A view on how housing finance is affected by the central banks’ monetary policy actions

Probably all of us will agree that monetary policy regulators or simply, Central/Reserve Banks, exercise considerable control over a nation’s economy. They have to exercise control over inflation and money supply primarily though managing the interest rate.  These central banks have the noble goal of providing monetary stability and fostering economic growth of a country.

Unfortunately, sometimes in this endeavour, interest rate sensitive sectors tend to suffer and be constrained – especially during a period of high inflation. Housing is such a sector. Credit to the housing sector is generally intensive and long term, therefore, a small change in the interest rate, either up or down, may have profound effects on the amount of housing finance available in the country and the affordability of consumers. When the central bank seeks to reduce inflationary pressures (which are caused by excess money supply) by increasing the interest rate, this hampers the property market. With rampant high inflation in so many African countries, we can expect that many will therefore also experience persistent and increasingly higher interest rates.  Regrettably, this will lead to housing finance becoming increasingly expensive: hence less borrowing, less housing development start-ups, and probably an increase in slum dwelling and wide-spread incremental construction.

So far,  empirical research in housing supply has sustained the hypothesis that delivery of new housing units is a factor of house prices and cost shifters (Poterba, 1984; Topel and Rosen, 1988). Among the key cost shifters to housing developers is the cost of construction finance, which is always represented by real or nominal interest rates. Statistics from the Kenya National Bureau of Statistics on house start-ups in Kenya, for instance in Figure 1, show a significant change in new house start-ups towards the opposite direction with a change in lending rates. This implies that high interest rates considerably discourage housing supply.

Figure 1:House Start-ups Vs Lending Interest rates in Kenya, 2007 – 2012

According to Figure 2 below, it is alarming to see that house prices in Kenya do not seem to respond to movements in the interest rate or the inflation rate. Instead, it seems that house prices are more influenced by other factors (some of suggested speculation, illicit money from Somali piracy, ransoms and, perhaps, diaspora remittances). According to Fischer’s formula of inflation expectations, nominal interest rate[1] is a simple summation of real interest rate and the inflation rate. Therefore, it would be  true to say that  high inflation rates rampant in Africa is a key cause of the low levels of housing finance and house delivery. By deductive reasoning, we can say that to increase the house supply, African governments must first tame inflation.

Figure 2: House Price Vs Lending Interest Rate in Kenya

Let us take a snapshot of inflation rates and mortgage finance (measured by mortgage-to-GDP) across the continent in 2010 to illustrate that whenever inflation rates are low housing finance tends to be high and low whenever inflation is rampant. Consider Figure 3 below, clearly, one can see a steady fall in mortgage finance as the inflation rate steadily increases. In statistical terms, mortgage-to-GDP ratio had a significant Pearson correlation of -0.61 with lending interest rates for the sampled nine African countries. Normally, a correlation that is above -0.5 or +0.5 is considered to be a strong measure of association, therefore, -0.61 indicates a strong co-movement but in different directions between the two variable. (More on this will be provided after more plausible regression analysis later). 

Figure 3: Inflation rate Vs. Mortgage the Relative Size across various countries

(Inflation is computed as a geometric mean for inflation from 2006-2010 and Mortgage-to-GDP obtained from Centre for Affordable Housing Finance in Africa (2010)

References

Poterba, J.M., 1984. Tax Subsidies to Owner-Occupied Housing: An Asset-Market Approach. The Quarterly Journal of Economics 99, 729-752.

Topel, R., Rosen, S., 1988. Housing Investment in the United States. Journal of Political Economy 96, 718-740.