Ricochet effect eyed as housing market teeters

Published 26th Jun 2008

As the credit crunch brings a decade of cheap mortgage finance to an end it is not just the foundations of the housing market, but its economy too, that are shaking.

House prices in Britain have jumped three-fold since 1996, providing households with a windfall stash of equity that has helped fund a consumer boom.

Now the market has turned. House prices are falling at the fastest rate since the recession of early 1990s and sales have slumped.

UK house prices have already fallen almost 8 percent from their peak last August, according to the Halifax house price index, and record low mortgage approvals figures suggest further pain ahead.

So will a sliding housing market inevitably take the broader economy down with it?

In a country where two-thirds of households own their homes, the link between house prices and consumer confidence is clear. Since the 1960s, there has never been a slowdown in Britain's housing market without a slowdown in consumer spending growth.

What complicates the equation is that house prices and consumer spending are influenced by similar factors. So distinguishing the "spillover effect" from what George Buckley at Deutsche Bank terms the "common shock" is not easy.

Buckley argues there are four main channels through which a weakening housing market affects the economy.

Firstly, there's the wealth effect: people are less inclined to splash out when they know their wealth is being eroded.

Secondly, there's a collateral effect: consumers are less able to borrow against the value to their homes to splash out even if they wanted to. Housing equity withdrawal totalled 41 billion pounds last year. Capital Economics expects it to fall to around 25 billion pounds this year and less than 10 billion pounds in 2009 -- the equivalent of less than one percent of households' income.
Photo

Then, there's the direct impact of a fall in transactions on demand for furniture, kitchens and carpets. Sofa retailers SCS Upholstery and Land of Leather have both warned of additional funding needs, sending their shares plummeting.

Fourthly, there's a hit to the construction sector. In Britain, construction accounts for around 6 percent of gross domestic product. That's less than half what it accounts for in Spain but not insignificant. If you add in the services of estate agents, surveyors and solicitors the hit to the economy is palpable.

Construction activity dropped last month at its fastest pace since records began more than a decade ago and house-builders like Persimmon and Bovis Homes have already warned on profits.

Figures this week show 40 percent fewer homes are changing hands in Britain than at the same time last year while 56 percent fewer mortgages are being approved for new homebuyers.

For Michael Saunders at Citigroup, the writing is on the wall: "The link between house prices and consumer spending in the UK is the closest among major industrial countries."

"We view the extreme weakness in housing as a precursor to a generalised sharp slowdown in domestic demand across the economy as a whole."

GRIN AND BEAR IT

Despite mounting evidence that pain is spreading through the economy, Bank of England Governor Mervyn King remains sanguine.

"There is no causal link between house prices and consumer spending," King told a gathering of City of London bankers last week. "How closely they move together depends on the underlying forces that are driving them both."
Photo

The bank's chief economist and soon-to-be deputy governor Charles Bean has also criticised those who "blithely assume" a tight link between house price growth and consumer spending.

Many economists think the bank is being complacent and point to the experience of the United States which is now facing with recession as real estate prices plunge.

Fears that Britain could follow suit are already playing out on the foreign exchanges where the pound has shed 10 percent against the euro and 5 percent against the dollar since October.

One Bank of England policymaker has already broken ranks. David Blanchflower argued recently that falling house prices could push Britain over the tipping point, where falling confidence and spending feed off each other.

"Developments in the UK are starting to look eerily similar to those in the United States," he said as far back as April.

Simon Rubinsohn, chief economist at the Royal Institution of Chartered Surveyors, agrees with Blanchflower that most Bank of England policymakers are being too sanguine.

"There are real risks out there from second-round effects," he said.

Christina Fincher

Source: ' reuters '

View All Latest Articles