Financial Stability Review – March 2004 1. The Macroeconomic Environment

1.1 The Global Environment

The period since mid 2003 has been marked by a significant pick-up in the global economy which, in turn, is bolstering the strength of the Australian economy.[1] This is welcome news from a financial stability perspective, given the strong historical link between economic conditions and the health of financial institutions. The improved economic environment is also having a favourable effect on household and business balance sheets in a number of countries.

The pick-up in economic conditions has been most pronounced in the United States but conditions have also improved, to varying degrees, in other major regions. Consensus forecasts for GDP growth in 2004 in key economic areas have generally been revised up again in recent months and overall, Australia's trading partners are forecast to grow by over 4 per cent (Table 1).

A more optimistic tone has also been evident in financial markets. Major equity markets have rallied over the past half year, and spreads on corporate and emerging market bonds have fallen to their lowest levels for several years (Graph 1).

Notwithstanding the more buoyant mood, short-term interest rates have remained at exceptionally low levels – at an average of one per cent in the US, Germany and Japan, which is the lowest level in more than one hundred years (Graph 2). To a considerable extent, this reflects the low rates of goods and services price inflation in the major economies and few signs that consumer price inflation is picking up materially.

The low interest rates in the major financial centres are, in turn, tending to anchor interest rates globally at historically low levels – an outcome which is not without some medium-term risk to the global financial system. On one hand, low nominal rates are stimulating demand and providing a welcome boost to those economies where there is excess capacity.

On the other hand, there is a danger, particularly in those countries where economic growth is already well established, that low interest rates could fuel excessive borrowing and unsustainably high asset prices. If this were to occur, adjustments in private-sector balance sheets would ultimately be required to put them on a firmer footing. This could pose difficulties both for financial institutions and the global economy.

The low-interest-rate environment also seems to be increasing the appetite of investors for risk – manifesting itself as a search for yield. The result has been a pronounced narrowing of credit spreads in global financial markets with investors willing to substantially discount the risk they attach to the borrowings of both sovereigns and corporates, even those with low credit ratings. This is giving rise to concerns about the possibility of the mispricing of global credit risk and a misallocation of global capital. If this were to occur it would be a worrying outcome from a longer-run financial stability perspective.

The low level of interest rates in the US, combined with the large US current account deficit, is also fuelling a major realignment of exchange rates, with the US dollar depreciating by 22 per cent on a major-currency trade-weighted basis over the past two years (Graph 3). With a number of countries, notably in Asia, resisting the appreciation of their own currencies against the US dollar, exchange rate adjustment has been most pronounced against those countries that have freely floating currencies, such as the Euro area, the UK, Canada, Australia and New Zealand. While these exchange rate adjustments have been very large, the foreign exchange markets have remained orderly throughout.

1.2 Australia

In line with the improvement in global conditions, the Australian economy has picked-up significantly since around the middle of last year, with GDP increasing at an annualised rate of 5½ per cent over the second half of 2003. The economy is in its thirteenth consecutive year of expansion without experiencing a recession, with growth averaging 3¾ per cent per year since mid 1991.

The strong growth outcomes have, since the mid 1990s, been associated with significant gains in residential property prices and rapid growth in borrowing by the household sector. In contrast, business borrowing has been restrained and commercial property prices have grown only modestly, in many cases remaining below their peaks of the late 1980s. In assessing risks to financial stability, it is important to understand developments in both household and corporate balance sheets and how these developments are affecting the risk profiles of the two sectors.

Household Sector

Balance sheets

A striking feature of the household sector's balance sheet over recent years has been the rapid growth in borrowing. Since 1996, the level of household credit outstanding has risen at an average annual rate of 15 per cent and an even faster 22 per cent over the year to January 2004. This run-up in debt has taken the debt-to-income ratio in Australia from a level that was low by international standards a decade ago, to a level that is now in the top end of the range seen in most other countries.

