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Is 50% of all income tax in Australia paid by 10% of the working population?

From The Conversation Fact Check:

According to the 2015-16 Federal Budget, Australians paid around A$176 billion in personal income taxation in the 2014-15 financial year (Table 5 of Budget Paper 1). The Treasurer, Joe Hockey, claims that around 50% of this taxation is paid by the top 10% of the working age population as ranked by their income.

NATSEM’s STINMOD model of the Australian tax and transfer system can be used to evaluate the accuracy of such a claim.

STINMOD, which stands for Static Incomes Model, is NATSEM’s model of taxation and government benefits. It simulates the taxation and government benefits system and allows us to evaluate current and alternative policies and how they would affect different family types on various income levels.

STINMOD is based on ABS survey data (Survey of Income and Housing) which provides a statistically reliable and representative snapshot of household and personal incomes and demographics.

Since the survey is a few years old, NATSEM adjusts the population in accordance with population and economic changes since the survey.

STINMOD is not publicly available, but as a NATSEM researcher, I was able to use the model to check Hockey’s claim against the evidence. STINMOD is benchmarked to taxable incomes data from the latest Australian Tax Office taxation statistics on the distribution of tax payments by income.

When I restricted the STINMOD base population to the working age population only (aged 18 to 65) and rank these people by their taxable income, I found that the top 10% (those with taxable incomes beyond $102,000 per annum) do pay around 52% of all personal income taxation.

Tax1July2015

Different measures, similar result

Since high income earners usually have greater scope for minimising tax through deductions, such as negative gearing, we can use an alternative income measure called “total income from all sources” to rank personal incomes. On this ranking, the share of personal income taxation paid by the top 10% drops to 50.5%.

Australia’s personal income taxation system is strongly progressive, with higher income earners paying both a higher marginal tax rate and average tax rate compared to lower income earners. According to STINMOD, the 90th percentile of working age taxable income is $102,000 per year, while the median taxable income is $39,000 per year. The average tax rate of the 90th percentile is 26.7% while that of the median tax payer is less than half that at 12.3%.

This analysis does include a large number of people who are of a working age but not in the labour force – around 21% of this population (2.9 million persons). These people are not in the labour market for a range of reasons such as disabilities, students, young parents or through personal choice or a range of other reasons. Removing these people from the analysis reduces the tax share to 46% paid by the top 10%.

Tax2July2015

In 2014-15, personal income taxation made up around 47% of all tax received by the federal government. Other taxes are paid to state and local government. While personal income taxation is highly progressive, the incidence of these other taxes tend to be less progressive, or indeed mildly regressive. One example is the GST, which makes up around 14.4% of federal taxation receipts.

Verdict

The Treasurer’s statement that the top 10% of incomes from working age persons pay 50% of personal income tax is correct. This reflects the progressive nature of Australia’s personal income tax system, which is applied to a society that features significant income inequality.

The progressive nature of income taxation in Australia plays a very significant role in altering the distribution of disposable income (after-tax) and provides Australia with a more equal distribution of disposable income.


Review

The FactCheck seems reasonable and correct. It benchmarks the ABS household income and expenditure survey against the official ATO Taxation Statistics, and then confines to working age (18 to 65), to test the Treasurer’s claim.

There were about 12.8 million individuals filing tax returns in 2012-13. The ATO Statistics in its “100 persons” picture of Australian taxpayers, explains that the top three taxable incomes paid 27% of all net tax and the top nine taxable incomes paid 47% in total – pretty close to the working age estimate.

I agree with the author that the FactCheck demonstrates Australia’s progressive income tax system, which has long been considered fair.

Australia has a high tax-free threshold of $18,200 so many working age low earners pay very little income tax. In contrast, New Zealand taxes from the first dollar of income.

And many working age people pay no tax simply because they are unable to find a job – as Australia has an adjusted 6% unemployment rate.

Household Net Worth now over $8 Trillion, but Savings down

The ABS released the latest national accounts, to March 2015. The Household Finance and Wealth data confirms again what we know, overall household net worth is up (thanks to asset appreciation) but savings are down.

At the end of March quarter 2015, household net worth was $8,090.9b, made up predominantly of $5,451.8b of land and dwelling assets and $4,131.0b of financial assets, less $2,121.6b of household liabilities. During the quarter, household net worth increased by $231.5b, driven mainly by holding gains of $207.0b. Financial assets ($129.0b) and land and dwellings ($79.8b) were the drivers of holding gains this quarter, with financial assets seeing the largest quarterly holding gains on record. The large increase in holding gains from financial assets was driven by net equity in reserves ($90.6b) and equities ($36.2b).

The increase of $17.6b in transactions in net worth was driven by $9.7b increase in net capital formation of land and dwellings; and net financial transactions of $7.3b, of which transactions in financial assets were $30.8b and liabilities were $23.5b. The March quarter 2015 transactions in financial assets were driven by $13.8b of transactions in net equity in reserves of pension funds and $11.2b of transactions in deposits. Transactions in liabilities in March quarter 2015 were driven by transactions of $24.3b in long term loan borrowing.

ABS-HousholdsBoth household assets and liabilities continued to grow over March quarter 2015, resulting in 2.9% growth in household net worth. Net worth has continued to grow over the last eight quarters, passing the $8 trillion mark in March quarter 2015.

ABS Household 1
Household financial assets grew faster than both residential land and dwelling assets and liabilities, growing by 4.0% ($159.8b), 1.9% ($96.1b) and 1.4% ($30.2b) respectively. Insurance technical reserves – superannuation, and shares and other equities were the key drivers of growth in financial assets this quarter. Insurance technical reserves – superannuation grew by 4.8% ($104.9b), recording its highest quarterly percentage growth since the June quarter 2012 growth of 8.4% ($131.4b). Shares and other equity grew 5.7% ($37.1b), recording its highest quarterly percentage growth since the March quarter 2013 growth of 6.1% ($32.4b).

The financial ratios graphs presented here are derived from the household balance sheet, financial account and income account. The interest payable to income ratio represents the proportion of household gross disposable income that is required to meet interest payments. Interest payable in the graph is the “adjusted interest payable”. It includes the financial intermediation services indirectly measured (FISIM) on the dwelling loan plus the dwelling interest payable from the household income account. It therefore represents the total nominal amounts paid as interest by the household sector. The interest payable to income ratio is relatively volatile in the short term, however some long term trends may be observed. After a period of volatility during the Global Financial Crisis, the ratio stabilised from March 2010 onwards, settling into a gradual downward trend. The ratio at March quarter 2015 was 11.1%, an increase of 0.6p.p from the December quarter ratio of 10.5%.

ABS Household 2The mortgage debt to residential land and dwellings ratio shows the extent that household residential real estate assets are geared. The ratio has declined since peaking at 30.6% in September quarter 2012, but has remained unchanged since December 2014 at 29.2%, indicating that household mortgage debt grew at the same rate as residential real estate owned by the household sector for the past two quarters.

