Financial Stability Review – September 2004 1. The Macroeconomic and Financial Environment

1.1 The Global Environment

The global economy has strengthened further through 2004, and is providing a supportive environment for the Australian financial system and the Australian economy. Improved conditions are evident in most major regions. The recovery in the United States appears to be well established, conditions in Japan are the brightest in over a decade, and economic activity in the euro area is gradually gaining momentum. Growth also remains strong in most Asian countries, notwithstanding some slowing in China. Overall, forecasts compiled by Consensus Economics are for above-average growth in world GDP in both 2004 and 2005 (Graph 1).

The improvement in the global economy partly reflects substantial policy stimulus. Policy rates in key economies remain at or near 40-year lows and budget deficits in the G3 countries – the US, Japan and Germany – are high by historical standards (Graph 2).

As discussed in the previous Financial Stability Review, this period of low interest rates and low volatility in financial markets has been associated with a general decline in risk premia and an increase in risk appetites as investors chase higher yields. Relatively steep yield curves in some countries have created incentives for investors to participate in ‘carry trades’, in which short-term borrowings are used to finance longer-term, more risky assets (Graph 3). Moreover, some institutions have been prepared to accept more risk in an effort to ensure that earnings on their assets do not fall below promised rates of return on their liabilities. Another manifestation of the general increase in risk appetite is that net private capital flows into emerging markets increased in 2003 to be at their highest level since 1996. There has also been a greater willingness of the largest international banks to take on market risk, with the total value at risk estimated to have risen by around 50 per cent in the past two years. While there are some signs that the tolerance for risk has declined a little since the start of this year, bond spreads have remained largely unchanged (Graph 4).

In the United States, the process of removing some of the monetary stimulus commenced in June, with the federal funds rate raised by a cumulative 50 basis points to mid September. The reaction of financial markets to the increase has been measured. Some unwinding of carry trades occurred in anticipation of the tightening in June and volatility has remained low in both bond and equity markets.

This experience stands in contrast to the tightening cycle that started in February 1994, which saw a rapid change in interest-rate expectations and a significant sell-off in the bond market. Within eight weeks of the 1994 tightening, yields on long-term bonds had increased by almost 100 basis points, whereas this time, yields fell by less than 50 basis points over the same interval (Graph 5). Similarly, the share market has fared much better in 2004 than it did in 1994, when the S&P 500 Index fell by 9 per cent within two months of the initial tightening. In the current episode, the share market is down only 1 per cent since the Federal Reserve first tightened.

In part, the recent benign outcomes reflect the Fed's communication strategy, which has carefully telegraphed the tightening of monetary policy. Despite this, a risk remains that the trajectory of interest rate increases will turn out to be sharper than currently expected, particularly if economic growth or inflation were to surprise on the upside. In such an environment, there is the potential for some market instability, as investors simultaneously attempt to unwind the leveraged positions built up over the low-interest-rate period. In the bond market, in particular, the potential for exaggerated moves in yields may have increased over recent years due to the extensive use of this market for the hedging of interest-rate risk associated with US mortgage-backed securities. Similarly, as hedge funds have become more important in price setting in global financial markets, the potential for them to contribute to market instability has also increased.

Currency markets have been relatively stable this year following large swings over recent years. While concerns remain regarding the historically large US current account deficit, the US dollar, on a trade-weighted basis, has been relatively steady of late. After appreciating strongly in 2002 and 2003, the Australian dollar has depreciated by around 8 per cent since March, broadly reflecting market expectations of movements in relative short-term interest rates (Graph 6).

Not surprisingly, the combination of better economic conditions, low interest rates and relatively stable financial markets has been good for the global banking system. The largest international banks have been delivering higher returns reflecting stronger demand for credit, sustained improvement in asset quality and good trading income. Global investment banks have experienced a pick-up in fee income in the first half of 2004, supported by stronger debt and equity issuance as well as resurgent mergers and acquisitions activity. Conditions in the weaker Japanese and German banking systems have also improved over the past year and a half, as balance sheets have been restructured on the back of stronger corporate profitability and declining bad debts expense. Reflecting the better environment, bank share prices have tended to increase over the past year and a half, after falling in 2001 and 2002 (Graph 7).

The global insurance sector is also benefiting from a stronger world economy, higher share prices and the positive impact of higher long-term yields on the discounted value of their liabilities. Non-life insurers are profiting from rising premium revenue and a low incidence of large losses, although the life industry is still in the process of rebuilding its capital base, particularly in Europe. Reinsurers have also improved their financial positions over the past year, reflecting greater underwriting discipline and a below-average incidence of natural catastrophes.

