Through Deniz Igan
In Spain, credit to the private sector as a percentage of GDP almost doubled between 2000 and 2007. This increase was accompanied by soaring house prices, which doubled in real terms over the same period. The economy as a whole has also grown at a record pace.
But in 2008, Spain’s credit bubble burst, leading to defaults, bank failures and a prolonged economic downturn.
A less noticeable development in Spain was in the construction sector, where employment increased by 47%, compared to an increase of 27% in the economy as a whole.
New IMF staff research, based on a large sample of advanced and emerging market economies since the 1970s, shows that long-term credit booms, characterized by rapid construction growth, never ended well.
New evidence on credit booms
Rapid credit growth – known as the “credit boom” – presents a trade-off between immediate, dynamic economic performance and the danger of a future crisis. The risk of a “bad boom” —where an episode of rapid credit growth is followed by a financial crisis or below-normal economic growth — increases when there is also a credit boom. house prices.
Long-term credit booms characterized by rapid construction growth never ended well.
Our research shows that the experience of the dangerous combination of credit booms and rapid expansion in the construction sector extends beyond Spain’s borders and extends to periods unrelated to the global financial crisis.
We find that signals from construction activity can help distinguish dangerous booms, which must be controlled, from episodes of sustained but healthy credit growth (“good booms”).
Credit booms don’t lift all boats the same
During booms, production and employment grow faster. But not all industries behave the same. Most of the additional growth is concentrated in a few industries, particularly construction and, far behind, finance.
However, the same industries that profit the most during booms experience the most severe downturns during recessions. This implies that credit booms tend to leave little long-term imprint on a country’s industrial makeup.
The construction is special
Construction is the only industry that consistently behaves differently between good and bad credit booms. On average, production and employment in the construction sector increase between 2 and 3 percentage points more in bad booms than in good ones. In all other sectors the difference is smaller and not significant (except trade, but only when it comes to output growth).
What makes construction special? Construction does not have the growth potential of many other industries. In other words, too much investment in construction can divert resources from more productive activities and lead to lower production.
In addition, the temporary increase in construction employment and the relatively low level of skills required may discourage some workers from investing in their education and skills. This can have lasting effects on production after the boom ends.
Finally, construction projects have significant up-front financing needs, and end consumers of the product (eg homes or hotels) also tend to borrow to finance their purchases. As a result, debt can increase much more during construction-led booms.
The predictive power of construction activity
Unusually rapid expansion in the construction industry helps signal bad credit booms. A 1 percentage point increase in construction output and employment growth during a boom increases the likelihood of the boom being bad by 2 and 5 percentage points, respectively.
Growth in construction is also a strong predictor of the economic costs of bad booms than other variables. A 1 percentage point increase in construction output growth during a bad boom corresponds to an almost 0.1 percentage point decline in aggregate output growth during the recession.
If policymakers see rapid expansion in the construction sector during a credit boom, they should consider tightening macroeconomic policies and using macroprudential tools (such as higher down payments for mortgages).
In some cases, political action will be triggered by other indicators, such as house prices or household mortgages. Sometimes, however, these other indicators may not sound the alarm (for example, because the construction boom is financed by the corporate sector or by foreigners), but the risks mount. Then, unusually rapid growth in construction could signal, for example, to impose limits on banks’ exposure to real estate developers and other construction companies.
Finally, since data on production and employment in the construction sector are often available with a lag of a few months, more frequent indicators such as building permit applications could be valuable signals. Construction indicators should also be included in models that assess risks to future economic activity.