Low Interest Rates Are Underpinning Europe's House Price Recovery

Economic Research:

Low Interest Rates Are UnderpinningEurope's House Price Recovery

Economist:

Sophie Tahiri, Paris 33 1 44 20 67 88; [email protected]

EMEA Chief Economist:

Jean-Michel Six, Paris (33) 1-4420-6705; [email protected]

Table Of Contents

Belgium's Housing Market Is Softening

France: Low Interest Rates Keep The Market Resilient

German House Prices Are Still On Solid Ground

Ireland: Supply-Demand Mismatch Drives A Surge In Prices

Italy: A Slight Recovery Is In Sight

The Netherlands Is Emerging From Its Price Slump

Portugal's Housing Market Is Improving

Spain: The End Of Adjustment Is Coming Closer

The Swiss Housing Market Is Cooling

For The U.K. Housing Market Moderation Is In Sight

Housing Markets Are Vulnerable To A Sudden Rise In Interest Rates

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 28, 2014 1

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Economic Research:

Low Interest Rates Are Underpinning Europe'sHouse Price Recovery

Very low interest rates are strongly supporting a recovery or stabilization of house prices in European markets, even in

countries where credit conditions are still tight and household debt is high. In the U.K., in particular, an

ultra-accommodative monetary policy has underpinned a sturdy revival following the 2008-2009 correction, with

house prices likely to rise strongly by 7% this year on average, according to our forecasts (see table 1). Yet, even in

countries in which house prices are still falling, the markets are nevertheless showing remarkable resilience. In France,

where the economy is weak and unemployment is continuously rising, we forecast house prices will fall by 4% this

year but stabilize over the next two years as a result of the low interest rate environment. In Spain and Italy we

forecast prices will decline more slowly this year than in the recent past by just 2% and return to growth in 2015 and

2016. We forecast prices will rise in all other major European housing markets this year and that all markets will be in

growth mode in 2015 and 2016.

Given that unemployment is still elevated and household incomes are under continued pressure in most European

countries, very low interest rates appear the number one explanation for the resilient performance of the markets over

the past two years. This would make them highly vulnerable to a sudden rise in interest rates, although this is not our

base-case scenario. According to our simulation, in which interest rates were to rise by 100 basis points (bps) due to a

hypothetical external shock, we found that the Dutch and Portuguese housing markets would deviate the most from

our baseline projections. This is because their housing market revivals are still very recent and fragile, and household

debt is still high. The U.K. market would decline by just 1% one year after the shock, protected to some extent by the

strength of its overall economy. Only Germany's housing market would escape contraction.

Overview

Very accommodative monetary policies by central banks are supporting a recovery in house prices in most

markets in Europe.

We forecast the U.K. housing market will experience the highest price rises this year, averaging 7%, followed

by Germany, and Ireland (both 4%).

We forecast price declines in just three housing markets this year, the heaviest in France (4%), followed by

Spain and Italy (both 2%).

All markets would be vulnerable to a sudden fall in interest rates, according to our analysis, although we

currently consider such a scenario unlikely.

The Netherlands and Portuguese housing markets would be the most vulnerable to an interest rate shock

because the market revivals in these two countries are still young and private debt is still high.


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Table 1

European Housing Market Forecasts

2012 2013 2014f 2015f 2016f

Nominal house prices (% change year on year)

Belgium 1.5 1.2 1.0 0.5 1.5

France (2.1) (1.4) (4.0) 1.0 2.0

Germany 3.7 5.0 4.0 4.0 3.5

Ireland (6.1) 6.0 4.0 2.0 3.0

Italy (5.2) (5.3) (2.0) 1.0 2.0

Netherlands (7.6) (4.2) 2.0 2.0 2.5

Portugal (2.7) (3.0) 0.5 1.0 1.5

Spain (10.4) (4.6) (2.0) 0.0 2.0

Switzerland 3.6 4.6 2.0 1.5 1.5

U.K. 2.2 5.4 7.0 4.5 3.0

f--Forecast. Sources: S&P, OECD, Hypoport.

Belgium's Housing Market Is Softening

Having been resilient since the onset of the financial crisis, the Belgian housing market has started to soften since the

end of last year. Declining household affordability and the phase-out of various fiscal incentives in a context of fiscal

consolidation are weighing on price gains. Nevertheless, resilient economic conditions, only moderate household debt,

and low interest rates are preventing a slump in prices. As a result, we forecast that house price rises in Belgium will

decelerate marginally to just 1% this year, and to just 0.5% in 2015, before accelerating to 1.5% as economic

conditions improve further in 2016 (see table 2).

Recent trends

National statistics indicate that house prices declined by 1.1% year on year in the first quarter of 2014 after gaining

1.2% on average last year. This is the first time prices have fallen since December 2009, when they lost 0.9% year on

year. Belgian notaries' data show that the average price for a standard house remained stable in the second quarter

(Q2), rising by just 0.9% on the previous quarter to 234,042, while the average price for a flat declined again by 1.3%

in Q2, after -1.5% in Q1. According to the same source, purchase transactions increased by 2.6% in the first half of

2014 on the same period last year. European Central Bank (ECB) data suggests that households remained cautious, as

mortgage volumes continued to decline in the five first months of the year. The three-month moving average value of

new loans fell by 16% year on year in May. The average mortgage loan increased slightly to 133,222 in Q1 2014,

from 131,733 in 2013.

Several factors explain the Belgian housing market's resilience and still robust demand for housing, in our opinion. The

Belgian economy remained relatively resilient in 2013, growing by 0.2%, and expanded by 0.4% quarter on quarter in

the first three months of 2014 (see table 2). Belgium has been one of the better-performing economies in the eurozone.

In real terms, households' disposable income increased by 0.3% in 2013, in line with GDP growth. A cautious recovery

of real economic activity continues, the latest data revealed, and it is even slightly accelerating. The growing

attractiveness of real estate as an investment asset is also driving demand. Household financial assets continued to


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Economic Research: Low Interest Rates Are Underpinning Europe's House Price Recovery

increase, reaching 1,058 billion at the end of September 2013, which is among the highest in Europe. Elevated

savings enable Belgians to make large down payments when buying a house, hence making them less dependent on

credit conditions. Between 1996 and 2013, the average loan-to-value ratio on new lending has never exceeded 82%

and has been on a declining path, suggesting that large down payments have helped households to keep up with price

increases. As a result, the house price boom in Belgium was not accompanied by an excessive debt accumulation by

Belgian households. Household indebtedness remains modest, at 56% of GDP in December 2013, which is below the

eurozone average of 64 %.

Supportive tax policies have also encouraged home buying. We believe the tax amnesty (Dclaration Libratoire

Unique) the government introduced in 2005 and extended through Dec. 31, 2013, has encouraged Belgian households

to repatriate funds and reinvest a portion of them in residential property, so supporting house price increases. In 2004,

the average price for a standard house was equivalent to the average mortgage loan, at approximately 101,000. By

2013, the difference between the value of the property and the loan had increased as much as 65,000. Other fiscal

incentives on deductibility of borrowing costs (or "Bonus Logement") led more households to take out a mortgage.

Finally, in a low-rate environment, housing investments in Belgium and especially Brussels are still attractive to foreign

investors, who are looking for safe and relatively inexpensive assets to purchase. An apartment in Brussels cost

226,000 on average in 2013 compared with 390,000 in Paris, according to Century21, a real estate agency, or

414,000 (500,000) in London, according to figures from the Land Registry.

Further supporting the resilience of Belgium's housing market is the supply-and-demand balance that indicates the

country has no supply overhang. The house price boom in Belgium was not accompanied by a surge in house building.

While the number of households expanded by about 40,000 per year between 2005 and 2009, construction of new

dwellings, including second homes, has averaged 45,000 per year. Between 2010 and 2013, 186,000 new dwellings

were built. If the number of households continued to grow by 40,000 per year, the number of dwellings constructed

should therefore cover households' needs (160,000). These numbers are nevertheless for the country as a whole, and

the Brussels region continues to report some supply shortages.

Finally, declining interest rates also support households' affordability. Interest rates on mortgages have been declining

to historically low levels of 3.4% in April 2014, ECB data shows. Interest rates should remain low, given the ECB's

current policy stance.

