Statement on Monetary Policy – August 2009 Domestic Financial Markets

Money markets and bond yields

Domestic money market conditions have improved significantly over the course of the year. The spread between the bank bill rate and the expected cash rate, which has been a good guide to the tension in money markets over the past two years, has now fallen back to around 20 basis points, only a little higher than the levels that prevailed prior to the financial turmoil (Graph 55). The narrower spread, in part, reflects relatively lower short-term issuance by banks (see below). Bank bill rates are also closer to the yields the Australian Government pays on Treasury Notes – for most maturities, the spread between these rates has declined from 30 basis points earlier in the year to be around 10 basis points currently. This is about the same spread that prevailed when Treasury Notes were last issued earlier in the decade.

As funding conditions for money market participants have improved, the Bank has unwound most of the earlier measures it had taken to address the market turbulence. Aggregate exchange settlement (ES) balances held at the Reserve Bank by the commercial banks have been reduced from over $2 billion in May (and over $10 billion at their peak late last year), to be a little over $1 billion currently (Graph 56). This, together with the lower money market spreads, reflects the considerable diminution in concerns about bank counterparty risk.

Although the Bank's US dollar swap facility with the Federal Reserve was recently extended until February 2010 in line with those of other central banks, the improvement in market conditions has meant that the Bank has not seen the need to auction funds from this facility since April. By July, all of the transactions under this facility had matured.

Having reduced the target for the overnight cash rate by 425 basis points since last September, the Reserve Bank has maintained the cash rate at 3 per cent since April (Graph 57). At the time of the last Statement, money market pricing pointed to further reductions in the cash rate during 2009. However, the strength of recent economic data and more positive sentiment within financial markets generally has seen these expectations recede.

Long-term bond rates have continued to rise in recent months, with the yield on the 10-year Commonwealth Government security (CGS) now around 5.6 per cent (Graph 58). Largely reflecting the better economic performance of the domestic economy, the rise in domestic yields has generally exceeded that seen in overseas markets, with the spread between US and Australian 10-year government rates widening by 30 basis points to almost 200 basis points.

The volume of CGS issuance has increased in recent months, but coverage at bond tenders declined during June and yields on CGS are now above those of equivalent investments based on futures contracts that reference CGS. CGS are also being issued into a market in which a large volume of other AAA-rated bonds have been issued, many of which carry a guarantee from the Australian Government. Both the NSW and Queensland Governments have had their eligible long-term debt guaranteed. While the yields on this debt have narrowed relative to CGS, as have spreads on guaranteed bank paper, both still remain relatively wide for what is a very similar credit risk. Spreads on unguaranteed semi-government debt (such as that issued by the Victorian Government) have declined only marginally less (Graph 59).

There was also strong issuance of AAA-rated Australian-dollar denominated bonds by non-residents in the domestic market (Kangaroos) in the June quarter, after issuance recommenced in late April. During the quarter, this AAA-rated issuance totalled almost $6 billion, close to the volume typical for all issuance by non-residents in the pre-crisis period. A further $2 billion has been issued in July and August to date. While spreads on Kangaroo bonds have narrowed, the relatively high level of the cross-currency basis swap spread (received by entities swapping out of A$) continues to provide a significant pricing incentive for these issuers.

Financial intermediaries

While dislocations in many markets have eased, the effects of the turbulence in capital markets continue to be seen in the cost and composition of financial intermediaries' funding. Banks have continued to reduce their use of short-term capital market debt (Graph 60). Banks' domestic short-term debt outstanding – predominantly bank bills and CDs – have fallen below $400 billion from a peak of $490 billion in November last year. During the June quarter 2009, the share of banks' funding that was sourced from deposits was little changed at 42 per cent, after rising by 5 percentage points over 2008 and early 2009. The shares of banks' funding that come from long-term capital market debt and equity increased slightly as banks continue to manage their balance sheets conservatively. There have been some differences across the main bank types, with the regional banks relying mainly on deposits to grow their funding bases but the major banks increasing both their deposits and long-term capital market debt.