The debt to assets ratio gives an indication of the extent that the overall household balance sheet is geared. That is the degree to which assets are dependent on debt. At 31 March 2015, household debt was equal to 20.8% of assets, dropping below 21% for the first time since December quarter 2010.

The debt to liquid assets ratio reflects the ability of the household sector to extinguish debts in a short period of time using their readily available, or liquid, assets. The following are classified as liquid assets: currency and deposits, short and long term debt securities, and equities. The ratio of household debt to liquid assets fell from 134.1% at 31 December 2014 to 131.8% per cent at 31 March 2015, the third consecutive quarter of decline and the lowest ratio since September quarter 2008.

ABS Household 3Household net saving was $16.4b for the quarter, decreasing from $22.8b in the December quarter. Despite the decrease in net saving, household net worth increased by $231.5b to $8,090.9b in March quarter 2015. With the inclusion of real net wealth effects, net saving increased to $215.9b for the quarter. The largest driver of the increase in other changes in real net wealth was real holding gains, which made up $192.2b of the $199.6b increase. Real holding gains for financial assets was $121.4b, which overtook land and dwellings as the biggest driver of real holding gains this quarter, and is the highest recorded holding gain for financial assets in the series.

ABS Household 4

Australians are saving more, but are more comfortable with debt

From The Conversation. Australians know that adequate savings can help provide for a rainy day, help a family put down a deposit on a home, or ensure a comfortable retirement.

Debt also offers a way for households to make purchases that would otherwise be impossible and to achieve a higher current standard of living. Debt invested into an asset that will also grow in real value and is able to be serviced without placing too much financial pressure on a household, is generally considered to be good debt.

The key is balance. Since the 2008 financial crisis, Australians have actually decreased their propensity to take on debt and have increased their savings. But debt rates still remain uncomfortably high and there is evidence that this savings discipline is beginning to fade. Have we grown too comfortable with debt?

Household debt is three times what it was 20 years ago. Image sourced from www.shutterstock.com

Saving more, but more indebted

Bankwest Curtin Economics Centre’s second ‘Focus on the States’ report, Beyond our Means? Household Savings a Debt in Australia finds Australians have more debt and are more comfortable with it.

While household savings portfolios have seen an increase of 54% in real terms since 2005, household debt has risen by 51% in the same period. Many households are able to access and service this debt, with higher debts associated with higher incomes. On average, Australia’s estimated 9.1 million households have savings in the form of financial assets of $340,900 and debts of $148,700.

However, there is a gulf between those at the top of the distribution and those at the bottom. The inequality in the distributions of household savings and debt are considerably worse than the much talked about inequality in incomes.

The average household disposable income of the top 20% of savers is less than four times those in the lowest savings quintile. However, their savings at an average of almost $1.3 million is 200 times the bottom 20%. This top quintile may receive one-third of all income, but they own three quarters of the total value of savings in the form of financial assets.

Average household savings by savings quintile, Australia 2015 (mean $‘000)

The trifecta of debts, low (or no) savings and low incomes presents many low economic resource families with an unenviable challenge to maintain an acceptable quality of life for themselves and their families on a day-to-day basis.

Since the global financial crisis, the household savings rate have risen, with households exhibiting discipline in their expenditure at a time when the economic outlook was uncertain. In an economic downturn income can decline quickly while reining in spending can be more difficult, for both households and governments. Debts can quickly get out of hand and become unmanageable in this situation.

Becoming used to debt

While Australian households have decreased their propensity to take on debt and have increased their savings in the post-GFC period, household debt still remains three times higher now than what it was 20 years ago. Australians are now more comfortable with debt and currently hold debt equal to 1.5 years of income, whereas in the past they had only debt equivalent to six months of annual income.

The share of debt associated with investment property loans has tripled from one-tenth to three-tenths between 1990 and 2015.

Unlike previous generations accustomed to more rigid financial products, current households can access a greater number of financial products, which have arguably become more complex and more flexible.

This flexibility delivers benefits, but with complexity comes risk and it is important to promote good financial decisions and encourage a longer term outlook. Mortgage equity withdrawal has become a popular tool to derive a higher current standard of living by using the family home as collateral.

More households now use these schemes to smooth consumption or relieve short-term financial pressures. But this may have contributed to the average mortgage debt as a proportion of property values almost tripling over the last 25 years, rising from 10% to 28% since 1990.

Ratio of housing debt to housing assets, June 1990 to December 2014

Another issue is the use of superannuation savings to pay down mortgage balances, leading retirees to rely more on the pension.

So are we living beyond our means? With household debt to income ratios three times higher now than a quarter of a century ago, household debt up by over 50% in real terms over the last decade and the debt of those approaching retirement (55-64 year olds) up 64% in real terms, it would seem on the face of it to be true.

However, the reality is more nuanced. Household savings are growing faster than income and 8.5 cents in every dollar is being saved, and there is now $2 trillion tucked away in superannuation, while riskier investments are making way for more a more conservative approach. This is far better than we were 10 years ago, but with a note of caution that savings are again on the decline.

Authors: – Alan Duncan, Director, Bankwest Curtin Economics Centre and Bankwest Research Chair in Economic Policy at Curtin University and Rebecca Cassells, Adjunct Associate Professor, Bankwest Curtin Economics Centre at Curtin University

 

The Budget is Still Unfair – The Conversation

From The Conversation’s “Looking inside the sausage machine.” NATSEM’s analysis of the 2015-16 federal budget, the same as used by the Howard and Rudd–Gillard governments as a policy tool, has been likened by Treasurer Joe Hockey to a sausage machine.

What makes Hockey’s analogy particularly striking is its applicability to this year’s budget process. While the government threw away the very toughest bits of gristle from last year, a number of the most unpalatable cuts are still in the mince, plus some added sweeteners.

Like last year, we have made some calculations showing the impact of the budget measures on disposable income in July 2017, once most of the proposed indexation pauses have taken effect.

Our assumptions are conservative. We consider as status quo the repeal of changes to income tax rates and the low-income tax offset. Like last year, we do not factor in the abolition of the Schoolkids Bonus, or the Income Support Bonus, because this was not strictly speaking a budget measure.

Restricting eligibility for Family Tax Benefit Part B, or FTB-B, may lead to substantial losses of disposable income for families with school-aged children – even before the Schoolkids Bonus is taken away. Our figures show that a couple with two children aged 11 and 8, where one parent earns A$60,000 per year, would lose A$84.43 per week, or 7.4% of disposable income. A single parent with one child aged 8 and no private income stands to lose A$49.93 per week, or 10.9% of disposable income.

