Housing Activity during Business Cycles

August 2013
The purpose of this note is to explore the relationship between housing activity and other economic indicators during previous business cycles. Starting with the early 1980s, we consider four distinct business cycle phases consisting of an upturn, downturn and recovery. The main findings are: New home building tends to suffer disproportionately large declines during economic downturns. It can take many years for activity to recover to predownturn levels. Activity in the renovations side of the market also tends to suffer during downturns, but the pace of recovery is quicker than for new home building. During downturns, residential construction activity has shown itself to be very responsive to stimulatory policies like interest rate cuts and targeted fiscal measures towards the industry. The reduction of the taxation burden as well as reform in the areas of regulation, planning and land supply would help strengthen new home building activity following a period of considerable under-performance which now extends for three years.

The chart below illustrates the development of quarterly Gross Domestic Product (GDP) growth between 1980 and 2012. For almost all of this period, the economy of Australia has expanded compared with the previous quarter. On only seven occasions over this timeframe were reductions in GDP recorded, although recovery has tended to follow quite quickly in most cases. The four business cycles explored in this paper are: A: The early 1980s B: The early 1990s C: The introduction of the GST [mid 2000] D: The Global Financial Crisis [from 2008]

GDP Growth - relative to previous quarter (%)

4%

3%

2%

1%

0%

-1%

Housing Industry Association Ltd 79 Constitution Ave Campbell ACT 2612 p 02 6245 1393 f 02 6257 5658 hia.com.au

-2%

Dec-1980

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Source: ABS

Dec-2012

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HIA Economics Group Note August 2013 Housing Activity during Business Cycles

The Early 1980s Figure 1 below illustrates the development of several indicators during the business cycle of the early 1980s. For reasons of series continuity, detached home commencement numbers are used as the indictor of new residential construction activity in this paper. The chart below shows how activity fared compared with that indicators cyclical peak immediately prior to the downturn. It is important to stress that indicators did not necessarily peak all in the same quarter. In fact, most indicators peaked in different quarters during the downturn. The early 1980s downturn was one that was replicated globally and had its roots in political instability in the Middle East. The resulting surge in oil prices disrupted economic activity and led to a sharp escalation of the inflation rate. Attempts to stifle inflation led to a hike in policy interest rates which further depressed activity. Recovery eventually took hold when inflation and interest rates declined. Prior to the early 1980s business cycle hitting a peak, the level of activity across most indicators grew strongly. When the downturn kicked in, new dwelling commencements were badly hit. Commencements fell by around 35 per cent relative to their peak within two years of the start of the downturn. Alternations and Additions (A&As) to dwellings also fell off sharply, although not as severely as for new dwelling activity. Non-residential construction fell sharply during the downturn, although not as steeply as new dwelling construction. Once the bottom had been reached, detached house construction and non-residential construction both bounced back very strongly and had recovered to their pre-downturn peak within four years. The recovery of A&As was much more hesitant; activity was still below its pre-downturn level a full five years after the onset of the downturn. Employment plays a crucial role in determining disposable income levels in an economy as well as generating household confidence. Accordingly, major commitments such as home purchases and renovations will be strongly affected by labour market developments. It is worth noting that during the early 1980s business cycle, housing activity started to recover only when employment was again on the increase and after it had returned to pre-downturn levels.

Figure 1: Early 1980s Cycle Indicators

15% 10% 5% 0% -5% -10% -15%

Percentage Change from Peak

-20%
-25%

-30%
-35% -40%

-12-11-10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Number of Quarters before/after Peak

Source: ABS
Detached House Commencements A&As Employment Non-Res. Construction

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HIA Economics Group Note August 2013 Housing Activity during Business Cycles

Figure 2 below provides a comparison between housing activity and mortgage interest rates during the early 1980s downturn. It is interesting to note that detached house commencements began their strong recovery at almost exactly the same time as mortgage interest rates began to fall. Renovations activity bottomed out at around the same time as the interest rate easing cycle began.

Figure 2: Early 1980s Cycle Additional Indicators

30%

20% 18%

20%

Percentage Change from Peak

16%
10%

14%
12%

0%

10% 8%

-10%

6%
-20%

4% 2%

-30%

0%

-12 -11 -10 -9

Source: ABS

-8

-7

-6

-5

-4

-3 -2 -1 0 1 2 3 4 5 6 Number of Quarters before/after GDP Peak

A&As GDP

10 11 12

Detached House Starts

Mortgage Interest Rate (RHS)

