Economists warn of a property bust if interest rates stay too low

Two leading international economists have forecast a property bust, if interest rates stay low and house prices continue to rise faster than wages growth.

Former top government economist Quentin Grafton has signalled the growth in house prices is a concern.

“While I am cautious enough not to claim there is a ‘boom’ that inevitably implies a bust, the recent growth in the national median house price of 9% in 2013 (14% in Sydney) is of concern, especially when it is about three times greater than nominal wage growth (and also inflation),” he will say in a speech to the Australian Bureau of Resources and Energy Economics.

“Should the house price growth spurt continue for much longer there could be an overshoot that may create an ‘overhang’.”

Australia’s ratio of house prices to income is the second highest in the world, although it remains slightly below its peak.

Grafton, now a professor with the Australian National University’s Crawford School says Australia has had one of the most rapid rises in nominal house prices of all developed countries since 1997.

Australia also has a household debt-to-income ratio of around 150%.

“The risk is that if Australia were to continue its historically low interest rates (the cash rate is at 2.5%), the housing price surge will continue,” Grafton says.

It’s unlikely the Reserve Bank will lower the official cash rate again, choosing on Tuesday to keep interest rates on hold. However, the RBA is still faced with a need to keep rates low enough to support economic growth.

“Successfully achieving all of these objectives simultaneously while avoiding a housing price boom, and in the midst of competitive devaluations from key trading partners, is a big ask of any central bank,” Grafton says.

“Given that Australia’s major banks borrow 30-40% of their funds from offshore capital markets, any rapid fall in house prices would pose a dilemma for the big four banks and would likely result in an Australian-made credit crunch.”

A UBS survey of bank chief financial officers released yesterday revealed banks are lowering their lending criteria, offering more competitive mortgages and discounting fees.

“Loan officers indicated lending standards have been loosened materially in both mortgages and large corporate lending over the last six months,” the report says.

“In housing, improved market prospects and competition were cited as the factors driving a loosening in standards. This has led to a material reduction in both price and fees in mortgage lending.”

Grafton’s predictions are not as dire as other forecasters, with United States demographer and economist Harry Dent saying this week Australian property prices will fall between 30-50%.

Dent says Melbourne and Sydney will be the worst affected and the crash will likely occur if the stock market suffers major losses or the Chinese property market declines.

“I see it like a popcorn popper, different markets are bursting at different times … but all of real estate in coastal cities all around the world is greatly overvalued and they're all going to burst whether it be 30 per cent or 40 per cent ... or 90 per cent in the worst case.”

Dent predicts the “China bubble” will burst next year and when it does, Australia will be the hardest hit.

“I see real estate going down 60-65% in the US, it's probably more like 30-50% in Australia, but that's still enough for you to say, ‘Hey why would you go buying real estate?’” he says.

Dent accurately predicted the 2008 GFC, but Australian Property Monitors senior economist Andrew Wilson told SmartCompany there will always be doomsday predictions when the market is doing well.

“These predictions are no surprise because there is a revival in the market at the moment. However they’re fruitless. They suggest catastrophic outcomes, but the underlying fundamentals and the historical evidence suggests this won’t occur,” he says.

“Equating incomes with house prices lacks relevance. The real issue is income versus mortgage repayments. The evidence clearly shows the average income required to pay a mortgage in most capitals is about 25% of weekly disposable income and that’s remained the same for a number of decades.”

Wilson says the only way there will be a major crash in house prices is if there is another global financial crisis “unlike what we’ve ever seen before”.

“We have a very rigid lending environment which is another factor in insuring a resilient housing market over the median to long term,” he says.

“Banks are competing more vigorously for market share at the moment which is pushing mortgage rates down…. But interest rate levels are really only where they were in 2008. They haven’t dropped to levels you might associate with a higher risk.”

This article first appeared on SmartCompany.