Pausing indexation of all FTB payment rates affects the most vulnerable families. A couple with no private income and one 3-year-old child would lose A$11.24 per week, or 1.8% of disposable income, while a single parent would lose A$8.80 per week, or 1.6% of disposable income.

Working families on modest wages face a double hit if indexation pauses apply both to payment rates and thresholds. A couple with one child aged 3, where one parent earns A$60,000 per year, would lose A$21.86 per week, or 2.1% of disposable income. The same family with two children aged 6 and 3 would have A$27.81 per week less to spend, a loss of 2.4 % of disposable income. The losses for a working single parent are A$20.75, or 2%, and A$26.69, or 2.3% respectively.

Families with teenagers will also forgo indexation and receive no compensation for the wind back of FTB-B. For a single parent with one child aged 14, this means a loss of A$63.70 per week – 13.4% of disposable income if the parent is unemployed and 7.4% on an income of A$40,000. A couple on income of A$60,000 with a 14-year -old could lose up to 79.61 per week, or 7.5%.

These figures represent maximum losses of disposable income. Couples may experience lower losses if both members work. Single parents may also have different outcomes if, for instance, their family tax benefits are subject to the maintenance-income test.

Importantly, we do not include the impact of changes to child care, but if families are not currently using child care and do not use it after the changes, then our figures will be a reasonably accurate guide to the impact on these families (for example, those with school age children not using after-school care).

What NATSEM measured

Our figures broadly agree with the cameo analysis produced by NATSEM, when tax changes and the Schoolkids and Income Support Bonuses are taken into account. The NATSEM microsimulation model comes to the fore, however, in its ability to model the overall impact of complex policy changes such as the Child Care Subsidy, and its estimation of distributional impacts for the whole population – not just selected family types.

The childcare package is the centrepiece of the budget for households. It is estimated to cost A$4.4 billion over 4 years. In isolation, the package appears progressive and increases assistance more for low and middle income families than for higher income families, with the subsidy for childcare costs reducing from 85% to 50% as family incomes rise.

To finance these reforms the government proposes to maintain some initiatives from the 2014-15 budget. These include freezing family tax benefit (FTB) rates for two years, adjusting supplements linked to the benefits and freezing the upper income test threshold so that more people lose payments as their incomes increase, and most significantly to stop paying FTB Part B when the youngest child turns six.

There is uncertainty about the overall size of these savings. Because these changes were factored into last year’s budget they are not identified as new measures in the 2015-16 budget. Just before the budget, the Weekend Australian estimated these changes would cut payments by A$9.4 billion over four years. In addition, the government is proposing new changes to family payments and paid parental leave that would save more than A$1.6 billion over four years.

Clearly, the total volume of assistance for families is going down. To assess the overall household impact of the budget, it is necessary to balance who wins from the generally progressive child care assistance proposals versus who loses from last year’s and the new savings proposals.

The impact

NATSEM analysed the impact of much more than the changes in family assistance and child care and include 25 changes in the first two Abbott government budgets, comparing these with what would have happened if the previous government’s policy parameters had been unchanged. This distributional analysis involves modelling policy changes for some 45,000 real families included in two years of the Australian Bureau of Statistics Survey of Income and Housing.

NATSEM produces distributional impacts for quintiles (20%) of households by family type – couples with and without children, lone parents and single person households. Both couples with children and lone parents lose on average, with the poorest quintile of couples losing just over A$3,000 a year or 7.1% of their disposable income and the poorest quintile of lone parents losing just under A$3,000 a year or around 8% of their disposable income. Most households without children – except the poorest 20% – are estimated to have minor increases in real disposable incomes by 2018-19.

The government in Question Time has emphasised that the NATSEM calculations do not include any “second round” impacts of the budget changes. That is, the policy package put forward by the government makes work more attractive both by reducing the cost of childcare but also by cutting benefits to families, giving them greater “incentive” to increase their hours of work to make up for the loss of FTB-B in particular.

Will the Budget increase workforce participation?

Asked about the modelling during question time, the prime minister said this omission meant the modelling was “a fraudulent misrepresentation” of the government’s budget because returning people to work was “the whole point of the policy measures”.

At one level, this sounds like a reasonable criticism. The explicit aim of the budget changes is to make increased hours of work more attractive to families.

However, Treasurer Joe Hockey has also conceded that “as a rule second-round effects are not taken into account” in any budget. This is because while there are likely to be some behavioural responses to these changes, the size of that response is unclear. A 2007 Treasury Working Paper points out that estimates of labour supply responses to tax and benefit changes can vary widely.

The Productivity Commission in its report on childcare that formed the basis of the proposed childcare changes in the budget was cautious about the size of the labour supply response to its recommendations, arguing that additional workforce participation will occur, but it will be small, and is estimated to increase the number of mothers working by 1.2% (an additional 16,400 mothers).

It is also worth pointing out that the economic parameters underlying the overall budget suggest that employment effects are not likely to be substantial. The labour force participation rate is projected to rise marginally from 64.6% to around 64.75% over the forward estimates, but the unemployment rate is projected to increase from 5.9% to between 6.25% and 6.5%, which implies a small fall in the proportion of the adult population who are actually employed.

Overall, while there will be some second-round positive effects it is highly unlikely that they will offset the losses in disposable income experienced by many families with children.

Governments should welcome the type of evidence-based policy analysis exemplified by NATSEM’s work, and ideally provide it themselves. It focuses the debate on concrete questions of how policy changes affect people’s lives. To criticise the straightforward modelling approach because it yields the “wrong” answer smacks of shooting the messenger. The government should be upfront with the public about exactly what is in the budget sausage.

Australian Mortgage Holders Sensitive to Interest Rate Movements – CoreLogic RP Data

An article by Cameron Kusher, CoreLogic RP Data senior research analyst highlights that according to data from the Reserve Bank the ratio of household debt to disposable income is 153.8% and the ratio of housing deb to disposable income is 140.3% both of which are record highs.

Each quarter the Reserve Bank (RBA) publishes selected household finance ratios which show some key statistics about the level of debt held by Australian households. Although Australia has relatively low levels of public debt, private debt is extremely high and unlike many other countries there hasn’t been a decline in that debt in the aftermath of the financial crisis.

The latest household finances data from the RBA shows that in December 2014, the ratio of household debt to disposable income was 153.8%, its highest level on record. Housing debt accounts for 91% of total household debt and is recorded at a record high ratio of 140.3%. The chart shows that the level of debt has been relatively unchanged since 2005 but is now heading higher.

Focussing on the housing component of this debt, of the 140.3% ratio, 92.2% of that figure was owner occupier housing and 48.0% was investor housing. Once again, both are currently at record high levels. As with total housing debt, both had been relatively unchanged over recent years but have lifted over the past couple of years. It is important to note that the gap between owner occupier debt and investor debt is at near record high levels too.

