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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.

How The Mining Boom Lifted Living Standards

In the RBA Bulletin for December 2014, there is a detailed analysis and modelling to show how the mining boom impacted the Australian economy. This is important because as we know the boom is fading, and the RBA has been looking for the housing sector to take up the slack.

The world price of Australia’s mining exports more than tripled over the 10 years to 2012, while investment spending by the mining sector increased from 2 per cent of GDP to 8 per cent. This ‘mining boom’ represents one of the largest shocks to the Australian economy in generations. This article presents estimates of its effects, using a macroeconometric model of the Australian economy. It summarises a longer research paper, which contains further details and discussion of the results (see Downes, Hanslow and Tulip (2014)). The model estimates suggest that the mining boom increased Australian living standards substantially. By 2013, the boom is estimated to have raised real per capita household disposable income by 13 per cent, raised real wages by 6 per cent and lowered the unemployment rate by about 1¼ percentage points. However, not all parts of the economy have benefited. The mining boom has also led to a large appreciation of the Australian dollar that has weighed on other industries exposed to trade, such as manufacturing and agriculture. However, because manufacturing benefits from higher demand for inputs to mining, the deindustrialisation that sometimes accompanies resource booms – the so-called ‘Dutch disease’ – has not been strong. Model estimates suggest that manufacturing output in 2013 was about 5 per cent below what it would have been without the mining boom.

Graph 3 also shows an estimate of the increase in the volume of goods and services produced arising from the boom. Higher mining investment directly contributes to higher aggregate demand. Furthermore, higher national purchasing power boosts consumption and other spending components. Higher mining investment also increases the national capital stock and hence aggregate supply. There are many further compounding and offsetting effects. The estimated net effect is to increase real GDP by 6 per cent.

RBABoom1The mining boom raises household income through several different channels within the model (Graph 8). As of 2013, employment was 3 per cent higher than in the counterfactual, largely due to the boost to aggregate demand. Real consumer wages were about 6 per cent higher, reflecting the effect of the higher exchange rate on import prices. Property income increased, reflecting greater returns to equities and real estate. A larger tax base led to lower average tax rates, all of which helped raise real household disposable income by about 13 per cent. As can be seen in Graph 8, household consumption is estimated to initially rise more slowly than real household disposable income. That is, the saving rate increases. This reflects inertia in consumption behaviour, coupled with a default assumption that households initially view the boom as temporary. In the medium to long run, as it becomes apparent that the change in income is persistent, savings return toward normal and consumption rises further. In the long run, consumption will adjust by about the same proportion as the rise in household disposable income.

RBABoom3Changes in the composition of consumption are an important determinant of how the mining boom affected different industries (Graph 9). Demand for motor vehicles and other consumer durables are estimated to have increased strongly, reflecting lower import prices and strong income growth. Relative price changes for most other categories of consumption were smaller, with consequently less effect on their relative demand.

RBABoom4 The mining boom can be viewed as a confluence of events that have boosted mineral commodity prices, mining investment and resources production. This combination of shocks has boosted the purchasing power and volume of Australian output. It has also led to large changes in relative prices, most noticeably an appreciation of the exchange rate. The combination of changes in income, production and relative prices has meant large changes in the composition of economic activity. While mining, construction and importing industries have boomed, agriculture, manufacturing and other trade-exposed services have declined relative to their expected paths in the absence of the boom. Households that own mining shares (including through superannuation) or real estate have done well, while renters and those who work in import-competing industries have done less well.

Property Momentum On The Slide

We just updated the DFA household surveys, with data to end November, and there are some interesting transitions in play, which taken together with potential action on foreign buyers, suggests we will see property momentum easing in the next few months. This actually may be a “get out of jail card” for the RBA and provide reasons why macroprudential may not be required after all, and why interest rates may need to be cut further next year, not lifted. Today we look at our cross segment summaries. You can read about our segment definitions and survey approach here. This update will later be incorporated on the next edition of the Property Imperative Report.

