Understanding asset prices

Below are extracts from:

Understanding asset prices:an overview
2006 Autumn Meeting of Central Bank Economists
Peter Hördahl and Frank Packer

The role of credit



As with other asset prices, rising property prices in many countries have been encouraged by low and falling real interest rates. Lower interest rates can operate to loosen credit constraints: Ellis (2005) at the RBA finds that the reduction in the interest rate burden for households was very important for the rapid rise in property prices in Australia in the late 1990s and early 2000s, when the ratio of housing prices to household disposable income doubled. The contribution from Coleman (Reserve Bank of New Zealand, 2006) develops an overlapping generations model of the housing market in New Zealand, where low interest rates also contributed greatly to the amounts that a typical borrower can borrow. Interestingly, the estimated model finds that the relaxation of mortgage credit constraints does not account for the large increase in housing prices in New Zealand, since older unconstrained households easily offset changes in demand from (younger) constrained households. Rather, the price of rental property has been highly sensitive to the decline in real interest rates. In this case, the transmission from lower real interest rates to higher housing prices appears to have been more through the lower discount rate applied to expected cash flows than through the relaxation of liquidity or cash flow constraints.



Other central bank research has been supportive of an independent role for credit in property price determination, given the importance of external finance and credit constraints in many markets. Using an error correction model, the Bank of Korea’s Jung (2006) finds Korean housing prices to be significantly influenced by private credit growth as well as GDP, with private sector lending actually being the most significant variable in an economic sense. In addition, the wide use of real estate as collateral suggests a possible feedback from real estate valuations to mortgage credit availability. The linkage between property prices and bank credit has been recently confirmed in a wide variety of empirical studies based on VAR analysis (Hofmann (2001), Davis and Zhu (2004), Zhu (2003)). Some of the research described in the meeting contributions documents the significance of credit by controlling separately for interest rates in empirical estimation procedures. In a cross-sectional analysis of land prices in different Japanese prefectures, Kamada (2006) finds bank lending to have a significance apart from lending rates, one which has continued after the end of the bubble era. Lecat and Mesonnier (2005) from the Bank of France use dynamic panel data techniques along the lines of Arellano and Bond (1991) to investigate housing price developments in 18 countries. They find that three financial variables – the short-term rate, the term spread and real credit growth – are highly significant. The paper thus suggests that over the past six years, with varying consequences across countries, monetary policy easing associated with completion of the disinflation process has increased housing prices.


Research has shown that the importance of credit conditions on real estate prices can vary widely across countries. The Égert and Mihaljek study (2006) uses the panel dynamic OLS (DOLS) estimator – separating central and eastern European (CEE) countries from panels of other European economies – and documents that private credit growth is more important in driving real estate prices in the CEE economies. Tsatsaronis and Zhu (2004) show that for a group of countries in which mortgage equity extraction is never used, and banks’ lending practices – as measured by low loan-to-value ratios and the use of historical property valuations – are relatively conservative, the link between bank credit and housing prices is relatively weak, whereas in a group where equity extraction is common and banks’ lending practices are more aggressive, the impact of bank lending on real estate valuation is much greater. Systems moving towards more deregulated housing finance markets often show an increased sensitivity of housing prices to credit conditions. Many countries now exhibit more flexible mortgage financing terms, an increased availability of home equity, high loan-to-value and interest-only loans. In Australia, the increased availability of credit due to financial innovation probably put upward pressure on property prices (RBA (2003b, 2005)). In France, where financial deregulation in the mortgage market also contributed significantly to reducing borrowing constraints on households, property price increases have been accompanied by a marked increase in household indebtedness. New measures which modernised the mortgage market have probably increased household vulnerabilities to income and asset price fluctuations as well (Messonier (2004)).

Some studies look at real estate prices jointly with equity prices to examine the question of whether credit growth – and other variables reflecting liquidity conditions – results in asset price “booms”. Examples of this line of research include Detken and Smets (2004), Borio and McGuire (2004) and the conference contribution of Bruggeman (National Bank of Belgium, 2006). Bruggeman defines excess liquidity in terms of cumulative deviations from trend of growth in money-to-GDP exceeding a specific threshold level. Using this identification scheme, the author finds that, in her data set of 18 industrialised countries since 1970, around one third of the periods of sustained excess liquidity have been followed by an asset price boom. Logit model estimations indicate that an asset price boom is more likely to materialise when the driving factors behind the build-up of liquidity include low interest rates, when credit growth is also strong and when asset price inflation is already well advanced. By contrast, using French data, researchers from the Bank of France (Gouteron and Szpiro (2005)) test for Granger causality in a VAR framework and find no clear signs of causality going from excess liquidity measures (such as the deviation from their long-term trends of money supply over nominal GDP, excess credit to nominal GDP and interest rate relative to natural rate) to asset prices.

Rapid credit growth, in part due to its association with property prices, also tends to result in banking and/or currency crises (eg Borio and Lowe (2002b)). The contribution of Kiss et al (Central Bank of Hungary, 2006) focuses on the characteristics of generally rapid credit growth in CEE countries, to disentangle the extent to which credit growth may be due to equilibrium convergence or to unsustainable credit booms. The authors use an error-correction model to estimate the long-run equilibrium level of credit-to-GDP based on fundamental macro variables, and apply the method to euro area countries in order to obtain a benchmark level against which emerging countries can be compared. With the exception of a few smaller countries, the results suggest that credit-to-GDP growth in CEE countries has been consistent with economic fundamentals or with convergence to the long-run equilibrium.

References

Ellis L (2005): “Disinflation and the dynamics of mortgage debt”, in “Investigating the relationship between the financial and real economy”, BIS Papers, no 22.

Hofmann B (2001):"The determinants of private sector credit in industrialised countries: do property prices matter?” BIS Working Papers, no 108.

Davis P and H Zhu (2004): “Bank lending and commercial property cycles: some cross-country evidence”, BIS Working Papers, no 150.

Zhu H: (2003): “The importance of property markets for monetary policy and financial stability”, presented at the IMF/BIS Conference on Real Estate Indicators and Financial Stability, 27-28 October, Washington DC.

Lecat R and J S Mésonnier (2005): “What role do financial factors play in house price dynamics?”, Banque de France Bulletin Digest, no 134, pp 21-37, February.

FAST CREDIT EXPANSION IN CENTRAL AND EASTERN EUROPE: CATCHING-UP, SUSTAINABLE FINANCIAL DEEPENING OR BUBBLE?

Detken C and F Smets (2004): “Asset price booms and monetary policy”, ECB Working Papers, no 364, May.
Peter Backé, Balázs Égert and Tina Zumer