The housing market is of great economic importance in every country. In poor Ukraine where most people's wealth coincides with their housing wealth, owning an apartment is considered as an inalienable right for every Ukrainian household. Because of the recent housing price surges, millions of Ukrainians have experienced a considerable jump in their home's worth. Nowadays the average price of residential housing in the three million city of Kyiv is about $2,600 a square meter.
Taking into account that Kyiv's residential housing stock is close to 66 million square meters, one can conclude that the total value of Kyiv's housing stock ($172 billion) is equal to about 1.64 times Ukraine's nominal GDP (estimated at about $104.8 billion in 2006). For comparison, the total value of the whole U.S. housing stock ($19.8 trillion) is 1.5 times larger than U.S. GDP ($13 trillion). Therefore, if there is a bubble in Kyiv's housing market, it is of significantly larger proportions than anything observed in the U.S. housing market.
There are a lot of overpriced local markets for housing in the United States. At the same time, it is almost impossible to determine if there is an economic bubble in a market because buyers' expectations of future prices are a valid part of demand. According to Stiglitz's 1990 definition, a bubble exists "if the reason the price is high today is only because investors believe that the selling price will be high tomorrow - when 'fundamental' factors do not seem to justify such a price." So, in order to check if the level of prices is consistent with underlying fundamentals, economists use specially developed indices. One of them is the home-price-to-income ratio.
To compute it, median, not average, values are used to identify the midpoint of the corresponding distributions since average wages, for example, in poor countries are skewed upward by a few reports of high wages.
Naples, Florida is widely regarded as one of the most overpriced real estate markets in the United States. In March 2006, Naples's median single-family home price was $505,000 and Naples' median household income was $63,300. Therefore the home-price-to-income ratio was about 8. In Illinois, for example, it was about 2.5. Since then, housing prices have fallen in nearly every major U.S. housing market. The number of homes foreclosed by lenders rose by 42 percent in 2006 from a year earlier. The mortgage industry has been plunging deeper and deeper into distress because of a conspicuous rise in mortgage defaults.
Unfortunately, no information is readily available regarding Kyiv's median household income and median housing price. From real estate listings, one can conclude that Kyiv's median housing price is at least $160,000, with studios not fit for a family included. For example, the median price for two-bedroom apartments is about $210,000. Since Kyiv's average monthly salary is close to $400, the median monthly household income is not more than $600. Therefore, Kyiv's apartment-price-to-income ratio exceeds 22. It also matters that prices for dollar-denominated mortgages in Ukraine are about twice as high as U.S. mortgage prices, not to mention hryvnia-denominated predatory mortgages. According to the CNNmoney.com mortgage calculator, a family with $24,000 in yearly income and $30,000 in savings can "aggressively" buy a house worth $82,196 if the mortgage interest rate is a "Ukrainian moderate" 15 percent and there are no property taxes. These calculations show that risky mortgages and speculative demand have played not the least role in inflating the bubble.
A housing bubble cannot develop without excess monetary liquidity and inadequate regulation and supervision of the financial sector. This is the case for both developed market economies and emerging market economies. Inadequate regulation makes extending risky real estate loans by financial institutions possible and the central bank provides excess liquidity.
In 2003-04, Ukraine experienced an export-led boom. Two major factors were a surge in world commodity prices and the depreciation of the U.S. dollar against the euro. As a result of keeping the hryvnia significantly undervalued, the National Bank of Ukraine (NBU) piled up considerable foreign exchange reserves, about which the bank proudly boasted. The NBU's exchange rate policy also resulted in impressive money supply growth and a two-digit rate of inflation. With Ukrainian goods becoming relatively more expensive, the current account balance showed a deficit of 1.5 percent in 2006: Ukraine imported more than it exported. Boosting the money supply without antagonizing international organizations became quite of a problem for the quasi-independent central bank in 2006. Along with increased borrowing, refinancing operations and reserve requirement reductions were used by monetary authorities to offset the shortage.
