His topic: The Spanish and Irish housing booms (or bubbles). The Spanish and Irish economies are even more housing-centric than the US economy ... and potentially are even more exposed to a housing slump.
Red alert in the Euro zone-periphery – some are still riding the housing bubble
As argued all along the housing euphoric “literature”, global factors have greatly fuelled housing prices in Europe. The historical lowness of interest rates has played a great role, but also the development of financial systems that allow people to borrow against their future income and the home’s value.
Yet even amid a global housing boom, Spain and Ireland stand out. France –which has experienced very strong home price appreciation recently seems bound to cool (see my previous contribution). But Ireland and Spain are still rocketing, with home price growth of around 10% yoy (INE and CSO) over 2006 … (UK too, though after a pause). These two EU periphery countries exhibit the biggest housing price hikes, highest residential investment (relative to GDP) and most jobs in construction sector. They are consequently among the most housing-centric economies in the entire world ….
Spain and Ireland have benefited from strong convergence-related growth and positive population dynamics. But it now seems clear that those fundamentals don’t suffice to justify their housing prices dynamics. Economic agents are increasingly exposed to interest rate hikes, and the economy as a whole is increasingly tied to their construction sector. Hence Spain and Ireland have ridden the housing boom more than most, with better than average economic performance… but now a red alert looms.
What explains the biggest housing booms in the OECD? Ireland and Spain’s over-muscled fundamental
Spain and Ireland both greatly benefited from low interest rates, from favourable migration dynamics, and their housing sector has both benefited from (and contributed to) strong local economic growth. By importing the credibility of the European Central Bank, they benefit from low nominal interest rates, in spite of their vivid growth and consequent higher than average inflation. Thus in addition to the global savings glut which exercised downward pressure on nominal interest rates, both countries exhibit very low real interest rates.
Up until European monetary integration, both countries used to be European outliers. Both countries had not benefited from the European post-war wealth surge, and had living standard well below the European average. However, membership in the European Union and EMU triggered a strong “catch-up process”. On its current path, Spain will have fully converged with the Euro zone’s big three (France, Germany and Italy) in only 7 more years.
Such development have unleashed “animal spirits,” made both countries attractive destinations for immigrants (a big historic change), and laid down a strong basis for their real disposable income growth. Simultaneously, the perception of increased economic certainty, changes in financial markets and financial innovation in Spain and Ireland have made mortgage credit more available. The deepening of mortgage markets has helped to sustain the unprecedented persistence of demand for housing amid surging home prices. In fact, the total value of mortgage debt in Ireland tripled over the 2000-2005 horizon, and mortgage lending is still growing at a 20% pace. Spanish lending is still growing at a 23.6% pace. Given that in Ireland 83% of total outstanding mortgage debt in 2005 and in Spain, 97% of the debt is at variable rate interest, households are considerably exposed to interest rate hikes.
The sensitivity of both countries’ market to interest rate change is thus considerable, and could rapidly trickle down to households’ balance sheets as monthly repayments are bound to rise (considering the current lowness of interest rates in the Euro area). Also a sharp increase in interest rates may trigger reduction in housing demand, raise the repayment service of indebted households and could backfire onto the financial system. Already in Spain, the average person with a mortgage allocates fifty five percent of their wage on their principal or secondary home repayments a share which increased by 4.1% since 2003 (La Caixa, 2005).
Both Spain and Ireland are more American than the US: they have comparable population dynamics (thanks to migration) and faster growth in both real disposable income and real housing prices.
Chart 1: Growth over the 1999-2005 period
Source: OECD database, Eurostat.
However, Spain looks a bit frothier than Ireland. Spain has lower real income growth than Ireland but faster home price appreciation. Spanish nominal wage increases have remained above the euro area average despite low productivity gains. Amid strong demand pressures and weak competition, companies have been able to pass on relatively rapid labour cost increases into prices. And strong wage growth, in turn, has helped to support the surge of housing prices (this works both ways: given the labour intensive character of the housing industry, higher wages have pushed up new home prices). Home construction costs have risen by 25% for Ireland and 33% for Spain between 2000 and 2005, contributing to the 64% and 84% respective increases in home prices over the 2000-2005 period.
