Financial Stability Review – September 2006
The Macroeconomic and Financial Environment
1.1 The International Environment
Developments in the international economy over the past six months have been broadly supportive of financial stability. Global growth remains strong and financial markets have generally coped well with the partial removal of the global monetary stimulus that has been in place since early this decade. At the same time, however, buoyant energy prices and rising capacity utilisation in some countries have contributed to higher headline inflation. Another notable development has been a renewed appetite for debt by the corporate sector, with business credit currently growing at around the fastest rate in more than 10 years in a number of countries.
The world economy continues to expand at a solid pace, with GDP growth expected to exceed 5 per cent in 2006 (Table 1). This is the fourth consecutive year in which growth has been above its 30‑year average. Growth in both Japan and Europe has picked up over the past year, and the emerging market economies, in particular China, continue to expand strongly. Looking forward, global growth in 2007 is expected to remain strong, although forecasts for the United States have been revised down a little recently. These generally favourable outcomes have meant that, over the past few years, the number of corporate defaults has been at a low level, as has the number of credit rating downgrades.
The ongoing expansion of the global economy and strong growth in China have contributed to large increases in the prices of commodities most notably for oil and base metals. As a result, headline inflation has increased, and in many countries, is higher than the average inflation rate of the past decade. There has also been a modest pick-up in underlying inflation in a number of countries. Reflecting these developments, inflation expectations have also been revised up over the course of the past six months.
The strong growth outcomes and higher inflation have led central banks in the major financial centres to tighten monetary policy in the past six months (Graph 1). As noted in previous Reviews, recent years have been characterised by official interest rates in these centres being at very low levels. These low interest rates have encouraged rapid growth in borrowing by the household sector, and have contributed to increases in the prices of many assets as investors have sought higher-risk asset classes as a way of maintaining absolute returns. The withdrawal of some of the monetary stimulus has, therefore, been a welcome development. The process is most advanced in the United States, with the Federal Reserve having increased official interest rates for a 17th consecutive time in June; the federal funds rate now stands at 5¼ per cent, up from 1 per cent in mid 2004. Official interest rates have also been increased in the euro area and Japan, although in both cases the current setting of monetary policy is still generally viewed as expansionary. Monetary policy has also been tightened in a number of other countries over the past six months, including the United Kingdom, Canada, Switzerland, Sweden, Norway and China. In most countries, financial markets continue to view additional increases in interest rates as more likely than reductions; the most notable exception is the United States, where a softer housing market has contributed to market expectations of a decline in the federal funds rate in 2007.
Concerns that the tightening of monetary policy in the largest economies could be the catalyst for significant, and potentially disorderly, adjustments in financial markets have so far proved unfounded. The increases in official interest rates have been well anticipated by markets, and have not led to disruptive adjustments in financial and other asset markets.
Notwithstanding these benign outcomes, the past six months have seen more volatility in a range of markets than has been the case for some time (Graph 2). This volatility mainly reflected concerns about the sustainability of high commodity prices and some higher-than-expected inflation outcomes around mid year. Between mid May and mid June, base metals prices, as measured by the RBA Base Metals Price Index, fell by around 20 per cent (in SDR terms), after having risen by more than 50 per cent since the start of the year. Prices have subsequently recovered somewhat, reversing around half of this decline. Similarly, equity prices in emerging market countries have been more volatile over the past six months, with a number of markets experiencing falls of between 25 and 30 per cent over the five weeks to mid June, before recovering some of these losses in subsequent weeks.
The rise in volatility in these markets was associated with an increase in credit spreads on emerging market and lower-rated corporate bonds in May and June, although in some cases spreads have subsequently declined (Graph 3). Overall, credit spreads remain below their average levels of recent years. Spreads on credit default swap indices also widened around the middle of the year but they remain at relatively low levels. On the whole, financial markets have displayed considerable resilience over the past year or so, riding out a number of potentially disruptive events. These include the downgrading of some major corporate bond issuers, political turmoil in some emerging market economies and large losses at some hedge funds.
