Central Bankers Hone Tools to Pop Bubbles

July 8, 2013, 11:04 p.m. ET

Central Bankers Hone Tools to Pop Bubbles

DAVID WESSEL and ALEX FRANGOS

In Seoul’s upscale Gangnam neighborhood, made famous by pop star Psy’s viral music video, government curbs on real-estate lending froze a market in which home prices had been rising as fast as 25% a year. In Toronto, housing prices reversed their rapid rise and fell for five months after the government changed rules to effectively increase monthly payments on new loans. But in Tel Aviv, home prices kept right on climbing—up 11% over the past year for a three-bedroom apartment—even after the central bank boosted minimum down payments and made mortgage lending less attractive to banks.

Central bankers everywhere else are watching these experiments closely, among them Ben Bernanke, chairman of the U.S. Federal Reserve. He and his counterparts around the world, seared by the worst financial crisis in 75 years, are searching for ways to halt borrowing binges before they morph into bubbles, and to push lenders to shore up their defenses before the next crisis arrives.Lifting interest rates to discourage borrowing has long been considered a blunt but effective weapon. But that isn’t a step central banks are eager to take when inflation is low or unemployment is high—as they are in many places now.

So some central bankers are experimenting with targeting only pockets of financial excess. Because financial bubbles so often involve real estate—and because that sector was at the center of the last crisis—many are focusing on ways to control booms in housing prices by curbing mortgage lending.

That’s not the only focus: Indonesia last year outlawed zero-down payment loans for motorcycles, for example, and South Korea has imposed levies to discourage banks from short-term dollar borrowing.

Thus far, the results trickling in from around the world are distinctly mixed. In some places, the experiments are producing the desired effects, while in others, they aren’t.

The point of the new tools is to protect the entire financial system and economy, so economists refer to them as macroprudential. That distinguishes them from microprudential, which describes traditional oversight to assure safety and soundness of individual banks.

At the moment, such concerns are largely hypothetical for the U.S., Europe and Japan. Their central banks, for now, are trying to encourage more lending. But the Fed’s pledge to keep interest rates low for a long time—as long as unemployment remains high and inflation low—has already fueled the return of some of the types of risky lending that preceded the 2008 crisis.

After the crisis, Congress expanded the responsibilities and authority of the Fed and other regulators, but it didn’t give them all the powers that central banks in some countries have, such as the ability to set minimum down payments. Nevertheless, Mr. Bernanke has spoken favorably about a more targeted approach: “Explicit incorporation of macroprudential considerations in the nation’s framework for financial oversight represents a major innovation in our thinking…one that is taking hold abroad as well as in the U.S.”

The whole idea makes some economists uneasy. “Macroprudential tools are new, and little is known about how effective they can be,” says Olivier Blanchard, chief economist at the International Monetary Fund, which has published 23 working papers that touch on the subject in the past three years.

The techniques have ignited a debate among central bankers, bank regulators and academics over whether they can do what proponents promise.

Some see “macroprudential” as a euphemism for the largely discredited practice of governments deciding where capital should flow.

But proponents say the cost of leaving everything to the markets was the worst financial crisis in generations.

“Many thought it was rather adequate to wait until a crisis breaks out and then clean it up,” says Kim Choong-soo, governor of South Korea’s central bank. “The crisis we faced was so enormous and had such an enormous impact on us that we began believing that prevention may cost less.”

Underlying much of the debate is the question of when macroprudential tools should be used rather than broader interest-rate increases, which are seldom popular. Some critics recall that too much easy money has produced inflation in the past, and worry that the tools are an excuse for dillydallying on rate hikes.

Adair Turner, until recently Britain’s chief financial regulator, counters that “the interest rate required to slow down a property price boom is probably so high that you’d really screw up some other bit of the economy long before you’ve slowed down the property boom.”

While attractive to some in theory, the new instruments may prove politically treacherous in practice. Using interest rates to steer an economy, while sometimes controversial, is widely accepted by markets, banks, politicians and the public. Making it hard for families to buy homes isn’t.

When Israel’s central bank boosted the minimum down payment on a home to 30%, it made it 25% for first-time home buyers. Stanley Fischer, who stepped down as central banker on June 30, attributes that to “straightforward political reasons.”

“It is inconceivable,” Moshe Gafni, a member of Parliament, told Mr. Fischer at a hearing, “that a young couple can’t get an apartment because they aren’t rich.”

South Korea

Determined to avoid a repeat of the wrenching Asian financial crisis of the late 1990s, South Korea’s government, in concert with its central bank, has used macroprudential tools aggressively for the past decade. It wants home prices to rise, but not too quickly, so it has repeatedly adjusted down-payment minimums and debt-to-income maximums for home loans. It also has taxed banks to limit short-term borrowing in foreign currencies, hoping to protect banks from swings in global market sentiment.

In Gangnam, sometimes called the Beverly Hills of Seoul, and in other communities designated as “speculative,” regulators required home buyers to come up with 50% down payments and show that mortgage payments wouldn’t consume more than 40% of their income. To discourage speculators, taxes as high as 60% were imposed on sales by people who own more than one house.

