Tag: IMF

IMF Lowers Growth Projections – Again

The latest World Economic Outlook, just released, contains a lower growth projection of 3.4 percent in 2016 and 3.6 percent in 2017 and so raising actual and potential output through a mix of demand support and structural reforms is even more urgent.

Recent Developments

In 2015, global economic activity remained subdued. Growth in emerging market and developing economies—while still accounting for over 70 percent of global growth—declined for the fifth consecutive year, while a modest recovery continued in advanced economies. Three key transitions continue to influence the global outlook: (1) the gradual slowdown and rebalancing of economic activity in China away from investment and manufacturing toward consumption and services, (2) lower prices for energy and other commodities, and (3) a gradual tightening in monetary policy in the United States in the context of a resilient U.S. recovery as several other major advanced economy central banks continue to ease monetary policy.

Overall growth in China is evolving broadly as envisaged, but with a faster-than-expected slowdown in imports and exports, in part reflecting weaker investment and manufacturing activity. These developments, together with market concerns about the future performance of the Chinese economy, are having spillovers to other economies through trade channels and weaker commodity prices, as well as through diminishing confidence and increasing volatility in financial markets. Manufacturing activity and trade remain weak globally, reflecting not only developments in China, but also subdued global demand and investment more broadly—notably a decline in investment in extractive industries. In addition, the dramatic decline in imports in a number of emerging market and developing economies in economic distress is also weighing heavily on global trade.

Oil prices have declined markedly since September 2015, reflecting expectations of sustained increases in production by Organization of the Petroleum Exporting Countries (OPEC) members amid continued global oil production in excess of oil consumption.1 Futures markets are currently suggesting only modest increases in prices in 2016 and 2017. Prices of other commodities, especially metals, have fallen as well.

Lower oil prices strain the fiscal positions of fuel exporters and weigh on their growth prospects, while supporting household demand and lowering business energy costs in importers, especially in advanced economies, where price declines are fully passed on to end users. Though a decline in oil prices driven by higher oil supply should support global demand given a higher propensity to spend in oil importers relative to oil exporters, in current circumstances several factors have dampened the positive impact of lower oil prices. First and foremost, financial strains in many oil exporters reduce their ability to smooth the shock, entailing a sizable reduction in their domestic demand. The oil price decline has had a notable impact on investment in oil and gas extraction, also subtracting from global aggregate demand. Finally, the pickup in consumption in oil importers has so far been somewhat weaker than evidence from past episodes of oil price declines would have suggested, possibly reflecting continued deleveraging in some of these economies. Limited pass-through of price declines to consumers may also have been a factor in several emerging market and developing economies.

Monetary easing in the euro area and Japan is proceeding broadly as previously envisaged, while in December 2015 the U.S. Federal Reserve lifted the federal funds rate from the zero lower bound. Overall, financial conditions within advanced economies remain very accommodative. Prospects of a gradual increase in policy interest rates in the United States as well as bouts of financial volatility amid concerns about emerging market growth prospects have contributed to tighter external financial conditions, declining capital flows, and further currency depreciations in many emerging market economies.

Headline inflation has broadly moved sideways in most countries, but with renewed declines in commodity prices and weakness in global manufacturing weighing on traded goods’ prices it is likely to soften again. Core inflation rates remain well below inflation objectives in advanced economies. Mixed inflation developments in emerging market economies reflect the conflicting implications of weak domestic demand and lower commodity prices versus marked currency depreciations over the past year.

The Updated Forecast

Global growth is projected at 3.4 percent in 2016 and 3.6 percent in 2017.

Advanced Economies

Growth in advanced economies is projected to rise by 0.2 percentage point in 2016 to 2.1 percent, and hold steady in 2017. Overall activity remains resilient in the United States, supported by still-easy financial conditions and strengthening housing and labor markets, but with dollar strength weighing on manufacturing activity and lower oil prices curtailing investment in mining structures and equipment. In the euro area, stronger private consumption supported by lower oil prices and easy financial conditions is outweighing a weakening in net exports. Growth in Japan is also expected to firm in 2016, on the back of fiscal support, lower oil prices, accommodative financial conditions, and rising incomes.

Emerging Market and Developing Economies

Growth in emerging market and developing economies is projected to increase from 4 percent in 2015—the lowest since the 2008–09 financial crisis—to 4.3 and 4.7 percent in 2016 and 2017, respectively.

  • Growth in China is expected to slow to 6.3 percent in 2016 and 6.0 percent in 2017, primarily reflecting weaker investment growth as the economy continues to rebalance. India and the rest of emerging Asia are generally projected to continue growing at a robust pace, although with some countries facing strong headwinds from China’s economic rebalancing and global manufacturing weakness.
  • Aggregate GDP in Latin America and the Caribbean is now projected to contract in 2016 as well, albeit at a smaller rate than in 2015, despite positive growth in most countries in the region. This reflects the recession in Brazil and other countries in economic distress.
  • Higher growth is projected for the Middle East, but lower oil prices, and in some cases geopolitical tensions and domestic strife, continue to weigh on the outlook.
  • Emerging Europe is projected to continue growing at a broadly steady pace, albeit with some slowing in 2016. Russia, which continues to adjust to low oil prices and Western sanctions, is expected to remain in recession in 2016. Other economies of the Commonwealth of Independent States are caught in the slipstream of Russia’s recession and geopolitical tensions, and in some cases affected by domestic structural weaknesses and low oil prices; they are projected to expand only modestly in 2016 but gather speed in 2017.
  • Most countries in sub-Saharan Africa will see a gradual pickup in growth, but with lower commodity prices, to rates that are lower than those seen over the past decade. This mainly reflects the continued adjustment to lower commodity prices and higher borrowing costs, which are weighing heavily on some of the region’s largest economies (Angola, Nigeria, and South Africa) as well as a number of smaller commodity exporters.

