Financial Stability Review – March 2005 1. The Macroeconomic and Financial Environment

1.1 The Global Environment

The International Economy and Financial Markets

The international economy has performed strongly recently, providing a favourable backdrop for the Australian economy and financial system. In 2004, growth in world economic activity is estimated to have been 5 per cent, well above the average of recent decades, though outcomes have varied widely across countries, with the United States, China and emerging Asia significantly outperforming the euro area and Japan (Table 1). Expectations are that above-average growth will continue in both 2005 and 2006. Despite a pick-up in commodity and producer prices, inflation expectations remain subdued.

Growth has been underpinned by expansionary monetary policy and, to a lesser extent, fiscal policy in a number of countries. Despite increases in some countries, policy interest rates remain very low, and long-term interest rates have also been at historically low levels (Graph 1). This combination of healthy economic outcomes and low interest rates has had significant effects on financial markets and borrowing decisions, contributing to risk being perceived as low and/or priced very cheaply, and to an increase in leverage in both financial markets and household balance sheets.

The clearest evidence on risk perceptions and pricing is from bond markets, where spreads on lowly rated corporate and sovereign bonds have fallen to levels not seen since before the Asian financial crisis in 1997/98 (Graph 2). But it is also evident in global equity prices, which have increased strongly over the past six months, particularly in emerging market economies, while at the same time, implied equity market volatility has fallen to historically low levels in many countries (Graph 3). There have also been very strong inflows into hedge funds, which often take on more risk and leverage than many other forms of managed investments (Graph 4).

The impact of low nominal interest rates on borrowing decisions is most evident in the data on household credit growth. Over the past few years, growth in household borrowing in a range of countries, including the United States, the United Kingdom and New Zealand, has been rapid by historical standards, with much of this borrowing being for housing (Table 2). The result has been a significant rise in household debt levels and housing prices relative to income. Saving rates have also tended to decline in a number of these countries, as increased household wealth and loan refinancing has been used to support consumption (Graph 5).

In contrast, business credit growth has been more subdued in most countries. One reason for this is the relatively important role that cash flow plays as a determinant of household borrowing compared to business borrowing. In particular, low nominal interest rates have allowed households with a given cash flow to service a larger housing loan than was previously the case, with many households taking advantage of this opportunity, particularly in countries with reasonable economic growth. Low nominal interest rates have not provided the same strong impetus to borrowing by businesses and to commercial property prices.

The willingness of some investors to take on more leverage and, apparently, accept less compensation for holding risk has a number of possible explanations. One is that the perceived likelihood of a recession – or some other adverse event serious enough to cause an increase in defaults – has declined over recent years, as have concerns about a sudden increase in inflation. Such views may have been reinforced by the apparent increased stability over the past decade of both economic activity and prices. These outcomes have given investors the confidence to take on more debt and buy assets at lower risk spreads than would have been the case some years ago. They have also been important in generating the confidence that has allowed households to take advantage of low interest rates through increased borrowing. A second explanation is that the long period of very low interest rates, combined with a high level of global savings, has prompted a ‘search for yield’ by investors. In an effort to diversify expanding portfolios and maintain returns close to historical averages, investors have sought alternative assets, pushing up their prices and in so doing reducing the compensation that they receive for accepting risk.

With risk spreads at historically low levels, a reassessment of risk is likely at some point in the future. Exactly when this might occur and what might prompt it are largely unpredictable. One possible trigger would be higher-than-expected inflation globally, but particularly in the United States, leading to a sharp rise in interest rates. In such a scenario, there could be an abrupt reappraisal of risk across a broad range of assets and a rapid unwinding of highly leveraged speculative positions, with potential disruption to financial markets. There could also be significant effects on household borrowing and spending decisions.

