ESRI warns of slowdown in housebuilding

The Institute is concerned about the impact of a decline in housebuilding on the economy, but generally takes a bright view on the future, writes Cliff Taylor, Economics Editor.

To what extent is the economy being driven by the housing boom? Earlier in the week, the Central Bank warned that borrowers were not taking sufficient account of the risk of higher interest rates.

Yesterday the International Monetary Fund (IMF) warned that house prices here were vulnerable to a fall as interest rates rise and that this could disrupt economic activity.

And today the Economic and Social Research Institute (ESRI) cautions that a fall in housebuilding activity, now at record levels, could slow economic growth, though it generally remains optimistic on the outlook.

We are not short of forecasts about a collapsing property market . The old story about economists predicting five of the last three recessions comes to mind.

However, the ESRI is making a different - if related - point. It is that the housebuilding boom is supporting the level of economic growth and that the inevitable fall-off in activity will affect growth rates over the coming years.

The ESRI estimates that house construction is contributing about one-fifth of the growth rate being recorded by the economy at the moment. In other words almost one percentage point of the 4.8 per cent growth rate that the ESRI is forecasting for this year is expected to come from housebuilding.

Building reached record levels last year, with 69,000 houses completed, and this is expected to be comfortably exceeded this year, with the ESRI forecasting 80,000 completions.

On balance, the ESRI expects that housebuilding might edge higher again next year. However, the point it is making is that housebuilding is bound to ease off sooner rather than later.

The ESRI is careful not to predict a collapse in building activity in the near future. And it is optimistic that other parts of the economy can take up the slack.

However, clearly the slowdown in housebuilding - likely to happen some time over the next couple of years - will, in the words of the ESRI, act as as a "drag on growth" when it happens. The booming property market in all its manifestations has also boosted the Exchequer finances. The new house boom has boosted VAT receipts while sales of second-hand homes has led to a surge in stamp duty.

Sales of investment properties have no doubt helped to support capital gains tax. If the market slows, then the Exchequer finances will suffer too; if the ESRI is correct that other areas of economic activity will take up the slack, then this may not matter too much as rising activity in pretty much all areas of economic activity benefit the Exchequer in one way or another.

The risk - and the economic cost - of a fall in house prices is a related, but separate, issue. Obviously a fall-off in confidence in the property market could hit both prices and the rate of house building.

However, given the record rate of building, some slowdown appears inevitable over the next couple of years, while the likely trend in house prices remains a matter of intense debate.

Few would argue with the IMF analysis that prices here are looking toppy - although there would of course be debate on by how much. However, the key issue is whether the market is heading for a "soft landing", when price growth slows, or whether the property market is heading for a bust.

And the issue exercising analysts is what is the catalyst that would trigger a downturn? Nothing obvious, is the answer, with unemployment looking set to remain low and interest rates set to rise only gradually.

However, the Central Bank and the IMF both warn that higher interest rates could hit the housing market, even if the increases are gradual.

Looking at interest rates, the ESRI echoes the recent warning from the Central Bank that borrowers can expect higher interest rates in the years ahead. The ESRI says that European Central Bank (ECB) rates could rise from 2 per cent to 4.5 per cent, given the likely trend of growth and inflation in the euro area. This would mean a substantial rise in interest rates for borrowers.

The Central Bank's analysis was similar, predicting that mortgage rates charged to borrowers could rise from around 3.5 per cent now to 6 per cent at the top of the interest rate cycle. There is a view that interest rate increases in the coming cycle may be less dramatic than this, given the lacklustre state of growth in the EU economy, although this remains debatable.

Nor is there consensus on when interest rates will begin to increase. Some analysts believe that recent statements suggest the ECB could move before the end of the year. However, other analysts feel that it could be well into 2005 before we see an increase.

Either way, the pace and timing of interest rate increases will be central to the evolution of the property market over the next couple of years.

And, as the IMF points out, if house prices do start to fall, then it can disrupt overall levels of activity.

Fortunately, the ESRI believes that the overall economic outlook is bright, meaning the economy could survive a housing slowdown , if not a collapse.

The ESRI has increased its forecast for economic growth and now expects Gross National Product to increase by 4.8 per cent this year and 5 per cent in 2005, providing a considerable boost to the public finances.

Despite higher oil prices, the ESRI says that Ireland will benefit from relatively strong growth in the world economy, with a robust performance in most major economies and strong growth in emerging markets such as China. For this reason, prospects for Ireland are "very positive", with strong growth and unemployment expected to hold around current lows.

It is a broadly optimistic outlook, albeit surrounded by the usual caveats about the risks facing the international economy.

The foundations on which economic growth is built remain stable, the ESRI believes. Whether the foundations of the property boom are quite so strong - and the implications for the wider economy if they are not - remains an open question.