Future trends

We believe Belgium's house prices could face downward pressures related to uncertainty over the future of fiscal

incentives for house purchases and limited growth of income through the forecast horizon. Uncertainties over--or an

end to--certain tax measures encouraging home buying are likely to curb housing investment, in our view. First, the tax

amnesty DLU, which allowed residents to regularize undeclared funds held abroad and repatriate them to Belgium in

exchange of a financial contribution, expired at the end of 2013. Therefore, fewer funds will be repatriated to Belgium,

so reducing household investment in housing. Second, the "Bonus Logement" (tax deductions on the capital and

interest payments of a mortgage loan on a primary residence) will be administered at regional rather than federal

government level by 2015, thereby increasing uncertainties as to whether regions would maintain or reduce the fiscal

advantage. Hence, households may delay their building projects for a while.


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We expect housing demand to be limited by sluggish income growth. While we expect real GDP to expand by 1.1%

this year, 1.5% in 2015, and 2.0% in 2016, household income will unlikely increase at the same rate. Slow improvement

in labor conditions, wage moderation decided by the government, and an erosion of property incomes due to very low

interest rates, will constrain domestic demand. With fewer fiscal incentives and slow real disposable income growth,

households are unlikely to be able to absorb large additional house price increases. The affordability (price-to-income)

ratio is well over its long-term average, suggesting that homes may have been overvalued by 58% at the end of last

year, making them still among the least affordable in the EMU. However, affordability should be still supported by low

interest rates as the ECB is committed to keeping interest rates at very low levels at the short end of the curve until

2016.

Table 2

Belgian Housing Market Statistics

2012 2013 2014-f 2015-f 2016-f

Nominal house prices, % change year on year 1.5 1.2 1.0 0.5 1.5


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Table 2

Belgian Housing Market Statistics (cont.)

Real GDP, % change -0.1 0.2 1.1 1.5 2.0

CPI inflation (%) 2.6 1.2 0.8 1.0 1.1

Unemployment rate 7.6 8.4 8.5 8.2 7.9

f--Forecast. Sources: S&P, Eurostat, Banque Nationale de Belgique, OECD, Statistics Belgium.

France: Low Interest Rates Keep The Market Resilient

The French residential real estate market is still demonstrating strong resilience, in spite of a weak economy and

continuously rising unemployment. We believe the accommodative interest rate environment, as well as strong

structural demand for housing in certain urban areas, are propping up the market. In our baseline scenario, prices will

decline by 4% in 2014 and grow by 1% in 2015 and 2% in 2016 (see table 3). However, an interest rate shock, although

currently unlikely, would throw the market into sharper decline.

Recent trends

Economic activity ground to a halt in the first quarter and household consumption contracted by 0.5% The January

VAT rate hike was a temporary negative factor but, more fundamentally, a steady deterioration in real disposable

incomes that is no longer offset by a lower savings rate is weakening consumer demand. This deterioration is

attributable in part to the rise in direct income taxes in 2013, with further increases factored in for this year.

Furthermore, unemployment is steadily increasing. The jobless rate (ILO definition) reached 10.3% in Q1 and although

unemployment growth is likely to slow in the coming quarters a decline appears still some way off. Furthermore,

despite a robust revival for two of its key trading partners, the U.K. and Germany, France's exports haven't been

providing the economy any significant boost, a reflection of deteriorated French foreign competitiveness.

Against this disheartening backdrop, the only modest decline in house prices looks puzzling. In the 12 months to

March 2014, prices were down 1.3%. The short-lived improvement in the affordability ratio between March 2008 and

June 2009 has been all but erased, and the price-to-income ratio has now returned very close to its 2008 peak (see

chart 2). This market resilience has a structural cause, linked to a chronic imbalance between supply and demand for

dwellings. In a country with a dynamic demography, there are simply not enough new dwellings being built to satisfy

demand. The number of households has been increasing by 1.2% on average per year between 1975 and 2010,

according to INSEE. The shortage has increased amid the economic downturn of the past five years. Last year,

housing starts reached their lowest level since 2000 at 330,000 units, down 20% from the previous year, when,

according to 2013 INSEE estimates, the potential demand for dwellings is slightly below 400,000 per year. Yet, these

estimates consider the country as a whole, while activity centers are concentrated in a limited number of large cities,

such as Paris or Aix-Marseille, where there is little space available to add new dwellings. Still, the structural deficit of

available dwellings appears insufficient on its own to explain the recent market resilience.

Another key explanation relates to interest rates and credit conditions. After a short rise in 2008, interest rates have

been steadily declining to reach a historical low of 2.85% in June. Since the beginning of the year, the average rate

applied to housing loans lost 35 basis points. This is because lenders fund those loans with resources, the cost of which

is pegged to the 10-year sovereign bond yield. French sovereign bonds, as other sovereigns in the eurozone, have been


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benefiting from abundant liquidities on capital markets, and yields have come down to their lowest levels in over 50

years (to 1.76% in June). The 35 bps decline in loan rates since the beginning of the year has mechanically increased

the purchasing power of buyers by 2.8%. Taking into account the drop in prices over the same period (-0.6%), this

boost equals 3.4%. Yet, at the same time the average loan duration has steadily declined since 2007. At that time, 33%

of housing loans exceeded 25 years. That share is now only 14.8%. The average loan duration is now 16.8 years (202

months). Typically, loans with a long maturity are particularly attractive for first-time buyers requiring a higher

loan-to-value ratio, as longer maturity loans imply lower monthly repayments. This is why the market resilience is

deceptive. Very low interest rates have underpinned demand, but only from the most solvent buyers with elevated

creditworthiness. First-time buyers, and more generally buyers needing to smooth out repayments over a longer

period, have found it difficult to access the market. Statistics released by realtors confirm the relative shortage of

solvent buyers: while last year there were on average 1.2 potential buyers to one seller, that ratio is now 1:1.

Future trends

We expect the economic revival in France to be slow, with real GDP growth averaging 0.7% this year, below the

eurozone average of 1.1%. Growth is likely to pick up only gradually in 2015 and 2016, remaining below 2%, and we

expect that unemployment will come down only very slowly. Against this backdrop, structurally strong housing

demand will continue to support the market: only 57% of households owned their home in 2011 compared with 67%

on an average in the EU. However, future trends will be highly dependent on interest rates. The ECB is committed to

keeping interest rates very low at the short end of the curve. In the longer run, investor demand for safe haven

investments should remain strong. Our baseline scenario has long-term rates rising 60 bps by the end of 2016. In that

case, house prices are likely to experience a benign decline of about 4% this year before stabilizing next year. But the

downside risks should not be underestimated. Not many other factors than very low interest rates explain the current

market resilience. Were rates to rise more rapidly due to an external shock, which we consider unlikely but not

implausible, the real estate market reaction would be swift.


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Table 3

French Housing Market Statistics

2012 2013 2014-f 2015-f 2016-f

Nominal house prices, % change year on year (2.1) (1.4) (4.0) 1.0 2.0

Real GDP, % change 0.0 0.2 0.7 1.4 1.7

CPI inflation (%) 2.2 1.0 1.2 1.2 1.3


f--Forecast. Sources: S&P, Eurostat, OECD, INSEE.

German House Prices Are Still On Solid Ground

Residential property prices in Germany have been rising steadily since 2010, with the increase in prices quite marked

in some dynamic urban centers. We nevertheless don't consider that a bubble is forming in the German housing

market, as some commentators have suggested. We believe that low financing rates and a yearning for financial safety


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will continue to lift housing demand. What's more, the increase in prices has occurred from a fairly low base, while

affordability indicators do not indicate any significant overheating in the German housing market as a whole. More

structurally, low ownership rates and the conservative characteristics of mortgage financing are limiting the prospects

of any credit-fueled bubble. We forecast nominal house prices will continue to rise by 4% both this year and next (see

table 4).

