## _cr14234 ## Source details **Canonical URL:** [_cr14234](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14234.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14234.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14234.pdf.json) --- ### Housing-related Sectors: Finance, Real-Estate, and Construction — Historical perspective and market structure - Real estate sector value added: about 6 percent of GVA in 1990 and 12 percent in 2013. - Finance, real estate, and construction (FREC) share: about 25 percent of GVA when combined. - Long-run house price performance: - Annual real house price increases averaged 3 percent in the UK over the past 30 years versus 1 percent for the OECD as a whole. - UK house prices have been more volatile than in other advanced economies. - Residential investment: - Residential investment in the UK as a share of GDP is among the lowest across the OECD economies. - Planning and permitting: - Obtaining a planning permit in the UK takes about 25 weeks (NAO) versus 13 weeks average in OECD (DBI). - Monetary cost of obtaining building permits in the UK: 66 percent of per capita income; OECD average: 56 percent of per capita income. - Rejection rate of major housing projects rose from 15 percent in the mid 1990’s to 35 percent in 2008. ### Housing booms, busts, and cycle characteristics — UK versus advanced economies - UK housing-cycle features: - Large fluctuations in real house prices combined with a limited response of residential investment. - The UK has the largest fluctuations in real house prices among G7 economies; volatility exceeds that of the US and Canada. - Residential investment in the UK is less volatile than in most OECD economies; influenced by housing supply elasticity. - Supply-side constraints (restrictive planning regulations and inadequate incentives for local authorities to grant building permits) reduce house price elasticity of residential investment. - Mortgage loans with high loan-to-value (LTV) ratios have been more pervasive in the UK and boosted housing demand. - Split-sample empirical finding: - Countries with high planning costs and high LTV ratios exhibit high house price volatility (thresholds defined by the sample median). - Quantitative changes over time: - Duration of upturns: average of 31 quarters during 1980–96 increased by 50 percent to 47 quarters during 1997–2013. - Amplitude of upturns (difference between trough and peak of real house prices) increased from 98 to 170 percent. - Volatility amplified by a loosening of credit conditions prior to the crisis. - Household balance-sheet implications: - Housing net worth reached 200 percent of GDP in 2007. - Aggregate net wealth masked vulnerability concentrated among first-time buyers with relatively high LTVs. ### Planning restrictions, LTV ratios, and housing-cycle transmission - Planning constraints: - Planning costs are relatively high in the UK and reduce the elasticity of residential investment to house prices. - Uncertainty over planning outcomes and longer processing times (including appeals) contribute to sluggish supply. - High LTV ratios: - Increase demand, exacerbate price volatility, and heighten household vulnerability. - Empirical split-sample evidence: - High planning costs → larger changes in real house prices over the cycle (upturns and downturns). - High LTV → larger changes in real house prices over the cycle (upturns and downturns). ### The Great Recession (2008–10) — impact, recovery, and valuation - Housing bust severity and dynamics: - Real house prices in the UK declined by 15 percent during the Great Recession (2008–10). - Residential investments as a share of GDP declined by 50 percent. - Only the housing bust in the US was more severe among the G7. - Post-crisis, GDP in the UK was 18 percent below the pre-crisis trend in 2012; OECD average decline relative to trend was 14 percent. - Pre-crisis boom: - In 1997–2007, real house prices in the UK increased by 150 percent (more than in other OECD countries except Ireland). - Post-crisis recovery and valuation: - Standard valuation ratios (Price-to-Income and Price-to-Rent) show an overshooting in house prices in the range of 10–30 percent (benchmarks: average of the ratios over the past 15 and 30 years). - Recovery has occurred with weak credit growth: - Ratio of credit to the private sector to GDP (measured by M4 and M4LXex lending) is declining. - M4LXex excludes effects of securitizations and loan transfers. - Increase in house prices amid weak credit growth suggests a greater role for cash transactions, particularly by foreigners. - Recovery is unbalanced: - Demand outpacing supply, especially in London. - Real house prices in London have reached their pre-crisis peak, while other regions have not. - Residential investment is recovering at a sustained pace; housing transactions have been growing, accelerating house price inflation. ### Housing and the business cycle — VAR evidence and historical decompositions - VAR specification and data: - Seven-variable macroeconomic VAR with quarterly data for 1987–2013. - Variables: CPI inflation rate, residential investment, private consumption, GDP, interest rate, ratio household debt to income, house price. All except inflation and interest rate expressed in logarithms. - Identification: Cholesky decomposition in the listed variable order. - Lag selection: Akaike criterion; model estimated with 2 lags. - Impulse responses: - A 10 percent increase in house prices raises private consumption up to 2 percent in 5 quarters. - Household debt ratio reaches a peak response of 10 percentage points of disposable income after 12 quarters. - UK-specific responses relative to OECD medians: - Response of residential investment in the UK is half of the median OECD response. - Response of household debt is more than twice the median OECD response. - Historical decomposition: - Housing shocks reduced GDP by 3 percent during the Great Recession — about a third of the fall in output experienced during the Great Recession. - Early 1990s housing bust impact on GDP was 2 percent but the recession was short-lived due to rapid expansion in exports and investment compensating for the housing shock. - Mechanisms: - Wealth and collateral effects (including mortgage equity withdrawal) explain consumption responses. - High elasticity of household debt to house prices reflects rapid mortgage credit expansion during booms. - Low elasticity of residential investment to house prices indicates binding supply constraints. - Supply constraints combined with credit fluctuations amplify the housing cycle and business cycle. ### Policy recommendations on housing and financial stability (housing sections) - Supply-side policies: - Alleviate supply-side constraints, notably planning restrictions, to moderate housing cycles. - Changes to the planning system and tax reforms can alleviate housing supply constraints. - Reform property and land taxation: current regime discourages institutional investment in rental accommodation and exempts undeveloped land from business taxes, incentivizing land hoarding. - The National Planning Policy Framework is creating incentives for local councils to increase available land for construction; early signs contributing to recovery in housing construction. - Macroprudential measures: - Pursue targeted macroprudential measures to address financial stability risks from house price inflation. - Recognize increased vulnerability of first-time buyers due to relatively high LTV offerings. - Recommendation: targeted, early and gradual macroprudential policies to increase bank resilience and reduce housing cycle volatility. - Specific UK measure: the Financial Policy Committee (FPC) recommended a cap on mortgages with high loan-to-income ratios: no more than 15 percent of new mortgages could have a loan-to-income ratio of 4.5 or higher. This measure will be effective from October 1, 2014. --- ### Business investment: recent developments, long-run trends, and diagnostics - Recent developments: - Business investment fell by 20 percent in 2008–09. - Business investment grew 10 percent year on year in Q1 2014. - Pre-crisis long-run view: - Business investment grew 4 percent a year on average in the decade leading to the global financial crisis. - Capital-to-labor ratio rose faster than in many other economies. - Capital productivity (output divided by net capital stock) grew faster than in many other advanced economies, reaching the highest level just before the global financial crisis. - Growth accounting (1997–2007; annual percent change; contributions to GDP growth — selected countries): - UK(ONS) 1/: GDP growth 3.2; Labor 0.9; Capital 1.3; services 0.7; ICT 0.6; Non ICT 1.0. - US: GDP growth 3.1; Labor 0.9; Capital 1.5; services 0.8; ICT 0.7; Non ICT 0.7. - Germany: GDP growth 1.7; Labor 0.0; Capital 0.6; services 0.3; ICT 0.3; Non ICT 1.0. - France: GDP growth 2.3; Labor 0.6; Capital 1.2; services 0.4; ICT 0.8; Non ICT 0.5. - Japan: GDP growth 1.0; Labor 0.0; Capital 0.7; services 0.3; ICT 0.5; Non ICT 0.3. - Crisis impact and post-crisis dynamics: - Between 2008 and 2010, GDP growth averaged minus 1.5 percent. - Contraction largely due to a sharp decline in total factor productivity; reduced labor inputs and slower capital accumulation also contributed. - Rebound driven mainly by strong labor growth in 2011–12; capital accumulation remained weak; total factor productivity continued to drag on growth. - Capital productivity fell sharply at onset of the crisis and remains well below pre-crisis levels. - Pre-crisis positive allocational effects supporting capital productivity weakened after the crisis. ### Firm-level diagnostics and empirical investment determinants - Data and method: - Firm-level panel data on listed non-financial firms (Worldscope; about 5,000 firms; 1997–2012 annual). - Estimation: GMM-System estimator (Arellano and Bond; Arellano and Bover; Blundell and Bond). - Sample excludes oil and gas; public administration and defense; outliers outside 1–99 percent distributions. - Key regression insights: - Demand determinants: - Sales Gap coefficient: positive and