First International Conference on Construction In Developing Countries (ICCIDCI) Advancing and Integrating Construction Education, Research & Practice

August 4-5, 2008, Karachi,, Pakistan

The Effect of Macroeconomic Policies on Project (Housing) Finance In Emerging Economies

Adeboye Akinwunmi School of Engineering and the Built Environment, University of Wolverhampton, Wulfruna Street, Wolverhampton WV1 1SB, United Kingdom. adeboyeakin@yahoo.co.uk Rod Gameson School of Engineering and the Built Environment, University of Wolverhampton, Wulfruna Street, Wolverhampton WV1 1SB, United Kingdom Felix Hammond School of Engineering and the Built Environment, University of Wolverhampton, Wulfruna Street, Wolverhampton WV1 1SB, United Kingdom Paul Olomolaiye. School of Engineering and the Built Environment, University of Wolverhampton, Wulfruna Street, Wolverhampton WV1 1SB, United Kingdom

Abstract
Most countries in the emerging economies have their financial institutions regulated by government. With the notion that financial institutions have become less regulated in the developed economies, emerging economies like China, India, Brazil and Nigeria are gradually adopting deregulation as a pivotal form of governance. Various macroeconomic policies adopted in these countries using monetary and fiscal instruments have limited the ability of their financial institutions to provide long term lending in the form of syndicated loans and bond issuance needed for infrastructural development, project finance and in particular housing finance. It is obvious that the housing sector is closely connected to the overall economy, and therefore, macroeconomic instability has a negative effect on the housing market. This paper examines the impact of various instruments of macroeconomic policies on lending activities by the financial institutions to the housing sector. It is concluded that there is the need for the countries in the emerging world to adopt investment friendly and risk averse macroeconomic policies as well as develop the bond and pension fund markets in order to provide the needed finance for the housing sector.

Keywords
Emerging Economies, Developed Economies, Housing Finance, Infrastructural Development, Macroeconomic Policies.

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1. Introduction
The application of wrong macroeconomic policies to solve economic problems being encountered by millions or even billions of individuals/families in a sovereign country could have a devastating effect on that economy, whether developed or emerging. These macroeconomic policies are described as captured impacts of exogenous interventions at the aggregate or economy-wide level (Burda and Wyplosz 1997; Hammond 2006 and Roy 2007). The macroeconomic policies so adopted might be classified as Traditional Macroeconomic or Dynamic General Equilibrium Macroeconomic. Under the Traditional Macroeconomic system tutelaged by Keynes in The General Theory (Keynes 1936), the emphasis was on the short-run behaviour of the economy, why the economy seemed to persist in a state of disequilibrium and how to bring it back to equilibrium (how to stabilize the economy).However the central issue in Dynamic General Equilibrium (DGE) is the inter-temporal nature of decisions: whether to consume today, or to save today in order to consume in future. DGE models are forward looking and hence inter-temporal. These financial activities could be achieved by holding financial assets or by borrowing against future income. These decisions could be arrived at, through an 1 E-mail: adeboyeakin@yahoo.co.uk economy-wide market system and by market prices (Wickens 2008). Economic agents take 3 different types of decisions. They relate to goods and services, labour and assets: physical assets (the capital stock, durables and housing) or financial assets (money, bonds and equity) each wit its economy-wide market. The theory of finance is largely related to pricing of financial assets, and financial assets play a crucial role in macroeconomics and sometimes substitutes in wealth portfolio. Therefore, for a typical houseowner, the house is a major physical asset in his portfolio and for many household, the purchase of a house represents the largest (and often only) life long investment and a store of wealth (Goodman 1989; Malpezzi 1999). To this end, this paper discuss some clarifications, review factors that have contributed to the cost-efficient nature of housing finance in developed economies and effect of macroeconomic policies on housing finance in emerging economies. The remainder of the paper is structured as follows: Development of Bonds and Pension Funds in Emerging Economies as alternative source of funding housing finance and problems encountered in the growth process of Bonds and Pension Funds in Emerging Economies.

