Gloom in the US housing market

Business Standard, 6 September 2006

Trend GDP growth in India has accelerated from around 5 percent in the 1980s to 6.5-7 percent. India has not graduated to 8 percent trend growth. The band around the trend, of business cycle fluctuations, is around 2.5 percentage points up or down when compared with the trend. The current high of GDP growth rates above 8 percent should be interpreted as a combination of a high of the business cycle, coupled with a trend growth rate of 6.5-7 percent.

One of the big factors shaping the outlook for the Indian business cycle is the world economy. If there is a sharp downturn in US GDP, this will influence our local business cycle. US economic growth has been under stress, with high oil prices and "global imbalances", where the Chinese government has done "vendor financing" of over $1 trillion, giving loans to the US to finance purchases of Chinese goods. In the resolution of global imbalances, the first piece of the puzzle might prove to be the US housing market.

The real estate market is not transparent, and it is hard for speculators to take short positions or trade in derivatives, so as to restore sanity. This increases the risk of violations of market efficiency. From 1997 onwards, US house prices had run far ahead of rental values. Robert Shiller has pointed out that the `standard house', which sold in 1890 for $100,000 (inflation-adjusted), was at just $110,000 in 1997, and has now risen to $199,000.

In recent weeks, there has been a rather sharp downturn in US house prices. Builder's sentiment is 52% down in August 2006 against one year ago. Building permits were also 21% down. Housing starts were 13% down. Existing-home sales were down 11% and unsold inventory up 40%. Out of the Dow Jones industry indexes covering the US, the Home Construction index has been the worst performer over the last one year, going from a 52-week high of 1037 to a present value of 620. Home prices have, as yet, only dropped by 5% to 10%, after taking into account "incentive packages", or side payments, which many sellers are throwing in. As fear sets in, prices are likely to drop further.

This is a big change in the US housing scenario when compared with just one year ago. One year ago, new home sales were up 26% -- now they are down 22%.

Given that residential real estate directly accounts for 6% of US GDP, why do weak home prices matter so much? There are several factors at work. Most US recessions are related to sharp declines in real investment, where a period of exuberance leads to overcapacity, and investment drops sharply in the period when demand catches up with capacity. In the recent US housing boom, residential investment was an important part of investment demand.

High house prices had induced a "wealth effect" : consumers felt rich knowing their house was worth a lot, and they went out and bought a 42 inch TV. There has been an enormous business of building and refurbishing homes, which fueled demand and employment. Consumption was directly boosted by `home equity extraction', where home owners took a loan against a house as collateral, and went out to buy a TV.

These factors will now act in reverse. Lower house prices will induce a negative "wealth effect". The construction business will take a beating (as is already visible in the DJ Home Construction index). Fewer housing starts mean lower purchases of furnishings and appliances. Home equity extraction will not prop up consumption like it did in recent years. These factors act to slow down the US economy, in addition to the two other factors which are already in play (i.e. higher oil prices and interest rates). US consumer confidence has showed the lowest value for the year so far in August.

The incidence of households defaulting on their home loans has risen by 20% compared with last year, but the numbers are (as yet) below historical standards. If the rise in default is big enough, it could adversely affect the processes of loan-financed house buying. Some difficulties could reach the exchequer, owing to the credit enhancements given out by "Fannie Mae" and "Freddie Mac" which are guaranteed by the government.

In this episode, traders are more sanguine than economists. Markets hope that this drop in the US housing market will shape up like the events of 1994, where the Fed was able to achieve a "soft landing". Financial markets are "priced for perfection", with very low volatility, which appears to reflect expectations that everything will work out fine. The macroeconomists of the world are not so sure that it will.

The US Fed might be faced with agonising choices between growth and inflation. On one hand, the Fed could keep rates flat or start cutting them in response to a sagging economy. But a stagflation scenario, with high inflation and low growth, could materialise precisely if there is doubt in the mind of the market about the Fed's commitment to an inflation target.

What does this mean for us in India? The Indian economy is much more globalised than we think. Gross flows on the current and capital accounts, put together, added up to a full 91% of GDP in 2005-06. This means that we are more affected by global economic news, as compared with our relative insulation in the past. This is the inexorable logic of globalisation: along with greater prosperity comes a new set of interdependencies. In the olden days, fluctuations in Indian GDP growth were driven by monsoons; now we need to shift attention to factors such as the US housing market.

A slowing world economy will affect export-oriented companies. Healthy Indian companies will continue to grow by improving quality and reducing cost, but it is harder to sell into a slowing world economy. The second channel will be prices and profitability. Chinese companies, which have an over-investment and over-capacity problem, will cut prices of manufactured goods when the world economy slows. This will affect profit rates in India, and deter investment, for industries such as steel, where the local price is set by the world market. Stock speculators in India need to factor these considerations into their price discovery process.

Back up to Ajay Shah's 2006 media page
Back up to Ajay Shah's home page