Politics and Property - How Do They Mix?
Jan 25, 2006
Elga Bartsch (London)
A revived German economy is good for the government… At a recent Morgan Stanley German Property Day, I was asked to discuss whether the German Grand Coalition government would be good for the economy, in general, and the real estate market, in particular. In a nutshell, my answer was that it was more likely to be the other way around. A revived German economy — and, possibly, a revitalised German property market — will be good for the government. With 85% of the population wanting her to take a more important role in German politics, the newly elected Chancellor Angela Merkel is not only the most popular German politician right now, she is also more popular than her predecessors, Gerhard Schroeder and Helmut Kohl, were when they were still in office.
Some are already speaking of a Merkel factor. Personally, I find it a dangerous strategy to ascribe an economic recovery to one person, no matter how politically powerful. By claiming that an economic recovery is your doing, it is almost guaranteed that the next downturn will become your problem. The surge in approval ratings for Mrs. Merkel and her Christian Democrats, CDU/CSU, is somewhat puzzling, if you take into consideration that the Grand Coalition’s government programme is heavily skewed towards a Social Democratic agenda. Meanwhile, the approval ratings of the Social Democrats, the SPD, remain in the doldrums. In my view, the Grand Coalition has a rather weak political mandate (see A Clear Neither Nor, September 19, 2005). This is despite the fact that the coalition enjoys a broad majority in both houses of parliament. As this coalition was and is a marriage of convenience rather than of love, the Grand Coalition might even find it difficult to stay the full four-year course. …and should benefit the property market. What we are seeing in Germany at present is a smart cyclical recovery that is spilling over from export demand to domestic demand as we speak. With an above-trend GDP growth rate of 1.8% this year, on our forecasts, the German economy looks about to stage an impressive comeback (by German standards). Following a remarkable export performance, we have already witnessed a recovery in corporate investment spending in the second half of last year, and I believe it is only a matter of time before we see consumer spending following suit this year. The groundwork for this smart cyclical recovery wasn’t laid by bold macroeconomic or structural reforms though. It was laid by myriads of micro restructuring at the corporate level (see Macro Reforms Meet Micro Restructuring, August 24, 2005). The experience of the previous restructuring episodes in the US and the UK, which started already in the 1980s, shows that restructuring efforts eventually bear fruit in the form of more dynamic job and income growth. As a country becomes more attractive again as a location of economic activity and starts to attract foreign capital and overseas workers, the property market tends to benefit. The resulting property market boom will often mark the last innings of the restructuring play, I think. Further deregulation, notably of the service sector, should be encouraged. Over and above a number of legislative initiatives specific to the property market — such as deliberations to launch REITS (Real Estate Investment Trusts) or to open individual retirement accounts to owner-occupied housing — there is one key area where the government could and should lend a helping hand to the property market, I think. First and foremost, it should advance the deregulation of product markets, notably the service sector, and of labour markets. In my view, the rules of the EU Single Market, notably the country-of-origin principle, should be fully applied also in the realm of services. The country-of-origin principle stipulates that a good or a service that is legally sold in one EU Member’s State should also be granted market access in all other Member States (see Not in Service, April 22, 2005). The ensuing institutional competition would ensure that the best institutional set-up — which economists like to think is a free-market one — will gain market share. But, across Europe, governments are presently trying to prevent a fully-fledged Single Market in services and instead opt for a watered down version of the Single Market Directive for Services. This and other efforts to harmonise national legislations ex-ante in Brussels could potentially undermine the success of the Single Market Programme. Make no mistake: there is more at stake here than property. Good opportunity to transform the German property market… In my view, there is currently a unique opportunity in Germany to transform the property market and to raise the home-ownership rates, which at 42% are far below the European average. Not only is a vast amount of excess liquidity suppressing mortgage rates globally to historically low levels, but there is also a baby-boom generation starting to think about their pension prospects. After all, property is an inflation-protected, long-duration asset; one that you can even live in. A number of other factors, which have propelled property markets in other parts of Europe towards the stratosphere, are unlikely to be present in Germany though. Contrary to the experience in some peripheral euro-area countries, Germany probably won’t see interest rates falling much from present levels. In addition, the spread of mortgage rates over refinancing costs in Germany is already very close to the international average. Investors should also be aware that thrifty German consumers are rather heavily indebted already. Outstanding household debt amounts to 105% of annual disposable income, a level that within the G7 is only surpassed in the US, the UK and Japan. German household mortgage debt, at 73% of disposable income, is already twice as high as the Italian and a quarter higher than the French mortgage debt. Hence, a massive balance-sheet extension and re-leveraging in the household with a spending spree to match seems less likely in Germany than elsewhere in the euro area. It is also worth bearing in mind that debt service ratios in Germany, at around 6.5% of disposable income, are only a notch shy of the elevated levels in the US and the UK — two markets about whose consumer debt levels many economists fret these days. In addition, there probably still is a considerable, albeit possibly shrinking, supply overhang in the German property market. In this respect, the decision to scrap the first-home buyer allowance, which like many other oddities in the German residential housing market still has roots in the logic of a post-war housing shortage, is a welcome step. …that would be aided by an improvement in national statistics. There is another key area where politics could help the better functioning of the German property market, and that’s making sure that all economic agents have access to sound statistical information. Not only is there no official property price index from the Federal Statistics Office, we also do not have solid statistics on how many people actually live in Germany right now and how many dwellings there are. The latter is due to the fact that Germany has not had a census, that is, a full count of the population and its living conditions since 1987 in the Western part and since 1981 in the Eastern part. Over such a long time span, extrapolating developments by small annual sample surveys, so-called micro census, can introduce a considerable margin of error in the population statistics. According to press reports, there is reason to believe that the official population statistics still count 1.6 million people who have long left Germany. In some regions, for instance in Berlin, as much as 6% of the population might have moved elsewhere since the last full count. Together with official estimates of the housing stock, which offer only very rough guesses these days, this introduces considerable uncertainties into any estimates of fair valuation of the German property market. These margins of error could completely overturn the verdict from valuation models for residential properties. The grand coalition has decided not to commission a new census before the planned EU-wide census in 2011. Until then, the statistical fog stays and the German property market will likely offer interesting opportunities to those who believe to have access to more accurate data and/or better information.
