Correlation between current account deficits and Real estate prices

Let’s understand the Current account from the perspective of an economy first. Current Account is a part of Balance of Payment for a country, the other part being the Capital Account.

Factors of Current Account for an economy

As we can see from the chart above, Imports and exports form a major part of current account of a country. If import is more than the export of a country, it leads to a current account deficit for the country which is the case in a country like India.  

Imports for India in 2011-12:               $ 485 bn

Exports for India in 2011-12:               $ 300 bn

Oil and Gold imports are two major contributors of rising current account deficit in India. India spent a staggering $ 160 billion to import crude oil in 2011-12, an amount equivalent to more than half of the country's total earnings from exports during the same period. Gold is the second major import item for India after petroleum and constituted 11.3 per cent of total imports in 2011-12 in value terms. A current account deficit in excess of 2.5% of GDP is seen as worrisome in case of India. (Source: Bureau of Economic Analysis)

But why write this article on effect of CAD on housing prices? The rationale to emphasize on current account deficit is the dependence of Indian economy on large foreign capital inflows.

House price changes depend on certain macro-economic factors such as GDP per capita, inflation, mortgage rates as well as current account deficits of the country.

HP = c + β₁ GDPC + β₂ INF + β₃ MR + β₄ CAD + €

Where,

GDPC = Gross Domestic Product of India per capita

INF = Inflation %

MR = Mortgage rate (% per year)

CAD = Current Account Deficit/GDP (%)

€ = error

All I am trying to say is that changes in house price would depend on certain macro-economic factors as mentioned above. As we can see, current account deficit is one of those factors. Literature published on effects of CAD on House price changes states that CAD has a positive effect on the house price changes. At first look it seems that increasing real estate prices is good for a country with significant current account deficits. This is because lenders feel comfortable in providing credits on seeing the increasing valuation of the property.

But then, there is a threshold point beyond which lenders start feeling uncomfortable about the economy as a whole and quality of collaterals in particular. I assume this is what happened during the sub-prime mortgage crisis in U.S. Moreover, increasing valuation makes people wealthier, leading to increasing purchases which in turn leads to increase in imports. When people start investing in houses, prices of which are rising, more and more money gets relocated to the construction sector thereby reducing investments in manufacturing sector, thereby reducing exports and increasing imports of construction material. This increases CAD even further.

Capital inflows should help reduce the CAD instead of aggravating it further. If such inflows are invested in real estate, it will only increase the prices further. I think an in depth research should be conducted in this field by real estate companies to understand the effects of CAD and realize the future of real estate in the coming months. Because ever increasing CAD in India currently can actually prove devastating. FDIs are surely considered a boon for an economy, especially one where the economy is suffering from CAD. Such inflows are welfare improving. But in the absence of proper rules and regulations, it can also prove to be a bane for the economy.