Statement on Monetary Policy – May 2009 Domestic Financial Markets

Money market and bond yields

The Reserve Bank Board lowered the target for the overnight cash rate by a further 25 basis points in April, to 3 per cent. This brought the cumulative reduction in the cash rate to 425 basis points since September 2008. Money market yields imply there is an expectation of a further policy easing in the next six months, with the cash rate expected to reach a low of 2½–2¾ per cent. This is higher than in early March – when expectations were for the cash rate to reach a low point of under 2 per cent – reflecting the subsequent improvement in market sentiment.

Short-term interest rates in Australia have also remained close to historical lows since the last Statement. The yield on the 3-month bank bill is around 3.1 per cent, close to where it has been since February. The funding pressures that have been evident within money markets since mid 2007 have eased, with volatility declining and the spread between bank bill rates and the expected path of the cash rate narrowing to be at the lower end of the range over the crisis period (Graph 47).

The improvement in money market conditions has allowed the Bank to adjust its own operations in the domestic market. The Bank has seen less need to accommodate large holdings of central bank balances by private banks, either in the form of overnight exchange settlement (ES) balances or term deposits (Graph 48). Indeed, the Bank ceased offering its term deposit facility in late March. ES balances have been gradually reduced to around $2½ billion, well below the peak levels of late 2008. Throughout the recent period, this level of ES balances has allowed the overnight cash market to function well and the cash rate has traded at the target set by the Reserve Bank Board on all days.

Government bond yields have increased from the historical lows reached at the start of the year (Graph 49). The 10-year yield is around 4.9 per cent, with the spread between US and Australian yields increasing by 20 basis points since the last Statement to be around 165 basis points.

The Australian Office of Financial Management (AOFM) has significantly increased its issuance of Commonwealth Government securities (CGS) this year and, in March, recommenced the issuance of short-term Treasury Notes for the first time since 2003. Auctions for both bonds and notes have been well subscribed. The bid-to-cover ratio on bonds has been around 3½ in recent months, a little above its average over the past couple of decades, while the bid-to-cover for Treasury notes has averaged five. The yield at auction of Treasury notes has tended to be a little under the overnight index swap rate (OIS) for 3-month notes, similar to where they traded at the beginning of the decade, while yields on 6-month notes have genereally been around 10 basis points over OIS. Given the wider spreads on bank bills, these yields on Treasury notes are at a significantly lower margin to bank bills compared with when they were last issued.

In contrast, the market for state government debt has been somewhat dislocated in recent months with heightened uncertainty and low liquidity. The downgrade to the Queensland Government's credit rating in February saw spreads over CGS widen further (Graph 50). In March, the Australian Government announced that it would be willing to guarantee the debt of the states. The fees payable for such a guarantee (between 15 and 35 basis points per annum) will be significantly less than those levied on the (lower-rated) authorised deposit-taking institutions. While the relevant legislation is still to be passed by Federal parliament, spreads on their debt have narrowed significantly.

Financial intermediaries

The ongoing turbulence in capital markets continues to affect the cost and composition of financial intermediaries' funding. Over the March quarter 2009, the shares of banks' funding that were sourced from deposits and long-term debt increased further (Graph 51). Strong ongoing demand for low-risk assets such as deposits, and improved access to long-term debt markets, has allowed banks to reduce their issuance of short-term debt. In addition, reflecting the improvement in financial market conditions, banks have slightly reduced their precautionary holdings of liquid assets, some of which had been short-term debt of other banks, that they had built up in the early stages of the crisis. In recent months long-term debt raisings have tended to be issued under the Government guarantee, however, only a very small share of short-term debt issuance has been guaranteed.

Competition for deposits remains strong. The average rate on financial intermediaries' at-call deposits – including online savings, cash management and bonus saver accounts – has fallen by 115 basis points since end January, a little less than the decrease in the cash rate over this period.

