2008–09 and the sluggish recovery recorded since 2009. In the fall of 2008, the SNB lowered the policy rate significantly to counter unwarranted tightening of financial conditions and the risk of deflation and recession. Since then, the policy rate has been kept close to zero and, in September 2011, the SNB set a minimum exchange rate for the euro against the Swiss franc to ensure appropriate monetary conditions for the Swiss economy. In this environment the interest rate is not available as an instrument for influencing developments in the credit market. As a consequence of this exceptional period of low rates, Swiss mortgage rates have fallen substantially over this time period, with advertised rates for 10 year mortgage credits hitting all-time lows in 2012 at 2.1%, substantially below the pre-crisis average of 4.7% (Figure 7b).
It thus comes as no surprise that credit growth, mainly driven by the growth of residential mortgage loans, accelerated from 2009 onwards (as shown before in Figure 2a). Given the rather rigid Swiss rental market, the decrease in mortgage rates has not been, until recently, accompanied by a similar decrease in rental rates. This has led to a situation where it may seem relatively more attractive to buy than to rent. Such a prolonged period of ultra-low rates is also fertile ground for behavioral biases. It is, for instance, tempting to compute the cost of home ownership on the basis of a permanently low rate, a practice which can lead to grossly overestimating the cost advantage of home ownership. The persistent real estate price increases reported in Figure 1 are also relevant in this context. This can lead to an overestimation of housing wealth, on the one hand, or to an underestimation of the riskiness of mortgages granted on the basis of these elevated housing prices, on the other. A long period of rising prices also tends to feed beliefs that prices can only go up, contrary to all historical experience (“this time is different”-argument)1. At the same time the low interest rates put pressure on the margins of lenders. This increases their propensity to compensate lowered margins with increased volumes. All this leads to increasing fragility and added riskiness. For Switzerland, indications of such a high risk appetite are found in recent survey data.2
Summing up, the analysis of the Swiss situation suggests that although structural factors can possibly explain a high level of credit-to-GDP in Switzerland in international comparison, they are unlikely to rationalize the most recent upward move in this ratio. The latter is likely to be a cyclical movement that could reverse when interest rates themselves return to more normal levels at some point in the future.
5. Conclusion: Fasten your seat belts!
What does this analysis imply for market participants? As observed earlier, credit volume has gone from around 150% to around 170% of GDP in the past few years. This is the result of an average growth of credit of nearly 4%, while nominal GDP growth has averaged slightly above 1% over the same period. For this movement to be fully reversed, credit growth would have to significantly undershoot nominal GDP growth. The critical question is: could such a reversal happen smoothly, or in other words, is a soft landing possible? International experience (Figure 3) suggests this is a significant challenge. Credit-to-GDP ratios often fall in the wake of a severe crash, with pronounced falls in property prices and large increases in credit default rates; but this is exactly what we aim to avoid.
While the diagnosis cannot be totally certain until history has run its course, the lessons from the analysis are, in my mind, crystal clear. The large increase in leverage, presumably of a cyclical nature,
- Reinhart, C. and Rogoff, K. (2009 [↩]
- According to SNB survey data, about 20% of new mortgages are granted for investments with a loan-to-value ratio above 80%, and 25% of newly originated mortgages are granted to lever existing mortgages. Moreover, in the case of 40% of new mortgages the imputed costs would exceed one-third of gross income at a mortgage interest rate of 5% [↩]