Forecast Revisions

Overall, forecasts for global growth have been revised downward by 0.2 percentage point for both 2016 and 2017. These revisions reflect to a substantial degree, but not exclusively, a weaker pickup in emerging economies than was forecast in October. In terms of the country composition, the revisions are largely accounted for by Brazil, where the recession caused by political uncertainty amid continued fallout from the Petrobras investigation is proving to be deeper and more protracted than previously expected; the Middle East, where prospects are hurt by lower oil prices; and the United States, where growth momentum is now expected to hold steady rather than gather further steam. Prospects for global trade growth have also been marked down by more than ½ percentage point for 2016 and 2017, reflecting developments in China as well as distressed economies.

Risks to the Forecast

Unless the key transitions in the world economy are successfully navigated, global growth could be derailed. Downside risks, which are particularly prominent for emerging market and developing economies, include the following:

  • A sharper-than-expected slowdown along China’s needed transition to more balanced growth, with more international spillovers through trade, commodity prices, and confidence, with attendant effects on global financial markets and currency valuations.
  • Adverse corporate balance sheet effects and funding challenges related to potential further dollar appreciation and tighter global financing conditions as the United States exits from extraordinarily accommodative monetary policy.
  • A sudden rise in global risk aversion, regardless of the trigger, leading to sharp further depreciations and possible financial strains in vulnerable emerging market economies. Indeed, in an environment of higher risk aversion and market volatility, even idiosyncratic shocks in a relatively large emerging market or developing economy could generate broader contagion effects.
  • An escalation of ongoing geopolitical tensions in a number of regions affecting confidence and disrupting global trade, financial, and tourism flows.

Commodity markets pose two-sided risks. On the downside, further declines in commodity prices would worsen the outlook for already-fragile commodity producers, and increasing yields on energy sector debt threaten a broader tightening of credit conditions. On the upside, the recent decline in oil prices may provide a stronger boost to demand in oil importers than currently envisaged, including through consumers’ possible perception that prices will remain lower for longer.

Policy Priorities

With the projected pickup in growth being once again weaker than previously expected and the balance of risks remaining tilted to the downside, raising actual and potential output through a mix of demand support and structural reforms is even more urgent.

In advanced economies, where inflation rates are still well below central banks’ targets, accommodative monetary policy remains essential. Where conditions allow, near-term fiscal policy should be more supportive of the recovery, especially through investments that would augment future productive capital. Fiscal consolidation, where warranted by fiscal imbalances, should be growth friendly and equitable. Efforts to raise potential output through structural reforms remain critical. Although the structural reform agenda should be country specific, common areas of focus should include strengthening labor market participation and trend employment, tackling legacy debt overhang, and reducing barriers to entry in product and services markets. In Europe, where the tide of refugees is presenting major challenges to the absorptive capacity of European Union labor markets and testing political systems, policy actions to support the integration of migrants into the labor force are critical to allay concerns about social exclusion and long-term fiscal costs, and unlock the potential long-term economic benefits of the refugee inflow.

In emerging market and developing economies, policy priorities are varied given the diversity in conditions. Policymakers need to manage vulnerabilities and rebuild resilience against potential shocks while lifting growth and ensuring continued convergence toward advanced economy income levels. Net importers of commodities are facing reduced inflation pressures and external vulnerabilities, but in some, currency depreciations accompanying reduced capital inflows could limit the scope for monetary policy easing to support demand. In a number of commodity exporters, reducing public expenditures while raising their efficiency, strengthening fiscal institutions, and increasing noncommodity revenues would facilitate the adjustment to lower fiscal revenues. In general, allowing for exchange rate flexibility will be an important means for cushioning the impact of adverse external shocks in emerging market and developing economies, especially commodity exporters, though the effects of exchange rate depreciations on private and public sector balance sheets and on domestic inflation rates need to be closely monitored. Policymakers in emerging market and developing economies need to press on with structural reforms to alleviate infrastructure bottlenecks, facilitate a dynamic and innovation-friendly business environment, and bolster human capital. Deepening local capital markets, improving fiscal revenue mobilization, and diversifying exports away from commodities are also ongoing challenges in many of these economies.

Macroprudential, Capital and LVR Controls

A newly released IMF working paper examines the impact of macroprudential controls, including lifting capital ratios, and reducing allowable loan to value (LVR) ratios. They find that first, monetary policy and macroprudential policies related to bank capital are likely to be transmitted through the same channels in the banking system as they both affect the cost of loans. So, they should be expected to reinforce each other. Second, capital buffers or liquidity ratios targeting specific sectoral exposures are likely to be effective in slowing down credit growth in the mortgage market. Third, macro-prudential instruments affecting the cost of capital or the liquidity position could usefully be complemented by instruments related to non-price dimensions of mortgage loans such as limits on LTVs. The evidence also suggests that tightening of LTVs is more effective in slowing down credit growth and house price  appreciation when monetary policy is too loose.

The design of a macro-prudential framework and its interaction with monetary policy has been at the forefront of the policy agenda since the global financial crisis. However, most advanced economies (AEs) have little experience using macroprudential policies, while there is, by contrast, more evidence about macro-prudential instruments aimed at moderating the volatility of capital flows in emerging markets. As a result, relatively little is known empirically about macroprudential instruments’ effectiveness in mitigating systemic risks in these countries, about their channels of transmission, and about how these instruments would interact with monetary policy.

Many countries publish bank lending surveys that provide very useful information on how banks modify the price and non-price terms of loans to the private sector, and on the drivers of these lending conditions. Some of the terms of loans (such as actual loan-to-value ratios (LTVs)) or some of the drivers of the lending standards (such as the cost of bank capital or the liquidity position of a bank) are directly related to macro-prudential instruments considered to be key in the policy toolkit of many jurisdictions. In this paper, we make use of the European Central Bank Lending Survey to develop a methodology and estimate empirically the likely effectiveness of some of these macro-prudential policies, their channel of transmissions and their interactions with monetary policy.