2. Conceptual Clarification
2.1 Definition of Emerging Economies The words Emerging and Developing economies are interchangeably used, it is a term coined in 1981 by Antoine W. van Agtmael of International Finance Corporation, a part of World Bank. It is simply defined as an economy with low-to-middle per capita income. Such countries constitute approximate 80% of the global population, representing about 20% of the worlds economies (Obadan 2006 and Upadhyay 2007). Developing countries have existed for a long time, and for much of their history, they have attempted two related tasks- to build their local financial institutions / markets and to attract international investment. A growth in foreign investment by a country is an indication that the country has been able to build confidence in its local economy (Upadhyay 2007). As time goes by, the word used to describe these countries and their markets have undergone considerable change. Between the 1950s and 1960s, it was common to speak of underdeveloped countries. From 1970s to 1980s, it was changed to more polite less developed countries and from 1990 upwards, they are referred to as emerging financial market (EME). The name is a reflection of a worldwide change of ideas, away from state-sponsored development and toward the opening of free markets bringing a bust of progress and performance (Beim and Calomiris 2001).

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The definition of emerging economy was given in Luo (2002) as A country in which its national economy grows rapidly, its industry is structurally changing, its market s promising but volatile, its regulatory framework favors economic liberalization and the adoption of a free-market system and its government is reducing bureaucratic and administrative control over business activities. Luo (2002) however noted that it is misleading to assume that emerging economies are homogenous. Luo (2002) identified some commonalities and distinctions among them. The common factors identified are Legal infrastructures are made up of legal system development and enforcement, which are generally weak; factor market and institutional support needed for economic development and business growth are weak (factor market such as capital market, labour market, production materials market, foreign exchange market and information market are generally underdeveloped and still intervened governmental institutions and departments);emerging markets tend to experience faster economic growth than other types of economies but this growth is often accompanied with uncertainties and volatilities; emerging economies are often featured with strong market demand, especially from middle-class customers. The distinction amongst the different nations of the emerging economies as identified by Biem and Calomiris (2001) ; Luo (2002) included being not possible to determine by size, while countries like China, India, Brazil, Russia and Mexico are large, we have other smaller emerging states especially in the Asia-Pacific Region. While some nations adopt fiscal and monetary policies to oversee their national economies, countries like India, China and Indonesia manages their national economies by adopting fiscal, monetary and administrative policies. 2.2 Corporate Finance, Project Finance and Housing Finance Corporate Finance: Corporate Finance is considered as a way of raising funds for the expansion of an existing organization. There are two broad ways of raising finance which might be through equity or debt issuance. Equity finance gives its suppliers the right to the firms residual returns after payment to the suppliers of debt finance. However, debt finance on the other hand yields a fixed return to its suppliers (Edward and Fischer 1994; Buckle and Thompson 1998). In some cases, the funding required might be so large that two or more financial institutions comes together to execute the financing. The process of loan syndication is however time consuming. The corporate term loans provider has a lien /recourse to the corporate assets of the organization raising the finance. Retained Earnings constitute a large percentage of sources of finance (Buckle and Thompson 1998; Tirole 2006). Project Finance: When funds are being raised to execute a specific project, it is called Project Finance. Pretorius et al (2008) noted that multinational corporations (MNC) has the widest possible array of financing options available to finance any feasible chosen projects and identified constraints encountered in choosing project financing to include: Corporate consolidated balance sheet constraints Public sector financing constraints The Contractual discipline and focus impose on project managers working on contracts being executed with borrowed funds. Housing Finance: Housing Finance is a major factor determining the quality and tenure of housing consumption, the overall financial portfolio of the public and the stability and effectiveness of the financial system (Diamond and Lea 1992). Struyk and Turner (1986), Stephens (2000) noted that the housing finance plays an important role in shaping each countrys wider housing system and the housing system takes important social and economic consequences.

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3. Factors Affecting Housing Finance in Developed Economies.