statistically significant. - Return on Assets (profitability) coefficient: positive and statistically significant. - Cost of Debt (effective interest rate) coefficient: negative and statistically significant. - Financing and balance-sheet effects: - UK firms rely on internal funds for at least 60 percent of business investment; reliance on internal funds increased since the onset of the crisis. - Retained Earnings to capital: positive association with investment. - Long-Term Debt to capital: positive and statistically significant (greater access to external finance supports investment). - Cash Dividend Payments to total profit: negative and statistically significant. - Uncertainty and irreversibility: - Bloom’s policy uncertainty coefficient: negative and significant; firms postponed investment as uncertainty rose. - Allocation efficiency: - Pre-crisis interaction with profitability: positive (0.058) and significant, indicating investment more sensitive to profitability pre-crisis than post-crisis. - Long-run elasticity of investment to profitability fell from 0.17 pre-crisis to 0.08 post-crisis. - Exporters versus non-exporters: - Exporter dummy: significant and positive. - Exporters: higher sensitivity to Return on Assets; smaller Sales Gap coefficient compared with non-exporters; long-term debt positive and significant for exporters. - Non-exporters: investment more sensitive to Effective Interest Rate and Policy Uncertainty. - Cross-country comparisons: - No clear evidence of reduced capital allocation efficiency since the crisis in the U.S., France, and Germany. - France: demand variable interacted with pre-crisis dummy negative and significant (firms more cautious post-crisis). - Pooled model suggests similarities between UK and US firms; UK dummy coefficient smaller than Germany and France dummies. ### Regression estimates (selected coefficients and diagnostics) - All Firms (examples from Appendix Table 1): - Lagged investment to capital: 0.331***, 0.333***, 0.331***, 0.358***, 0.360***, 0.323***, 0.323***. - Sales gap: 0.416***, 0.415***, 0.772***, 0.448***, 0.446***, 0.543***, 0.543***. - Lagged return on assets: 0.092***, 0.091***, 0.054*, 0.092***, 0.045, 0.087**, 0.066. - Effective interest rate: -0.072***, -0.072***, -0.073***, -0.007, -0.008, -0.158***, -0.159***. - Retained earnings to capital: 0.211***, 0.208***, 0.210***, 0.180***, 0.179***, 0.219***, 0.219***. - Long-term debt to capital: 0.038***, 0.037***, 0.039***, 0.050***, 0.050***, 0.000, 0.000. - Cash dividends payment to total profit: -0.062***, -0.063***, -0.060**, -0.021, -0.021, -0.141***, -0.141***. - Bloom's policy uncertainty: -0.106***, -0.120***, ..., -0.090**, ..., -0.251**, -0.387 (omitted in some specifications due to collinearity). - Model diagnostics (examples): - AR(2) test p-values: 0.246; 0.251; 0.295; 0.401; 0.406; 0.232; 0.231. - Hansen test p-values: 0.221; 0.197; 0.200; 0.525; 0.512; 0.701; 0.699. - Example sample sizes: Number of observations 5,216; Number of firms 1,038 (in several specifications). ### Policy messages on investment and allocative efficiency - Business investment growth is important for rebalancing the economy away from consumption and strengthening productive capacity, but restoring allocational efficiency of capital is essential for productivity recovery. - Policy recommendations (explicit): - Continue efforts to improve financial intermediation, ensuring adequate access to finance for business innovation and restructuring. - Improve infrastructure, especially in transport, energy, and housing. - Review corporate governance structures to address “short-termism” and encourage longer-term investment (as recommended by LSE Growth Commission (2013)). - Support human capital development, including enhancing vocational training and apprenticeship programs and not halting efforts to attract foreign talents. - Observations on financial intermediation: - UK banking sector was hit hard by the global financial crisis. - Real lending rates for large firms dropped to around zero percent; rates for smaller firms remained relatively elevated, possibly due to insufficient collateral or credit records. --- ### Sectoral credit allocation, financial intermediation, and macroprudential policy - Sectoral credit allocation: - A measure of sector credit shift (dispersion of growth rate of bank loans across sectors) has decreased since the Great Recession, indicating weakened financial intermediation channels together with stagnant aggregate loan growth. - Macroprudential context and empirical effectiveness: - Context: - Rapid house price increases in London and rising loan-to-income ratios for first-time buyers and households in London pose financial stability risks. - Macroprudential policy is the first line of defense against housing-related systemic risks. - Role of instruments: - Caps on LTV and DTI ratios reduce mortgage supply, dampen credit growth, and reduce leverage of marginal borrowers. - Caps on LTV/DTI ratios are the most common macroprudential measures; other tools include property taxes and changes in risk weights. - Event-study empirical effectiveness (advanced-economy sample, 1997–2013): - Caps on DTI ratio: reduces nominal mortgage credit growth by 1.4 percent and reduces house price inflation by 1.8 percent (point estimates). - Caps on LTV ratio: reduces mortgage credit growth by 0.8 percent and reduces house price inflation by 1.9 percent. - Tax policy (widely used in Asian economies): reduces house price inflation by almost 4 percent (on average). - Changes in risk weights and provisioning: limited impact on mortgage credit and house prices. - Using multiple instruments simultaneously maximizes impact; combined effect can be substantially larger than single instruments. - Implementation approach: - Authorities commonly implement macroprudential measures gradually due to uncertainty in transmission and implementation lags. ### Empirical magnitudes on combining instruments - Single instrument effect: can reduce mortgage credit growth by 0.4 percentage points (example). - Combined effect: several instruments combined can reduce mortgage credit growth by 2 percentage points — about 5 times the impact of a single instrument. - Case example: Hong Kong (Q1 2013) used four macroprudential tools; house price inflation and credit growth fell by 11 percent and 3 percent respectively. ### Case studies and lessons - Korea (regional macroprudential policies): - Regional “speculative zones” criteria and successive LTV and tax measures led to real house prices declining by 5 percent after October 2003 measures; policies stabilized housing and mortgage markets and curtailed speculative incentives. - Canada (mortgage insurance and gradual implementation): - Household debt as share of disposable income rose from about 110 percent in 2000 to 165 percent in 2013. - Government-backed mortgage insurance tightened in several rounds (2010, 2011, 2012) leading to a slowdown in mortgage credit and house price growth. - New Zealand (comprehensive toolkit and targeted LTV cap): - May 2013: Reserve Bank adopted macroprudential framework with four instruments (CCB, SCR, CFR adjustments, restrictions on high LTVs). - October 2013: cap on proportion of new loans with high LTV ratios (80 percent or higher) limited to 10 percent of new mortgage lending over a six-month window; measure temporary. - Outcomes: - Share of high LTV loans declined from 25 percent of new mortgage lending in September 2013 to 5.6 percent at end-March 2014. - National house sales dropped by 23 percent between September 2013 and March 2014. - Ongoing monitoring required to prevent regulatory arbitrage. ### Policy implications for the UK (macroprudential) - Macroprudential policies should be implemented gradually and possibly in several rounds to assess impacts and recalibrate; large discrete changes risk financial disintermediation. - Caps on LTV/DTI ratios are effective and can be targeted regionally (e.g., London vs rest of country) to address localized systemic risks. - Combined use of multiple tools maximizes effectiveness. - UK-specific measure reiterated: - FPC recommendation effective October 1, 2014: no more than 15 percent of new mortgages could have a loan-to-income ratio of 4.5 or higher; this measure could be adjusted gradually over the business cycle. --- ### Shadow banking, repo market stress, and outward spillovers — thought experiment on snapback - Scope: - Thought experiment on repo market channel for stress transmission from global shadow banks to UK banks following a world interest-rate “snapback”; focus on US$5 trillion segment linking US MMFs to leveraged global shadow banks via G14 dealer banks. - Environment and vulnerabilities: - Low interest rates, asset price inflation, tight bank regulation, record-low implied volatilities have driven risk migration to shadow banking. - Shadow banking (in this section) defined as nonbank institutions capable of liquidity and maturity transformation and leverage creation, with emphasis on the “fund sector” (bond and equity funds, hedge funds, mREITs). - Contribution to UK systemic risk: - Around two-third of overall systemic risk in the UK financial system can be attributed to major UK banks. - Contribution of equity funds to systemic risk increased by one-fourth (from 3.2 to 4 percent). - Fund-sector contribution to banking distress-dependence disproportionately from bond and hedge funds (they account for three-fifth of fund sector’s contribution while being one-fifth the size of pension funds in the sample). - Estimated share of UK-resident dealers in the repo chain: c. 30-40 percent. - Mechanics of contagion after a snapback: - Snapback modeled as symmetric instantaneous upward shift in yield curves for the dollar, euro and sterling. - Shadow banks face variation margin calls as repoed collateral loses value. - Identification of “limit points” where shadow banks exhaust usable collateral, forcing repo unwind and potential fire sales. - Many G14 dealers intermediating borrowing are UK-headquartered G-SIBs or UK subsidiaries/branches of foreign banks. - Quantified stress magnitudes: - 100 basis