There is thus far little knowledge about how (policy driven) changes in the cost of bank capital (which could be the result of the implementation of a countercyclical capital buffer, of time contingent or sectoral risk weights, or more generally of bank specific changes in the capital adequacy ratio) or in the bank liquidity position would be transmitted to credit supply. Specifically, would such policy actions be transmitted through non-price factors (such as LTVs, collateral requirements, or maturity) or through price factors (such as price margins or fees)? There is also relatively little knowledge about whether limits on LTVs could significantly slow down house price appreciation and/or mortgage loan growth. Should measures affecting capitalization be complemented by non-price measures constraining lending standards? Can some of these macro-prudential policies be effective during housing booms when traditional monetary policy is typically too loose? Assessing such interactions and the transmission channel of macro-prudential instruments, with a specific focus on the real estate market, is important, as shocks to the real estate market have been a key source of systemic risk during the recent financial crisis.

The Euro-system Bank Lending Survey (BLS) contains information on overall changes in lending standards, or net tightening of lending standards and changes in lending standards related to non-price factors (LTVs, collateral requirements, maturity), price factors (such as margins) and factors contributing to the changes in lending standards, including balance sheet characteristics (such as capital and liquidity ratios) which can be mapped to specific macroprudential targets set by national regulators. However, identification of the impact of macro-prudential policies requires addressing specific challenges. The BLS does not require banks to specify the exact nature of the shocks that cause a change in lending standards or in the cost of capital, even though it provides information on perceptions of risks, economic activity, and competition pressures, and their contribution to the change. Hence, our approach is potentially subject to omitted variable bias, reverse causality and measurement bias (as expectations about house prices and credit growth may be mis-measured). Moreover, our observable variables (lending standard, and the contribution of balance sheet factors to lending standard) are not policy variables, which in our case are unobserved shocks affecting our observables. To address these issues, we develop methodologies relying upon instrumental variables and GMM estimators; our study also includes various control variables such as growth prospects, financial conditions, perception of risks and monetary policy cycle. Still, a potential advantage of our approach is that we would be able to capture the impact of the announcement of macro-prudential measures on lending standards, even before the actual implementation of the policy.

IMF-Macro-Modelling-Jan-2016Our main findings are the following. First, our estimates suggest that measures that increase the cost of bank capital are effective in slowing down credit growth and house price appreciation. Second, changes in LTV also impact credit growth and house price appreciation but their impact tends to be more moderate. Third, macro-prudential policies affecting the cost of capital are transmitted mainly through price margins, with very little impact on LTV ratios or other non-price characteristics of mortgage loans. The evidence also suggests that tightening of LTVs is more effective in slowing down credit growth and house price appreciation when monetary policy is too loose.

Note: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

IMF Head Warns of Slow Growth and Economic “Shocks” in 2016

International Monetary Fund Managing Director Christine Lagarde offered a bleak economic forecast for 2016 and beyond in a guest column published Wednesday in the German financial newspaper Handelsblatt.

The IMF head wrote that global economic growth next year would be “disappointing” and the outlook for the medium term had also deteriorated. Lagarde pointed to the continuing slowdown in China and the prospect of rising interest rates in the US as major factors leading to a continued slowdown in world growth rates and the potential for financial shocks.

Lagarde also noted the substantial decline in the growth of world trade, the ongoing fall in oil and other commodity prices, and the worsening economic and financial crisis in so-called “emerging market” and “developing” countries whose economies are heavily dependent on commodity exports and expanding trade.

“All of that means global growth will be disappointing and uneven in 2016,” Lagarde said. She warned, in particular, of “spillover effects” resulting from the decision of the US Federal Reserve Board earlier this month to begin raising its benchmark interest rate from near zero, the first Fed rate increase in over nine years.

Lagarde and the IMF had lobbied against the Fed move, warning that it could spark a panic outflow of capital from emerging market countries with high levels of dollar-denominated corporate debt such as Brazil, Turkey and South Africa.

In the Handelsblatt article, Lagarde said that she was concerned about the ability of such countries to absorb “shocks,” citing in particular an increase in financing costs for corporations that sold large volumes of dollar-denominated bonds during the emerging market and oil boom that followed the financial crisis of 2008. The rise in the dollar means the real cost of debt repayment for these companies, whose revenues are in sinking local currencies, increases.

Lagarde hinted that the crisis could spread more broadly across the financial system, suggesting that emerging market and energy sector companies defaulting on their payments could “infect” banks and state treasuries.

The Impact of Unconventional Monetary Policy Measures

An IMF Working Paper has been released “The Impact of Unconventional Monetary Policy Measures by the Systemic Four on Global Liquidity and Monetary Conditions“.  The paper examines the impact of unconventional monetary policy measures (UMPMs) implemented since 2008 in the United States, the United Kingdom, Euro area and Japan—the Systemic Four—on global monetary and liquidity conditions. Overall, the results show positive significant relationships. However, there are differences in the impact of the UMPMs of individual S4 countries on these conditions in other countries. UMPMs of the Bank of Japan have positive association with global liquidity but negative association with securities issuance. The quantitative easing (QE) of the Bank of England has the opposite association. Results for the quantitative easing measures of the United States Federal Reserve System (U.S. Fed) and the ECB UMPMs are more mixed. Of significant concern are the spill-over effects, which will continue to impact many economies, including those in developing countries as attempts are made to bring policy settings back to “more normal” settings.

In recent years, central banks in several systemically important countries have adopted unconventional monetary policy measures (UMPMs)—ranging from large scale purchases of public and private debt securities to direct lending to banks—designed to inter alia, repair the monetary transmission mechanism by ensuring depth and liquidity in financial markets and provide monetary accommodation at the zero lower bound of policy interest rates.  One distinguishing feature of UMPMs, which has also been referred to as quantitative easing (QE), is that the central bank actively uses its balance sheet to influence market prices and conditions beyond the use of a short-term or “policy” interest rate. As a result of these policies, the balance sheets of the central banks implementing the UMPM programs expanded significantly over the period 2008–14. This has led to large injections of money into the economy through increased reserves (which, by a “money multiplier,” increased broad money), as well as introduction of negative interest rates for some policy instruments in some advanced countries. With money and securities being imperfect substitutes, these programs resulted in portfolio rebalancing of assets of the United States, the United Kingdom, Euro area, and Japan—the Systemic Four (S4)— banks and corporations, which in turn increased asset prices. Investors responded by acquiring more risky assets outside the S4 that became relatively more attractive compared with S4 government bonds and securities: capital outflows from the S4 rebounded leading to increased inflows and issuance of new securities in emerging market economies (EMEs).

