The Reserve Bank of New Zealand (RBNZ) yesterday gave a speech (below) entitled Perspectives on housing, which provided a useful overview of some of the factors driving New Zealand’s housing market and monetary/prudential policy. Below are some key extracts.
On housing and the New Zealand economy:
The RBNZ notes that New Zealanders have a disproportionate amount of wealth tied-up in housing, which makes the economy overly sensitive to swings in house prices:
The most recent data on household balance sheets is shown in Table 1. Two observations are key: first, the value of housing is a large share of total household assets in New Zealand compared to Australia (and the United States) where financial assets play a much greater role in saving for retirement. Consequently, house price movements in New Zealand have a relatively large impact on household confidence and spending compared to many other developed countries where the state of the financial markets plays a larger role in driving consumer confidence and spending…
Housing cycles in New Zealand can have important macroeconomic effects. Figure 1 shows long-term house price cycles against GDP growth and the exchange rate.
Housing has often been associated with real activity cycles, and is even more correlated with financial cycles, as represented by changes in credit demand and the exchange rate.
In the housing boom of 2003-07, for example, housing had a significant impact on the growth of aggregate demand and GDP through a number of channels: wealth and confidence effects where people felt richer, making them willing to spend and borrow more; direct effects on investment as higher house prices improved the return to residential construction; and financial accelerator effects where increased collateral values supported increased spending through credit expansion. The latter channel has created a strong link between house prices and the financial cycle. During the boom that link was accentuated with the emergence of widespread housing investment activity, bringing with it rapid credit growth, a high volume of offshore borrowing and upward pressure on the NZD exchange rate.
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Supply pressures building:
The RBNZ also notes the building house price pressures in New Zealand’s two biggest markets – Auckland and Christchurch – where price inflation is running well ahead of incomes, growth and the rest of the country, due in part to constraints on housing supply:
We are again facing a strong housing market with median house prices having risen by 8 percent over the past year. So far, the nature of the current market is different to the boom of 2003-07. As seen in Figure 2, the current house price pressures are concentrated in Auckland and Christchurch. House price inflation in the rest of the country is less pronounced, around 4 percent over the past 12 months, although there is considerable variation among districts.
Supply constraints in Canterbury and Auckland and pent up demand from first-home buyers are important factors. There is an element of investor demand and of new foreign buyers entering the market in Auckland, but these factors – at least as yet – are not as influential as they were back in 2003-07.
The relevance of housing supply constraints has been discussed in earlier Reserve Bank/Treasury reports and, most recently, in the Productivity Commission’s report on housing affordability.2 Contributing to the current national housing shortage has been the low level of residential construction activity in recent years. From 2007 to 2011, residential investment as a share of GDP fell by 2-and-a-half percentage points.
In Christchurch, the general shortage of accommodation is reflected in median house prices up 12 percent, rents up 16 percent, and the cost of building up 10 percent over the year to December 2012. These pressures are likely to persist for some time despite the insurance industry’s plans to finance 10,000 new houses over the next three to four years.
In Auckland the situation is more complex – and more uncertain. The Auckland Council puts the current shortfall at around 20,000 to 30,000 homes, with an additional 13,000 per year needed going forward. However, the current rate of building is hardly making a dent in that, with residential building consents for new dwellings in Auckland currently running at just 4900 per annum. The Ministry of Business Innovation and Employment estimates that land ready for subdivision in Auckland has the capacity for 14,500 new homes. But, while zoning and utilities infrastructure may be complete for those subdivisions, only 2000 sites are ready to build on – with utilities actually connected and consents approved. These numbers reinforce the complexity of supply constraints noted by the Productivity Commission. It is not just a zoning or Metropolitan Urban Limit issue. The cost and the duration of subdivision development and house construction are also major constraints, particularly for the supply of ‘affordable’ homes to first-home buyers.
Easier credit also pumping demand:
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The RBNZ also notes that lower mortgage rates combined with loosening credit standards is also inflating demand, which is contributing to the price increases (obviously made worse by unresponsive supply):
Current ‘best in market’ rates are around 4.8-5.0 percent. These are down half a percent over the past year due to lower funding costs on international markets. They are the lowest mortgage rates on offer since the 1960s. While there are good reasons for this – low CPI inflation and very low international interest rates – the cost of credit is now only slightly above average rental yields of 4.5 percent per year. Added to this, credit has become easier to obtain, with banks competing aggressively to gain or protect their mortgage market shares.