Recent trends

Since March 2010, German house prices have increased by 23% or 5.3% per year. However, data from Europace AG

shows that the rises have been decelerating in the first half of this year: they rose by 1.5% year on year in May after

increasing by 3.3% in the first quarter and by 5% last year. The increase in new buildings after 15 years of declining

construction investment may have started to ease the pressure on prices: 214,800 dwellings were completed in 2013,

up by 7.2% on the previous year. Construction permits issued for residential buildings also increased by 15% to 63,897

in the first quarter of this year, suggesting that dwelling completions will increase sharply this year. Nevertheless, the

expansion of supply will unlikely be enough to cover increasing demand, which the Bundebank estimates at around

260,000 new dwellings a year by the Bundesbank.

A strong labor market, buoyant income prospects, and a rise in immigration flows are contributing to this strong

housing demand. The unemployment rate remained at a very low 5.1% in May, while wage growth is stronger than in

the past, owing to little slack in the labor market. Besides, net immigration to Germany totaled 437,000 last year, the

highest in 20 years.

Very favorable financial conditions are further boosting demand. Still very low interest rates are increasing household

borrowing capacity and bolstering decisions to invest in real estate. Since November 2013, average interest rates on

new mortgages started to decline again to 2.75% in April. However, banks' mortgage lending growth remains modest,

rising by 2.0% year on year in April this year. In an environment of only modest credit growth, we believe price

increases are also due to foreign investments in German real estate. The German residential property market is still

considered a safe haven instrument for international investors looking for ways to protect the value of their assets in an

environment that is still uncertain and offers low returns on financial assets. The housing market in the seven largest

cities--Berlin, Dsseldorf, Frankfurt am Main, Hamburg, Cologne, Munich, and Stuttgart have gained 9.0% per year

since 2011.

Future trends

We forecast that the upswing in the German residential property market will continue over the next few years amid

strong macroeconomic indicators. We forecast real GDP will strengthen by 1.8% this year, 2% in 2015, and 2.3% in

2016, which is above the average of most European peers. On the back of solid economic growth, employment and

wage growth should accelerate, boding well for household incomes. We forecast the unemployment rate will decline to

4.9% in 2016, while income growth should accelerate with the introduction a minimum wage from next year,

improving the incomes of as many as 17% of lower wage workers. However, if investment in residential construction

continues to expand at the same fast rate seen in the past, pressures on prices may start to ease in the coming years.

Low financing rates and a yearning for financial safety will continue to lift house prices for some time, in our view. We

expect financial conditions to remain supportive, at least until 2016. In response to inflation and economic weakness in


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the eurozone, the ECB is likely to keep its policy rates very low, and possibly introduce additional unconventional

measures in the last quarter of 2014. Investors' demand for safe haven instruments should remain strong a plus for the

German sovereign. Consequently, we forecast yield increases on the 10-year German government bond to remain

limited, rising to 1.9% next year and 2.3% in 2016. However, as we believe the period of low interest rates outside the

eurozone is nearing, investment in the German residential property market is likely to become less attractive and raise

international investors' interest in other financial assets in the years to come, additionally easing pressures on prices.

Hence, we forecast price increases will slow to a 3.5% growth in 2016.

However, we don't think the market will overheat. The increase in prices has occurred from a fairly low base. Between

2000 and 2010, prices barely expanded, keeping the price-to-income ratio 25% below its long-term average in

December 2010. Since then, this ratio has trended upward, indicating an undervaluation of 17% as of December 2013.

What's more, lenders typically demand a 30% deposit, while mortgage lending rates are usually fixed of about 10

years. Households are less sensitive to interest rate rises because lenders charge strong penalties for early termination

of contracts by borrowers.

Structurally, German households continue to favor rental rather than owned property, although rents have also

increased since 2011 in tow of higher purchase prices. A large and highly regulated rental market with strong tenant

protection still makes renting the a preferred option for many Germans. Hence, only 46% of households own their own

homes, compared with 67% on average an EU average, according to European Mortgage Federation data. As the

home ownership rate is low, households have less incentive to sell their homes and reinvest in the housing market in

anticipation of future price increases, preventing an upward spiral in house prices.


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Table 4

German Housing market Statistics

2012 2013 2014-f 2015-f 2016-f


Real GDP, % change 0.7 0.4 1.8 2.0 2.3

CPI inflation (%) 2.1 1.6 1.4 1.5 4.8


f--Forecast. Sources: S&P, Eurostat, Hypoport.

Ireland: Supply-Demand Mismatch Drives A Surge In Prices

The housing market recovery in Dublin, the Irish capital, is racing ahead of the rest of the country. Prices are now 26%

higher than their low point in August 2012, compared with just a 3.2% rise in the rest of the country from their low

point in March 2013. Home prices for the country as a whole are still 45.1% lower than at their boom-time peak in


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September 2007. As supply shortages in urban areas have exerted upward pressure, we expect that residential prices

will expand by 4.0% this year in Ireland as a whole (see table 5). What's more, we don't expect the housing market

revival to stay as strong beyond 2014. Bank lending conditions remain tight and high mortgage arrears will maintain

downward pressure on house prices, in our view. We therefore forecast that house prices will rise by 2% in 2015 and

by 3.0% in 2016.

Recent trends

House price rises are accelerating. Latest Central Statistics Office (CSO) data show home prices up 10.6% year on year

in May on a national basis, after gaining 6.0% in December 2013. However, the upward trend is once again led by

Dublin, where prices are up 22.0% over the same period. Outside Dublin, residential property prices are recovering

only sluggishly, with annual prices growth reaching 1.8% in May. Reflecting the upward momentum in the housing

market, however, the Property Services Regulatory Authority indicates that transactions were up 10% for the country

as a whole during Q2 2014 on Q2 2013 (see chart 4). Transactions are still below par, at around or 1.6% of the housing

stock.

A pick-up in house construction was gaining momentum in the first half of 2014. Completions grew by 31% in the five

first months of 2014 on the same period of 2013. House guarantee registrations were 53% higher in the year to May,

reflecting developer activity. The total number of residential units commenced registered a big increase in February,

but the introduction of new building regulations in March appear to have played a role in this surge, so

commencement notices may fall back again. However, the current construction output of around 9,000 units per year

is still far below the estimated demand, at 23,000 units.

Future trends

The improvement in the economy and the labor market, as well as limited supply in Dublin will help support the

residential property market over the next two years, in our view.

We expect that the Irish economy will largely outperform the overall euro area and grow by 1.9% this year before

accelerating to 2.9% and 3.2% in 2015 and 2016 (compared with just 1.1%, 1.6%, and 1.8% for the euro area). The Irish

economy will benefit this year from the improving external demand from its main trading partners, the U.S. and the

U.K. This recovery may widen to domestic demand and, notably, to investment from next year, driven by global

demand cycle. As a result, we forecast that unemployment will drop significantly to 9.7% on average in 2016.

The improving labor market situation, alongside rising employment and wages, should support a continued increase in

housing demand. A rise in demand in the context of home supply shortages (mainly in urban areas such as Dublin) will

likely put upward pressure on prices, leading to rises nationally. The damage or bankruptcy that many building firms

suffered during the financial crisis has contributed to the housing supply shortage. Meanwhile, existing homeowners

are currently unwilling to sell due to high home-to-loan debt. Despite a recent pick-up in homebuilding activity, the

mismatch between supply and demand is likely to persist, so maintaining the upward pressure on prices. The shortfall

in property for sale is also pushing rents to rise. Rents rose by 9.0% year-on-year in May.

We nevertheless don't expect the recent increase in house prices to stay as strong beyond 2014. According to the Irish

Banking Federation, cash buyers represented more than half of all transactions in early 2014. Financing conditions

remain difficult and mortgage lending low, owing to still low demand, stiffer regulation, and high levels of


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nonperforming loans. The Central Bank of Ireland indicates that lending for house purchases declined by 3.7% year on

year in May, after falling 4.1% in January. The Central bank's latest quarterly report showed 12.2% of residential

mortgages in arrears for more than 90 days at the end of March, down from the 12.6% at the end of December.

Households and banks will therefore need some time to work through the large stock of arrears. Therefore, a recovery

in prices is likely to remain slow and uneven.