point rise: implied variation margin flows c. US$550 billion (unchanged collateral haircuts). - 200 basis point rise: implied variation margin flows US$1 trillion. - G14 dealers’ own collateral “cushion”: ~US$300bn (= Reverse Repo book minus Repo book). - mREITs leverage: 7.3 times; mREITs “limit point” reached with a 200 basis point shock. - Amplifying dynamics: - Lenders likely to raise collateral haircuts as borrower leverage increases; earlier or smaller shocks could trigger limit points. - Speed of rate rise and repo maturities are critical; an instantaneous jump is modeled for tractability, but slower rises allow breathing space. - Short maturities amplify risk (example: at 20 percent, mREITs’ repo borrowing with maturity <30 days is non-trivial). - Systemic market outcomes: - Repo-chain stress can contaminate G14 dealers, cause intra-day trading freezes, raise dealers’ CDS premia, and trigger credit valuation adjustments on derivatives. - Rising counterparty risk would likely increase unsecured borrowing costs (measured by LIBOR-OIS spread). - A major liquidity shock cannot be ruled out; systemic implications depend on complex interconnectedness. - Quantified outward credit spillover scenario: - Historical reference: end-Sep 2007 to end-Dec 2009, 3-month UK LIBOR-OIS remained on average 80 basis points above “normal” 10 basis points and accompanied by an 11 percent decline in UK banks’ foreign claims. - Illustrative assumption: shock half that size/duration implies implied external deleveraging by UK banks of c. 3 percent (US$120 billion, given US$4trn in foreign claims). - Simple apportionment of US$120 billion by share of foreign claims: Hong Kong domestic credit falls by 2 percent; Mauritius and Bahamas by 1.5 percent; Luxembourg, Ireland, Singapore and South Africa by 1 percent. - Strategic deleveraging (protecting core jurisdictions, exiting others) could cause some emerging and low-income economies (Panama, Djibouti, Pakistan, Mozambique, Philippines, Uruguay) to see credit reduce by 10 percent or more. - Net effect on recipient economies depends on their stage in economic and credit cycles. - UK mitigants and policy levers: - UK and US banks are more resilient in terms of capital and funding than during the GFC. - Sterling Monetary Framework changes (announced October 2013): banks deemed healthy ex-ante by the PRA assured access to the Bank’s permanent liquidity facilities at lower cost and longer maturities, against a broader range of collateral, and with less stigma. - Decision to extend liquidity supports to central counterparties and major broker-dealers. - Stronger backstops require commensurately strengthened supervision to avoid moral hazard. - Policy recommendations and priority actions: - Ensure adequate oversight of the nebulous shadow banking system, including global shadow banking activity. - Prioritize additional budgetary resources, regulatory perimeter adjustments, and international coordination initiatives related to global shadow banking. - Ongoing FCA and PRA efforts: joint work with FSB and IOSCO to identify global systemically important finance companies, insurers, investment funds, hedge funds; BoE monitoring of systemic linkages between US MMFs and UK banks; initiatives to enhance transparency of repo and securities lending markets; regular FPC reviews of adequacy of regulatory perimeter. --- ### UK role in Chinese banking internationalization and renminbi spillovers — thought experiment and stages - Projections and scale under full liberalization scenarios: - Bayoumi and Ohnsorge (2013) project net increase of Chinese international assets of US$ 1.6–2.7 trillion over the next 15 years or so. - Hooley (2013) projects China’s gross international investment position could increase from 5 percent to 30 percent of world GDP by 2025 under full liberalization. - If Chinese banks adopted a US-like external orientation, gross cross-border claims of almost US$ 5 trillion could be accumulated by Chinese residents. - UK generated over US$ 3.7 trillion in cross-border claims from branches and subsidiaries of foreign-owned banks over 2005–13. - Ballpark arithmetic (thought experiment assumptions and results): - Assumptions: - (i) Chinese banks’ cross-border/total asset ratio rises to one-quarter → release of c. US$ 4.9 trillion in cross-border bank claims. - (ii) 21 percent [US$ 1,029 billion] of US$ 4.9 trillion held in the UK (mimicking US/Japan allocation). - (iii) 43 percent [US$442 billion] of US$ 1,029 billion received by UK nonbanks and assumed to “end” in the UK. - (iv) Of remaining US$ 587 billion received by UK-resident banking entities, one-third recycled back to China. - (v) Result: US$ 391 billion remains as China-originated gross cross-border bank claims available for global distribution from the UK. - Qualification: nearer-term and gradual scenarios produce much smaller figures (see alternatives). - Nearer-term and alternative scale scenarios: - If Chinese banks’ cross-border/total assets ratio rises only to levels of advanced economies with moderate financial integration, total increase in cross-border bank claims could be closer to US$ 1.2 trillion (vs c. US$ 4.9 trillion). - Then China-originated bank claims available for global distribution from the UK could approach c. US$ 100 billion (not c. US$ 400 billion). - Composition effects and capacity: - Liberalization implies both scale and composition effects: shift from low-yielding government bonds to more FDI and portfolio debt and equity investment as private outflows liberalize. - Chinese-owned banks currently have limited international experience and capacity; initial liberalization likely facilitated by global investment banks, many operating out of London. - Likely UK roles and channels: - (a) Chinese institutional investors investing in world capital markets via major investment banks in London. - (b) Chinese corporations issuing debt and equity in London. - (c) London as leading centre for FX and derivatives trading for hedging currency and interest rate risks. - Legal, design, sales, marketing and execution work often carried out in London even when assets domiciled elsewhere. - Renminbi internationalization metrics and UK position: - Renminbi now second most used currency for trade finance after the dollar; overtook the euro. - SWIFT: renminbi second most used currency for cross-border payments with China and Hong Kong; for Middle East and Central and Latin America, renminbi is the most used currency for payments with China and Hong Kong. - Globally, renminbi is the seventh most used payments currency by value, at 1.47 percent of global payments. - Percent of Chinese exports settling in renminbi projected to rise from below 10 percent in 2011 to about 20 percent in 2014. - London is the largest renminbi trading centre outside China and Hong Kong SAR; by end-2013 almost two-third of renminbi trading outside China and Hong Kong SAR took place in London. - London’s shares: FX trading 40 percent; OTC derivatives trading 50 percent. - Institutional steps supportive of UK role: - June 2013: Bank of England and People’s Bank of China established a sterling-renminbi swap line. - October 2013: PRA outlined position for non-EEA wholesale branches in the UK, enabling Chinese wholesale branches. - China allocated RMB 80 billion quota for UK-based asset managers to invest into Chinese onshore securities. - June 2014: People’s Bank of China appointed China Construction Bank as clearing bank for offshore renminbi in London. - Constraints and dynamics: - Renminbi deposits are scarce outside China and Hong Kong; Euro-renminbi market underdeveloped. - Offshore internationalization can proceed with capital controls but depends on supply and demand conditions and can complicate onshore policy effectiveness. - Stages of spillover evolution: - Near term: increase in Chinese residents’ FDI and greater renminbi use for trade invoicing; UK activity centered on FDI and trade finance. - Next stage: Chinese institutional investors trading large-scale cross-border assets via London; Chinese corporates issuing offshore bonds on large scale. - Final stage: Chinese-owned banks (including via UK operations) become major global players; effective supervision by UK and Chinese authorities needed. - Bayoumi & Ohnesorge (2013) estimate increase in Chinese residents’ cross-border portfolio assets could account for up to 3 percent of global bond and equity markets. --- ### Overarching findings, transmission channels, and policy priorities - UK features: - Housing market characterized by large house price volatility, constrained supply response, and significant credit-driven demand (high LTVs and loan-to-income growth in parts). - Business investment recovery underpinned by improved demand, profitability, and lower policy uncertainty, but allocative efficiency and capital productivity remain below pre-crisis levels. - Financial intermediation shows signs of weakness (reduced sectoral credit reallocation and constrained access to external finance for some firms). - UK’s large, globally interconnected financial system can generate outward spillovers via repo market stresses and through facilitating internationalization of Chinese banking and renminbi activity. - Key policy priorities: - Housing: alleviate planning and supply constraints; reform property and land taxation; pursue targeted, gradual macroprudential measures (caps on high loan-to-income and LTV ratios) to contain financial stability risks. - Investment: improve financial intermediation (access to finance for innovation and restructuring); strengthen infrastructure (transport, energy, housing); address corporate governance “short-termism”; support human capital and talent attraction. - Macro-financial stability: implement macroprudential measures gradually and use multiple instruments where appropriate; monitor regional dynamics (e.g., London) and consider targeted regional measures. - Shadow banking and internationalization risks: - Enhance oversight of shadow banking, improve transparency of repo and securities lending markets, and coordinate internationally (FSB, IOSCO). - Position UK regulation and supervision to manage outward spillovers from Chinese financial integration and renminbi internationalization. - Specific measure noted: - FPC recommended cap effective October 1, 2014: no more than 15 percent of new mortgages could have a loan-to-income ratio of 4.5 or higher. *Prepared by IMF staff; content as presented in the source document.