1.2 Australia

Recent developments in Australia have been favourable from a financial stability perspective. The economy has continued to grow strongly, expanding by 4.1 per cent over the year to the June quarter, and the unemployment rate is around 20-year lows. Consumer confidence remains high and businesses are optimistic about the future.

Perhaps the most notable development over the past six months has been a small decline in house prices. This comes after prices rose by around 20 per cent in 2003 and doubled over the six years to end 2003 (Graph 8). The recent turnaround is more pronounced than expected, but it is a welcome development, reducing the probability of a much larger and more costly correction at some point in the future.

Household Sector

The changed conditions in the housing market can be clearly seen by comparing house price movements over the two halves of 2003/04 (Table 1). While the precise numbers differ, all four main measures of national house prices show a marked slowing in growth over the first half of 2004, and all recorded a decline in the June quarter. Similarly, the four series show a fall in prices in Melbourne over the first half of 2004, and three of the four show a decline in prices in Sydney. In the other capital cities, prices have continued to increase, but at a much slower pace than over previous years. On a year-ended basis, the various measures are all showing average nationwide increases of around 10 per cent or less.

The slowdown in the housing market has been associated with some revision in the household sector's attitudes towards property investment. The Melbourne Institute and Westpac Survey shows a fall in the proportion of respondents reporting that property is the wisest place for their savings (Graph 9). Similarly, survey evidence suggests that the number of people planning to purchase an investment property over the next year has declined a little from the peak reached in mid 2003. This is supported by the Bank's liaison, which suggests that there has been a significant decline in interest in off-the-plan purchases by investors. This change in sentiment is a pleasing development, particularly given the unrealistic expectations of future price increases that had developed in some parts of the market in recent years.

The change in the housing market and sentiment towards residential property investment has had little effect on households' perceptions of the health of their personal finances, or their views about future economic conditions. Households continue to report that their personal finances are in very good shape and that they are optimistic about the future (Graph 10).

As growth in house prices has slowed, the pace of household credit growth has also declined. This is now more evident than it was a few months ago, particularly after recent revisions to the data. Growth in household credit peaked in the final months of 2003, at much the same time as the peak in house prices. On a six-month-ended annualised basis, household credit is currently growing at around 16 per cent, down from 21 per cent late last year (Graph 11).

The turnaround is most pronounced in the growth rate of credit to investors. Over the past six months, investor housing credit has increased at an annualised rate of around 20 per cent, compared with a rate of more than 30 per cent over the second half of 2003. Given the recent fall in investor loan approvals, a further decline appears to be in prospect over coming months (Graph 12). As noted above, there has been some reassessment of the desirability of residential property investment. A stronger equity market may have played a role here. Also, the Australian Taxation Office announced in June that it will be subjecting deductions associated with property investments to greater scrutiny, and the NSW Government has introduced a vendor duty on the sale of investment properties. While there have been some reports of investors not being able, or willing, to settle off-the-plan apartment purchases, this does not appear to have become a widespread phenomenon.

Non-housing components of household credit continue to grow at slower rates than housing-related credit. Over the year to July, other personal credit, including credit card debt, increased by 13½ per cent.

While overall household credit growth has slowed, it remains strong by historical standards. The current level of housing loan approvals points to some further slowing in household credit growth over coming months, although additional declines in approvals are likely to be required if growth is to return to rates more consistent with that in household disposable income.

The combination of still strong credit growth and a decline in house prices has seen household gearing increase over the past six months (Graph 13). The ratio of household debt to household assets currently stands at around 17 per cent, and has increased steadily from around 9 per cent in 1990. The relatively mild increase in gearing, despite strong growth in debt, reflects the large appreciation in house prices.

One way the household sector is accessing equity in the housing stock is through refinancing of existing mortgages. Since end 1999, refinancing of owner-occupier mortgages has grown at an average rate of almost 30 per cent per year, and currently accounts for around one quarter of total owner-occupier loan commitments (Graph 14). The total volume of refinancing is likely to be higher than this, as the ABS data do not capture owner-occupier loans refinanced with the same institution or refinanced investor loans. Liaison with the major banks suggests that such refinancing is common.

