Sunday, 9 March 2008

The twin engines of the coming Spanish economic crisis are a collapsing housing market and a current account deficit, now at 10 per cent of gross domestic product. The two are related, of course, as the property bubble has been a driving force behind a credit-financed spending boom.
In response to a question about what to do about the rising current account deficit, I heard a respected Spanish economist say the best response would be to stop publishing it. He was joking, I think, but I am not entirely sure. There can be no currency crisis, of course, since Spain does not have its own currency. But even for countries in a monetary union, huge current account imbalances have a meaning. They point to future adjustment. In no sector is that adjustment going to be more painful than in the housing market.
I have become a collector of scary housing statistics of late. One of my favourites is a chart from the Bank of Spain, which shows that building approvals and permits*have fallen off the edge of a cliff since the end of 2006. At their peak, building permits were rising at an annual growth rate of 25 per cent. In the autumn of 2007, their annual change was minus 20 per cent – probably still going down. House prices have not fallen nearly as much, but this is only a matter of time, as sellers tend to suffer from a collective delusion at this stage in the housing cycle.
Between 1995 and last year, Spanish house prices tripled in nominal terms, and doubled in real terms. Several explanations have been offered: a trend for young people to leave their parental homes earlier; a rise in immigration; and the country’s popularity among northern European homebuyers. But beware of demand-side arguments. They are usually cyclical, and the cycle is just turning. Also, as supply increases with demand, there is now a glut of unsold homes.
I would expect real Spanish house prices to fall by almost as much as they have risen over the past 10 years. If one looks at real house prices in the US or Germany over very long periods, one finds that they have been virtually flat – as they should be.
The cost of building a house is relatively constant, and the land is not used for productive work. The purchase of a home protects its investor against inflation, for sure. But as long as the housing supply is relatively elastic, housing prices should not rise in real terms. Since Spain still happily generates fairly robust rates of inflation, the impact on nominal prices will be somewhat less severe.
There are some notable exceptions to the zero-price increase rule, for example the UK, where real prices have been going up over the years, but for very pathological reasons that are not necessarily present in other countries. The Spanish market is structurally more similar to the US and Germany, in the sense that a rise in demand is usually met by an offsetting rise in supply. By this logic, a substantial part of the abnormal inflation-adjusted house price gains we have seen will be reversed as the housing cycle turns down.
The economic impact of this downturn in the housing cycle is going to be worse for Spain than for other countries. A truly staggering statistic about Spain is the fact that construction investment constitutes 18 per cent of the Spanish gross domestic product, according to the European Union’s Ameco database. In France and Germany, that proportion is about 10 per cent.
When house prices fall, GDP will be hit in two ways: the first is the direct effect of a fall in construction investment, and the second is the indirect consumption effect, as people cannot extract new liquidity from their homes, which they could use for consumption spending. If the construction sector’s share of GDP were to shrink to 10 per cent gradually over a period of, say, four years, the direct effect on growth would be close to 2 percentage points per year.
Add the consumption effect from lower house prices, and you easily get a half-decade of zero growth – perhaps longer, perhaps worse, perhaps both.
Of course, the Spanish economy has some notable strengths. One is the fiscal position. The country has been running budget surpluses and has a manageable debt-to-GDP ratio. Spain is therefore relatively better equipped to compensate for a short cyclical shock than, for example, countries that have started out with excessive deficits, such as the UK. For a long period of adjustment, fiscal policy, however, is not going to help.
Second, Spain has a modern and robust banking sector that has avoided some of the pitfalls of modern credit markets. Yet Spanish banks will have problems once mortgage default rates are rising. And in terms of structural reforms, Spain ranks low in league tables on product market and retail regulation, and in terms of competition policy.



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