The average rate offered by the five largest banks on $10,000 term deposits has decreased by 65 basis points since end December, less than the falls in bank bill rates which traditionally serve as pricing benchmarks for these deposits. The five largest banks' average rate on their term deposit ‘specials’ remains about 75 basis points above the 90-day bank bill rate (prior to the capital market turbulence, specials rates were about 40 basis points below the bank bill rate) and the proportion of term deposit indicator rates that are ‘specials’ has increased by 15 percentage points since December 2008 to about 35 per cent (Graph 52). The five largest banks' average term deposit rate (including both specials and regular rates) is currently about 50 basis points below the 90-day bank bill rate, compared with about 75 basis points below in December 2008. The regional banks' and foreign banks' rates on $10,000 term deposits have fallen by an average of 115 basis points and 95 basis points, respectively, since end December. Competition for large deposits also remains reasonably strong with falls in average rates for $250,000 term deposits roughly in line with the decrease in bank bill rates.

Australian banks have issued $43 billion of bonds since the last Statement, highlighting their good access to funding from capital markets (Graph 53). About half of this issuance has been into the domestic market, with the remainder offshore mainly in US dollars and yen. The slowing of issuance in recent months is consistent with the major banks being well ahead on their funding plans as a result of the large amount of bonds issued earlier in the year; in addition, over the past month three of the major banks were in a blackout period prior to reporting their profit results. The banks continue to access a range of markets, providing for a diverse range of funding sources.

In the few months after the Australian Government Guarantee Scheme became operational on 28 November 2008, most bank bonds were issued under the Scheme, and are accordingly rated AAA. There has been robust investor demand for this debt, with many issues being oversubscribed and spreads at issuance falling. However, in the past month there has been a substantial pick-up in the issuance of non-guaranteed debt by the major banks. In April and early May, three major banks issued large non-guaranteed bonds domestically, totalling $3.7 billion. The non-guaranteed bonds attracted a wide range of investors and were all upsized and/or had allocations scaled back due to strong demand. They were the largest non-guaranteed bonds issued in the domestic market in six months.

Spreads on banks' bonds have continued to decline in recent months (Graph 54). Including the cost of the Government guarantee fee, spreads on 5-year domestically-issued guaranteed major bank debt are currently around 170 basis points above CGS, about 30 basis points below where they were trading at end January. Non-guaranteed debt of equivalent maturity is trading at a slightly wider spread. In contrast, for 3-year bonds, recent trade indicates that spreads on non-guaranteed debt are roughly equivalent to those on guaranteed debt (including the guarantee fee). Overall, the pick-up in 3-year and 5-year CGS yields has more than offset the fall in spreads, so that yields on banks' (guaranteed and non-guaranteed) debt is higher than at the time of the last Statement.

The introduction of the Government guarantee has allowed banks to issue bonds with a longer tenor than non-guaranteed bonds issued since the onset of the turbulence in financial markets. The average tenor of banks' bonds issued in the March quarter was four years, one year longer than debt issued in the few months before the Guarantee Scheme became operational.

S&P and Fitch maintain the major banks on a stable outlook. In early March Moody's revised its outlook for ANZ, CBA and Westpac to negative (from stable). All of the major banks now have a rating of Aa1 from Moody's, with a negative outlook, one notch higher than the comparable ratings from S&P (NAB's outlook was revised to negative in August 2008). Moody's commented that even in a severe downturn they expect the major banks to remain comfortably within the Aa rating band. Consequently, the major banks are likely to remain among the highest-rated banks in the world. Moody's downgraded the banking operations of Suncorp to A1 from Aa3 in March, reflecting the impact of the economic downturn on its asset quality and earnings.

Securitisation markets remain dislocated, with the bulk of residential mortgage-backed securities (RMBS) issued since the last Statement purchased by the AOFM. Six prime RMBS were issued, amounting to $3.5 billion, each with the AOFM as a cornerstone investor. The AOFM purchased $2.75 billion of the senior tranches (rated AAA or A-1+); private investor interest has largely been confined to the most senior tranches with an expected life of less than one year. The AOFM has now invested $4.75 billion in RMBS, with the remainder of the Government's $8 billion injection into the market expected to be allocated in coming months, beginning with three transactions to be issued in May.