Competition for deposits, which are perceived as a more stable source of funding than short-term raisings in wholesale markets, remains strong. The average rate offered on the major banks' term deposit ‘specials’, the most relevant rate for term deposit pricing, has increased by around 90 basis points since end April. At 4.75 per cent, it is 150 basis points above the 90-day bank bill rate compared with 50 basis points below the bill rate prior to the onset of the capital market turbulence (Graph 61). The smaller Australian banks have increased their average ‘special’ term deposit rates by around 70 basis since end April; their rates are currently in line with the major banks' rates.

The average rate on the major banks' existing at-call deposits (including online savings, cash management, and bonus saver accounts) has risen slightly over the past three months, and at 2.6 per cent, is currently only 40 basis points below the cash rate. In mid 2008, the average rate on at-call deposits was 90 basis points lower than the cash rate.

Australian banks have issued $61 billion of bonds since the previous Statement. Issuance has been into a number of different markets, providing banks with a diverse range of funding sources. Around 35 per cent of issuance has been onshore, with the remainder issued offshore, mostly in US dollars. Bonds have also been issued in yen, British pounds, and for the first time in nearly a year, euros.

An increasing amount of issuance by the major banks in recent months has been unguaranteed (Graph 62). Most unguaranteed bonds have been issued onshore and have been met by strong demand from investors, with many issues upsized. Much of the demand has come from fund managers, making up over half of investors in some recent issues, although other banks continue to purchase these bonds as relatively high-yielding assets to hold in their liquidity portfolio. In recent weeks, there have also been some large unguaranteed issues offshore by the major banks, which attracted strong investor interest.

In contrast to the major banks, the smaller, lower-rated Australian-owned banks continue to issue only guaranteed bonds, mostly offshore. However, the Australian subsidiaries of foreign banks have been active in recent months in issuing bonds under the Australian Government Guarantee Scheme, raising $6 billion. Branches of foreign banks have also issued unguaranteed bonds and foreign-government guaranteed bonds, totalling $8 billion.

Reflecting the solid investor demand for bank debt, spreads on guaranteed and unguaranteed bonds have continued to decline in recent months and are now at their lowest level since early 2008 (Graph 63). At the 3-year maturity, Government-guaranteed debt (including the fee) and unguaranteed debt are both trading at around 100 basis points above CGS. At longer tenors, guaranteed debt remains cheaper to issue than unguaranteed debt. The decline in spreads across all tenors has only partially offset the increase in CGS yields, so that yields on the major banks' bonds have risen in recent months.

In addition to accessing a wide range of bond markets, Australian banks have continued to raise equity at a strong pace. In the past three months, $8 billion of equity has been raised, bringing banks' equity raisings over the past year to a record $27 billion – well above the annual average since 2002 of around $4 billion. Most equity has been raised by placements of shares to institutional and retail investors, usually at modest discounts to prevailing market prices. Investor demand for the additional equity has been strong.

In contrast, securitisation markets remain dislocated, with all residential mortgage-backed securities (RMBS) issued since October last year having the Australian Office of Financial Management (AOFM) as a cornerstone investor. Five RMBS have been issued in the past few months, amounting to $2.6 billion. Of this, $1.9 billion was purchased by the AOFM, with private investor demand continuing to be relatively limited. These investors have tended to purchase only the most senior tranches (rated A–1+ or AAA) that have a weighted-average life of less than one year, reflecting their preference for liquid, high-quality assets. The AOFM's purchases of RMBS now amount to $6.7 billion, with the remainder of the Government's $8 billion injection into the market expected to be allocated in coming months.

Reflecting the slowing of issuance and the ongoing amortisation of principal (i.e. mortgage repayments), the value of Australian RMBS outstanding has fallen by around 40 per cent since its peak in June 2007, to $110 billion (Graph 64). RMBS outstanding offshore have declined by more (around 50 per cent) because there has been no offshore issuance, while paper outstanding onshore has fallen around 15 per cent. The AOFM's holdings amount to around 6 per cent of all Australian RMBS on issue (and 10 per cent of the domestic market).