We begin with the updated estimate of the number of households by DFA segment. We find that there are 6.5 million households who are property active, and 2.25 million households who are property inactive (meaning they live in rentals, with family, friends or other accommodation). Those who are inactive continues to increase, with 26% of all households in this group now.

Of those who are active, we split them out into those with owner occupied property, those with investment property, and those who invest via SMSF. This is the national picture, to end November 2014. Of those households who are property active, 68.2% are owner occupiers, 31% have investment properties, and 0.8% have property investments via SMSF.

SegmentCountsDec2014Looking at the cross segment results, we are seeing a steady decrease in those saving in order to enter the property market. This includes the Want-to-Buys and the First Timers, the latter who are to some extent active in market exploration. Up-Traders and Down-Traders are saving a little more, but the lack of momentum in savings means households are less likely to try and enter the marker later. Three factors have influenced this trend. First, low deposit interest rates, second lower disposable incomes, and third, a view that prices are so high they will never be able to enter the market.

SavingDec2014Looking at the need to borrow, we see a continual rise in the demand for loans from those expecting to transact. Only Down-Traders are less likely to borrow. The need to borrow more is a reflection of higher prices in many states, though as we highlighted yesterday, there appears to be a change in the wind with regards to property prices. Lending for investment property will continue, so we may see additional controls on this type of lending coming though in due course as part of the regulatory review, but overall demand is unlikely to grow significantly beyond this.

BorrowMoreDec2014In our surveys, we see a consistent lowering of expectations, across the segments in relation to whether prices will rise in the next 12 months. Property investors are also a little more sanguine on house price growth, though still more optimistic that owner occupiers. That said, more than half across the board still are expecting a further rise, despite stretched loan to income ratios and high benchmarks.

PriceExpectationsDec2014So, turning to question of whether households will transact in the next year, we see falls in several significant segments – Portfolio Investors, and Down-Traders are most likely to transact. In sheer volume terms, it is the Down-Traders who are most likely to keep the property ship afloat as they attempt to liquidate some of the capital locked away in their property. We see a supply/demand re-balancing ahead, and as a result, a slowing in house price growth. If investors get cold feet, prices will fall from current levels.

Transact12MonthDec2014In the next few days we will delve into our segment specific results.

RBA’s Outlook for Australia’s Economy

In a speech today, Christopher Kent, Assistant Governor (Economic) outlined the current state of global and local economies, and commented on the outlook.  Significantly he stressed that the RBA was looking for household expenditure to trickle through to stimulate business investment and thus lead to a lift in the labour market. However, noting the fall in average real income, and waning consumer confidence, we think this will take a long time, even at current very low interest rates. In addition, we have very high loan to income ratios, and this is absorbing household wealth significantly. Raises an interesting point, are the underlying economic assumptions valid this time around?

Our expectation is that growth will continue to be a bit below trend for a time, picking up gradually to be a bit above trend pace by 2016. And the unemployment rate is likely to remain elevated for some time.

The near-term weakness reflects a combination of three forces: a sharper decline in mining investment over the coming quarters than seen to date; the effects of the still high level of the exchange rate; and ongoing fiscal consolidation at state and federal levels. In contrast, resource exports are likely to make a further strong contribution to growth, with LNG exports expected to begin ramping up over coming quarters. At the same time, very low interest rates are working to support growth of household expenditure. In time, growth of household demand and the impetus to domestic demand provided by the exchange rate depreciation we have seen since early 2013 are expected to spur non-mining business investment.

Given this outlook, I want to touch on two relevant aspects of the business cycle that are important sources of uncertainty for our forecasts. One is related to household consumption, the other to business investment.

