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Global macro & geopolitics from a small economy perspective

QE fallout in small advanced economies

David Skilling
Global Public Investor
June 2017

The programme of QE by large economy central banks has had a global effect over the past several years, on both asset prices and the real economy in countries around the world. The experience of small advanced economies provides a useful perspective from which to assess the effects of QE – as well as what to expect as normalisation commences.

Small economies are deeply exposed to the global economy on multiple dimensions, from exports and direct investment to flows of portfolio capital. This makes small economies the canaries in the mine of the global economy: international economic dynamics show up quickly and cleanly in small economies.

In the context of QE, this is particularly the case for the eight small advanced economies outside the Eurozone: Norway, Denmark, Sweden, Switzerland, Israel, Hong Kong, Singapore and New Zealand (although Denmark pegs to the euro and Hong Kong to the USD). This is a diverse set of countries on many dimensions, but they share an acute exposure to the global economy. Taken together, they provide a distinctive perspective on the impact of loose monetary policy on a range of asset prices.

The direct impact, of course, is in terms of interest rates. The lower interest rate regime in the US, the Eurozone and elsewhere has led to steadily falling rates in advanced economies around the world.

However, for several small advanced economies, differences in yield have emerged. This divergence has placed sustained upward pressure on the effective exchange rates of these small economies. For example, Israel has been one of the best performing currencies in the world. And central bankers from Switzerland to New Zealand have routinely decried the unjustifiably high levels of their respective currencies: Switzerland was forced to remove its peg to the euro, allowing it to appreciate sharply, and New Zealand has consistently tried to talk its currency down (with little success).

This exchange rate pressure has created two issues for small open economies with their own monetary policy: it has weakened export competitiveness in an environment in which world trade growth was already sluggish; and it has made achieving the inflation mandate challenging (from Sweden to Singapore, there were sustained periods of negative inflation readings). In response to these concerns, policy rates in many small economies have been reduced sharply – and into negative territory in Sweden, Denmark and Switzerland.

This small country central bank response was useful. But it has created distortions in asset markets. In particular, real estate markets in small advanced economies have been under sustained upward pressure over the past several years. In the five years from Q1 2012, real property prices have increased by about 20% in the small advanced economies group, about twice the pace of the large advanced economies group (refer Exhibit 1). And for small advanced economies outside the Eurozone, the increase is about 25% to Q4 2016.

There is a broad distribution of outcomes (refer Exhibit 2). At the top end, New Zealand, Sweden, Hong Kong and Ireland have registered very strong rates of real property price appreciation: New Zealand residential real estate prices are up by 50% since 2012, and Sweden and Hong Kong by around 40%. But Singapore is a notable exception to this pattern. Recognising its exposure to speculative inflows driving prices up, Singapore implemented aggressive macro-prudential policy, as well as acting to increase the supply of residential real estate. After a 40% run up in prices from 2009, property prices have drifted down by about 12% since 2013.

Of course, larger advanced economies also saw pressures on property prices – notably in the Anglo countries of Australia, Canada, the UK and the US, as they recovered from the housing crisis. But, overall, the pressures have been more acute in smaller advanced economies. And house price to income ratios have also increased more sharply in small economies over the past several years, worsening housing affordability and raising issues about financial sector risk.

This increase in property prices is stronger again in the main cities of these small countries (Auckland, Copenhagen, Stockholm, and so on). In Auckland, real prices have doubled since 2012, Hong Kong is up by over 75%, Copenhagen and Stockholm are both up by 60%, and Tel Aviv by over 50%. In Singapore and Swiss cities like Zurich, however, price appreciation has been more modest because of restrictions on demand.

There are various country-specific factors at play, from strong migration to supply-side constraints, but the lower interest rate profile has been a key factor behind this common small economy experience. Indeed, the pace of property price appreciation seems to be slowing in small economies such as New Zealand, as interest rates begin to nudge up. As the forces that have propelled property prices up begin to weaken or reverse, there may be some sharp moves in asset price.

The past several years have been a particularly challenging time for small economy central banks. And it is likely that the process of unwinding these effects will also be challenging, as a rising interest rate profile places pressure on asset prices, household balance sheets, and the real economy. Indeed, Goldman Sachs recently identified New Zealand and Sweden as the two economies most exposed to a housing bust. Small economies will need to continue to manage the cross-winds from the global economy.