The Early 1990s The business cycle during the early 1990s initially saw strong expansions in economic activity driven by the deregulation of credit markets and a strong international backdrop. The emergence of inflationary pressures resulted in interest rates rising internationally, a development which tipped most developed economies into recession. Geopolitical tensions surrounding the first Gulf War and the disintegration of the Soviet Union further undermined confidence and activity during this phase. Most economies started to recover quickly from the downturn, but others including Australia endured a prolonged reduction in activity. Figure 3 below provides an overview of housing activity and other economic indicators during the early 1990s business cycle. Detached house commencements increased very strongly in advance of the peak in activity. When the downturn hit, activity eventually declined by over 30 per cent at its lowest ebb. Recovery was very slow, with activity still stuck below pre-downturn levels a full five years later. In contrast, the rise of A&As activity was much more gentle prior to the downturn. Following the peak of activity, A&As fell by no more than 10 per cent and had recovered within two years of the downturn. This was a particularly incongruous outcome given how badly employment suffered during the downturn of the early 1990s; numbers employed fell by 3.5 per cent during the height of the downturn and the pace of recovery was extremely slow with employment taking over four years to return to its pre-downturn level. Non-residential construction also saw a very sharp decline during the downturn followed by a very slow recovery.

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HIA Economics Group Note August 2013 Housing Activity during Business Cycles

Figure 3: Early 1990s Cycle Indicators

30%

20%

Percentage Change from Peak

10%

0%

-10%

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-50%

-12 -11 -10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0

Source: ABS

9 10 11 12 13 14 15 16 17 18 19 20

Number of Quarters before/after Peak

Detached House Commencements A&As Employment Non-Res. Construction

During the early 1990s cycle, it is interesting to see how mortgage interest rates interacted with housing activity. Interest rates rose in the run up to the start of the economic downturn. Once the downturn commenced, mortgage interest rates embarked on a significant downward journey, illustrated in Figure 4 below. The A&As segment of the market responded quite strongly to the lower interest rates being in place. Detached house commencements also responded well to lower interest rates, although the recovery fell far short of pre-downturn levels. The weakness in new home building may be partly explained by the behaviour of real house prices which surged in the lead up to the peak, but then declined by up to 10 per cent before stagnating.

Figure 4: Early 1990s Cycle Additional Indicators

50%

20% 18%

40%

Percentage Change from Peak

16%
30%

14%
20%

12% 10% 8% 6%

10%

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-10%

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-30%

-12 -11 -10 -9

Source: ABS

-8

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-3 -2 -1 0 1 2 3 4 5 6 Number of Quarters before/after GDP Peak

A&As GDP Real House Prices

10 11 12

Detached House Starts

Mortgage Interest Rate (RHS)

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HIA Economics Group Note August 2013 Housing Activity during Business Cycles

The GST Business Cycle The GST business cycle was born out of the stimulus which followed the Asian financial crisis during the late 1990s. This was accompanied by reduced interest rates internationally and strong growth in several key developed economies. The downturn was propagated by the escalation of interest rates and oil prices during 2000, the collapse of the technology stock bubble, the 2001 terrorist attacks in the US and the subsequent heightening of geopolitical tensions. In Australia, the introduction of the Goods & Services Tax (GST) in July 2000 resulted in a large amount of spending being dragged forward to the first half of 2000 and a sharp fall off in activity post July 2000. This is illustrated in Figure 5 below. The associated effects on economic activity were substantial: detached house commencements fell by almost 50 per cent in the immediate aftermath of the GSTs introduction, with a similarly sharp decline in non-residential construction. Motor vehicle sales also suffered to a lesser degree, while the reduction in A&As activity was also more muted. A&As had returned to pre-downturn levels within three years, but new home building was still significantly lower five years after the start of the downturn. Indeed, detached house commencements have never fully recovered to pre-GST levels at any stage over the subsequent thirteen years. Interestingly, the GST downturn did not involve any significant decline in employment. Rather, activity in the labour market stagnated for a few quarters before resuming a growth trajectory.

Figure 5: GST Cycle Indicators

20%

10%

Percentage Change from Peak

0%

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-12-11 -10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Number of Quarters after Peak

Source: ABS
Detached House Commencements A&As Motor Vehicle Sales Employment Non-Res. Construction

The GST business cycle was also marked by strong housing price activity before and after the beginning of the downturn. This is illustrated in Figure 6 below. Real house prices declined very slightly before the economic downturn but quickly resumed a very strong growth path. Robust price developments were probably supported by the lower interest rates in place after the start of the downturn. As was the case during the early 1990s cycle, both new house building and A&As activity were responsive to lower interest rates. The strength of housing price growth also contributed to the accumulation of home equity which would have supported borrowing for home renovations, during a time of competitive and accessible credit markets.

