Posted on December 07, 2014

The rising risk of deflation in selected markets poses downside risks to the anaemic recovery in global house prices. The global housing market has struggled to recover from the steep correction during the Great Recession of 2008-09. The recent drop in commodity prices has significantly raised the risk of deflation, especially in the Eurozone (see our economic commentary dated 21 October 2014). As in the case of Japan during its “lost decades”, deflation could feed through to a general decline in asset prices, including housing. This could imply a significant correction in house prices in selected markets going forward.

Deflation poses risks to global [].jpgIn real terms, average global house prices in 50 large countries reached a trough in the second quarter of 2009. The recovery since then has been fairly anaemic, with average real house prices up only 1.2% a year over the last five years. Broadly speaking, advanced economies were the most heavily impacted by the crisis, mainly in the US, UK and most of the Eurozone. In these countries, house prices fell sharply in 2007-09 and recovered only slowly since then. Elsewhere (mostly emerging markets [EMs]), house prices were more resilient during the crisis and rebounded earlier in line with higher economic growth.

The Eurozone is at the root of the weak global recovery in house prices. Sluggish growth and the disinflationary environment have led to a gradual and steady decline in house prices. The Eurozone’s house price index has declined 15.4% in real terms since its peak in Q3 2007. Property markets in Greece, Italy and Spain were particularly affected, given the sharp recession that followed the Eurozone crisis. The recent sharp decline in commodity prices has significantly dampened the outlook for global inflation with rising risks of deflation, particularly in the Euro Area. This is likely to have a negative impact on global house prices. Falling goods prices can feed through to asset prices leading to expectations of further price falls, creating a downward spiral of asset price deflation.

In 2013-14, the recovery in UK and US housing markets has strengthened. Low interest rates and policies to support the housing sector have helped. However, rising price increases have raised concerns about potential overheating. IMF analysis suggests that the UK house prices may be overvalued by about 30% when compared with long-term average incomes and rents. At the same, the IMF assesses current US house prices to be broadly in line with fundamentals. Deflationary pressures, however, could impact markets in the UK and the US as well, notwithstanding their relationship with fundamentals.

Deflation poses risks to global 2 [].jpgIn most EMs house prices were relatively resilient to the impact of the global financial crisis and recession and have been rising steadily over the last few years. However, the slowdown in EM economies in 2013-14 has dragged down housing prices and led to a slowdown in price growth.

China is of particular concern. The increase in real house prices slowed from 16.3% in the year to Q4 2013 to 5.1% in Q2 2014 and real prices actually fell 2.0% in Q3 2014. This suggests that the Chinese real estate market could be nearing a crunch point. A sharp correction in property prices could lead to an increase in defaults, risking a crisis in the overextended shadow banking system. Measures to constrain credit to the real estate sector and restrict speculation appear to have taken some heat out the market, but any further house price declines going forward could have significant repercussion on private consumption and the banking sector.

In summary, global deflationary pressures add to the risk of a correction in house prices in 2015. In some countries, particularly in the Eurozone with slow or negative house price growth, the risk of deflation and a downward spiral in house prices is rising. In other countries where a recovery has taken hold up to now, there is a risk that real estate markets may be overvalued and a destabilising