Financial Stability Review – September 2005
1. The Macroeconomic and Financial Environment
1.1 The International Environment
Over the past year, financial systems around the world have enjoyed favourable operating conditions. In most countries, financial institutions' profits have been high, and earlier fears of costly adjustments in financial markets have not been realised.
These favourable outcomes partly reflect the continued strength of the world economy. In 2005, growth in world GDP is forecast to be around 4¼ per cent, well above the average of the past 30 years, although somewhat slower than the very strong growth in 2004 (Table 1). The Chinese economy continues to expand rapidly, and domestic demand in the United States has been growing solidly. In Japan, recent indicators of economic activity have also been encouraging. In contrast, in Europe there continue to be few signs of a sustained recovery.
One of the important factors underpinning these generally good growth outcomes has been the historically low level of policy interest rates in many countries. Interest rates in the United States, Japan and the euro area have all been well below average in recent years, with policy rates in all three areas being at their lowest levels in 40 years in early 2004 (Graph 1). While the Federal Reserve has recently unwound some of the monetary stimulus in the United States, increasing interest rates by a cumulative 2.75 percentage points since mid 2004, interest rates there are still at relatively low levels. In Japan and the euro area, policy interest rates remain at historic lows, and elsewhere around the world there are few countries in which interest rates are above long-term averages.
This combination of generally low interest rates and good economic growth has, to date, not been associated with a generalised pick-up in inflation. Indeed, in a number of countries, inflation outcomes have been lower than anticipated, and expectations are that inflation will remain in check, despite significant increases in commodity prices, particularly oil prices.
In contrast to low goods and services price inflation, recent years have seen significant upward pressure on asset prices around the world. This is evident not just in commodity markets, but also in government bond markets, where price increases have seen long-term bond yields fall to historically low levels. In the United States, 10-year bond yields are currently lower than they were in June 2004 when the Federal Reserve initiated the current tightening cycle, in contrast to the experience in previous tightening cycles in which long-term bond yields increased, at least initially. The downward pressure on bond yields is also evident in the corporate and emerging bond markets, where spreads are currently around their lowest levels for some years (Graph 2).
Upward pressure on asset prices has also been evident in many residential property markets, although the timing and magnitude of price increases has varied from country to country. The United States has recently had this experience, with house prices in a number of states recording substantial gains over the past year or so (Graph 3). For example, house prices in California, Florida and Nevada all increased by more than 20 per cent over the year to June 2005. Many stock markets have also recorded significant gains over the past couple of years (Graph 4). The global MSCI share price index, for example, is 62 per cent higher than its 2003 trough. Share markets in the traditionally more risky emerging countries have recorded larger gains, with the MSCI Emerging Markets index rising by 21 per cent over 2005 to be more than double the level at its 2003 trough.
These strongly performing asset markets have recently coincided with a further reduction in investors' perceptions about future volatility. In the United States, the implied volatility of 1-year swap rates (calculated from options prices) has fallen to its lowest level since 1998, suggesting that market participants view it as unlikely that there will be significant monetary policy surprises in the period ahead (Graph 5). Similarly, the implied volatility of 10-year yields and the main stock market indices are also at very low levels.
This combination of increases in asset prices and relatively low volatility has contributed to a willingness of investors to increase their indebtedness, and to purchase assets at historically high prices, including those assets traditionally viewed as quite risky. One example of this general phenomenon is that bond issuance in domestic currency by emerging market sovereigns more than doubled in 2004, and has picked up further in 2005. There has also been substantial growth in hedge fund activity, with some funds moving into a broader range of markets and investments, partly in response to the difficulty of generating high returns in a low-volatility environment (Graph 6).
The general trend to greater leverage is also evident in the household sectors in a range of countries, with households increasing their borrowings mainly for the purpose of housing. In turn, this has reinforced house price appreciation over recent years and supported strong consumption growth. These trends have been most evident in the predominantly English-speaking countries, reflecting their more liberalised financial systems and their better growth outcomes. In North America, household debt is currently growing at around the fastest rate for more than a decade, and while growth rates in household debt have recently eased in Australia, New Zealand and the United Kingdom, they remain higher than in many other parts of the world (Graph 7).
Recent developments in the United States show some parallels with those seen earlier in Australia and the United Kingdom. There has been increased interest in investment properties and some lowering of lending standards as intermediaries compete for business. At the same time, households have increasingly taken advantage of higher property prices to access unrealised capital gains. While loan refinancing to benefit from lower interest rates has been a common practice in the United States for many years, in recent years there has been a pick-up in the number of households taking out larger loans when refinancing in order to extract equity from their homes. In 2003 and 2004, the amount of equity withdrawn through these so-called ‘cash out’ refinancings was the equivalent of over 1½ per cent of annual household disposable income, up considerably from the experience in the 1990s (Graph 8).