* ### 1. Housing-related Sectors: Finance, Real-Estate, and Construction ______________________ 4 ### 1. Housing-related Sectors: Finance, Real-Estate, and Construction ### A. The UK Housing Market: A Historical Perspective - The value added of the real estate sector: about 6 percent of GVA in 1990 and 12 percent in 2013. - When finance, real estate, and construction (FREC) are taken into consideration, the share rises to about 25 percent of GVA. - Over the past 30 years, annual real house price increases averaged 3 percent in the UK, compared with 1 percent for the OECD as a whole. - House prices in the UK have been more volatile than in other advanced economies. - Residential investment in the UK as a share of GDP is among the lowest across the OECD economies. - Obtaining a planning permit in the UK takes about 25 weeks (NAO), longer than the average OECD economy (DBI reports 13 weeks). - The monetary cost of obtaining building permits in the UK is 66 percent of per capita income, higher than the average OECD economy at 56 percent of per capita income. - Rejection rate of major housing projects increased from 15 percent in the mid 1990’s to 35 percent in 2008. ### B. Housing Booms and Busts in Advanced Economies — Does the UK Stand Out? Findings on UK housing-cycle characteristics: - Large fluctuations in real house prices combined with a limited response of residential investment. - The UK has the largest fluctuations in real house prices among G7 economies; volatility exceeds that of the US and Canada. - Residential investment in the UK is less volatile than in most OECD economies; this volatility is influenced by the elasticity of housing supply. - Supply-side constraints—particularly restrictive planning regulations and inadequate incentives for local authorities to grant building permits—contribute to low house price elasticity of residential investment. - Mortgage loans with a high loan-to-value (LTV) ratio have generally been more pervasive in the UK and contributed to boosting housing demand. - An exercise splitting OECD countries by high/low planning costs and high/low LTV ratios shows house price volatility tends to be high in countries with high planning costs and high LTV ratios (thresholds defined by the sample median). Quantitative changes over time: - Duration of upturns: average of 31 quarters during 1980–96 increased by 50 percent to 47 quarters during 1997–2013. - Amplitude of upturns (difference between trough and peak of real house prices) increased from 98 to 170 percent. - Volatility amplified by a loosening of credit conditions prior to the crisis. Household-sector balance-sheet implications: - Sustained increases in house prices ahead of the crisis led to a sharp increase in housing wealth and higher mortgage debt. - Housing net worth reached 200 percent of GDP in 2007, but aggregate net wealth masked vulnerability concentrated among first-time buyers with relatively high LTVs. ### C. Planning Restrictions, LTV Ratios, and the Housing Cycle - Planning costs are relatively high in the UK compared to the average OECD economy and reduce the elasticity of residential investment to house prices. - Uncertainty over planning outcomes and longer processing times (including appeals) underlie sluggish supply. - High LTV ratios increase demand and exacerbate price volatility and household vulnerability. - Empirical split-sample evidence indicates: - High planning costs → larger changes in real house prices over the cycle (upturns and downturns). - High LTV → larger changes in real house prices over the cycle (upturns and downturns). ### D. The Great Recession and Its Aftermath — Impact of the Crisis - In the run-up to the crisis (1997–2007), real house prices in the UK increased by 150 percent, more than in other OECD countries except Ireland. - Post-crisis, GDP in the UK was 18 percent below the pre-crisis trend in 2012. - On average, OECD economies experienced a decline in GDP relative to trend of 14 percent. - Countries with milder pre-crisis housing booms (for example, Switzerland or Germany) experienced smaller declines in de-trended GDP. - The pattern illustrates that large swings in the housing market are correlated with economic activity and macroeconomic outcomes. ### Policy implications and recommendations (as presented in the source) - Alleviate supply-side constraints, notably pertaining to planning restrictions, as imperative for moderation of housing cycles in the UK. - Address risks to financial stability in the context of current house price inflation by pursuing targeted macroprudential measures. - Recognize the heightened vulnerability of first-time buyers due to relatively high LTV offerings in the mortgage market. *Prepared by Ruy Lama and Stephanie Denis (EUR); content as presented in the source document.* ### 9. During the Great Recession (2008–10), the UK’s housing bust was more severe than in ### 9–D. Housing Market, Bust, Recovery, and Macroeconomic Effects ### Severity of the Great Recession housing bust - Real house prices in the UK declined by 15 percent during the Great Recession (2008–10). - Residential investments as a share of GDP declined by 50 percent. - Only the housing bust in the US was more severe among the G7. - Canada and Germany experienced a housing boom shortly after the Great Recession. - More recently, UK real house prices and residential investment have been recovering but remain significantly below the pre-crisis peak. ### Post-crisis recovery and valuation - Standard valuation ratios (Price-to-Income and Price-to-Rent) indicate an overshooting in house prices. - Assessment using two benchmarks (the average of the ratios over the past 15 and 30 years) shows the overshooting is in the range of 10–30 percent. - The current housing recovery is taking place with weak credit growth: - The ratio of credit to the private sector to GDP (measured by M4 and M4LXex lending) is declining. - M4LXex is a measure of credit to the private sector excluding the effects of securitizations and loan transfers. - The increase in house prices amid weak credit growth suggests a greater role for cash transactions, in particular by foreigners. - The recovery is unbalanced: - Demand is outpacing supply, especially in the London market. - Real house prices in London have reached their pre-crisis peak, while other regions have not. - Residential investment is recovering at a sustained pace, and housing transactions have been growing, accelerating house price inflation. ### Housing and the business cycle — empirical VAR findings - A seven-variable macroeconomic VAR model was estimated with quarterly data for the 1987–2013 sample period. - Variables included: CPI inflation rate, residential investment, private consumption, GDP, interest rate, the ratio household debt to income, and house price. - All variables except the inflation rate and the interest rate are expressed in logarithms. - Identification follows a standard recursive ordering (Cholesky decomposition) in the variable order listed above. - Lag selection follows the Akaike criterion; the model is estimated with 2 lags. - Impulse responses and historical decompositions: - A 10 percent increase in house prices raises private consumption up to 2 percent in 5 quarters. - The household debt ratio reaches a peak response of 10 percentage points of disposable income after 12 quarters. - The UK’s response profile relative to other OECD economies: - The response of residential investment in the UK is half of the median response for OECD economies. - The response of household debt is more than twice as high as the response in the median OECD economy. - Historical decomposition simulations: - Housing shocks reduced GDP by 3 percent during the Great Recession — about a third of the fall in output experienced during the Great Recession. - The effects of housing busts are persistent and account for the weak recovery in the aftermath of the crisis. - In the early 1990s, the impact of the housing bust on GDP was 2 percent, but the recession was short-lived and a rapid expansion in exports and investment compensated for the housing shock. ### Key mechanisms and interpretations - Wealth and collateral effects explain the consumption response, including mortgage equity withdrawal that allows households with positive equity to extract housing wealth to finance consumption. - High elasticity of household debt to house prices reflects rapid mortgage credit expansion during housing booms, increasing household leverage. - The UK’s low elasticity of residential investment to house prices points to binding housing supply constraints. - The combination of supply constraints and credit fluctuations makes the UK housing cycle highly volatile and amplifies the business cycle. ### Policy conclusions and recommendations - A more stable housing market requires policies addressing both supply constraints and excessive fluctuations in mortgage credit. - Supply-side measures: - Changes to the planning system and tax reforms can alleviate housing supply constraints. - The new National Planning Policy Framework is creating incentives for local councils to increase available land for construction, with early signs contributing to recovery in housing construction. - Inefficiencies remain in property and land taxation: the current tax regime discourages institutional investment in rental accommodation, and undeveloped land is exempted from business taxes, incentivizing land hoarding. - Reform of property and land taxation could improve land-use efficiency and encourage an expansion in housing supply. - Macroprudential measures: - Targeted macroprudential policies can address financial stability risks stemming from the housing market. - Although mortgage credit as a share of GDP has been declining in the current recovery, loan-to-income ratios are increasing in London and among first-time buyers. - Macroprudential policies are recommended early and gradually given uncertainty in transmission mechanisms; they increase bank resilience and reduce housing cycle volatility. - The Financial Policy Committee (FPC) recommended a cap on mortgages with high loan-to-income ratios: no more than 15 percent of new mortgages could have a loan-to-income ratio of 4.5 or higher. This measure will be effective from October 1, 2014. *Source: IMF staff analysis as provided in the chapter content.