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RESERVE BANK OF AUSTRALIA

Financial Stability Review – March 2007

The Macroeconomic and Financial Environment

The International Environment

Over the past four years, the global macroeconomic environment has provided a very supportive backdrop to many financial systems around the world. Over this period, the world economy has grown at well above its long-run trend rate and both short- and long-term interest rates have been below average, and at multi-decade lows for a time, in some countries (Graph 1). Corporate profitability has been strong, default rates have been low by historical standards, and volatility in financial markets has generally been subdued. Not surprisingly, in this environment many asset prices have risen significantly and investors have been prepared to seek out alternative assets and increase leverage in an effort to lift their returns.

Against the background of these very favourable operating conditions, there have been occasional periods of heightened concern about a return to a less benign environment. In 2003, for example, some observers were concerned that the commencement of the process of returning interest rates to more normal levels in the United States could be a catalyst for greater volatility in financial markets. More recently, the same concerns were heard about the beginning of the monetary policy tightening process in Japan. In both cases, however, the adjustment to higher interest rates has proceeded relatively smoothly, although there remains some way to go before interest rates in Japan are back to more normal levels (Graph 2). Indeed, rather than serving as a catalyst for disruptive adjustments, the tightening process has been a positive development from a financial stability perspective, increasing the cost of debt finance from the extraordinarily low levels seen a few years ago.

Last year there was also a brief period of increased market volatility in May and June, largely reflecting concerns about higher inflation, particularly in the United States. These concerns led to declines in a number of stock markets, a small rise in some credit spreads and greater volatility in commodity prices. This episode though turned out to be relatively short-lived, with equity markets resuming their upward movement, credit spreads reversing their rise, and volatility declining again.

In the past month, financial markets have again experienced an increase in volatility, reflecting a sharp fall in the Chinese share market, problems in the US sub-prime mortgage market and some disappointing economic data in the United States (Graph 3 and Box A). Many of the major share markets experienced falls in the order of 5–10 per cent over a five-day period, with larger declines being experienced in some emerging market economies. In addition, bond yields in the major economies declined as investors sought assets which were perceived to be less risky. Credit spreads on lower-rated debt widened and in currency markets, the Japanese yen appreciated against high-yielding currencies, including against the Australian dollar, as investors reassessed the riskiness of borrowing in yen and investing in these currencies (the so-called carry trade).

Whether this turbulence in global financial markets turns out to be temporary, or the start of a broad reversal of the very favourable environment seen over recent years, remains to be seen. It has, however, highlighted the strong inter-linkages between financial markets around the world, and the potential for developments in one part of the global financial system to have significant effects elsewhere. It has also provided a timely reminder to investors that the recent period of strong returns and low volatility is unlikely to continue indefinitely, and has prompted, at least to some extent, greater discrimination between different levels of risk.

While equity markets fell in late February, most are still up considerably on levels a year ago. In a number of the developed economies, share prices are above the peaks reached in 2000 following four years of strong gains. Share markets have also generally been strong in the emerging market countries, with the MSCI Emerging Markets Index up 18 per cent over the past year and 190 per cent since early 2003 (Graph 4).

Recent developments have also seen a small rise in credit spreads on emerging market debt and lower-rated corporate debt. Despite this, these spreads remain at levels that are historically low (Graph 5). For lower-rated corporate bonds in the United States, spreads have fallen by about two thirds since late 2002, with the default rate on high-yield bonds reaching a 25-year low of 1.57 per cent in 2006. Since 2002, spreads on emerging market sovereign bonds have also fallen noticeably. A measure of the strength of sovereign debt markets is the way in which political uncertainties in some emerging markets – for example Brazil, Hungary, Mexico and Thailand – have had little impact on pricing over recent years, in contrast to some earlier experiences.

The levels of government bond yields in the major economies also remain quite low (Graph 6). The fairly muted response of long-term bond yields to increases in official interest rates has meant that yield curves have flattened, and even become inverted in some countries. This is particularly evident in the United States, where the federal funds rate has been increased by 4¼ percentage points since mid 2004, but over the same period, 10‑year bond yields have been broadly unchanged. Recently the increases in most major economies’ government bond yields seen earlier in 2007 have been unwound, partly in response to investors seeking less risky assets following the stock market movements and problems in the US sub-prime mortgage market.