From a financial stability perspective, the concern is that the increase in prices and leverage across a range of asset markets might be sowing the seeds for future problems. In many markets, there seems to be considerably more scope for asset prices to fall than to increase. From this perspective, as is usual when financial imbalances emerge, the earlier any adjustments occur, the less likely they are to be damaging to the economy.
Predicting the timing and cause of any adjustment is intrinsically difficult. It is plausible (although probably undesirable) that the current situation will continue for a number of years yet. One possible trigger is a generalised reassessment of risk in global financial markets. Such a reassessment could occur for a number of reasons, including, for example: a shift in international capital flows; a further increase in oil prices; the default of a significant borrower; or an unexpected rise in inflation. While some of the pre-conditions are in place for quite abrupt swings in sentiment and prices to occur, some reassessment of risk in the immediate period ahead would be likely to reduce the probability of potentially costly adjustments later on.
The continuing strength of the global economy has provided positive conditions for financial institutions over the past half year. Bank sector share prices in most major countries are around the highest level for the past few years, with earnings buoyed by lending growth and low levels of non-performing loans (Graph 9). In the United States, strong growth in housing and business loans coupled with increased fees have boosted profits of large banks, though the flatter yield curve has acted as a drag on interest margins. Across the euro area countries, strength in housing lending growth, reduced provisions for bad debts and cost savings have improved bank returns. Large Japanese banks have continued their recovery, reflecting better macroeconomic conditions and falling levels of non-performing loans.
Operating conditions have also been generally favourable in global insurance markets, notwithstanding considerable insured losses arising from Hurricane Katrina in the United States. This hurricane may be the single most expensive natural catastrophe on record – preliminary estimates are for insured losses of US$40-60 billion – prompting Standard & Poor's and Fitch to downgrade their outlook for some major global insurers and reinsurers affected by the disaster. Nonetheless, the insurance industry's ability to absorb such claims will be supported by strong underwriting and investment returns over recent years. In the United States, holdings of short-term interest-bearing securities, a significant component of insurers' investment portfolios, have benefited from the rise in short-term interest rates since mid 2004. Profits have also been strong among European insurers, as relatively high premium rates have supported underwriting results and investment returns have benefited from rising share prices. Global life insurers have also experienced relatively benign operating conditions over recent years.
As with the international situation, recent developments in Australia have been favourable. The correction in the housing market has, to date, proceeded smoothly, without damaging either the macroeconomy or financial institutions, and has helped alleviate earlier concerns of a potentially more damaging adjustment at some point in the future. There are also welcome signs that households are taking steps to consolidate their finances, after a period of particularly rapid growth in borrowings, much of it to invest in property. While this adjustment is weighing somewhat on consumption growth, the strong global environment and significant increases in Australia's terms of trade flowing from commodity price increases are important offsetting influences on overall activity. The latter developments are contributing to a strong corporate sector, where balance sheets remain in good shape.
Over the past year and a half, there has been a marked change in the Australian housing market. Nationwide, average prices have been broadly flat over this period, following an increase of almost 20 per cent in 2003, and an average annual increase of 11 per cent over the preceding seven years (Graph 10).
This cooling in conditions is evident in all capital cities, although it is most pronounced in Sydney where house price growth during the boom was higher than elsewhere (Table 2). Averaging across the various available measures, the median price of a house in Sydney declined by around 5 per cent over the year to June 2005, while prices in Melbourne and Brisbane have been broadly stable. In most other capital cities, prices have risen, albeit at much slower rates than previously.
This adjustment in the housing market comes after the previous boom pushed the ratio of house prices to household disposable income to very high levels, not just by the standards of Australia's past experience, but by international standards as well. With house prices flat recently and household incomes continuing to rise, this ratio has fallen but remains high; Australia-wide, the median house price is around 5½ times average annual household income, with the ratio considerably higher in Sydney (Graph 11). Similarly, stable house prices, combined with modest growth in rents, has seen the gross rental yield on houses increase a little since 2003, although yields remain very low in terms of both historical and international experience.
A particular characteristic of the Australian housing boom was the very strong demand for property from household investors. At the peak of the boom, housing loan approvals to investors accounted for an unprecedented 45 per cent of total loan approvals (Graph 12). Since then, approvals to investors have fallen more markedly than those to owner-occupiers, with the result that loan approvals to investors currently account for around 36 per cent of total housing loan approvals. In contrast, the share of loan approvals to first-home buyers has increased over the past two years, although it remains below its historical average.