In the developed economies, Gyntelberg (2007); Girouard (2007) and CGFS (2006) identified factors that contribute to the cost-efficient and efficiency of their housing finance system to include: Macroeconomic Trends and Developments, Advances in Information Technology with financial innovations, Deregulation / Financial Liberalization, Broadened Mortgage contracts, Funding sources for lenders and supportive Government Policies. These factors are briefly discussed below:

3.1 Macroeconomic Trends and Developments

We have three types of macroeconomic issues that have played fundamental roles in the development of the housing finance markets in both the developed and the emerging economies (Gyntelberg 2007; Girouard 2007 and CGFS 2006). While they have made positive impacts in the developed economies, the opposite is the case in most of the emerging economies. Firstly, the level and volatility of inflation and then interest rates have declined. Secondly, output growth has become more stable. The available evidence suggests that this decline in nominal interest rates has stimulated both the demand and supply of mortgage loans. In terms of lower output volatility, the lower frequency and severity of economic downturns has reduced the volatility of household income and may have contributed to an increased attractiveness of flexible rate mortgages and a willingness to assume higher debt burdens. Gyntelberg et al (2007) argued that if lower interest rates are perceived to be permanent, households can thus afford to borrow more, which tend to push up house prices. Also, rising disposable incomes in the household sector and faster economic growth and lower output volatility in many countries have aided house price increases because households can afford to pay more for their homes. Higher incomes combined with lower interest rates also meant that more households can gain access to the credit market, thereby helping to boost demand for houses and housing finance. Demographic factors may have also influenced house price development (CGFS 2006 and Gyntelberg et al 2007). As an example, in the United Kingdom and Denmark, there are signs that the proportion of first-time buyers in relation to the total population may have a positive impact on house prices. When a large number of first-time buyers enter the market, the demand for houses increases, leading to a rise in prices and ultimately an increase in the demand and supply of housing finance.

3.2 Advances in Information Technology with financial innovations

Improvements in Information Technology Advances in computer programs, database and statistical computation methods, coupled with financial innovations, have created higher efficiency (CGFS 2006 and Gyntelberg et al 2007). When these improvements are combined with increased competition, it has helped to reduce credit institutions margins- which are the difference between cost of mobilizing deposit and the cost of lending, which resulted in the lowering of mortgage rates. Technological improvements have also aided the enablement of better pricing of risk and return on the underlying collateral and meant that it is easier for borrowers and lenders to obtain information about each other. Also, households can now choose between a wide range of mortgage contracts with different terms and conditions. Despite the fact that the variable-rate contracts stand out as most attractive option, in some other countries, there is also a growing interest in loans with interest-only payments over a number of years, or even loans with an initial negative amortization plan (CGFS 2006; Gyntelberg et al 2007).

3.3 Deregulation and Financial Liberalization

Deregulation and Financial Liberalization have made various changes in housing finance markets attainable in several countries over the past two decades (CGFS 2006; Gyntelberg et al 2007 and Girouard

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et al 2007). Issues considered as official barriers and credit restrictions have been relaxed or removed as governments have reassessed the legal and regulatory framework in which financial institutions operate. Over time, regulatory framework of financial institutions have moved from focus entirely on safety- for example, consumer protection and prevention of failures towards enhancing efficiency through market discipline, supervision and risk-based capital guidelines.

3.4 Broadened Mortgage Contracts

In both developed and emerging economies, many countries have embraced wider varieties of mortgage contracts. Notably, countries that historically relied predominantly on fixed rate mortgages have seen a growth in the use of variable rate type mortgages. In addition to the increased product choice, many housing finance markets have had a trend towards higher loan-to-value (LTV) ratios (Jappelli and Pistafferri 2000; CGFS 2006 and Gyntelberg et al 2007), partly reflecting changing market practice and regulatory changes, resulting in lower down payments for housing loans.