* ### 1. After a prolonged period of weakness, ### _cr14234 - 1. After a prolonged period of weakness, ### Overview and recent developments - Business investment was hit hard by the global financial crisis, falling by 20 percent in 2008–09. - Business investment has begun to grow, up 10 percent year on year in the first quarter of 2014. - A durable recovery in business investment is critical to anchor sustainable economic growth and to contribute to rebalancing away from consumption and towards external demand. ### B. UK Investment Trends and Economic Performance—the Long-Run View - Pre-crisis (decade leading to the global financial crisis): - Business investment grew 4 percent a year on average. - The capital-to-labor ratio rose faster than in many other economies. - Capital productivity (measured as output divided by net capital stock) grew faster than in many other advanced economies, reaching the highest level just before the global financial crisis. - Growth accounting for 1997–2007 (selected countries; annual percent change; contributions to GDP growth): - UK(ONS) 1/: GDP growth 3.2; Labor 0.9; Capital 1.3; services 0.7; ICT 0.6; Non ICT 1.0. - US: GDP growth 3.1; Labor 0.9; Capital 1.5; services 0.8; ICT 0.7; Non ICT 0.7. - Germany: GDP growth 1.7; Labor 0.0; Capital 0.6; services 0.3; ICT 0.3; Non ICT 1.0. - France: GDP growth 2.3; Labor 0.6; Capital 1.2; services 0.4; ICT 0.8; Non ICT 0.5. - Japan: GDP growth 1.0; Labor 0.0; Capital 0.7; services 0.3; ICT 0.5; Non ICT 0.3. - Pre-crisis growth was broad-based: - Capital was the most important driver of overall growth. - Large accumulation of capital in information and communication technology (ICT) boosted growth directly and indirectly. - Total factor productivity explained about 20 percent of growth; labor accounted for about one third of overall growth. - Resource allocation: - Before the crisis, fast growing industries with higher total factor productivity growth (information, communication, professional, and technical services) attracted more capital, indicating efficient capital shifts that contributed to aggregate productivity and output. - Crisis impact: - Between 2008 and 2010, GDP growth averaged minus 1.5 percent. - The contraction was largely accounted for by a sharp decline in total factor productivity, and to a lesser extent by reduced labor inputs and slower capital accumulation. - Post-crisis rebound: - The economy rebounded driven mainly by strong labor growth in 2011–12. - Capital accumulation remained weak, and total factor productivity continued to be a drag on growth. - Capital productivity and allocation after the crisis: - Capital productivity fell sharply at the onset of the crisis and remains well below pre-crisis levels. - Decomposition indicates that pre-crisis capital productivity growth was supported by positive allocational effects offsetting negative direct effects; after the crisis, sectoral productivity dropped and the reallocation effect weakened. ### C. Diagnostic: Explaining Business Investment Performance in the UK - Empirical approach: - Firm-level panel data on listed non-financial firms (Worldscope database; about 5,000 firms; 1997–2012 annual) used to estimate investment models. - Main regression insights (Appendix Table 1 Model 1 and extensions): - Demand determinants: - Sales Gap (firm’s de-trended sales) coefficient is positive and statistically significant: firms cut investment during the large negative demand shock after the crisis and increased intentions to invest as prospects improved. - Return on Assets (profitability) coefficient is positive and statistically significant. - Cost of Debt (proxy for cost of capital) coefficient is negative and statistically significant. - Policy interest rate was reduced to near the zero-lower bound, but borrowers’ risk premium rose and the cost of debt did not fall as much. - Financing and balance-sheet effects: - UK firms rely on internal funds for at least 60 percent of business investment; reliance on internal funds has apparently increased since the onset of the crisis. - Retained Earnings coefficient is positive (retained earnings positively associated with investment). - Long-Term Debt coefficient is positive and statistically significant (greater access to external finance would support more investment). - Cash Dividend Payments (as a share of operating profits) coefficient is negative and statistically significant (owners may prioritize near-term outcomes over longer-term investment). - Uncertainty and irreversibility: - Many investment projects are irreversible; Policy Uncertainty coefficient is negative and significant, indicating firms postponed investment as uncertainty rose. - Capital allocation efficiency: - Pre-crisis dummy interacted with profitability shows the coefficient on profitability interaction is positive (0.058) and significant, indicating business investment was more sensitive to profitability in pre-crisis periods than post-crisis. - Long-run elasticity of investment to profitability fell from 0.17 in the pre-crisis period to 0.08 in the post-crisis period. - Exporters versus non-exporters: - Exporter dummy is significant and positive: exporters tend to invest more than domestically oriented firms, all else equal. - For exporters: - Coefficient on Return on Assets is higher than for non-exporters (exporters more sensitive to productivity). - Coefficient on Sales Gap for exporters is smaller than for non-exporters (exporters are more cautious given particular demand). - Long-term debt for average exporters is positive and significant (exporters constrained more by demand prospects and less by financing). - Evidence of weakened resource allocation efficiency is more apparent for exporters: the profitability interaction with pre-crisis dummy is positive and significant (Model 5). - For non-exporters: - Investment is more sensitive to Effective Interest Rate and Policy Uncertainty (coefficients negative and relatively large). - Profitability-interaction evidence of weakened allocation is weaker (interaction term not statistically significant in Model 7). - Cross-country comparisons (U.S., France, Germany): - No clear evidence of capital allocation mechanisms becoming less efficient since the crisis in the U.S., France, and Germany (coefficients on return on assets interacting with pre-crisis dummy are negative and insignificant). - For French firms, the demand variable interacting with pre-crisis dummy is negative and significant, suggesting French firms have become more cautious in investment following the crisis, similar to UK firms. - Pooled country model (Model 12) suggests similarities between UK and US firms; size of UK dummy coefficient much smaller than Germany and France dummies. ### D. Discussion - Near-term outlook from regressions: - Improvements in investment determinants underpin the ongoing recovery in business investment. - Indicators: firms increasingly confident about turnover; Bloom’s policy uncertainty index has fallen significantly in recent months; firms’ profitability has returned to its pre-crisis level. - These indicators suggest the upturn in business investment would be durable. - Continuing concerns on allocation efficiency: - Capital allocation mechanisms continue to be weak; no clear consensus on causes. - One possible explanation is weakness in financial intermediation: - The UK banking system was hit hard by the global financial crisis. - Firms rely on bank financing to expand and restructure; banking sector weaknesses could affect firm productivity via higher interest rates or difficulty securing bank financing. - Although real lending rates for large firms have dropped to around zero percent, those for smaller firms have remained at relatively elevated levels, possibly due to lack of sufficient collateral or credit records. *Prepared by Kotaro Ishi, Stephanie Denis (both EUR), and Carolina Osorio Buitron (RES). The analysis in this chapter is based on the data available as of end-June 2014.* ### 20. There is also evidence that banks are less ### _cr14234 - 20. There is also evidence that banks are less ### Sectoral credit allocation and financial intermediation - A simple measure of sector credit shift is calculated as the dispersion of growth rate of bank loans across sectors (Text Figure). - The size of sectoral credit shifts has decreased since the great recession, which, together with stagnant growth in aggregate loans, would evidence weakened financial intermediation channels. - Sectoral credit shift indicator: visual series shown for 2000–2012 with a 1998-2008 avg. and a 2009-2013 avg. (Sources: Haver Analytics; and IMF staff calculations). ### Empirical results on business investment dynamics - The empirical results suggest that the current pick-up in business investment is likely to be sustained. - Determinants that have recently improved and support recovery in business investment: demand prospects, firms’ profitability, and policy uncertainty indicators. - Historical context: after the global financial crisis firms held back investment due to a large negative demand shock; profitability dropped sharply; policy interest rate reduced to the zero-lower bound but the cost of capital did not fall as much because the risk premium for firms’ borrowing rose; policy uncertainty rose markedly. ### Regression model, sample, and estimation - Model: firm-level dynamic investment model including lagged dependent variable, time fixed effects (dt), firm fixed effects (ηi), idiosyncratic shock (vit), determinants vector Dit (sales