Financial Stability Review – March 2006 The Macroeconomic and Financial Environment
1.1 The International Environment
Recent global developments have been broadly positive from a financial stability perspective, although concerns remain about the pricing of risk in global markets. The world economy is continuing to expand at an above-average pace, volatility in financial markets has been unusually low, and banking systems in most countries are experiencing strong profitability. In this environment, investors have been prepared to purchase historically risky assets at relatively high prices, and have also been prepared to take on more debt. Given this, a concern for some time now has been that the apparently optimistic expectations that underpin many asset valuations and borrowing decisions may not be realised, prompting sharp adjustments in a range of markets. To date, however, this has not happened, with the global financial system showing resilience to a range of developments.
In the past three years, growth in world GDP has averaged around 4½ per cent, well above its long-run average of around 3¾ per cent. This strong growth is forecast to continue in 2006, with the composition of global growth expected to be more balanced than it has been for a number of years. In particular, there are signs that the recovery in Japan is becoming more firmly entrenched, and that prospects for economic growth in the euro area are improving (Table 1).
Against the backdrop of solid growth outcomes, problem-loan expenses in many banking systems have declined, and there have been few defaults on corporate bonds. Indeed, the current global default rate on speculative-grade bonds is around record lows, after reaching very high levels in the immediate aftermath of the high-tech boom (Graph 1). These favourable developments have coincided with low volatility in a range of financial markets. Investors expect that this will continue, with measures of implied volatility (extracted from option prices) in most major foreign exchange, interest rate and equity markets all around multi-year lows (Graph 2). The main exception to this general pattern is commodity prices, which have shown considerable volatility at times over the past couple of years.
Another notable feature of the current environment is that yields on most long-term bonds continue to be well below their long-run averages, although they have increased a little recently (Graph 3). Ten-year bond yields in Japan, the euro area and the United States currently stand at 1.7 per cent, 3.7 per cent and 4.7 per cent respectively. The continuation of low bond yields has occurred despite the removal of at least some of the monetary stimulus that has been in place over recent years (Graph 4). The United States is the most advanced in this process, with the federal funds rate now at 4½ per cent, up 3½ percentage points from its low and slightly above the average level of the past 15 years. In the euro area, the policy rate has been increased by 50 basis points, and currently stands at 2½ per cent, while in Japan the central bank has announced the end of its quantitative easing policy.
There are a number of possible explanations for the low level of bond yields. One is that inflation expectations are well anchored, reflecting the price stability over the past decade or so. A second is that there is an ex ante excess supply of global saving over investment. And a third is that the low level is attributable to structural and regulatory factors. In the United Kingdom, for example, both pension funds and corporates with defined-benefit pension plans are seeking to better match the duration of their assets and liabilities, spurring an increase in demand for longer-dated nominal and inflation-linked securities.
The low levels of both bond yields and policy interest rates have contributed to strong growth in borrowing in a number of countries, particularly by the household sector. In turn, this has boosted asset prices, and especially house prices, in these countries (Graph 5). Investor interest in commercial property has also increased in the past year or two, resulting in a strengthening in commercial property prices, particularly in the United States and the United Kingdom (Graph 6 and Box A).
The current environment has led to investors being prepared to accept less compensation for holding historically risky assets and to take on investments with more leverage. There are a number of manifestations of this general phenomenon.
One is the low level of credit spreads on bonds issued by emerging markets and companies with low credit ratings. These spreads have fallen a little further recently, and are around their lowest levels since 1997 (Graph 7). Partly in response to these very positive borrowing conditions, an increasing number of emerging market countries have been able to issue long-term debt in their own currency, a positive development from the sovereign's perspective as it reduces the country's foreign currency exposure and rollover risk (Table 2).
A second is a sharp rise in leveraged buy-out (LBO) activity. The value of LBOs is now back around the levels of the late 1980s, although in contrast to that episode when much of the activity was concentrated in the United States, there is now considerable activity in Europe and Asia. While LBOs, or the threat of them, can strengthen the management of firms, they can also lead to more fragile corporate structures by reducing available cash flow. The prospect of debt injections weakening the position of existing creditors in firms subject to LBOs is, in some cases, leading to increased spreads on debt issued by these firms.