An increasing proportion of new mortgage lending is going out at high loan-to-value (LVR) ratios: now around 30 percent of new lending is at LVRs over 80 percent, compared to around 25 percent of lending in late 2011-early 2012. Annual growth in housing credit is just over 4 percent and has been running at higher rates over recent months.
Easy credit conditions, combined with the upward trend in house prices, are strengthening the incentive for renters to become first-home buyers and for existing owner-occupiers to upgrade. With new construction still at a slow pace, this excess housing demand increases house price pressures.
Implications for RBNZ policy:
The RBNZ notes the risks inherent in New Zealand’s house price inflation:
We are left with concerns that the current escalation of house prices is increasing risk in the New Zealand financial system by increasing both the probability and potential effect of a significant downward house price adjustment that could result from a future economic or financial shock. The more that house prices continue to overshoot their long-run sustainable levels, the greater the prospect of an eventual significant downward correction…
We have seen in those countries most affected by the GFC the significant damage that can result from sharp declines in house prices, both in terms of financial system losses and the economic stresses placed on borrowers. The impact of such an adjustment could be worsened by existing economic headwinds in the form of an overvalued exchange rate, drought affected agriculture and the government’s significant fiscal consolidation.
We are not the only ones concerned. This view of increasing housing risk in the New Zealand financial system is shared by the International Monetary Fund in their recent ‘Article IV’ assessment and was voiced during the recent OECD mission to New Zealand. It is also shared by Moody’s and Standard and Poor’s in their most recent risk assessments of the New Zealand banking system…
New Zealand needs to avoid another housing boom, which could potentially be more costly than the last, particularly at a time when the economy faces headwinds from an overvalued exchange rate, drought and a substantial programme of fiscal consolidation.
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Fixing the imbalances:
The RBNZ sees freeing-up of the supply-side, as well as a combination of macro-prudential controls on lending, increased bank capital, and higher interest rates as keys to mitigating housing risks:
An important medium- to long-term policy response is to work on alleviating the housing supply constraints, particularly in Auckland. That means freeing up land for subdivisions and also reducing the time and cost barriers faced by developers. As recommended by the Productivity Commission, there is also a need to promote/facilitate productivity improvements in the building sector itself, in order to bring unit costs more into line with international norms. The Government is working on measures to address many of these supply constraints, but we know it could take many years to correct the supply/demand imbalances through supply measures alone…
In the short-to medium-term, we want to ensure that the banking system is adequately capitalised for the risks associated with mortgage lending and also avoid demand pressures that could exacerbate a house price overshoot that is in no-one’s best interest. A continued escalation of house prices would frustrate first-home buyers; it would risk drawing more investors into the market which would reinforce the price overshoot; it would likely reverse the recent improvement of household debt relative to income; and it would add a further layer of risk to the banking system.
From a Reserve Bank monetary policy perspective, if the house price and credit expansion begin to fuel excessive consumption spending and inflationary pressures, a monetary policy response would become more likely. The Reserve Bank’s flat interest rate outlook in our recent Monetary Policy Statement would need to be revisited.
In the financial policy area we are currently consulting on a potential increase in bank capital requirements against high LVR lending. We also expect to soon have in place a macro-prudential policy framework that could be used to increase resilience in the banking system against a future housing downturn while having a moderating influence on credit expansion to the housing sector. Macro-prudential policy is primarily aimed at enhancing financial stability, but it may also contribute to achieving monetary policy objectives. It is not seen as a replacement for monetary policy and it is not expected to be as powerful a tool as monetary policy. Macro-prudential policy could nevertheless have a stabilising impact on credit supply decisions by the banks as well as credit demand decisions by households…
While as yet untested in New Zealand, such [macro-prudential] policies are deployed in Canada, Switzerland, Sweden and Hong Kong, for example… Practically, this means that additional prudential requirements may be applied for a period during credit up-cycles and then removed during down-cycles. The tools operate directly to improve the resilience of bank balance sheets and indirectly to moderate the extremes of the credit cycle.
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness.
Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.