Although household debt is high, the value of household assets is much higher than the debt. According to the data from the RBA the ratio of household assets to disposable income is 813.8%, much higher than the ratio of household debt at 153.8%. From the housing perspective, the ratio of housing assets to disposable income is recorded at 444.0% compared to a ratio of 140.3% for housing debt to household income. The chart shows that the ratio for both household and housing assets had been higher before the financial crisis however, both are now clearly trending higher again.

The data also shows that the ratio of household debt to household assets is 16.7% while the ratio of housing debt to housing assets is 28%. This highlights that although household and housing debts are high, the value of those assets is substantially higher than the level of debt. While this may be true at a national level it doesn’t mean that everyone is immune from the effects of an economic and/or housing market downturn.

Although these figures would provide some comfort that most households have the ability to sell assets to repay debt if they hit trouble, it is important to remember that it is a national view. There are areas of the country where households are much more susceptible to housing and economic downturns. Some specific areas and household types are recent first home purchasers, areas where there has been very little home value growth in recent years, single industry townships and areas where households have re-drawn a large proportion of their home’s equity.

With regards to the recent increases in household and housing debt, obviously very low interest rates (which have just got lower) are encouraging increased borrowing, particularly for housing. On the other hand, saving is not attractive because there is virtually no returns available. While most households can comfortably meet their mortgage requirements with mortgage rates at these levels, it is important to remember that a mortgage is usually a 25 to 30 year commitment and mortgage rates can fluctuate significantly over that time. The fact that household debt levels merely flat-lined rather than reduced following the financial crisis creates some concerns about what will happen once mortgage rates start to normalise (whenever that may be). Furthermore, the rate cut delivered this week may encourage even further leveraging into the housing market.

These are of course average figures across all household. However, as we have shown already, if you segment the household base, you discover that household debt is concentrated in different segments. Some are well able to cover the debts they owe, even if rates were to rise, but others are, even in the current low rate environment close to the edge, and with incomes static, vulnerable even to small rises in interest rate.

Basel IV – Is More Complexity Better?

In December 2014, The Bank For International Settlements issued proposed Revisions to the Standardised Approach for credit risk for comment. It proposes an additional level of complexity to the capital calculations which are at the heart of international banking supervision.  Comments on the proposals were due by 27 March 2015. These latest proposals, which have unofficially been dubbed “Basel IV”, is a continuation of the refining of the capital adequacy ratios which guide banking supervisors and relate to the standardised approach for credit risk. It forms part of broader work on reducing variability in risk-weighted asset. We want to look in detail at the proposals relating to residential real estate, because if adopted they would change the capital landscape considerably. Note this is separate from the proposal relating to the adjustment of IRB (internal model) banks. Whilst it aspires to simplify, the proposals are, to put it mildly, complex

For the main exposure classes under consideration, the key aspects of the proposals are:

  • Bank exposures would no longer be risk-weighted by reference to the external credit rating of the bank or of its sovereign of incorporation, but they would instead be based on a look-up table where risk weights range from 30% to 300% on the basis of two risk drivers: a capital adequacy ratio and an asset quality ratio.
  • Corporate exposures would no longer be risk-weighted by reference to the external credit rating of the corporate, but they would instead be based on a look-up table where risk weights range from 60% to 300% on the basis of two risk drivers: revenue and leverage. Further, risk sensitivity would be increased by introducing a specific treatment for specialised lending.
  • The retail category would be enhanced by tightening the criteria to qualify for the 75% preferential risk weight, and by introducing a fallback subcategory for exposures that do not meet the criteria.
  • Exposures secured by residential real estate would no longer receive a 35% risk weight. Instead, risk weights would be determined according to a look-up table where risk weights range from 25% to 100% on the basis of two risk drivers: loan-to-value and debt-service coverage ratios.
  • Exposures secured by commercial real estate are subject to further consideration where two options currently envisaged are: (a) treating them as unsecured exposures to the counterparty, with a national discretion for a preferential risk weight under certain conditions; or (b) determining the risk weight according to a look-up table where risk weights range from 75% to 120% on the basis of the loan-to-value ratio.
  • The credit risk mitigation framework would be amended by reducing the number of approaches, recalibrating supervisory haircuts, and updating corporate guarantor eligibility criteria.

Real Estate Capital Calculation Proposals

The recent financial crisis has demonstrated that the current treatment is not sufficiently risk-sensitive and that its calibration is not always prudent. In order to increase the risk sensitivity of real estate exposures, the Committee proposes to introduce two specialised lending categories linked to real estate (under the corporate exposure category) and specific operational requirements for real estate collateral to qualify the exposures for the real estate categories.

Currently the standardised approach contains two exposure categories in which the risk-weight treatment is based on the collateral provided to secure the relevant exposure, rather than on the counterparty of that exposure. These are exposures secured by residential real estate and exposures secured by commercial real estate. Currently, these categories receive risk weights of 35% and 100%, respectively, with a national discretion to allow a preferential risk weight under certain strict conditions in the case of commercial real estate.

Residential Owner Occupied Real Estate

In order to qualify for the risk-weight treatment of a residential real estate exposure, the property securing the mortgage must meet the following operational requirements:

  1. Finished property: the property securing a mortgage must be fully completed. Subject to national discretion, supervisors may apply the risk-weight treatment  for loans to individuals that are secured by an unfinished property, provided the loan is for a one to four family residential housing unit.
  2. Legal enforceability: any claim (including the mortgage, charge or other security interest) on the property taken must be legally enforceable in all relevant jurisdictions. The collateral agreement and the legal process underpinning the collateral must be such that they provide for the bank to realise the value of the collateral within a reasonable time frame.
  3. Prudent value of property: the property must be valued for determining the value in the LTV ratio. Moreover, the value of the property must not be materially dependent on the performance of the borrower. The valuation must be appraised independently using prudently conservative valuation criteria and supported by adequate appraisal documentation.

The current standardised approach applies a 35% risk weight to all exposures secured by mortgage on residential property, regardless of whether the property is owner-occupied, provided that there is a substantial margin of additional security over the amount of the loan based on strict valuation rules. Such an approach lacks risk sensitivity: a 35% risk weight may be too high for some exposures and too low for others. Additionally, there is a lack of comparability across jurisdictions as to how great a margin of additional security is required to achieve the 35% risk weight.

In order to increase risk sensitivity and harmonise global standards in this exposure category, the Committee proposes to introduce a table of risk weights ranging from 25% to 100% based on the loan-to-value (LTV) ratio. The Committee proposes that the risk weights derived from the table be applied to the full exposure amount (ie without tranching the exposure across different LTV buckets).