The overall effect of the S4 UMPMs on the rest of the world (RoW) liquidity and monetary conditions is not yet clear, as positive trade and capital spillovers may likely be accompanied by increased macro-financial vulnerabilities. While empirical studies find evidence of significant spillovers of monetary easing in the S4 on the RoW through trade and finance channels, research on the impact of the S4 UMPMs on the RoW banks’ balance sheets, liquidity, and money supply is still in an embryonic stage. Indeed, the substitution of cross-border banking flows with portfolio flows of non-banks does raise new concerns about financial vulnerabilities. The growing role of non-financial corporations (NFCs) as de facto “financial intermediaries” may reduce the effectiveness of macroprudential policies and limit the ability of policy makers to respond to future shocks.

Seen from a broader perspective, such UMPM programs might also lead to a loosening of fiscal discipline and shifts in the allocation of resources. In this context, the overall effect of the S4 UMPMs on the RoW is likely to be dependent on both the specific policy frameworks of affected countries and each UMPM program. Likewise, the affect of S4 UMPMs reversals on the RoW, i.e., monetary policy normalization, could also be varied. Against this background, this paper attempts to break new ground in empirically investigating UMPM spillovers on global liquidity and monetary conditions and financial sector balance sheets in other countries. In particular, we focus our analysis on spillovers from S4 monetary policy easing (conventional and QE/UMPMs) on the RoW’s monetary aggregates, banks’ balance sheets (NFC deposits), and NFC securities issuances. We also assess potential threats stemming from UMPMs unwinding to the RoW. To the best of our knowledge, this topic remains largely unexplored, which is a major gap in understanding of UMPM spillovers/leakages.

The paper focuses on specific QE programs and UMPMs implemented by the S4: (i) the large-scale assets purchase (LSAP) by the U.S. Fed, split by type of securities into purchases of U.S. treasuries, mortgage backed securities (MBS), and securities of government sponsored enterprises (GSE); (ii) the QE strategy implemented by the Bank of England (BoE); (iii) the assets purchase program of the Bank of Japan (BoJ); and (iv) the ECB’s government bond purchases (phases one and two), the ECB’s three-year long-term refinancing operation (LTRO), and the ECB’s securities market program (SMP).

We find positive and statistically significant relationships between UMPM implementation and global liquidity and monetary conditions in terms of global NFC deposit growth (including China), banks’ cross-border flows, and issuance of securities (particularly in foreign currency). We also find significant differences in the impact of the UMPMs implemented by individual S4 on broad money, NFC deposits, and securities issuance in EMEs. The BoJ’s asset purchases programs appear to have a positive impact on global liquidity and other countries’ monetary conditions, while they appear to have a negative association with issuance of securities. In contrast, the effects of the QE program implemented by the BoE have strong negative association with global liquidity, measured by broad money and NFC deposits and positive impact on issuance of NFC securities. Results for QE implemented by the U.S. Fed and ECB UMPMs are mixed.

The paper develops a new quarterly dataset covering the period Q1:2002–Q2:2014, leveraging monetary data reported by IMF member countries through the IMF’s standardized report forms (SRFs), which have the advantage of providing a consistent set of definitions based on the IMF’s Monetary and Financial Statistics Manual, and can be replicated over time and across countries using officially reported data. Core and non-core liabilities of banks are computed using detailed SRF data reported to the IMF on a confidential basis. Leveraging the IMF’s SRFs is our major advantage, relying on broad money as monetary aggregate, which is comparable across SRF reporting countries. In contrast, other studies have typically relied on countries’ self-reported monetary aggregates under more traditional classifications (e.g., M0, M2, etc.) subject to different national definitions, which make cross-country comparisons less meaningful.

The UMPMs implemented by the S4 and analyzed in this paper are negatively correlated with the nominal long term (LT) interest rates (Figure 1), confirming existing results of the empirical studies that show that UMPMs had significant impact on respective long-term government bond yields (LT interest rates).

Flows1This suggests that S4 UMPMs contributed to the compression of long-term interest rates in S4, which prompted a materialization of rebounded private capital outflows from these countries (Figure 2).Flows2Through a detailed descriptive and econometric analysis the results of this paper suggest that the impact on global liquidity, monetary conditions, and bank balance sheets from individual S4 UMPMs differ depending on the nature of each program, initial macro-economic conditions, and countries’ policy response. The U.S. QE programs might dominate in impact due to its size and the relevance of the U.S. dollar as a global transaction currency.

In addition, while we find a positive impact of S4 UMPMs on global liquidity and money growth, the differential nature of these programs can potentially have countervailing effects on each other and on global liquidity. For example, the U.S. Fed was concentrating on the asset side of the balance sheet to support the financial intermediary function, while the BoJ was targeting the liability side to provide a buffer against funding liquidity by increasing private banks’ excess reserves. The difference in policies explained in part by the differences in financial systems (market-based system in the United States versus bank-based system in Japan). Targeted assets purchases programs may have a potential positive impact on asset markets as they may prevent excessive swings in asset prices.

The S4 UMPM policies had a statistically significant impact on the EMEs’ banks money supply and funding liquidity though their impact on bank balance sheets, NFCs deposits, and NFC securities issuance. The portfolio rebalancing channel of QE/UMPM policies has led to the redistribution and increased issuance of EMEs’ debt and has increased the non-core liabilities in EME banking sectors.

