IMF Oomph - Village Magazine

2 0 December - January 2017

S WE head for 2017, the global economy is

desperately trying to shake off the legacy of

the years past. Yet, fuelled by monetary-pol-

icy activism, and supported by financial

markets herd mentality, one old reliable of

financial and economic crises rears its ugly head: the

prospect of property bubbles.

According to a recent IMF study, there are reasons to

worry about a new housing-markets-triggered financial

blowout. And although IMF data suggest that we are not

at panic level regarding house-price inflation its

researchers conclude that “there are several reasons to

think that the present conjuncture is a time for

vigilance”.

Keep in mind: in 2004, the IMF correctly warned about

the rising dangers of house-price bubbles across the

advanced economies. Back then, writing in the Irish

press, I used the IMF model to estimate the extent of the

property bubble in Ireland at around 30-40 percent. As

we know, by 2012, Irish property prices fell by about 31

percent compared to late 2004 levels.

Adding urgency to the IMF call for vigilance on house

prices, a range of academic studies has noted that prop-

erty boom-and-bust cycles have been central to

triggering financial crises. For example, a study

published in 2013 in the Journal of Financial Stability (2)

noted that “…of the 46 systemic banking crises for which

house price data are available more than two-thirds were

preceded by boom-bust patterns in house prices”.

In other words, IMF warnings should not be taken

lightly.

Global problem: Irish concerns

Today, the IMF index of global house prices shows that

residential property prices are almost back at pre-2007

levels. The global index has averaged 153.8 over the first

six months of 2016, against 154.9 for the same period in

2007. For Ireland itself, based on data from the CSO

indexed to the IMF’s, the first six months of 2016 is 82.7.

Indexing CSO data to ESRI data for the pre-2005 period,

today’s Irish house prices are some 8 percentage points

below 2004 levels. This is more unnerving but still sug

gests we around 12 months out from the point where

prices become a serious concern.

The more pressing problem, however, is not prices,

but price inflation.

A range of studies suggests that rapid acceleration in

growth rates of prices can, in itself, represent a warning

signal of a property bubble emerging. Since the onset

of the recovery in Irish property markets in 2Q 2013, the

average annual rate of growth in house prices in Ireland

was almost 10 percent, which is five times the average

rate of growth in global house prices. So far, in 2016,

based on IMF data, Ireland has posted the third highest

rate of house-price growth in the euro area. Including

data for 2Q and 3Q 2016, Irish house-price inflation is

2.7 times the rate of growth in global residential property

prices.

The European Central Bank’s ESRB ‘Risk Dashboard’

for 3Q 2016 confirms the IMF data. It shows Ireland is an

extreme outlier when it comes to house-price inflation

in the EU, with cumulative 3-year inflation in Irish prop

erty markets standing at just over 35 percent, against

the EU average (ex-Ireland) of around 8 percent.

IMF Oomph

We must heed IMF warnings of a property

bubble - as it’s usually right

by Constantin

Gurdgiev

INTERLOPER

NEWS

House Price Indices, 2005=100

115

140

2005q1

2005q4

2006q3

2007q2

2008q1

2008q4

2009q3

2010q2

2011q1

2011q4

2012q3

2013q2

2014q1

2014q4

2015q3

2016q2

Ireland Global

Source: Author own calculations based on data from the IMF and CSO

The real problem with

the Irish market is not

Central Bank regulation,

but the chronic volatility

of the regulatory regime

undermining already fragile

supply fundamentals

CHART 1: House Price Indices, 2005=100

December - January 2017 2 1

Where’s Next?

The ECB’s ESRB Risk Dashboard provides a quar-

terly insight into the estimated degree of

mispricing in residential real estate markets

across the EU. The chart below highlights the

most recent results - for 3Q 2016.

Note: For each country, the blue bars repre-

sent the range of estimates across the four

valuation methods: price-to-rent ratio,

price-to-income ratio, asset-pricing and

estimated-demand.

The chart above shows that Irish property

markets are currently priced in the range of sig-

nificant under-valuation of between 4 percent

and 22 percent. In other words, based on the ECB

assessment, Irish property prices can rise by an

average of 12-13 percent before the residential

real estate market can be considered to be

valued in line with fundamentals.

