Sweden (42%), and Israel (36%).  And Norway has continued solid growth, with house price levels (and price to income ratios) near the top of the small economies group.  In general, the rate of price increase since 2011 is not out of line with historical precedent.  But house price levels, as well as house price to income ratios, are well into uncharted territory.

A powerful dynamic supporting nation-wide house price growth has been growth in the major cities of these small economies.  House price appreciation has been strong in cities like Auckland (up 88%), Oslo (67%), Stockholm and Copenhagen (both 57%) and Tel Aviv (41%) since Q1 2011.  And inside the Eurozone, Dublin prices have surged close to 60% since 2013.

Singapore is a notable exception to this pattern.  After a 50% increase in prices from 2009, partly due to speculative inflows, Singapore implemented aggressive macro-prudential policy, as well as acting to increase the supply of residential real estate. And since 2013 property prices have drifted down by about 13%.  This contrasts with Hong Kong where nominal prices are up by over 90% since January 2011.

Of course, larger advanced economies have also experienced pressures on property prices – notably in the Anglo countries of Australia, Canada, the UK and the US, as they recovered from the housing crisis.  But, overall, the nation-wide pressures have been more acute in smaller advanced economies. 

Despite the many differences in small economy property cycles, supply side issues, tax treatment, and the like, there is a remarkable similarity in profile across the small advanced economies group.  Lower interest rates have been a key factor behind this common small economy experience.  This is a clean example of the exposure of small economies to global forces.  Similar dynamics can also be seen in equity markets across these small countries, which in several cases (such as New Zealand and Denmark) have out-run house prices.

The implication is that, just as the low interest rate regime has supported strong house price growth over the past several years, so the normalisation process will likely have a meaningful impact in weakening house prices.  Indeed, the pace of property price appreciation is slowing in small economies such as New Zealand, Norway and Israel.  However, this is not yet universal: there is no slowdown in real estate price growth in Hong Kong – and in data out this week, Iceland’s nationwide house price index was up 22% in the year to May.

Small economies are acutely exposed to global dynamics such as QE, and several will be deeply impacted by a rising interest rate profile.  Real estate has been an important contributor to GDP growth in many of these small economies over the past period.  Small economies will need to continue to manage the cross-winds from the global economy, as interest rates begin to rise in a period when the GDP growth path is beginning to soften in many small economies.  This experience is also relevant to larger economies as well: where small economies go, larger economies often follow.

The past several years of QE have been a particularly challenging time for small economy central banks.  And it is likely that the process of unwinding QE will also be challenging, as a rising interest rate profile places pressure on asset prices, household balance sheets, and the real economy.  As with the new season of House of Cards, the question is how long a messy ending can be postponed.

Dr David Skilling, the Director of the Singapore-based Landfall Strategy Group, was formerly the Chief Executive of the New Zealand Institute and before that, a Principal Advisor at the New Zealand Treasury. 


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