Downside Risks to House Prices

Introduction

• Developments in the housing market are important for households, firms, and banks. Housing serves both as a long-term investment and a good that is consumed as it is used and generates considerable utility for households (a consumption good).
• In most countries, housing makes up a large share of households’ wealth, and higher house prices increase households’ net worth and thus can boost consumption. Housing is also an important source of collateral that homeowners can use to borrow when facing temporary income shocks and to obtain financing for their small businesses.
• On the other hand, rising housing prices may lock out potential buyers from buying a house if they have trouble coming up with a down payment, or may reduce households’ disposable income if they must cut their spending to meet increasing mortgage or rental outlays. This can dampen economic growth and depress firm sales and profits.
• Households spend significant amounts of money on housing-related services. Notably, housing consumption and investment accounted for about one-sixth of the US and the euro area economies in 2017, representing one of the largest components of GDP in both cases. Finally, in many countries, mortgages and other housing-related lending make up a large fraction of banks’ assets; hence changes in house prices can significantly affect the quality of banks’ portfolios and profitability.
• House price dynamics and macroeconomic and financial stability are tightly connected. Recessions are deeper and last longer when house prices fall more and more quickly.
• More than two-thirds of the nearly 50 systemic banking crises in recent decades were preceded by boom-bust patterns in house prices. The 2007–08 global financial crisis is a case in point, in which the housing crisis spilled over onto other sectors and resulted in a full-blown crisis.
• In recent years, the simultaneous increase in house prices in many countries has raised concerns about the potential consequences of coordinated, large declines.

Main Findings:

1. House prices at risk move in response to pricing factors. The house-prices-at-risk measure deteriorates in response to changes in fundamental factors, which include tightening of financial conditions, a decline in real GDP growth, and higher credit growth. It also worsens with greater house price overvaluation—a measure of deviation from fundamentals.
2. The house-prices-at-risk measure is a useful early-warning indicator that can be used for financial stability surveillance. Adding the house-prices-at-risk measure to standard growth-at-risk and financial-crisis-prediction models enhances the predictive power of these models.
3. Macroprudential and monetary policy measures can reduce downside risks to house prices.
4. Capital inflows seem to increase downside risks to house prices in advanced economies, which may justify capital flow management measures in specific cases.

The Behavior of House Prices at Risk

• In the United States, house prices at risk gradually deteriorated beginning in the early 2000s, leading up to the global financial crisis. This pattern was initially related to house price overvaluation. Over time, past house price movements and credit also started to have a negative effect, partially offset by relatively loose financial conditions. Once the global financial crisis set in, the tightening of financial conditions weighed negatively on house prices at risk. Since late 2016, US house prices at risk appear to have deteriorated gradually due to overvaluation concerns and high credit growth, but they have been partly offset by still-easy financial conditions and past house price momentum.
• In China, house prices at risk seem more volatile, partly following the volatility in house price growth. Easy financial conditions kept house price risks contained until 2010. After 2010, high credit-to-GDP gaps and tightening of financial conditions contributed to increased downside risks. Since 2016, house price overvaluation has also contributed to the deterioration of house prices at risk.

House Prices at Risk and Financial Stability

• Sharp declines in house prices help forecast risks to real GDP growth. Growth at risk measures the degree to which future GDP growth faces downside risks, and its relationship with measures of financial vulnerabilities, including in the housing sector, is a metric for financial stability.
• Given that large declines in house prices are associated with contractions in GDP growth and financial stability risks, a deterioration in house prices at risk should help forecast downside risks to GDP growth, over and above other measures of house price imbalances that are only indirectly related to future risks.

Policies and House Prices at Risk

Empirical results show that macroprudential policies help reduce downside risks to future house prices. Macroprudential policy measures may affect house prices at risk in three ways:

1. They may have a direct effect where tightening these measures reduces house prices at risk—consistent with macroprudential policy measures leading to the accumulation of buffers, so that house prices at risk are lower for any combination of factors.
2. Macroprudential policies may change how other factors, such as financial conditions or credit, are related to house prices at risk. This could occur if, for instance, a credit expansion in the presence of macroprudential policy measures were to flow to less-leveraged households.
3. Macroprudential policy measures may affect the variables that are related to house prices at risk—previous studies find, for instance, some evidence that macroprudential policy measures reduce credit growth.

Conclusion and Policy Recommendations

1. Macroprudential policymakers should be mindful of broader implications for systemic risk to avoid precipitating declines in house price levels when the economy and the housing market are in a fragile state.
2. When nonresident buyers are a key risk for house prices, contributing to a systemic overvaluation that may subsequently result in higher downside risk, capital flow measures might help when other policy options are limited or timing is crucial.
3. As in the case of macroprudential policies, these measures would not amount to targeting house prices but, instead, would be consistent with a risk management approach to policy. In any case, these conditions need to be assessed on a case-by-case basis, and any reduction in downside risks must be weighed against the direct and indirect benefits of free and unrestricted capital flows, including better smoothing of consumption, diversification of financial risks, and the development of the financial sector.