Overall, the current valuations in many markets continue to factor in expectations of relatively favourable outcomes in terms of inflation and/or economic growth. Credit spreads remain low by historical standards, and while long-term bond yields have increased since the beginning of the year, the increases have been relatively small when viewed against a background of higher official interest rates and the increase in expected inflation (Graph 4).
While it is possible that outcomes will continue to be generally favourable, valuations remain susceptible to disappointing economic news, as evidenced by the volatility that surrounded the higher-than-expected inflation outcomes mid year. Given this, it is possible that the extended period of monetary stimulus might yet prove more inflationary than widely expected and that more restrictive policies than are currently factored into market prices may be required in some countries. Equally, of course, there is always the risk that disappointing growth outcomes might undermine the optimism incorporated into current valuations.
One particularly noteworthy development over the recent past has been the pick-up in the growth of business credit in a range of countries (Graph 5). This pick-up reflects low global interest rates and solid prospects for economic growth and comes after an extended period in which growth in business credit had been only modest and, in most countries, had been outpaced by growth in credit to the household sector. Another factor boosting business credit growth is the desire by firms to increase their return on equity through higher leverage, particularly given the large increase in merger and acquisition activity over recent years. In the eight months to August, the value of announced global mergers and acquisitions was US$2.2 trillion, nearly 40 per cent higher than in the corresponding period last year (Graph 6).
A related development is the surge in leveraged buyout (LBO) activity. According to Dealogic, the global value of lending for LBOs in the year to June 2006 was US$324 billion, compared with US$200 billion for the corresponding period in the previous year (Graph 7). In contrast to previous periods of high activity, when much of the focus was concentrated in the United States, the latest increase in LBO activity is broadly based, both across countries and industries. While the leverage involved is typically much less than was the case in the late 1980s, it is not uncommon for buyouts to be financed at least two thirds by debt, significantly increasing the leverage of the purchased company. In many cases, the new owners aim to restructure the company and, by taking it private, lessen corporate governance costs and avoid the pressure to meet short‑term performance targets that can sometimes face listed companies. While the existing equity holders can sometimes gain significantly from the purchase premium that is often paid in a LBO, existing debt holders can be significantly worse off if the seniority of their debt is not preserved.
Much of the increase in LBO activity is being underpinned by strong inflows into private equity funds. In the year to June 2006, industry estimates suggest that US$110 billion was raised from investors in the United States by these funds, compared with US$70 billion in the corresponding period a year earlier. These funds have been active in forming bidding groups and arranging debt financing, often secured against the cash flows of the target company. Senior secured debt, which can account for two thirds of the debt raised, is typically provided by banks, while lower-ranking mezzanine and subordinated debt is generally provided by institutional investors, including insurance companies, pension funds and hedge funds.
In addition to private equity, there continues to be large inflows into hedge funds and a strong appetite for structured finance products. This strong demand for alternative investments reflects a number of factors, including the combination of above-average global growth and relatively low global interest rates. As discussed in previous Reviews, low interest rates have prompted investors to seek out alternative higher-yielding investments, and positive growth outcomes have encouraged some investors to revise down their perceptions of the risk involved in alternative asset classes.
Investor inflows into hedge funds remained strong in the first half of 2006 at around US$66 billion, double the average rate of the past three years. These inflows have added depth to a number of financial markets, including the credit derivatives market, as hedge funds are generally quite active portfolio managers. Nonetheless, it is not clear that this liquidity will remain during periods of stress, owing to the very large positions of some hedge funds and the possibility of ‘herd like’ behaviour as funds seek to exit positions simultaneously. Another consequence of the strong growth in assets under management of hedge funds is intensified competition between banks to provide ‘prime brokerage’ services. This competition has led to concerns that banks are reducing margin requirements for hedge funds and providing relatively easy access to finance in order to win business.