Another possible, though less likely, trigger is a sharp and disorderly depreciation of the US dollar in response to concerns about the US budget and current account deficits (Graph 6). The adjustment in the US dollar, to date, has been orderly, with the currency depreciating, on a real trade-weighted basis, by around 15 per cent from its peak, to around its 30-year average (Graph 7). Notwithstanding this, concerns have been expressed in some quarters that with the current account deficit at 6¼ per cent of GDP, investors may become less willing to accumulate progressively larger holdings of US-dollar assets. While an abrupt change in sentiment cannot be ruled out, the historical experience is that external imbalances in industrialised countries with floating exchange rates and sound financial systems have typically been resolved in an orderly manner. Perhaps of greater concern in the medium term is the deterioration in the US fiscal position over recent years.

There are other possible catalysts for a reassessment of risk, including disorderly exchange rate adjustments in Asia and the default of a major borrower. While it is difficult to assess the exact probabilities of any of these events, many in financial markets appear to be pricing assets on the basis that the current, relatively benign, conditions will continue. While this may well turn out to be the case, there is relatively little room for credit spreads to compress further, while the scope for spreads to return to levels closer to historical averages appears considerable.

Financial Institutions

Overall, the global economic environment over the past year has provided a favourable operating environment for international financial institutions. Reflecting this, indices of financial institutions' share prices have generally increased over this period (Graph 8).

Banks have profited from strong investment returns and benign conditions in financial markets. In addition, solid credit growth and falls in both impaired assets and bad-debts expense have generally supported profitability. The German banking sector is a notable exception, with banks' balance sheets adversely affected by high non-performing loans stemming from poor lending decisions over the past decade and the stagnating national economy.

The balance sheets of global insurers have also benefited from the stronger world economy and favourable conditions in financial markets. In the US, non-life insurers have experienced growth in premium income, which has supported profits, even in the presence of high losses stemming from severe weather-related catastrophes. Consistent with this, Standard & Poor's upgraded the credit ratings of eight insurers in 2004 and made only one downgrade. Similarly, European non-life insurers have enjoyed higher premium rates and relatively low claims. The performance of life insurers in 2004 was comparatively less positive, but strong investment returns saw ratings outlooks in some countries improve from negative to stable. Concerns remain, however, about the health of some life insurers, and that regulatory changes, such as the new solvency requirements in Europe, may increase the existing pressure on them to raise capital.

1.2 Australia

The economic and financial environment in Australia remains favourable from a financial stability perspective. While economic growth has slowed recently, the economy is in its fourteenth year of expansion, and the prospects are that demand conditions will remain broadly supportive of overall growth in the period ahead. The housing market has clearly cooled from its overheated state in 2003 and credit growth has slowed, although it remains quite strong relative to historical experience. From an overall perspective, these adjustments are welcome, as they reduce the likelihood of a costly correction in house prices and household behaviour at some time in the future. Notwithstanding this, household balance sheets remain more exposed to changes in economic and financial conditions than they have been in the past.

Household Sector

As has been well documented in various Bank publications, the household sector has borrowed heavily over the past decade, primarily for housing, and correspondingly house prices have risen considerably. In the 10 years to end 2003, household debt grew, on average, by 15 per cent per year, with house prices increasing at an average annual rate of 10 per cent. As a result, by end 2003, a number of potential indicators of household financial vulnerability – including the ratios of debt, house prices and interest payments to income, and household gearing – had reached record highs (Graph 9).

These long-run developments primarily reflect fundamental shifts in both demand for, and supply of, housing loans. As mentioned above, the shift to a low-inflation and low-interest-rate environment in Australia has, as in other countries, significantly increased the capacity of households to borrow, particularly for housing. The more stable macroeconomic environment that has gone hand-in-hand with these developments has also apparently meant that households now view a given debt-servicing burden as less risky than in the past. On the supply side, financial institutions have become keener to lend for housing and have significantly increased the variety and flexibility of loan products, as well as the intensity with which loan products are marketed to both owner-occupiers and investors. Competition has also brought about a significant fall in margins on housing loans (as discussed in the Financial Intermediaries chapter).

Notwithstanding these structural factors, by 2003 there were clear signs that the housing market had become overheated. Residential property investors accounted for a historically high share of financing activity – despite rental yields having fallen to very low levels – and growth in house prices and household borrowing had both accelerated to annual rates of around 20 per cent or more by the December quarter. These developments, had they continued, risked building up significant imbalances in household balance sheets.