The surge in prices in both countries does not reflect limits on supply: unlike in the UK and France, investment in the residential sector in Spain and Ireland has boomed. In Ireland investment in housing represents 14% of GDP, and Spain 9%, while most other Eurozone countries exhibit a share of 5% of GDP (Eurostat 2005 data). (Residential investment in the US peaked at 6.2%).
Consequently, both countries are increasingly exposed to a slump in investment even if it doesn’t spill over to slump in consumption. Spain and Ireland also are at the top of the European scale when it comes to employment in construction, with home construction accounting for approx. 12% of employment in 2005. Construction output per capita in Ireland is highest relative to Euro zone countries at approximately €7,600 and house completion was four times the average of other European countries in 2005 (CSO report), twice the corresponding figure for the UK.
The National Bank of Ireland recognizes that a sharp reduction in housing output would lower employment, investment and growth. But the exposure of the Irish economy to a slowdown of the housing sector seems even large than the monetary authorities admits. Too lenient tax incentives have caused housing price overvaluation and lured too many resources towards residential investment. This has lead to an inefficient allocation of resources, which could particularly hamper Irish and Spanish growth going forward.
A reversion to mean in the housing sector would imply a big fall in all economic measures, and might introduce a temporary recession in Europe’s periphery. As emphasized in my first post, the wealth effect from a slump in housing prices is considerable in Spain and Ireland. However even if these indirect effects reveal to be more contained, direct effects through investment and employment in the housing sector will curb growth and necessitate considerable reallocation of resources away from housing.
Sociology intertwined with Economics
The housing markets in both Ireland and Spain have been supported by a recent influx of migrants’. Approximately 54 per cent of new immigrants belong to the 25-44 age categories, the age category most likely to invest in housing.
But migration matters less that domestic social factors – and national policy choices. Spain and Ireland have -- with Italy -- the highest home ownership rates in Europe (Spain 85%, Ireland 77% and Italy 80% as of 2002) as a result of long term national policies favouring of house owners. In Ireland, tax treatment of housing is very favourable for home ownership compared to other EU countries (van den Noord, 2005). In Spain, any housing property is tax-deductible and for every sort of income source, whereas ordinary rental properties are not. Such asymmetrical treatment of rental compared to property has lead to high ownership rates (see BIS paper).
Such regulatory measures impeded the emergence of a rental market. Indeed, Spain (and Italy)’s population relies on a traditional family structure to compensate for lack of rental opportunities, infrastructure, and low public transfers for the young. Young Spaniards and Italians face the so-called Delay Syndrome; 63% of 20-34 year old unmarried co-habited with their parents in Italy. In Spain, the equivalent figure is 40% as of 2004 (compared with 20% in Germany). The average size of Spanish households, while falling, is the highest in Europe (INE stats). A more differentiated housing market which allows for all age categories to choose between living at home, renting and owning would be better than the status quo.
On the one hand, the lack of rental market in those countries inhibits the Spanish youth to gain independency from their parents. On the other, the house owners refraining from renting their housing property are this generation’s parents…
To develop Spain and Ireland’s rental markets fiscal incentives favoring owners have to be abolished or at least rebalanced to the benefit of tenants. In Spain an institutional setup has to be implemented that secures alternatives for renting out owned housing, so that owner’s don’t need to occupy it. Such measures would reduce the amount of vacant properties which in Spain amounts to three million properties, and ease housing prices.
Red alert in the periphery
Central banks are concerned that recent pursuance of housing price growth in both countries wasn’t supported by fundamentals. The Irish national Bank stated in its latest financial stability report that the 2006 price surge wasn’t expected. In Spain, the Central bank has already issued some warnings regarding credit risk monitoring. The IMF Directors noted “that an abrupt correction cannot be ruled out” in Ireland.
Cotis from the OECD has acknowledged that several big countries are at risk of a housing downturn: with the USA, France and the UK topping the list. But, given the extreme dependence of both Spain and Ireland on housing, both countries are even more exposed to a sharp correction.
And there is one key difference between the small – and no longer so small countries like Spain -- countries on the periphery and the bigger economies: just as the ECB hasn’t raised rates to offset the boom in home prices in Europe’s periphery, it is unlikely to lower rates just to help smaller economies. Wine and roses don’t last forever. Monetary union has offered huge advantages to both Ireland and Spain, but it won’t always generate the favourable dynamics both countries have enjoyed recently.