The Committee believes that the LTV ratio is the most appropriate risk driver in this exposure category as experience has shown that the lower the outstanding loan amount relative to the value of the residential real estate collateral, the lower the loss incurred in the event of a default. Furthermore, data suggest that the lower the outstanding loan amount relative to the value of the residential real estate collateral, the less likely the borrower is to default. For the purposes of calculating capital requirements, the value of the property (ie the denominator of the LTV ratio) should be measured in a prudent way. Further, to dampen the effect of cyclicality in housing values, the Committee is considering requiring the value of the property to be kept constant at the value calculated at origination. Thus, the LTV ratio would be updated only as the loan balance (ie the numerator) changes.

The LTV ratio is defined as the total amount of the loan divided by the value of the property. For regulatory capital purposes, when calculating the LTV ratio, the value of the property will be kept constant at the value measured at origination, unless an extraordinary, idiosyncratic event occurs resulting in a permanent reduction of the property value. Modifications made to the property that unequivocally increase its value could also be considered in the LTV. The total amount of the loan must include the outstanding loan amount and any undrawn committed amount of the mortgage loan. The loan amount must be calculated gross of any provisions and other risk mitigants, and it must include all other loans secured with liens of equal or higher ranking than the bank’s lien securing the loan. If there is insufficient information for ascertaining the ranking of the other liens, the bank should assume that these liens rank pari passu with the lien securing the loan.

In addition, as mortgage loans on residential properties granted to individuals account for a material proportion of banks’ residential real estate portfolios, to further increase the risk sensitivity of the approach, the Committee is considering taking into account the borrower’s ability to service the mortgage, a proxy for which could be the debt service coverage (DSC) ratio. Exposures to individuals could receive preferential risk weights as long as they conform to certain requirement(s), such as a ‘low’ DSC ratio. This ratio could be defined on the basis of available income ‘net’ of taxes. The DSC ratio would be used as a binary indicator of the likelihood of loan repayment, ie loans to individuals with a DSC ratio below a certain threshold would qualify for preferential risk weights. The threshold could be set at 35%, in line with observed common practice in several jurisdictions. Given the difficulty in obtaining updated borrower income information once a loan has been funded, and also given concerns about introducing cyclicality in capital requirements, the Committee is considering whether the DSC ratio should be measured only at loan origination (and not updated) for regulatory capital purposes.

The DSC ratio is defined as the ratio of debt service payments (including principal and interest) relative to the borrower’s total income over a given period (eg on a monthly or yearly basis). The DSC ratio is defined using net income (ie after taxes) in order to focus on freely disposable income. The DSC ratio must be prudently calculated in accordance with the following requirements:

  1.  Debt service amount: the calculation must take into account all of the borrower’s financial obligations that are known to the bank. At loan origination, all known financial obligations must be ascertained, documented and taken into account in calculating the borrower’s debt service amount. In addition to requiring borrowers to declare all such obligations, banks should perform adequate checks and enquiries, including information available from credit bureaus and credit reference agencies.
  2. Total income: income should be ascertained and well documented at loan origination. Total income must be net of taxes and prudently calculated, including a conservative assessment of the borrower’s stable income and without providing any recognition to rental income derived from the property collateral. To ensure the debt service is prudently calculated, the bank should take into account any probable upward adjustment in the debt service payment. For instance, the loan’s interest rate should (for this purpose) be increased by a prudent margin to anticipate future interest rate rises where its current level is significantly below the loan’s long-term level. In addition, any temporary relief on repayment must not be taken into account for purposes of the debt service amount calculation.

Notwithstanding the definitions of the DSC and LTV ratios, banks must, on an ongoing basis, have a comprehensive understanding of the risk characteristics of their residential real estate portfolio.

The risk weight applicable to the full exposure amount will be assigned, as determined by the table below, according to the exposure’s loan-to-value (LTV) ratio, and in the case of exposures to individuals, also taking into account the debt service coverage (DSC) ratio. Banks should not tranche their exposures across different LTV buckets; the applicable risk weight will apply to the full exposure amount. A bank that does not have the necessary LTV information for a given residential real estate exposures must apply a 100% risk weight to such an exposure.

Basel-4-RE-WeightingsSome points to note.

  1. Differences in real estate markets, as well as different underwriting practices and regulations across jurisdictions make it difficult to define thresholds for the proposed risk drivers that are meaningful in all countries.
  2. Another concern is that the proposal uses risk drivers prudently measured at origination. This is mainly to dampen the effect of cyclicality in housing values (in the case of LTV ratios) and to reduce regulatory burden (in the case of DSC ratios). The downside is that both risk drivers can become less meaningful over time, especially in the case of DSC ratios, which can change dramatically after the loan has been granted.
  3. The DSC ratio is defined using net income (ie after taxes) in order to focus on freely disposable income. That said, the Committee recognises that differences in tax regimes and social benefits in different jurisdictions make the concept of ‘available income’ difficult to define and there are concerns that the proposed definition might not be reflective of the borrower’s ability to repay a loan. Further, the level at which the DSC threshold ratio has been set might not be appropriate for all borrowers (eg high income) or types of loans (eg those with short amortisation periods). Therefore the Committee will explore whether using either a different definition of the DSC ratio (eg using gross income, before taxes) or any other indicator, such as a debt-to-income ratio, could better reflect the borrower’s ability to service the mortgage.
  4. There are no specific proposal to treat loans that are past-due for more than 90 days.

 Investment Loans

Bearing in mind that 35% of all loans are for investment purposes in Australia, the proposals relating to loans for investment purposes are important. So how will they be treated under Basel 4?

There are a number of pointers in the proposals, though its not totally clear in our view. First, we think the proposals would apply to separate loans where repayment is predicated on income generated by the property securing the mortgage, i.e. investment loans rather than a normal loans where the mortgage is linked directly to the underlying capacity of the borrower to repay the debt from other sources. Such loans might fall into a special commercial real estate category, specialist lending category, or a fall back to the unsecured category, each with different sets of capital weights.

The Committee proposes that any exposure secured with real estate that exhibits all of the characteristics set out in the specialised lending category should be treated for regulatory capital purposes as income-producing real estate or as land acquisition, development and construction finance as the case may be, rather than as exposures secured by real estate. Any non-specialised lending exposure that is secured by real estate but does not satisfy the operational requirements should be treated for regulatory capital purposes as an unsecured exposure, either as a corporate exposure or other retail exposure, as appropriate.

Specialised lending exposure, would be defined so if all the following characteristics, either in legal form or economic substance were met:

  1. The exposure is typically to an entity (often a special purpose entity (SPE)) that was created specifically to finance and/or operate physical assets;
  2. The borrowing entity has few or no other material assets or activities, and therefore little or no independent capacity to repay the obligation, apart from the income that it receives from the asset(s) being financed;
  3. The terms of the obligation give the lender a substantial degree of control over the asset(s) and the income that it generates; and
  4. As a result of the preceding factors, the primary source of repayment of the obligation is the income generated by the asset(s), rather than the independent capacity of a broader commercial enterprise.