gap, return on assets, effective interest rate, Bloom’s policy uncertainty), and additional controls Zit (retained earnings, long-term debt, cash dividend payments). - Estimation method: GMM-System estimator (Arellano and Bond (1991); Arellano and Bover (1995); Blundell and Bond (1998)) with lagged levels of explanatory variables used as instruments. - Sample period: 1997 to 2012. - Sample composition: annual firm-level panel dataset of listed non-financial companies; excludes oil and gas sector and public administration and defense sector; firms with data outside 1–99 percent of sample distributions excluded as outliers. - Variable data source: Worldscope database (except uncertainty variable). Uncertainty: Bloom’s policy uncertainty measure http://www.policyuncertainty.com/europe_monthly.html ### Key regression estimates (selected coefficients and diagnostics from Appendix Table 1 and Appendix Table 2) - All Firms (Models reported): - Lagged investment to capital: 0.331***, 0.333***, 0.331***, 0.358***, 0.360***, 0.323***, 0.323*** (standard errors shown in table). - Sales gap (difference from historical linear trends): 0.416***, 0.415***, 0.772***, 0.448***, 0.446***, 0.543***, 0.543***. - Lagged return on assets: 0.092***, 0.091***, 0.054*, 0.092***, 0.045, 0.087**, 0.066. - Effective interest rate: -0.072***, -0.072***, -0.073***, -0.007, -0.008, -0.158***, -0.159***. - Retained earnings to capital: 0.211***, 0.208***, 0.210***, 0.180***, 0.179***, 0.219***, 0.219***. - Long-term debt to capital: 0.038***, 0.037***, 0.039***, 0.050***, 0.050***, 0.000, 0.000. - Cash dividends payment to total profit: -0.062***, -0.063***, -0.060**, -0.021, -0.021, -0.141***, -0.141***. - Bloom's policy uncertainty: -0.106***, -0.120***, ... , -0.090**, ... , -0.251**, -0.387 (note: "..." indicates dropped due to collinearity in some specifications). - Cross-country / selected advanced countries (Models): - Example: Model 8 (UK): Lagged investment to capital 0.331***; Sales gap 0.772***; Lagged return on assets 0.054*; Effective interest rate -0.073***; Retained earnings to capital 0.210***; Long-term debt to capital 0.039***; Cash dividends -0.060**. - Bloom's policy uncertainty effects vary across country specifications; in some regressions Bloom's policy uncertainty is omitted due to collinearity (denoted by "........." or "..."). - Model diagnostics (selected): - AR(2) test p-values reported (examples): 0.246, 0.251, 0.295, 0.401, 0.406, 0.232, 0.231. - Hansen test p-values reported (examples): 0.221, 0.197, 0.200, 0.525, 0.512, 0.701, 0.699. - Number of observations and firms vary by model (examples): Number of observations 5,216; Number of firms 1,038 (in several specifications). ### Concluding policy messages on investment and allocative efficiency - Business investment growth is important for rebalancing the economy away from consumption and strengthening productive capacity, but is not sufficient alone; restoring allocational efficiency of capital is essential for productivity recovery. - Policy challenge: formulate appropriate prescriptions; government has taken measures (boosting capital expenditures, expanding financial incentives, establishing new institutions such as Business Bank, strengthening the banking system) but more could be done. ### Policy recommendations (explicit bullets from the source) - First, efforts should continue to improve financial intermediation, especially aimed at ensuring adequate access to finance for business innovation and restructuring. - Second, infrastructure should continue to be improved, especially in the areas of transport, energy, and housing. - Third, as recommended by LSE Growth Commission (2013), corporate governance structure could be reviewed to address “short-termism” and encourage firms to invest more. - Finally, policies should continue to support human capital development, including through enhancing vocational training and apprenticeship programs to help bolster productivity. In this regard, the UK should not halt efforts to attract foreign talents. ### Macroprudential policy: lessons from advanced economies (housing market risks and tools) - Context and risk: - The UK is experiencing a rapid increase in house prices, particularly in London, and greater numbers of new mortgages with high loan-to-income ratios could represent risks to financial stability. - Loan-to-income ratios of first-time buyers and households in London have been increasing in the last 12 months; if the trend continues, banks’ and households’ balance sheets will become more vulnerable to income, interest rate, and house price shocks. - Role of macroprudential policy: - Macroprudential policy is the first line of defense against housing-related financial stability risks. Caps on loan-to-value (LTV) and debt-to-income (DTI) ratios can mitigate systemic risks by reducing supply of mortgages, dampening credit growth, and reducing leverage of marginal borrowers. - Cross-country usage and stylized facts: - Macroprudential policies have been used intensively in advanced economies, particularly since 2004. - Caps on LTV/DTI ratios are the most common macroprudential measures. Other measures include property taxes and changes in risk weights (RW). - Countries often implement macroprudential measures gradually, possibly due to uncertainty in transmission and implementation lags. - Empirical effectiveness (event study results; sample of advanced economies; 1997–2013 data from Haver Analytics): - Macroprudential tightening quantified as difference in growth rates of mortgage credit and house prices 6 months after vs. 6 months before implementation. - Most effective instruments (point estimates reported): - Caps on DTI ratio: reduces nominal mortgage credit growth by 1.4 percent and reduces house price inflation by 1.8 percent. - Caps on LTV ratio: reduces mortgage credit growth by 0.8 percent and reduces house price inflation by 1.9 percent. - Tax policy (widely used in Asian economies): reduces house price inflation by almost 4 percent (on average). - Changes in risk weights and provisioning: limited impact on mortgage credit and house prices. - Using multiple macroprudential instruments simultaneously maximizes impact. - A gradual implementation approach is common; the recent cap on high loan-to-income ratio mortgages recommended by the Financial Policy Committee (FPC) is judged appropriate. *Prepared by IMF staff; content as presented in the source document.* ### 7. The effect of macroprudential policy is maximized when several instruments are used ### 7. The effect of macroprudential policy is maximized when several instruments are used ### Key empirical findings on combined versus individual instruments - Macroprudential policy is much more powerful when several instruments are used at the same time. - A single instrument can reduce mortgage credit growth by 0.4 percentage points. - The combined effect is 5 times more powerful than a single instrument. - Several instruments combined are capable of reducing mortgage credit growth by 2 percentage points. - Example: Hong Kong used four different macroprudential tools in the first quarter of 2013, resulting in a reduction in house price inflation and credit growth of 11 and 3 percent, respectively. ### Findings from other studies and regional evidence - Kuttner and Shim (2013): caps on the DTI have the maximum effect on containing credit growth; tax measures are effective at reducing house price inflation. - Krznar and Morsink (2014): in Canada, a cap on the LTV ratio is a powerful tool for reducing mortgage credit growth; cross-country econometric estimation finds changes in risk weights and caps on DTI ratios effective at containing credit growth. - Asia evidence (REO, 2014): caps on LTV ratios and taxes on housing transactions have a strong impact on credit growth, house price inflation, and bank leverage. ### Case studies: implementation and effects - Korea: regional macroprudential policies - Two major housing cycles in 2001–05 and 2005–13; by 2002 house prices were growing at 18 percent nationally and 32 percent in Gangnam; household credit was growing at an annual rate of 36 percent. - Regional “speculative zones” designation criteria: - Monthly nominal house price index increase of 30 percent more than the CPI inflation rate during the previous month. - Either (i) The average house price inflation in the previous two months increase 30 percent more than the national house price inflation in the previous two months; or (ii) the average monthly house price inflation over the previous year was higher than the average monthly national house price inflation over the previous three years. - Policy actions and outcomes: - May 2003: reduced the LTV threshold on mortgage loans with a maturity of less than three years from 60 to 50 percent. - October 2003: LTV restrictions on mortgage loans with a maturity shorter than 10 years and properties located in speculative zones were reduced to 40 percent; after this measure, real house prices declined by 5 percent. - June 2005: reduced the LTV to 40 percent on properties priced above 600 million won. - August 2005: increased the capital gains tax for homeowners with three or more properties in speculative zones. - Evidence: these policies stabilized housing and mortgage markets and curtailed speculative incentives. - Canada: mortgage insurance and gradual implementation - Risks: house prices, residential mortgage credit, and consumer credit grew rapidly in the 2000s; household debt as a share of disposable income rose from about 110 percent in 2000 to 165 percent in 2013. - Mortgages and consumer loans secured by real estate (mostly HELOCs) are estimated to account for 80 percent of household debt and to represent the single largest exposure for Canadian banks (about 35 percent of their assets). - Government-backed mortgage insurance is a de facto macroprudential tool because most lenders must have insurance for high LTV mortgage loans and the government plays a central role in providing such insurance. - Effectiveness: initial measures were not effective; after three further rounds of mortgage insurance