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Building boom best warning sign of an imminent debt crash, says IMF

Phil Thornton
A man works near buildings under construction in Mumbai,India, Saturday, 1 February, 2020 (AP Photo/Rafiq Maqbool)

Financial regulators worried about a repeat of the boom-bust cycle that has plagued many western economies including the UK should keep an eye out for a jump in the number of builders, according to the International Monetary Fund.

Based on analysis of crashes in both advanced and developing countries stretching back to the 1970s, it found that long-lasting debt-based booms that featured a surge in construction activity always ended in tears.

The worst booms — that is, the costliest of the bad booms, based on the severity of the ensuing recession — are associated with higher growth in the construction sector during the boom phase.

The pace of construction activity during the boom phase is a better predictor of the economic costs associated with bad booms than other signals including household borrowing, that has traditionally been seen as a warning sign.

Deniz Igan, the deputy chief of the IMF’s research department's macro-financial division, highlighted the example of Spain in 2008 where the property market crashed, triggering loan defaults and bank failures. She said that construction employment has surged 47 per cent in the run-up to crash compared with 27 per cent across the economy as a whole.

“Our research shows that the experience with the dangerous combination of credit booms and rapid expansion in the construction sector goes beyond the Spanish borders and extends to time periods not related to the global financial crisis,” she said.

“We find that signals from construction activity may help to tell apart the dangerous booms, which need to be controlled, from the episodes of buoyant but healthy credit growth or ‘good booms’.”

A good boom tends to last around three years with moderate growth in lending and borrowing. A bad boom, on the other hand, lasts for longer but is followed by a major economic downturn or even a systemic financial crisis.

“An unusually rapid expansion of the construction sector helps flag bad credit booms,” Igan said, adding that a one percentage point increase in employment growth in the construction sector during a boom raises the probability of the boom being bad by five percentage points.

The IMF, which also acts as global financial watchdog, urged policymakers to keep a watch for rapid expansions in activity in and lending to the construction sectors.

The fund does not recommend raising interest rates but instead using other tools such as imposing higher deposits on mortgage-funded house sales or limits on banks’ exposure to real estate developers and other construction firms.

Despite the event-present display of cranes on the skyline of London and other UK cities, the construction sector been contracting for the last eight months according to the monthly purchasing managers index (PMI).

The PMI for January published last week showed that employers continued to cut back on their workforce. “Construction firms are not yet ready to scale

up plans to increase workforces in the coming months without a stronger economic and political recovery clearly in sight,” Duncan Brock, Group Director at the Chartered Institute of Procurement & Supply said at the time.

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Rising interest rates will not yet lead to another financial crash