Table 5

Irish Housing Market Statistics

2012 2013 2014-f 2015-f 2016-f

Nominal house prices, % change year on year (6.1) 6.0 4.0 2.0 3.0

Real GDP, % change 0.2 (0.3) 1.9 2.9 3.2

CPI inflation (%) 2.0 0.5 0.6 1.1 1.2


f--Forecast. Sources: S&P, Eurostat, OECD, Central Statistics Office.


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Italy: A Slight Recovery Is In Sight

House prices in Italy have fallen by 15% since March 2008, mainly owing to weak domestic demand and tightening

credit. Assuming a modest strengthening of the economy, however, we forecast price declines will slow to just -2.0% in

2014 and start to gradually increase again by 1% in 2015 and 2% in 2016 (see table 6).

Recent trends

The market is beginning to show some signs of stabilization. House prices only declined by 0.7% in Q12014 on the

previous quarter, and by 4.6% year on year, according to ISTAT. Meanwhile, home sale transactions were up 4.1%

year on year over the same period. This resulted in nearly 407,000 transactions in the 12 months to March, after

403,000 in 2013 (see chart 5). Reflecting the stabilization of the market, the business confidence indicator for

construction increased to 81.1 in June from 73.4 on the previous month, although it remains well below the 105 point

seen before 2007.

The stabilization in Italy's residential property market reflects the slight recovery in the domestic economy and easing

credit conditions, in our view. After rising until February, the unemployment rate has been stabilizing, although it

remained a high 12.6% in May. Meanwhile, household disposable income was flat quarter on quarter in the first quarter

but still slightly negative (by -0.1% quarter on quarter and by -0.2% year on year when adjusted for inflation),

according to ISTAT. Consumer confidence has picked up markedly after the change of government and the fiscal

boost announced in March that will lower income tax receipts by 10 billion per year to the benefit of 10 million low-

and middle-income workers from May 1, 2014. This should support a slow improvement in spending and an increase

in the saving rate, which was at 10% in the first quarter, near historical lows.

Lending conditions to households show some signs of easing. The bank lending survey for the first quarter of 2014

indicates that a significant percentage of banks reported a net easing of their supply policies to households. Meanwhile,

new house lending has started to pick up significantly: the three-month moving average value of loans grew by 19.0%

year on year in May after being negative between June 2011 and December 2013. Still, net lending for house

purchases was down by 1.2% year on year in May.

Future trends

Assuming a modest strengthening of the economy, we expect that the contraction in house prices will ease in the

course of 2014 and start to rise in the two following years. We expect real GDP to rise by 0.5% in 2014, and we have

lifted our forecasts for 2015 to 1.1% and for 2016 to 1.2%. Domestic demand will remain constrained by the weak

labor market, given that the unemployment rate is likely to decline only slowly and to stay as high as 12.5% in 2015

and 12.0% in 2016, while real earnings will likely expand at a moderate pace (see table 6).

Supporting an ease in house price declines, however, the real estate market itself does not show signs of significant

overvaluation. The price-to-income ratio, a good indicator of affordability, has declined markedly from its 2009 peak

and is now close to its long-term average (see chart 5). Similarly, the price-to-rent ratio remains at its historical average

as rents continue to rise.

Provided that more benign sovereign financing conditions persist, the contraction in net lending to households should


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continue to ease. Italian sovereign 10-year bond yields have tumbled to record pre-financial crisis lows, reaching

2.81% on July 7, 2014. Lower sovereign bond rates should reduce funding rates for banks, and an ease in ECB

monetary policy should lead to lower mortgage rates. Average interest rates on new mortgages have decreased to

3.36% in May, and we think the downward trend is set to continue. Added to this, outstanding mortgages in Italy

represented 45% of GDP in December 2013, significantly below the eurozone average of 64% of GDP, suggesting that

households could assume more debt.

Table 6

Italian Housing Market Statistics

2012 2013 2014-f 2015-f 2016-f


Real GDP, % change (2.4) (1.9) 0.5 1.1 1.2

CPI inflation (%) 3.3 1.3 0.7 0.8 0.8


f--Forecast. Sources: S&P, Eurostat, OECD, Nomisma.


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The Netherlands Is Emerging From Its Price Slump

After five years of price declines, the housing market in The Netherlands is starting to recover. House sale volumes are

increasing rapidly, while prices are picking up slightly, owing to an improvement in the economic situation, increased

affordability of houses, more stability in fiscal policy reforms, and limited housing supply. Increased demand,

especially from first-time buyers who have been putting off purchases in recent years, is likely to increase prices in the

short term. However, price upside will be limited, in our view, because high debt and still high unemployment

compared to historical standards will keep potential buyers cautious. We continue to expect house prices to increase

by 2% this year and in 2015 and 2.5% in 2016. (see table 7).

Recent trends

Demonstrating the upward trend in the Dutch housing market, home sales in the first half of 2014 increased by 39%

from the same period last year. This brings the total number of transactions over the past 12 months to 128,000, the

highest number since September 2010 Initially, the rebound in sales led to a steady decrease in the stock of houses for

sale. However, as prospects of selling improve, more people are putting houses on the market, which is limiting the

upward movement in prices. House prices have reflected the increase in transactions with a time-lag: they picked up in

June, and have gained 1.1% since the beginning of the year, according to Statistics Netherlands. Prices were up 2.3%

year on year in June, indicating the first rise in house prices increases in five years.

Several factors are supporting the recent upward trend. Confidence has gradually returned to the housing market as

households' assessment of the economic situation improves. After contracting 0.8% last year, GDP is expected to

expand by 1.0% this year, driven by exports and investments. Higher profitability and capacity utilization are

encouraging businesses to invest. Meanwhile, the labor market is improving unemployment fell for the second month

in a row in June, and now stands at 6.8% of the labor force. A further increase in employment is likely to support

disposable income, which is already rising thanks to improved financial stability of the pension system. Also

underpinning the house-price rebound is the increased affordability of homes. House prices have tumbled by 20%

since 2008, while the average interest rate on new mortgages has declined by 200 basis points. The price-to-rent ratio

was only 4% above its long-term average in March 2014, from 51% in March 2008, owing to adjustments in rental

regulation that has caused rents to rise. The price-to-income ratio has also declined since 2008, although it remains

21% above its long-term average (see chart 6). The increase in affordability is supporting demand, especially from

first-time buyers who have been waiting to make their first purchase. Growing demand is reflected in rising mortgage

volumes: the three-month average value of new loans grew by 13.0% year on year in May. Further adding to house

buyers' confidence is more political clarity about the tax treatment of home ownership. Since 2013, first-time buyers

are only eligible for tax deductibility on their mortgages if they take out a linear or annuity repayment mortgage

(instead of the formerly popular interest-only mortgage).

Future trends

Although we think increased demand will support prices in the short term, several difficulties will prevent a strong

longer-term recovery in the Dutch housing market, in our view. First, we expect the economy to remain on a relatively

modest recovery path in 2015 and 2016. With unemployment still high by historical standards, we expect households

to remain cautious both this year and next about stepping up their spending. We do, however, expect to see a small


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rise in private consumption next year, thanks to an increase in real disposable household income. The expected

gradual acceleration of economic growth--from 1% this year, to 1.3% in 2015, and 2.0% in 2016--will lead to a slight

drop in unemployment next year.

However, we expect that domestic demand will remain under pressure. The Netherlands' household debt ratio is the

highest in the eurozone, at 125% of GDP in December 2013. This ratio has only just started to decline since 2012 from

a peak of 129% in September 2012. One other concern for many households is negative home equity. Data from

Statistics Netherlands show that 1.4 million of the 3.6 million homeowners have a net mortgage debt that is higher than

the value of their home. Hence savings are on the increase, as these households will continue to deleverage or else

build up savings. However, the number of people in arrears of over 120 days on their mortgage has remained modest:

101,000 households were struggling to pay their mortgage costs in April 2014, representing only 2% of the 3.6 million

households with a mortgage, according to the Central Credit Registration Office (BKR). It nevertheless reported that

these figures are rising less quickly.

