Housing market volatility in Finland

1. Housing market volatility in Finland Risto Herrala Economist of the Bank of Finland, Risto.Herrala@bof.fi , presentation in a conference by the Bank of Latvia 19.9.2005 Osastolyhenne/päiväys

2. The international debate on housing price volatility • Why does the value of (housing) wealth fluctuate? • traditional asset pricing models: wealth serves consumption, and its value equals the expected marginal consumption value. This would intuitively seem to imply an unrealistically stable value of housing wealth • "Holmström and Tirole 2001 LAPM": with agency costs, wealth serves as insurance. Asset prices are then sensitive to, for example, aggregate economic shocks.Complex dynamics (sunspot equilibria) may arise. • The anatomy of a boom/bust cycle • Kindleberger (1978) Manias, panics and crashes. • literature on housing wealth as crisis indicator/predictor Osastolyhenne/päiväys

3. The role of central banks • Housing not an explicit target for monetary policy. The literature suggesting that it should be, is not mainstream. • However, the market is relevant for mopo, as it is believed to affect growth, inflation, and financial stability. Central banks do follow housing/mortgage markets. • The public often seems to expect some form of central bank involvement. • Comments by central banks on housing market/mortgage debt often receive immediate and extensive media coverage! Everyone is interested in the value of their home. Osastolyhenne/päiväys

4. Housing price inflation (nominal) in Finland Osastolyhenne/päiväys

5. Economic policy in the 1980's • Late 1970's: significant change in monetary policy with markka peg to currency basket, significant disinflation, increased aversion to devaluations by policy makers. • In 1980's, financial markets were liberalised to foster competition. • Gradual lifting of forex regulations and interest rate controls of loans and operation of foreign banks. • Debt was favourably treated in taxation up to mid 1990's. • Tax exception of debt interest payments at marginal income tax rate. Osastolyhenne/päiväys

6. Credit growth House price inflation 40 35 30 25 20 15 10 5 0 1981 1983 1985 1987 Source: Tilastokeskus. Credit and housing pricesduring the boom Osastolyhenne/päiväys

7. Signs of euphoria • It was difficult to pin down expectations: historical experience on wealth values seemed irrelevant after the liberalisation. • Ordinary people started to trade in real estate, the stock market and forex for capital gains. Much of this was done on credit. Prices were rising but we built up huge risk positions. • People queued to buy newly issued stocks. • Banks were heavily involved in the corporate game. • We all felt rich !!!? • At the housing market, you had to act quickly, else you lost the bargain. Osastolyhenne/päiväys

8. Euphoria… • Also: • Consumption on (ex post) ridiculous items, symbolized by the booming demand of 'powerboats'. • The public hero was a young male (cylinder hat + monocle + pipe), who had just made a fortune at the stock market. Osastolyhenne/päiväys

9. The bust • Bad news: Interest rates up 1989 in line with international developments, a decline in exports. • A sharp decline in economic sentiment. • A strong recession, decline in housing prices, stock market crash, investment and consumption decline, a sharp increase in unemployment and government debt. • The whole banking system went into a crisis. Osastolyhenne/päiväys

10. Credit growth House price inflation 25 20 15 10 5 0 -5 -10 -15 -20 -25 1989 1991 1993 1995 Source: Statistics Finland. Osastolyhenne/päiväys

11. The current situation • Nominal house price grow typically 5%–7% a year in Finland during the 2000's. This is pretty average in international comparison. • Mortgage indebtedness grows 10%–15% a year, which is slightly alarming. • structural change of the mortgage market; • almost all credit tied to short rates=>interest rate risks building again. • Good points: the level of indebtedness still moderate, the macroeconomy more diverse than before, the rental market works well, interest rates stable. Osastolyhenne/päiväys

12. House price inflation in international comparison Source: ECB. Osastolyhenne/päiväys

13. Bank of Finland Policy • Analysis of housing/mortgage markets part of biannual forecast report. • Regular commenting on various media. • Analytical tools: • international comparisons; • affordability calculations; • arbitrage calculations; • listen to market info & debate. Current assessment: No bubble, supply bottlenecks and build-up of interest rate risk a concern. Osastolyhenne/päiväys