The AAA-rated tranches of the RMBS issued in recent months priced at an average of 130 basis points above BBSW, well above the 15–20 basis point spread in the few years prior to the onset of the turbulence in financial markets. Part of the reason for the low private investor demand for recent RMBS deals appears to be the higher secondary market spreads on existing RMBS. While the secondary market is illiquid, with small volumes and values of transactions, reports of spreads in excess of 300 basis points are typical. These higher spreads initially reflected an overhang of supply as some investors, particularly foreign, looked to deleverage and liquefy their portfolios, though there has been a pick-up in demand in recent months that has contributed to some fall in secondary market spreads. Given the underlying mortgages in an RMBS pool are repaid relatively quickly, the stock of outstanding RMBS, at around $120 billion, is 30 per cent lower than its peak in June 2007. Australian RMBS issued offshore are down over 40 per cent due to a cessation of offshore issuance, while domestic RMBS outstanding are down a little over 10 per cent.

The elevated spreads on RMBS in both primary and secondary markets do not appear to reflect investor concern about the credit quality of Australian RMBS. While losses on prime RMBS (after the proceeds from property sales) increased slightly in the December quarter 2008 – the latest data available – they remained quite low as a share of outstanding loans (at less than 2 basis points) and were predominantly covered by lenders' mortgage insurance. Losses on non-conforming RMBS were higher (around 25 basis points of outstanding loans), with the bulk continuing to be covered by RMBS credit enhancements (mainly the profits of securitisation vehicles). No investor in a rated tranche of an Australian RMBS has suffered a loss of principal stemming from default on the underlying mortgages.

Despite a slight pick-up in February – the latest comprehensive data available – the amount of asset-backed commercial paper (ABCP) has fallen to $38 billion, 50 per cent below its peak in July 2007 (Graph 55). Preliminary data suggest that ABCP outstanding onshore fell in March and April. Falls in onshore ABCP over the past 18 months have been reasonably broad-based among issuers, though ABCP issued by non-Australian banks has fallen the most. Spreads on ABCP remain elevated, at around 65 basis points above BBSW.

Household financing

Interest rates on household loans have fallen significantly since end January (Table 12). Variable rates for new prime full-doc housing loans, including discounts, have fallen by an average of 106 basis points, with the major banks reducing their rates by a little more than the smaller lenders. At 5.16 per cent, this rate is around 380 basis points lower than just prior to the start of the current monetary policy easing cycle in September 2008, and at its lowest level since 1964. Interest rates on riskier housing loans have also declined noticeably since the last Statement, with rates on prime low-doc loans and non-conforming loans around 100 basis points lower.

The five largest banks' average 3-year fixed interest rate is broadly unchanged since end January, and at 5.85 per cent, is close to its lowest level in at least 15 years. Nonetheless, with variable rates below fixed rates at present, and borrower expectations of further cuts to variable housing rates in coming months, the share of owner-occupier loan approvals at fixed rates remains very low. In February, only 2½ per cent of owner-occupier loan approvals were at fixed rates; close to its lowest share in at least 17 years, and markedly lower than the decade average of 11½ per cent.

Financial institutions' average variable rates on unsecured personal loans, margin loans and standard credit cards have fallen by 60 to 90 basis points since end January, but average rates on low-rate credit cards have declined by only 25 basis points.

Overall, the average interest rate on all outstanding housing loans (variable and fixed) is estimated to have declined by about 80 basis points since end January, to 5.90 per cent (Graph 56). Since the peak in borrowing costs in August 2008, this interest rate has fallen by 285 basis points, to be around 175 basis points below its post-1993 average, and 15 basis points below its trough in early 2002.

In response to the decline in borrowing costs and the increase in grants paid to first-home buyers, the value of housing loan approvals has continued to rise in 2009, and in February was 16 per cent above its recent trough in July 2008. The increase since July mainly reflects a sharp increase in the value of approvals to first-home buyers (Graph 57). However, recently there has been some tentative evidence that the pick-up in approvals is becoming more broad-based.

The five largest banks have continued to gain market share at the expense of the smaller lenders over recent months. The five largest banks' share of gross owner-occupier loan approvals was 82 per cent in February 2009, 21 percentage points higher than just before the onset of the financial market turbulence in mid 2007, with only a very small part of this reflecting the acquisition of BankWest by CBA (Graph 58).

The increase in housing loan approvals is consistent with a slight increase in the pace of housing credit growth, which averaged 0.6 per cent a month over the March quarter, up from 0.5 per cent a month over the second half of 2008. This predominantly reflected faster growth in owner-occupier credit, whereas growth in investor credit was little changed over the quarter.