In part, the high rate of refinancing reflects the competitive nature of the mortgage market. By shopping around, often with the assistance of a mortgage broker, borrowers can sometimes find a loan with a lower interest rate or more attractive features. Refinancing is also often associated with an increase in the size of the outstanding debt, with the average size of a refinanced loan typically larger than that of a new loan originated three or more years earlier. In terms of purpose, an ABS survey for the period 1997–99 found that 21 per cent of refinancing households cited consumption spending as a reason for doing so, a finding broadly supported by more recent liaison with banks (Table 2). Home improvements also appear to be an important use of funds accessed through refinancing.

Similar trends have also been observed in other countries that have experienced strong growth in housing debt and house prices, including the Netherlands, UK and US (Graph 15). As in Australia, mortgage refinancing in these countries has been associated with an increase in loan size, and with a significant part of the additional funds being spent on consumption and home improvements.[1]

With household credit in Australia continuing to expand at a strong pace, the ratio of interest payments to household disposable income has increased further over the past six months, although it fell marginally in the June quarter as a result of a large increase in disposable income flowing from higher government payments. This ratio currently stands at 9.3 per cent, slightly above the peak in the late 1980s (Graph 16). The bulk of these interest payments is associated with residential mortgages, rather than consumer debt.

Despite the historically high level of interest payments as a share of disposable income, there are few signs of financial stress among households. The share of housing loans for which repayments are overdue is extremely low (see the following chapter). Spreads on issues of mortgage-backed securities have contracted over the past year, suggesting that investors in these securities perceive a reduced likelihood of problems in the household sector. (This is explored further in the article ‘Asset Securitisation in Australia’.) Similarly, current readings from credit card data, which can potentially be used as a leading indicator of stress in the household sector, are benign (see Box A). The number of personal administrations has also fallen over the past year and, as reported above, consumer confidence remains high.

Assessment of vulnerabilities

Overall, the household sector is currently experiencing favourable financial conditions. While debt levels have risen significantly over the past decade, households appear to be having relatively little difficulty meeting the higher level of interest payments. The sector is currently benefiting from a favourable labour market and solid returns on financial assets.

In this relatively benign environment, one risk has been that household indebtedness and house prices would increase to levels that would ultimately prove unsustainable. During 2003, the rate of increase in both household credit and house prices accelerated from an already fast pace, raising a concern that some households were making spending decisions based on unrealistic assessments of future returns and the associated risks. From a stability perspective, the risk has been that, at some point in the future, the household sector would need to adjust its balance sheet, reining in spending to reduce debt levels and servicing burdens. If this were to occur, consumption could weaken, reversing the pattern of recent years whereby consumption growth has outstripped that of income. In an environment in which the economy was slowing for other reasons, this type of balance-sheet adjustment could make for a more extended downturn.

The strong growth in consumption over recent years is reflected in the steady decline in the saving ratio. Using the gross measure, which excludes items such as depreciation of the dwelling stock, the ratio has fallen from 13 per cent in 1995 to 8 per cent in 2004 (Graph 17). On a net basis the ratio is −2 per cent. Strong spending is also suggested by the willingness of the household sector to borrow against its equity in the housing stock – a phenomenon known as housing equity withdrawal. Prior to the late 1990s, the usual pattern was for the household sector to inject equity into housing, but since that time, households have borrowed more against their houses than they have spent building and renovating them (Graph 18). While households have used the extra borrowing for a variety of purposes, one of these is to finance consumption. That a turnaround in these trends after a period of rising housing prices and credit can adversely affect consumption and economic growth is confirmed by the recent experience in the Netherlands (see Box B).

Given the possibility of such an outcome in Australia, recent developments, especially the modest decline in house prices and the slowing in household credit growth, have been favourable from a financial stability perspective. If 2004 had seen a repeat of 2003, with house prices increasing by around 20 per cent and credit growth accelerating, the risk of an uncomfortable correction in household finances would have been somewhat higher than is now the case. While the possibility of a fall in house prices was viewed with trepidation by some commentators, the adjustment to date has been orderly and without noticeable adverse side effects. Importantly, it has taken place against the backdrop of a strong economy and a high level of consumer confidence.

Recent developments have, of course, not eliminated the risk of the household sector reducing spending in order to restructure its balance sheet. A number of financial ratios – including debt to disposable income, interest payments to disposable income, and house prices to disposable income – are at, or near, record high levels. As noted in the previous Financial Stability Review and in the Reserve Bank's Submission to the Productivity Commission Inquiry on First Home Ownership, the change in household balance sheets is partly explained by structural factors. Foremost amongst these is the decline in nominal interest rates that has accompanied lower inflation. A second is financial deregulation and innovation which, amongst other things, has allowed households to take advantage of the tax treatment of investor housing. And a third is the reduction in the volatility of both interest rates and the economy, with lower volatility providing households with the confidence to take on larger debt levels and higher servicing burdens.