The disparity with economic fundamentals,

estimated by the ECB, however, is much more

dramatic than the IMF-revealed difference

between Irish and global prices. Which gives a

false sense of comfort to those Irish policymak

ers and regulators who read ECB reports.

The reason for this is that the ECB explicitly

models demand using demographic and income

factors. In this context, there is a glut of sup-

pressed demand sitting in the Irish market, and

a dire shortage of supply. The latter factor con

tributes around two thirds of the price gap and

is exacerbated by the duration of the current con-

struction-sector slump, now eight years old.

Meanwhile, demand is heating up, driven by

rising rents (which improve the investment out

look for Irish property and create added

incentives for households to secure mortgages)

– though threatened by recently announced rent

controls, and by demographic trends, including

changes in net migration.

But, there are also some false positives in the

ECB’s demand-based pricing model for Ireland.

For example, the ECB analysis is based on

GDP-linked data, which overestimate Irish

households’ ability to pay for housing. It also

includes no adjustment for income distribution

across various demographic cohorts, meaning

that the incomes of potential purchasers are

exaggerated because of the typically higher

incomes of older households.

The IMF estimates for house prices as a func

tion of household income and as a function of

rents suggest that currently Irish property prices

are roughly 8 percentage points below their fun-

damentals-determined values.

All in, there is still some room for house prices

to rise before we hit long-term-sustainability

bounds. Based on 2015-2016 rates of growth in

house prices, rates that already reflect changes

in macroprudential policies instated by the Cen

tral Bank in 1Q 2015, excessive inflation of house

prices in Ireland is likely to start around late 2017

to early 2018.

Managing the Next Bubble

While much criticism of the macroprudential

risk-management policies of the Central Bank

(including restrictions on mortgage lending) has

been ventilated in the Irish media and political

circles, these policies act to suppress demand

growth on the owner-occupier side, while prop-

ping up demand from investors. Overall, the two

factors should balance each other out, decreas-

ing demand for owner-occupied housing, but

increasing the supply of rental investments. (4)

This is exemplified by the experience of Austral

ian and Canadian markets, where stricter

lending policies and higher borrowing costs, as

well as additional taxes on property for foreign

buyers, have failed to arrest price inflation.

The real problem with the Irish market is not

Central Bank regulation, but the chronic volatil

ity of the regulatory regime undermining already

fragile supply fundamentals.

Consider the regulation of Irish property mar

kets. On the supply side, Ireland’s approach to

regulation has been predominantly focused on

allowing local authorities to determine what can

be built, where it can be built and at what cost.

As a result, we have a dire undersupply of homes

in the key urban areas.

While roughly 30-35 percent of the total eco

nomic activity in the country takes place in the

Greater Dublin area, the same area accounted for

just under 8.6 percent of all residential planning

permissions granted (on average, based on the

number of units granted) for the first six months

of every year between 2001 and 2007. In 2015

and 2016, this proportion rose to almost 35 per-

cent, but there is no doubt that severe

underinvestment in housing stock from 2001-

2014 has sustained shortages of supply in

Dublin.

The problem is not likely to get any better

soon. The reason for this is that the regulatory

climate for Irish residential property has swung

from improperly managing approvals to manipu-

lating construction costs and rents.

These policy changes ignore the reality of eco-

nomics and finance: all of the recent measures

introduced by successive governments act to

reduce risk-adjusted rates of return to invest-

ment in property. Regulatory uncertainty,

coupled with the never-ending push for more

control measures for pricing, rents, and quantity

and quality of supply, increases the risk premi-

ums required in the market for developers to

undertake housing investments. Tax and pricing

uncertainty when it comes to capital gains also

raises the required rate of return that any devel

oper needs to achieve before raising construction

financing.

The sustainability of supply of new residential

properties in Irish markets is a long-established

problem. Without dramatically reversing the sit-

uation in the supply of housing, Ireland faces the

risk of developing a new property-price bubble,

this time around without much new investment

in property to accompany rampant price infla

tion.

While roughly 30-35

percent of the total

economic activity in

the country takes place

in the Greater Dublin

area, the same area

accounted for just

under 8.6 percent of

all residential planning

permissions

CHART 2: Over/undervaluation of residential property prices

(percentages) Sources: ESRB Risk Dashboard, September 2016