The generally strong macroeconomic and financial environment over recent years has made for a very favourable operating environment for financial institutions. Many banking systems are enjoying historically high rates of return on equity – in excess of 20 per cent – and share prices of banks in a number of countries have shown significant gains over recent years (Graph 7). Conditions have been particularly favourable for investment banks, with their profits typically up by more than 30 per cent in the past year on the back of higher trading income. The global insurance industry has also been very profitable of late, benefiting from high investment returns and favourable underwriting results, the latter boosted in 2006 by a sharp reduction in global insured losses compared with the previous couple of years. Reflecting this, broad insurer share price indices in all major economies, except Japan, have risen over the past six months, and spreads on insurers’ credit default swaps have remained very low.

The strong performance of banks has been underpinned recently by a pick-up in business credit growth and strong corporate balance sheets (Graph 8). Following more than a decade in which the demand for debt finance by businesses was relatively subdued, business credit is now growing as fast as, or faster than, household credit in a range of countries. Leverage has also been increased by the growing tendency of firms to return cash to shareholders through dividend payouts and share buybacks; in 2006, US S&P 500 companies returned US$656 billion to shareholders in the form of repurchases and dividends, up almost 20 per cent on the previous year. Some of these cash distributions are simply a response to strong profits, but others appear to form part of a defensive strategy by companies looking to reduce their cash holdings to make themselves less attractive to private equity firms.

The clearest manifestation of this trend towards higher leverage in the corporate sector is the surge in leveraged buyout (LBO) activity. In 2006, around US$810 billion of LBOs took place globally compared to around US$365 billion in 2005 (Graph 9). This surge in LBO activity has been underpinned by large inflows into private equity firms. In the first half of 2006, for example, the amount of capital flowing into private equity funds in the United Kingdom exceeded the amount of capital raised in initial public offerings on the London Stock Exchange. Private equity funds have been able to use this capital, together with debt raised on favourable terms, to purchase companies that they perceive to have potential for restructuring and, hence, for resale at a profit. The debt is typically underwritten by banks, but it is increasingly being distributed to participants in the institutional debt market, including hedge funds, pension funds and insurance companies.

While this surge in activity has attracted much attention, and has led to the purchased companies having much more leveraged balance sheets, in aggregate, business sector balance sheets in most countries remain in good shape. Just as the run-up in household leverage took place over the better part of a decade, it is possible that the increase in corporate borrowing that we are currently seeing will run for some years yet. Further details on private equity are provided in the article in this Review.

On the regulatory front, central banks and supervisors in a number of countries are attempting to understand the implications of the LBO-private equity phenomenon. On the one hand, private equity clearly has the potential to improve the performance of underperforming firms, and thus contribute to the efficient allocation of global capital. On the other hand, there are concerns that the current boom might turn out to have a number of less welcome consequences. These include: the amplification of a future economic downturn due to a sharp rise in leverage in a period when capital markets have provided debt on very generous terms; a reduction in the flow of information to investors if the size and depth of public equity markets are reduced; and the increased potential for market abuse reflecting the sizeable flows of price-sensitive information in the period leading up to the transaction, and the conflicts of interest that can often exist for management and financial institutions over these deals.

A second issue continuing to attract considerable attention in the international arena is the growth of the hedge fund industry (Graph 10). In common with private equity firms, most hedge funds have had no difficulties in recent years in attracting funds from investors hoping to earn higher returns than those offered on more traditional investments. According to Hedge Fund Research, the average US dollar return earned by hedge funds was almost 13 per cent last year, which was more than double the average return available from investing in government bonds, but below the returns from investing in buoyant global equity markets. Globally, hedge fund assets under management are estimated to have increased by nearly 30 per cent in 2006, to US$1.4 trillion, above the average annual growth rate of 18 per cent over the previous five years.

Hedge funds use a wide range of investment strategies, including short-selling securities and using derivatives to create leverage. While these strategies can add to market depth and help reduce anomalies in market pricing, the rapid growth of hedge funds is prompting concerns among some regulators, particularly in Asia and continental Europe. These concerns largely relate to issues of transparency, specifically the lack of disclosure around hedge fund activities, which is making it difficult for regulators to determine where risk in the global financial system resides. This is in contrast to the situation during the 1997 Asian crisis, when large hedge funds were heavily criticised on the grounds that they were using their size to manipulate markets in a destabilising fashion.

