Assessing the risk of a real estate bubble in developed markets
The interest rate hikes being implemented by central banks in order to combat inflation are leading to concerns regarding the impact such tighter financial conditions may have on real estate markets. In many developed economies, house prices have risen considerably in recent years, a trend that accelerated during the pandemic, fuelling fears of real estate bubbles. Given this situation, the authorities in several countries have implemented a series of macroprudential instruments to cool down their market. However, in Spain the risk of a real estate bubble appears to be contained.
During the pandemic, housing demand and prices increased in the real estate markets of a large number of advanced economies. In many cases, this upward trend was already occurring before the pandemic but accelerated afterwards due to the savings accumulated during confinement and changing housing preferences. The aggregate indicator for house prices in developed countries therefore grew by 13.9% year-on-year in Q4 2021, a notable acceleration compared with its pre-pandemic growth (4.1% on average over the period 2015-2019).15
- 15. Data based on the Federal Reserve Bank of Dallas’s house price indicator, which aggregates prices from 25 developed countries.
The shift in central bank monetary policy could cool down some developed residential markets that are showing signs of overheating.
However, this situation might be about to change as a result of tighter monetary policies. In fact, central banks are raising interest rates faster and more sharply than previously expected, raising concerns regarding the impact this may have on real estate markets which, in some cases, could be overheated. The Exuberance Index produced quarterly by the Federal Reserve Bank of Dallas16 indicates that the number of economies with an overvalued residential market is approaching the highs of 2006 (the peak of the housing boom in the previous cycle).
- 16. This indicator attempts to identify periods in which the growth in house prices does not seem to be based on housing market fundamentals. For more details on its construction and estimates, see the work by Mack, A. and Martínez-García, E. (2011), «A Cross-Country Quarterly Database of Real House Prices: A Methodological Note».
The Dallas Fed’s Exuberance Index shows that the number of economies with an overvalued housing market is approaching the peak reached in 2006.
Overall aggregate house prices
Number of countries with overvalued housing according to the Federal Reserve Bank of Dallas’s Exuberance Index*
In order to assess the current residential market situation in different developed countries, we analysed several relevant indicators: (i) house price growth (since the start of the pandemic plus an indicator of whether the upward trend in prices was pre-pandemic), (ii) residential investment (as a percentage of GDP and its growth since the pandemic), (iii) household indebtedness (as a percentage of gross disposable income), and (iv) housing valuation models by the Dallas Fed and the European Systemic Risk Board (ESRB). The results for the economies in question are summarised in the table below.
The markets of most concern are those where the upward trend was already present before the pandemic, as this would reflect longer-term currents and an accumulation of imbalances over a greater period of time (see the table’s second column). New Zealand, Canada and Australia stand out in this group of countries, in which there was also a significant rise in house prices during the pandemic, an increase in the share of residential investment and high levels of household indebtedness. In Europe the most worrying cases would be the Netherlands, Luxembourg and Sweden, as all the indicators show clear signs of overheating.
However, in some of these countries, such as Australia, Canada, Sweden and New Zealand, we are already beginning to see signs of a change in the real estate trend (prices are already adjusting downwards) as a result of tighter monetary policy and years of macroprudential policies. The vital question is whether it will be possible to engineer a soft landing for these markets or whether the imbalances they have accumulated over the years will lead to a sharp correction, impacting the wealth of households and the financial sector.
The most worrying cases in Europe are the Netherlands, Luxembourg and Sweden. Among the non-European developed countries, New Zealand, Canada and Australia stand out.
A second group would consist of countries where some of the indicators are of concern but with more reassuring signs in other areas. In this group we find Germany, Portugal and France, countries in which the upward trend in prices pre-dates the pandemic but whose levels of household indebtedness are not worrying.17 In this group we would also place three countries whose upward trend is of concern, namely Denmark and Norway, in this case because of high household indebtedness, and the US18 because of the country’s sharp rise in house prices during the pandemic. Nevertheless, US household wealth show an overall sustainable level of debt, there is no indication that the construction sector is too large and no evidence of excessive growth in credit or a relaxation of credit standards, which could fuel a real estate boom in the US. In fact, it is precisely these aspects that radically distinguish the current situation from that of 2008, when the real estate bubble burst. Moreover, the signs of overheating are from the last few months, due to the effects of the pandemic, and therefore seem to be temporary factors that will tend to dissipate. All in all, it is to be expected that higher financing costs will tend to slow down housing demand and prices (in fact, this can already be seen in the latest figures) but any sharp correction is unlikely.
- 17. The European Systemic Risk Board (ESRB) classifies these three European countries, along with Ireland, as having a medium risk of overvaluation. Note that already in 2016 the ESRB issued its first warnings after detecting systemic imbalances in the real estate markets of Austria, Belgium, Finland, France, Germany, Luxembourg, the Netherlands and Slovakia.
- 18. See «Real-Time Market Monitoring Finds Signs of Brewing U.S. Housing Bubble», March 2022.
Although the US housing market has recently started showing signs of overvaluation, there is no evidence of excessive growth in mortgage or developer credit and a sharp 2008-style market correction is unlikely.
Finally, at the bottom of the table we find countries such as Spain and Italy where, for the moment, there are no signs of overvaluation or excessive imbalances in their real estate markets. In fact, the ESRB classifies these two countries as having a low risk of overvaluation.
Macroprudential policies emerged as a consequence of the severity of the 2007-2008 global financial crisis, when monetary authorities realised it is not enough to ensure the solvency of financial institutions and markets on an individual (or microprudential) basis to maintain a secure and stable financial system, but that an aggregate (macro) approach is also necessary to prevent macrofinancial imbalances from accumulating in the form of systemic risks that could potentially have a very negative effect on the economic cycle.