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Rate Hike Continues
Jan 25, 2006
Chetan Ahya (Mumbai) and Mihir Sheth CFA (Mumbai)
What’s new? The Reserve Bank of India (RBI) has announced another 25 bps hike in short-term policy rates, moving the reverse repo rate (rate at which RBI sucks out excess liquidity) to 5.5% and the repo rate (rate at which RBI infuses liquidity) to 6.5%. This was in line with our expectations, but contrary to consensus expectations. Conclusion: The hike in policy rates has been prompted by rising concerns that are threatening macroeconomic and price stability. The RBI highlights the increase in crude oil prices, strain on credit quality and surge in imports/current account deficit as downside risks to macroeconomic stability. Implications: We believe that the widening current account deficit and slowing rate of arbitrage-related debt capital flows will mean that forex reserve accretion remains slow, impacting domestic liquidity. Apart from the macroeconomic concerns pointed out by the Central Bank, we believe that this decline in excess liquidity is also likely to weigh on domestic interest rates going forward. We expect the yield on the 91-day T-bill to rise further to about 6.75% by end-2006. Summary In the Third Quarter Review of the Annual Monetary Policy, the Reserve Bank of India (RBI) announced another 25 bps hike in short-term policy rates, moving the reverse repo rate (rate at which RBI sucks out excess liquidity) to 5.5% and the repo rate (rate at which RBI infuses liquidity) to 6.5%. This was in line with our expectations but contrary to consensus expectations. Indeed, 18 out of 22 economists surveyed by Bloomberg had expected no change in rates. The hike in policy rates has been prompted by rising concerns that are threatening macroeconomic and price stability. RBI Maintains Bullish Stance on Growth The RBI has upgraded its GDP growth estimate for F2006 to 7.5-8% from its earlier estimate of 7-7.5%. The Central Bank indicated that the upward revision has been prompted by improved prospects for the winter crop, sustained industrial growth, all-round expansion of the services sector; stability of the financial markets and strengthened international investor appetite for the Indian economy. We continue to believe that this above-trend growth has been achieved primarily due to an unsustainable increase in consumption growth sponsored by a sharply increased leveraging trend. Our approximate financial leverage measure suggests that aggregate debt to GDP will have risen to 127% by March 2006 from 95% in March 2000. RBI Has Raised Level of Concern on Downside Risks In the Mid-term Review of the Annual Monetary Policy (announced in October 2005), the RBI highlighted five key risks: “credit quality concerns, rising asset prices especially housing, high and volatile international crude prices with a substantial part of the increase in crude prices being regarded as permanent, the widening trade deficit and the upturn in the international interest rate cycle”. In today’s announcement, RBI has maintained this stance. It has announced further rate hikes to “avert the compulsion of undertaking larger and more drastic adjustments in the future, should the prevailing situation evolve in a manner that threatens macroeconomic and price stability”. The RBI highlighted the following as downside risks to macroeconomic stability: I) Increase in crude oil prices: The Central Bank notes that, though increases in crude oil prices have so far been managed via fiscal and monetary measures, any further escalations in crude oil prices could “endanger the fragile balance” that has been maintained between the government, oil companies and consumers. II) Strain on credit quality: Over the past three policy announcements, the RBI has become more and more vocal about its concerns on credit quality. In today’s monetary policy stance, the RBI indicated that it would provide appropriate liquidity to meet genuine credit needs “with due emphasis on quality”. According to the RBI, housing, commercial real estate and personal loans have together accounted for over a third of incremental non-food credit in F2006. We believe the extent of potential deterioration is evident given that banks have been less discerning in pricing in the risk associated with different types of loans. III) Surge in imports/current account deficit: India’s current account balance posted a deficit of US$7.7 billion (4.2% of GDP, annualized) during July-September 2005 compared with a deficit of US$3.5 billion (2.2% of GDP) during the same period last year. Apart from higher oil prices, increasing domestic absorption (rise in domestic consumption and, more recently, investments) has been the key factor behind the widening current account deficit. The RBI also mentions that stronger aggregate demand is being reflected in a spill-over into the external sector in the form of widening trade and current account deficits. Indeed, in the current economic cycle, India is one of very few countries to run such a large current account deficit. Bottled Up Inflationary Pressures Continue to Worry