This shift is largely explained by the move to a low-inflation/low-interest-rate environment, which significantly increased the capacity of households to borrow. At the same time, financial deregulation and the associated competition among lenders has made cheaper, more innovative mortgage products available, including those specifically tailored for investor housing.[2]

Most components of household borrowing have grown strongly, although the bulk of the increase in debt has been in loans for the purchase of housing, which now account for 85 per cent of total household debt (Graph 4). Borrowing for owner-occupier housing is still the largest component of household debt, although borrowing to invest in rental housing has been growing much more quickly over recent years. Since 1996, the value of investor housing loans outstanding has grown at an average annual rate of 23 per cent, with the pace of growth accelerating in recent years, to be currently around 31 per cent.

Besides housing purchases, households appear to be using debt secured against housing to support strong growth in spending. Borrowing for housing has grown much more quickly than the value of dwelling investment – a phenomenon known as housing equity withdrawal. Since late 2000, housing equity withdrawal has amounted to an average of around 4½ per cent of household disposable income; prior to this, the usual pattern was for the household sector to inject equity into the housing stock (Graph 5).

The rise in household debt has been associated with strong growth in household asset values (Table 2). This largely reflects higher house prices, which have risen at an average annual rate of 12 per cent since 1996 (Graph 6). An important feature of the current upswing is that it has continued over a more prolonged period, and over a broader geographic range, than has been typical in the past, and has occurred at a time when the general inflation rate has been low. As a result, the cumulative increase in house prices in real terms is the largest recorded during the period for which reliable data are available.

With the value of the housing stock having risen at around the same rate as housing-related debt since the mid 1990s, the housing gearing ratio has remained broadly unchanged since 1996. This follows a significant increase in this ratio over the first half of the 1990s, when gains in residential property prices were modest and debt levels were rising solidly. A broader measure of household gearing is the ratio of the household sector's total debts to its assets. This measure has drifted up over recent years, as the household sector's holdings of financial assets have not risen as quickly as its debt levels (Graph 7). Currently, household debt outstanding is equivalent to 14½ per cent of the value of the household sector's assets.

With housing prices growing much more quickly than incomes over a number of years, the ratio of house prices to household disposable income has more than doubled since the mid 1980s. In addition, the house-price-to-income ratio is at a record level and considerably above its previous peak (Graph 8). While international comparisons of house prices are difficult, the available evidence suggests that housing prices in Australia relative to income are higher than in many other countries. In part this reflects the tendency for Australians to live in large urban centres and in detached housing.

These aggregate data on the household sector's balance sheet obviously hide considerable variation across households. Owner-occupier housing debt is concentrated in less than a third of Australian households, and this degree of concentration has not significantly changed in the past decade, despite strong growth in housing debt since the early 1990s. Census data for 2001 show that 29 per cent of households owned their home with a mortgage, 43 per cent owned their home outright and the remaining 28 per cent lived in rental accommodation, proportions broadly unchanged since the early 1990s.

Data on the distribution and characteristics of individuals owning investment property are available from the Australian Taxation Office. These data indicate that in 2000/01, the latest year for which detailed data are available, around 12½ per cent of taxpayers received rental income with the bulk of these investors financing the property with some debt.[3] Ownership rates increase with income, with around 20 per cent of taxpayers with incomes in the range of $50,000 to $100,000 owning a rental property, and around 80 per cent of these financing the property with at least some debt (see Box A for more details). The data also suggest that, over the 1990s, both the share of taxpayers with an investment property and the share of investors with debt have increased significantly.

Debt servicing

The rapid increase in debt levels relative to income has seen the debt-servicing ratio – the ratio of interest payments to disposable income – trend up over recent years, although the increase has been muted considerably by the fall in nominal borrowing rates (Graph 9). Mortgage interest payments now represent almost 7½ per cent of household disposable income, a level that exceeds the peak of nearly 5½ per cent in the mid 1990s.[4] The total interest costs of the household sector (i.e. including interest on other forms of household borrowing) are also above the previous peak in the late 1980s at just over 9 per cent of household income.

ABS data suggest that, after a lengthy period as a net interest recipient, the household sector has been a net payer of interest over the past decade. The rising trend in net interest payments reflects both the growing indebtedness of the household sector, and a shift among households toward assets other than interest-bearing instruments.