In 2006, the reserve requirements for hryvnia-denominated deposits were lowered from 8 percent to 0.5-1 percent in three steps on May 10, August 1, and October 1. The steepest reduction of the reserve-to-deposit ratio took place on August 1. Ukrainian banks had no options but to drastically expand credit in order to get rid of swelling excess reserves. A huge explosion in prices ripped through Kyiv's previously dormant housing market at the end of last August. It is unreasonable to assign all the blame for the August housing price explosion to seasonal factors. The NBU could not have chosen a worse moment for carrying out the money supply expansion. The ensuing insignificant increase in the rate of inflation showed that the housing market, together with the credit market, was truly a great absorber of monetary shocks.
Among the other factors preventing the housing market from functioning properly are corruption, and undeveloped and missing markets. The fact that Kyiv's scarce supply of housing is insensitive to changes in housing prices (see Table 1 on the page15) shows that there are supply-side restrictions. Many of them can be linked to the wild corruption in Ukraine. Certainly, the non-existence of a legalized market for land and the undeveloped stock market have also been contributing to housing bubble growth, with the housing market again playing the role of a great absorber of excess monetary resources. Moreover, the lack of investment opportunities has led to poor diversification of Ukrainian bank's assets: more than two-thirds of banks' total assets are loans, much higher than in neighboring European countries.
In reporting figures for 2006, everything looks fantastic: a 7 percent growth in Ukraine’s GDP, a 134.2 percent increase in credit to households (up from 126.6 percent in 2005). Ukraine has been going through a credit boom. Consequently, the current account balance has been moving in the opposite direction. According to a 2004 IMF study titled “Are Credit Booms in Emerging Markets a Concern?” private credit booms in emerging markets are associated with consumption and investment boom (70 percent probability) followed by banking crises (75 percent probability) and currency crises (85 percent probability). In other words, credit booms are typically followed by sharp economic downturns and financial crises.
Those in charge of economic policy in Ukraine are not fully aware of the existence of the rental market for housing. Until now, it has been part of the shadow economy. So, in an interview published on February 1 by the Cabinet of Ministers of Ukraine’s official newspaper “Uryadovy Kuryer (Government Courier),” Finance Minister Azarov stated that “in Europe expenditures on public utilities constitute, on average, 35-40 percent of total income. In our country, they are twice as low.” Unfortunately, Kyivites did not understand how lucky they were and pressured Kyiv’s city council into lowering the utility tariffs on February 8. What is missing in Azarov’s explanation is the understanding that housing expenditures in Europe also include rent and mortgage payments, not just utilities-related expenses.
The NBU has been simply setting monetary policy with an eye toward exchange rate stability and the government’s priorities, which certainly attests to its quasi-independence. The bank has not paid due attention to growing inflationary pressures for a number of years. Last year’s 7 percent economic growth was accompanied, in a very direct sense, by explosions in housing prices (67 percent) and credit growth. So there is an urgent need for the government to switch to another economic growth strategy, not employing monetary expansions without restraint.
What do an economy and a nuclear reactor have in common? The answer to this question is square: They both tend to overheat. Everyone in Kyiv knows what happened to the fourth block of the Chernobyl nuclear plant in April 1986. The world’s worst nuclear accident was the outcome of a controlled experiment. In the course of the experiment an operator retracted too many control rods, including manual control rods. An uncontrollable nuclear reaction ensued. The operator pressed the emergency button too late.
The latest news from the NBU is that it sterilized more than 5.5 billion hryvnias over the first three weeks of February through auctions of deposit certificates. Another 6,639 million hryvnias worth of banking resources were sucked out the Ukrainian banking system by the NBU last month. In the terminology of nuclear science, the monetary control rods have been put in place.
Pavlo Prokopovych, Ph.D., Kyiv Economics Institute and the Kyiv School of Economics. The views expressed are purely the author's.
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