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EM crises are old news – today’s risks from higher rates lie in housing

In justifying his dissenting call for a 50-basis point hike at the Federal Reserve’s March meeting, St Louis Fed President James Bullard cited the experience of the 1994 tightening cycle, arguing that it was “discrete…and the results were excellent”.

Emerging markets investors with long memories would disagree. Although that cycle – which included a 75-basis point rate increase in November of that year – resulted in a soft landing for the US economy, it also fuelled economic crises in Mexico, Asia and Russia through the rest of that decade.

However, while monetary tightening inevitably focuses attention on the potential ripple effects of higher rates, we explained across two reports last week that the risks in this cycle lie more in housing markets than in EMs.

Fed tightening cycles caused problems for EMs in the past because those economies tended to borrow large amounts from overseas (in the jargon, they have had large external financing requirements.) Accordingly, when interest rates increased, they were squeezed. This was often compounded by balance sheet strains caused by currency mismatches – because the dollar strengthened against EM currencies during previous tightening cycles, the local currency cost of servicing dollar-denominated debt increased in emerging economies. The result was a spate of EM crises. 

But the picture today is very different. External balance sheets are generally stronger: EMs have reduced their reliance on foreign borrowing and increased their holdings of foreign assets. (See Chart 1.) At the same time, most emerging economies have shifted from fixed to floating exchange rates, which has provided a safety valve to release balance of payments pressures gradually rather than allowing them to build to the point that they break violently and plunge economies into crisis.

Chart 1: EM Gross External Financing Requirement
(% of EM Gross Foreign Exchange Reserves)

Sources: Refinitiv, Capital Economics

Admittedly, there are a handful of small and mid-sized EMs that look vulnerable to higher global interest rates. External debt is unsustainably high in Turkey, Tunisia and Sri Lanka. Meanwhile, current account deficits are large in a few countries, such as Chile and Romania, and a period of much weaker domestic demand growth now looms. But we don’t expect a rerun of 1994 (or for that matter the early 1980s), where Fed tightening caused a series of crises to reverberate across the emerging world. 

If all that sounds reassuring, the message from our analysis of housing market vulnerabilities is more troubling.  

You don’t need to look far for evidence of froth in the residential property market. As Chart 2 shows, in real terms global house prices are now running well above their trend. This looks alarmingly similar to what happened in the run-up to the global financial crisis in 2007-08. 

Chart 2: Global Real House Price Index* (2016=100)

Source: Refinitiv. *Weighted by GDP

In fact, the situation now is markedly different from that of the mid-2000s. Back then, a housing market bubble was inflated by lax lending and a rapid expansion of mortgage debt. When the bubble then burst, homeowners found themselves in negative equity and forced selling created a self-reinforcing downward spiral. However, there is now less leverage in the housing market. Household debt as a share of income increased sharply between 2000 and 2007, but it dropped back during a period of post-crisis deleveraging and has been stable for the past few years. (See Chart 3.) 

Chart 3: Household Debt as a % of Disposable Income in Advanced Economies

Source: Refinitiv

Instead, the high level of house prices is underpinned by the extremely low level of nominal (and real) interest rates. In the US, mortgage payments as a share of median family income are not only below the peaks seen in 2007, they are also lower than in the early-2000s when the housing bubble began to inflate. (See Chart 4).

Chart 4: Measure of Housing Affordability for New Buyers in the US
(Mortgage Payments as a % of Median Family Income)

Source: Capital Economics

The counterpart to this is that housing markets are now vulnerable to higher interest rates. A modest rise in interest rates might only cause house prices to fall in a few obvious candidates where valuations are extreme, such as Canada, Australia, New Zealand and Hong Kong. But rates would only have to rise a bit further than we currently expect to cause more widespread falls. A rise in interest rates to 4% or so would be enough to cause a drop in prices in the US and the UK, and the tipping point could be lower than that if quantitative tightening has a bigger impact on financial conditions than expected. 

It’s important to stress that a combination of lower levels of leverage and better-capitalised banks means that even widespread property price falls would probably not cause another global financial crisis. But falling prices would still hit activity in the real economy, particularly in those countries that have relied heavily in recent years on residential investment (Canada) or where the relationship between house prices and consumer spending is strongest (New Zealand). 

Monetary tightening cycles in the past have been associated with problems for emerging economies. This time though, it is property that may prove to be the weakest link. 

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