Given the concerns about transparency, financial regulators have been focusing their attention on the institutions that provide prime brokerage services to hedge funds, encouraging them to develop a full understanding of the risk profile of the hedge funds that they deal with and to conservatively manage their exposures to them. There is, however, concern among some regulators that this approach is not sufficient and that further action is required. This reflects a view that relying solely on counterparties to manage the risk associated with hedge funds does not take account of the systemic consequences of the increasingly complex inter-relationships between participants in the hedge fund industry. While there is little appetite for regulating hedge funds as closely as banks, there is interest in finding ways to improve the information available to regulators on their activities. Accordingly, the G-7 Finance Ministers and Central Bank Governors have asked the Financial Stability Forum for a report on hedge funds by May.

Rapid growth in the use of credit derivatives is also posing financial regulators with a number of issues relating to transparency (Graph 11). In some cases, the balance sheet data received from financial institutions are becoming less meaningful, as credit exposures are taken on or divested through derivatives. The growth of credit derivatives markets has also meant that it is less clear where the credit risk actually resides, and how those holding this risk will react in a less benign environment. While there are clearly benefits in having credit risk widely held, rather than concentrated on the balance sheets of systemically important banks, these markets also pose new risks. In particular, their rapid growth has, to some extent, outpaced the capacity of banks and other participants to manage the operational aspects of these instruments leading, at times, to a backlog of unconfirmed trades. Regulators in the major financial centres have been monitoring this issue closely and encouraging sounder market practices around derivatives trading.

This intersection of private equity, hedge funds and credit derivatives is rapidly transforming credit markets. This transformation is mostly for the better, improving the allocation of global capital, and leading to risk being more broadly held than in the past. Despite this, there remains considerable uncertainty as to how the system would react to a very large shock. It is possible that the very developments that have contributed to the increased robustness of the financial system to most events, through the wider dispersion of risk, could actually amplify the disruption following a serious shock. In particular, there is uncertainty about just how credit risk transfer markets, on which so many institutions now rely, might perform. Dealing with this potential paradox – a decline in the likelihood of a significant disruption but an increase in the potential costs of such a disruption – is likely to remain a key issue over the years ahead for central banks and financial regulators charged with maintaining financial stability.

The Domestic Environment

Household Sector

As has been discussed in previous Reviews, the past decade has seen a significant transformation of household balance sheets in Australia, with large increases in the value of both assets and liabilities (Graph 12 a, b, c, d). On the assets side, the strong rise in house prices between 1996 and 2003 has been followed over the past few years by a significant increase in the value of the household sector’s holdings of financial assets as a result of the buoyant stock market. On the liabilities side, debt has increased significantly, to about 160 per cent of annual income at the end of 2006, more than double the level a decade ago.

Taken together, these developments have resulted in a substantial increase in the wealth of the household sector. As at September 2006, net worth was equivalent to 6½ times annual household disposable income, up from 4½ times annual income in the mid 1990s. At the same time, the overall leverage of the household sector has increased, with the ratio of debt to assets standing at 17½ per cent as at September 2006, up from around 11 per cent in the mid 1990s.

Over the most recent year for which data are available (ending September 2006), the value of the household sector’s financial assets grew by 12 per cent, mainly due to a rise in the value of superannuation assets. Holdings of cash and deposits have also grown fairly solidly, as they have for much of the past five years, partly reflecting the higher interest rates that financial institutions have been offering on some savings accounts.

Growth in the household sector’s holdings of non-financial assets (largely housing) has been a little slower in recent years than that in holdings of financial assets. Reflecting this, the contribution to the growth in household wealth from financial assets exceeded that from non-financial assets in 2004 and 2005 (Graph 13). However, growth in the value of non-financial assets has recently picked up, to 11½ per cent in the year to September 2006, reflecting the firmer tone in house prices.

On a national basis, the median house price rose by about 7 per cent in 2006, compared with average annual growth of around 1½ per cent over the two previous years. As has been the case for some time, there were significant differences across Australia, with prices broadly flat in Sydney and up sharply in Perth and Darwin. While the ratio of house prices to average household disposable income is below the peak reached at the end of 2003 – following a couple of years in which growth in incomes has outpaced that in house prices – it remains high by both historical and international standards (Graph 12 a, b, c, d).

On the liabilities side of the balance sheet, household credit continues to grow solidly, although well down on the pace of growth seen earlier in the decade. Over the year to January, household credit increased by 14 per cent, compared with average growth of 18 per cent in 2002 and 2003.