A third factor pointing to a greater risk appetite is the growth of investments in hedge funds. According to Hedge Fund Research, these funds now have in excess of US$1 trillion under management, more than double that of five years ago (Graph 8). This growth is likely to have contributed to an increase in leverage of the financial system as some hedge funds hold highly leveraged positions in derivatives markets and borrow from financial institutions. There has also been borrowing by ‘funds of hedge funds’ – asset management vehicles which invest in a range of hedge funds. While hedge funds generally have a relatively small capital base, they have a systemic dimension via their close relationship with financial institutions providing prime-brokerage services, and through the potential for the unwinding of large positions in individual asset markets to cause market disruption.
Finally, there has also been strong growth in structured credit markets. Issuance of credit products tailored to the risk-profile requirements of investors has increased significantly – according to JPMorgan, global issuance of funded collateralised debt obligations (CDOs) in 2005 was nearly US$300 billion, compared with around US$190 billion in 2004. The reallocation of this credit risk within the financial system is generally a positive development from a financial stability perspective. However, the complexity and embedded leverage attached to some of the newer products is not without its challenges when it comes to assessing how markets will perform in periods of stress. This was evident last year following the rating downgrades of General Motors and Ford, when liquidity in some CDO instruments quickly evaporated and prices spiked after investors and market-makers began questioning some of the assumptions that had been used to price these products.
These various developments do not pose particularly large risks on their own and can be seen as part of the evolution of a competitive and efficient global financial system. However, collectively, they paint a picture of a financial system in which risk is being very finely priced and one in which investors are increasing leverage. To the extent that, going forward, the macroeconomy, inflation and asset prices are more stable than they have been historically, this behaviour is understandable. The concern, however, is that the expectations underpinning many pricing and borrowing decisions might turn out to be too optimistic.
While financial markets have been resilient to a range of events over recent years, a more serious test would obviously occur if global economic growth were to falter. A shock such as an avian influenza pandemic could also pose difficulties for financial markets, as could a substantial pick-up in global inflationary pressures. Other possible catalysts for a reassessment of risk in global financial markets include an increase in borrower defaults and a sharp unwinding of ‘carry trades’ as the period of zero per cent financing in Japan eventually comes to an end.
One aspect of the current expansion that has been the subject of vigorous debate has been the changes in current account balances. In particular, the ex ante excess level of global saving over investment has manifested itself in large current account deficits in several industrialised economies, most notably the United States. For a number of years there have been concerns in some quarters that the deficits are unsustainable and would eventually trigger disorderly movements in global markets. This has not happened, and these concerns seem to have dissipated somewhat over the past year. Instead, there seems to be a broader acceptance that the existing current account positions will persist for some time yet, and are unlikely to be a source of turbulence in major markets
The strong global economy has provided a favourable platform for international financial institutions over the past year. Banking sector share price indices have trended higher as bank earnings have risen, despite continued contractions in interest margins (Graph 9). Most notably, the share prices and profits of Japanese banks have increased markedly as economic conditions have improved, the demand for bank lending has strengthened, and the level of non-performing loans has fallen.
In the euro area, bank profits in many countries have risen as increases in housing lending and non-interest income have combined with lower provisions for bad debts. Banks in the United Kingdom have also reported strong returns over the past year, owing largely to improved non-interest income from trading activities. Similarly, bank profits have grown solidly in the United States, with relatively weak growth in net interest income offset by very strong growth in non-interest income from trading and other activities.
The global insurance industry withstood the large natural catastrophe losses in 2005 relatively well, aided by solid premium revenue and strong investment markets. The insured loss associated with Hurricane Katrina, which hit the United States in August, is estimated to be more than double the previous highest single-event loss (associated with Hurricane Andrew in 1992). The reinsurance industry is expected to bear a large part of this loss. As a result, several reinsurers had their credit ratings downgraded, and a few had to raise additional capital. Overall, however, share price indices for the insurance sector weakened only moderately following the hurricanes and have rebounded somewhat in the euro area and Japan (Graph 10). Credit markets also appear comfortable with the outlook for the sector, with spreads on insurers' credit default swaps, which rose in the aftermath of Hurricane Katrina, falling significantly in subsequent months.
As with the international environment, domestic developments have been largely favourable from a financial stability perspective. Growth in house prices and household credit has moderated from the very fast pace seen at the end of 2003, and the business sector's financial position remains sound, buoyed in particular by strong profit growth in the mining sector. As a result of these developments, the issue is less one of unsustainably fast growth rates in house prices and household debt, than of the implications of the much higher level of household debt arising from more than a decade of strong credit growth.