Household consumption

At this phase in the business cycle, it’s natural to worry about the possibility that consumption will be weighed down by slow growth in household incomes, driven in turn by the subdued state of the labour market. It is true that stronger growth of employment and wages would provide more support for consumption. However, that dynamic usually kicks in later in the cycle. In the meantime, it’s reasonable to expect that very low rates of interest will enable and encourage households to shift some expenditure from the future to now, including via higher asset prices. This would see a decline in the share of disposable income that households save (i.e. a lower saving ratio). There are limits to this, and it would be unwise to build a recovery on a foundation of a sharp decline in the saving ratio.

Our latest forecasts, however, suggest that there will be a gradual decline in the saving ratio over the next couple of years, of the same order of magnitude as we’ve already seen over the past couple of years.

A decline in the household saving ratio would be consistent with the tendency for labour market developments to lag developments in economic activity, including consumption, by a few quarters. Consumption and GDP growth tend to pick up ahead of an improvement in employment growth, which would in turn be expected to occur before we see wage growth start to return to more normal levels. This was the case during the recessionary episodes of the early 1990s and following the global financial crisis.


Non-mining business investment

I’ve spoken at length recently about the factors that might have led to subdued non-mining business investment over recent years.

In short, I concluded that this outcome had been consistent with a period of greater uncertainty and below-average confidence. Both of these have changed for the better more recently, yet firms still seem reluctant to take on risks associated with substantial new investment projects. If the appetite of businesses (and shareholders) for risk were to improve, investment could pick up. It’s hard to know when such a turning point in spirits might take place. But it is more likely when the fundamental determinants of investment are in place as they seem to be now. The ready availability of internal and external finance, at very low cost, is one such element of that. Also, there is the stronger growth of demand across the non-mining parts of the economy over the past year or so and measures of capacity utilisation have increased to around long-run average levels. So there is a reasonable prospect of business investment picking up, in time.

Even so, let me note some reasons why the anticipated recovery in non-mining business investment might not be quite as strong as in earlier episodes. But I will stress at the outset that if that comes to pass, it does not mean that growth of activity or of our prosperity need suffer.

One reason why investment in the non-mining sector might be lower than in the past is that service industries account for an increasing share of our economy – rising by about 12 percentage points in terms of the employment share over the past three decades. This is relevant to investment because service industries, on average, have much lower levels of capital relative to labour. So, in an economy in which services account for a higher share of economic activity, other things equal, the optimal (non-mining) capital stock should be lower  than it otherwise would be (as a share of that economy). However, that doesn’t imply that GDP growth will be lower, nor does it suggest that the economy will be a less prosperous one. What matters for these things is whether we are taking advantage of profitable opportunities and using labour and capital in the most productive ways that we can. Also, it is worth emphasising that many services require high levels of human capital – in the form of education and training – which does not get picked up in investment as measured by the national accounts.


Investment today might also be lower (as a share of nominal GDP) than in the past for another reason. Over time there has been a sizeable decline in the price of many types of machinery and equipment (particularly those related to information and communications). So, businesses are able to spend less to obtain a given level of capital services. For example, they can purchase a lot more computing power for a given level of nominal spending. Once again, if this leads to lower investment (as a share of nominal GDP) than in the past it does not imply less output growth or lower prosperity. Indeed, given that Australia imports much of our machinery and equipment, a lower price of that capital is to our benefit.


The major advanced economies are in different stages of the business cycle. The recovery from recession is well established in the United States, but has a long way to go in the euro area. Japan has made some progress in reducing the extent of spare productive capacity, but inflation is still some way from the Bank of Japan’s target. Nevertheless, growth of Australia’s major trading partners has actually been around average for some time now and, as best we can tell, it is likely to remain at that rate in the year ahead.

Australian GDP growth has been a bit below trend pace over the past couple of years, consistent with a gradual rise in the unemployment rate. Much of the growth this past year owed to rising resource exports, although growth outside the mining sector also picked up. However, with mining investment set to fall more sharply over coming quarters, GDP growth is expected to be below trend for a time before gradually picking up to an above-trend pace by 2016.