Innovations in structured finance have also played a key role in providing access to higher-risk investments. According to the US-based Bond Market Association, global issuance of funded collateralised debt obligations (CDOs) amounted to US$177 billion in the first two quarters of 2006, compared with US$108 billion in the corresponding period last year (Graph 8). One concern is that investors may not fully understand the risks they are assuming, given the complexity of some of the products. This raises the possibility that a less favourable environment, in which the risks become more evident, could be the catalyst for market turbulence as investors adjust their portfolios.
Overall, despite continuing strong demand for historically risky investments, the international financial system has performed well over the past six months. While a continuation of the benign outcomes is possible, at some point conditions are likely to be less favourable than is currently the case. One concern is that in such an environment the basic assumptions that underpin current asset values and investment strategies would need to be reassessed, prompting large and potentially disruptive balance-sheet adjustments. The risk of this occurring is increased by the complexity and lack of transparency of many investment products.
The strong global economy and increase in financial market activity have been a boon for financial institutions. Banks and security houses are reporting record profits and balance sheets continue to expand strongly. The newer segments of the credit risk transfer and structured finance markets, where the risk of illiquidity (and operational risk) is perhaps greatest, continued to operate in an orderly fashion. While banking sector share prices in most countries declined in May due to increased uncertainty about the outlook for growth and inflation, they subsequently recovered much of this decline (Graph 9).
Bank profitability in the United States has been strong despite a further tightening of margins in a rising interest rate environment. Similarly, in the United Kingdom bank profits have grown rapidly, particularly those arising from investment banking activities, though there are signs that bad debt expenses are on the rise. The profitability of Japanese banks continues to recover, driven by the stronger economic environment and lower levels of non-performing loans. Euro-area banks have also had strong results on the back of increased fee income, continued strong lending to the household sector and an improvement in lending to businesses.
Despite record insured losses from natural catastrophes in 2005 – estimated to be around US$80 billion – the global insurance industry remains profitable. This strong financial position reflects the combination of several years of high investment returns and positive underwriting results. Reinsurers have increased premiums for coverage of natural disasters, leading direct insurers to also increase premiums in catastrophe-related business, and in some cases to reduce coverage in risky areas.
Overall, broad insurance sector share price indices weakened in May, though they have subsequently recovered somewhat (Graph 10). Credit markets appear comfortable with the outlook for the sector, with spreads on insurers’ credit default swaps approaching record lows, after rising in the aftermath of Hurricane Katrina and again in May‑June this year.
1.2 The Domestic Environment
Domestic economic and financial conditions also remain broadly favourable from a financial stability perspective. The economy is in its 15th consecutive year of economic expansion and the unemployment rate is around its lowest level in three decades. The household sector, in aggregate, has adjusted relatively smoothly to the changed dynamics of the housing market over recent years, although there is clearly a diversity of experience across individual households. In the business sector, developments are broadly reassuring, with balance sheets in good shape. Businesses have, however, significantly increased their borrowings, with business credit growing at the fastest pace since the late 1980s.
As noted in previous Reviews, the structure of household balance sheets has changed considerably over the past decade or so, with a marked rise in both debt levels and the value of the household sector’s assets relative to disposable income (Graph 11). Over this period, leverage of the household sector has increased, but so too has the sector’s net worth (Graph 12). Currently, the net worth of the household sector – measured as the difference between the value of its assets and its liabilities – is equivalent to around 6¼ times annual disposable income, up from 4½ times annual income in the mid 1990s.
Over the past few years, net worth has grown broadly in line with income, after increasing more strongly than income for a number of years. On the asset side of the balance sheet, the household sector has recently benefited from large gains in the value of its financial assets, primarily due to the strength of equity markets. Over the year to March 2006, household holdings of financial assets increased by 18.8 per cent, the highest rate of increase since June 1987 (Table 2).