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HIA Economics Group Note August 2013 Housing Activity during Business Cycles

Figure 6: GST Cycle Additional Indicators

100%

20% 18%

80%

Percentage Change from Peak

16%
60%

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10% 8%

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-12 -11 -10 -9

Source: ABS

-8

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-3 -2 -1 0 1 2 3 4 5 6 Number of Quarters before/after GDP Peak

A&As GDP Real House Prices

10 11 12

Detached House Starts

Mortgage Interest Rate (RHS)

The Global Financial Crisis Business Cycle The GFC is widely regarded as the most serious global economic challenge since the Great Depression in the 1930s. Following the Asian crisis of the late 1990s, large global financial imbalances emerged involving high savings rates in countries like Japan and China. The excess funds of these countries were recycled through international financial markets with much of the cash being lent to the real estate sector in the US and parts of Europe. The creation of complex financial instruments linked to securitised mortgage debt meant that investors seeking low risk products unwittingly poured money into much higher risk areas. When this was eventually discovered, investors realised severe losses on their investments. Some of these massive losses on market instruments were insured, meaning that several major insurance companies were pushed towards insolvency. The inability to distinguish between high and low-risk debt securities resulted in lending activity in financial markets grinding to a halt. The shortage of financing forced a severe contraction in economic activity in many large economies. Over time, the crisis in financial markets spread to sovereign debt markets, with several European countries entering bailout programmes through the International Monetary Fund (IMF). The prolonged sense of crisis has prevented recovery from taking hold across the global economy. Remarkably, Australias economy weathered the GFC storm quite resiliently. Figure 7 below shows the development of several key indicators for Australia during the GFC cycle. In the run up to the GFC, detached house commencements had largely been static. The beginning of the GFC downturn saw activity fall sharply but a strong recovery in detached house building was prompted by the governments stimulus programme and record reductions in interest rates. However, the withdrawal of the stimulus and interest rate increases saw a second dip in detached house building. Similarly, A&As as well as motor vehicle sales saw smaller but significant reductions in activity, especially A&As. Non-residential construction activity initially weakened during the onset of the GFC but subsequently recorded huge growth as the mining and natural resources (MNR) investment boom gathered pace. Non-residential construction activity in this area was also strengthened by large-scale investment in the education sector and in health infrastructure.

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HIA Economics Group Note August 2013 Housing Activity during Business Cycles

Figure 7: Global Financial Crisis Cycle Indicators

70% 60%

Percentage Change from Peak

50% 40% 30% 20%

10%
0% -10% -20% -30% -40%

-12 -11 -10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0

Source: ABS
Detached House Commencements

9 10 11 12 13 14 15 16 17 18 19 20
Employment Non-Res. Construction

Number of Quarters before/after Peak

A&As Motor Vehicle Sales

Interest rate and house price developments during the GFC business cycle are shown in Figure 8 below. It is worth noting that both detached house commencements and renovations activity recovered strongly from their initial falls and the era of low mortgage interest rates is likely to have played some role in this, in addition to some of the factors mentioned above. The close relationship between renovations activity and real house prices post-GFC is also worth noting. Declines in prices dampened the accumulation of home equity, thereby restricting the scope for renovations financing.

Figure 8: Global Financial Crisis Cycle Additional Indicators

25% 20%

20% 18% 16%

Percentage Change from Peak

15% 10% 5%

14%
12% 10%

0%

8%
-5%

6%
-10%
-15% -20%

4% 2% 0%

-12 -11 -10 -9

Source: ABS

-8

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-5

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-3 -2 -1 0 1 2 3 4 5 6 Number of Quarters before/after GDP Peak

A&As GDP Real House Prices

10 11 12

Detached House Starts

Mortgage Interest Rate (RHS)

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HIA Economics Group Note August 2013 Housing Activity during Business Cycles

Conclusion This paper reviewed indicators of economic activity in Australia over the past thirty years. For almost all of that period, the economy grew and experienced mostly short-lived contractions on only a handful of occasions. The four business cycles examined here included phases of growth, contraction and recovery. Several common features are discernible: first, residential construction activity tends to take a disproportionately large hit during economic downturns, particularly new home building. Second, Alterations & Additions work tends to recover more quickly than detached house construction and the magnitude of its recovery appears dependent on house price growth. Third, new home building activity tends to take a very long time to recover once it experiences cyclical decline. These observations underline the vulnerability of the home building sector during periods of economic weakness and demonstrate that strong policy support for the sector during cyclical downturns is warranted. The experience of the GFC shows that stimulatory policies in the sector are capable of lifting activity but also that abrupt withdrawal of such measures has the potential to tip activity back into decline. In addition to the weak economic environment, there are a range of structural factors currently obstructing a sizeable and sustainable recovery in residential construction, related to land supply, taxation, planning, regulation, and a squeeze on credit. A focus on reform measures to lift residential construction activity is a crucial area for policy development across all levels of government, and obviously needs to be led at a Federal level.

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