Within household credit, housing credit is the largest component, accounting for 86 per cent of the total. Over the year to January, owner-occupier housing credit grew by 16 per cent, up slightly on the rate of growth experienced over the previous year (Graph 14). Over the same period, investor housing credit grew by 12 per cent, not far above the lowest rate seen in the past two decades. To a large extent, the sharp slowing in the rate of investor housing credit growth over the past few years reflects the changed dynamics of the housing market. With investors no longer experiencing large capital gains, they have had to rely more on rental income for their returns, and, as discussed in the recent Statement on Monetary Policy, rental yields have been at historically low levels.

Growth in personal credit has also picked up over the past year, and is currently running at around 12½ per cent in year-ended terms, compared with 10 per cent a year earlier. The pick-up has been most noticeable in fixed-term loans, although growth in outstanding credit card balances has also been a bit firmer (Table 1). Recent data on the purpose of personal loan approvals point to an increase in borrowing for travel and holidays, housing alterations and additions, and debt consolidation.

One component of personal credit that has been growing very rapidly is margin lending for the purchase of shares and managed funds, associated with the strength in the share market. Outstanding margin debt (excluding loans over $10 million) rose by 35 per cent over 2006, contributing about two fifths of the increase in total personal credit. This growth reflects both a rise in the average loan size, which reached $147,000 in December, and an increase in the number of loans. On average, the leverage that margin loan investors are currently employing, at around 40 per cent, is about 10 percentage points below the levels seen in late 2002. Reflecting this, and the generally subdued volatility in share markets, the frequency of margin calls was very low in 2006, at about a tenth of what it was in the second half of 2002.

The strong growth in household debt since 2002, together with higher interest rates, has resulted in a significant increase in the ratio of household interest payments to disposable income (Graph 15). In the December quarter 2006, this ratio stood at 11.7 per cent, up from 6.9 per cent at the start of 2002. As discussed in the previous Review, part of the trend increase in this ratio over the past decade or so can be explained by a rise in the share of owner-occupier households with a mortgage, with many households now prepared to carry debt later in life. Another important influence has been the strong growth in investor housing loans, with interest payments on these loans currently equivalent to 3 per cent of household disposable income, up from 1½ per cent in early 2002. Notwithstanding the increase in the aggregate ratio of household interest payments to income, the repayments on an average new owner-occupier loan, as a share of average disposable income, are still below the previous peak. Box B provides further details of trends in owner-occupier debt and assets at a disaggregated level.

While the aggregate interest-servicing ratio has risen significantly, there are few signs that the household sector is struggling to meet the higher debt-servicing costs. Households are continuing to benefit from strong employment growth, with the unemployment rate falling by around ½ of a percentage point over the past year to 4.6 per cent, the lowest level in around 30 years. Consistent with this, nominal household disposable income has been growing strongly, up by 7½ per cent over the past year. While income growth continues to be underpinned by solid growth in wages and salaries, it has also been boosted in the past few years by stronger growth in investment income, including dividends and interest receipts.

Reflecting these generally favourable developments, a relatively high share of households report that their personal finances are more favourable than was the case a year ago (Graph 16); the picture is similar for households with a mortgage, those who own their home outright, and those who rent.

While there are no aggregate data available on the extent of mortgage prepayments, our liaison with banks indicates that many borrowers have substantial prepayment buffers. Rough indications are that around one quarter of owner-occupier borrowers are more than a year ahead of their scheduled mortgage repayments, with around one half ahead by more than a month. The equivalent figures for investor loans are somewhat lower, reflecting the lesser incentive to pay off these loans quickly. Recently there has been a sharp increase in the share of households that view paying off debt as the wisest place for their savings, suggesting that some borrowers may be seeking to accelerate debt repayments, partly in response to higher interest rates (Graph 17).

The various measures of loan arrears also suggest that the household sector is coping reasonably well with the higher levels of debt and interest servicing.

As at end December 2006, the ratio of non-performing to total housing loans on the banks’ Australian books stood at 0.31 per cent (Graph 18). This ratio had increased steadily from early 2004 to early 2006, but has shown relatively little change over the past six months. Of these non-performing loans, banks report that around three quarters are fully covered by collateral. Overall, the ratio of non-performing loans remains lower than at any time in the 1990s and low by international standards.

The share of loans that have been securitised that are more than 90 days in arrears has also increased since 2003, but like the figures for loans on banks’ balance sheets, has shown little change recently. At end December 2006, the 90-day arrears rate for securitised loans stood at 0.4 per cent, somewhat higher than the rate for loans on banks’ balance sheets, primarily reflecting the larger share of low-doc loans in the pool of securitised loans. The securitisation data also suggest that the repayment record for housing loans made in 2005 has been a little better than for those made in 2004, reversing some of the deterioration seen over the previous two years (Graph 19).

