Housing boom not justified by economics

The International Monetary Fund (IMF) has warned that the housing boom in a number of countries has taken prices to levels that cannot be justified by economic fundamentals and that a market correction poses a significant risk to global growth. The fund singled out the UK, Australia, Ireland and Spain as countries in particular danger. Increases of more than 50 per cent in a number of countries since 1997 could not be explained by fundamentals such as low interest rates. Indicators, including ratios of house prices to incomes and housing rents, have hit records, the IMF warned in a chapter released from its forthcoming World Economic Outlook. In these countries “there is a danger that higher interest rates could trigger a much larger downward adjustment in house prices, with considerably more severe consequences for real economic activity”.

However, the increasingly close movements of house prices across countries meant a market slowdown was a significant risk to global growth, the report said. The IMF also stepped up its call for greater exchange rate flexibility in emerging markets; the fund has identified a need for more flexibility in Asia to help correct the global current account imbalance and reduce the global risks associated with trade and fiscal deficits in the US. The house price boom has different explanations in the countries that have seen the biggest increases. But over the past 30 years, house prices across the world’s largest economies have been synchronised and common movements, the report said. “Just as the upswing in house prices has been a global phenomenon, it is likely that any downturn would also be highly synchronised, with corresponding implications for global economic activity,” it said.

Higher interest rates are expected to slow house price rises across the world, but the IMF highlighted the risk of “a more pronounced drop” in countries where house prices are out of line with the fundamentals. “The slowdown is likely to start in those countries where prices have risen above the fundamentals. What this does is to highlight a risk that because of the commonality of factors we should be worried about housing,” said Raghuram Rajan, IMF chief economist. Central banks should raise rates as gradually as possible and governments should consider tightening lending requirements and paying more attention to the development of mortgage industry infrastructure, including providing wider mortgage options, the report said.

It also provided evidence to back up its call for greater exchange rate flexibility in emerging markets, showing that countries that had shifted to more flexible rates had not sufferered from worse growth, inflation or exchange rate volatility outcomes as a result. Whereas virtually no emerging markets had freely floating exchange rates in the early 1990s, a third of those countries now do, the IMF said. Countries that chose to move to more flexible exchange rate regimes voluntarily rather than in response to crises, had not experienced greater macroeconomic instability, it said. Growth was little affected by the shift, inflation performance improved and while exchange rate volatility increased after the shift, it soon returned to normal levels, the report said. Part of the reason is that countries strengthened their macroeconomic policy frameworks to address those concerns including independent central banks with inflation targets but many countries were able to shift to more flexible regimes while still in the process of improving their frameworks.