The results also suggest that non-core liabilities of EME banks exhibit higher volatility than those of developed countries, making EMEs banking systems more vulnerable to the S4 monetary policy reversals and unwinding of the programs. At the same time, macroprudential regulation in EMEs may become less effective due to the increased significance of the non-banking sector as de facto “financial intermediary.”

Furthermore, UMPM programs have been accompanied by economic costs, since they seem to have led to the reallocation of resources on banks’ balance sheets and possibly contributed to loosening fiscal discipline in EMEs. Therefore, close monitoring of macro-financial vulnerabilities in EMEs and undertaking debt sustainability analysis on a frequent basis may be prudent to head-off policy mistakes and to maintain financial stability. Finally, as monetary policy begins to normalize in the S4, RoW liquidity and monetary conditions might get tighter. As the “taper tantrum” episode of 2013 showed, simply signaling a change in future monetary policy can create a wave of extreme volatility in the markets, influencing RoW exchange rates, flows and asset prices. This suggests the need for better communication among central banks and with the financial markets in addition to strengthening of the global financial safety net.

A full assessment of the effects of the UMPMs can be made only after a complete return to a normalized monetary policy. Nonetheless, at this point, our analysis can help shed light on the potential impact of the UMPMs on global monetary and liquidity conditions.

Note that IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Housing Price and Household Debt Interactions

A newly published IMF working paper looks at the relationship between house prices and household debt, in Sweden. The work is interesting because house prices have risen significantly, and household debt has risen substantially at a time when supply was limited. Australia is not the only country with these synonyms!

Sweden1The swings in house price growth have had wider amplitude than those of credit growth since the GFC. Whilst a loan-to-value ratio cap of 85 percent on all new mortgage loans was introduced in 2010 which may have affected lending growth, they still have tax relief on mortgage repayments.

Sweden-2The question the paper examines is the relationship between these higher prices and household debt levels. A common interpretation of the link between these markets is that mortgage lending drives housing prices up, motivating measures to curb credit. Yet, mortgage lending can also be driven by rising housing prices through the wealth
and collateral channels. Home ownership generally requires debt financing, especially as households usually acquire this major asset early in their life cycle. When house prices appreciate, households who own housing may perceive that their higher wealth allows for greater lifetime consumption, inducing households to borrow and spend more. At the same time, the higher value of housing assets expands the value of collateral against which borrowing is generally much cheaper than unsecured credit. Relaxing this collateral constraint thereby expands households’ borrowing capacity, which could be reflected in a combination of higher consumption and larger asset holdings. For households that do not yet own a house, higher prices increase the need to borrow but also relax collateral constraints.

The paper examines the interactions between housing prices and household debt using a three-equation model, finding that household borrowing impacts housing prices in the short-run, but the price of housing is the main driver of the secular trend in household debt over the long-run. Both housing prices and household debt are estimated to be moderately above their long-run equilibrium levels, but the adjustment toward equilibrium is not found to be rapid. Whereas low interest rates have contributed to the recent surge in housing prices, growth in incomes and financial assets play a larger role. Policy experiments suggest that a gradual phasing out of mortgage interest deductibility is likely to have a manageable effect on housing prices and household debt.

Note that IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

IMF Updates Global and National Housing Outlook, Australian Property Overvalued

In the latest release, the IMF have provided data to October 2015, and also some specific analysis of the Australian housing market. We think they are overoptimistic about the local scene, and we explain why.

But first, according to the IMF, globally, house prices continue a slow recovery. The Global House Price Index, an equally weighted average of real house prices in nearly 60 countries, inched up slowly during the past two years but has not yet returned to pre-crisis levels.

chart1_As noted in previous quarterly reports, the overall index conceals divergent patterns: over the past year, house prices rose in two-thirds of the countries included in the index and fell in the other one-third.

house prices around the world_071814Credit growth has been strong in many countries. As noted in July’s quarterly report, house prices and credit growth have gone hand-in-hand over the past five years. However, credit growth is not the only predictor for the extent of house price growth; several other factors appear to be at play.

house prices around the world_071814For OECD countries, house prices have grown faster than incomes and rents in almost half of the countries.

chart2_House price-to income and house price-to-rent ratios are highly correlated, as documented in the previous quarterly report.

chart2_ Turning to the Australia specific analysis, Adil Mohommad, Dan Nyberg, and Alex Pitt (all at the IMF) argue that house prices are moderately stronger than consistent with current economic fundamentals, but less than a comparison to historical or international averages would suggest. Here is just a summary of their arguments, the full report is available.

Argument: House prices have risen faster in Australia than in most other countries, suggesting, ceteris paribus, overvaluation.

OZ-House-Prices-to-GDPCounter argument 1: House prices are in line on an absolute basis – Price-to-income ratios have risen in Australia and now near historic highs. However, international comparisons suggest that Australia is broadly in line with comparator countries, although significant data comparability issues make inference difficult.
Counter argument 2: The equilibrium level of house prices has also risen sharply – Lower nominal and real interest rates and financial liberalization are key contributors to the strong increases in house prices over the past two decades. The various house price modeling approaches indicate that house prices are moderately stronger (in the range of 4-19 percent) than economic fundamentals would suggest.
Counter argument 3: High prices reflect low supply – Housing supply does indeed seem to have grown significantly slower than demand, reducing (but not eliminating) concerns about overvaluation.
Counter argument 4: It is just a Sydney problem, not a national one – The two most populous cities, Sydney and Melbourne, have seen strong house price increases, including in the investor segment. A sharp downturn in the housing market in these cities could be expected to have real sector spillovers, pointing to the need for targeted measures—including investor lending—to reduce risks from a housing downturn.
Counter argument 5: There are no signs of weakening lending standards or speculation – While lending standards overall seem not to have loosened, the growing share of investor and interest-only loans in the highly-buoyant Sydney market, is a pocket of concern.
Counter argument 6: Even if they are overvalued, it doesn’t matter as banks can withstand a big fall – While bank capital levels are likely sufficient to keep them solvent in the event of a major fall in house prices, they are not enough to prevent banks making an already extremely difficult macroeconomic situation worse.