3.5 Funding Sources for Lenders

There are differences across markets with respect to funding patterns. In Europe, the dominant funding mechanism remains deposits which consumers place with banks as savings or in current accounts. However there is a problem with this type of funding for mortgage loans in that short-term liabilities are being used to fund long-term assets (EMF 2007 and Akinwunmi et al 2007). As at the end of 2006, the European Mortgage Federation estimated the total value of residential mortgage outstanding in the European Union being funded as shown in Table 1 Table 1: Sources of Mortgage Funding in the EU Sources of Funding Retail Deposits Mortgage / Covered Bonds Mortgage-Backed Securities (MBS) Others Percentage 66% 15-20% 5% 9-15%

Source: European Mortgage Federation (Feb. 2007) Deposits have historically been the dominant source of funding, but capital market funding or securitization is becoming increasingly important (CGFS 2006 and Gyntelberg et al 2007). A large portion of mortgage loans are held off-balance sheet and funded through securitization in the United States, but securitization remain relatively costly and capital intensive in Europe. Mortgage / Covered Bonds continue to be very popular and the second most popular funding instrument in Europe after retail deposits and there is no centralized issuing institutions (Van Order 2000 and Akinwunmi et al 2007). In summary, all these attributes have contributed to the cost-effective and improved efficient nature of their housing finance system with a low-cost of credit intermediation and significant increase in the availability of funds and range of contract terms. In the next section, the paper discusses the effect of macroeconomic policies on housing finance in the emerging economies.

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4. Effect of Macroeconomic Policies on Housing Finance in Emerging Economies

With the magnitude of housing needs in most of the countries in the emerging economies, Buckley & Kalarickal (2004) and Hassler (2005) argued that a stable macroeconomic condition is one of the requirements that emerging economies must embrace and attain. These macroeconomic policies are impacts of exogenous interventions at the aggregate or economy-wide levels (Burda and Wyplosz 1997; Hammond 2006 and Roy 2007). Macroeconomic instability and its corollary of high and volatile domestic interest rates have a disproportionate impact on long-term mortgage finance. Various factors contributes to greater macroeconomic volatility in emerging markets, the most important is that their production structure is typically much less diversified than that of developed countries and often dependent on primary commodities. The macroeconomic policies might be adopted to affect (decrease / increase) in the nominal interest rate, or volatility of inflation, which has affected the efficiency of housing finance. In differentiating between housing affordability and housing finance affordability, Buckley et al (1994) argued that housing finance affordability arises when inflation makes housing unaffordable at the market rates of interest. This resulted in indexation as means of addressing the housing finance affordability problem especially in the Latin America and few African countries like Ghana. Therefore, the objective of indexation and redesigning mortgage contracts is to eliminate financial constraints that impede the affordability of housing and provide a financing vehicle so that those who can afford to and so desire, can purchase homes (Buckley et al 1993). In most countries of the emerging markets, the financial regulatory bodies (the Central Bank), have used policies like Cash Reserve Requirement (CRR) and Liquidity Ratio as instrument of monetary policy and variation of tax rate as instrument of fiscal policy. Cash Reserve Requirement is the percentage of the banks total deposit liabilities to be kept in an account with the monetary authorities. This policy is adopted to control volume of funds available for financial institutions in granting loans and advances. Recently, the Central Banks of both China and India raised the reserve requirement for banks several times in 2008 to mop excess liquidity with interest rate left unchanged (The Economist 2008). Also, in Nigeria, the CRR was increased from 3% to 4% in June 2008. This 1% increase, when multiplied with the total deposit liabilities within the Banking system, it has a multiplier effect for credit creation. However, unlike the Central Banks in the developed economies, Central Banks in the emerging economies cannot be considered to be independent and urged by their employers (the government) to hold interest rates so low to boost growth and jobs. In the emerging economies, the inflation rate is on the upward trend. This might be attributed to surge in food and energy prices. Food accounts for a bigger slice of spending in poor countries and they have bigger impact on inflation. Core inflation rates are moving up due to lax in monetary policies, Chinas official rate of consumer-price inflation is at a 12-year high of 8.5% from 2.2% in early 2007, Russias have moved from 8% to over 14%, Indias wholesale-price inflation rate (the Reserve Banks Preferred measure) is 7.8%, a four-year high, Indonesia inflation rate is 9% and likely to hit 12% by June 2008, when government is expected to raise the price of subsidized fuel by 25-30% (The Economist 2008). In Nigeria, the inflation rate was 8.2% in April 2008 and interest being increased from 10% to 10.25% in June 2008.