RBI From the peak of 8.5% YoY during the quarter ended September 2004, the headline inflation rate declined to 5% YoY in January 2005 and has remained largely below the central bank’s comfort zone of 5-5.5% over the past 12 months. Headline inflation has declined significantly over this period due to a deceleration in the year on year price trend for global commodity-linked products and government tinkering with domestic oil product prices. However, the RBI remains worried about the potential inflationary pressures that could emanate from the pass-through of higher oil prices and tight non-oil commodity markets. The RBI highlights that the remaining pass-through of international crude prices into domestic petroleum products prices could lend “upward bias” to inflation in F2007. We continue to believe that, in an environment with a high level of integration with the global trade market, loose monetary policy sponsored consumption growth being higher than domestic capacity creation (investments) will not necessarily show up in inflation. In a world with low import tariff rates and loose boundaries, inflation pressure in India is unlikely to be high, independently of it being the trend globally. Hence, we expect the policy focus to continue to shift towards the impact of higher trade and current account deficit. Declining Excess Liquidity Will Continue to Weigh on Interest Rates Since F2003, rising capital flows caused a huge increase in forex reserves, resulting in excess liquidity. Foreign capital inflows not absorbed by the domestic economy (excess liquidity) were sterilized by the Central Bank in the form of short-term paper issued in the money market. However, the forex reserve accretion trend has slowed over the past six months. The trailing 12-month forex accretion has slowed to US$10 billion as of January 2006 (US$17 billion adjusted for IMD redemptions) from US$26 billion as of August 2005 and a peak of US$29 billion as of March 2005. The reversal in the forex reserve trend has been due primarily to the following: 1) The current account deficit widening to US$7.7 billion (4.2% of GDP, annualized) during July-September 2005, compared with US$3.5 billion (2.2% of GDP) during July-September 2004. 2) Given that interest rate differentials in India and the US have narrowed and the rupee has begun to depreciate, interest arbitrage has become less attractive. As a result, net foreign debt inflows are estimated to have declined by US$3.1 billion between April and December 2005, compared with US$7.9 billion during the same period last year. The combined effect of a widening current account and slowing debt flows has caused a sharp decline in the stock of excess liquidity over the past three months. According to the RBI, the outstanding stock of excess liquidity declined to a 21-month low of about US$10 billion as of January 14, 2006, compared with a peak of US$28.9 billion as of end August 2005. Apart from the macro-economic concerns pointed out by the Central Bank, we believe that this decline in excess liquidity is also likely to weigh on domestic interest rates going forward. Reverse Repo Rate Could Become Irrelevant Soon? We believe that, unless capital flows rise sharply from current levels, there is a fair possibility of the excess liquidity balance being completely wound up over the next six months. In such a case, the Central Bank would move back to injecting liquidity into the system. This would result in the short-term policy rate effectively be the repo rate (rate at which RBI injects liquidity into the system), which is currently at 6.5%, instead of the reverse repo rate (rate at which RBI sucks out excess liquidity), which is currently 5.5%. Indeed, the short-term market rate (inter-bank call rate) has started moving gradually towards the repo rate, reducing the relevance of the reverse repo rate. No More Zero Real Short-Term Rates The RBI has been running a near zero term policy rate, with a sharp rise in capital flows and consequently foreign exchange reserves, even as real GDP growth rates have been strong and the requirement for higher financial savings would have warranted higher real interest rates. However, with slowing forex reserve accretion and declining excess liquidity, the market is transitioning back towards a positive real interest trend. Over the last six months, real 91-day bill rates have moved up back into positive territory after staying negative for about two years. Indian banks have increased their deposit rates by 50-75 basis points recently, pushing up their cost of funds. Banks have been increasing their lending rates for the first time in five years to protect against weak treasury income and a sharp rise in cost of funds, as reflected in the short-term benchmark rate (91-day T-bill), which has risen to 6.2% from 5.5% in October. We expect this cost pressure to be maintained, with the 91-day T-bill rate rising further to about 6.75% by end-2006. We believe this will weigh on domestic consumption growth and challenge India’s efforts to pursue an aggressive investment cycle.
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