IMF – Page 15 – Digital Finance Analytics (DFA) Blog

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.

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.

Credit 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.

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

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

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.

Counter 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.

First, the financialisation of society is not just an Australian thing (though we have some of the highest household debts in the world), so just because we are following a global trend, does not make it ok.
Second, we agree, in the main centres, house prices are about 20% over fundamentals, and in some pockets up to 30%, so yes this is a problem, especially at a time of flat income growth.
Third, supply has been increasing, but this has stoked investment housing speculation, and is not equally strong in all areas and price brackets. We still have a massive under-supply of affordable housing, just ask prospective first time buyers – and many are having to reach for the skies just to buy something, so we thing prices are still hiked because of supply problems.
Fourth, Sydney and Melbourne markets do indeed seem to be on the turn (and record low interest rates remember), so there is risk.
Fifth, underwriting standards had declined, refer to recent APRA. ASIC and RBA comments. Guidelines on assessment of income, and baseline interest rate assumptions have been tightened. Speculation is also rife, especially in the investment sector (refer our surveys).
Sixth, banks are being forced to raise capital because there is risk in the system, and the APRA stress tests showed that whilst individual banks are strong, they had not taken into account the fact that in a downturn, all banks would be trying to access capital markets at the same time and so may not be successful.

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”.

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.

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?

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.

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.

Are 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.

Statistical filter. Deviations from an HP filter suggest overvaluation of about 5 percent.

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.

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.

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.

Bottom 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.

IMF’s Latest On Greece

Ms. Christine Lagarde, Managing Director of the International Monetary Fund (IMF), says Greece debt is unsustainable, further fiscal reforms are needed and confidence in the banking sector needs to be improved.

“The policy package specified in the Memorandum of Understanding (MoU) recently agreed between the Greek authorities and European institutions, with input from Fund staff, is a very important step forward. It not only reverses much of the policy backtracking that caused the previous program to run seriously off track, but puts in place wide-ranging policies to restore fiscal sustainability, financial sector stability, and a return to sustainable growth. I particularly welcome the authorities’ efforts to overcome the serious loss of confidence in recent months through strong upfront actions. Most of these actions have been fully specified in the MoU, and key measures including in the fiscal structural areas will be implemented as prior actions for the disbursement of the first European Stability Mechanism (ESM) tranche.

“In two areas that are of critical importance for Greece’s ability to return to a sustainable fiscal and growth path—the specification of remaining parametric fiscal measures, not least a sizeable package of pension reforms, needed to underpin the program’s still-ambitious medium-term primary surplus target and additional measures to decisively improve confidence in the banking sector—the government needs some more time to develop its program in more detail. This is understandable, and I am encouraged in this regard by the government’s commitment to work with its European partners and the Fund on completing these essential reforms in the coming months. With the detailed specification of these outstanding reforms, the recently agreed MoU will entail a very decisive and credible effort on the part of the Greek authorities to restore robust and sustainable economic growth.

“However, I remain firmly of the view that Greece’s debt has become unsustainable and that Greece cannot restore debt sustainability solely through actions on its own. Thus, it is equally critical for medium and long-term debt sustainability that Greece’s European partners make concrete commitments in the context of the first review of the ESM program to provide significant debt relief, well beyond what has been considered so far.

“In conclusion, I believe that the actions to be taken by the authorities by the time of the first review, in conjunction with the policies specified in the MoU, once they have been supplemented by the above-mentioned fiscal structural and financial sector reforms, as well as by significant debt relief, will provide the basis for a credible and comprehensive program to restore medium-term sustainability. We look forward to working closely with Greece and its European partners in the coming months to put in place all the elements needed for me to recommend to the Fund’s Executive Board to consider further financial support for Greece.”

What Factors Drive A House Price Boom?

Interesting working paper from the IMF – “Price Expectations and the U.S. Housing Boom”. Essentially, expectation of future prices – unrelated to any fundamentals – has had a significant role to play.

