Dublin property prices fall amid general market slowdown

The Irish housing market has slowed in recent months on a variety of metrics, including turnover, mortgage lending and prices. Research published by the Central Bank indicated that its mortgage controls, introduced in early 2015, would likely depress lending and dampen prices, albeit modestly in the latter case, and the evidence of late would indicate that the measures are indeed biting. The Dublin market has been most affected, with prices falling in four consecutive months, by a cumulative 3%, although the annual change is still positive, at 4%.

Turnover in the Irish market as a whole, as measured by the Property Price Register, picked up sharply in 2014,  with  the number of transactions rising to over 43,000 , and last year saw a further increase, to over 48,000. That masked a pronounced change in trend , however, with the final quarter witnessing a 12.7%  annual decline. In December alone transactions were some 27% below the same month a year earlier, and the available figures for January show a 24% annual fall. That figure is likely to improve somewhat as more January sales are added but the general picture is unlikely to be materially altered.

Credit has not played a defining role  in  the housing  market over the past few years ( mortgage drawdowns accounted for 47% of transactions in 2014 and 50% last year) but a significant change in lending would obviously have some impact. The number of mortgage loans for house purchase rose by 20% last year, to over 24,000, but again the later part of the year saw a marked slowdown, with the final quarter recording an annual decline. That fall was very modest but data on approvals points to a much sharper decline in the months ahead; approvals for house purchase fell by an annual 20% in the final quarter of 2015 and the data for January shows a similar pace of change.

House prices are still rising on an annual basis, but the more recent data points to a slowdown, and not just in Dublin. Prices excluding the capital rose very strongly in the latter part of 2015, by 4.8% in q3 and 3.6% in q4, perhaps indicating a switch  by prospective buyers from Dublin to outlying counties, but prices rose by just 0.2% in the first two months of 2016. Nevertheless, the gap between prices in the capital and the rest of the country is continuing to narrow; on our estimate, Dublin prices exceeded those elsewhere by over 70% in late 2014 but that premium has now fallen to 55%, which is still above the long term average (48%) but  converging.

The Central Bank may well welcome the slowdown in house price inflation but it might be concerned if  mortgage lending did indeed fall sharply, particularly as the ECB is now offering euro zone banks money at zero or even negative rates, so desperate has it become to generate credit growth.

The ECB’s Scattergun

The provision of credit in the Euro Area (EA) is largely delivered through the banking system, in contrast to the US, where capital markets are the main source of  loans. That explains, to some degree, why the ECB sought to flood the banking sector with liquidity following the financial crash in 2008, as opposed to seeking to influence the real economy more directly via the purchase of assets (QE). The Bank has  subsequently travelled a long way in its quest to boost economic activity  and is now utilizing a plethora of instruments in an attempt to hit its inflation target , although this scattergun approach may yield further disappointment.

In June 2014 the ECB was still of a mind that bank funding costs were the problem and announced a Targeted Long Term Refinancing Operation (TLTRO). Banks could borrow up to 7% of their existing loan book (defined as  lending to the non-financial private sector excluding mortgages) in two tranches, in September and December, at a cost equal to the refinancing rate (at that time 0.15%) plus 10 basis points. Banks could borrow more in subsequent quarterly tranches if their lending grew above stated benchmarks, with all lending to be repaid by September 2018.. In the event the take-up was disappointing, amounting to €212bn in the first two tranches , rising to a cumulative €418bn by end-2015, with the take-up in December just €18bn. This compares with total outstanding loans to the private sector of €10,600bn. The funding could not be used for mortgage lending and banks were no doubt influenced by the fact that loans had to be repaid early (by June 2016) if the benchmarks were not being met.

The ECB effectively accepted that the first TLTRO was not a success by announcing TLTRO II last week,allowing banks to repay early existing loans under the first scheme to encourage a switch into the new variant. This one  is designed to boost ‘lending’ as opposed to ‘lending to the real economy’ and there does not appear to be any restrictions. The scheme will start in June, with four quarterly tranches up to March 2017, and loans mature in four years from the time of origination, Banks this time can borrow up to 30% of their non-mortgage loan book at the refinancing rate , which is currently zero. Moreover, banks that are growing their loan book can borrow at a lower rate, down to the deposit rate, which is currently -0.4%. The pool of existing loans amounts to €5,600bn so in theory the amount of TLTRO borrowing could be substantial, with a 60% take-up implying a figure of €1,000bn.

So the ECB has sought to offset the impact of a negative deposit rate on the profitability of the banking system by allowing banks to borrow at that rate, or at least some of them. But is weak lending a function of funding costs?. The answer is probably no, at least for many banks; market rates have tumbled, allowing banks to borrow at very low rates anyway, without tying up collateral for years at the ECB, with capital , profitability and risk aversion the key issues on the supply side of the credit market. Others would argue that the demand for credit is weak anyway, given the uncertain economic outlook, and that the ECB’s decision to cut the deposit rate deeper into negative territory reinforces that uncertainty rather than assuaging it. Deleveraging is also a factor, particularly in Ireland, with many households and firms preferring to repay rather than add to debt.