Changing mortgage regulations will also weigh on loans granted for homes. The stock of housing loans is stabilizing,

with housing loans adjusted for securitizations increasing only slightly by 0.3% year on year in May 2014 compared

with 1.1% in May 2013. Rules reducing the maximum amount that home buyers may borrow on the basis of income

and setting a maximum loan-to-value on properties, will also restrict loans. Since Jan. 1, 2014, loan to value has fallen

to 104% from 105% in 2013 and will decline further to 100% by 2018. International policymakers are keen to see LTV

decline further to 80%. This suggests that potential house purchasers will need to put aside extra funds to pay

additional fees and taxes related to buying a home. On July 1, 2014, the cost ceiling for a mortgage with a National

Mortgage Guarantee (NHG) was lowered from 290,000 to 265,000. The ceiling will be lowered annually to reach the

level of the average house price.

One positive factor for house price developments is that the weakness in construction activity is aggravating the

structural supply deficit in the country. In 2013, only 26,000 building permits for new houses were granted,

representing a 30% decline on 2012. Since the onset of the economic crisis in 2008, the number of residential building

permits has fallen by 40% to the lowest level since 1953. The small number of new-build permits issued suggests that it

could be a while before more houses are completed.


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Table 7

Dutch Housing Market Statistics

2012 2013 2014-f 2015-f 2016-f

Nominal house prices, % change year on year (7.6) (4.2) 2.0 2.0 2.5

Real GDP, % change (1.2) (0.8) 1.0 1.3 2.0

CPI inflation (%) 2.8 2.6 0.9 1.0 1.2


f--Forecast. Sources: S&P, Eurostat, Kadaster, OECD, CBS Statistics Netherlands.

Portugal's Housing Market Is Improving

After more than three years of house price falls, we think that Portugal's housing market is stabilizing on the back of

improved economic conditions and stronger demand for residential property from foreign investors. We expect prices

to stabilize this year, before experiencing slight increases in 2015 (of 1.0%) and 2016 (1.5%, see table 8).


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Recent trends

Residential property prices rose on an annual basis between the start of the year and April, before slightly declining by

0.1% in May to an average of 995 per square meter, according to INE statistics. Prices grew more strongly in certain

regions, such as Alentejo or Lisboa (+2.6% and +1.2% year on year in May), while others are still struggling (in the

Algarve prices fell by 2.5% year on year in May).The May RICS Portuguese housing market survey results show that

buyer interest and sales activity have risen more or less consistently since the beginning of the year. Meanwhile, price

expectations have moved out of negative territory for the first time since the survey was launched in 2010, while sales

expectations remain buoyant. However, construction activity has not yet recovered. Completions of new construction

of family housing units plunged by 53% year on year to 2919 during the first quarter of 2014. Looking ahead, the

number of construction permits has been stabilizing, although at an extremely low level. The number of construction

permits issued for residential building has hovered at around 500-550 per month since the end of last year to March.

However, the total number of construction permits issued in the 12 months to March was only 7,100 per year

compared with 65,000 in 2007 and 120,000 in 1999.

Banks have started to gradually relax their credit conditions, although they remain very tough. Housing loans have

declined steadily since the end of 2011 (see chart 7). Gross mortgage lending has been rising since May last year, but

was not sufficient to offset repayments. The recent policy measures unveiled by the ECB early last month will ease

credit conditions, by ensuring low funding costs for Portuguese banks for an extended period.

We think that the housing market stabilization is due to the improving economic conditions as well as to increased

demand from foreign investors. In mid-2012, Portugal granted a five-year residency permit to non-EU citizens who buy

properties costing at least 500,000. As of May 2014, the Portuguese government had issued about 1,100 such golden

visas, resulting in real-estate investment totaling about 650 million. Renewed investor interest in Portuguese real

estate also reflects the country's recovery. The economy has been growing since the second quarter of 2013, and

confidence indicators have shown a remarkable improvement since the start of that year. Portugal's structural

adjustment has also been impressive, with the economy running its first current-account surplus in 20 years in 2013.

An improved domestic economy in addition to ECB actions have also resulted in improved bond market conditions.

Future trends

We expect the economy to rebound in the second quarter following a worse-than-expected first quarter. GDP fell by

0.6% quarter on quarter during the first three months of the year. Nevertheless, the sharp contraction in activity during

Q1 highlights the risks attached to the Portuguese recovery. Positively, short-term indicators still point to improving

underlying fundamentals. Improving business confidence and a stabilizing economic situation are starting to feed into

firms' employment and investment spending. The unemployment rate fell sharply during the first quarter of 2014,

while real investment spending rose for the third consecutive quarter. Very low inflation should also help to sustain

households' purchasing power, therefore providing a lift to private consumption. As a result, we forecast GDP growth

of 1.1% this year, accelerating to 1.6% in 2015, and to 1.8% in 2016.

Nevertheless, the economy is facing several headwinds. The main risk stems from the sharp tightening of fiscal policy

at the start of 2014, which will keep domestic demand under pressure. Moreover, domestic demand will continue to

suffer from high unemployment (despite the recent improvements in the labor market), while private debt remains

elevated. Household indebtedness fell from a peak of 99% of GDP in March 2009 to 82.6% of GDP during the last


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quarter of 2013, but this is still far above the eurozone average of 64%.

On a positive note, mortgage interest rates are likely to decline after sovereign bond yields experienced record lows in

recent weeks. Nevertheless, given their high indebtedness, households will be reluctant to take on more debt,

particularly in an environment of high unemployment. Furthermore, tighter fiscal policy, including sharp public

spending cuts and substantial increases in direct taxation will encourage households to keep saving because the

duration of fiscal austerity measures remains uncertain. Added to this, Portuguese citizens continue to leave the

country in search of employment, pushing down housing demand. Latest official data indicate that total resident

population declined by 146,000 people between 2009 and 2013. Net emigration reached 36,000 people in 2013 after

37,000 people on the previous year.

The market may benefit from more positive structural factors over the longer term. First, Portugal didn't experience a

house price boom that swept through many OECD countries from the mid-1990s to 2006. Portugal's housing market

performance has been lackluster throughout the last decade, and was even negative in real terms, with no signs of a

bubble. The affordability index (price to income) continued to hover around an all-time low in the second quarter of

2014, showing an undervaluation of 6%. Meanwhile, the price-to-rent ratio is in freefall. The housing rental market

reforms made the market more dynamic, enabling landlords to update rents, giving them more flexibility in the choice

of contract duration, setting better incentives for renovation, and providing new and fast extrajudicial eviction

procedures. Since 2011, rents have been rising, while at the same time purchase prices were on a decline. As a result,

the price-to-rent ratio reached an all-time low in June 2014, suggesting that the market may be undervalued by 17%.


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Table 8

Portuguese Housing Market Statistics

2012 2013 2014-f 2015-f 2016-f

Nominal house prices, % change year on year (2.7) (3.0) 0.5 1.0 1.5

Real GDP, % change (3.2) (1.4) 1.1 1.6 1.8

CPI inflation (%) 2.8 0.4 0.4 1.0 1.3


f--Forecast. Source: S&P, Eurostat, BIS/private sector.

Spain: The End Of Adjustment Is Coming Closer

The heavy slump that the Spanish housing market has experienced in recent years should bottom out next year, owing

to improving economic conditions and increasing interest from foreign investors in Spain's real estate sector. Although

we expect house prices will continue to fall this year by 2% year on year, we forecast the market will be flat next year


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and rise by 2% in 2016 (see table 9). Nevertheless, high household debt, a still heavy oversupply of unsold homes, and

a declining population will continue to weigh on any market recovery over the coming decade.

Recent trends

Home price declines continue to slow in Spain. The Bank of Spain's house price index declined by 4.2% year on year in

the first quarter of 2014 after falling by 6.3% on average in 2013. The ease in price declines suggest that Spain's

economy is recovering, but above all it signals that more foreign private buyers and investors are buying property in

Spain, which is supporting prices. House prices in some coastal tourist and wealthier areas, such as the Balearic

Islands, the Basque Country, or Madrid even recorded annual price increases in the first quarter. The number of

foreign buyers increased by 27% in the first quarter of 2014, and accounted for 19% of all Spanish residential sales,

according to the Spanish General Council of Notaries. The number of transactions by foreign buyers expanded in the

Basque country, Catalonia, and the Balearic Islands. However, some regions in the west or center of the country less of

a tourism industry, such as Castilla-La Mancha, recorded house price declines. Overall, home sales continued to fall by

10% in the first four months of 2014 on the same period in 2013.

