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Saturday, October 20, 2007

Global Economic Outlook: As safe as houses?


As safe as houses?
The English phrase "as safe as houses" seems ironic in the US today. American house prices are falling — the S&P Case Shiller Index showed a 3.9% fall in July. The house is the most important asset that a typical US family will ever own, and its value is sinking.

Investors are now worried about the housing market "contagion", that US house price declines will trigger falls in property values elsewhere in the world.

Fortunately for property owners, housing is not like other assets. Selling the family home in fear that prices will fall is not practical, if one does not have another place to live. Cultural attitudes to property ownership also create significant differences in national markets. Problems for US housing (caused by oversupply) should not impact other markets. However, there are two areas where housing has been globally driven.

The first global trend has been rising house price-to-income ratios. Any mortgage lender is interested in the ability of the borrower to repay the debt. This is judged by comparing monthly debt costs (known as debt service) with the borrower's income. If the lender knows what a "safe" ratio is, it can then calculate the amount of money the borrower can "afford" to borrow.

In the 1990s, global interest rates started to fall. Interest rates averaging 15% or more at the start of the 1990s (in Spain for instance) have been replaced by rates of 5% or less in recent years. As global interest rates fell, debt service costs fell. Thus, borrowers could increase their debt, but keep the same debt service cost they had under high interest rates.

If everyone can borrow more money, it does not mean that everyone can buy a bigger house. It means house prices rise. If average mortgage levels rise from three to four times average income, average house prices will move in sympathy (from three to four times average income).

As long as property buyers realise this, all is well. However, if house buyers become greedy (or think that house prices could continuously rise relative to incomes), bubbles develop. As the US demonstrates, bubbles will burst.

The second global trend has been the rise of "global cities", like London. High-value London property is divorced from the UK economy. Property is bought by Middle Eastern or Russian investors (who tend not to worry what the Bank of England is doing with interest rates). Wealthy financial market professionals (whose compensation depends on the movements of global financial markets rather than local factors) also have significant influence.

Last year, 65% of all £1million plus property sales in London were acquired by non-British investors. This adds a global distortion to a local market, and means that some cities have more in common with each other than they do with their local economies.

Malaysia's residential property market did not experience the same buoyancy as the US market prior to the current bust. In December 2006, average house prices were 37% (19% after adjusting for consumer price inflation) above the low reached in the aftermath of the Asian financial crisis, well below the scale of increase recorded in the US. Thus, the "bursting of a bubble" has to be much less of a concern. Moreover, while the property market would suffer if the economy slowed, government policy should lend support. The reduction in stamp duty for houses below RM250,000 in Budget 2008, the abolition of the Real Property Gains Tax in April and the potential use of Employees Provident Fund money to make monthly house payments are all positives for the Malaysian residential property market.

Although housing markets have had common global drivers in recent years, this does not mean that the US housing slump will be repeated elsewhere. There are enough global problems to worry about, as US consumption slows and credit markets exhibit volatility. Adding a global housing slump to the list of world economic problems seems unnecessary.

Paul Donovan is the deputy head of global economics at UBS Investment Bank. The co-author for this article is Edward Teather, who is the executive director of equities research at UBS.

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