Again, these aggregate figures hide considerable variation across households. According to the Household Income and Labour Dynamics in Australia (HILDA) Survey, the median total servicing payment (interest plus repayment of principal) on owner-occupier housing debt is 20 per cent of disposable income. For households in the lower income ranges, the ratio is considerably higher (Graph 10). Many households are, however, repaying their mortgages more quickly than required, with the Survey suggesting that around 60 per cent of households are ahead of required repayments on their primary mortgage.

The HILDA Survey does not record interest payments on loans on investor property, which according to the taxation data, are considerable for many middle-income households. For those households with both an owner-occupier and an investor loan, the debt-servicing ratio is likely to be above 30 per cent in many cases.

Despite servicing burdens that have increased and are high by historical standards, there are currently few signs that households are having difficulty meeting their interest payments. This reflects a number of factors. One is that the increase in the debt-servicing ratio has been driven by household decisions to increase their level of debt, and not by a large and unexpected increase in interest rates as was the case in the late 1980s. In that episode, there was considerable mortgage stress even though, in aggregate, interest payments accounted for a smaller share of household disposable income than is currently the case. Another difference between current conditions and that period is that household incomes have not been disrupted by rising unemployment. Over the past five years, employment has grown at an average annual rate of around 2 per cent, and the unemployment rate is currently around the lowest levels in two decades.

Reflecting the strong macroeconomic environment, housing-loan arrears have recently fallen slightly and are now at a very low level at less than 0.2 per cent of total housing loans. Credit-card-arrears – a potentially useful leading indicator of financial stress in the household sector – have also fallen over the past two years, both in absolute terms and as a percentage of total balances. Growth in credit card cash advances – another potential leading indicator of stress – has been subdued. The number of personal bankruptcies has also declined, although this has been partly offset by the growing use of debt agreements as an alternative to bankruptcy (see Box B for more details).

Survey data also suggest that, in aggregate, households are comfortable with their financial position both in terms of the current period and looking ahead (Graph 11). Survey data show that consumers are more positive about their personal finances than a year ago, and sentiment for the year ahead is also above the long-run average.

Assessment of vulnerabilities

While there are currently few signs of stress in the household sector, an important issue is whether the run-up in debt and housing prices over recent years poses a risk to the stability of the financial system, and the macroeconomy more generally.

As discussed in the chapter on Financial Intermediaries, the Australian financial system is currently in good shape. It is difficult to envisage scenarios in which developments in the housing market alone could cause losses on a sufficient scale to result in major difficulties for the Australian financial system. Notwithstanding this, the emergence of an active mortgage market in loans to borrowers with lower credit quality, the development of new ways of originating housing loans, and the strong growth in loans to investors carry the risk that any downturn in the housing market and, more importantly, the economy, could cause default rates to increase by considerably more than would be suggested by historical experience.

A more medium-term risk is that, at some point, after borrowing heavily for a number of years, the household sector will decide to undertake a period of balance-sheet restructuring. If this were prompted by a deterioration in economic conditions it could amplify what might otherwise have been a relatively mild slowdown.

The likelihood of such an outcome is difficult to quantify. There have been few instances in either Australia or elsewhere in which balance-sheet adjustment by the household sector has been a major factor amplifying an economic downturn. In previous episodes, it has typically been adjustments by the corporate sector and by financial institutions that have amplified the business cycle. Notwithstanding this, the recent run-up in household debt and residential property prices has increased the risk of such an outcome, although this risk is still likely to be relatively small, particularly given the continuing strong performance of the Australian economy.

In assessing the likelihood of such adjustments, developments in the residential property market are obviously important. As the Reserve Bank has noted on previous occasions, the main reason house prices have risen so much relative to incomes is that mortgage interest rates have approximately halved since the second half of the 1980s. Another factor has been the reduced volatility of interest rates and the greater stability of the economy which together have given households the confidence to take on larger loans. It might be expected, however, that the upward movement in prices due to these effects would be tapering off by now, with house prices rising by no more than could be explained by underlying growth in incomes. While the rate of growth of house prices has slowed considerably in Sydney and Melbourne, and prices in some inner-city apartment markets have fallen, the latest data (up to the December quarter 2003) indicate that prices are, on average, still increasing.