From the perspective of assessing risk, a difficulty has been in knowing exactly how much of the change in the key financial ratios is explained by these structural factors. Notwithstanding this difficulty, by 2003 it seemed apparent that the increase in house prices was probably at the top end of the range that could be explained by the reduction in interest rates, and that further significant increases risked pushing prices to unsustainable levels. Despite this, for much of the year prices continued to rise strongly, with demand by investors particularly robust.

While the trajectory of house prices has now clearly changed, and household credit growth has slowed, risks remain in both directions. A deterioration in the economic climate, or a further and significant change in investors' attitudes, could see a more pronounced fall in house prices with consumers adjusting spending to reduce debt levels. Alternatively, the housing market could again race ahead on the basis of continuing high levels of consumer confidence and solid growth in employment and income. While this would likely add further strength to consumption in the short term, it could increase the probability of difficulties further down the track.

Business Sector

Conditions in the business sector have remained very positive in 2004. Profitability and trading conditions are strong, and gearing and interest burdens are low.

Business sector profits, as measured by gross operating surplus (GOS), increased by more than 14 per cent over the year to the June quarter. As a share of GDP, profits are at the highest level since mid 1990, while on an after-interest basis, they are at the highest level since 1981 (Graph 19).

In the strong profit environment, businesses have relied more on internal than external funding for some years now – a sharp contrast with the second half of the 1980s. Over the year to June 2004, new internal funding represented around 60 per cent of new business finance (Graph 20). Business credit continues to grow relatively slowly, up by 6 per cent on an annualised basis over the six months to July. Net equity raisings have moderated over recent months after being reasonably strong late last year and into this year.

Reflecting the limited use of debt finance, measures of indebtedness have declined to low levels and are well below those experienced during the episode of corporate stress in the late 1980s and early 1990s (Graph 21). The combination of low gearing and relatively low interest rates means that the interest burden is at the lowest level for a number of decades.

In the past, difficulties in the commercial property markets have been a significant cause of problems in the corporate sector. At the moment, however, there are few signs of the major imbalances that characterised these markets at the end of the 1980s. In contrast to the over-building that characterised that episode, particularly of office space, the commercial property construction cycle has since been far more moderate (Graph 22).

Although there has been recent downward pressure on prices and rents in the office property market, those for retail and industrial properties appear to have picked up. Partly reflecting this, listed property trusts (LPTs) have continued to perform strongly. Gains in the ASX 200 Property Trusts Accumulation Index, which comprises capital and income returns, have continued to outpace the broader market (Graph 23). The growth of the LPT sector over recent years has been useful, not only by providing an observable market-based indicator of conditions in the commercial property sector, but also by providing an alternative to banks for the financing of commercial property.

Assessment of vulnerabilities

The strength of the business sector is a positive for financial stability. Business surveys report that the majority of firms expect trading conditions and profitability to remain above long-run averages. Forecasts collected by Consensus Economics show expected growth in corporate sector GOS of around 11 per cent for 2004 and 6 per cent for 2005. Financial markets also see a benign outlook for the corporate sector. Measures of corporate credit risk, including credit default swap (CDS) premia and corporate bond spreads, remain at low levels, despite increasing slightly this year (Graph 24).

Movements in the share market also reflect a sanguine outlook. The ASX 200 Index increased by around 6 per cent over the past six months, while most key overseas markets were flat or slightly lower (Graph 25). Since 2000, the Australian share market has considerably outperformed international markets and is the only one among major countries to be currently around record levels. Share prices of resource companies have risen particularly strongly in recent times, largely reflecting the market's assessment that international demand will remain firm and continue to underpin commodity prices, particularly if the Chinese economy remains strong. Uncertainty, as measured by the implied volatility of equity prices, also remains at low levels.

One risk to this generally favourable outlook is related to developments in the household sector. If there were to be a period of balance-sheet restructuring by households, leading to an episode of weak economic growth, conditions in the business sector would obviously be less favourable than is now the case. There is, however, little risk that balance-sheet considerations in the business sector would adversely impinge on business decisions as they did in the early 1990s.


In the US, the majority of mortgages have fixed interest rates and favourable refinancing terms, making it attractive to refinance when long-term interest rates fall. [1]