The strong demand by investors during the boom is also evident in data from the Australian Taxation Office. Over the 10 years to the 2002/03 financial year (the latest year for which data are publicly available) the share of individuals reporting rental income increased from 10 per cent to 13 per cent. Many individuals appear to have bought property in the expectation of substantial capital gains, with rental income often below financing and other costs. In 2002/03, 60 per cent of property investors claimed a rental loss (i.e. deductible expenses exceeding rental income), with the average loss experienced by these investors almost $5,500. Five years earlier, 51 per cent of individuals reported a loss, with the average loss below $4,000.
The turnaround in the housing market has been associated with a slowdown in the pace of household credit growth, although recent revisions to the credit data suggest that the slowdown is less marked than previously thought. Over the six months to July 2005, household credit increased at an annualised rate of 13 per cent, down from a peak growth rate of around 20 per cent in the second half of 2003. As noted above, the slowdown has been more pronounced in borrowing by housing investors, which is currently growing at an annual rate of around 12 per cent, down from over 30 per cent at its peak.
The overall slowdown in household credit growth is linked to the change in price trends and the substantial fall in turnover in the housing market. In 2002 and 2003, around 7 per cent of the housing stock changed hands, considerably above the average turnover rate of preceding years (Graph 13). By itself, an increase in turnover tends to increase credit growth, as sellers typically have less debt remaining on properties being sold than the debt taken on by purchasers (unless the purchaser is downsizing). This is even more so during a period in which prices increased significantly.
While household credit growth has slowed, it continues to outstrip growth in household disposable income by a reasonable margin. As a result, the ratio of household debt to disposable income has risen further to 150 per cent as at June 2005 (Graph 14). The increase in housing debt in recent years largely reflects an increase in average loan size, though it is also partly explained by an increase in the number of households with owner-occupier housing debt (see Box A).
Both as a result of higher debt levels, and the increase in mortgage rates earlier this year, the ratio of aggregate household interest payments to disposable income has increased further to 9.8 per cent, the highest level on record. The total repayment burden, allowing for principal repayments, is higher again relative to past experience, given the increase in average loan size. In addition to aggregate measures of indebtedness and the debt-servicing burden, the distribution of debt across households is important in assessing the sensitivity of the household sector to changes in economic and financial conditions. Available data show that the bulk of housing debt is owed by upper-income households, who tend to have lower debt-servicing burdens and relatively higher assets than lower-income households.1 Among borrowers with housing debt, those with the highest debt-servicing burdens, or the smallest buffers on which to fall back in adverse circumstances, are often those that have taken out loans only recently as well as lower-income households and investors.
In contrast to the general slowdown in household credit growth, refinancing activity by owner-occupiers has increased substantially over 2005, after falling for a period from late 2003 (Graph 15). In part, this pick-up reflects the strong competition in housing finance markets, which has seen many borrowers seek a change in loan terms and conditions. In addition, some households have also refinanced to tap the existing equity in their home.
The slowdown in household credit growth largely reflects an easing in housing-related credit growth, rather than a slowdown in the pace of personal borrowing. Over the past 12 months, personal credit – which, in total, represents around 15 per cent of household debt – has increased by 14 per cent, down slightly from the recent peak of 16 per cent in early 2004. Within personal credit, outstanding debt on credit cards has increased by around 13 per cent over the past year, much the same rate as in the previous three years, and well down on growth rates in the late 1990s (Graph 16). Growth in other components of personal credit, including ‘personal’ borrowing using a line of credit secured against housing, has tended to slow. An exception to this is margin lending (used to purchase equities and invest in managed funds) which has increased by around twice the pace of overall personal credit growth over the past year. Despite this strong growth, the average number of margin calls per day has declined, reflecting the buoyant stock market. As at June 2005, total outstanding margin loans equalled $18 billion, compared with total credit card debt of $28 billion, and total housing-related debt of $676 billion.
With nationwide house prices broadly flat, the ratio of the household sector's assets to annual income has generally stabilised over the past year or so, after increasing steadily from the early 1990s; as at March 2005, total assets were equivalent to around 7.6 times household disposable income (Graph 17). Over the year to March 2005, the household sector's holdings of equities and superannuation fund assets increased by 16 per cent and 18½ per cent, respectively, largely reflecting the strong equity market over this period. Combined, these two asset types account for 22 per cent of the household sector's total assets, while housing assets account for 61 per cent of total assets.
