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European Housing: Solid but Cooling

After some countries' double-digit gains in 2005, euro zone property prices rose 6.4% in 2006. Still, overvaluation likely exists

Euro zone property markets have started to cool as a result of the European Central Bank's rate policy. The latest annual data, published in the ECB's May monthly report, show that euro zone house prices rose 6.0% year over year in the second half of 2006, down from 6.9% year over year in the first half. This means 2006 property price inflation slowed to 6.4% from 7.9% in 2005. The 12-country average conceals a certain amount of heterogeneity, but it appears that most countries saw moderation.

By comparison, 2005 saw very strong house price gains in most countries, with double-digit growth in France, Spain, Ireland, and Belgium. Italy reported house price inflation of 9.6% year over year. (The German construction sector, on the other hand, continues to suffer from the overcapacity built up after reunification, and home prices contracted for a fourth consecutive year in 2005.)

We saw a moderation in house price inflation in 2006 in most property hot spots. Of the countries for which data are available, Spain reported a deceleration in house price inflation to 9.5% year over year in the second half, down from 11.4% in the first half. In the second half of 2005, prices rose 13.1% year over year.

Demand-Side Developments

Equally, French house price inflation slowed to 10.4% year over year in the second half of 2006, down from 13.9% in the first half and 15.1% the previous year. German house prices actually rose for the first time since 2001, but at 0.3% year over year, the growth rate was very small.

The deceleration is partly due to demand-side developments, as crude affordability (the ratio of household disposable income to residential property prices) declined last year. Household nominal disposable income improved in 2006 vs. 2005, but the growth rate remained far below the increase in residential property prices.

Interest-adjusted affordability measures (the ratio of disposable income to the income households would require to buy a house under prevailing borrowing conditions) have moved in the same direction. This was largely a reflection of rising nominal and real bank lending rates, as inflation started to slow in the second half while the ECB continued to hike interest rates.

Rapid Credit Growth

However, despite the slowdown, house price inflation still remains very high in countries such as France and Spain. The ECB suggested last year that, viewed as an asset class investment, the deviation of house price-to-rent ratios from their historical averages suggests that houses are overvalued by 15% to 25% in the euro zone, with increasingly large deviations in France, Italy, and Spain. With house price inflation still at relatively high levels, overvaluation likely still exists, which means there is a risk of a sudden correction in the case of a revaluation of risks and gains over coming years.

This seems especially true given that much of the rise in house prices has been fueled by rapid credit growth in recent years. The combination of rising interest rates and slowing house price growth has led to a deceleration in the growth rate of loans for house purchases, from around 12% year over year in April last year to 8.9% year over year in March this year. However, as the ECB has stressed, these growth rates remain at relatively high levels, which means housing markets need to be monitored closely.

For the euro zone as a whole, household indebtedness remains relatively low with respect to international comparisons, but has increased considerably in recent years. The ratio of outstanding household debt to gross domestic product in the euro zone reached 59% of GDP in the fourth quarter of 2006, compared to just 44% of GDP in 1995. Rising indebtedness and the increase in interest rates last year also meant that the interest rate burden rose in 2006 to an estimated 2.3% of GDP in the fourth quarter, up from around 2.1% in 2005, according to the European Commission.

Deteriorating Balance Sheets

The situation differs considerably among euro zone countries. Countries such as Spain and Ireland not only have high house price inflation, but at 77% and 80%, respectively, their levels of household indebtedness also are very high. Furthermore, in these countries variable interest rate contracts are widespread, which means rises in bank lending rates will be felt relatively quickly.

The combination of a rising interest rate burden and slowing house price inflation suggests deterioration in household balance sheets that could affect consumption and overall growth. If households have taken on loans based on an overestimation of income prospects and underestimation of future debt burden, this could lead to debt servicing problems and higher default rates, which would also affect banks' balance sheets.

For the euro zone as a whole, it does not seem to be the case that rising house prices and debt accumulation have boosted consumption in recent years. Furthermore, the slowdown in overall house price inflation and the growth rate in loans for house purchases would suggest a gradual and orderly correction of possible house price bubbles.

Spain Is Most Vulnerable

Yet, it is clear that, at least in some countries, rapid debt accumulation has been associated with weakened balance sheets, fast growth in household spending, and soaring house prices. In these countries further increases in interest rates, lower growth, and a correction in house prices could have severe effects, as the recent Dutch example shows.

As we pointed out in our Mar. 22 commentary, the country most likely at risk is Spain. However, the Bank of France has also warned in its latest monthly report that French household debt levels have risen to record highs. So while credit growth may be slowing, there are still risks and the ECB will be keeping a very close eye on the market. The central bank is monitoring asset price inflation, though it cannot directly respond to the situation in individual countries.

However, there seems to be the perception that exceptionally easy financing conditions and the liquidity overhang in the euro zone have at least contributed to the possible buildup of imbalances in housing markets. The need for a gradual correction in order to prevent a sudden burst of any potential bubble could provide an argument for official interest rates above the neutral level, and hence further tightening in the second half. We still see the possibility of a refi rate of 4.50% by yearend, depending on growth and exchange-rate developments.

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