Even though the banking sector has undergone a deep restructuring process, this has not yet translated into looser

financial conditions for households. In April 2014, bank mortgage lending was still falling at a rapid pace of 4.1% year

on year. Weak demand alongside funding constraints are still weighing on Spanish credit growth. The banks' ratio of

nonperforming loans was a high 13.4% in March, up from 10.5% a year earlier, so constraining bank lending. The

recent policy measures unveiled by the ECB early last month will ease credit conditions, by ensuring low funding costs

for Spanish banks for an extended period.

Future trends

We think prices will continue to decline slightly this year, bottom out in 2015, and start to rise in 2016. Economic

fundamentals are improving faster than we previously expected. Although major difficulties persist, we revised up our

forecasts for GDP growth to 1.3% this year, and 1.8% in 2015 and 2016 (from previously 0.8% in 2014 and 1.4% in

2015), which is well above the average growth in the eurozone. Spain has regained competitiveness, owing to

adjustments in unit labor costs and implementation of structural reforms. This should fuel more rapid export growth

this year. We expect that growth will continue to broaden gradually to private investment and consumer spending. We

also expect that unemployment will decline more rapidly than we previously believed. It fell by 112,000 in May 2014,

while registered employment rose by 198,000, the largest increase since 2005.

However, negative drags persist on domestic demand as consumers struggle to cope with still high debt. Although

household debt is declining--to 77% of GDP in Q4 2013 from a peak of 87.5% in Q2 2010--it remains well above the

eurozone average of 64% of GDP. Deleveraging is slow because households' disposable incomes are still falling: they

dropped by -2.4% year on year in the first quarter of 2014. To support consumption, the household saving rate slipped

further in the first quarter to a new historical low of 9.4% from 10.4% in the last quarter of 2013 and from 10.6% on

average in 2013. However, we expect that net job creation and loosening fiscal policy are likely to support income

growth in coming quarters.

With the economy now in the recovery phase, we think that international investors will help put a floor on prices Since

the end of 2012, Spain's state-organized "bad bank" (Sareb) has received 50.5 billion of troubled property loans


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houses and lands from the balance sheets of the country's nationalized banks and those that received public aid for

recapitalization via the Fund for Orderly Bank Restructuring. Between 2013 and 2018, Sareb will have to place these

assets in portfolios to be sold to investors, which has helped generate confidence that a floor may have been set on

prices.

Over the longer term, the very high stock of unsold new homes will still dampen prospects for a sustained recovery in

prices. Although construction of new buildings has been very slow in recent years, the stock of unsold houses has been

only slowly declining. Declining demographic trends will also weigh on housing demand and house-price growth. The

population continued to shrink in 2013, by 0.9% relative to 2012 to 46.7 million, according to INE data. INE expects

the population to decline by 2.6 million over the next 10 years as a result of aging and continuing migration outflows.

A shrinking population would clearly cap overall potential growth in housing demand over the next decade.


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Table 9

Spanish Housing Market Statistics

2012 2013 2014-f 2015-f 2016-f


Real GDP, % change (1.6) (1.2) 1.3 1.8 1.8

CPI inflation (%) 2.4 1.5 0.1 0.5 0.5


f--Forecast. Sources: S&P, Eurostat, Banco de Espana, OECD.

The Swiss Housing Market Is Cooling

House price inflation in Switzerland will moderate to more comfortable levels over the next two years, in our view.

Average residential real estate prices have increased by nearly 30% since December 2007 on the back of growing

immigration, rising employment and incomes, low borrowing costs, and a lack of performing investment alternatives.

In some urban regions, such as Geneva, prices have surged by up to 6% per year since 2008, additionally fueled by

limited housing supply. However, regulations, limited affordability, and an increase in housing construction have now

started to cool market increases. We expect house price inflation will ease this year to 2.0% and to 1.5% in 2015 and

2016 (see table 10). Continuing economic growth and relatively loose financial conditions, however, make price falls in

Switzerland unlikely, in our view.

Recent trends

Swiss National Bank data show that home prices are slowing: they expanded by just 2.8% year on year in the first

quarter this year compared with 4.7% growth on average in 2013. There are, however, large regional differences in the

pace of market cooling. Momentum has slowed most in the high-priced neighborhoods around the Lake of Geneva and

the Lake of Zurich as well as in some tourist areas, while price growth remains stronger outside urban centers in

central and eastern Switzerland.

Three main factors explain the cooling in the housing market. First, we think that regulatory measures have prompted

the deceleration in mortgage volume growth and price increases. Given the dramatic rise in residential prices in some

parts of the country and continuous increases in mortgage lending, the Swiss National Bank (SNB) has repeatedly

raised concerns about the potential risks to financial stability should the situation be left unchecked. The Swiss

Financial Markets Supervisory Authority (FINMA) issued new constraints on lending from July 1, 2012, narrowing the

range of potential buyers. Part of the stricter self-regulation includes the requirement for borrowers to make at least a

10% cash down-payment from their own sources, instead of drawing the entire down-payment from their pension fund

assets. FINMA has also stipulated that mortgages must be paid down to two-thirds of the lending value within a

maximum of 20 years, and this period will be shortened for new mortgage loans to 15 years as of 1 September 2014.

This puts a stop to homeowners waiving amortization in expectation of rising property prices, as was previously

authorized. Meanwhile, Swiss Federal Council decided to double the size of the capital buffer that banks must hold to

guard against mortgage write-downs to 2% of risk-weighted positions secured by residential real estate to combat

growing imbalances. As a result, risk-weighted positions secured by residential property in Switzerland must be backed

with additional capital from June 30, 2014. As a result, housing loan growth slowed to 3.8% year on year in January


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2014 and to 3.5% in April 2014 from 5.0% on average in 2013, suggesting that the effects of such measures are only

gradually unfolding.

Limited housing affordability is also slowing price rises. Residential property prices have been rising faster than

incomes since the end of 2007, especially in the Geneva and Zurich areas. Even so, current prices look less elevated

when compared to income and rents compared with their long-term average. Following a boom in the late 1980s,

housing prices fell dramatically, and their subsequent growth was subdued relative to growth in rents and in income

until the late 2000s, when housing price growth accelerated. Although price-to-income ratios suggest that affordability

has declined (see chart 9), the market was still undervalued by 9.7% in March 2014 compared to the long-term

average, against 24% in December 2007. The price-to-rent ratio suggests no market undervaluationit now stands at

its long-term average. Both price-to-income and price-to-rent ratios are still well below the levels reached at the peak

of the previous boom.

Third, strong investment in residential construction has also likely cooled house price rises, in our view. Investment in

housing construction has surged, increasing by 18.7% year on year in Q1 2014. Order books in the residential

construction sector remain completely full. As a result, vacancy rates are increasing. According to the Vacant Dwelling

Survey conducted by the Swiss Federal Office of Statistics on June 1, 2013, 0.96% of the total Swiss housing stock (or

40,008 units) was vacant, a tiny rise from 0.94% on the previous year. The canton of Geneva has just 0.36% vacant

dwellings, suggesting the market remains very tight.

Future trends

We expect price momentum for owner-occupied housing to decelerate further over the coming quarters, owing to

policy measures, limited housing affordability, an increase in housing supply, and perhaps lower immigration flows.

But price growth is likely to remain positive unless stricter regulatory measures are implemented or interest rates rise

abruptly.

Recent regulations, and expectations for further measures, could continue the cooling process. Although the rise in

mortgage volumes has slowed somewhat, the SNB sees no evidence of any sustainable easing. The central bank

monitors and regularly reassesses the need to adjust the countercyclical capital buffer. The high level of mortgage debt

is a concern for the central bank. Although household income was stable in Q1 2014, debt is growing quickly and is

already high by international comparison. Household debt, at 108% of GDP in March 2014, is among the highest in

Europe, well above the eurozone average of 40%. Although home ownership in Switzerland is among the lowest in

Europe, at 34.6% according to OECD data for 2009, debt is high. This is because the Swiss tax system encourages debt

accumulation. Mortgage interest payments can be fully deductible. As a result, there is little incentive to repay

principal. Reforms of these tax incentives to shorten the amortization period and increase the share of debt paid off,

will likely put a brake on debt accumulation.

