Central banker makes housing sense! by Leith van Onselen

I was disappointed in RBA Governor, Glenn Stevens, speech Wednesday. I had expected that Mr Stevens would at least acknowledge Australia’s Achilles heel – its high level of household indebtedness and house prices – and warn of the significant risks that these pose to the economy. Instead, Mr Stevens ignored the debt Godzilla and linked Australia’s house price appreciation to population growth.

Interestingly, the Bank of Canada (BoC) Governor, Mark Carney, also delivered a speech yesterday. And unlike Mr Stevens, Mr Carney was refreshingly open about Canada’s record high levels of household debt and over valued housing market, and the risks inherent to the Canadian economy.

As mentioned previously, Canada and Australia have a lot in common. Both economies are commodity exporters. Both countries have experienced similar rates of immigration. Both countries largely dodged the global recession that has recently shocked the developed world. And both are said to have world-beating banking systems, with Canada’s ranked as the strongest and Australia’s ranked third strongest in the world by the World Economic Forum.

As in Australia, there is also widespread debate about whether Canada is experiencing a speculative housing bubble, or asset inflation based upon sound fundamentals.

With these similarities in mind, it is worth reviewing the BoC’s comments on the Canadian housing market and whether any lessons can be drawn for Australia.

It should be noted at the outset, however, that Canada’s household debt is significantly lower than Australia’s, meaning that, other things equal, its household sector should be less vulnerable to external shocks (see below chart).

Similarly, Canada’s home prices have risen at a slower rate than Australia’s (see below chart).

These factors suggest that Australia is probably more exposed to a housing correction than Canada.

Anyway, on to Mr Carney’s speech.

Mr Carney began by noting the strong rise in Canadian house prices and how Canada, as a nation, is no better off as a result, with the younger generations losing relative to the older generations.

The value of residential real estate holdings in Canada has climbed more than 250 per cent in the past 20 years, vastly outpacing increases in consumer prices and disposable income over that period (Chart 1).

However, Canada is arguably no better off because of it. That’s because while homeowners may feel wealthier because of this rise in prices, housing is not net national wealth. Some Canadians are long housing; others are short. Housing developments can have important implications for equality both across and between generations. Though some people in this room may have been enriched, their children and neighbours may have been relatively impoverished.

Mr Carney then explained the importance of Canadian housing to price stability and financial stability. The most interesting observation was the ‘wealth effect’ positive feedback loop from house price movements – a topic discussed regularly on this blog.

…while changes in housing values may not lead to changes in net wealth, they do influence consumption by affecting households’ access to credit. Through this “financial-accelerator” effect, homeowners can borrow more against increases in home equity to finance home renovations, the purchase of a second house, or other goods and services. Such expenditures can accelerate the increase in house prices, reinforcing the growth in collateral values and access to borrowing, leading to a further rise in household spending. Of course, this financial accelerator can also work in reverse: a decrease in house prices tends to reduce household borrowing capacity, and amplify the decline in spending.

Mr Carney then provides an overview of recent developments in the housing market. First, he compares the recent price performance against other nations.

Nationally, our house prices have risen 31 per cent from their trough in early 2009, to stand 13 per cent above their pre-crisis peak (Chart 3). Here in Vancouver, the recovery has been even stronger, with prices up 55 per cent from their trough to a level 29 per cent above the prior peak. The rebound in housing market transactions and new construction, both locally and nationally, has been similarly robust.

He then notes how Canada’s rapid recovery from the recent financial crisis was unusual compared with previous housing cycles, and gives credit to the BoC for dropping official interest rates to zero and providing significant liquidity support to the financial system.

…it took nearly 12 years for real residential investment to regain its level on the eve of the 1990s recession; this time it took only a year and a half (Chart 4). This rapid recovery importantly reflects the evolution of monetary policy during the recent recession. In response to the sharp, synchronous global recession, the Bank lowered its policy rate rapidly to its lowest possible level, doubled our balance sheet, and provided exceptional guidance on the likely path of our target rate.

What Mr Carney didn’t mention was that actions taken by the Canadian Government were equally helpful in reflating the housing market. In 2007, the Government significantly loosened mortgage eligibility criteria, culminating in the introduction of the zero-deposit, 40 year mortgage (since reversed). Further, the amount that Canadians could borrow was increased, with many individuals in 2009 being granted loans in the $500,000 to $800,000 CAD range provided their household income ranged from 110,000 to 170,000 CAD.

Finally, in an effort to support the housing market in 2008 (when affordability fell sharply and the economy stalled), the Government directed the CMHC – the Government-owned guarantor of high loan-to-value-ratio mortgages (explained here) – to approve as many high-risk borrowers as possible in order to keep credit flowing. As a result, the approval rate for these risky loans went from 33% in 2007 to 42% in 2008. By mid-2007, the average Canadian home buyer who took out a mortgage had only 6% equity in their home, suggesting the risk of negative equity is high even if there is only a moderate correction.