The ECB has also partially undermined the rationale for the TLTRO by announcing the decision to extend its asset purchase scheme to corporate bonds . This will presumably encourage firms to issue debt and so disintermediate the banking system. Purchases will only include investment grade debt. which also implies that many corporates in the periphery of the euro zone will be excluded, with bank borrowing their only option. So bank lending to low risk corporates may fall, raising the risk profile of any remaining bank lending.

The ECB may also have hoped that’s this suite of measures would help to push the euro down, but that has not transpired, at least for the moment, partly due to  Mario Draghi’s comment that  ‘we don’t anticipate that it will be necessary to reduce rates further’. In that context it is interesting that Peter Praet, a member of the Executive Board, has subsequently sought to emphasize that we are not yet at the lower bound on rates, an indication that the Bank was not happy that the euro appreciated post- conference.

 

Negative rates are a mistake

The next ECB policy meeting is scheduled for March 10th, and the market is expecting further monetary easing. This was flagged in January , when it was announced that the Governing Council would ‘review and possibly reconsider the policy stance‘  given that downside risks had risen. The minutes  show that some Council members favoured  immediate action but the consensus was to await the publication of the quarterly macroeconomic forecasts, incorporating projections out to 2018. The current forecasts envisage inflation rising from 1.0% this year to 1.6% next, but are predicated on an oil price of $52 a barrel in 2016, which looks untenable in the absence of a seismic shift in global oil supply. Headline inflation had turned positive again in late 2015 and rose to 0.3% in January but the flash reading for February was surprisingly weak, at -0.2%, with  core inflation also slowing to 0.7%.

Euro bond yields have fallen and the euro has depreciated of late in anticipation of ECB action, but the Bank has been cautious in terms of inflating expectations, mindful of the market reaction to its December announcements, which were deemed disappointing relative to what Mario Draghi was interpreted as signaling. The euro’s effective exchange rate subsequently appreciated , rising by 6% to mid-February, and speculative short positions in the euro/ dollar fell sharply. Of course there were other factors at work, including changing expectations about US monetary policy, but it is noteworthy that the ECB minutes warned against raising ‘undue or excessive expectations about policy action’ given what had happened in December.

What can the ECB do?. One option is to reduce the Deposit rate further into negative territory, as other central banks have done, The rate, currently -0.3%, is paid on overnight deposits at the ECB and  the idea is that  banks will be encouraged to lend to other banks or to use these reserves to support lending to the private sector, rather than face losses by continuing to park it with the ECB. A cut in the deposit rate, it is  also argued, will put further downward pressure on money market rates and bond yields, so precipitating a fall in the currency, which would in turn help to boost inflation.

Yet rates paid by banks to depositors are unlikely to turn negative and many loans are based on money market rates, such as 3 or 6- month euribor. Consequently negative rates hit bank margins and hence profitability. Some argue , including ECB Board Members, that this can be offset by strong lending growth but that is certainly not happening in the euro area, with the annual growth in loans to the private sector at just 0.6% in January . Consumers and firms in many countries are still reducing their debt levels (including Ireland, where net credit has been contracting now for 6 years) and on the supply side banks are building capital to meet changed regulatory requirements and are saddled with high  levels  of non-performing loans. Moreover, lending to consumers or businesses is risky and requires higher capital cover than lending to governments , where zero capital is required, particularly when the ECB is in the market buying government debt. The general public may feel that bank profitability is the least of their concerns but a healthier bank system is required if the euro area is to see stronger economic growth and negative rates will not help.

Moreover, negative rates send the signal that economic conditions are far from normal and may exacerbate the perception that monetary policy has indeed reached its limits, and may now be adding to problems rather than easing them. It is also not a given that a further rate cut by the ECB will lead to a sharp depreciation in the euro- witness the recent rally in the Yen following the bank of Japan’s move into negative rate territory- and the euro area’s huge current account surplus means capital outflows have to be enormous to push the currency lower on a sustained basis.

Conceptually, negative deposit rates, if expected to last a long time, could  also lead to a fundamental change in the financial system. Rates on cash are not negative ( excluding some storage costs ) so banks may decide to hold excess reserves in cash rather than deposit them with the central bank. Similarly, retail depositors would have an incentive to do the same thing if commercial banks sought to introduce negative deposit rates on a large scale, so threatening the main function of the banking system, the intermediation of savers and borrowers.

In sum, negative rates are not the answer and symptomatic of a refusal by central banks to accept that the emperor no longer has any clothes. Time  for Governments to take advantage of historically low or even negative bond yields and fund some sensible capital spending , which would boost demand in the short term and support higher growth further out.