4.1 Loanable Funds Theory and the rate of interest

The Loanable Funds theory of the rate of interest developed by Knut Wicksell, a Swedish Economist, in 1898 has been central to the theory of interest rates. According to Philbeam (2005) and Nwaoba (2006), the Loanable Funds approach views the interest rate as being determined by the supply and demand for loanable funds in the financial market. The theory explains that investments and savings determine the long-term level of interest rate whereas the financial and monetary conditions in the economy

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determines the short-term interest rate, while the equilibrium interest rate is such that it clears both the money market and the loanable funds market. The increase in the supply of loanable funds necessitates downward trend in the cost of funds and interest rate, all other things being equal. Alternatively, an increase in the demand for loanable funds exerts pressure on the available loanable funds resulting in a rise in the cost of funds and interest rate. This position was supported by Turner (2007 & 2002) where it was argued that the rise in inflation rate, with action not being taken about interest rate resulted in the virtual elimination of long-term, fixed rate local currency debt in several countries of the emerging world, which needed long-term investment for infrastructural development.

4.2 House Mortgages and Gross Domestic Product

The Macroeconomic policies adopted in the emerging economies have contributed to the low investment in their housing sector as shown in Table 2 below: Table 2: House Mortgages as a Percentage of GDP (2006) Country Morrocco Nigeria India Korea Thailand Malaysia Taiwan Hong Kong Germany Singapore USA United Kingdom Denmark House Mortgages Percentage of GDP 2% 2% 4% 14% 18% 23% 37% 60% 52% 68% 86% 72% 90% as a

Source: Saravanan (2007) Having looked through the part played by macroeconomic policies in housing finance in emerging economies, a searchlight is to be made towards the bonds and pension funds markets as an alternative means of funding long-term investment particularly housing finance.

5.0 Bonds and Pension Funds in Emerging Market Economies

The Bank for International Settlement Paper No 11 highlighted the major reasons for developing a bond market in most countries of emerging economies as predominantly to finance government fiscal deficits. The fact that they had a highly regulated financial sector before the 1980s, governments in these countries usually meets their funding requirements by making it mandatory for local banks to hold government paper as part of reserve requirements. With the progressive liberalization of the financial systems, adoption of anti-inflationary policies and flexible exchange rate, governments were being forced to borrow from the domestic markets. Other reasons include: Making financial markets more complete by generating market interest rates that reflect the opportunity cost of funds at each maturity. To avoid concentrating intermediation uniquely on banks.

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Such markets can help the operation of monetary policy. A well functioning money market is essential for the smooth transmission of policy as monetary policy relies increasingly on indirect instruments of control. Again, prices in the long-term bond market give valuable information about expectations of likely macroeconomic developments and about market reactions to monetary policy moves.