Between 1996 and 2006 the United States has experienced an unprecedented boom in house prices. There is no agreement on the ultimate cause for the boom. Explanations include a long period of low interest rates, declining credit standards, as well as shifts in the supply of houses and the demand for housing services. Several studies have, however, pointed out that it is difficult to explain the entire size of the boom with these factors and have offered speculation or “unrealistic expectations about future prices” as an alternative explanation. The empirical argument for an important role of house price expectations is often indirect: it is a residual that cannot be explained by a model and its observed fundamentals.

Instead of treating speculation as a deviation from a benchmark, the present paper aims to identify shifts in house price expectations directly and compare their importance to other explanations. To that purpose, we estimate a structural VAR model for the United States and use sign restrictions to identify house price expectation shocks. We then compare their effect to other shocks, including shocks to mortgage rates and shocks to the demand for housing services and the supply of houses.

Results indicate that house price expectation shocks are the most important driver of the recent U.S. housing price boom between 1996 to 2006, explaining about 30 percent of the increase. Over the entire sample, their contribution to fluctuations in housing prices in the U.S. has been smaller, accounting for about 20 percent of the long run forecast error variance of house prices. This suggests that the large contribution of price expectation shocks is historically exceptional. Regarding other shocks, mortgage rate shocks are the second most important driver of the boom: their contribution amounts to about 25 percent. Over the entire sample, they are the most important driver and account for almost 30 percent of the long run forecast error variance. Shocks to the demand for housing services and supply of houses play a subordinated role for fluctuations in house prices, both for the boom period and over the entire sample. Taken together, the four shocks explain about 70 percent of the house price boom, leaving a residual of about 30 percent. This indicates that attributing the entire residual that cannot be explained by standard shocks to price expectations will lead to an overestimation of their contribution. We also find that a model-based measure of house price expectations is positively correlated with leads of a survey based measure of house price expectations. The positive correlation with leads indicates that our measure contains similar information as a survey-based measure. In addition, it tends to provide the information more timely.

We find that the contribution of price expectation shocks to the U.S. housing boom in the 2000s has been substantial. In our baseline specification, price expectation shocks explain roughly 30% of the increase. Another 30% of the increase in house prices remains, however, unaccounted for by the four identified shocks. This indicates that attributing the entire residual that cannot be explained by standard shocks to price expectations will lead to an overestimation of their contribution. We also find that a model-based measure of house price expectations is strongly positively correlated with leads of a survey based measure of house price expectations. This indicates that our measure contains similar information as a survey-based measure, but tends to provide the information more timely. Our approach to identify price expectation shocks leaves the reason why expectations change open. When using an additional constraint to distinguish realistic from unrealistic price expectation shocks, we provide evidence that the housing boom was driven to an important extent by unrealistic price expectations. The analysis has focused on exogenous changes in expectations. An interesting topic for future empirical research is how expectations respond endogenously to other shocks.

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.

Does A Regional Trade Agreement Lessen or Exacerbate Growth Volatility?

A timely working paper from the IMF. “Does A Regional Trade Agreement Lessen or Exacerbate Growth Volatility? An Empirical Investigation” by Kangni Kpodar and Patrick A. Imam. They suggest the benefits outweigh the costs and countries that are more prone to shocks are more likely to join a RTA.

The paper assesses how regional trade agreements (RTAs) impact growth volatility on a worldwide sample of 170 countries with data spanning the period 1978-2012. Notwithstanding concerns that trade openness through RTAs can heighten exposure to shocks, in particular when it leads to increased product specialization, RTAs through enhanced policy credibility, improved policy coordination, and reduced risk of conflicts can ease growth volatility. Empirical estimations suggest the benefits outweigh the costs as RTAs are consistently associated with lower growth volatility, after controlling for trade openness and other determinants of growth volatility. Furthermore, regression results also suggest that countries that are more prone to shocks are more likely to join a RTA, in particular with countries with relatively less volatile growth, additionally enhancing the stabilization effect.

Note: The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

Global House Price Index Up; Australia In The Middle Of The Pack

The IMF just released their Global House Price Index update. It is also worth noting that Australia, whilst experiencing significant house price growth and affordability issues, is in the middle of the pack. House prices are being impacted by significant international issues, not just local ones (factors such as financial globalisation, QE, low interest rates, low growth, rise of the Asian property investor).

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.

