With odds at 3:1, Brazil is favorites to win the World Championship in football this summer. Investors, on the other hand, will play Brazil cautiously this year, the Financial Times predicts. Why? The brief answer is that Brazil finds itself in a situation that is more than difficult. With economic growth close to zero, nagging problems with inflation and a prolonged bubble in housing prices, the big question is: can Brazil tame its real estate bubble, without causing an economy already on the brink of recession to grind to a halt?
If the Brazilian slowdown in growth was mainly a ‘natural’, and inevitable, response to low growth in the world economy, and the slowdown in the Chinese growth engine, there might be less reason for concern. But Brazil is edging closer to zero growth for domestic reasons too. Brazil’s growth model is “overly dependent on public spending and flagging consumption and credit” and suffers from a serious investment deficit; its investment rate is among the lowest in the region (at 18.4 %).
With such fundamental difficulties, why worry about taming a housing bubble? Is that not the lesser problem for Brazil, compared to the challenge of rebalancing its growth model and avoiding outright recession? At first glance perhaps, but in reality it makes little sense to address these problems separately. Indeed, failure to tame the real estate bubble may turn out to be what eventually pushes the Brazilian economy off the cliff. Just a few years ago, we witnessed how much a housing market turning sour can wreak havoc of an economy. Indeed, the parallels between Brazil today and the US in 2005 are deeply troubling.
Before we get to that, it may be worth noting that macroeconomic experience tells us that if there is anything we know about systemic risks it is that no risk exists greater than that of a housing bubble. Franklin Allen – Professor of Economics at the University of Pennsylvania, speaking at a Bundesbank symposium a few weeks ago – gave particular strong emphasis to this point. A number of studies, said Professor Allen, have “provided evidence that the most important source of systemic risk is the collapse of real estate prices”. If a real estate bubble bursts, other asset prices will likely fall too and there will be significant risk of a banking crisis with repercussions far beyond the financial sector, he stressed.
Strikingly, Franklin Allen singled out Brazil as a particularly troubling case, with real estate prices having tripled in Rio de Janeiro and Sao Paolo since 2008. Indeed, data from the Bank of International Settlements shows that over the past five years “no market was hotter than Brazilian housing”.
In the past year, Brazil’s central bank has raised its benchmark interest rate no less than seven times, so that it now stands at 10.5 %, up from 7 % a year ago. And yet, inflation remains high – at almost 6 %, considerably above the 4.5 % target – and real estate prices show little signs of abating. The Brazilian central bank may consider further raising interest rates, to contain inflation in consumer and real estate prices, but the adverse side-effects could be considerable: a further slowdown of investment, along with an increase in already high debt-service-to-income ratios.
Brazil’s predicament calls for macroprudential policy, some would argue. A boom in real estate prices can be dampened, or contained, without raising interest rates by deploying macroprudential tools such as loan-to-value (LTV) and debt-service-to-income (DTI) ratios. There are, however, good reasons to question that such policies will do the job for Brazil.
First, one should note that Brazil has already received praise for its macroprudential policies, several years ago, by the IMF and others. If Brazil’s praiseworthy macroprudential policies have hitherto failed to contain the boom in Brazil’s real estate markets, why should we trust them to succeed in that respect, going forward? Although it may be too harsh to say that the policies have been ineffective, they surely have, so far, been inadequately effective, it would seem.
Second, to the extent that macroprudential policy can be effective in mitigating systemic risks it is likely to be so mainly as preventive medicine, dampening and containing a boom, not so much as damage control, once the fire is on. Though it remains disputed whether the large real estate price increases in Brazil in the past six years do in fact constitute a housing bubble, or simply reflects real economic growth and the fact that housing prices were largely stagnant for decades prior, it seems to me that pessimists have a stronger case than optimists.
Talking about the housing bubble during a recent trip to Brazil, Robert Schiller, the Nobel-prize winning Yale University Professor, noted that it felt like being in the US in 2005: “Interest groups develop that want to cheerlead the housing boom… it sounds like something I’ve seen before”. This is not the only troubling parallel that strikes observers. For instance, given that average debt servicing was 15 % of income just before the crisis in the US, it is worrying that in Brazil today it is even higher. Debt servicing in Brazil is “eating up an ever-increasing share of income”, recently reaching 20 per cent, according to David Rees, emerging markets economist at Capital Economics in London.
A few factors may play to the advantage of Brazil, as noted by the IMF. Its mortgage-loan-to-GDP ratio remains low (6.9%) by international standards, the ratio of its real estate loans that are non-performing is also “fairly low” around 2 %, and securitization in Brazil is “still incipient and not complex”. Add to this that the Brazilian banking sector is significantly better capitalized than is the case in most other countries around the world, and you have a case for some resilience to adverse events in the Brazilian housing market.
But will it be enough to avoid, first, a collapse in real estate prices and, second, a wider financial crisis?
Jakob Vestergaard, GEG Watch, 17 March 2014.
References and suggested readings
Allen, Franklin (2014). Monetary Policy, Systematic Risk and Financial Stability
Deutsche Bundesbank Eurosystem (2014). Symposium on Financial Stability and the Role of Central Banks
Financial Times (2013, 30. December). Brazil: football and reality
International Monetary Fund (2013). Brazil – 2013 Article IV Consultation
Leahy, Joe and Samantha Pearson (2013, 3. December). Brazil Economy turns in worst quarter for 5 years
Pearson, Samantha (2014, 9. January). Challenging year forces Brazil to rethink growth strategies
Pearson, Samantha (2014, 16. January). Brazil raises benchmark rate to 10.5 %
Pearson, Samantha (2014, 14. February). Brazil housing bubble fears as economy teeters
Pearson, Samantha (2014, 27. February). Brazil economic growth allays recession fears
Rapoza, Kenneth (2014, 18. January). When It Comes to Real Estate Bubbles, China’s Got Nothing on Brazil
Selvanayagam, Ruban (2013, 19. September). Brazil’s Largest Private Bank Denies Existence of Property Bubble
Vestergaard, Jakob (2014, 3. March). Macroprudential Policy: the New Black in Central Banking