Over recent years, the big run-up in house prices, and associated record-high levels of household assets, have underpinned strong growth in household spending. By mid 2004, dwelling investment, as a share of GDP, had increased to the highest level on record – fuelled by unprecedented spending on housing renovation – and the measured saving rate from current income had fallen to its lowest recorded level (Graph 10 and Graph 11). The concern arising from these developments was that further increases in house prices, and a continuation of very rapid credit growth, risked sowing the seeds of future problems, not so much for the banking system, but for the economy more broadly. In particular, the unwinding of imbalances in household balance sheets could make for a period of very weak consumption and overall economic growth.

From this perspective, developments since the end of 2003 have been welcome, with a range of indicators suggesting a cooling of the housing market over the past year.

Measures of average nationwide house prices have either fallen or shown little change over the past year, after increasing by an average of 21 per cent over 2003 (Table 3). During the first three quarters of 2004, many series show that prices fell in a number of cities, before recording small gains in the final quarter of the year. The slowing has been broadly based, with the biggest adjustments – involving price falls over the year – in Sydney and Melbourne.

Other housing-market indicators also show an easing in activity. Houses are currently taking longer to sell by private treaty than they were in 2003, auction clearance rates are below the average of recent years, and auction volumes have fallen. Through 2004, the total number of auction sales in Sydney and Melbourne was more than 50 per cent lower than in the previous year, partly reflecting an increase in the number of properties withdrawn prior to auction. The lower volume of sales is also reflected in many state government estimates of a sharp fall in stamp duty revenue from property sales over 2004/05.

Sentiment towards housing shows a similar pattern. The proportion of respondents to the Melbourne Institute and Westpac Survey who perceive real estate to be the ‘wisest place for savings’ fell in late 2003, but has subsequently levelled out. The Wizard Home Loans and Nielsen Media Research Survey on the number of people planning to purchase an investment property over the next year has also fallen since end 2003, although it has shown some signs of stabilising in recent quarters (Graph 12).

The value of housing loan approvals also declined substantially through early 2004 before partially recovering (Graph 13). From the peak in October 2003, the value of total approvals fell by more than 20 per cent by mid 2004, with the correction particularly pronounced for investor loan approvals. More recently, however, both owner-occupier and investor loan approvals have risen, with the flow of approvals for owner-occupiers now almost back to its peak.

Owner-occupier mortgage refinancing also declined in the first half of 2004, in sharp contrast to average annual growth of around 30 per cent in the preceding three years (Graph 14). Recently, the level of refinancing has again picked up, to be just below the peak in September 2003. Refinancing activity partly reflects the strong competition in housing finance, which has seen many borrowers seek a change in loan terms and conditions, including the size of the loan.

Reflecting these trends, growth in housing credit – the largest component of household debt – slowed to 12 per cent (on an annualised basis) over the six months to January 2005, down from the peak of 22½ per cent at the end of 2003 (Graph 15). Despite this slowdown, household credit growth remains considerably faster than growth in incomes. Consistent with the pattern of loan approvals, the decline in the rate of growth of housing borrowing has been most pronounced among investors: after growing at double the rate of owner-occupier housing debt in late 2003, investor housing credit is now growing at a comparable pace.

The slowdown in household credit growth has meant that, over the past year, the dollar increase in outstanding debt secured by housing has exceeded the value of spending on dwelling investment by only a relatively small margin. This is in contrast to 2003, when the household sector borrowed much more against the housing stock than it spent building and renovating houses (Graph 16). The Bank is currently undertaking a survey of households to improve its understanding of these trends, and in particular the extent to which households are using mortgage financing, including refinancing, for non-housing purposes. The results of the survey will be published later in the year.