The AAA-rated tranches of the RMBS issued over the past few months have priced around 130 basis points above BBSW. While spreads on equivalently-rated RMBS trading in the secondary market are higher, between 200 and 300 basis points currently, they have continued to fall in recent months as the market works through the overhang of supply that resulted from the deleveraging of structured investment vehicles (SIVs). These entities are estimated to have accounted for around a third of the investor base for Australian RMBS prior to the onset of the financial turbulence. However, it appears that the bulk of their holdings have now been liquidated in the secondary market.

The elevated spreads on RMBS in both primary and secondary markets do not appear to reflect concerns about credit quality. While the arrears rate on Australian RMBS has picked up over the past year, it remains at less than 1 per cent, a low level relative to international standards. Losses on Australian RMBS (after proceeds from property sales) remain very low as a share of the stock outstanding, at 5 basis points per annum for prime and 95 basis points for non-conforming loans. The bulk of losses continue to be covered by credit enhancements, including lenders mortgage insurance and the profits of securitisation vehicles. No losses have been borne by investors in a rated tranche of an Australian RMBS.

Short-term securitisation markets also continue to be strained. Asset-backed commercial paper (ABCP) outstanding has roughly halved from its peak in mid 2007 to around $35 billion, though it appears to have stabilised around this level in recent months. Spreads on ABCP have fallen a little since the previous Statement, though remain elevated at around 60 basis points above BBSW.

Intermediated credit

While financial intermediaries continued to be readily able to raise funds, moderating demand for borrowing and some tightening in lending standards, meant that total outstanding credit was little changed over the June quarter (Table 10, Graph 65). This follows growth at an annualised rate of around 3 per cent over the December and March quarters. Solid growth in housing credit was largely offset by declines in business and personal credit.

Household financing

Interest rates on variable-rate household loans are little changed since end April, consistent with the unchanged cash rate, though interest rates on new fixed-rate housing loans have risen in line with the increases in capital market yields (Table 11). Overall, the interest rates faced by households remain very low by historical standards.

The average variable interest rate on prime full-doc housing loans (including discounts), at 5.17 per cent, remains around its lowest level since 1964. Interest rates on riskier housing loans have fallen by somewhat less since August 2008 but also remain at low levels.

The major banks have raised their interest rates on new 3- and 5-year fixed-rate housing loans by about 85 basis points since end April to 6.69 per cent and 7.39 per cent respectively (Graph 66). Nonetheless, rates are still well below their averages over the past two decades. Despite fixed rates being 1½–2 percentage points higher than variable rates, the share of owner-occupier loan approvals at fixed rates has risen noticeably over recent months.

Overall, the average interest rate on all outstanding housing loans (variable and fixed) is estimated to have declined slightly since end April, to 5.80 per cent (Graph 67). This is around 300 basis points lower than its peak in August 2008 and 180 basis points below its post-1993 average.

The value of housing loan approvals has risen significantly over the past year and, in May, was 36 per cent above its trough in mid 2008 (Graph 68). There has been particularly strong growth in approvals to first-home buyers. This reflects the additional incentives currently available to first-home buyers, but also that for much of this decade, demand from first-home buyers has been subdued given reduced housing affordability.

The five largest banks' share of gross owner-occupier loan approvals has stabilised at about 82 per cent over the past few months, up from 60 per cent just before the onset of the financial market turbulence in mid 2007 (Graph 69). The market shares of the smaller banks, credit unions and building societies and wholesale lenders have also been little changed over recent months, but they have all ceded significant market share over the past two years.

While housing loan approvals have increased further in the June quarter, housing credit growth has been steady at a monthly average pace of 0.6 per cent. Owner-occupier housing credit continues to grow at a faster pace than investor housing. The significant increase in new loan approvals but stable housing credit growth implies that principal repayments on housing loans have increased (for further details, see the ‘Domestic Economic Conditions’ chapter).