This general pattern of rising arrears in 2004 and 2005 and little change in 2006 is evident in the data for full-doc loans, low-doc loans and non-conforming loans (Graph 20). According to securitisation data, the 90-day arrears rate on full-doc loans currently stands at 0.28 per cent, compared to 0.89 per cent for low-doc loans, and 5¼ per cent for non-conforming loans, which are made to borrowers with poor credit histories. Unlike in the United States, there has not been a recent sharp deterioration in the performance of non-conforming loans in Australia (see Box A).

Similar to housing loans, the share of credit cards and other personal loans that are non-performing has also levelled out recently, after picking up slightly over the previous year or two (Graph 21). For both types of loans, this share is currently just below 1 per cent.

While the overall picture suggests that, in aggregate, the household sector is coping well with the higher levels of debt and interest servicing, there are some limited pockets where financial stress is evident. Areas of western Sydney, in particular, look to have been adversely affected by the fall in residential property prices, with a disproportionate number of households in this area taking out loans with high loan-to-valuation and debt-servicing ratios near the peak of the house price boom. Partly reflecting this, the arrears rate and the number of personal administrations has increased by more in New South Wales than in the other states (Graph 22). However, like the pattern for the aggregate data, the arrears rate for New South Wales did not increase over the course of 2006, after increasing in 2004 and 2005.

Consistent with the increase in housing loan arrears over recent years, there has been a pick-up in the number of court applications for property possession (which include applications for both residential and commercial property). In New South Wales and Victoria, the number of such applications increased by around 50 per cent in 2005 compared with the previous year, but only by about 10 per cent in 2006. Banks too have reported a modest rise in mortgagee sales, though these remain low.

The increase in loan arrears in 2004 and 2005 was not unexpected given the general lowering of credit standards that has occurred since the mid 1990s. The resulting expansion in the availability of credit has meant that for any given level of unemployment and interest rates, a higher share of loans could be expected to be in arrears. Overall, the household sector remains in good financial shape, which is not surprising given the ongoing strength in the economy. While at a disaggregated level there are some areas of financial stress, these remain fairly contained.

Business Sector

The long-running expansion of the Australian economy also continues to underpin strong conditions in the business sector. Profitability and investment have been at high levels over recent years and, in aggregate, business balance sheets remain in good shape. For the past decade or so the business sector has had relatively low levels of gearing, following the problems in the early 1990s; unlike the household sector, it did not take advantage of the lower nominal interest rates of the past decade to substantially increase its level of borrowing. There are, however, some signs that this period of conservative balance-sheet management may be drawing to a close, with stronger growth in business credit and a sharp increase in leveraged buyout activity.

Aggregate business sector profits – as measured by the gross operating surplus of private non-financial corporations and gross mixed income of unincorporated enterprises – increased by 6 per cent over the year to the December quarter 2006 and, as a share of GDP, remain well above the average of the past 15 years (Graph 23). After profits increased more quickly than nominal GDP for much of the first part of the current decade, the past few years have seen profit growth broadly in line with GDP. For much of this period, exceptionally strong growth in mining sector profits has offset somewhat weaker profit growth in the non-mining sectors, though this divergence has narrowed recently. Looking forward, equity analysts continue to forecast growth in aggregate profits, albeit at a slightly slower pace than over the past few years.

The strong performance of the business sector has been reflected in the equity market, notwithstanding the recent volatility. Over the past four years, the ASX 200 has recorded an average annual increase of 20 per cent, with the market up by 19 per cent over the past year (Graph 24). The ASX Resources sub-index has been particularly strong, although it has underperformed the broader market recently. The price/earnings (P/E) ratio for the market as a whole currently stands at around 14, which is lower than the level of recent years and also below the average level of the past two decades. The P/E ratio for the resources sector has declined over the past year, reflecting the strong growth in earnings, while there has been little change in the P/E ratio for the rest of the market.

The generally strong growth in profitability since early in this decade has meant that businesses’ internal funding as a per cent of GDP has been high by historical standards (Graph 25). This has allowed financing of the investment boom largely through internal funding. Recently, however, recourse to external funding has increased noticeably, with net raisings rising from the equivalent of around 5 per cent of GDP in 2003 to over 10 per cent in 2006. This pick-up in external funding has mostly been in the form of intermediated business credit, which increased by 16 per cent over the year to January, around the fastest pace since the late 1980s (Graph 26).