In contrast to households’ holdings of financial assets, the value of real estate assets has grown only modestly over the past few years. House prices increased at an average annual rate of around 12 per cent from end 1997 to end 2003, but since then measures of national house prices show relatively little net change. Indicators suggest that, overall, the market has been a little firmer recently than it has been for much of the past two years or so, although there is significant variation across cities. In Sydney, the market remains subdued, whereas in Perth, prices have increased by more than 30 per cent over the past year (Table 3). At the national level, the ratio of house prices to disposable income has declined over the past two years, although it remains high both by historical and international standards (Graph 13).
The slightly firmer tone in the housing market has been associated with a modest increase in the pace of household borrowing. Household credit increased at an annualised rate of 14.7 per cent over the six months to July 2006, up from 12.1 per cent over the six months to January 2006. This pick-up is evident in housing lending to both owner-occupiers and investors (Graph 14). There has also been an increase in the value of housing loan approvals, although the ratio of approvals to credit outstanding remains considerably below the peak reached in 2003.
Growth in personal credit has also increased slightly over the past six months (Table 4). Credit card debt grew at an annualised rate of 15.4 per cent over the six months to July, compared with an average of 13 per cent over the preceding four years. In part, this is explained by the wider availability of low-interest-rate cards, which make it considerably less expensive for individuals to carry credit card debt. Margin lending has accounted for some of the growth in the fixed and revolving components. Over the year to June, margin loans – used to purchase equities and invest in managed funds – grew by 39 per cent, compared with 30 per cent over the previous year. This growth reflected both an increase in the number of margin loans and an increase in their average size.
As has been discussed in previous Reviews, the household sector, in aggregate, is devoting an increasing share of its income to interest payments. In the June quarter, the ratio of interest payments to household disposable income stood at 11.4 per cent, up from an average of 6¾ per cent in the 1990s, and 2 percentage points higher than the previous peak in September 1989 (Graph 15). Given current mortgage rates and ongoing household credit growth, this servicing ratio is likely to rise further in the period ahead.
The increase in this ratio is explained by a number of factors.
One is an increase in the number of households with an investment property. In 2003/04, 10½ per cent of taxpayers had a geared property investment, up from 7 per cent a decade earlier. With growth in investor credit averaging 21 per cent per year over the past decade, the ratio of interest payments on investor loans to household income currently stands at around 3 per cent, up by 2 percentage points since the mid 1990s. This rise accounts for almost half of the increase in the overall servicing ratio.
A second factor is the increase in the share of households with an owner-occupier mortgage (Graph 16). This increase has occurred despite rates of home ownership remaining broadly unchanged over the past decade. According to the ABS Household Expenditure Survey, in 2003/04 (the most recent year for which data are available) around 35 per cent of households reported that they had an owner-occupier mortgage, up from 27 per cent in 1993/94. The increase has been most pronounced for middle-aged households with, for example, almost 50 per cent of households with the head aged between 45 and 54 years having an owner-occupier mortgage in 2003/04, up from 30 per cent ten years earlier (Graph 17).
This increase in the share of older households with an owner-occupier mortgage partly reflects a willingness to carry debt later in life. Households appear to be increasingly prepared to use the equity in their houses for a range of purposes, and to take on additional debt later in life to ‘trade up’ houses. In addition, as households take on larger debts relative to their incomes, the average time taken to pay off debt is likely to have risen.
A third factor has been a broad-based easing of credit standards, which has allowed borrowers to take out loans with repayments as a share of gross income well above the 30 per cent maximum that commonly prevailed until the mid 1990s. However, while some borrowers have taken full advantage of this greater borrowing capacity, most have not. The share of average disposable income required for principal and interest payments on the average new owner-occupier housing loan is currently just under 28 per cent, below the comparable figure in 1989, although this average undoubtedly conceals considerable variation across households (Table 5).