Financial institutions' average variable rates on unsecured personal loans, margin loans and credit cards are all little changed since end April. Across all loan products, the current rates are a little below their post-1993 averages. Credit card lending has continued to slow as households focus upon repaying debt (Graph 70). Over the 12 months to June, there has been little growth in outstanding credit card balances.

The value of margin loans outstanding decreased by 2 per cent over the June quarter 2009 to $18 billion, however the pace of decline has moderated from the falls of 15–25 per cent over recent quarters. Stronger equity markets meant that the incidence of margin calls declined to be below the decade average (Graph 71). Borrowers' gearing levels also declined significantly over the June quarter to 40 per cent, as the value of investors' collateral rose by 14 per cent, and outstanding debt fell slightly. Borrowers' average leverage is now reasonably low by historical standards.

Business financing

Interest rates on business loans have risen a little since end April. Overall, the interest rates faced by businesses remain low by historical standards, though there is some dispersion in lending rates across industries.

Increases in risk margins have meant that interest rates on new and refinanced business facilities have fallen by much less than interest rates on existing facilities over the current easing cycle. The available evidence suggests that risk margins on loans to large businesses have generally risen by 100–200 basis points since mid 2008. Liaison with banks and businesses suggests that there has been significant dispersion in the changes in risk margins across industries, with transport and commercial property companies experiencing large increases in risk margins. With 90-day bank bill rates and 3-year swap rates having fallen by 460 and 260 basis points respectively since mid 2008, this means that the interest rate faced by most large businesses on new and refinanced borrowings will have declined. Overall, the average rate on outstanding large business loans is still 335 basis points lower than at the beginning of the current easing cycle, although the ongoing gradual repricing of existing business lending will continue to push up this average.

The major banks' average indicator rate on residentially secured term loans to small businesses is 300 basis points lower than in mid 2008. The average indicator rate for 3-year fixed-rate loans to small businesses has risen by 100 basis points since end April, reflecting the increases in capital market yields. Nonetheless, it is still 230 basis points lower than its peak in 2008.

Australian corporates continue to restructure their balance sheets in response to the strains in financial markets and the deterioration in the economic outlook. This has been reflected in an increase in equity funding and a fall in the use of debt as corporates deleverage – a trend that was also evident during the recession of the early 1990s. As a result of the strong equity raisings, and some bond issuance, in net terms corporate funding continued to increase in the June quarter despite the fall in business credit (Graph 72).

Total business debt declined slightly in the June quarter, with further declines in business credit partially offset by an increase in non-intermediated debt. Over the June quarter, intermediated business credit contracted at an annualised rate of 7 per cent, with the weakness broadly based across industry sectors, and evident for banks and non-bank financial institutions. The decline in business credit since its peak in November 2008 has been due mainly to falls in foreign-currency-denominated lending to domestic businesses. These falls reflect both the appreciation of the Australian dollar over this period and some reduction in the stock of foreign currency denominated lending. These loans are mainly used to fund the offshore operations of Australian companies. The contraction in business credit over the June quarter was evident for both large loans (those greater than $2 million) and small loans (those less than $2 million).

Commercial loan approvals have levelled out in recent months, following significant declines in 2008. In the syndicated lending market, there was just $10 billion of new lending to Australian corporates in the June quarter, compared to a quarterly average of $19 billion during the period 2000–2009 (Graph 73). A little over half of these loans were used to refinance existing debt, with most of the remainder being used for capital expenditure or ‘general corporate’ purposes.

Reflecting corporates deleveraging and the relatively small amount of bonds maturing in coming months, corporate bond issuance has been modest in the past few months. Around half of funds were raised offshore, and there is evidence of some broadening of the type of companies able to raise funds in the bond market, with a few medium-sized companies issuing bonds domestically. Consistent with some pick-up in investor demand, spreads in the secondary market have fallen. BBB-rated corporate bonds are currently trading around 380 basis points above CGS in the domestic market, down from their peak of 580 basis points in April 2009. The robust investor demand was also evident earlier this year when BHP Billiton and Rio Tinto issued large bonds offshore.