As has been documented in previous Reviews, there have been significant changes in the structure of household balance sheets in Australia over the past decade (Graph 11 a, b, c, d). The ratio of household debt to income has more than doubled to just over 150 per cent, and the ratio of interest payments to income has increased from an average of 6¾ per cent in the 1990s to almost 11 per cent currently. Similarly, the ratio of house prices to income has increased markedly, although with national house prices little changed over the past couple of years, this ratio has fallen a little recently. Measures of household leverage have also increased, with growth in housing debt consistently outpacing growth in the value of the housing stock.
These longer-term adjustments in household balance sheets are a reflection of some fundamental changes to both the demand and supply side of the housing finance market in Australia. On the demand side, the lower nominal interest rates associated with lower inflation have allowed households to take on larger debts. In addition, the relative stability of interest rates and the economy have given households greater confidence that they can service larger debt burdens. On the supply side, the stable macroeconomic environment and very low mortgage default rates by borrowers have encouraged lenders to compete more keenly to provide housing finance on cheaper and more flexible terms.
Nonetheless, by 2003, there were clear signs that the housing market had become overheated. Fuelled by speculative activity, annual rates of growth in both house prices and household borrowing were around 20 per cent. These developments were associated with very strong growth in spending: consumption and expenditure on renovations and new dwellings were at very high shares of income. The concern was that should growth continue at an unsustainable pace, it would ultimately pose significant risks to the stability of the economy. Developments since 2003, however, have proved largely favourable, with a cooling in the housing market and a slowdown in household credit growth.
On a national basis, house prices have shown little change since the end of 2003, although the outcomes have varied considerably across the major cities, reflecting both the relative strength of economic growth and the extent of previous price rises (Table 3). Prices in Perth have recorded significant further gains, while in Sydney, prices are lower than at the end of 2003. Over recent months, there have been some tentative signs of firmer conditions in a number of markets, with auction clearance rates in Sydney and Melbourne around their highest levels of the past two years.
Growth in household credit has also slowed significantly from its peak, although recent outcomes suggest it has again picked up slightly. Housing credit, which accounts for 86 per cent of total household credit, grew by 12¾ per cent over the year to January, down from a peak year-ended growth rate of almost 22 per cent in early 2004 (Graph 12). The deceleration has been most pronounced in borrowing by investors, which grew by 11 per cent over the past year, down from a peak of around 30 per cent over the year to February 2004.
One factor contributing to more subdued housing credit growth has been the slower rate of turnover in the residential property market, with property transactions as a proportion of the dwelling stock falling from over 7 per cent in 2003 to around 5 per cent in 2005. When turnover slows, housing credit growth also tends to slow given that the debt taken on by home buyers is typically greater than the amount of debt owed by sellers, particularly when house prices are rising rapidly.
Personal credit growth has also slowed, with growth of 10 per cent over the year to January, compared with around 15 per cent over the year to early 2004. The deceleration has been most notable in personal loans secured against residential property, while in contrast, there has been a marked pick-up in growth of margin loans used to purchase equities and to invest in managed funds (Table 4). Credit card debt continues to grow at around 12 per cent per year, around the average rate over the preceding four years. Data on other specific components of personal credit are not collected, although recent figures on personal loan approvals suggest that growth in car loans has eased over the past year, while that in loans for debt consolidation has picked up, consistent with other indications of some households consolidating their finances.
An aspect of the slower growth in house prices and household debt since late 2003 has been the decline in investor participation. The share of loan approvals granted to investors has fallen from a peak of 46 per cent in late 2003 to 36 per cent recently, with the decline greatest in New South Wales. Further, the share of households that view property investments as the wisest place for their savings has also fallen, to around the levels prevailing in 2000 (Graph 13).
Among investors, the absence of capital growth appears to have prompted a more measured assessment of prospective risks and returns. Around late 2003, the national vacancy rate had risen above its long-run average, and traditional valuation yardsticks such as the ratio of house prices to household income and rental yields were at historical extremes (Graph 14). At a national level these ratios have recently reversed a little of the previous movements, with the average vacancy rate falling, growth in income outpacing that in house prices, and rental yields rising as a result of average rental growth of 4.7 per cent per annum since the end of 2003. Notwithstanding this, both house price-to-income ratios and rental yields remain well away from their long-run averages, although the relevance of historical comparisons is complicated by the structural shift to lower inflation and lower interest rates.