On the other hand, in order to qualify as a commercial real estate exposure, the property securing the mortgage must meet the same operational requirements as for residential real estate. If the loan is a commercial real estate category, the risk weight applicable to the full exposure amount will be assigned according to the exposure’s loan-to-value (LTV) ratio, as determined in the table below. Banks should not tranche their exposures across different LTV buckets; the applicable risk weight will apply to the full exposure amount. A bank that does not have the necessary LTV information for a given commercial real estate exposure must apply a 120% risk weight.
LTVBasel-4-Commercial-LTVNote, if this LTV refers to market value, the threshold should be set at a lower level: eg 50%.

Where the requirements are not met, the exposure will be considered unsecured and treated according to the counterparty, ie as “corporate” exposure or as “other retail”. However, in exceptional circumstances for well developed and long established markets, exposures secured by mortgages on office and/or multipurpose commercial premises and/or multi-tenanted commercial premises may be risk-weighted at [50%] for the tranche of the loan that does not exceed 60% of the loan to value ratio. This exceptional treatment will be subject to very strict conditions, in particular:

  1.  the exposure does not meet the criteria to be considered specialised lending
  2. the risk of loan repayment must not be materially dependent upon the performance of, or income generated by, the property securing the mortgage, but rather on the underlying capacity of the borrower to repay the debt from other sources
  3. the property securing the mortgage must meet the same operational requirements as for residential real estate
  4. two tests must be fulfilled, namely that (i) losses stemming from commercial real estate lending up to the lower of 50% of the market value or 60% of loan-to value (LTV) based on mortgage-lending-value (MLV) must not exceed 0.3% of the outstanding loans in any given year; and that (ii) overall losses stemming from commercial real estate lending must not exceed 0.5% of the outstanding loans in any given year. This is, if either of these tests is not satisfied in a given year, the eligibility to use this treatment will cease and the original eligibility criteria would need to be satisfied again before it could be applied in the future. Countries applying such a treatment must publicly disclose that these and other additional conditions (that are available from the Basel Committee Secretariat) are met. When claims benefiting from such exceptional treatment have fallen past-due, they will be risk-weighted at [100%].

Implications and Consequences

We should make the point, these are proposals, and subject to change. But it would mean that banks using the standard approach to capital could no longer just go with a 35% weighting, rather they will need to segment the book based on LTV and servicability at a loan by loan level. Investment loans may become more complex and demand higher capital weighting. The required data may be available, as part of the loan origination process, but additional processes and costs will be incurred, and it appears net-net capital buffers will be raised for most players. The capital would be determined using two risk drivers: loan-to-value and debt-service coverage ratios with risk weights ranging from 25 percent to 100 percent. Investment loans may require different treatment, (and the RBNZ discussion paper recently issued may be relevant here, where investment loans are handled on a different basis.)

Finally, a word about those banks on IRB. Currently, under their internal models, they are sitting on an average weighting of around 17% (compared with 35% for standard banks). There are proposals to lift the floor to 20% minimum, and the FSI Inquiry recommend higher. Indeed, Murray called for the big banks to lift the average mortgage risk weighting to a range of 25% to 30%. This would bring them closer to the average mortgage risk weighting used by Australia’s regional banks and credit unions, though as described above, these, in turn, may change. Incidentally, the Bank of England thinks 35% is a good target. Basel 4 will also reduce the variance between standardised banks and those using their own models by requiring the internal models not to deviate from the RWA number in the standardised model by a certain amount: the so-called “capital floor”.

Interestingly the US is focussing on an additional measure, The Tier 1 Common measure, which is unweighted assets to capital, and has set a floor of 5%, or more.  The Major Banks in Australia carry real, or non-risk-weighted, equity capital of just 3.7% of assets. Some banks are leveraged over seventy times the equity capital to loans, which is scarily high, but then the RBA (aka the tax payer) would bail them out if they get into trouble, so that’s OK (or not). This means that just $1.70 in assets will now support a $100 loan.

We wonder if the ever more complex models being proposed by Basel are missing the point. Maybe we should be going for something simpler. Many banks of course have invested big in advanced models to squeeze the capital lemon as hard as they can. But stepping back we need approaches which allow greater ability to compare across banks, and more transparent disclosure so we can see where the true risks lay. Certainly capital buffers should be lifted, but we suspect Basel 4, despite the best of intentions,  is going down the wrong alley.

Economic Implications of High and Rising Household Indebtedness

The Reserve Bank of New Zealand just published an interesting report on this important topic. High and rapidly rising levels of household debt can be risky. A high level of debt increases the sensitivity of households to any shock to their income or balance sheet. And during periods of financial stress, highly indebted households tend to cut their spending more than their less-indebted peers. This can amplify a downturn and helps to explain why many advanced economies since the 2008-09 crisis have had subdued recoveries. Financial institutions can suffer direct losses from lending to households, although these losses are rarely enough on their own to cause a systemic banking crisis. The sustainability of household debt can be assessed best by looking at data detailed enough to build a picture of how debt and debt servicing capacity is distributed across different types of borrowers.

Households, either individually, or in aggregate, can ‘over-borrow’, and financial institutions can ‘over-lend’ to them. A high level of household debt can affect both the financial system and the economy in several ways that are explained in this article.

Two sets of comparative data makes interesting reading. First, household debt-to-disposable income ratio – by country. Cross-country comparisons of debt levels need to be treated with caution, given a variety of measurement issues and different institutional features. That said, the rise in household debt in New Zealand over the last cycle was not exceptional compared to other countries, and Australia is higher.RBNZ-Household-RatioSecond, Household debt-to-income ratios – selected countries. The Reserve Bank comments that “in quite a few countries there was no domestic financial crisis and little sustained fall in house prices. Policymakers in several of these economies, including New Zealand, have subsequently become concerned by household sector developments over the past several years – developments underpinned by low interest rates and an easing in lending standards. Household debt levels have started to increase from already high levels, while house prices are growing from a starting point of ‘over-valuation’.

RBNZ-Debt-To-Income The implementation of an LVR speed limit in New Zealand reflected emerging developments in the housing market that if left unchecked, could have threatened future macroeconomic stability. Some other jurisdictions have also used new macro-prudential tools, in combination with improving the existing underlying prudential framework. In addition to LVR restrictions, other measures include: maximum debt servicing-to-income limits, maximum debt to-income limits, higher risk weights on banks’ housing loans and prudent (or responsible) lending guidelines.