The combined effect of higher levels of debt and slower growth in the value of assets has seen the household sector's gearing ratio increase further over the past year. At end March 2005, the ratio of household debt to the total value of household assets stood at 17 per cent, up from 16 per cent a year earlier (Graph 18). The increase in the ratio of housing-related debt to the value of housing assets has been somewhat larger over the past year, reflecting the fact that the value of housing assets has grown considerably more slowly than the value of financial assets owned by the household sector.
While measures of household indebtedness, debt servicing and leverage have all increased recently there are few signs that the household sector is having difficulty meeting its financial obligations. According to survey measures, consumer sentiment was around its long-term average in September 2005, notwithstanding falls over the year from historically high levels. The level of housing loans in arrears remains very low, although the ratio of arrears to total housing loans has increased a little over the past year (see Financial Intermediaries chapter). Similarly, credit card arrears remain at a low level, although these have also marginally increased recently. There has been no increase in the average size of cash advances per credit card account (an expensive way of obtaining funds), with the total value of advances in the June quarter around 5 per cent higher than a year earlier, though the series is volatile. Similarly, the ratio of monthly credit card repayments to outstanding balances has not changed materially over the past year, although it is down a little from its peak in 2002 (Graph 19).
To a significant extent, these favourable outcomes are attributable to the continued strength of the Australian labour market and the corresponding growth in household incomes. The unemployment rate is currently at 5 per cent, the lowest level since the mid 1970s, and over the six months to August 2005, employment has increased at an annualised pace of 3.6 per cent (Graph 20). Over the first half of 2005, real household disposable income increased at an annualised rate of 3.6 per cent, and more recently, growth has been further supported by the round of income tax cuts that took effect from July.
Assessment of vulnerabilities
The softer housing market and the slowdown in the pace of growth of household credit are welcome developments from a financial stability perspective. Had the trends evident in earlier years continued over the past year and a half, the risk of a disruptive adjustment at some point in the future would have increased significantly. The concern was not that such an adjustment would directly imperil the health of the financial system. But it could have ushered in a period of unusually weak consumption growth and thus weak economic growth which would make for more difficult operating conditions for financial intermediaries.
To date, the adjustment has proceeded smoothly. Household spending growth has slowed from the unsustainable pace of earlier years as households have taken a more cautious approach to their finances. Consumption, nonetheless, continues to grow at a solid rate; over the year to the June quarter, it increased by 3 per cent, compared with peak annual growth of more than 6 per cent over the year to the March quarter 2004. Recent growth has been broadly in line with growth in household incomes, so that the saving rate has stabilised after a long period of decline (Graph 21).
There has also been a significant slowdown in the growth of renovation spending. Over the year to the June quarter, total spending on alterations and additions (in real terms) was broadly unchanged, after growing at an average annual rate of 11 per cent over the previous three years. Despite the slowing, spending on renovations as a share of GDP remains at a historically high level.
Taken together, spending on renovations and investment in new housing over the past year has been exceeded by the increase in housing-related credit, suggesting that the household sector has continued to withdraw equity from the housing stock (Graph 22). The amount withdrawn over the past year is, however, significantly down on that withdrawn over the year to June 2004. This decline is to some extent the result of lower turnover in the property market, although it also reflects the more cautious approach by households to their finances.
Looking forward, risks remain in both directions.
On the one hand, there is a risk that the property market will reignite and household credit growth will again accelerate. This risk, however, looks to have receded further over the course of the year. Investor interest in housing has declined significantly, and fewer people report that housing is the wisest place for their savings than was the case at the peak of the boom (Graph 23). In addition, the recent price falls in some locations are likely to have dispelled the notion held by some households that residential property prices never fall. High levels of indebtedness and debt servicing, and the current high level of house prices relative to income, also suggest that the boom is unlikely to reignite.
On the other hand, the adjustment in household balance sheets and the housing market could turn out to be more disruptive than seen to date, although again the risk of this occurring seems to have declined a little over the past six months. The economy is currently benefiting from strong increases in the terms of trade and above-average growth in the world economy, and employment has been growing strongly (Graph 24). There are few signs of financial stress in the household sector and measures of consumer sentiment are around their long-run average levels. In the property market, auction clearance rates have increased from their trough, although they remain below historical averages, and the average time to sell a property has stabilised over the first half of this year, after increasing over the second half of 2004. Notwithstanding this assessment, the high levels of household debt make the household sector vulnerable to a change in the generally favourable economic and financial climate. Given this, developments in household sector finances and the housing market will bear close watching in the period ahead.