Personal credit, which is a much smaller component of household credit, has declined further during the March quarter as ongoing stock market volatility reduced margin loan debt and credit card lending has continued to slow. Personal credit fell by 6.2 per cent over the year to March.

The value of margin loans outstanding declined by 12 per cent over the March quarter to $18 billion, and is now 52 per cent lower than its peak in December 2007. Volatile equity markets meant that the incidence of margin calls remained high in the March quarter, at five calls per day per 1,000 clients, though this was down from a record 10 calls in the December quarter (Graph 59). Investors' average gearing level declined slightly over the March quarter, as the value of collateral was little changed in net terms, and investors continued to pay down their loans.

Business financing

Benchmark interest rates for business loans have also fallen in recent months, however, higher margins on new and refinanced facilities have offset this to some extent. Because the higher margins only apply to new and refinanced lending, the average interest rate on the outstanding stock of business borrowing has fallen significantly further than that for new lending.

Variable interest rates on outstanding small and large business loans are estimated to have fallen by around 100–125 basis points since end January, and are about 295 and 375 basis points lower respectively since the start of the easing cycle. The declines in the average rates on outstanding small and large business loans over the past three months have reflected greater pass-through of cash rate reductions to small business indicator rates, and the ongoing rolling-over of large business loans at the current low bank bill rates. However, interest rates on new and refinanced business loans have fallen by considerably less, as lenders have revised up their margins.

The spread between the major banks' average indicator rate on residentially secured small business term loans and the cash rate has risen by 5 basis points since the last Statement, to be around 200 basis points higher since mid 2007. The major banks' small business indicator rates are currently around their late 2003 levels, even though the cash rate is at its lowest level since 1960. In comparison, the average variable interest rate on outstanding large business loans is estimated to be at its lowest level since at least the early 1970s.

The major banks' average indicator rate on 3-year fixed small business loans has risen by around 40 basis points since end January, a little less than the increase in the 3-year swap rate. At 6.60 per cent, the rate is 330 basis points lower than its peak in mid 2008, and in line with levels last seen in mid 2003.

The average interest rate on all outstanding business loans is estimated to have fallen by around 325 basis points since the start of the easing cycle to a little over 5.50 per cent. This is around 225 basis points below its post-1993 average, and 80 basis points below its trough in early 2002. The estimate takes account of any increase in margins that occurred up until the end of March 2009, but does not take account of any subsequent widening in risk margins.

Total business debt has grown by an annualised 1½ per cent over the March quarter (Graph 60). The slowdown in the growth of business debt mainly reflects reduced demand from some firms due to lower planned investment and lower desired gearing levels, as well as some tightening in lending standards. A rise in the volatile capital market debt component more than offset a fall in intermediated business credit, which declined by an annualised 1.6 per cent over the three months to March. Commercial loan approvals have declined further in early 2009, consistent with the weakness in business credit.

The slowdown in business credit growth in the March quarter was more evident for larger loans (those greater than $2 million) and was reasonably broad-based across industry sectors. The five largest banks' and foreign banks' outstanding business loans have fallen slightly over recent months, while lending by the smaller Australian banks has risen a little.

In the March quarter, 19 syndicated loan approvals totalling $10½ billion were recorded, compared with $17 billion in maturities. About $8 billion of the syndicated loan approvals written in the March quarter were for refinancing, with only $2½ billion of lending being for capital expenditure and general corporate purposes, and $250 million for acquisitions (Graph 61). Of the maturing syndicated loans, the available evidence indicates that all ongoing companies were able to obtain replacement financing. Foreign lenders do not appear, at present, to be withdrawing from syndicated lending to Australian businesses. For individual loan facilities refinanced during the March quarter, there was no evidence of a systematic withdrawal by foreign lenders, with foreign lenders participation in recent approvals similar to their share over the past year. Over the remainder of 2009 and 2010, there are about $156 billion of syndicated loans to Australian companies that mature, with about 10 per cent of these loans being to real estate companies.