In contrast to housing credit, growth in other personal credit – which accounts for around 16 per cent of total household debt – picked up over the second half of 2004, with strong growth across all the main categories. Margin loans – loans typically used to purchase equities – have grown particularly strongly. Over the second half of 2004, this type of lending increased at an annualised rate of around 23 per cent, as households borrowed to invest in the rising equity market. At end December, around $15 billion in margin loans were outstanding, with an average loan size of around $107,000. Typically, these loans are well collateralised by the underlying securities, with an average loan-to-valuation ratio of around 43 per cent at end December. Another type of personal lending that has grown strongly recently is revolving loans secured by residential mortgages. Over the year to January, this type of credit increased by around 13 per cent, although the pace of growth appears to have picked up since mid 2004. Credit card debt has increased by around 14 per cent over the year to January, around the average rate of growth for the past three years.

The housing market slowdown has dampened overall growth in the value of household assets, although this has been somewhat offset by the strong equity market. In the three quarters to September 2004, the aggregate value of assets owned by the household sector grew at an annualised rate of 6.4 per cent, after having increased at an average annual rate of nearly 11½ per cent over the five years to end 2003 (Table 4). Overall, the total value of the household sector's assets is historically high at around 7½ times household income. As this figure has increased over time, balance sheet considerations are likely to have played a more important role in shaping the household sector's spending decisions.

Compared with other countries, a high share of Australian households' assets are held in the form of housing (61 per cent, compared with around 44 per cent in the United Kingdom and 32 per cent in the United States). This reflects the fact that house prices in Australia tend to be higher, relative to household income, than in other countries, and that the rental housing stock in Australia is largely owned directly by the household sector. It also means that movements in house prices might be expected to have a more important influence on household spending decisions in Australia than is the case in many other countries.

Notwithstanding the large share of housing assets in household balance sheets, holdings of financial assets have grown quickly over the past couple of years, as households have channelled funds towards market-linked financial assets, both through institutional investors, such as superannuation funds, and through direct holdings of equities (Graph 17). The household sector has therefore benefited from strong gains in the equity market.

Claims on superannuation funds and life offices (including unfunded superannuation) now account for 52 per cent of households' financial assets, up from 46 per cent in 1990. Within superannuation holdings, increased exposure to market risks has been reinforced by the trend away from ‘defined-benefit’ to ‘defined-contribution’ or ‘accumulation’ superannuation schemes, in which individuals accumulate financial assets to finance their retirement. Of directly held financial assets, the most recent Australian Stock Exchange Survey shows that 44 per cent of Australian adults own shares, up from 10 per cent in the early 1990s.

In addition to the continuing expansion in balance sheets, the household sector has benefited from strong employment growth and solid increases in real wages. Over the year to February 2005, employment grew by 3.4 per cent, with momentum particularly strong in the second half of the period. Together with ongoing increases in wages, real disposable income grew by 5½ per cent over 2004. The unemployment rate is currently at its lowest level since 1976, and the proportion of workers moving from employment to unemployment each month is around the lowest level over the period for which data are available (Graph 18).

Given this supportive environment, there are few signs of financial stress in the household sector. Notwithstanding historically high levels of debt and interest payments relative to income, arrears on credit cards, which might be an early indicator of financial stress, remain benign (Graph 19).[1] Growth in cash advances, another potential barometer of household cash-flow problems, has moderated over the past six months, and housing loan arrears remain around historical lows. Consistent with low levels of unemployment, personal administrations also fell slightly over 2004.

Assessment of vulnerabilities

The adjustment in the housing market to date has occurred relatively smoothly and has not been associated with the type of costly adjustments in household balance sheets that some commentators had feared. Housing credit growth remains very strong – at a six-month-ended annualised rate of around 12 per cent – with loan approvals data suggesting that growth will remain at around this rate in the immediate period ahead. While consumer sentiment fell significantly from historically high levels in March following the increase in the cash rate and release of lower-than-expected GDP growth data early in the month, households are still generally reporting that their finances are in good shape, perhaps not surprisingly given strong gains in employment over the past year.