In the medium term, the Swiss vote in February 2014 to restrict free labor mobility by the introduction of a quota

system will, if implemented, limit housing demand. So far, high net immigration is set to continue this year. After

reaching 80,000 persons in 2013, a net 21,300 foreigners had already settled in Switzerland by March, almost as many

as in the same period of the previous year, and more than in 2010 and 2012. Immigration growth has boosted house

prices and rents in recent years, especially in urban regions. We think the vote has clearly increased economic


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uncertainty, which in turn could cut housing investments, and slow down immigration flows and employment growth.

The risk is that if demand were to drop off suddenly, developers could quickly find themselves with unsold properties.

Expectations of a potential rise in interest rates could also dampen house price growth over the coming two years, in

our view. We nevertheless believe the SNB will maintain its low-interest policy given that inflation is low. We forecast

that inflation will remain subdued and well below the SNB's definition for price stability of less than 2% per year in the

foreseeable future. We expect inflation of 0.2% this year, 0.8% in 2015, rising to 1.0% in 2016. The SNB does not

expect a return to inflation above 2.0% within its three-year horizon, projecting only 1.4% in Q1 2017, already making

the technical assumption of unchanged policy rates at zero. We do not foresee a rise in key rates before the end of

2016, which means that mortgage rates should trend sideways in the coming year before trending up slightly as the

process of normalizing interest rates will likely gain the upper hand.


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Table 10

Swiss Housing Market Statistics

2012 2013 2014-f 2015-f 2016-f


Real GDP, % change 1.0 2.0 2.2 2.5 2.3

CPI inflation (%) (0.7) 0.1 0.2 0.8 1.0


f--Forecast. Sources: S&P, Eurostat, OECD, Department for Communities and Local Government.

For The U.K. Housing Market Moderation Is In Sight

The U.K. housing market remains buoyant on the back of a strong economic recovery. Prices in the 12 months to June

were up 9.7%, the strongest increase since 2007. First-time buyers have returned to the market, encouraged in part by

the Help to Buy scheme and more generally by a very strong labor market, with the jobless rate down to 6.6% in May.

The BoE has been sending increasingly frequent signals that it is about to start gradually tightening its monetary policy

stance, with a first rate hike possible before year-end. Additional macro-prudential measures will also curb lending

growth. We therefore expect the very strong upward momentum to come off the housing market over the coming

quarters, with prices rising by 7% this year, 4.5% next year, and 3% in 2016 (see table 11).

Recent trends

The recovery in the U.K. economy has continued to gain momentum through the first half of the year. Real GDP grew

by 0.8% quarter on quarter in Q1 and by 3.1% year on year, the highest gain since 2007. The revival, initially driven by

consumer spending and a falling savings rate, is broadening to include corporate investment and exports. The

improvement in the labor market has been equally impressive. Between February and April, employment surged by

345,000, the largest gain since data began 40 years ago. The number of full-time employees was up 2.4% year on year,

a pace that's not been exceeded since 1998. Symmetrically, the jobless rate has come down by 1.2% in the past 12

months to reach 6.6%. The share of population aged 16-64 years in work is now the second-highest in the G7, after

Germany.

The tightening labor market has so far, however, not been reflected in compensation trends. Average weekly earnings

were down 0.2% year on year in the first quarter. Between Q3 2012, the start of the economic revival, and Q1 2014,

earnings rose by a total of 0.6%. Consumer prices, meanwhile, increased by 3%. This unusually long delay between the

pickup in GDP growth and the rise in real wages reflects increased flexibility in the U.K. labor market on the back of

strong labor force growth. This is due in part to the continued inflow of job seekers from the rest of the EU, and a very

high participation rate of 78.2%, the highest level since 1990. The net result is a rather unusual recovery in that it has

been associated with falling productivity.

With mortgage rates close to all-time lows and a very strong labor market, the residential real estate market has

continued to show signs of strength. Prices were up 9.7% in the 12 months to June, according to the Halifax,

representing the 20th consecutive month of positive year-on-year growth. If we compare the current peak-to-trough

cycle with the previous downturn between 1989 and 1993, we see that the current cycle had a steeper initial fall, with

prices declining by 23% between their peak in August 2007 and the trough in April 2009. The peak-to-trough decline


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after 1989 was 13%. Furthermore, this recovery has been swifter: 84 months on, the market is only 7.6% below its

peak. After the same number of months it was still 12% below peak during the previous downturn. The swiftness of

this recovery clearly has to do with the very proactive response of the monetary authorities. Since the Bank of England

(BoE) policy rate reached the low point of 0.5% in March 2009, its monetary policy has been based on keeping money

market rates close to the BoE rate and on large-scale asset purchases as part of quantitative easing. Five years later,

the bank now manages a 375 billion portfolio of gilts, representing about 40% of the total stock.

First-time buyers have played an increasingly important role in the housing market recovery, accounting for 48% of

house purchase activity in March, according to Nationwide, which is well above the long-term average of 38%. The

Help to Buy (HTB) scheme has provided support to first-time buyers, who accounted for over 80% of HTB loans to

date.

At the same time, there have been early signs that the trend in key activity indicators is moderating. The introduction

of tougher mortgage rules in April has created a level of additional caution among sellers and buyers. Indeed, following

its mortgage market review, the Financial Conduct Authority, the City's regulator, introduced new rules leading to a

tightening in underwriting standards. Among the most important changes, interest-only mortgages have to be

associated with a "credible strategy for repaying the capital". Furthermore, lenders are now required to stress-test

affordability. This means that not only will they have to check that borrowers have sufficient cash flows to repay their

loan at its current interest rate, but also at a higher rate-typically at 6% to 7% during the first five years of the loan. On

June 26, the BoE's Financial Policy Committee (FPC) went a step further when it asked that mortgage lenders limit the

proportion of mortgages at loan-to-income multiples of 4.5x and above to no more than 15% of their new mortgages.

These measures aim to restrain the fringe of lending. The FPC says that high loan-to-income loans accounted for 9.8%

of new mortgages in the first quarter, from 8.5% a year earlier. For first-time buyers, 30.5% of new loans in Q1 were at

loan to incomes of 4.5x or more, which is unchanged from a year earlier.

Another strong warning that regulators and monetary policymakers were keeping a close eye on asset markets came

when the BoE governor Mark Carney said in a speech on June 12 that the first interest rate hike "could happen sooner

than markets currently expect". This was an attempt to dispel the common belief that he was committed to keeping

rates on hold until mid-2015 regardless of the data inflow. On the back of continued broad-based strength in economic

activity and as a result a narrowing output gap, the BoE is now setting the stage for a very gradual policy tightening. In

our view, the first hike is likely to take place in the final quarter of this year, and we expect that it will be followed by at

least two more hikes next year.

Future trends

We expect activity in the housing market to moderate in the coming quarters from the highs reached earlier this year.

The most recent RICS survey for the month of May already points to a levelling off of new buyer demand, coinciding

with a fifth month of decline in house supply. The balance of chartered surveyors expecting greater market activity in

the coming months has come down markedly from 66% six months ago to 29% in May. The latest available data

(April) also points to a slowdown in housing loan growth, although lending remains quite buoyant. Market

fundamentals, as expressed by the price-to-income and the price-to-rent ratios have started to deteriorate somewhat

over the past two quarters (see chart 10), suggesting the market is becoming less affordable.