In recent months, there has been evidence of an increase in investor appetite for corporate debt, with the first such bonds issued since October 2008. Australian corporates have issued a record $16.7 billion of bonds since the last Statement, almost all of which was issued offshore (Graph 62). The bulk of issuance was accounted for by BHP Billiton and Rio Tinto, which issued bonds denominated in US dollars and euros.

Despite the increased investor appetite for corporate bonds, spreads on recently issued debt have been much higher than for bonds issued previously by the same entities. Indeed, the increase in spreads has more than offset falls in government bond yields over the past couple of years, so that the yields on these bonds at issuance were higher than on previously issued debt. This is also evident in the secondary market, where spreads and yields on BBB-rated bonds remain high by the standards of the past decade (Graph 63). This is consistent with the increased cost of intermediated corporate finance exhibited over recent months.

Listed non-financial companies' response to the turmoil in financial markets was evident in changes to the structure of their balance sheets over the December half 2008. While the aggregate book value gearing ratio was little changed, abstracting from the effects of Rio Tinto's 2007 debt funded purchase of Alcan it fell (Graph 64). This fall reflected a decline in gearing by a handful of large resource companies. Although non-resource companies' gearing picked up slightly in the December half, it is likely to fall in coming months as debt levels are reduced using funds from recent equity raisings. Overall, current levels of gearing are comparable to those around 1990, though because interest costs are lower, in aggregate, listed companies are better placed to service existing debt than they were at that time.

Listed companies also increased the liquidity of their balance sheets over 2008 by holding more cash. Cash holdings of these companies are currently at a high level compared with history, at around 7½ per cent of assets. Reflecting the pick-up in cash holdings and a fall in the proportion of debt that is short term, in aggregate listed companies have more cash than short-term debt on their balance sheets (Graph 65); at the individual company level, over 50 per cent of companies have more cash than short-term debt. There is evidence to suggest that companies' cash conserving behaviour has continued into 2009; for example, around half of ASX 200 companies that recently reported their profit results announced cuts to dividend payments to shareholders.

In response to concerns that foreign lenders could withdraw from the market for commercial property finance, the Federal Government has proposed establishing the Australian Business Investment Partnership (ABIP) as a contingency measure. Under the current proposal, ABIP would be able to provide up to $30 billion of finance for commercial property projects.

Aggregate credit

Total credit grew at an annualised rate of around 3 per cent over the March quarter, a similar pace to growth over the December quarter. The slowing in business credit growth over the March quarter was offset by an increase in the rate of growth of household credit (Table 13; Graph 66). Growth in broad money has been solid over recent months.


Volatility of the Australian share market has continued to decline, with absolute daily movements now averaging close to 1 per cent, well below the peak of more than 3 per cent following the collapse of Lehman Brothers last year (Graph 67). Current levels of volatility are below the average since the onset of turbulence in financial markets in 2007, but still nearly twice the long-run historical average.

In the weeks immediately following the publication of the last Statement, the ASX 200 continued to decline, reaching a trough in early March which was 54 per cent below its November 2007 peak (Graph 68). Since the March trough, the ASX 200 has increased by around 25 per cent, to be slightly above end 2008 levels, but still around 40 per cent below its peak.

The gain in the Australian share market since early March has been broad-based, though there have been particularly large gains among financials, which are up around 30 per cent, partly reversing their earlier large falls. Non-financials' share prices are up around 20 per cent. The relatively large increase in financials since early March predominantly owes to banks, whose share prices have benefited from improvements in sentiment stemming from developments overseas. Reflecting the health of the domestic banking system, Australian banks' share prices have performed well relative to major countries' banks over the past six months, though remain 42 per cent below their peak in November 2007 (Graph 69).

Profits announced by ASX 200 companies during the recent reporting season declined, though large companies' results were broadly in line with expectations. Underlying profits – which exclude significant items and asset revaluations/sales – were 3 per cent lower than in the corresponding period of 2007. Headline profits were around 81 per cent lower, with the sharp fall largely due to asset write-downs by resource and real estate companies.

By sector, resource companies' profits increased by 15 per cent, bolstered by strong production volumes in the third quarter of 2008 and the depreciation of the Australian dollar. Underlying profits for financials were around 18 per cent lower, with profits significantly lower for insurance companies and diversified financials as a result of investment losses, higher borrowing costs and lower fee revenue. Real estate companies also reported lower profits partly due to a fall in rental income from property assets. Profits for companies in other sectors fell by 13 per cent, led by a sharp fall in profits by some large infrastructure companies.