Notwithstanding this, households do appear to have taken a slightly more cautious approach to their finances over 2004. In the second half of the year, the national accounts suggest that real consumption spending grew at an annualised rate of 3 per cent, well down on the 7 per cent pace over the same period in 2003. Accordingly, measures of the saving rate, though notoriously volatile, have increased slightly in recent quarters after declining markedly over the past two decades. Dwelling investment, including spending on renovations, has also slowed from the very high levels of recent years, and the appetite of investors for residential property has moderated. While these developments have contributed to a slowdown in the pace of growth of the economy, they are welcome from a stability perspective, reducing the potential for a costly adjustment later on.

In assessing the vulnerability of households to further changes in economic and financial conditions, the distribution of debt across households, as well as its aggregate level, is important. At any point in time, debt-servicing burdens vary considerably across the population. Among housing borrowers, those with loans taken out only recently, lower-income households, and investors, often have either the highest debt-servicing burdens or the smallest buffers on which to fall back if something goes wrong. For many borrowers, the main financial risk that they face is a loss of employment, although for highly geared property investors even small increases in interest rates can sometimes cause considerable difficulty. While detailed data on the distribution of debt are available only with a lag, the most recent data are discussed in Box A.

It is too early to detect any material effect of the recent 25 basis point increase in the cash rate – and thus most mortgage rates – on household borrowing and spending decisions, although these are now more sensitive to a given change in interest rates than was once the case. At the aggregate level, the increase in interest rates in March will modestly add to the debt-servicing burden. The rise in this ratio represents a continuation of the trend seen over recent years, though most of the trend increase is due to housing-debt growth exceeding income growth, rather than rising interest rates.

In broad terms, housing-related risks remain two-sided. On one hand, there is the possibility that last year's favourable developments turn out to be only a temporary reprieve and that the housing market reignites, an outcome that would throw the possibility of a future costly correction back into sharp focus. On the other hand, there is a risk that house prices could fall further over the course of 2005, and that households, after taking a slightly more cautious approach to their finances over the past year, attempt to adjust their balance sheets more sharply than has occurred to date.

On the possibility of the market reigniting, the most recent data suggest a slight rebound in prices and market activity from late 2004, although more data are required before firm conclusions can be drawn. Nonetheless, the recent experience of a decline in prices is likely to lead to a better appreciation by some households of the relative risk-and-return characteristics of investment in residential property. In addition, the recent increase in the cash rate in response to emerging inflationary pressures may also prompt a reassessment by some households of the attractiveness of investment in residential property. At this stage, the risk of the market recording the type of growth seen a few years ago looks to be low.

The other risk is that the moderation in housing markets could turn into something more pronounced, with significant balance sheet adjustments by the household sector affecting spending. Again, this risk currently looks to be low. A range of factors, including a favourable world environment, rising commodity prices, strong employment growth and high levels of business confidence are likely to continue to support the Australian economy in the period ahead. There are few signs that the household sector is having difficulty meeting the higher level of financial obligations. Notwithstanding this outlook, the household sector has become more exposed to changes in financial and economic conditions and its behaviour will bear close watching in the months ahead.

Business Sector

The business sector has been experiencing favourable financial conditions for some time. Profitability is at a high level, gearing is relatively low, the equity market has been strong, and finance is widely available on competitive terms.

These favourable conditions are perhaps most evident in the equity market. In 2004, the ASX 200 increased by 23 per cent, which was the largest increase amongst the major industrial countries. So far in 2005, the ASX 200 has recorded a further small increase. The strength of the market has been reasonably broadly based, with stock prices of resource companies recording particularly large gains, reflecting the strong global demand for commodities, especially from China (Graph 20). The overall measured price-earnings ratio currently stands at 21, which is around the average of the past 20 years.

Business surveys reflect the buoyant environment, with the NAB Survey showing that perceptions of profitability and trading conditions were well above the long-run average in early 2005, notwithstanding recent declines.

Business sector profits, as measured by non-financial sector gross operating surplus (GOS), have remained above the average of the past decade as a share of GDP, as firms have benefited from strong domestic demand and a substantial increase in the terms of trade (Graph 21). Following rapid growth in the 2003/04 financial year, the national accounts reported a slowdown in profit growth over the second half of 2004, although recent profits announced by publicly listed companies have generally shown large increases on last year's outcomes and have been slightly ahead of market expectations.