One important impetus to house prices over the past couple of years has been the unusually strong demand by investors for rental property. This demand has been underpinned by investors seeking capital gains, ready access to finance and a taxation system that makes such investments very attractive. Demand by investors has been strong, despite the fact that rental yields have fallen to levels that are very low, both in comparison to previous experience in Australia and overseas.

Encouragingly, recent data indicate that over the past few months the demand by investors has subsided. While loan approvals to investors are still high, they have fallen by almost 24 per cent from the peak in October 2003 (Graph 12). Approvals for loans to owner-occupiers have also fallen over recent months, although they too remain at high levels. Survey evidence also suggests that residential property investment is seen as a less attractive proposition than was the case for much of 2003 (Graph 13).

It is too early to tell whether this decline in demand will be sustained, and what effect it will have on prices. Recently, there have been reports that some investors who made speculative off-the-plan purchases in the hope of reselling at a profit before settlement have failed to settle when faced with a decline in price. More generally, given the evidence that many investors are middle-income earners facing relatively high debt-servicing burdens, a fall in prices, and perhaps more importantly, a fall in rents and a rise in vacancy rates, could cause financial stress for a number of households. Any attempt by a large number of investors to sell their rental properties quickly would add to the downward pressure on house prices. If this were to occur, the probability of a broader pull-back in household borrowing and spending would be higher.

More broadly, should economic outcomes turn out to be disappointingly weak, there is considerable uncertainty about how the household sector is likely to behave, given much higher debt levels than in the past. Over recent years, the rapid growth in borrowing has underpinned growth in consumption at a faster pace than growth in household disposable income, with the saving rate falling considerably (Graph 14). If the household sector were to decide that the level of borrowing had become too high, a period of quite weak consumption might be expected, as households attempt to reduce their debt levels.

Business Sector

The Australian business sector is, overall, in a strong position, reflecting the long running expansion of the Australian economy. The level of profitability is high, gearing is relatively low and current conditions are positive.

Over the year to the December quarter, business profitability, as measured by total gross operating surplus (GOS) increased by almost 12 per cent. As a share of GDP, profits are around the peak levels seen since the early 1990s (Graph 15). After interest payments, the profit share is at its highest level since the early 1980s, with businesses having benefited substantially from relatively low levels of gearing and the downward shift in interest rates.

The strong growth in profits has allowed firms to use internal funding to finance increasing levels of investment. This is evident in the ‘financing gap’ – the difference between investment expenditure and available internal funds – falling to low levels by historical standards (Graph 16). A consequence of this is that the business sector has made relatively little recourse to bank lending over recent years. Since the mid 1990s, business credit has grown at an average annual rate of around 7 per cent, only slightly faster than growth in nominal GDP.

Reflecting these developments, the aggregate gearing ratio is relatively low by historical standards. For non-financial firms currently listed on the Australian Stock Exchange (ASX), the value of debt outstanding appears to be around 60 per cent of the book value of equity. This is lower than was the case for the same group of firms in the late 1980s and much lower still than for all firms listed on the ASX in the late 1980s (Graph 17).[5] With low levels of debt and interest rates, corporates' debt-servicing costs have fallen to the lowest level for at least a couple of decades.

Recent months have seen the demand for external funding pick up a little, with business credit growing at an annualised rate of 11 per cent in the six months to January 2004 (Graph 18). Larger corporates also substantially increased bond issuance in 2003, taking advantage of relatively low yields and strong demand for Australian dollar debt by overseas investors. Foreign demand for Australian equities was also evident in 2003, with foreign portfolio equity inflows increasing through the year. As evidenced by very strong net equity raisings in the December quarter, and sizeable expected equity issuance in coming months, companies have taken advantage of the sharemarket reaching its highest level since mid 2002.

In the past few years, Australian firms have become more exposed to fluctuations in interest rates with a trend away from fixed-rate bank borrowing, such that only 20 per cent of bank-sourced funding is now at fixed rates (Graph 19). Somewhat counterbalancing this, however, larger firms with direct access to financial markets have made increased use of longer-term fixed-rate funding, issuing bonds at a much faster pace than short-term securities. Overall, at present levels of indebtedness and interest rates, vulnerability seems to be low.