Together, the BoC and Government were successful in enticing Canadian households to resume borrowing for housing, thereby stimulating the recovery (see below chart).

While the authorities were successful in kick starting the Canadian economy by reflating the housing market, it has made housing even more overvalued:

And, by further increasing debt levels, has made households and the financial system more vulnerable to adverse shocks.

Financial vulnerabilities have increased as a result. Canadians are now as indebted (relative to their income) as the Americans and the British. The Bank estimates that the proportion of Canadian households that would be highly vulnerable to an adverse economic shock has risen to its highest level in nine years, despite improving economic conditions and the ongoing low level of interest rates.

Rather than focusing on the role played by the BoC’s interest rate settings in fuelling the Canadian housing market, Mr Carney instead shifts the blame to the “global savings glut” for lowering market interest rates and providing households with easy credit. He also notes the deleterious impacts on the productive sectors of the Canadian economy.

…the so-called “global savings glut” has been particularly important in underpinning the trend decline in long-term borrowing rates over the past decade. Flows of excess savings from emerging markets into the U.S. Treasury market have restrained the long-term U.S. interest rates that provide the benchmark for yield curves globally. Rough calculations suggest that the lower real rates from this phenomenon could justify a substantial proportion of the increase in house valuations across mature markets. The eventual rebalancing of the global economy from deficit countries, like the United States, to surplus countries, like China, should dampen this effect.

As in many other countries, cheap credit has been used to bid up the price of Canadian houses, a non-tradable good, rather than invest in expanding the productive capacity and export competitiveness of our businesses. For example, over the past decade, housing debt grew by more than 150 per cent, while business borrowing rose by only 40 per cent. As a result, the stock of housing-related debt went from less than business debt to almost two-thirds more.

The global savings glut is a popular argument used by central banks globally to justify the sharp rises in house prices. For example, RBA Deputy Governor, Ric Battellino, made a similar argument in 2008:

While there has been much discussion about the causes of the low long-term interest rates, I think it is fair to say that the majority view is that it has reflected a global excess of desired saving over desired investment – i.e. the so-called savings glut. Put another way: With the amount of money that people wanted to save running ahead of the amount that people wanted to invest in physical assets, there was a strong incentive for the financial sector to find ways to issue more financial claims against the stock of existing investment. That, of course, is a recipe for rising asset prices.

Anyway, back to the speech.

Mr Carney then singles out Vancouver as being particularly overvalued, with average selling prices currently around 11 times incomes, driven in part by investment from Asia (see below chart).

It should be noted, however, that Vancouver was ranked as the third most unaffordable housing market in the latest Demographia International Housing Affordability Survey, just behind Sydney (second) and in front of Coffs harbour (fourth) and Melbourne (fifth) (see below chart).

Mr Carney then warns that pockets of the Canadian housing market are experiencing bubble-like behaviour, rather than pricing based upon sound fundamentals.

Given such developments, one cannot totally discount the possibility that some pockets of the Canadian housing market are taking on characteristics of financial asset markets, where expectations can dominate underlying forces of supply and demand. The risk is that expectations become extrapolative, prompting the classic market emotions of greed and fear—greed among speculators and investors—and fear among households that getting a foot on the property ladder is a now-or-never proposition.

In his concluding comments, Mr Carney warns Canadians that the current low interest rate setting is unlikely to last and that affordability is likely to worsen. Accordingly, households should be prudent in their borrowings.

…while measures of housing affordability remain favourable, this is largely because interest rates are unusually low. Rates will not remain at their current levels forever. The impact of eventual increases is likely to be greater than in previous cycles, given the higher stock of debt owed by Canadian households. At a 4 per cent real mortgage interest rate—equivalent to the average rate since 1995—affordability falls to its worst level in 16 years. As I have observed, some markets are already severely unaffordable even at current rates.

…households will need to be prudent in their borrowing, recognising that over the life of a mortgage, interest rates will often be much higher.

It’s great to hear the BoC governor speaking so frankly about the risks posed to the Canadian economy by high household indebtedness and inflated housing valuations, even if the BoC’s low interest rate settings have contributed to the problems.

At the same time, it is disheartening that Australia’s RBA governor, Glenn Stevens, continually ignores what are key risks to the Australian economy, instead claiming that Australian housing values are unexceptional by global standards.

Mr Stevens could take a page out of Mr Carney’s book. Instead of treating Australians like mugs, Mr Stevens should acknowledge that Australia has an unhealthily overpriced housing market.

Cheers Leith

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