Let us think about each in turn.

Thus, DFA concludes the IMF initial statement is correct, and despite their detailed analysis, their counterarguments are not convincing. We do have a problem.

IMF Says Financial Stability Risks Rotating to Emerging Markets

The IMF has released the October 2015 Global Financial Stability Report.

Financial stability has improved in advanced economies since April, but risks continue to rotate toward emerging markets. The global financial outlook is clouded by a triad of policy challenges: emerging market vulnerabilities, legacy issues from the crisis in advanced economies, and weak systemic market liquidity. Although many emerging market economies have enhanced their policy frameworks and resilience to external shocks, several key economies face substantial domestic imbalances and lower growth. Recent market developments such as slumping commodity prices, China’s bursting equity bubble and pressure on exchange rates underscore these challenges. The prospect of the U.S. Federal Reserve gradually raising interest rates points to an unprecedented adjustment in the global financial system as financial conditions and risk premiums “normalize” from historically low levels alongside rising policy rates and a modest cyclical recovery.

Only some markets show obvious signs of worsening market liquidity, although dynamics diverge across bond classes. The current levels of market liquidity are being sustained by benign cyclical conditions and accommodative monetary policy. At the same time, some structural developments may be eroding its resilience. Policymakers should have a policy strategy in hand to cope with episodes of dry ups of market liquidity. A smooth normalization of monetary policy in advanced economies and the continuation of market infrastructure reforms to ensure more efficient and transparent capital markets are important to avoid disruptions of market liquidity in advanced and emerging market economies.

Corporate debt in emerging markets quadrupled between 2004 and 2014. Global drivers have played an increasing role in leverage growth, bond issuance, and corporate spreads. Higher leverage has been associated with, on average, rising foreign currency exposures. The chapter also finds that despite weaker balance sheets, firms have managed to issue bonds at better terms as a result of favorable financial conditions. The greater role of global factors during a period when they have been exceptionally favorable suggests that emerging markets must prepare for the implications of global financial tightening.

Uncertainty, Complex Forces Weigh on Global Growth

The IMF’s latest World Economic Outlook (WEO) makes 230 pages of sober reading. Global growth for 2015 is projected at 3.1 percent, 0.3 percentage point lower than in 2014, and 0.2 percentage point below the forecasts in the July 2015 World Economic Outlook (WEO) Update.

They list a litany of potential down-side risks to growth, including China’s economic transformation—away from export- and investment-led growth and manufacturing, in favor of a greater focus on consumption and services; the related fall in commodity prices; and the impending increase in U.S. interest rates, which can have global repercussions and add to current uncertainties. They foresee lower global growth compared to last year, with only modest pickup in advanced economies and a slowing in emerging markets, primarily reflecting weakness in some large emerging economies and oil-exporting countries.

Whilst global real GDP grew at 3.4 percent last year, and is forecast to grow at only 3.1 percent this year, growth is expected to rebound to 3.6 percent next year. However, we note that expected future growth is consistently being moved into the future.

“Six years after the world economy emerged from its broadest and deepest postwar recession, the holy grail of robust and synchronized global expansion remains elusive,” said Maurice Obstfeld, the IMF Economic Counsellor and Director of the Research Department. “Despite considerable differences in country-specific outlooks, the new forecasts mark down expected near-term growth marginally but nearly across the board. Moreover, downside risks to the world economy appear more pronounced than they did just a few months ago”.

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In this global environment, with the risk of low growth for a long time, the WEO underlines the need for policymakers to raise actual and potential growth.

Recovery in advanced economies on course

Growth in advanced economies is projected to increase modestly to 2 percent this year and 2.2 percent next. This year’s pickup reflects primarily a strengthening of the modest recovery in the euro area and a return to positive growth in Japan, supported by declining oil prices, accommodative monetary policy, and improved financial conditions, and in some cases, currency depreciation.

While growth is expected to increase in 2016, especially in North America, medium-term prospects remain subdued, reflecting a combination of lower investment, unfavorable demographics, and weak productivity growth.

Slower growth in emerging and developing economies

Growth prospects in emerging markets and developing economies vary across countries and regions. But the outlook in 2015 is generally weakening, with growth for these economies as a group projected to decline from 4.6 percent in 2014 to 4.0 percent in 2015.

The fifth straight year of slowing growth reflects a combination of factors: weaker growth in oil exporters, a slowdown in China with less reliance on commodity-intensive investment, adjustment in the aftermath of credit and investment booms, and a weaker outlook for exporters of other commodities, including in Latin America, following declines in their export prices. In addition, geopolitical tensions and domestic strife in a number of countries remain high, with immense economic and social costs.

External conditions are becoming more difficult for most emerging economies. The prospect of rising U.S. interest rates and a stronger dollar has already contributed to higher financing costs for some borrowers, including emerging and developing economies. And while the growth slowdown in China is so far in line with forecasts, its cross-border repercussions appear larger than previously envisaged, including through weaker commodity prices and reduced imports.

The projected rebound in growth in emerging market and developing economies in 2016 therefore reflects not a general recovery, but mostly a less deep recession or a partial normalization of conditions in countries in economic distress in 2015 (including Brazil, Russia, and some countries in Latin America and in the Middle East), spillovers from the stronger pickup in activity in advanced economies, and the easing of sanctions on the Islamic Republic of Iran.

Growth in low-income developing economies is expected to slow to 4.8 percent in 2015, from 6 percent in 2014, in large part due to weak commodity prices and the prospect of tighter global financial conditions. Some countries (e.g., Kyrgyz Republic, Mozambique) have been running large current account deficits, benefiting from easy access to foreign savings and abundant foreign direct investment, especially in resource-rich countries, and hence are particularly vulnerable to external financial shocks.