The measures have had the desired effect, much to the displeasure of local real-estate agencies.

“Nothing moves at all,” says real-estate agent Park Soon Seo. “The government intervened too deeply and almost destroyed the market.”

Housing prices in Gangnam fell 5% last year.

On a recent afternoon, there were no customers or ringing phones at several neighborhood real-estate offices. Agents fiddled with smartphones and tended to potted plants. Maps on the walls showed property developments in the area, the newest of which is now four years old.

In April, with prices on the downswing, Korea’s newly elected government loosened some down payment restrictions in Gangnam and other speculative zones. Mr. Park, the agent, says the move hasn’t yet spurred sales.

A decade into the experiment, scholars and central bankers still aren’t sure how the rules have affected the economy.

“We have a relatively short period of experiences,” says Mr. Kim, the central-bank governor, adding that it is hard to know what would have happened had the controls not been imposed.

IMF economists Deniz Igan and Heedon Kang, formerly at the Bank of Korea, say the down payment and debt-to-income limits led to a decline in home-price appreciation and sales activity. “Furthermore,” they said in an IMF working paper, “the limits alter expectations, which play a key role in bubble dynamics.”

Kwanho Shin, a Korea University economist who was a consultant to the government, says the rules have a limited effect if house prices are rising fast: Borrowers can simply refinance into bigger mortgages. But when prices fall, the rules can make it harder for homeowners to refinance existing loans.

—Alex Frangos

Canada

Although Canada escaped the worst of the global financial crisis, it still had a recession. That prompted the Bank of Canada to cut its benchmark short-term interest rate to 0.25%. Rates have since inched up to 1.0%, but that didn’t prevent a surge in borrowing by Canadians that the central bank last year called “the biggest domestic risk” to the economy.

The government had begun tightening the mortgage spigot in 2008, without much effect. In June 2012, the skyline of Toronto was dominated by construction cranes. House prices there, according to the benchmark Teranet-National Bank index, had been climbing at an annual clip between 5% and 13% in recent years.

With prodding from then-central banker Mark Carney, Finance Minister Jim Flaherty set out to make home buying more expensive. Government-backed mortgage insurance is required for any home purchase with a down payment of less than 20%—roughly 60% of purchases.

Mr. Flaherty said insured loans would have to be paid off in 25 years instead of 30, which meant larger monthly payments. He set a minimum down payment of 20% on any home costing more than one million Canadian dollars, or about US$946,000. And he reduced the size limit on refinancing loans to 80% of a home’s value, from 85%.

“Some of the builders…were worried that people were buying too much house, and paying too much for condos,” Mr. Flaherty explained at a recent parliamentary hearing. “So we have tried to tighten up on that.”

Home sales nationwide have dropped about 8% from last spring, says Adrienne Warren, economist at Bank of Nova Scotia BNS.T +0.22% in Toronto. According to the Teranet-National index, home prices in Canada’s six biggest cities fell between September 2012 and February of this year. They have since begun to rise, but in May were still a hair shy of the August 2012 peak.

Sales of condos in Toronto in the first three months of this year were 55% below year-earlier levels, says Urbanation, a Toronto-based research firm. The Bank of Canada’s latest Financial System Review said the number of unsold high-rise units under construction in Toronto remains near the high levels observed since early 2012.

“I actually think what the government did was good,” says Jesse Banwait, a Re/Max Legacy Realty Inc. agent in Toronto. “We saw a lot of buyers entering the market and getting preapproved financing when they shouldn’t have been.”

Mr. Carney, who has since become governor of the Bank of England, was pleased with the initial result. “We are now seeing household debt levels stabilize—albeit at high levels,” he said in April. The Bank of Canada said recently that while the pace of household borrowing has slowed since late 2012, it remains “elevated.”

Many mortgage brokers say Mr. Flaherty overdid it. “We were already in a soft-landing housing market during the first half of 2012. Prices had stabilized…and credit growth was starting to taper off,” said Will Dunning, chief economist with the Canadian Association of Accredited Mortgage Professionals.

—Paul Vieira

Israel

With interest rates very low in much of the world, cheap money is everywhere, even flooding into smaller economies such as Israel’s. The money is driving up Israel’s currency, threatening its important export sector.

That presents Israel’s central bank with a dilemma: Raising interest rates would likely exacerbate the problem by boosting the currency further, but low rates can fuel a borrowing binge, particularly for home buying.

For three years, the Bank of Israel and bank regulators have been trying to cool the sizzling real-estate market—both home prices and rental rates have been rising rapidly—without raising interest rates. So far, they haven’t had much success.

The central bank limited the use of adjustable-rate mortgages tied to the low Bank of Israel short-term rate. It forced banks to set aside more capital for certain mortgages. Last October, it set the minimum down payment at 30% for most home buyers, and at 50% for investment properties.

“It’s all going in exactly the opposition direction of what they [the Bank of Israel] wanted,” says Micha Goldberg, a banking analyst with Nesuah Zannex Securities Ltd.

Israeli home prices rose 3.2% in the four months ended in March, according to the most recent government data, an annual rate of more than 13%.

The new rules have slowed the home-buying process in some cases.