Conditions in the business sector remain highly favourable. Trading conditions and profitability are strong, especially in a number of export-related industries, and though indebtedness has recently increased, the sector's overall debt-servicing ratio remains low by historical standards.
Corporate sector profits, as measured by private non-financial corporate sector gross operating surplus (GOS), grew by almost 10½ per cent over the year to June 2005, and as a share of GDP, are at their highest level on record (Graph 25). This reflects both the recent strength in profits, and the longer-run trend towards incorporation by unincorporated businesses. In contrast, profitability of the unincorporated sector rose only slightly over the year to June, partly as a result of the effect of the drought on farm production. Overall business sector profits, as measured by total private non-financial GOS, rose by 7½ per cent over the year.
The recent increase in corporate profitability is largely accounted for by the strong growth in profits in the mining sector; over the year to June, profits in this sector were up by 52 per cent, reflecting the strength in the global economy and favourable terms of trade (Graph 26). In contrast, after strong growth in preceding years, profits in domestically focused sectors have stabilised recently in line with the general slowing in domestic demand. In a number of industries there have also been pressures on costs, particularly for skilled labour and raw materials.
The generally buoyant business conditions are reflected in ongoing share price gains, with the resources and mining sector showing particular strength; the ASX Resources market index has risen by 35 per cent over 2005, compared with a 12 per cent rise in the overall share market index. In contrast, the consumer discretionary index has underperformed the market, falling by 5 per cent so far this year, reflecting the slower pace of consumer spending. The bulk of ASX 200 companies that report on a June/December basis have done so for the six months to June 2005, and net profits for those companies are 26 per cent higher than the previous corresponding half. Earnings have typically equalled or surpassed analyst expectations.
Overall, the ASX 200 price/earnings (P/E) ratio has declined over the past couple of years, as growth in reported profits has outstripped price gains (Graph 27). The ratio is currently around 30 per cent lower than its average level since 1995. As with many global markets, volatility has also declined recently and measures of expected volatility derived from options prices are at historically low levels.
Despite the ready availability of internal funds resulting from generally strong profit results, the demand for external finance by the business sector has increased over the past year. This is consistent with very strong growth in business investment, which was up by 16 per cent over the year to June 2005, and is reflected in a pick-up in business credit, which has grown at an annualised rate of around 14 per cent over the six months to July, after average growth of around 6½ per cent over the previous five years (Graph 28). Partly in response to the slowing in housing credit growth, competition among banks for business loans has increased recently, with interest-rate margins falling further and a variety of new products being introduced.
The corporate sector is comfortably placed to service the higher levels of debt. Growth in profits means that the ratios of business debt and interest payments to business profits have been broadly unchanged over the past year, with the ratio of interest payments to profits at a particularly low level (Graph 29).
In the commercial property market there are few signs of the excesses that caused difficulties for companies and lenders in the early 1990s. Non-residential building construction, as a ratio to GDP, remains well below the peak reached during that period, although the ratio has increased over the past few years, and is currently at around its highest level since 1991 (Graph 30). The increase in construction activity reflects the generally favourable conditions persisting across commercial property markets. Over the year to June 2005, average retail property rents increased by 5.7 per cent, continuing the solid growth of recent years. In the sectors for which data are available, prices of capital city office property and industrial property have grown by 3.7 per cent and 9.6 per cent, respectively, over the year to June, although in real terms, both remain considerably below their 1989 peaks.
Australian listed property trusts have performed particularly well in recent years, outperforming the broader market and typically displaying less volatility (Graph 31). The pattern of relative outperformance of domestic property trusts has also been a feature of many offshore markets, consistent with the attraction of high yielding investments in the low-interest rate environment.
Assessment of vulnerabilities
While the health of the business sector is clearly dependent upon the health of the overall economy, the strength of corporate profits and business balance sheets means that the sector does not currently pose a threat to financial stability.
Broad surveys show that business conditions are above their long-run average, albeit somewhat lower than the very high readings of late 2004, consistent with the easing in domestic spending growth. According to the NAB Business Survey, conditions in the mining industry remain by far the strongest, with the retail, wholesale and transport industries more subdued. The positive operating environment is reflected in the views of rating agencies; since end 2003, Australian corporate rating upgrades by Standard & Poor's have outnumbered downgrades.
The overall favourable conditions are also evident in financial markets' assessment of corporate sector health. As noted above, share prices have been high and volatility low. Likewise, indicators of corporate credit risk remain at quite low levels by historical standards, reflecting a perception of low risk by financial market participants (Graph 32).
- See Reserve Bank of Australia (2005), ‘Box A: A Disaggregated Analysis of Household Financial Exposures’, Financial Stability Review, March.