New Zealand's house prices outperform Australia's but face “significant” correction risk: RBNZ deputy governor

New Zealand is facing the increasing risk of a “significant” downward house price adjustment as house prices continue to rise, most notably in Auckland and Christchurch.

The warning comes from Grant Spencer, deputy governor and head of financial stability, at the Reserve Bank of New Zealand (RBNZ) in a speech where he highlighted that New Zealand’s economy and banking system is even more reliant on a stable housing market than Australia.

New Zealand house prices are up 8% over the past year (compared with just over 2% in Australia), but unlike the boom of 2003 to 2007, the current house price pressures are concentrated in Auckland and Christchurch due to supply constraints and pent up demand from first-home buyers with house price inflation in the rest of the country less pronounced - around 4% over the past 12 months.

“We have concerns that the current escalation of house prices is increasing risk in the New Zealand financial system, by increasing both the probability and potential effect of a significant downward house price adjustment that could result from a future economic or financial shock," said Spencer in a speech to the Employers and Manufacturers Association in Auckland.

“Unlike many other countries, New Zealand did not experience a major house price correction during the GFC and the median house price is now 12% above its end-2007 level. This has left us with house prices that are already high relative to international norms.

Spencer references the contentious US-based Demographia survey (dismissed by RP Data as “flawed”) in his observation that New Zealand house prices “are already high relative to international norms”.

“For example, in a recent international study of housing affordability, median New Zealand house prices (relative to disposable incomes) were the third highest amongst comparable countries.”

“The more that house prices continue to overshoot their long-run sustainable levels, the greater the prospect of an eventual significant downward correction,” he goes on to say.

Spencer warns of the “significant damage that can result from sharp declines in house prices, both in terms of financial system losses and the economic stresses placed on borrowers”.

“The impact of such an adjustment could be worsened by existing economic headwinds in the form of an overvalued exchange rate, drought affected agriculture and the government’s significant fiscal consolidation,” he says.

Spencer presented figures comparing New Zealand economic reliance on its housing market versus the situation in Australia.

Housing assets account for 73% of New Zealand’s total asset base compared with 56% in Australia.

“Two observations are key: first, the value of housing is a large share of total household assets in New Zealand compared to Australia (and the United States) where financial assets play a much greater role in saving for retirement,” says Spencer.

“Consequently, house price movements in New Zealand have a relatively large impact on household confidence and spending compared to many other developed countries where the state of the financial markets plays a larger role in driving consumer confidence and spending.”

Spencer also noted the New Zealand banking sector’s exposure to the housing sector with mortgage credit “by far the biggest asset class of the New Zealand banking system, making up just over half of total banking system lending” meaning housing is a “significant source of risk to both the household sector itself, and the New Zealand banking system”.

The RBNZ expects that household spending will generally pick up in line with stronger incomes but not to the extent to encourage “a rise in speculative investment that could extend house price pressures to the rest of the country”.

But he does warn of an alternative scenario:

"There is a risk of course that our assumptions turn out to be wrong: that the housing market continues to gather momentum and that households return to their pre-GFC ways of borrowing and spending in excess of incomes. The recent fourth quarter GDP numbers, which showed expenditure GDP growth of 1.4% and private consumption growth of 1.6% over the quarter, remind us that this alternative outlook for household behaviour is a real risk," he says.

The New Zealand cash rate is currently at 2.5% with current ‘best in market’ mortgage rates around 4.8% to 5%.

Spencer says mortgage rates are down half a percent over the past year due to lower funding costs on international markets.

Image courtesy of Flickr.