Financial Stability Review – March 2007
Over recent years, financial systems around the world have benefited from generally favourable economic and financial conditions. The world economy has grown at an above-average pace over the past four years and, for most of this period, volatility in financial markets has been unusually subdued. In addition, credit spreads generally remain low, many asset prices are at historically high levels, and financial institutions in Australia and elsewhere are recording strong profit growth, with problem loans at quite low levels. Against this favourable background, the past month has seen an increase in volatility in some markets, and notably, a sharp pick-up in loan arrears in sub-prime residential mortgages in the United States.
The generally favourable conditions of recent years have persisted despite a number of potential setbacks. A few years ago there were concerns that when the major central banks started increasing short-term interest rates there might be sharp adjustments in financial markets. In the event, these concerns were not realised, although the process of returning interest rates to more normal levels still has a way to run in Japan. More recently, financial markets have reacted calmly to events that, in the past, might have been the catalyst for disruptive adjustments (for example, the Thai coup and the imposition of capital controls, the disputed Mexican election, and the failure of Amaranth, a large hedge fund).
There are a number of (not mutually exclusive) possible explanations for this recent strong performance of the global financial system.
One is that it represents an appropriate response to the greater macroeconomic stability and low inflation of the past decade or so. If this greater stability is here to stay, then term and credit risk premia should be lower than previously, leverage can be higher without implying more risk, and higher asset prices are justifiable. Complementing these developments, the robustness of the financial system has been reinforced by the wider dispersion of credit risk among investors, a trend facilitated by innovative developments in credit risk transfer markets. The main debate here is over the extent to which the macro and financial stability of the past decade is likely to continue.
A second explanation is that financial pricing has been heavily influenced by developments in Asia and, in particular, the high savings rates relative to investment in that part of the world. In the first instance, this saving, finding its way into global capital markets, has put downward pressure on government bond yields and the cost of capital to businesses and households. Given the macroeconomic stability of recent years, investors have been prepared to buy a range of alternative assets, pushing up their prices – the so-called ‘search for yield’. They have also been prepared to increase leverage, and have been encouraged to do so by the low level of interest rates, particularly in Japan. The main debate here is over the sustainability of this flow of savings from Asia and other capital exporting countries to the rest of the world.
There are also a variety of views as to the implications of these favourable outcomes for the future stability of the global financial system.
Many investors appear to be behaving as though the benign macroeconomic environment will continue for the foreseeable future and/or that the flow of saving from Asia will not come to an end in a disruptive fashion. Underlying this behaviour may be an assessment that policy-makers, armed with more robust and credible policy frameworks, can continue to oversee muted business cycles and low inflation.
A more cautious interpretation is that while the global economy is indeed more stable than in the 1970s and 1980s, and recent trends may well be sustainable for a time, there inevitably remains some probability of a significant recession at some point. In the event that such a recession did occur, the need to restructure more leveraged balance sheets, and for asset prices to adjust, could significantly amplify the downturn.
A decidedly more pessimistic view is that the current favourable environment is inexorably sowing the seeds of its own demise, with investors seriously underestimating risk and taking on too much leverage. According to this view, the longer the underestimation of risk continues, the greater the imbalances in the system are likely to become, and hence the greater the potential for disruption when the correction takes place.
It is difficult to dismiss the view that the world economy is more stable than in previous decades, and that there is a reasonable probability that global capital markets will adjust without significant disruption to a change in the saving-investment dynamics in Asia or other shocks. At the same time, since valuations in a number of markets appear to be based on quite optimistic assumptions about future conditions, central banks and regulators charged with safeguarding financial stability need to pay attention to the downside risks attached to the otherwise favourable environment.
Turning to the domestic economy, the downside risk that has attracted most attention over recent years is the possibility that adjustments in household balance sheets following the housing boom could amplify an economic downturn. There are, however, very few signs of this risk materialising, although households are taking a more cautious approach to their finances than they were a few years ago. Surveys suggest that, in aggregate, households are generally positive about the outlook for their personal finances, and while mortgage arrears have increased following the general lowering of credit standards over the past decade, they remain relatively low both by historical and international standards. There are some pockets where household finances are under strain, particularly in western Sydney, and among households that took out loans with high loan‑to‑valuation ratios in 2003 and 2004, but the overall picture remains, at present, quite reassuring.
Recently, a second area of interest has been developments in the business sector. Over the past decade, the Australian business sector has had a relatively low level of gearing after the problems in the early 1990s. There are, however, some signs that this period of conservative leverage may be starting to draw to a close, with growth in business credit up significantly on rates a few years ago. Perhaps the clearest manifestation of this change has been the recent spate of leveraged buyout activity by private equity funds, which has led to pockets of significantly increased leverage within the corporate sector. Overall though, while this trend may well have some way to run, business balance sheets currently remain in good shape.
In the financial sector, both the banking and insurance sectors continue to record high rates of return on equity, benefiting from continued balance sheet expansion, low levels of non-performing loans and the strong performance of equity markets. While there has been robust competition in lending to households for a number of years, recently there has also been a noticeable pick-up in competition for business lending, with margins under downward pressure and an easing of lending conditions. As has been the case for some time, the challenge for financial institutions is how best to measure, and price for, risk in an economy that is now in its 16th year of expansion.