While some new borrowers have debt-servicing burdens higher than was the case historically, much of the increase in the aggregate servicing burden reflects the greater number of households with debt, either for investor or owner-occupier purposes. Nonetheless, the increase in the aggregate servicing ratio does mean that the financial position of the household sector is more sensitive to changes in the economic and financial climate than was the case a decade ago.
Aggregate indicators of stress in household finances, however, continue to show a reasonably healthy overall picture. While the arrears rate on mortgages has increased recently, it remains low both by historical and international standards (see the Financial Intermediaries chapter). The higher arrears rate is hardly surprising, given the general lowering of credit standards that has occurred since the mid 1990s. Lower lending standards, and the resulting greater availability of credit, mean that at any given level of unemployment and interest rates, a higher share of housing loans can be expected to be in arrears than in the past.
While the aggregate arrears rate is still low, there is considerable variation across different groups of borrowers. For example, according to securitisation data, the arrears rate for borrowers who took out mortgages in 2003 and 2004 is considerably higher than for borrowers who took out mortgages in earlier years. For loans taken out in these two years, the weighted-average arrears rate 18 months after settlement was around 0.5 per cent; the equivalent arrears rate for loans taken out in 2001 and 2002 was 0.2 per cent. Borrowers that took out a loan in 2003 and 2004 are more likely to have bought at around the peak of the market and, with the higher level of interest rates, have had less opportunity to build up repayment buffers. Moreover, a higher share of loans securitised in these two years are ‘low doc’ loans, which have a higher arrears rate than conventional loans.
Arrears rates also vary across States, with New South Wales recording the largest increase over the past year (Graph 18). This is consistent with reports from mortgage insurers and debt collectors that suggest a rise in mortgagee sales in New South Wales. Disaggregated data suggest that the boom in house prices in Sydney continued for longer in those parts of the city with historically less expensive properties, and the subsequent decline in prices in these areas has been more pronounced (Graph 19). Data from the Australian Taxation Office also show that there was a greater tendency for individuals living in these areas to purchase an investment property in 2003/04 (Graph 20). Many of these individuals have seen a decline in the value of their investments.
Another commonly used indicator of the health of household finances is the behaviour of credit card borrowers. Recently, growth in credit card balances, particularly those accruing interest, has picked up, although, as noted above, this development is partly explained by the emergence of low-rate credit cards which make it considerably less expensive for consumers to carry credit card debt (Graph 21). In contrast to housing loans, there has been no increase in the aggregate arrears rate on credit cards in recent years.
The number of personal administrations – another potential indicator of the health of household finances – has risen over the past six months, but remains below its peak reached in the June quarter 2001. Survey data show that households still view their finances reasonably favourably, although sentiment is less positive than it has been, on average, over recent years (Graph 22). Sentiment fell sharply in August, following an increase in official interest rates and higher oil prices, but recovered much of this decline in September.
Overall, aggregate measures of the health of household finances show a reasonably positive picture, with solid growth in household disposable income, increases in net wealth and the unemployment rate around its lowest level in 30 years (Graph 23). Despite some households’ finances being stretched by recent developments, the household sector as a whole appears to be in sound condition. Given the changed dynamics of the housing market, households look to be taking a more cautious approach to their finances than was the case a few years earlier, although strong growth in household borrowing suggests that many households remain willing to take on further debt for the purchase of both housing and other assets. Reflecting this more cautious approach, consumption has increased broadly in line with income over the past couple of years, after having increased more rapidly than income over the previous decade. Looking forward, developments in household finances – both in aggregate and at a disaggregated level – will continue to warrant close attention.
The business sector continues to experience favourable financial conditions, with aggregate indicators showing strong balance sheets and high profits. To a significant extent, the strong aggregate position reflects developments in the resources sector, which is benefiting from a large rise in the terms of trade.