tightening (2010, 2011 and 2012) and successive increases in LTV and DTI caps, there was a slowdown in mortgage credit and house price growth. - New Zealand: comprehensive toolkit and targeted LTV cap - By end-2012: house prices growing at an annual rate of 7 percent while mortgage credit was expanding at 4 percent per year; new mortgage loans were growing in excess of 30 percent. - May 2013: Reserve Bank adopted a macroprudential framework with four instruments: - countercyclical capital buffer (CCB); - sectoral capital requirements (SCR); - adjustments to the minimum core funding ratio (CFR); - restrictions on high LTVs. - October 2013: cap on the proportion of new loans with high LTV ratios (80 percent or higher) limited to 10 percent of the new mortgage lending. - New mortgage lending was defined for a window of six months. - The measure was announced as temporary with a commitment to remove the cap once the housing market stabilized. - Outcomes: - Share of high LTV loans declined from 25 percent of new mortgage lending in September 2013 to 5.6 percent at the end of March 2014. - National house sales dropped by 23 percent between September 2013 and March 2014 across regions. - Ongoing monitoring required to prevent regulatory arbitrage; impact assessed twice a year in the Financial Stability Report. ### Policy implications for the UK - Macroprudential policies have been implemented gradually: - Experience from Canada and other advanced economies shows policies are enacted in several rounds to allow authorities to assess impacts and recalibrate; large discrete changes could disrupt the financial system and cause financial disintermediation. - Caps on LTV/DTI ratios are effective tools for housing market risks: - New Zealand’s example suggests reliance on caps on LTV/DTI ratios to deal with housing-related financial stability risks; caps are targeted and effective at mitigating housing market risks. - The Reserve Bank of New Zealand used CCB and SCR in common with the FPC but chose a cap on the proportion of high LTV mortgage lending as the first instrument for its directness and targeting. - Regional macroprudential policies can be effective: - UK house price dynamics vary by region (London house price inflation at 19 percent; rest of country at single digits, 7 percent). - Targeted regional limits on high LTV and DTI mortgages (e.g., in London) could directly address sources of systemic risk, but multiple rounds may be required. ### Conclusions and recent UK measure - Cross-country evidence indicates macroprudential policies are effective at containing housing market risks. - Caps on high DTI and LTV ratios are highly effective at reducing mortgage credit growth and house price inflation. - Effectiveness is maximized when several tools are used simultaneously. - Because of uncertainty about lags and transmission, advanced-economy authorities implement macroprudential policies gradually. - UK-specific measure: - The FPC recommended a cap on mortgages with high loan-to-income ratios due to take effect from October 1, 2014: no more than 15 percent of new mortgages could have a loan-to-income ratio of 4.5 or higher. - This measure could be extremely powerful at reducing household leverage and could be adjusted gradually over the business cycle. *International Monetary Fund, “7. The effect of macroprudential policy is maximized when several instruments are used”* ### 1. This paper comprises two distinct thoughts experiments to study outward spillovers ### This paper comprises two distinct thoughts experiments to study outward spillovers ### B. Contagion and Spillover from Shadow Banking Stress in World Repo Markets Following Global Interest-Rate Snapback - Scope and approach - Two thought experiments; Section B has a nearer-term focus on the repo market channel for stress transmission from global shadow banks to UK banks following a world interest-rate “snapback”. - Focus on the US$5 trillion segment of the world repo market linking US MMFs to leveraged global shadow banks via G14 dealer banks. - Context and vulnerabilities - Current environment: low interest rates, asset price inflation, tight bank regulation, and record-low implied volatilities. - Risk migration to shadow banking: negative real interest rates push investors into riskier assets; leverage is being used to boost returns. - Shadow banking definition (for this section): nonbank institutions capable of liquidity and maturity transformation and the creation of leverage, with primary focus on the “fund sector” (bond and equity funds, hedge funds, mortgage real-estate investment trusts). - Contribution of nonbanks to UK systemic risk and banking distress dependence - Around two-third of overall systemic risk in the UK financial system can be attributed to major UK banks. - Contribution of equity funds to systemic risk increased by one-fourth, from (from 3.2 to 4 percent). - The fund sector’s contribution to banking sector distress-dependence is disproportionately from bond and hedge funds: together they account for three-fifth of the fund sector’s contribution while being one-fifth of the size of pension funds in the sample. - Estimated share of UK-resident dealers in the repo chain is c. 30-40 percent. - Mechanics of contagion following a snapback - Snapback modeled as a symmetric instantaneous upward shift in the yield curves for the dollar, euro and sterling. - Shadow banks face variation margin calls triggered by sudden loss in value of repoed collateral. - Identification of “limit points” where shadow banks run out of usable collateral, forcing repo unwind and possible fire sales. - Many G14 dealers intermediating borrowing are UK-headquartered G-SIBs (RBS, HSBC and Barclays) or UK subsidiaries/branches of foreign banks (such as Citibank, UK). - Quantified stress and leverage outcomes - For a 100 basis point rise in the interest rate, implied variation margin flows for “unchanged” collateral haircuts would be c. US$550 billion. - For 200 basis points, the implied variation margin flows would be US$1 trillion. - G14 dealers’ own collateral “cushion” is ~US$300bn (= Reverse Repo book minus Repo book), suggesting potential stress if shadow banks cannot meet margin calls. - mREITs had amassed leverage of 7.3 times; for mREITs the “limit point” is reached with a 200 basis point interest-rate shock. - Automatic build-up in shadow bank leverage follows depressed asset prices after the snapback; leverage must stabilize or unwind once usable collateral is exhausted. - Amplifying factors and dynamics - Lenders are likely to raise collateral haircuts as borrower leverage increases; earlier or smaller shocks could trigger limit points. - During the GFC, US MMFs pulled funding and became extremely risk averse, triggering fire sales and panic—similar behavior could repeat. - Impact depends on speed of rate rise and repo maturities. Simulations assume instantaneous jump (for tractability), but a slower surge gives vulnerable shadow banks breathing space to spread out asset sales. - At 20 percent, the share of mREITs’ repo borrowing with maturity of less than 30 days is not trivial; expectation of rapid asset sales could be self-fulfilling. - Systemic market outcomes and transmission to unsecured markets - Stress in the repo chain can contaminate G14 dealers and lead to intra-day trading freezes. - Combination of large variation margin flows relative to dealers’ cushions, significant fire-sale impact on dealers’ trading/banking books, and cutbacks in dealers’ own funding could raise dealers’ CDS premia and trigger credit valuation adjustments on derivatives. - Rising counterparty risk would likely increase cost of borrowing in unsecured markets (measured by the LIBOR-OIS spread). - A major liquidity shock could not be ruled out; systemic implications are indeterminate given complex interconnectedness. - Quantified outward credit spillover scenario - Historical reference: from end-Sep 2007 to end-Dec 2009, the 3-month UK LIBOR-OIS remained on average 80 basis points above its “normal” level of 10 basis points and was accompanied by an 11 percent decline in UK banks’ foreign claims. - Illustrative assumption: shock half that size and duration implies implied external deleveraging by UK banks of c. 3 percent (US$120 billion, given US$4trn in foreign claims). - Simple apportionment of US$120 billion in line with share of foreign claims: Hong Kong domestic credit falls by 2 percent; Mauritius and Bahamas by 1.5 percent; Luxembourg, Ireland, Singapore and South Africa by 1 percent. - Strategic deleveraging (fully protecting core jurisdictions, fully exiting others) could cause some emerging and low-income economies (Panama, Djibouti, Pakistan, Mozambique, Philippines, Uruguay) to see credit reduce by 10 percent or more. - Whether spillovers are favorable or unfavorable depends on recipient economies’ stage in economic and credit cycles. - UK and UK-authority mitigants - Banks in the UK and US are more resilient in terms of capital and funding than during the GFC. - Sterling Monetary Framework changes (announced October 2013): banks deemed healthy ex-ante by the PRA would be assured access to the Bank’s permanent liquidity facilities at lower cost and longer maturities, against a broader range of collateral, and with less stigma. - Decision to extend liquidity supports to central counterparties and major broker-dealers. - Stronger backstops need commensurately strengthened supervision to avoid risk-taking moral hazard. - Policy recommendations and priority actions - Ensure adequate oversight of the nebulous shadow banking system, including global shadow banking activity. - Prioritize additional budgetary resources, regulatory perimeter adjustments, and international coordination initiatives related to global shadow banking. - Ongoing efforts at the FCA and PRA include: - joint work with the FSB and IOSCO to identify global systemically important finance companies, insurers, investment funds, hedge funds; - Bank of England monitoring of systemic linkages between US money market funds and UK banks, including through funding channels; - initiatives to enhance the