Osastolyhenne/päiväys Housing market volatility in Finland Risto Herrala Economist of the Bank of Finland, [email protected], presentation in a conference.

Osastolyhenne/päiväys

Housing market volatility in Finland

Risto Herrala Economist of the Bank of Finland, [email protected] ,

presentation in a conference by the Bank of Latvia 19.9.2005

Osastolyhenne/päiväys2

The international debate on housing price volatility

• Why does the value of (housing) wealth fluctuate?– traditional asset pricing models: wealth serves consumption, and

its value equals the expected marginal consumption value. This would intuitively seem to imply an unrealistically stable value of housing wealth

– "Holmström and Tirole 2001 LAPM": with agency costs, wealth serves as insurance. Asset prices are then sensitive to, for example, aggregate economic shocks. Complex dynamics (sunspot equilibria) may arise.

• The anatomy of a boom/bust cycle– Kindleberger (1978) Manias, panics and crashes.– literature on housing wealth as crisis indicator/predictor

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The role of central banks

• Housing not an explicit target for monetary policy. The literature suggesting that it should be, is not mainstream.

• However, the market is relevant for mopo, as it is believed to affect growth, inflation, and financial stability. Central banks do follow housing/mortgage markets.

• The public often seems to expect some form of central bank involvement.

• Comments by central banks on housing market/mortgage debt often receive immediate and extensive media coverage! Everyone is interested in the value of their home.

Osastolyhenne/päiväys4

Housing price inflation (nominal) in Finland

-40.0 %

-20.0 %

0.0 %

20.0 %

40.0 %

60.0 %

80.0 %

100.0 %19

01

1906

1911

1916

1921

1926

1931

1936

1941

1946

1951

1956

1961

1966

1971

1976

1981

1986

1991

1996

2001

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Economic policy in the 1980's

• Late 1970's: significant change in monetary policy with markka peg to currency basket, significant disinflation, increased aversion to devaluations by policy makers.

• In 1980's, financial markets were liberalised to foster competition.– Gradual lifting of forex regulations and interest rate controls of

loans and operation of foreign banks. • Debt was favourably treated in taxation up to mid 1990's.

– Tax exception of debt interest payments at marginal income tax rate.

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Credit and housing prices during the boom

0

5

10

15

20

25

30

35

40

1981 1983 1985 1987

Credit growth House price inflation

Source: Tilastokeskus.

Osastolyhenne/päiväys7

Signs of euphoria

• It was difficult to pin down expectations: historical experience on wealth values seemed irrelevant after the liberalisation.

• Ordinary people started to trade in real estate, the stock market and forex for capital gains. Much of this was done on credit. Prices were rising but we built up huge risk positions.– People queued to buy newly issued stocks.– Banks were heavily involved in the corporate game.– We all felt rich !!!?

• At the housing market, you had to act quickly, else you lost the bargain.

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Euphoria…

• Also:– Consumption on (ex post)

ridiculous items, symbolized by the booming demand of 'powerboats'.

– The public hero was a young male (cylinder hat + monocle + pipe), who had just made a fortune at the stock market.

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The bust

• Bad news: Interest rates up 1989 in line with international developments, a decline in exports.

• A sharp decline in economic sentiment.

• A strong recession, decline in housing prices, stock market crash, investment and consumption decline, a sharp increase in unemployment and government debt.

• The whole banking system went into a crisis.

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-25

-20

-15

-10

-5

0

5

10

15

20

25

1989 1991 1993 1995

Credit growth House price inflation

Source: Statistics Finland.

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The current situation

• Nominal house price grow typically 5%–7% a year in Finland during the 2000's. This is pretty average in international comparison.

• Mortgage indebtedness grows 10%–15% a year, which is slightly alarming.– structural change of the mortgage market;– almost all credit tied to short rates=>interest rate risks building

again.• Good points: the level of indebtedness still moderate, the macro

economy more diverse than before, the rental market works well, interest rates stable.

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House price inflation in international comparison

-10

0

10

20

30

Belgia

Saksa

Kreikk

a*

Espan

ja

Ransk

a*

Irlan

ti

Luxe

mbu

rg

Hollan

ti

Portu

gali

Suom

i

Tansk

a*

Ruotsi UK

2001200220032004

Source: ECB.

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Bank of Finland Policy

• Analysis of housing/mortgage markets part of biannual forecast report.

• Regular commenting on various media.• Analytical tools:

– international comparisons;– affordability calculations;– arbitrage calculations;– listen to market info & debate.

Current assessment: No bubble, supply bottlenecks and build-up of interest rate risk a concern.