Tuesday, 7 January 2014

"My house my castle"

By Fraser McKay, Intern, Motu Economic and Public Policy Research

“My house my castle.” This is a phrase uttered by countless New Zealanders from all walks of life, across different ethnicities, both genders and over a wide range of ages. Put simply, we like buying, selling and developing real estate. Talking about house prices, rental yields and leverage can sustain conversations well into the evenings at summer barbeques. There exists the persistent herd mentality that house prices will continue to rise – such beliefs can have disastrous economic consequences, as evidenced by the Great Depression. The fair value of an asset is the cumulative value of its expected future cash flows, which may be derived from future re-sale or from leasing, discounted back to today’s dollars at a rate of interest at which the capital tied up in the asset could be employed in an alternative use, for example by investing in government securities. Assets cannot sustainably maintain deviations from their fair values, though as Keynes famously noted, “The market can stay irrational longer than you can stay solvent.” Devout believers of laissez-faire would argue that there is nothing inherently harmful about housing bubbles and subsequent price corrections, on the basis that the market is merely reacting to the mutual forces of supply and demand. Few, if any, economists these days are completely anarchist: even Friedman acknowledges the role of government in upholding property rights and basic functioning of law and justice.

For most Western economies such as in New Zealand, it has been deemed appropriate to separate fiscal objectives from monetary and macro-prudential objectives, where the latter is the responsibility of the central bank. In particular, the Reserve Bank of New Zealand (RBNZ) is concerned with maintaining a healthy average level of inflation on the order of 1%-3% p.a., as measured by the Consumers Price Index (CPI). The CPI band does not take into account house price inflation, which for new home-buyers is very much a part of the cost of living. The RBNZ argues that house price inflation is largely attributable to two factors: housing shortages and easy credit, where loan-to-value ratios (LVRs) above 80% account for 30% of new lending. Of late, the monetary authorities have become concerned that this level may be threatened by upward pressure due to beliefs that Auckland housing is significantly overvalued, and due to the risk that house construction in Christchurch could otherwise be financed through high LVR loans. As such, they introduced a policy restricting LVRs greater than 80% on residential property to make up no more than 10% of the portfolio of each and every bank in the country.

The policy has been met with quite strong opposition, mostly from prospective first-home buyers and from the construction industry. While the former group is listed by the RBNZ as one of the reasons why the policy was introduced in the first place, it is the latter that is of more concern. Public opinion suggests dampening rising demand has come at the price of slowing supply. Research from consulting company, Branz, showed 5000 new houses could be jeopardised by applying LVRs to new house construction. RBNZ deputy governor Grant Spencer made a statement earlier this month claiming that while high LVR construction lending is only around 1% of total residential lending, it finances around 12% of residential building activity, which means that low deposit lending will fall outside the 10% speed limit if it is financing new construction. This fact contributed to the RBNZ’s decision to introduce an exemption clause allowing higher LVRs for new housing construction to generate new supply to ease inflationary pressure in the housing market. 

The exemption clause may enable continued development in Christchurch relative to the no-exemption situation. One may have similar expectations for the overheated Auckland housing market. Further, by relaxing the constraints on construction supply, the clause may help support and even boost employment in the construction industry as New Zealand construction workers may now have reduced incentives to migrate overseas in search of more attractive and abundant opportunities; likewise, foreign construction workers may be encouraged to migrate here.

One issue with the initial policy is that it has led to some banks charging higher interest rates on low-deposit loans, effectively imposing price discrimination on would-be first home buyers. This issue, in conjunction with the exemption clause, lends weight to the argument that these prospective home-owners would have increased incentives to obtain finance to construct new residential property, as opposed to saving for the required deposit on a mortgage under the new LVR restriction. 

The RBNZ cannot fix each and every problem within an economy. For political objectives, such as access to housing for those unable to afford it, to be achieved as well, government must take a long-term view and construct and implement appropriate fiscal policies that do not conflict with those of the central bank. What the RBNZ did not take into account in forming its initial LVR policy is the significant effect that wealthy investors, both domestic and foreign, are exerting on house prices – this responsibility may lie more in the hands of central government.

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