transparency of repo and securities lending markets to reduce pro-cyclicality; - regular reviews by the FPC of the adequacy of the regulatory perimeter for UK financial institutions and activities. ### C. Spillovers from UK Contribution to the Internationalization of Chinese Banking Liquidity and the Renminbi - Context and motivation - China’s capital account is relatively closed both de jure and de facto, so China’s financial integration in the world far undershoots its economic weight. - China’s share of world trade and GDP rose from 2 percent at the start of the 1990s to over 10 percent today (Figure 7, left panel). - China’s global financial integration increased modestly from c. 0.5 percent to c. 2 percent, reflecting restrictions on capital account convertibility (Figure 7, right panel). - Size and external orientation of banking systems - Chinese banking assets at about US$ 22 trillion, over 40 percent larger than those of US banks. - Almost all of China’s banking assets are domestically invested, whereas one-fifth of US banking assets are invested abroad. *Source: INTERNATIONAL MONETARY FUND* ### 16. An opening of the Chinese capital account would have major implications for global ### 16. An opening of the Chinese capital account would have major implications for global ### Projected scale of Chinese external asset growth and potential bank claims - Bayoumi and Ohnsorge (2013) project a net increase of Chinese international assets of US$ 1.6–2.7 trillion over the next 15 years or so. - Hooley (2013) projects that China’s gross international investment position could increase from 5 percent to 30 percent of world GDP by 2025 under a full liberalization scenario. - If Chinese banks adopted a similar-to-US external orientation, gross cross-border claims of almost US$ 5 trillion could be accumulated by Chinese residents. - As a global banking hub, the UK generated over US$ 3.7 trillion in cross-border claims from branches and subsidiaries of foreign-owned banks over 2005–13 (Figure 9, red column). ### Ballpark “thought experiment” of UK intermediation of China-originated bank claims (assumptions and arithmetic) - Assumptions: - (i) Chinese banks’ cross-border/total asset ratio rises to one-quarter, implying a release of c. US$ 4.9 trillion in cross-border bank claims of China vis-à-vis the rest of the world. - (ii) 21 percent [US$ 1,029 billion] of these US$ 4.9 trillion cross-border assets are held in the UK, assuming Chinese banks mimic the average of US and Japanese banks’ international asset allocation. - (iii) 43 percent [US$442 billion] of the US$ 1,029 billion is received by UK nonbanks and is thus assumed to “end” in the UK. - (iv) Of the remaining US$ 587 billion received by UK-resident banking entities, a third is assumed to be “recycled back” to China. - (v) Result: US$ 391 billion remains as the China-originated gross cross-border bank claims available for global distribution from the UK. - Note: Somewhat higher numbers obtain with top-down calculations; nearer-term and gradual scenarios produce much smaller figures (see next section). ### Nearer-term and composition effects of gradual liberalization (qualifications) - Scale alternatives: - (i) If Chinese banks’ cross-border/total assets ratio rises only to levels of advanced economies with moderate financial integration, the total increase in cross-border bank claims could be closer to US$ 1.2 trillion (i.e., less than one-quarter of the c. US$ 4.9 trillion scenario). - By extension, the amount remaining as China-originated bank claims available for global distribution from the UK could approach c. US$ 100 billion (and not c. US$ 400 billion). - Composition effects: - Capital account liberalization will have a scale effect (all types of cross-border assets and liabilities increase) and a composition effect: - Currently China’s external assets are predominantly held in low-yielding government bonds. - Future holdings are likely to shift towards more FDI and partly portfolio debt and equity investment as private sector outflows are liberalized. - Currently most of China’s external liabilities are FDI; these can be expected to shift toward more portfolio investment (consistent with international experience; He et al, 2012). - Capacity and intermediation: - Chinese-owned banks currently have limited international banking experience and capacity; initially, much liberalization and the bulk of capital flows will likely be facilitated by the world’s big investment banks, many operating out of London. ### Likely UK roles and channels of spillovers - UK facilitator roles over the medium term will likely center around: - (a) Chinese institutional investors investing in world capital markets, including via major investment banks based in London. - (b) Chinese corporations issuing debt and equity in London to access deep capital markets and lower borrowing costs (relevant if credit conditions tighten in China). - (c) Use of London as the world’s leading centre for foreign exchange and derivatives trading for hedging currency and interest rate risks. - Domicile and legal execution: - The legal, design, sales, marketing and execution work will often be carried out in London even when assets are domiciled in jurisdictions such as Luxembourg and Ireland. - Regulatory implication: - UK regulators will need to manage and mitigate adverse outward “risk” spillovers from increased Chinese banking activity in the UK. ### Renminbi internationalization and the UK’s position - Current renminbi usage metrics and trends: - Renminbi is now the second most used currency for trade finance after the dollar, overtaking the euro. - According to SWIFT, the renminbi is the second most used currency for cross border payments with China and Hong Kong, and for the Middle East and Central and Latin America the renminbi is the most used currency for payments with China and Hong Kong. - Globally, the renminbi is the seventh most used payments currency by value, at 1.47 percent of global payments. - The percent of Chinese exports settling in renminbi is projected to rise from below 10 percent in 2011 to about 20 percent in 2014. - London is the largest renminbi trading centre outside China and Hong Kong SAR; by end-2013 almost two-third of renminbi trading outside China and Hong Kong SAR took place in London. - London’s shares: FX trading 40 percent; OTC derivatives trading 50 percent. - Institutional and policy developments supportive of UK role: - June 2013: Bank of England and the People’s Bank of China established a sterling-renminbi swap line. - October 2013: PRA outlined its position in relation to non-EEA wholesale branches in the UK, paving the way for Chinese wholesale branches to be set up in the UK. - China allocated a quota of RMB 80 billion for UK-based asset managers to invest directly into Chinese onshore securities. - June 2014: People’s Bank of China appointed China Construction Bank as clearing bank for offshore renminbi in London, allowing onshore settlement of offshore transactions. - Constraints and dynamics: - Renminbi deposits are scarce outside China and Hong Kong; unlike the large Eurodollar market, a Euro-renminbi market remains underdeveloped. - Lessons from Eurodollar development indicate offshore internationalization can proceed even with capital controls, but depends on supply and demand conditions and can complicate onshore policy effectiveness. - Offshore markets can help separate currency from country risk but may enable arbitrage across regulatory and tax regimes. ### Stages and spillover evolution (near-term to final stage) - Near term: - Increase in Chinese residents’ FDI and greater renminbi use for trade invoicing. - Most UK-centered activity will be FDI and trade finance; signaling effect of renminbi usage in London is a major spillover. - Next stage: - Chinese institutional investors may begin large-scale trading of global cross-border assets via the London capital market, facilitated by major banks. - Chinese corporations may start issuing offshore bonds on a large scale, using UK financial infrastructure. - Spillovers could be a major increase in global equity and bond market assets and liabilities, requiring smooth functioning of UK capital, FX and derivatives markets. - Final stage: - Chinese-owned banks—including through UK operations—may become major global players and facilitators of China’s capital account liberalization. - Effective supervision by UK and Chinese authorities will be needed to safeguard expansion and ensure global financial stability. - Additional estimate: - Bayoumi & Ohnesorge (2013) estimate that the increase in Chinese residents’ cross-border portfolio assets could account for up to 3 percent of global bond and equity markets. *Source: IMF staff analysis as presented in the chapter content unit.* ### 27. The foregoing analysis shows that the UK’s systemic and globally inter-connected ### _cr14234 - 27. The foregoing analysis shows that the UK’s systemic and globally inter-connected ### Key findings - The UK’s systemic and globally inter-connected financial system can be a potential source of outward spillovers, negative and positive. - Two thought experiments in this paper lay out possible transmission mechanisms and quantifications for these spillovers. ### Thought experiments / transmission mechanisms - Repo market stress spilling over from global shadow banks to UK banks (and then to the rest of the world), following an interest-rate snapback. - The UK’s medium-to-long-term role in the internationalization of Chinese banking activity and the renmbinbi. ### Policy implications and recommendations for UK authorities - Ensure effective oversight of shadow banking activity and institutions, including through engagement with other regulators and international bodies. - Position the UK financial system for China’s rising global financial integration, including through maintaining the UK as a reliable and resilient center for international finance. *Source: _cr14234 - 27. The foregoing analysis shows that the UK’s systemic and globally inter-connected* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14234.pdf_