Downside risks more significant

Given the distribution of risks to the near-term outlook, global growth is more likely to fall short of expectations than to surprise on the upside. The WEO report outlines important shifts that could stall global recovery. These include:

• Lower oil and other commodity prices, which although benefiting commodity importers, complicate the outlook for commodity exporters, some of whom already face strained initial conditions (e.g., Russia, Venezuela, Nigeria).

• A sharper-than-expected slowdown in China, if the expected rebalancing toward a more market-based and consumption-driven growth proves more challenging than expected.

• Disruptive asset price shifts and a further increase in financial market volatility could involve a reversal of capital flows in emerging market economies. Further, renewed concerns about China’s growth potential, Greece’s future in the euro area, the impact of sharply lower oil prices, and contagion effects could be sparks for market volatility.

• A further appreciation of the U.S. dollar could pose balance sheet and funding risks for dollar debtors, especially in some emerging market economies, where foreign–currency corporate debt has increased substantially over the past few years.

• Increased geopolitical tensions in Ukraine, the Middle East, or parts of Africa could take a toll on confidence.

Policy upgrades to avoid low-growth traps

The report underscores that raising actual and potential output must remain the policy priority. This will require a combination of demand support and structural reforms.

In advanced economies, accommodative monetary policy continues to be essential, alongside macroprudential tools to contain financial sector risks, the report notes. On the fiscal side, countries with room for fiscal stimulus, such as Germany, should use it to boost public investment, especially in quality infrastructure.

Structural reforms are, of course, country specific. But the main planks include measures to strengthen labor force participation, facilitate labor market adjustment, tackle legacy debt overhang, and lower barriers to entry in product markets, especially in services.

Many emerging markets have increased their resilience to external shocks. Thanks to increased exchange rate flexibility, higher foreign exchange reserves, increased reliance on foreign direct investment flows and domestic-currency external financing, and generally stronger policy frameworks, many countries are now in a stronger position to manage heightened volatility.

Nevertheless, in a more complex external environment, emerging market and developing economies face a difficult trade-off between supporting demand amid slowing actual and potential growth and reducing vulnerabilities. The scope for policy easing varies considerably across countries, depending on macroeconomic conditions and sensitivity to commodity price shocks, as well as external, financial, and fiscal vulnerabilities.

For example, commodity exporters have to adjust to lower commodities-related revenue—gradually if fiscal buffers were built during the commodity boom, and more rapidly otherwise. In commodity-exporting countries with flexible exchange rate regimes, currency depreciation can help offset the demand impact of terms-of-trade losses. Yet, sharp exchange rate changes can also exacerbate vulnerabilities associated with high corporate leverage and foreign currency exposure. Therefore, exchange rate policy should not lose sight of financial stability considerations. At the same time, countries need to diversify their economies. Targeted structural reforms to raise productivity and remove bottlenecks to production can help countries to diversify their export bases.

In their analysis of commodity trade-exposed countries, like Australia, they highlight the fact that investment in the resources sector did not translate into broader economic development.

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Are Australian House Prices Overvalued?

Within the 65 pages of the IMF report there is a comprehensive section on Australian house prices.  Housing market risks they say remain heightened. They conclude that house prices are moderately overvalued, probably around 10 percent. The problem is concentrated in Sydney and is fuelled by investor credit and interest only loans. Current rates of house price inflation imply rising overvaluation. Current efforts to rein in riskier property lending might not be sufficiently effective.

International comparisons persistently signal warnings. The level of real house prices and the house price to income ratio is high relative to the OECD average (though similar to other buoyant markets). House price inflation picked up to 7-10 percent in 2014-15—driven by rapid increases in Sydney and to a lesser extent Melbourne (prices in the resource states have fallen back in recent months). While foreign investment in real estate has increased, the main driver has been local investor lending and interest-only loans. Sydney house price to income ratios are much higher than for other cities at around 7—similar to Auckland, London, Stockholm and Vancouver.

Can the increase in house prices be explained?

  1. The housing market and financial system have changed significantly over the past two decades with a shift to low inflation, low nominal interest rates and financial liberalization which loosened credit constraints. Households’ borrowing capacity increased and they moved to a higher steady state level of indebtedness and higher house prices relative to incomes.
  2. Supply side constraints may also keep prices high. Although Australia is big, much of the country is remote and the population is concentrated in a few cities where there are geographical or other barriers to expansion. Population growth has also been much more rapid than for other OECD countries, whereas housing investment as a share of GDP is only at OECD average levels. Supply bottlenecks also reflect planning issues and transport restrictions.

IMF-Aust-1IMF-Aust-2Are high and rising prices a problem? There has been no generalized credit boom and lending standards are generally high (and being tightened), so financial stability risks seem contained. The run-up in house prices has also not been accompanied by a construction boom (unlike Ireland and Spain). But with already high debt and house prices, rapid house price inflation raises the risk of a sharp reversal, which would damage the macroeconomy.

Do models point to overvaluation? Estimating overvaluation is inherently difficult. Rather than relying on one model, staff used four different approaches.

  1. Statistical filter. Deviations from an HP filter suggest overvaluation of about 5 percent.
  2. Fundamentals. The standard model used in the Fund, estimated since the early 2000s, with fundamental explanatory variables—affordability, incomes, interest rates, and demographics―estimates overvaluation of around 15 percent and equilibrium growth rates around 3-4 percent.
  3. Including supply factors. A model using similar longrun fundamentals, but adding credit and the housing stock to take into account supply constraints, points to an overvaluation of around 8-10 percent.
  4. User costs. Estimates of user costs (whether it is more expensive to own than to rent) suggests that renting is about as costly as buying a house based on average real appreciation since 1955 (Fox and Tulip, 2014). However, this estimate is highly sensitive to interest rates and expectations of future house price appreciation. Using a plausibly lower expected appreciation term results in an overvaluation of 10-19 percent.

IMF-Aust-3Bottom line: House prices are moderately overvalued, probably around 10 percent. The problem is concentrated in Sydney and is fuelled by investor credit and interest only loans. Current rates of house price inflation imply rising overvaluation.