Data from APRA suggest that the stock of outstanding loans greater than $2 million in size grew by 28 per cent over the year to December 2006, while there was a slight decline for loans of less than $500,000, which are more likely to be used by smaller businesses (Table 2).

The overall strength in intermediated borrowing has been associated with strong competition among lenders, which has been evident in the continued lowering of interest rate spreads on business loans. This has been more evident in larger loans, with the spread to the cash rate for loans greater than $2 million currently around half its level in 2002, while spreads on smaller loans have contracted by about one fifth. Competitive pressures have also been evident in the lowering of fees on business loans as well as the relaxation of non-pricing conditions, including covenants.

Unlike intermediated borrowing, net non-intermediated capital raisings of non-financial corporations have been fairly steady over the past three years, at around $30 billion per year (Graph 27). Within this, annual net equity raisings rose from $12 billion in 2004 to $17 billion in 2006, with stronger non-IPO equity raisings only partly offset by an increase in share buybacks; 2005 was a record year for IPO raisings, but they moderated a little in 2006. In contrast, annual net bond issuance has declined by about $5 billion since 2004, mainly reflecting reduced issuance of long-term debt.

One of the clearest signs of the business sector’s increased appetite for debt has been the acceleration in LBO activity over the past year, with 28 announced deals in Australia in 2006. The total value of transactions either undertaken or endorsed in the year was around $26 billion, up from an average of $1½ billion over the previous five years. It has not been uncommon for these deals to involve, or propose, an increase in the debt-to-equity ratios of the bought-out companies from around 50 per cent to 250 per cent. The buyout activity also appears to be having an impact on other publicly listed companies, with some boards deciding to return cash to shareholders through dividend payments and share buybacks, partly as a defensive strategy (Graph 28). The growth of private equity in Australia and its implications are discussed in an article in this Review.

While the willingness of businesses to borrow has clearly increased, the debt-to-equity ratio for listed non-financial corporations, at around 65 per cent, is still well below the peak in the late 1980s and only around the average of the past decade (Graph 29). This is in sharp contrast to the experience of the household sector where leverage has steadily increased since the early 1990s. As a ratio to profits, business debt also remains below previous peaks, whereas for the household sector the ratio of debt to income is more than three times its level in the early 1990s. Reflecting the strength in profits and contractions in lending margins, the interest-servicing ratio of the business sector remains at a low level, even after the increases in interest rates over the past few years. Consistent with these indicators of overall health, financial institutions continue to report very low levels of business loan arrears, as discussed in the Financial Intermediaries chapter. There have also been very few (rated) corporate bond defaults in Australia in recent years, the latest being in mid 2004.

The positive business environment is also reflected in business surveys, financial market prices and credit ratings. A range of business surveys, including the NAB survey, indicate generally high business confidence, with sentiment regarding business conditions in the non-farm sector above long-run average levels in the second half of 2006, but somewhat below the high levels seen in 2003 and 2004. The relatively low levels of corporate bond spreads and credit default swap (CDS) premia indicate that financial market participants continue to have a positive assessment of the credit worthiness of the corporate sector, although there has recently been a rise in the spreads and CDS premia for lower-rated companies, mainly reflecting the spate of LBO transactions (Graph 30). The positive assessment of financial market participants has also been reflected in the strength in the share market, notwithstanding the recent volatility. Credit rating agencies have also been more optimistic about the business outlook with Standard & Poor’s making more rating upgrades than downgrades for Australian companies in 2006, continuing the trend of the past couple of years.

Given that past excesses in the commercial property market have been associated with stresses in the banking sector, developments in this market warrant close attention. Bank lending for commercial property has been buoyant recently, increasing by 18 per cent over the year to September 2006, following a similar increase over the preceding 12 months. Prime office property prices in Australia rose by 22 per cent over the year to December 2006, the strongest annual growth since December 1988, while industrial property prices rose by about 12 per cent over the same period. For office property prices, growth has been particularly strong in Perth and, to a lesser extent, Brisbane.

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 much sounder than those seen prior to the collapse in the market in the early 1990s. Office property prices, in real terms, remain well below their late 1980s peak, while construction activity is also below the level that led to over-development in the 1980s (Graph 31).

Overall, businesses are in good financial shape, with high levels of profitability and strong balance sheets. Recently, however, there have been significant increases in the leverage of some companies and signs of releveraging in the business sector more generally. While the overall increase in gearing has been limited to date, these trends will bear close watching in the period ahead.