They conclude that:

“This article has focused on the various channels through which household debt can affect the financial system and broader economy. In this sense, households can ‘over-borrow’, although this is often not apparent in ‘real time’ and excess debt levels can lead to, or aggravate, economic downturns or periods of financial distress. The relationship between household indebtedness and consumption volatility is important for the macroeconomy, because it means that the behaviour of highly indebted households during periods of financial duress can amplify downturns. While historical evidence suggests losses on household lending are rarely the sole factor in systemic banking crises, housing-related credit booms and busts often occur alongside booms and busts in other sectors such as the (much riskier) construction and commercial property sector. It is also worth noting that, over time, housing loan portfolios have become a larger share of bank lending in many countries, including New Zealand, increasing their potential to play a larger part in future financial crises. Thus household debt is an important area of focus from a financial stability perspective.

Good micro-level household data provide an important window into how debt and debt servicing capacity is distributed across the household sector, and are also helpful for carrying out simple stress-tests of the sector using a range of large, but plausible shocks. New Zealand’s data in this area are improving. Data from the Household Economic Survey show a rise in the proportion of borrowers with a high LVR and high debt-to-income ratio, thereby supporting the view that LVR speed limits have been appropriate to curtail risks to financial stability. The Reserve Bank will continue to develop its framework for analysing household sector risk and vulnerabilities.”

New Zealand’s Potential New Capital Rules on Investor Mortgages are Credit-Positive – Fitch

Fitch Ratings views positively the Reserve Bank of New Zealand’s (RBNZ) consultation on the capital treatment for mortgages to residential property investors. Higher capital requirements for investor loans combined with the existing loan to value ratio (LVR) limit could help protect banks against material losses in the event of a property price correction.

The RBNZ proposes to modify existing capital rules by requiring banks to include investor mortgages in a specific asset sub-class, and hold appropriate regulatory capital for those assets. Investor mortgages in New Zealand have performed similarly to owner-occupied mortgages but the experience in other markets has shown weaker asset quality performance in a downturn. The consultation paper seeks to define the terminology of investor mortgages in order to make policy decisions by end-April 2015. Currently investor mortgages are treated the same as owner-occupier mortgages for regulatory capital purposes in New Zealand.

The introduction of higher capital rules for investor mortgages may also slow the growth rates of property prices, particularly in Auckland. Increased investor demand and a rise in investor mortgages appear to be a contributor to this strong growth, and the RBNZ’s proposed limit could address some of the risks associated with these loans. The agency expects banks to charge higher interest rates on investor mortgages to offset the higher capital requirements which may deter some of the more marginal investment activity in the market. Price rises in Auckland have exceeded 10% per annum over the last 24 months which is unlikely to be sustainable in the long-term.

Investor mortgages typically have lower LVRs relative to owner-occupier loans and therefore are less susceptible to the RBNZ’s existing LVR restrictions, introduced in October 2013. Banks are only allowed to underwrite a maximum of 10% of new mortgages with an LVR in excess of 80% which has reduced some potential risk in the banks’ mortgage portfolios.

The new measures could also indirectly help to limit growth in household indebtedness by reducing house price appreciation closer to income growth. New Zealand’s household debt, measured as a percentage of disposable income stood at 156% at end-September-2014, which is high relative to many peer countries and has increased by 5pp since 2012. Although interest rates are still low compared to the historical long-term average, a rise in the official cash rate could place borrowers at risk of being unable to service their mortgages, and may eventually lead to asset quality problems for the banks. However, this risk is partly mitigated through bank affordability testing, which includes adding a buffer above the prevailing market interest rate when assessing serviceability.

 

RBA Trading Economic Growth Against Sydney Property

In Glenn Stevens Opening Statement to House of Representatives Standing Committee on Economics today, we get a glimpse of the drivers to lower interest rates. In addition, they are prepared to cut rates even if it leads to more growth in the Sydney property market to drive growth, even if that lever is now less powerful than previously.

Since the hearing in August last year, the economy has continued to grow at a moderate, but below-trend pace. Inflation as measured by the CPI has been affected by movements in energy prices and government policy changes, but even aside from these effects, inflation is low and appears likely to remain so.

The international context is one in which the global economy likewise is growing, but according to most observers at a pace a little below its longer-run average. There are some notable differences in performance by region. The US economy has picked up momentum, growing above trend with a falling unemployment rate. China’s economy met its growth target in 2014. A slightly lower target seems likely to be set for 2015, perhaps something like 7 per cent. But that would still be robust growth for an economy of China’s size. On the other hand, the euro area and Japan have recorded lower growth rates than expected a year ago.

Commodity prices have fallen, in some cases quite sharply. These trends appear to reflect primarily major increases in supply, with some moderation in demand playing a role. That would appear to be the case for iron ore and oil prices (and, prospectively, liquefied natural gas prices, which are typically tied to oil prices). Base metals prices, where few significant supply changes have occurred, have fallen by much less.

So there has been what economists refer to as a ‘positive supply shock’: more of the product is available with lower prices. The effect of this on individual countries will vary, depending on whether they are a producer or a consumer of such raw materials. On the whole for the global economy, however, this is a positive development.

Inflation is quite low in a range of countries, and very low in some. The decline in energy prices is temporarily pushing headline CPI inflation rates even lower.

The very low interest rates in evidence around the world when we last met have fallen further. This has been most pronounced in Europe, where yields on long-term German sovereign debt have fallen to be about the same as those in Japan. German sovereign debt has recently traded at negative yields for terms as long as 5 years. Official deposit rates are negative in the euro area, and the European Central Bank has announced a large-scale asset purchase program – colloquially referred to as ‘quantitative easing’. The euro has depreciated. Some surrounding countries to which funds tend to flow in anticipation of further depreciation – such as Switzerland – have reduced interest rates to significantly below zero and indeed 10-year Swiss government debt has traded at a negative yield. The Swiss National Bank took the decision to remove the cap on the Swiss franc, as it assessed that the size of the intervention likely to be required to hold it was becoming just too large. This move occasioned considerable turbulence in foreign exchange markets.

Meanwhile, the US Federal Reserve, faced with a strengthening US economy and having ended its asset purchase program last year, is expected to begin a gradual process of lifting its policy rate in a few months from now. So the monetary policies of the major jurisdictions look like they will be heading in differing directions. This means there is ample potential for further turbulence in financial markets this year.

The falls in prices for key export commodities are lowering Australia’s terms of trade and hence the purchasing power of our national income. This is a well-understood mechanism and has been the subject of much discussion. It will continue to constrain income growth for households and mining companies, and revenues for both state and federal governments, over the period ahead.

Resource export shipments are increasing strongly, as the capacity put in place by the period of high investment is put to use. At the same time, the high levels of capital spending by the resources sector, which had been a strong driver of domestic demand for several years, peaked during mid 2012 and turned down. All indications are that this downswing will accelerate this year. That has always been our forecast. The recent declines in commodity prices don’t change it, though they do reinforce that this trend is well and truly under way.