The overall index conceals divergent patterns: since 2007:Q3 house prices rose in a third of the countries included in the index and fell in the other two-thirds. However, the picture may be changing: over the past year, real house prices increased in two-thirds of the countries and fell in the other third.

Cumulative Real House Price Growth Since 2007:Q3

Real House Price Growth Over the Past Year

Many countries in which house prices had been falling (such as Spain and the United Arab Emirates) have seen increases over the past year. Conversely, some countries where prices had been rising rapidly (as Brazil, China and Peru) have seen moderation in the rate of increase or a fall over the past year. As has been the case historically, house price growth and credit growth have gone hand-in-hand over the past five years. Clearly, 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 and Credit Growth

For OECD countries, house prices have grown faster than incomes and rents in almost half of the countries. These house price-to income and house price-to-rent ratios are highly correlated.

House Price-to-Income vs. House Price-to-Rent Ratio, OECD Countries

The Case For Tighter Financial Integration In Asia

The IMF released a working paper “Drivers of Financial Integration – Implications for Asia” which is highly relevant given that deeper intraregional financial integration is prominent on Asian policymakers’ agenda despite the fact that financial integration lags behind trade integration and that Asian economies maintain stronger financial links with the rest of the world than with other economies in the region. The paper concludes that financial integration in Asia could be enhanced through policies that lower informational frictions, continue to buttress trade integration and capital market development, remove restrictions to foreign flows and bank penetration, and promote a common regulatory framework.

Ever since the Asian financial crisis, Asian policymakers have embarked in a number of initiatives to foster regional cooperation and financial integration. This drive has been motivated to a large extent by the desire to enhance resilience against the vagaries of global financial markets by developing a local-currency denominated bond market and beefing up regional reserves. The “Manila Framework” was developed in 1997 as a “ new framework for enhanced Asian regional cooperation to promote financial stability”. Other important steps toward regional financial integration include liquidity support arrangements through the Chiang Mai Initiative Multilateralization, the Asian Bond Fund, the Asian Bond Market Initiative, and financial forums such as the Association of Southeast Asian Nations Plus Three and the Executives’ Meeting of East Asia–Pacific Central Banks. The Association of Southeast Asian Nations (ASEAN) has also outlined plans to foster capital market integration, including by building capital market infrastructure and harmonizing regulations.

In spite of these efforts, though, the empirical evidence indicates that regional financial integration lags behind trade integration and that Asian economies maintain stronger financial links with the rest of the world than with other economies in the region.

This paper takes a fresh look at the status of financial integration within Asia and at possible factors hindering progress, focusing on portfolio investment and banking claims. More specifically, it attempts to address the following questions: how financially integrated are Asian economies within the region? Has Asia’s regional financial integration increased? And how does it compare to other regions? What are the drivers of financial integration? And, hence, what are the implications for Asian policymakers pursuing deeper regional financial integration?

To answer these questions we first review recent trends in the share of cross-border holdings of portfolio investment assets and bank claims within Asia compared to outside the region. Next, we estimate the home bias—that is, the tendency to invest more in one’s home country than abroad—in Asia and other regions. Then, through a gravity model, we study the main drivers of financial integration—focusing in particular on the role of regulations—and use the results to draw implications for Asia.

The paper finds that the degree of financial integration within Asia has increased, but remains relatively low, especially when compared with Asia’s high degree of trade integration. Moreover, financial linkages within Asia are less strong than those within the euro area and the European Union, but tighter than those in Latin America. The home bias is found to be particularly strong in Asia, limiting cross-border financial transactions within the region.

The gravity model estimates indicate that cross-border portfolio investment assets and bank claims increase with the size and sophistication of financial systems and the extent of trade integration. In addition, restrictions on cross-border capital flows, informational asymmetries, barriers to foreign bank entry, and differences in regulatory and institutional quality create obstacles to financial integration.

Hence, initiatives to advance Asian policymakers’ agenda toward deeper regional integration could include steps to further promote financial market development and trade linkages, and reduce informational asymmetries through increased financial disclosure and reporting requirements. Lowering regulatory barriers to capital movements and foreign bank entry, as well as harmonizing regulation, especially for investor protection, contract enforcement, and bankruptcy procedures, appear particularly important.