Within the business sector, the commercial property market has, on occasion, been a source of vulnerability. Over recent years, however, this market, unlike the residential property market, has generally been quite subdued. In the office market, many prices remain below their peaks of over a decade ago, and the level of construction activity, while having picked up recently, is considerably lower than it was in the second half of the 1980s (Graph 20). While vacancy rates for office space have edged up over recent years, and there has been downward pressure on rents, conditions in industries employing a large number of office workers have picked up. In the retail property sector, conditions have been stronger, consistent with buoyant retail trade, with 3½ per cent growth in rents in 2003, the highest in three years. Industrial property prices increased by almost 5 per cent in the year to December 2003, though growth in rents was more subdued.

Assessment of vulnerabilities

Looking ahead, the healthy state of the business sector and the economic outlook are positive for financial stability. Forecasts gathered by Consensus Economics predict a positive outlook for corporate profits, with expected growth of around 7½ per cent for 2004. While recent readings of business confidence, as measured in the major business surveys, have receded from very high levels, businesses remain more confident than usual about the future.

Partly reflecting this outlook, a number of measures of corporate credit risk have fallen recently, although as elsewhere around the world, the good conditions in the corporate sector are causing investors to be less concerned about compensation for risk. Premia for credit default swaps (CDS), which measure the cost of insurance against a specific company defaulting, have fallen sharply in the past year and spreads between corporate bond and swap rates have also fallen (Graph 21). In contrast, interest rate spreads between corporate bonds and Commonwealth Government securities (CGS) have risen over the past six months, although this appears to reflect strong demand for CGS, particularly from overseas investors, rather than a judgement about credit quality in the Australian corporate sector.

Share price movements also convey a buoyant tone, particularly for resource companies. The S&P ASX 200 has risen by 3 per cent to date in 2004, to be only 3 per cent off its 2002 peak, a strong outcome by international standards (Graph 22). The ASX 200 Resources Index has fallen slightly to date in 2004, but remains around 35 per cent higher than in mid 2003. The ASX 200 Property Trusts Index has continued to rise, partly reflecting the attraction of relatively steady rental income streams in the low-interest-rate environment.

Measures of uncertainty about the outlook for share prices are a useful adjunct to other indicators of equity market sentiment. The most commonly cited measure of such uncertainty is ‘implied volatility’ which, being derived from prices for equity options, can be thought of as measuring the uncertainty investors attach to expected equity returns over the life of those options. Implied volatility is currently around historic lows, suggesting that the market is relatively comfortable with the risk outlook ahead (Graph 23).

Notwithstanding the generally favourable environment, the outlook is not without risks. In particular, if the household sector was to undertake a period of balance-sheet restructuring which amplified a slowdown in the economy, there would be negative effects on the business sector. Fluctuations in exchange rates and market interest rates also pose a risk for some firms, although to date, the business sector has weathered substantial swings in the exchange rate without major difficulty. Finally, a more medium-term risk arises from developments in the global economy. In the current environment of low global interest rates and reduced risk aversion, there is a possibility that investors are mispricing risk, too much borrowing takes place and misalignments develop in important asset markets. If this were to occur, the Australian business sector is unlikely to remain unaffected.


For further detail on international economic and financial market conditions refer to the Statement on Monetary Policy, Reserve Bank of Australia, February 2004. [1]

For further discussions see ‘Household Debt: What the Data Show’, Reserve Bank of Australia Bulletin, March 2003, pp 1–11; IJ Macfarlane, ‘ Do Australian Households Borrow Too Much’, Reserve Bank of Australia Bulletin, April 2003, pp 7–16; and Submission to the Productivity Commission Inquiry on First Home Ownership, Reserve Bank of Australia, Occasional Paper No. 16, November 2003. [2]

Data from the 2002 Household Income and Labour Dynamics in Australia (HILDA) Survey show that around 10 per cent of households invested in property (i.e. they both owned a property other than their primary residence and received rental income). [3]

Repayment of principal is estimated to amount to a further 2½ per cent of income. [4]

Given the greater tendency for highly leveraged firms to fail it is not unusual for the debt-to-equity ratio for firms listed at a given point in time to exceed the ratio for the same period calculated for firms currently listed. [5]