Systemic risks can have a number of different dimensions but, broadly speaking, there are two main types: (i) a time or cyclical dimension, related to how this risk develops throughout the financial cycle, and (ii) a transversal or structural dimension, in the sense that it may apply to various financial intermediaries due to the structural characteristics of the financial system itself. Given these dimensions of risk, macroprudential instruments can be applied to (i) lenders, generally by requiring a capital buffer,19 or to (ii) borrowers, by establishing conditions for new loans (e.g., limits to the amount of the loan in relation to the value of the property).
- 19. Capital buffers are additional requirements to microprudential capital requirements, designed both to curb the growth of systemic risk and to improve the solvency of institutions so they can absorb any losses that would occur in the event of such risks materialising.
At a European level, the European Systemic Risk Board (ESRB), together with the national macroprudential authorities (the central banks of each Member state) and the ECB are responsible for preventing the emergence of vulnerabilities in the region’s residential markets. The ESRB monitors a number of industry variables in order to observe trends with the potential to cause systemic risks and, on that basis, has the mandate to issue warnings and make recommendations to EU countries. In addition, in its 2021 report the ESRB conducted a two-fold exercise in which it assessed (i) the appropriateness of the measures put in place, taking into account not only the vulnerabilities accumulated but also the point in the cycle reached by each residential market, and (ii) the adequacy of the measures, assessing whether the measures implemented are capable of reducing such vulnerabilities (see the last two lines of the table below).
The ESRB monitors a number of industry variables in order to observe trends with the potential to cause systemic risk.
On balance, although it is true that a multitude of measures have been implemented in Europe, the standstill caused by COVID-19 and the increase in imbalances following the initial impact of the pandemic suggest that, currently, the measures implemented are not enough. Among the economies highlighted by the ESRB in 2019 (Denmark, Luxembourg, the Netherlands, Norway and Sweden), only Norway is implementing adequate and sufficient macroprudential policies to curb the systemic risk associated with the vulnerabilities accumulated in its residential market. On the negative side, the most notable cases are Denmark (mainly due to its high household indebtedness, which exceeds 220% of disposable income) and Luxembourg (in this case high household indebtedness is coupled with looser credit standards), countries in which the ESRB considers the risks to be high and where the current policy is neither appropriate nor sufficient.
The ESRB has issued no warnings or recommendations for the Spanish economy. In principle, the risk of a sharp correction in its real estate market is low. On the one hand, the current upward trend in prices can be explained by the considerable misalignment between a stable supply and very strong demand, which in many cases is replacement demand and, most importantly, there is no evidence of a boom in purchases due to expectations of property appreciating in value. On the other hand, there is no excessive growth in credit, no loosening of credit standards and banks are not excessively exposed to the sector (see the table below). In addition, given the growth observed in fixed-rate mortgages (60% in 2021 compared with less than 3% between 2003 and 2007), interest rate hikes will have a limited impact on newly mortgaged households.
The Bank of Spain also considers that, at an aggregate level, house prices are close to their long-term equilibrium values with no clear signs of overvaluation as yet. However, it recommends keeping an eye on trends in the Spanish real estate market.20 In fact, Spain’s regulatory body has just completed the development of macroprudential tools for credit institutions, with the aim of acting more effectively and precisely in the event of any systemic risk building up in the Spanish financial system. Since the end of 2021 (it was based on European legislation beforehand), it has had three new macroprudential instruments: the sectoral component of the countercyclical capital buffer (CCA), limits to sectoral concentration and limits to any new loans granted. The particular feature of these instruments is that they will make it possible to address risks that are concentrated in specific sectors, for which aggregate macroprudential tools were less effective as they were applied to all sectors equally.
- 20. Financial Stability Review, April 2022.
Experience regarding the use and effectiveness of macroprudential policies is limited, given that monetary authorities began to consider using them after the severe global financial crisis of 2007-2008 and, therefore, they were first implemented during the current period. In fact, the Bank of Spain itself believes that the current scenario should be used to draw conclusions regarding the usefulness and effectiveness of this type of instrument.
The greater persistence of the inflationary shock has resulted in a profound change in financial market sentiment and monetary policy implemented by the main central banks.
The very design of macroprudential policies suggests their effects on residential markets are more medium to long term. The fact that those European economies which were issued ESRB warnings as early as 2019 have continued to increase their vulnerabilities to date should not serve to undermine the work of such measures, as ultra-loose monetary policy in recent years and the consequences of the pandemic have distorted the part they play in reducing systemic risk in these economies. In addition, the economic literature is full of papers that demonstrate the effectiveness of this type of policy in moderating or stopping sharp rises in house prices.21
In any case, it does not seem appropriate to leave the correction of this type of macroeconomic imbalance exclusively to macroprudential policy. Rather it seems evident that reforms are required in the residential markets of some economies where imbalances between supply and demand persist. The ESRB itself points out that macroprudential policies should be introduced to improve market resilience but they are not designed to correct structural weaknesses, at least not directly.
Finally, it is important to note that the greater persistence of the inflationary shock has resulted in a profound change in financial market sentiment and the monetary policy of the main central banks. It is likely that widespread hikes in interest rates will cool down real estate markets more directly and decisively, leading to corrections of a greater or lesser extent depending on the vulnerability of each market. As a result, it will probably be necessary to relax macroprudential policy in some cases, given this new economic scenario.
- 21. The recent work by Bhupal Singh, published by the IMF, «House Prices and Macroprudential Policies: Evidence from City-level Data in India» (WP/20/291), provides evidence of the empirical relationship between the trend in house prices and credit standards or limits to the LTV ratio.