Blommestein and Horman (2007 p.17) while assessing Debt Management and Bond Markets in Africa described situation in South Africa as follows: The bonds markets in South Africa are relatively advanced. There is a well developed market for government securities, and corporate bonds have seen significant growth in recent years, although the latter still account for only 10% of the bond market. An issue for South Africa is to ensure that the government does not crowd out the corporate market. The situation in Nigeria was described as follows: Successful initiatives regarding domestic securities have included lengthening the maturity structure and smoothening the redemption profile. Much of domestic issuance is undertaken not to fill a funding gap but, instead, to provide securities to the market for its development. This statement about Nigeria regarding issuance of debt instrument might not be correct in all cases. Recently, the Federal Government of Nigeria is raising $400 million form the Capital Market to finance affordable housing projects, which is a funding gap. Out of about $300 million bond raised by Federal Mortgage Bank of Nigeria (FMBN) earlier on in 2004/2005, FMBN has disbursed a total of $94 million through 41 Primary Mortgage Institutions (PMIs) and $188million disbursed to private estate developers for estate construction as at December 2007 (Onyebuchi 2008). 5.1 Pension Funds in Emerging Market Economies The pay-as-you-go social security systems in the emerging market economies are being replaced by fully funded, defined-contribution pension systems (Chan-Lau 2005). With this reformation, asset under management in the pension fund subsector of these economies are fast growing. Chile, the most cited example of pension fund development in emerging market economies with her bond market development, launched a funded pension system in 1981. From that negligible level in 1981, the pension assets grew to about 60% of GDP in 2003, Bolivia pension assets amounts to 30% of GDP in 2005, six years after the introduction of pension reforms (BIS 2002; Chan-Lau 2005). With the removal of government bureaucracy from the savings for retirement process, pension reform has contributed in raising the savings rate, fostering the growth of institutionally managed assets and developing a strong domestic investor base. Reisen (2000) and Chan-Lau (2005) noted pension reform contributed to improvement in savings rate in Chile, Malaysia, Singapore and Korea. While Mackenzie et al (1997) and Chan-Lau (2005) argued conditions under which pension reform can increase a countrys savings rate. Chan-Lau (2005) noted that in Asia, retirement income is the sole responsibility of government through national provident fund. In Malaysia and Singapore, governments sponsor a fully funded, defined-contribution system for civilian workers but in Korea, the national pension system is fully funded but offers defined-benefits. However, Asher (2000), Holzmann et al (2000), Chan-Lau (2005) observed the main challenge to the systems being government intervention in the funds investment decisions. In Sub-Saharan Africa, for example in Nigeria, with the introduction of fully funded, defined-contribution pension systems through the Review of the Pension Reform Act of 2004, the pension fund was valued at $6.67 billion as at December 2007. Under the Pension Reform Act of 2004, Pension Fund Administrators, PFAs are given the responsibility of managing pension assets by investing in the following financial assets: Equities 30% Money Market 35% State Government Bonds 20%

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 Federal Government Bonds 100% Real Estate Investment Trust/ Mortgage-Backed Sec. 30% This is an opportunity for the Federal Government to have access to funds when bonds are floated for long-term investment purposes (Udenze 2006). 5.2 Problems in the Development of the Bond / Pension Fund Markets in Emerging Market Economies. The growth process of these markets in the emerging economies has been hindered by the following factors: Narrowness of the domestic investor base: In the developed economies, the domestic investor base is broad and they are made up of banks, pension funds, insurance companies, mutual funds which are all active participants in the market. In most of the emerging market economies, the main holders of local currency bonds are domestic banks and public financial institutions (Turner 2007). As it is, most of these financial institutions have low capital base that they are more interested in meeting their day-to-day obligations and invest in short-term assets. Even in recent survey by the Asian Development Bank, it was found that local market-makers in Asian Bond Market had a belief that a diversified investors base was the most important requirement for improving the liquidity of the local bond markets (ADB 2006). The expansion of funded pension systems can even create internal non-bank demand for local currency bond. Issuance dominated by government: Corporate bond markets in Emerging Market Economies remain underdeveloped and the development of securitization has been poor. Securitization is a way of transforming long-term assets into trade-able instruments with minimal credit risk. Government in Emerging Economies seeking to stimulate securitization can learn from German Pfandbrief model which is well-suited for a bank-centred financial system (Fritsch 2004). Liquidity of the Markets These markets are still in the early stages of development and some large investors adopt buy-and-hold attitudes that limit the liquidity and effective pricing mechanism in the markets. This buy-and-hold attitude impedes the development of secondary market and contributes to high interest rate.

Conclusion
For an economy to develop, it is important to have its financial system reformed. A reformed and deregulated financial system that works well would allow both households and firms to borrow against increase in permanent income. By increasing the marginal propensity to spend permanent income, an early stimulus to domestic demand would be provided. In most countries of the emerging economies, especially those with regulated financial systems, the bureaucracy in government circles have slowed down, if not totally eliminated competition and dynamism within the financial system. The development of local currency bond markets can improve the macroeconomic and financial stability of a country and even countries that have not yet establish a low-inflation financial environment can access benefits of bonds markets by issuing inflation-linked debt to finance their long-term investment, which are hitherto being reluctantly financed by the commercial banks.

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