Nachshohn Carmi, a father of two, says he was turned away by his bank when trying to buy his first home in Jerusalem’s Arnona neighborhood. A mortgage broker found a different lender, and he eventually got a loan to buy the home.

The lending restrictions can’t overcome the forces of supply and demand: Israel’s population is growing at a much faster rate than new homes are being built, so home prices just keep climbing.

“There’s so much pent-up demand that the regulations are being washed away,” says Bernard Raskin, director of the Israeli branch of the Re/Max real-estate broker, which enjoyed a 17% increase in commission revenue in the first quarter.

“Evidently the measures we have imposed have not been strong enough to reduce the demand for housing sufficiently to stop prices rising,” the former central banker Mr. Fischer concedes.

—Josh Mitnick

Indonesia

In Indonesia, a booming economy has put motorcycles within reach of millions. In 2000, fewer than one million were sold. In 2011, more than eight million sold, three-quarters on credit, many with no money down.

The central bank worried that banks might be overdoing it—making loans to consumers who wouldn’t pay them back. In June 2012, it began demanding that motorcycle buyers put at least 25% down. Sales last year fell by 12%, to about seven million. The Indonesia Motorcycles Industry Association predicts sales will fall further this year.

Tjio Hok Sie, 45, an electrical technician, recently bought a $1,400 orange-and-black Honda scooter, financing it with a loan that requires 16 monthly payments of $95. He says he would have preferred to avoid the down payment, but understands the government’s rationale. “Many people bought motorcycles without paying down payments, but they could not pay the installments,” he says.

Some motorcycle buyers figured out a way around the requirement—one of the hazards of using targeted tools instead of sweeping rate increases. The ban on no-down-payment loans initially didn’t apply to Islamic Shariah-compliant lenders. Their lending business boomed—until Indonesia’s central bank extended rules to cover them in April.

Muhammad Ikhwan, sales manager at a Honda dealership in central Jakarta, has seen a 20% drop in business.

“As a citizen, I agree with the government,” he said. “Higher down payments means fewer cases of bad debt. But as a motorcycle salesman I disagree because it means less income.”

—Alex Frangos and Ahmad Pathoni

Switzerland

In Switzerland, where the central bank is struggling to protect the economy from the euro-zone recession next door, mortgages are extraordinarily cheap and domestic debt is growing in relation to the economy.

“The large increase in leverage…the elevated property prices and the evidence of high-risk appetite translate for the Swiss economy into a state of high vulnerability,” said Jean-Pierre Danthine, vice chairman of the Swiss National Bank,SNBN.EB +0.10% in April.

Swiss banks, pushed by their regulators, last year began requiring home buyers to put down at least 10% of the purchase price of a house in cash. Previously, they could take money from their pension funds to cover the entire 20% minimum down payment. They also began requiring homeowners to repay at least one-third of the principal over 20 years.

Unhappy that those and other measures—including a dollop of central banker rhetoric—weren’t making much difference, the Swiss National Bank in February decided to require banks to hold additional capital equal to 1% of every residential loan they make. The policy, which doesn’t take effect until September, is intended to make it less attractive for banks to issue mortgages.

Switzerland is the first country to use such a technique. Some politicians have protested, arguing the policy would hurt smaller banks that rely more on mortgage lending than giants UBS AG and Credit Suisse Group CSGN.VX +0.76% AG.

In the 12 months ended in March, Swiss condominium prices rose 2.9%, less than the 6.3% increase in the year-earlier period, according to consulting firm Wüest & Partner. Developers and real-estate brokers say demand is shifting toward the middle and lower end of the market.

“In the midrange segment, there are still a huge number of buyers,” says Matthias Meier, spokesman for the Allreal ALLN.EB +0.23% Gruppe AG, a Zurich-based real-estate developer.

—Marta Falconi

Hong Kong

The government of Hong Kong has made at least 15 separate policy moves since late 2009, by the count of property brokers Knight Frank LLP, to try to restrain real-estate prices, which have been climbing at double-digit annual rates.

It has raised real-estate transaction taxes, increased the supply of land available to developers, required higher down payments, levied a tax on foreign buyers and extended curbs on loans to commercial properties, including purchases of parking spaces.

That has made the former British colony a laboratory for testing macroprudential tools.

Each time the government moves, property prices have tended to cool for a few months, if at all, then resume their climb. Residential property values have more than doubled since 2008. It is possible, of course, that prices might have risen even higher without the controls.

Rock-bottom interest rates have fueled the boom. Because Hong Kong pegs its currency to the U.S. dollar, it effectively imports U.S. Federal Reserve interest-rate policy. Also lifting prices is strong demand from mainland Chinese buyers, who see Hong Kong’s independent financial and legal system as a way to get their money abroad.

There are some signs the market is cooling. U.S. interest rates are creeping up, and thus Hong Kong’s. China’s economy is slowing, keeping mainland buyers at bay. Property transactions are down sharply since the latest government cooling measures were put in place in February.

The situation has made real-estate agents steaming mad. In early June, hundreds protested in front of the government’s headquarters with placards decrying “interference” in the market.

“It’s like breaking the city’s leg,” said Alex Yu of Bo Fung Property Agency.