Listed corporates (excluding banks) raised a record $21½ billion of equity during the June quarter, with resource companies accounting for almost half of this amount and the remainder evenly split between real estate companies and other non-resource companies (Graph 74). Equity raisings for the September quarter are also proceeding at a rapid pace. Around half of these raisings reflect the Australian component of Rio Tinto's rights issue ($4 billion) which settled in July; a further $15 billion was raised by Rio Tinto from the rights issue associated with its UK-listed shares. Corporates – including Rio Tinto – have tended to use these funds to reduce the leverage on their balance sheets by paying down debt, mostly bank loans, though some medium-sized resource companies plan to use the capital to fund investment.

It is estimated that equity raisings undertaken so far this year have reduced listed corporates' debt level by around 10 per cent since end 2008, to around $370 billion. Taken literally, this implies that the gearing ratio – the ratio of the book value of debt to equity – has declined from around 85 per cent to around 70 per cent (abstracting from profits, dividend distributions and further asset sales/writedowns). While there has been a tendency for more highly geared companies to raise equity, the deleveraging has been relatively broadly based. The bulk of new equity has been raised through placements and rights issues. Buybacks remain limited, reflecting corporates' preference to retain cash to strengthen their balance sheets given the uncertain outlook.

Some companies, particularly real estate investment trusts (REITs) (which tend to be more highly leveraged than other companies), have also been pursuing asset sales to raise cash and pay down debt. Last year, the leverage of many REITs increased due to falling property values, to the extent that some were in danger of breaching loan covenants. While they have undertaken significant equity raisings so far this year to reduce gearing, much of this is likely to be offset by further asset write-downs.


The ASX 200 has risen broadly in line with the increases in share markets overseas since the last Statement (Graph 75). Gains have been broadly based, with resources' share prices increasing the most. The ASX 200 is now up around 35 per cent since the trough in early March, but still remains around 35 per cent below its peak in November 2007 and around the same level as in July 2005.

For most of this calendar year, volatility of the Australian share market has remained below the average since the onset of turbulence in financial markets in 2007, and well below the very high levels reached after the collapse of Lehman Brothers last year. However, with daily movements of the ASX 200 averaging a little over 1 per cent, volatility is nearly twice its long-run historical average.

Analysts have continued to modestly revise down their forecasts for ASX 200 companies' earnings in recent months, albeit at a slower pace than earlier in the year. For the 2008/09 financial year – the reporting season which has just started for the bulk of companies – profits are expected to fall by 14 per cent, reflecting a combination of weakening domestic demand and lower commodity prices for resource companies. This outcome would be the largest fall in earnings for the Australian market since the recession in the early 1990s. Around half of ASX 200 companies announced dividend cuts in the first half of the 2008/09 financial year and market commentary suggests that dividend reductions as well as asset write-downs will continue to be major themes of the forthcoming reporting season. REITs and infrastructure companies, in particular, are expected to report significant asset write-downs, with some companies having already announced large asset write-downs for the June half. Market analysts expect profits to decline a further 6 per cent in 2009/10, before increasing by around 20 per cent in 2010/11 as economic growth picks up. However, uncertainty about the outlook persists with the dispersion of analysts' forecasts remaining at an elevated level.

Given the increases in share prices since early March and some falls in earnings and dividends, measures of share market valuation have moved closer to their historical averages in recent months. The Australian trailing P/E ratio – which is based on earnings for the past year – currently stands at around 18, a little above its long-run average (Graph 76). Of the 8 point increase in the P/E ratio since March, a little under half owes to increases in share prices, with the remainder accounted for by falls in earnings. The dividend yield for the Australian share market, at 5 per cent, has fallen significantly since the start of the year, though remains well above its average level. Of the 2½ percentage point fall in the dividend yield, around two-fifths owes to falls in dividends as companies have sought to conserve cash, and the remainder to increases in share prices.