In this study, we take both the short-run and long-run dynamics of real estate bubbles and monetary factors into account. Real estate bubbles are linked to monetary policy through two different channels. First, house prices are sensitive to the interest on other financial assets such as bonds or deposits at a bank. Low interest rates reduce the cost of capital and provide incentives for real estate investment. While the actual need for housing for living purpose remains the same, the investment demand goes up and artificially pushes up the demand for residential real estate and housing prices. Second, interest rates and money supply affect the debt financing conditions of borrowers. Lower interest rates reduce the cost of mortgage loans, which increases, the availability and accessibility to house purchasing loans. The interplay of both channels increases the demand for housing
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relative to the demand for rental housing. The unbalanced development of the demand in the two markets manifests, in a widening gap, between the market and fundamental value. The relationship between property bubbles and the two channels of monetary policy can be expressed as following.
𝐵𝑗𝑡 = 𝑓(𝐼𝑅𝑡, 𝐻𝐿𝑡) (5)
This expression shows that the bubble 𝐵𝑗𝑡is a function of the Euribor 𝐼𝑅𝑡 and the lending for house purchase-to-GDP 𝐻𝐿𝑡. Based on the theory of the two channels above, we suggest that the relationship is negative between the bubble and 𝐼𝑅𝑡 and positive for 𝐻𝐿𝑡 in the short run. As the financing costs increase, market housing prices might be affected inversely, and then reduce the gap between fundamental value and market price. The bubble consequently dwindles. In the long run, however, we suggest that the relationship is positive between the bubble and 𝐼𝑅𝑡. This is because that the long-term low interest rates may enhance investors’
confidence in housing investment, and consequently bolster the housing prices as well as the bubble.
The loan-to- GDP ratio is commonly used as a measure of bank lending activities (Oikarinen, 2009). We use the 3-month Euribor as it is a good proxy for the key interest rate set by the ECB. Hereby, the main refinancing operation is the most important monetary policy tool of the ECB. It provides liquidity through the national central banks to the domestic banking system in the member states of the Eurozone.
The interest rate for this instrument is set in a tender procedure where the domestic banks make a bid and receive a short-term loan with maturity of one week. The domestic banks receive the loan and provide financial assets as a guarantee. After the transaction is completed, the domestic banks pay interests to the central bank and receive the provided collateral in return. The interest rate set in the tender
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procedure is subject to a minimum bid rate. The minimum bid rate is set on a monthly basis by the Governing Council of the ECB. In the tender procedure, the total amount of funds to be allocated is defined by the ECB. Domestic banks that make the highest bid are served first until the full amount is allocated. Domestic banks unable to obtain liquidity through this mechanism have to borrow funds in the money market. Money market interest rates as the 3-month Euribor are usually very close to the minimum bid rate of the main refinancing operations set by the ECB (ECB, 2013).
In the empirical part, we apply VAR and VECM models to analyze the short- and long- run dynamics between the bubble, Euribor and the lending for house purchase-to-GDP ratio.
4 Data
In our analysis we cover the time period from the inception of the single monetary policy in the Eurozone in 1999 to the third quarter of 2012. As for the house price, we use price indices on residential property from the property price database of the ECB and the Bank for International Settlements (BIS). In the case of Ireland, there is no complete time series on house prices for the entire period available. In order to cover the full time period, we use two overlapping time series and consolidate it into a single item. The rent index is sourced from the ECB and available for the entire period. For the calculation of the WACC, due to data availability, we use data from two separate datasets. Historical quarterly data on retail interest rates is sourced from Eurostat and covers the time period from 1999 to 2003. The second dataset is sourced from the Monetary Financial Institute (MFI) database from the ECB and covers the period from 2003 to 2012. In order to allow the analysis of the full time period, we consolidate both datasets. As for the cost of debt, we use the average interest rates for housing loans. Regarding the cost of equity, we use the average interest rate on deposits of up to one year maturity. For Ireland, we use the average
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rate for overnight deposits as a proxy for the cost of equity as the previously mentioned interest is not available for this country. The data on the Euribor and the lending for house purchase-to-GDP is also sourced from Eurostat and available for the entire period. Figure 1 shows the bubble in the PIGS countries according to the definition in (4). In Figure 1, Portugal, Ireland and Spain experienced an increase in the bubble at the beginning of the 2000s, followed by a decrease up to 2005 in Portugal and a returning upwards trend in Ireland and Spain in 2003. In contrast to these countries, Greece experienced a constant negative trend up to 2005.