Although growth in owner-occupier activity in the housing market has also slowed since late 2003, the fall has been less pronounced than that in investor activity, and since mid 2005 loan approvals to owner-occupiers have picked up (Graph 15). The recent increase partly reflects stronger demand for finance by first-home buyers, with this group accounting for 25 per cent of the value of owner‑occupier approvals in the December quarter, the highest share since the March quarter 2002. Several lenders now offer first-home buyer schemes whereby borrowers can use the property of family or friends as security to access cheaper funds and/or larger loans. The expansion of low-doc and no-deposit products is also facilitating access for some borrowers that were previously excluded from the market. Refinancing activity has remained strong, reflecting competition in the mortgage market (Graph 16). Over the past couple of years, the average size of owner-occupier refinanced loans has increased at a faster pace than new loans, suggesting some tendency for households to increase loan size while refinancing.
Notwithstanding the slowing in house price growth, the value of assets owned by the household sector continues to grow faster than household income. Over the three quarters to September 2005, the total value of household assets increased at an annualised rate of 7¾ per cent, with the buoyant stock market boosting overall asset growth in the face of slower growth in the value of housing assets (which currently account for just under 60 per cent of the total) (Graph 17). The years post 2003 are the first since 1998 in which the increment to household wealth from assets other than housing has exceeded that from housing.
While the household debt-to-income and debt-servicing ratios, as well as measures of household gearing, continue to reach new highs, it is difficult to establish benchmarks as to when levels of indebtedness or credit growth become ‘too high’ or ‘too risky’. Although it is clear that a continuation of the combination of developments seen in 2003 was unsustainable, it is far less clear what constitutes a sustainable rate of household credit growth. For one thing, attitudes towards debt appear to be changing, with people becoming more willing to borrow against assets later in life. Also, a significant number of households still carry little or no debt, and may choose to borrow more in the years ahead. Some insight into the potential for the household sector to increase borrowing can be gleaned from the ABS Household Expenditure Survey, which shows that only a little over one third of households had owner-occupier housing debt in 2003/04. At that time, the average owner-occupier debt-servicing ratio (including principal repayments) was 25.6 per cent, with this measure lower among the higher income households that owe the bulk of owner-occupier housing debt and have higher net assets (Table 5).
To date, there are few signs that the current level of indebtedness is causing the household sector difficulties. This is perhaps not surprising given the favourable macroeconomic environment, with the ongoing strength of the labour market delivering solid income growth. Over the year to December 2005, real household disposable income grew by 5½ per cent, and the unemployment rate currently stands at 5.2 per cent, around its lowest level in three decades (Graph 18).
The higher level of indebtedness has, however, increased the sensitivity of the household sector to movements in interest rates, and appears of late to have prompted some households to take a more cautious approach to their finances. This is suggested by an easing in the very strong growth previously seen in consumption and housing-related expenditure. In early 2004, annual real growth in consumption was running at over 6 per cent, taking spending to an historically high share of household disposable income. More recently, however, growth in spending has slowed and is currently running a little below that in household disposable income (Graph 19). Similarly, spending on renovations and new dwellings has eased, but remains high relative to historical averages.
At the same time, there is little evidence of distress among households. Survey results show that while the share of respondents that consider their personal financial situation better than a year ago has declined since 2004, it remains above its long-run average (Graph 20). In recent years, trends in sentiment have been broadly similar amongst those households that own a home outright, and those that own a home with a mortgage or rent.
Similarly, while arrears on bank housing loans have recently increased a little, the arrears rate remains quite low relative to the average of the past decade (see Financial Intermediaries chapter). Bank credit card arrears also remain at low levels by historical standards. Credit card cash advances – a relatively expensive way of obtaining cash more likely to be used when households are in financial difficulties – have not increased in average size, although the total amount withdrawn has grown with the rise in the number of cards on issue. Over the past year, total credit card repayments have exceeded total new spending on credit cards, with growth in credit card debt outstanding largely accounted for by interest charges (Graph 21).
Overall, the cooling in housing markets and the associated moderation in household credit growth has been a welcome development. The household sector is taking a somewhat more cautious approach to its finances and there are few signs of stress. Nonetheless, the higher level of indebtedness has increased the vulnerability of the household sector to any unexpected deterioration in the hitherto generally favourable economic and financial climate.
