The different economic phases that Portugal faced had relevant implication on the housing market, particularly through the credit channel and the impact of households’ wealth on consumption. Therefore, a macroeconomic perspective may help understand the interaction between business cycle and house prices. Portugal today is regarded to be an example of economic resurgence and the real estate market is a clear sign of such revival. But what are the drivers that encouraged this dynamic?
The capital inflow curse
In 1990 the commitment of Portugal to join the Eurozone induced an output boom and a large current account deficit. Portugal at the time was a relatively wealth country, but the poorest among the others joining the Euro, and characterized by a relatively high level of unemployment. The expectation for an integrated credit market generated optimistic behaviors. Portugal – as other Southern European countries – was deemed from international creditors, while ECB strengthen anti-inflationary policy, borrowing rates decreased and the country experienced a large capital inflow. The latter came with a boom in consumption. Households reduced their savings and borrowed more in order to smooth consumption. The credit market was particular audacious when granting private loans and the balance sheet effect contributed to amplify the pro-cyclical business cycle. In fact, the real estate prices, before joining the euro zone, were relatively low, but they went through an inflationary path when the euro fever started spreading. The collaterals’ value expanded such that households could easily obtain more credit. In accordance with the Law of one Price, an excess demand in both tradable and non-tradable goods, led to a price expansion in non-tradable goods. Accordingly, wages in the in the non-tradable sector raised.
When the financial accelerator stopped working, the boom phase turned into a slump. The disappointment raised from the euro induced a decrease in the aggregate demand because firms reduced investments. Moreover, households decreased spending, since they faced a high level of debt. The result was a low growth rate, 1.1% on average over 2002-2007, far below the euro zone growth, and a consistent increase in unemployment rate from 4.4% in 2001 to 8.7% in 2007. In 2006, Oliver Blanchard – chief economist at the International Monetary Fund – was asked to assess the macroeconomic Portuguese status. He stressed that one of the main reason that lead the country to a subsequent downturn phase was a significant increase in households debt and a boom in consumption raising because of unrealistic expectation of default.
(Mis)allocation of resources
During the slump eve, the real exchange rate appreciated of almost 12%, and most of the variation is linked to the increase in prices of non-tradable sector. According to the Balassa-Samuelson effect, when nominal exchange rates are fixed – like in the Eurozone – the real exchange rate appreciation is due to an increase in productivity. This dynamic could have explained what drove to the Portuguese slump, if the economy had showed an income convergence among the Eurozone and an increase in productivity in the tradable sectors. Nonetheless, while the borrowing rate converged among countries in the Eurozone, a productivity growth gap arose. Growth in Euro area was more than twice in Portugal and while unemployment was falling in Europe, it was growing in Portugal. Blanchard first contribution to the Portuguese study case suggested that an intervention to push wages down, would have helped the economy to operate at its natural potential or at least to reduce the large unemployment rate. The process was supposed to be a painful one, but necessary to prevent a sudden stop to occur. After the financial crises his conviction was dismantled.
The contribution to the Portuguese economist, Ricardo Reis, seems to better analyze the future shock that the country faced, enlightening the repercussion on the housing market. His theory states that the illusion of the boom determined the reallocation of employment from the tradables to the non-tradables, but the flow was uneven among sectors. Community services, wholesale, retail trade registered an expansion, while construction and real estate deteriorated seem to expand rapidly and suddenly burst during the slump. According to Reis, the sectors growing relatively more during the slump were also the ones with the worst productivity.
The 2008 financial crises propagated in Portugal, like in other European countries, and the cost of capital clearly increased. The credit market become extremely tightened, despite the effort of the ECB and Banco de Portugal to inject funds. In order to face the liquidity shortage, a significant fiscal expansion arose. However, the growth rate turned negative in 2009. Moreover, Portugal faced a Euro crises just after the financial crises, such that the credit supply turned to be even more tightened. The two shocks combined induced the country to face a sudden stop. Sudden stops usually arise because of a rapid arrest in capital flow, forcing the countries to go from a large deficit in the external balance to a surplus, in order to repay the debt. However, Troika program for Portugal aimed to mitigate the sudden stop consequences through liquidity provision and imposing austerity measures.
The financial accelerator operated the other way around during the downturn phase. In accordance with the balance sheet effect, the average property price in Portugal dropped by 2.84% to €1128 per sq.m. As the environment became riskier, banks started charging higher interest rate, imposing a higher cost of debt repayment. For households, the credit market became inaccessible, while firms reduced their investment even more. Worries about the debt sustainability were spreading among the public opinion and the expectation of a dark future induced an increase in private savings. The aggregate demand declined sharply as a consequence of the reduced investments and the cut in expenditure.
While the upward change during the boom phase happened in a protracted period, the sudden stop required an abrupt adjustment. However, the Portuguese labour market was unable to adjust wages and prices in order to face the international competitiveness. During the slump most jobs were highly protected and covered by permanent contract. The rigidity of the market did not accommodate a smooth shift or resources to the non-tradable sectors, such that the productivity had been negatively affected.
The Portuguese housing market suffered a lot from the crises, and the average mortgage rate steady at 2.34% was a clear sign. Households stopped buying real estate since they had no access to the credit market. The demand for real properties dampen, while an increase in rental housing was recorded. For long time old buildings were abandoned and got deteriorated, such that the negative effect on the housing market was even amplified. One of the objective of the Troika memorandum for Portugal included the liberalization of the housing market, that also involved a decrease in restrictions on foreign property ownership in Portugal.
Since 2014, GDP growth in Portugal became positive again, but its growth rate is still timid. Nonetheless, the gradual recovery of the economy is reflected on the constructions sector and the housing market. After more than three years of depression, house prices in Portugal started to recover in 2014 and the same trend is registered for the productivity in the construction sectors. The Bank of Portugal highlights the investment in houses has been growing way above the economic activity rhythm. Yet, most of the capital corresponds to equity capital and comes from other countries. The question to account for is whether the house prices are being over-evaluated or they are a consistent sign of the Portuguese recovery.
To conclude, it has been highlighted that the financial market liberalization impacted the development of the housing market in different ways. First of all, a reduced borrowing rates generated euphoric behaviors in the credit market. The consequences spread to consumptions and investments through the financial accelerator. Second, a large capital inflow generate an inflationary trend in the non-tradable sector, thus a resallocation of employment. When the boom phase came to an end, the economy struggled to stabilize. The wage stickiness in the Portuguese labour market prevented the supply side to adjust, having a negative effect on productivity. Currently the Portuguese economy is recovering and real estate prices are growing promptly. Is this time different?
Ornella Dellaccio 
Banco de Portugal (2014). The Dynamics and Contrast of House Prices in Portugal and Spain. Economic Bullettin. pp.39 – 52.
Blanchard, O. (2006). Adjustment within the euro. The difficult case of Portugal. Portuguese Economic Journal, 6(1), pp.1-21.
Blanchard, O. and Portugal, P. (2017). Boom, Slump, Sudden Stops, Recovery, and Policy Options: Portugal and the Euro. SSRN Electronic Journal.
Reis, R. (2013). The Portuguese Slump and Crash and the Euro Crisis. Brookings Papers on Economic Activity, 2013(1), pp.143-210.