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At the same time, we do not believe the U.K, market is about to experience a new correction. A number of factors will

continue to underpin market activity. First, the economy as a whole will remain strong, although the rates of growth

experienced in recent quarters may not be replicated. We forecast real GDP growth will average 2.9% this year, 2.5%

in 2015, and 2.1% in 2017. Second, the imbalance between supply and demand has worsened since the beginning of

the crisis. Recent data reveals a modest pickup in housing starts (133,600 in the 12 months to March 2014, from a low

of 85,600 in 2009). Yet, excess demand remains substantial. Robust U.K. population growth (0.8% per year) continues

to exceed that of the housing stock (0.5% in 2011, the latest data available). The imbalance has been made worse by

the inflow of migrants looking for jobs in the U.K. and by strong demand from affluent foreigners. The latter essentially

affects the prime areas of London. Data released by Knight Frank in October 2013 estimated that 49% of sale above 1

million in central London in the 12 months to mid-2013 were to foreign nationals. The continued strengthening of the

pound sterling exchange rate may, however, somewhat curb this trend. Finally, we expect the BoE will start raising

interest rates at the end of the year and continue doing so in the following years, albeit from ultra-low levels. The

average interest rate on household loans secured on dwellings has in real terms (corrected for RPI inflation) been in

negative territory between Q1 2010 and Q1 2012. Since then, they've averaged 0.3%. From an historical perspective,

this compares with an average between 2000 and 2007 of 3.2%. We project that the average nominal interest rate on

loans secured on dwellings will rise from 3.3% at present (the Q1 2014 average, see chart 10) to 4.5% in Q4 2016. In

real terms, this would translate into a jump from 0.6% to 1.6%, which is still considerably below long-term trends.

Tighter lending criteria will contribute to the moderation house prices we've started to see. Yet, we believe the current

market revival that started in 2012 will remain on a sustainable path over the coming two-and-a-half years.


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Table 11

U.K. Housing Market Statistics

2012 2013 2014-f 2015-f 2016-f


Real GDP, % change 0.3 1.7 2.9 2.5 2.1

CPI inflation (%) 2.8 2.6 2.0 2.3 2.1


f--Forecast. Sources: S&P, Eurostat, OECD, Department for Communities and Local Government.

Housing Markets Are Vulnerable To A Sudden Rise In Interest Rates

The reasons behind the currently low long-term interest rates are well known. In the U.K., the Bank of England's

quantitative easing through large-scale asset purchases, and the swift decline in the bank's policy rate after 2007 have

had a strong impact on the U.K. gilt market and expectations for interest rates. The bank currently has a 375 billion


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portfolio of gilts, representing around 40% of the stock. Additional programs, such as the Funding for Lending scheme,

have amplified the impact of low interest rates. In the eurozone, the European Central Bank (ECB) has used different

techniques to pursue essentially the same objectives. Its fixed-rate full allotment policy, introduced in the third quarter

of 2008 and still in place today aimed to avoid a liquidity crisis in the eurosystem. The ECB also introduced covered

bond purchase programs, first after July 2009, for a limited total 60 billion, and then from November 2011 for a total

of 16.4 billion. But the ECB's greatest impact on long-term rates came when its President Mario Draghi pledged in

July 2012 that the central bank would ready to do "whatever it takes" to preserve the euro and later introduced

outright monetary transactions (OMT). This program potentially allows direct interventions on the eurozone's

sovereign bond markets in case of stress. Improving economic data from the periphery (current accounts) in 2013

reinforced the positive impact of the OMT on bond yields.

Our baseline forecast is that short- and long-term interest rates will remain historically low over the coming two years.

In the U.K., we expect a first hike in BoE policy before the end of this year given that the economy is staging a strong

revival. But we believe the policy tightening will be spread over several years and that the impact on long-term rates

will be benign. In the eurozone, the ECB is likely to introduce additional nonconventional measures in the form of

direct asset purchases to boost credit growth in the monetary union.

However, the past has shown that sudden shocks can never be fully ruled out. Unexpected events can hurt market

confidence and trigger massive sell offs and interest rate spikes. Given the critical role they have played in the

consolidation of European housing markets, we have assessed what impact a sudden rise in interest rates would have

on national housing markets and economies, even if such a development appears unlikely at present.

There is ample academic research on the link between interest rates and residential housing prices (a comprehensive

review of available research is presented in the IMF working paper 08/247 "Interest rate elasticity of residential

housing prices"). On average in developed markets the interest rate elasticity of house prices appears to be about -3.6,

but with important differences between countries (the elasticity measures the rate of response of prices due to a rise in

interest rates). The Netherlands' real estate market, for instance, has a much higher elasticity (estimated at -7.4 by the

OECD 2004 Netherlands' Economic Survey). The level of private sector debt is a key factor explaining variations

between countries.

To assess how vulnerable European housing markets are at present to an interest rate shock, we carried out a series of

econometric simulations, assuming a 100-bps spike in short-term rates in the U.K. and in the eurozone, spreading to

long-term rates. Such contagion reflects past experience, especially the 2011 episode in the sovereign bond markets of

the eurozone, and most affects economies in which rebalancing is less advanced (see chart 11). This uneven contagion

is reflected in the widening spreads with the German Bund (see chart 12).


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Chart 11


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Chart 12

In this exercise, we did not focus so much on what could cause such a shock. The goal of our stress test was to find out

which markets would be most affected.

Our simulation suggests that the two most vulnerable markets are The Netherlands and Portugal (see chart 13). It is

notable that these two countries have very different economies: Portugal's real GDP per capita is almost half that of

The Netherlands (as measured in purchasing-power parity dollars). However, both economies have in common that

this interest rate shock catches them when their revival is still fragile. Furthermore, the housing market correction, as

reflected by their respective affordability, is not fully complete. More crucially, The Netherlands' private sector debt

remains among the highest in the eurozone. In Portugal, household sensitivity to interest rate rises is increased by the

very large use of variable interest rate loans. Predominantly, the lenders use the six-month EURIBOR for adjusting

interest rates. In The Netherlands, meanwhile, mortgage contracts, such as interest-only mortgages, have been very

popular until recently, while reliance on home equity loans, including mortgage equity withdrawals, makes households

more vulnerable to rate rises.

At the same time, the simulation results for The Netherlands must be kept in perspective: the relatively large deviation

between our baseline and the stress test is caused by the fact that in our baseline we project a rise in Dutch house

prices this year, when in the stress test the spike in interest rates delays that revival by two additional years.


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Chart 13

Under our simulation scenario, Italy's housing market price index would fall about 5% lower than in our baseline

forecast. Although the Italian market correction is well under way when the shock takes place, the negative effects are

mainly felt from a contraction in overall investment and a collapse in business and consumer confidence. Instead of

resuming growth, as in our baseline forecast for 2015-2016, Italian house prices would experience two additional years

of relatively modest decline of -1.3% per year.

In view of its recent and fairly spectacular revival, the U.K. housing market response to an interest rate shock appears

relatively contained. According to our simulation, prices would remain in positive growth territory in year one, and

then decline by a modest 1% in year two. We believe that the U.K. housing market in this simulation is receiving some

form of protection from the overall economy. This is because the shock occurs at a time when the economic recovery

is becoming more rooted, with increased support from business investment. The negative effects of higher interest

rates therefore feed through more slowly.

The French house price index under our simulated interest-rate shock comes out 4% lower than in our baseline

forecast. In place of the modest growth that our baseline forecast predicts for 2015, the market continues to contract.

Given that the shock occurs at a time when the French economy remains weak, these results may seem too optimistic.

In part, they reflect the very low share of variable-rate housing loans in France, which spreads the negative effects of


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the shock over a longer period. But they also result from the French market's resilience since 2001. In this sense, they

could indeed be too optimistic: in the early 1990s the French market experienced a prolonged contraction induced by

a rise in interest rates.

Given that the Spanish market has experienced a long period of correction, the stress we introduced in our simulation

does not meaningfully change its outlook. It delays the market revival by about a year compared to our baseline

forecast, but returns to modest growth in year two, both in our stress and baseline scenarios. A similar set of results

emerges for Ireland. The interest rate shock occurs at a time when the Irish economy is experiencing a decent revival

and after a long correction in the housing market. Improved fundamentals help the real estate market to cope with a

new shock.

Finally, and rather unsurprisingly, Germany's housing market comes out relatively unscathed in our stress test. It did

not experience the boom-bust episodes of other European markets, and its recent revival is attributable mainly to

fundamental supply-demand factors. Besides, households are less sensitive to mortgage rate reduction. Interest rates

are usually fixed at about 10 years, and lenders charge strong penalties in the case of an early termination of a contract

by borrowers. H

Low Interest Rates Are Underpinning Europe's House Price Recovery

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