About $150 billion was wiped off home values in Sydney after property prices recorded the highest ever annual decline since 1990 on November 1, 2018. With around 60% of the wealth of Australian households invested in a family home, such fluctuations in property prices could have a serious impact on the economy of the nation.
The Housing Price Index (HPI) is used to measure changes in family house prices across a particular market. It is not only important for real estate, but policymakers as well. HPI has been used by policy experts and economists to analyse long-term trends in customer behaviour and the financial condition of an economy.
HPI becomes important as fluctuating house prices also indicate the direction of probable change in a country’s economy. Along with the gross domestic product (GDP), the consumer price index (CPI) and unemployment statistics, HPI is a crucial indicator analysed by currency investors before making an investment decision.
HPI helps economists and policy experts to predict the range of inflation, with constantly rising HPI indicating inflation. Inflation is a key factor in the decision making of central banks. When inflation is low, interest rates are reduced by central banks and when inflation is high, interest rates are increased.
When interest rates are raised, people are bound to avoid taking loans, especially for property purchases, and keep their money in banks because the bank offers higher returns. With an increase in interest rates, the demand for that currency also increases in the foreign exchange market. This is because higher returns on investment are guaranteed on that particular currency.
So, the demand and value of a currency rises following an increase in the interest rates in the nation that the currency belongs to. With a dip in the HPI, inflation decreases and banks reduce their interest rates. This results in a decline in the value and demand for that currency in the foreign exchange market.
This is why investors keep an eye on a country’s inflation and HPI as key indicators of inflation, with each release of an HPI report being followed by a fluctuation in the demand for a currency.
Property prices serve as a barometer for the health of an economy. Any decline in property prices, or even prediction of a decline, is likely to impact the financial markets. It has serious consequences for consumer confidence on the market too. A prediction of falling prices tends to make people skeptical about investing in real estate, resulting in a further decline in prices.
Falling property prices will reduce consumer spending and aggregate demand in the economy. This may result in lower growth and may even lead to an economic recession.
According to Daniel Blake, chief economist at Morgan Stanley, a slowing or slumping housing market can force a reevaluation of gearing and may lead to household balance sheet recession. This is likely to have a severe impact on the economy of a nation. A balance sheet recession takes place when high levels of debt in the private sector make individuals focus on saving money by paying down debt, instead of spending or investing. This leads to a slowdown or decline in the economic growth of the nation.
Recession will, of course, affect the exchange rate of the nation’s currency, by decreasing its value against other currencies. For example, you own Pound Sterling and you want to buy US dollars. If the UK market enters a recession, then the Pound Sterling’s value will depreciate against the US dollar, making it more expensive to buy USD.
If you wish to invest in property in USA or import machinery from USA, you will need more GBP to pay the total amount in US dollars.
This happens because when a market enters recession, it sends out negative signs about that economy to the global market. Interest rates are decreased, to make borrowing cheaper and promote more investment. Unemployment rises as businesses attempt to cut costs to survive in the market. Customers begin to focus more on saving then spending. In general, the economy becomes less prosperous.
All this makes it unattractive for foreign investors to invest in that economy because the potential of returns on investment decreases or is limited. This weakens the domestic currency, as demand for it decreases in the global market.
Recession doesn’t, however, guarantee that the value of the domestic currency will fall. For example, the UK is in recession while the Eurozone isn’t, although recently the value of the GBP has increased to a record high against the euro since 2008. This is because the political framework of the UK is more stable and rigid than that of the European Union. The UK economy is unlikely to collapse in the near future, while there is a possibility for European Union to disintegrate after the Brexit. This is due to major EU economies mulling an exit from the union, similar to the UK. This only goes to show how recession in an economy or slump in property prices doesn’t play a dominant role in the foreign exchange rate.
If property prices fall, it reduces consumer spending as well. It also reduces inflation in the economy. And, if the inflation rate falls below the targeted rate, the monetary policy committee or central bank will reduce interest rates. The decline in interest rates, in turn, will decrease the overall mortgage repayment amount. This will prove beneficial for entities with high mortgage interest repayments.
This could also slowdown the price decline in the property market and make investment in property lucrative once again. It could also make buying property achievable for first time buyers. In addition, it would decrease the need to save more for mortgage deposits, enabling consumers to invest more. Decreasing property prices might also increase the purchasing power of foreign investors in the property market.
The real estate market is a significant contributor to the economy of a nation. Growth and decline in this sector have direct influence on the GDP and the domestic currency of that nation.