“The abnormally high inelasticity of supply in relation to house prices, cannot continue without affecting the banking, financial systems and national economic system,” was the stark warning issued by the Luxembourg Centre Bank (BCL) in its latest Financial Stability Review.
Luxembourg’s unbalanced residential property market (where modest suburban houses now routinely fetch well over €1m) is a frequent topic of conversation. Less well-known is the potential threat to local mortgage lenders and the economy. “Vigilance is required, especially in view of the strong growth of household debt,” said the BCL report due to “high property prices in relation to household disposable income and the concentration of housing loans in a limited number of banks.”
Probably no housing bubble
The threat is probably not a speculative housing price bubble though. This might seem strange given that in the fourth quarter of 2020 prices were 99% higher than in 2009, compared to a 23% for the whole eurozone. Moreover, the ratios of prices to income and rent (see graphic) would usually point to fundamentals being out of kilter, because if they weren’t, these lines would be close to 100.
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However, the Luxembourg Central Bank tends to believe that supply and demand are the fundamental cause. They listed the reasons: income tax breaks for owner-occupier mortgages; low property taxes; persistently low interest rates; an easing of conditions for the granting of loans; and supply failing to keep pace with demand.
Not enough homes
On the latter point, between 2000 and 2018 the number of households increased by an average of 4,500 units per year as the population increased strongly, largely due to immigration. Yet over the same period 2,900 new dwellings were built per year. This lack of supply is due to tough local planning laws, private sector landowners being unwilling to sell and successive governments being unwilling to take the radical steps needed to calm the market. National statistics office Statec estimates that between 5,600 and 7,500 new homes will be needed each year to meet forecast population growth scenarios.
The Central Bank conducted a specific study into the conditions requested by banks for real-estate loans, finding that these had been “relaxed regularly in recent years”. Following this assessment, the law was changed to enable the CSSF to act on these factors, and it did so (on the recommendation of the Systemic Risk Committee) with effect from 1 January 2021. It imposed the requirement for minimum levels of own capital from lenders. However, the Financial Stability Review was unable to assess any impact on prices from this measure due to its recent implementation.
Rising indebtedness
It is the rise of indebtedness caused by surging prices that has the Luxembourg Central Bank most concerned. The ratio of total debt to disposable income in Q4 2020 was 102 in the EU, but 167 in Luxembourg. Housing loan debt as a percentage of household disposable income has risen from about 50% in 2000 to nearly 140% at the end of last year. Worryingly, nearly 90% of this debt is held by just five banks. “The institutions concerned could face difficulties in the event of a sudden increase in household payment defaults,” said the report.
Around half of all mortgages in Luxembourg have a variable interest rate. Plus 42% of Luxembourg households held mortgage debt in 2019, compared to only 27% in the euro area. “This may constitute a factor for increasing the risk of insolvency for some households in the event of a rapid rise in money market rates or a severe economic shock,” said the Central Bank. They also noted the unknowns around how the pandemic may have affected household balance sheets.
“A risk for financial stability”
There would also be second order effects on banks, as a significant fall in property prices would have negative wealth effects which would affect bank profitability. On the other hand, the Central Bank found that for 92% of indebted households, the burden of debt repayment represented less than 40% of their disposable income.
Given this overall scenario, the European Systemic Risk Board (ESRB) has judged that the combination of strong house price growth and rising household debt “presents a medium-term vulnerability for the Luxembourg residential property market”. These vulnerabilities “constitute a risk for financial stability and, in the long run, could also generate negative effects for the real economy.”