All hail the mighty Reserve Bank

The Reserve Bank may talk about targeting financial stability, but its implicit policy goals of improving housing affordability and squeezing investors out of the property market smack of a dogmatic approach to setting policy that lies well outside the Bank’s mandate. In a moment of clarity earlier this year, the Reserve Bank highlighted a number of structural issues that were contributing to the rampant Auckland housing market, and stated that monetary policy could not “be used currently to dampen housing demand, as CPI inflation is below the Reserve Bank’s target range.” In the speech by Deputy Governor Grant Spencer, the Bank talked about a number of factors feeding into Auckland’s housing boom, including impediments to development from the RMA and council zoning, migration, and the lack of a capital gains tax. But the Bank has not let the presence of structural problems with Auckland’s housing market, all of which are outside its sphere of influence, stop it from furiously fiddling the controls. The Bank’s hands may be tied in terms of the interest rate lever, but it has invented an increasing number of macroprudential buttons to let it try and micromanage the Auckland market. Ostensibly, the Bank has marketed these tools as aiding its goal of improving financial stability, but how well-founded are its interventions?

The effects of the 2013 LVR restrictions

Firstly, let’s assess the effects of the initial loan-to-value restrictions introduced in late 2013. House sales in Auckland over the year to October 2014 fell by 12%, and house price inflation slowed from 15% to 9.2%pa. But the effects weren’t only felt in Auckland – sales volumes around the rest of the country dropped by 8.7%. Looking at the data region by region, one of the most surprising aspects is that there was a positive correlation between sales growth in 2014 and the level of house prices before the LVRs were introduced. In other words, sales activity in regions with lower house prices was, on average, more negatively affected by the LVR restrictions! To be fair to the Reserve Bank, the original LVR restrictions were never explicitly about targeting the Auckland market specifically. But given that house prices and affordability ratios in Auckland imply that the city’s housing market poses the most financial stability risks due to a potential house price correction, it is reasonable to assume that the Bank was hoping for the biggest effects to be felt in Auckland.

Are LVRs the best tool?

In our view, it is questionable whether LVR restrictions are even the best way to deal with the financial stability risks posed by a housing market downturn. The Bank effectively limited the quantity of high-LVR lending that could take place, leaving the retail banks to decide who was “worthiest” of getting a mortgage with a deposit of less than 20%. But economic theory states that rationing via price, rather than via quantity, leads to a more optimal allocation of resources, because those people who are willing to pay the higher price (or, in this case, the higher mortgage rate) are the ones who expect to get the greatest benefit from the good or service they are purchasing. This utility-maximising outcome does not necessarily occur under quantity rationing, because the seller has no way of knowing which individuals will derive the greatest benefit from obtaining the product. Think back to the first half of the 1980s, when there were strict limitations around the availability of credit. At that time, having a good relationship with your bank manager was probably just as important in determining your ability to get a mortgage as all the necessary financials such as your income, estimated ability to service the mortgage, etc. If the Reserve Bank believed that high-LVR lending posed a greater risk to financial stability than other mortgage lending, it could easily have increased the capital adequacy requirements relating to this subset of mortgages for retail banks. Forcing the banks to keep more capital on hand to back their high-LVR lending would have effectively increased the relative cost of this type of lending for the banks, and pushed up the mortgage rates faced by buyers with low deposits [1].

The problem posed by Auckland

It was clear to us throughout 2013 and 2014 that the LVR restrictions would not permanently slow the Auckland market’s momentum, due to the significant housing undersupply problem in the region, as well as some of the structural issues mentioned earlier that were identified by the Reserve Bank. After initially being cold on the idea of regionally targeted restrictions, the Reserve Bank has done an about-face this year and is trying to clamp down specifically on the Auckland market. It would be disingenuous to suggest that the accelerating house price inflation we’ve seen to date in Northland, Waikato, and the Bay of Plenty has been a side-effect of the Reserve Bank’s policy – the data we have so far relates to the period before the Auckland-specific LVRs came into effect. But the spread of demand into Auckland’s neighbouring regions will only be exacerbated by a lower hurdle for lending on property in Pokeno rather than Pukekohe. It would be foolish to turn a blind eye to the Auckland housing market and suggest that it doesn’t pose any financial stability risks. In other words, it could be argued for the Reserve Bank that the ends justify the means – the side-effects of a regionally targeted policy are worth bearing if we can reduce the chance of a financial sector meltdown. As for investors, the fact that they are more likely to default on their mortgage means they should be treated more cautiously and face tighter restrictions, right?