In their house price modelling, they assume a  baseline projection is for a soft landing, with house price inflation slowing to a sustainable 3-4 percent, based on medium-term fundamentals. This implies no change in the estimated overvaluation and housing market risks thus remain heightened.

Current efforts to rein in riskier property lending might not be sufficiently effective. Against a backdrop of already high house prices and household debt, this could give rise to price overshooting and excessive risk taking. A sharp correction in house prices, possibly driven by Sydney, could be triggered by external conditions (e.g., a sharper slowdown in China or a rise in global risk premia), or a domestic shock to employment.

This might have wider ramifications if it affects confidence. The house price cycle could be amplified by leveraged investors looking to exit the market and a turning commercial property cycle. Though currently small, investors in self managed superannuation funds that have added geared property to their fund portfolios would also be adversely affected in a downturn. In a tail scenario, APRA’s stress tests suggest banks would probably face ratings downgrades/higher offshore funding costs and would likely resist capital ratios falling into capital conservation territory by sharply tightening credit conditions, thus transmitting and amplifying the shock to the rest of the economy.

IMF Report On Australia Shows Work Is Needed

The IMF released their latest review of Australia. They expect growth to remain under trend to 2.8% in 2020, house prices to remain high along with household debt, household savings to fall, and the cash rate to fall before rising later. Mining investment will continue to fall, and non mining investment to rise, with a slow fall in unemployment to 5.5% by 2020. They supported the FSI recommendations for banks to hold more capital. They cautioned that if investor lending and house price inflation do not slow appreciably, these policies may need to be intensified.

On September 14, the Executive Board of the International Monetary Fund (IMF) concluded the 2015 Article IV consultation1 with Australia.

Australia has enjoyed exceptionally strong income growth for the past two decades, supported by the boom in global demand for Australia’s natural resources and strong policy frameworks. However, the economy is now facing a large transition as the mining investment boom winds down and the terms of trade has fallen back. Growth has been below trend for two years. Annualized GDP growth was around 2.2 percent in the first half of 2015, with particularly weak final domestic demand, and declining public and private investment. Capacity utilization and a soft labor market point to a sizeable output gap. Nominal wage growth is weak, contributing to low inflation.

The terms of trade has fallen sharply over the past year. Iron ore prices have fallen by more than a third and Australia’s commodities prices are down by around a quarter since mid-2014. The exchange rate has depreciated further in recent months following news about economic and financial market developments in China. This has significantly reduced the likely degree of exchange rate overvaluation and should help support activity. Although the current account deficit narrowed to 2.8 percent of GDP in 2014 as mining-related imports declined, it is expected to widen somewhat in 2015.

With subdued inflation pressure, and a weaker outlook, the Reserve Bank of Australia (RBA) cut its policy rate by a further 50bps in the first half of 2015 to 2 percent. While housing investment has picked up strongly, consumer confidence indicators and investment expectations remain muted. Consumption growth has also been moderate reflecting weak income growth. But low interest rates have pushed up asset prices. Overall house price inflation is close to 10 percent, but is around 18 percent in Sydney. Buoyant housing investor lending has recently prompted regulatory action to reinforce sound residential mortgage lending practices.

Fiscal consolidation has become more difficult and public debt is rising, albeit from a low level. Lower export prices and weak wage growth are denting nominal tax revenues; unemployment is adding to expenditures. The national fiscal deficit remained at 3 percent in fiscal year

(FY, July–June) 2014/15, broadly unchanged from the previous year. The FY 2015/16 Budget projects a return to surplus in 2019–20. The combination of tightening by the States and the commonwealth implies an improvement in the national cyclically-adjusted balance by some 0.7 of a percent of GDP on average over the next three years.

Executive Board Assessment

Executive Directors commended Australia’s strong economic performance over the past two decades, which has been underpinned by sound policies, the flexible exchange rate regime, earlier structural reforms, and a boom in the global demand for resources. They noted, however, that declining investment in mining and a sharp fall in the terms of trade are posing macroeconomic challenges, while potential growth is likely to slow in the period ahead. Accordingly, Directors agreed that continued efforts to support aggregate demand and raise productivity will be critical in transitioning to a broader-based and high growth path.

Directors noted that a supportive policy mix is needed to facilitate the structural changes underway. With a still sizeable output gap and subdued inflation, most Directors agreed that monetary policy is appropriately accommodative and could be eased further if the cyclical rebound disappoints, provided financial risks remain contained. Directors also noted that the floating exchange rate provides an important buffer for the economy.

Directors broadly agreed that a small surplus should remain a longer-term anchor of fiscal policy. In this regard, many Directors supported the authorities’ planned pace of adjustment, which they viewed as striking the right balance between supporting near-term activity and addressing longer-term spending commitments. Some Directors, however, considered that consolidation could be somewhat less frontloaded, given ample fiscal space. Directors broadly concurred that boosting public investment would support demand, take pressure off monetary policy, and insure against downside risks. In this context, they welcomed the authorities’ continuing to establish a pipeline of high-quality projects.

Directors highlighted that maintaining income growth at past rates and boosting potential growth would require higher productivity growth. They expressed confidence that this could be achieved, given Australia’s strong institutions, flexible economy, track record of undertaking comprehensive structural reforms, and the opportunities created by Asia’s rapid growth. Nonetheless, further reforms in a variety of areas will be required. In this regard, Directors noted the findings of the Competition Policy Review and looked forward to their implementation. Furthermore, addressing infrastructure needs will relieve bottlenecks and housing supply constraints. Directors also encouraged a shift toward more efficient taxes, while ensuring fairness.

Directors supported the recommendations of the Financial System Inquiry. They noted that while banks are sound and profitable, significantly higher capital would be needed in a severe adverse scenario to ensure a fully-functioning system. Accordingly, they welcomed the authorities’ commitment to make banks’ capital “unquestionably strong” over time. To address risks in the housing market, Directors supported targeted action by the regulator. They cautioned that if investor lending and house price inflation do not slow appreciably, these policies may need to be intensified.