Gaynor: House boom builds shaky economy

By BRIAN GAYNOR

Reserve Bank Governor Dr Don Brash was in a hawkish mood this week when he raised interest rates 0.25 per cent to 5.25 per cent.

The hike came just a day after Statistics New Zealand revealed a 2.6 per cent inflation rate for the March year, just inside the bank's target band of 0-3 per cent.

Brash is the country's number one party pooper. It seems that every time the economy gets a head of steam, he slams on the brakes.

He normally blames the residential housing market and consumer spending and this time was no exception. Brash had this to say in a statement accompanying Wednesday's announcement: "Retail spending has been very strong, and house sales suggest a buoyant residential property market."

Although many commentators have criticised his caution, Brash had no option.

The economy has a serious imbalance caused by an overemphasis on residential housing and a lack of investment in the productive sector. This creates inflationary pressure and forces Brash to increase interest rates once economic momentum develops.

One of the unique features of the economy is that residential housing has clearly outperformed the sharemarket as an investment over the past 20 years. By contrast, equities greatly outperformed residential housing in each of the other 13 countries included in the table, except Japan.

New Zealand had the second-best housing market with Ireland over the period but the third-worst performing sharemarket. After adjusting for inflation the Stock Exchange was the worst-performing market.

The figures clearly demonstrate that housing has been a far better hedge against inflation than the NZSE.

The relative performance of the two asset classes has been mixed over the 20-year period.

From 1980 to 1985 the sharemarket outperformed housing, but bricks and mortar did much better after the October 1987 crash. Equities came to the fore again as the sharemarket recovered in the early 90s, but in recent years residential housing has delivered a higher rate of return.

Residential housing has outperformed the sharemarket by an even wider margin when gearing is taken into account.

Banks and other financial institutions have been aggressive lenders to the housing sector, and with most people able to borrow at least 70 per cent of the cost of a house, then the percentage return on their equity is far superior to the sharemarket.

The banking sector, particularly the trading banks, are playing a huge role in the housing market. The banks had $66 billion of housing loans at the end of February compared with $18 billion in December 1991.

As the total value of the New Zealand sharemarket has risen from $26 billion to just $44 billion over the same period, it is clear that we have a strong preference for housing over productive investment.

A recent study by the Massachusetts-based National Bureau of Economic Research - Comparing Wealth Effects: The Stock Market versus the Housing Market - makes a number of important observations.

The authors, Karl Case, John Quigley and Robert Shiller, looked at data for each US state and 14 countries. Their initial observation is that US householders held US$18 trillion worth of shares at the end of 1999 compared with $7.2 trillion of residential housing.

By contrast, New Zealanders have far more invested in housing than equities.

The study concluded that an increase in wealth through the housing market has a much bigger impact on retail sales than sharemarket-generated wealth.

The report concluded: "Evidence of a stock market wealth effect is weak; the common presumption that there is strong evidence for the wealth effect is not supported in our results. However, we do find strong evidence that variations in housing market wealth have important effects upon retail sales. The housing market appears to be more important than the stock market in influencing consumption in developed countries."

The authors don't explain why consumers respond more positively to an increase in housing-generated wealth. Other studies do.

First, housing wealth is considered to be permanent, whereas the stock market is more volatile. Secondly, individuals can borrow against an increase in the value of their house, but it is far more difficult to gear up against an appreciating share portfolio.

A preference for residential housing in New Zealand, and the strong relationship between it and consumer spending, has major implications for Reserve Bank monetary policy.

The bank's official cash rate was cut from 6.5 per cent in March last year to 4.75 per cent in November in response to softer overseas economies and in the aftermath of September 11.

The results were immediate; there was a strong upturn in the housing market and retail sales. Last month the Reserve Bank made the following comments on household spending: "A rise in housing construction activity, which typically correlates with a rise in spending on large ticket items such as furnishings, is also likely to have been a driver of recent stronger [retail] sales."

The impact of the drop in interest rates is also evident in financial statistics.

Between March 31 and December 31 last year mortgage debt rose from $61.8 to $65.1 billion, whereas the total amount invested through managed funds fell from $47.7 to $47.3 billion. These figures are consistent with long-term trends that show housing debt growing more rapidly than managed fund investments.

It is obvious that if a huge amount of investment goes into housing and not into the productive sector, then shortages of raw materials and big ticket durable items associated with housing construction will develop. This leads to inflationary pressure and higher imports without a corresponding increase in exports.

The Reserve Bank's dilemma is exacerbated when a strong migration inflow coincides with low interest rates. This puts further pressure on the housing market, particularly in Auckland where most new arrivals settle.

There is a strong argument that a migration inflow may be negative for the economy because lower interest rates are more sustainable when a net migration outflow reduces pressure on the housing market.

Rising house prices should be the byproduct of a vibrant economy rather than the engine of economic growth.

Spain and Ireland have achieved above average economic growth, particularly in recent years, and house prices have risen as a result. The Madrid and Dublin stock exchanges have grown more than tenfold over the past 20 years, indicating the relative strength of their productive sectors.

Brash gets a fair amount of stick for his hawkish attitude on interest rates, but he doesn't have any other option. Unless we find some way of channelling more investment into the productive sector, either through domestic savings or foreign direct investment, then the Reserve Bank will be forced to choke off housing and consumption-led recoveries before they get a head of steam.

The biggest concern is that the Reserve Bank is already slamming on the brakes when it is forecasting economic growth of no more than 3 per cent a year over the next three years. Under this scenario there is very little chance of us achieving economic growth in excess of 4 per cent on a sustainable long-term basis.

* bgaynor@xtra.co.nz