For the first half of the 2009 financial year, the major banks' reported underlying, after-tax profit was 7 per cent lower than the first half of 2008 at $8.4 billion, but 9 per cent higher than in the second half of 2008 and not far below its peak in 2007 (Graph 70). The banks' underlying, after-tax return on equity fell by 4 percentage points to 14 per cent, reflecting both the slightly lower profits and the increase in shareholder equity as the banks strengthened their balance sheets during the second half of 2008.

The banks' profits were underpinned by strong results from their Australian operations. Net interest income increased, driven by a 14 basis point rise in the net interest margin as higher lending spreads more than offset the increased cost of deposits, and solid balance sheet growth. However, the banks' overseas operations recorded lower profits, mainly due to sharp falls in their net interest margins, as they were unable to fully recover their higher funding costs in these markets.

The banks' bad and doubtful debt expense (as a proportion of assets) was twice as high as in the first half of 2008, but was only a little higher than in the second half of 2008. The increase was driven by higher specific provisions on the banks' corporate loan books, but there was also an increase in collective provisions reflecting the weakening economic outlook in Australia and overseas. The three major banks to most recently report reduced their half-year dividends per share by 20–25 per cent, to help further boost their very strong capital ratios.

Analysts have continued to revise down their forecast profits for ASX 200 companies, albeit at a slower pace than the previous few months. Aggregate earnings are now expected to fall by 16 per cent in 2008/09, decline a little further the following year before picking up by 19 per cent in 2010/11. Downward revisions have been widespread among ASX 200 companies, with earnings being downgraded for an average of 140 companies each month since the last Statement, compared with upgrades for an average of around 40 companies per month. However, considerable uncertainty about the outlook remains, with the dispersion of analysts' forecasts remaining at a very high level.

Measures of share market valuation have moved closer to their historical averages in recent months, in part due to the increase in share prices since early March. The Australian trailing P/E ratio – based on earnings for the past year – is up around 5 points over the past couple of months; of this increase, about a third owes to gains in share prices and the remainder reflects a decline in earnings. The Australian P/E ratio is currently 1 point below its long-run average (Graph 71).

The dividend yield on Australian shares has declined by 1 percentage point over recent months, though it remains high at around 6 per cent. The recent decline in the Australian dividend yield predominantly reflects gains in share prices. Australian shares have traditionally been higher yielding than the rest of the world, as dividend imputation provides a stronger incentive for Australian companies to pay dividends.

Equity raisings have been robust, with $17 billion raised by listed entities in the March quarter and a further $7 billion raised in the June quarter to date. The bulk of this was raised by non-bank entities, following banks' record raisings in the December quarter (Graph 72). The discounts on equity raisings have been broadly similar to those historically for large issues of equity. Most equity was raised through placements, with funds predominantly used by non-bank entities to strengthen balance sheets by paying down debt. Consequently, it is likely listed companies' gearing will fall in coming months. In contrast to the strength of equity raisings, IPO activity remains at a low level and buybacks also remain subdued, reflecting companies' preference to retain cash.

Merger and acquisition activity remained robust in the March quarter, though deal volumes are well below the levels seen in 2007 due to a fall in leveraged buyouts. Listed companies announced around $30 billion of deals in the March quarter, of which $19 billion was accounted for by Chinalco's proposed purchase of equity in a number of Rio Tinto mining projects. A further $7.5 billion of deals were announced in April and May. There are currently $41 billion of deals pending, of which a little less than half is the proposed Rio Tinto-Chinalco transaction.

The Australian Securities and Investments Commission (ASIC) extended its ban on covered short selling of financial companies – where an investor takes a short position and has arrangements already in place for the delivery of securities, typically by borrowing them – to 31 May 2009 from 6 March 2009. While naked short selling (of both financial and non-financial stocks) is banned indefinitely, covered short selling of non-financial companies has been permitted by ASIC since 19 November 2008. Since then, short sales have averaged around 15 per cent of the value of trades in ASX 200 companies, with materials companies tending to be most short sold.