At the aggregate level, conditions in the business sector have continued to be very favourable, with high profits and the debt-servicing ratio remaining around historical lows. This overall strength owes in large part to the significant rise in the terms of trade over recent years which, together with the relatively stable exchange rate, has created an extremely strong environment for the resources sector (Graph 22).
Total business sector profits – as measured by national accounts data for private non-financial corporations and the unincorporated sector – increased by 9.6 per cent over the year to December 2005 and, as a share of GDP, are well above the average of the past 15 years. The increase over the past year mainly reflects growth of 53 per cent in corporate mining profits (Graph 23). Among the non-mining corporate sector, and unincorporated enterprises, profit growth has slowed in recent years, in line with moderating growth in domestic demand.
Strong corporate profitability has been reflected in large gains in share prices. At the aggregate level, the ASX 200 is up by 21 per cent over the year to March (Graph 24). The increases have been largest in the resources sector, with the ASX Resources index 39 per cent higher over this period. Share prices in most other sectors have also recorded solid gains over the past year, with the telecommunications sector a notable exception. In aggregate, the share price increases have been well supported by earnings growth, so there has been little change in the price/earnings (P/E) ratio of the ASX 200, with this ratio around its 50-year average. Equity analysts are generally optimistic about future profits, with expected earnings per share being frequently revised upwards over the past few years as earnings surpass expectations (Graph 25). These upward revisions to forecasts have been particularly large for resource companies' earnings.
While continued strong profit growth means that businesses' internal funding as a share of GDP is around the highest on record, external fund raising has risen strongly in recent years, and as a share of GDP is the highest in 15 years. This is most evident in intermediated business credit, which grew by 16.3 per cent over the year to January, the strongest growth in a decade and a half (Graph 26). Firms have also been raising capital directly through financial markets, with solid issuance of non-intermediated debt and net equity raisings 25 per cent higher in 2005 than in 2004. The demand for business funding is consistent with the very strong growth in business investment, which is at its highest level as a share of GDP since 1989, and buoyant conditions in intermediated and wholesale finance markets.
Notwithstanding strong growth in intermediated debt, total business debt as a multiple of profits is below previous peaks (Graph 27). The business sector remains well placed to service the increased debt as interest payments as a share of profits have increased only slightly from historically low levels, primarily reflecting the underlying strength in profits. The effect of interest rate increases in recent years has also been partly offset by a contraction in lending margins. The spread over the cash rate of the interest rate paid on bank loans to business has declined by around 35 basis points over the past three years to 135 basis points, a little over half of what it was 10 years ago.
The commercial property market continues to show few signs of the excesses that caused difficulties in the early 1990s. Non-residential construction, as a ratio to GDP, remains well below the peak reached during that period, despite a steady increase in recent years. Although national office and industrial property price indices have both risen significantly over the past year, in real terms they remain well below their 1989 peaks (Graph 28). Available data suggest that other aspects of the market have also firmed over the past year with a decline in office vacancy rates and an increase in rents in many markets, notwithstanding some variation by city. As in residential property, the commercial property market has been particularly strong in Perth, with the office and industrial indices rising by 15 per cent and 19½ per cent respectively over 2005.
The current positive operating environment is reflected in attitudes of businesses, financial market participants and rating agencies. The NAB Business Survey for the December quarter shows generally favourable perceptions of business conditions, and business confidence around its long-run average, albeit somewhat below the high levels seen in late 2003 and 2004. Confidence remains strongest in the mining sector and weakest in the retail and wholesale sectors. Credit default swap premia and corporate bond spreads remain at low levels, indicating that financial market participants see low credit risk in the corporate sector (Graph 29). Among rating agencies, Standard & Poor's made more rating upgrades than downgrades for Australian corporates over 2005.
While the health of the business sector is clearly dependent on the overall economy, the strength of corporate profitability and debt-servicing capacity suggests that the sector is comfortably positioned from a financial stability perspective. This is not to say that all segments of the business sector are equally well placed. Clearly the current environment is particularly strong for those involved in, or servicing, the resources sector. But business surveys and liaison reports indicate that conditions are less positive in parts of the manufacturing industry, which are being affected by the slower growth of the domestic economy and strong competition from abroad.
See Reserve Bank of Australia (2005), ‘Collateralised Debt Obligations in Australia’, Financial Stability Review, September. 
For a discussion of changes in housing ownership see Reserve Bank of Australia (2005), ‘Box A: Rates of Indebted Home Ownership’, Financial Stability Review, September.