With profits strong, firms have had access to a relatively large pool of internal funds to finance investment. However, as investment expenditure has grown as a share of GDP over recent years, there has been an increased call on external sources of finance. As a result, business credit has picked up noticeably, growing at an annualised rate of 12 per cent over the six months to January 2005, around the fastest pace seen since the mid 1990s (Graph 22). Non-intermediated corporate debt issuance has rebounded strongly since mid 2004, while the rising share market has encouraged equity raisings.

Available data suggest that Australian businesses have increasingly borrowed intermediated funds on variable-rate terms (Graph 23). In particular, the proportion of bank business loans under $500,000 – typically those to small-to-medium sized firms – at variable interest rates has increased from 42 per cent to 60 per cent since the late 1990s. This has reduced firms' average interest payments over this period, as short-term variable rates have generally been below long-term rates. In contrast, larger corporates have taken advantage of strong foreign demand for highly rated Australian-dollar debt and low global interest rates to lengthen the maturity profile of their non-intermediated debt liabilities.

In aggregate, levels of business sector gearing and debt servicing remain benign. Outstanding debt as a ratio to GOS has fallen over recent years and is below the average of the past two decades. This decline, together with the low level of interest rates, has meant that the share of GOS devoted to interest payments is around the lowest level seen for many years (Graph 24).

In the past, imbalances in commercial property markets have been a significant cause of stress in the corporate sector. There are, however, few signs of the excesses in commercial property prices and construction activity that caused problems for many companies in the late 1980s and early 1990s. Office property prices remain below the peak reached during that period, and as a share of GDP, office property construction is currently around a third of the activity prevailing at that time (Graph 25).

Nonetheless, after a period of relatively subdued conditions, including rising vacancy rates and falling effective rents, office construction has picked up in recent years, with prices and the absorption of office space both firming in the second half of 2004. Consistent with developments in many other countries, the retail segment of the commercial property market has been particularly buoyant, reflecting the strength in household consumption in recent years. Retail property rents increased by 5 per cent over the year to the December quarter 2004, and relatively low vacancy rates have encouraged retail construction activity. Industrial property has also performed well, with average prices in the major capital cities increasing by almost 10 per cent over the year.

Solid conditions in commercial property markets have been reflected in the strong performance of listed property trusts in recent years, though investors' ‘search for yield’ has also played a role, with financial market participants placing a higher value on flows of rental income in the lower-interest-rate environment. While prices of Australian listed property trusts have fallen slightly in recent months, the cumulative gains over recent years remain well above those of the broader market, a trend also evident in many international markets (Graph 26).

Assessment of vulnerabilities

Overall, conditions in the business sector do not currently pose a threat to financial stability. Most business surveys report high levels of confidence about the period ahead, with the NAB Survey showing forward-looking indicators of profitability and trading conditions to be above their long-run average, despite recent declines. The latest forecasts collated by Consensus Economics also suggest a solid outlook for corporate sector profits.

This benign outlook is also reflected in financial markets. As noted above, the share market has been very strong and uncertainty about the outlook for share prices, as measured by implied volatility from equity options, is low. Similarly, indicators of corporate credit risk, including credit default swap (CDS) premia and corporate bond spreads, suggest that financial market participants see little risk of widespread credit-quality problems emerging in the corporate sector (Graph 27). To some extent, this is unsurprising given global attitudes to risk.

The question, however, is whether the risks inherent in the current situation are fully reflected in credit and asset pricing. The risks, admittedly, may well relate more to the macroeconomy, rather than to specific aspects of the business sector's finances. A sharp slowing in the world economy, prompted or amplified by an abrupt retreat from risk taking, would affect the Australian corporate sector adversely, as would a sharp adjustment in household balance sheets that triggered or exacerbated a broader economic slowdown. If these scenarios eventuated though, the business sector should be more resilient than in past episodes of adverse economic conditions, given the healthy state of its balance sheet.


See Reserve Bank of Australia (2004), ‘Box A: Credit Card Indicators’, Financial Stability Review, September. [1]