Aggregate business sector profits, as measured by the gross operating surplus of private non-financial corporates and gross mixed income of the unincorporated sector, grew by 6.6 per cent over the year to June and, as a share of GDP, are above the average of the past decade (Graph 24). This aggregate outcome, however, masks significant variation at a sectoral level. The mining sector continues to be the predominant contributor to overall growth in profits, with profits increasing by around 44 per cent over the year to June 2006. By contrast, profit growth has been relatively subdued in the non‑mining sector, where profits as a share of GDP are slightly below the average of the past decade.
The relative strength in the mining sector is reflected in movements in equity prices. Notwithstanding recent falls, the ASX Resources index has gained 12.7 per cent over the year to late September, outpacing the broader industrials category, which increased by 8.4 per cent (Graph 25).
Given the positive aggregate environment, investment growth has been strong, with investment as a share of GDP at around the highest level recorded in the past 25 years (Graph 26). Mining sector investment has risen particularly sharply, increasing by almost 80 per cent over the past year, though capital expenditure has also grown in most other sectors. In aggregate, firms have considerably more internal funding available to finance expenditure than on previous occasions when investment spending has been this high. Strong profitability has meant that aggregate internal funding, as a share of GDP, is around its highest level on record.
Notwithstanding the ready availability of internal funding, the increase in investment has been associated with a strong increase in business sector borrowing. Over the year to July 2006, business credit grew by 17.4 per cent, the fastest rate since the late 1980s (Graph 27). The rapid growth has been associated with strong competition among intermediaries for business lending, which is continuing to compress lending margins (see the Financial Intermediaries chapter). Liaison with banks suggests that growth in business credit is broadly based across sectors, a finding supported by the limited data available (Table 6).
Net financing through capital markets has grown less rapidly than borrowing from intermediaries (Graph 28). While market conditions remain favourable for debt and equity issuance, the aggregate funds raised through new bond and equity issuance have been partly offset, respectively, by maturities and an increase in share buy-backs. Although overall borrowing has increased sharply, the amount raised through net equity raisings remains well down on previous years, consistent with high profits and moves by some companies to increase gearing.
Despite the growth in debt, aggregate financial indicators remain in good shape. The debt-to-equity ratio for listed corporates shows a mild increase in gearing to around 65 per cent, but remains well below the peak levels reached in the late 1980s (Graph 29). In contrast to the servicing burden for the household sector, the ratio of business interest payments to profits remains at a historically low level, with strong growth in aggregate profits offsetting the increased interest payments arising from higher debt and interest rates. Consistent with strong profit growth, the gearing and interest burden of the mining sector are much lower than the aggregate.
Ratings actions also reflect the positive corporate environment, with more upgrades than downgrades by Standard & Poor’s over the past year. Indicators of corporate credit quality also remain favourable, with credit default swap (CDS) prices remaining at low levels, and arrears on business loans falling over the past year (Graph 30).
The commercial property market, a business sector exposure that has previously been a source of financial difficulty for financial intermediaries, continues to be associated with strong growth in prices and borrowing. Over the year to March 2006, bank lending for commercial property rose by 18.3 per cent, following a similar increase over the preceding 12 months. Office property prices rose by 13¾ per cent over the year to June, the strongest annual growth since September 2000, while industrial property prices rose by 11½ per cent over the same period (Table 7). The strong performance is also evident in listed property trusts, with the ASX 200 Property Trust Accumulation index rising by 21 per cent over the year to late September. As in residential property, commercial property conditions vary around the country, with the largest price gains in office property recorded in Brisbane and Perth. While the fast growth in property prices and borrowing suggests some potential for an increase in risks in the commercial property market, at an aggregate level, developments are sounder than those seen prior to the collapse in the market in the early 1990s. In the office property sector, prices generally remain below their late 1980s peak, and construction remains well below the pace that led to over-development in the 1980s (Graph 31).
Overall, the strength of aggregate profits and a relatively low interest burden suggest that current developments in the business sector do not pose a near-term risk to financial stability. To some extent, however, the favourable aggregate picture reflects the performance of the resources sector in the strong commodity price environment and, as always, the health of the business sector remains dependent on the broader economy.