How evil are investors?

This point is where things really get messy. Papers released by The Treasury under the Official Information Act in late October show that it is not convinced that property investors present any greater risk of default than owner-occupiers. The collapse in property markets internationally following the Global Financial Crisis seemed to include an exceedingly high proportion of investors defaulting on their mortgage payments. But when empirical research was undertaken, the analysis suggested that the higher default rate among investors was due to the stage of the cycle that they bought property. Late in the housing boom of the mid-2000s, investors made up a higher-than-average proportion of property purchasers. So when the economy entered the downturn and property prices plunged, a higher-than-average proportion of those people who were unable or unwilling to continue servicing their mortgage were also investors. Their debt-servicing costs were higher, and they were also more likely to have been left in a negative-equity position. Michael Reddell and Ian Harrison, both former employees of the Reserve Bank, have highlighted the Reserve Bank’s apparent willingness to misrepresent these overseas studies in its eagerness to control the housing market. Housing affordability and home-ownership rates have been politically sensitive topics for over a decade. In New Zealand, home ownership is a distinctly preferable living arrangement to renting because of the tax advantage it enjoys due to a lack of any capital gains tax on people’s primary dwelling. But high home-ownership rates are also seen by many as indicative of a well-functioning society. Home ownership is seen as being virtuous in and of itself, as opposed to the evils of renting – perhaps this attitude stems back to many New Zealanders’ British ancestry, where the land was owned and controlled by a wealthy few and society was heavily class-based as a result. But the Reserve Bank appears to have bought into this line as well. What other explanation can there be for the Bank’s misapplication of the research in its keenness to squeeze investors out of the Auckland property market?

Unelected megalomania

What is most concerning about the increasingly heavy-handed role that the Reserve Bank is taking on is that it does so from a place of unelected authority. The independence of the Bank from political interference in its day-to-day operations is unquestionably important, in terms of both its monetary policy and financial stability mandates. The Bank also unquestionably has more expertise in either of these areas than any politician is ever going to have, so being delegated these responsibilities makes sense. But that being the case, the Bank has a duty of care to undertake those responsibilities as “correctly” as possible. Seemingly misrepresenting the facts to pursue its own ideological aims is certainly not best practice. In our view, the Reserve Bank has adopted an increasingly superior attitude about its own understanding of the New Zealand economy, monetary policy, and financial stability over recent years. The assertion that “we know better” has meant that the Bank has been reluctant to engage in much debate, and instead has been quick to dismiss those who disagree with its viewpoints. But economics is not an exact science – the most cynical observers would argue it’s not a science at all – and there is always significant scope for wrongly interpreting the way the world works and what the data is telling us. By choosing to limit the amount of high-LVR lending to an arbitrary level of 10% of all mortgage lending, and by questionably singling out property investors as a source of heightened financial risk, the Reserve Bank has shown itself to be increasingly paternalistic in its pursuit of financial stability. It seems the Reserve Bank has a belief that it better comprehends the financial risks, either on a personal basis for individual borrowers, or on a systemic basis for banking institutions. In the wake of the GFC, almost everyone would argue that increased monitoring of banks and a greater availability and transparency of financial system information were desirable and necessary. But the increasing number of levers being pulled by the Reserve Bank to try and actively manage parts of the economy beyond its core focus of monetary settings and the financial system is concerning. When combined with the Bank’s superior assessment of its own abilities, the whiff of megalomania emanating from Number 2 The Terrace is inescapable.

[1] High-LVR borrowers did end up facing higher mortgage rates from October 2013 as well, but it is unlikely that this lift in mortgage rates was the primary or binding constraint on high-LVR lending.

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