The various areas of domestic demand outside mining investment are mixed. Dwelling construction is rising strongly and commencements of new dwellings will reach a new high over the coming 12 months. Consumer spending is responding both to income trends and financial incentives, which are pulling in different directions. Growth in wages, by historical standards, is quite subdued. This and the fall in the terms of trade is working to restrain growth in disposable incomes. Working the other way, the fall in petrol prices, assuming it persists, is adding noticeably to the real incomes of consumers. Increased asset values, which push up gross measures of wealth, and low interest rates are also working to push consumption up relative to income. The net effect of these opposing forces is producing moderate, though not strong, consumption growth.

Meanwhile, at this point non-mining business investment spending is still very subdued. While several key fundamentals are in place for stronger performance, clear signs of a near-term strengthening remain unconvincing at this stage. This is a weaker outcome than we had expected six months ago. Public sector final spending – about one-fifth of aggregate demand – is fairly subdued, and the intent of governments, as you know, is to restrain their own spending over the period ahead. The lower exchange rate is likely to help export volumes outside the resources sector, and of late better trends have been observed in some services export categories including tourism and education.

Overall, growth in non-mining economic activity has picked up, but is still a little below average. Our expectation had been that a further pick-up would occur in 2015. When we reviewed our forecasts in late January, we didn’t feel that growth in the recent past had been materially different from what we had estimated a few months ago. But when we tried to look ahead, we concluded that there were fewer signs of a further pick-up in non-mining activity than we had hoped to see by now. As a result, the revised forecasts we took to the February Board meeting embodied a longer period of below-trend growth, and a higher peak in the rate of unemployment, than earlier forecasts. They also suggested that inflation was likely to remain pretty low over the forecast horizon. The inflation outlook was revised slightly lower, in part reflecting the effect of declining oil prices as well as the weaker outlook for economic activity.

At its meeting in February the Board considered that this revised assessment – that is, sub-trend growth for longer, a higher peak in the unemployment rate, slightly lower inflation – warranted consideration of some further adjustment to monetary policy, after a fairly long period during which the cash rate had remained steady. These were incremental changes to the outlook but all in a consistent direction.

Another factor in our consideration was dwelling prices, which have continued to increase. Price rises in Sydney are very strong, and they are pretty solid in Melbourne. On the other hand they are much more mixed elsewhere. Excluding Sydney, the rise for Australia as a whole over the past year was about 5 per cent. That is a healthy pace but not alarming, and some cities have seen price falls. Developments in the Sydney market remain concerning, but in the end we did not see these trends as overwhelming a case for a further easing in monetary policy that was made on more general grounds.

I note that, on the regulatory front, APRA has announced its supervisory approach to managing the potential risks posed by the rise in lending to investors in housing. This involves more intense scrutiny of investor loan portfolios growing at over 10 per cent per year, with the possibility, ultimately, of additional capital being required if APRA deems it necessary. APRA has also reiterated its expectations for other elements of lending standards such as interest rate buffers and floors. And ASIC has begun a review of interest-only lending in the context of consumer protection legislation. The Bank welcomes these steps and will keep working with other regulators in these areas.

The Board is also very conscious of the possibility that monetary policy’s power to summon up additional growth in demand could, at these levels of interest rates, be less than it was in the past. A decade ago, when there was, it seems, an underlying latent desire among households to borrow and spend, it was perhaps easier for a reduction in interest rates to spark additional demand in the economy. Today, such a channel may be less effective. Nonetheless we do not think that monetary policy has reached the point where it has no ability at all to give additional support to demand. Our judgement is that it still has some ability to assist the transition the economy is making, and we regarded it as appropriate to provide that support.

The forecasts published last week in the Statement on Monetary Policy assume a lower path for interest rates and a lower exchange rate than both earlier forecasts and the ones the Board responded to at the February meeting. These are assumptions rather than forecasts or commitments to a course of action.

It is worth noting that, despite concerns at various times about whether the exchange rate would adjust appropriately to our changing circumstances, it has been doing so over the period since we last met with the Committee. Against the US dollar it has fallen by around 17 per cent since our last hearing. The US dollar itself has been rising against all currencies, of course, so much of this movement is an American story rather than an Australian one. Against a basket of relevant currencies the Australian dollar has fallen by less, but the decline is still about 11 per cent since August. Further adjustment is probably going to occur.

One other development since our last meeting with the Committee was the final report of the Financial System Inquiry. This was quite a wide-ranging report and there is now a further period of consultation. I simply note that the Inquiry did not find major problems in the financial system, but did make recommendations about capital, to enhance the resilience of the banking system, and about loss-absorbency more broadly in the context of resolution. These will be mostly in the province of APRA to consider. The Inquiry also made some observations about payments matters, generally supporting the steps the Payments System Board has taken since its inception in 1998, and pointing to some areas where further steps may be appropriate. The Payments System Board will be considering these matters at its meeting next week.

RBA Lowers Growth Forecast

The RBA published their statement on monetary policy today.  They point to a lower than expected growth and inflation forecast, but higher rates of unemployment. GDP is now projected at 2.25 per cent to June, and a quarter percent lower by the end of the year than their last projection.  They are expecting unemployment to remain higher for longer, and above 6 per cent during 2017. Inflation is forecast at a headline level of just 1.25 per cent, thanks to lower oil prices, although the bank’s favoured core inflation measure still sits within its 2-3 per cent target.

Looking at the economic drivers, the banks said that the 9 per cent fall in exchange rates had yet to flow through into higher prices, and the fall in oil prices are estimated to have increased real household disposable income by 0.25 per cent over the last half of 2014, and will lift spending power by an additional 0.5 per cent over the first three months of this year.

“While growth in non-mining activity has picked up a little over the past two years, all components except dwelling investment look to have grown at a below average pace over the past year,” the RBA said.

The ABS capital expenditure survey suggests that there will be only very modest growth in non-mining investment in 2015.

The most significant comment for me related to the behaviour of households who have experienced significant lifts in wealth thanks to rising house prices, yet may not be turning this into higher rates of consumption.

“However, another possibility is that ongoing buoyant conditions in housing markets will have less of an effect on consumption than previously. In particular, in recent years fewer households appear to have been utilising the increase in the value of their dwelling to increase their leverage or trade up”.

This cuts to the heart of the problem. Their core strategy was to allow housing to expand, to lift wealth, to encourage spending, to drive growth, until the business sector kicks in. However, there is mounting evidence that households are not convinced, and are unwilling or unable to spend. Retail is still below trend, and as interest rates of savings fall, households become more conservative. It could be that their core thesis is flawed.  Indeed, they had previously acknowledged

“we shouldn’t expect consumption to grow consistently and significantly faster than incomes like it did in the 1990s and early 2000s, given that the debt load is already substantial”.

In our recently published household finance confidence index we noted a consistent fall. No surprise then households are not performing as expected.