The very low level of interest rates is supporting, and will continue to support, growth of household expenditure. In time, this is expected to support a recovery in non-mining business investment, and the economy more broadly, including an improvement in conditions in the labour market. If history is any guide, the recovery is likely to proceed in that order, from household expenditure to business investment to labour market conditions. History also suggests that a pick-up in business investment (outside of the resources sector) will come, in time. The fundamental forces are in place to support that recovery. And while I have suggested some reasons why business investment might not be quite as strong as past episodes of recovery might suggest, these don’t imply that the economy overall will be less strong than otherwise, but rather just one element of expenditure that we measure via the national accounts.

Why Mortgage Loans Are Growing Slower Than House Prices

The RBA, in today’s monetary statement discusses the relationship between loan growth and house prices. They conclude that factors including fear of unemployment, low supply, high loan to income ratios and stamp duty are all contributing factors, as well as price hikes themselves.

Indicators of conditions in the established housing market, such as housing prices, housing turnover and new borrowing, are interrelated and often move together quite closely (Graph A1). However, in recent years, housing turnover and loan approvals have risen by less than housing prices when compared with previous cycles in the housing market.


Turnover and loan approvals are closely linked. Each new housing loan represents a new transaction in the housing market (as long as it is not used to refinance an existing property or construct a new dwelling). Hence, the value of new borrowing will grow at about the same rate as the value of turnover as long as the average loan-to-valuation ratio does not change too much. In Australia, it turns out that the relationship between new borrowing and turnover has been quite stable for the past decade or so (Graph A2).


Housing prices and turnover might move together over time for a number of reasons, although the relationship may not be quite as tight as that between turnover and loan approvals (and it is possible for prices to rise with only limited turnover). One strand of research has found that an increase in housing prices causes an increase in turnover because higher housing prices increase the net wealth of homeowners. This allows those owners who did not previously have a large enough deposit to trade up to a more expensive dwelling, thereby increasing turnover. A complementary strand of research has found that the causality can also run in the other direction, from turnover to housing prices.

It suggests that some vendors might discern a rise in housing demand by observing a rise in turnover, thereby encouraging them to raise their reserve prices.

Turnover and housing price growth have moved together over time, although the relationship appears to have weakened somewhat in recent years. The change is most evident in Sydney and Melbourne, where growth in housing prices has been strongest of late (Graph A3). The rate of turnover has remained low in those cities, both in terms of their longer-term averages and relative to growth in housing prices.


It is difficult to know why the turnover rate has remained relatively low compared with its history and compared with prices. There is tentative evidence to suggest that existing homeowners have become more reluctant to borrow against increases in their net wealth to trade up homes. For example, the survey of Household Income and Labour Dynamics in Australia (HILDA) suggests that in 2011 and 2012 (the two most recent survey years) a smaller share of households bought larger homes than in any of the previous nine survey years. Also, there has been unusually low participation of owner-occupiers in housing market transactions recently (Graph A4). The reasons are not clear, although it partly reflects the fact that state government incentives for first home buyers have been redirected away from established dwellings towards new dwellings.


One possibility is that a reluctance to trade up homes reflects households generally becoming less willing to take on additional debt in recent years. Following the increase in leverage over the 1990s and early 2000s, the debt-to-income ratio has been stable at high levels. Although interest rates are currently low, the expected repayment burden on loans is at 10-year average levels, when calculated using a longer term interest rate to account for the expectation that variable interest rates will move up over time. Indeed, in New South Wales and Victoria, which have experienced the greatest disparity between housing prices and turnover relative to historical norms, the share of current income required to service an average loan over the next 10 years is close to historical highs.

Another consideration is that homeowners may be less willing to borrow more because growth in labour income has slowed. Nominal labour income has grown at an average annual rate of 2.7 per cent over the past two years, compared with a decade average of 6.2 per cent. And the widespread expectation is that wage growth will remain subdued for a time. Moreover, the Westpac-Melbourne Institute survey suggests that the share of households expecting more unemployment a year ahead has been at above-average levels since late 2011, which is an unusually long time by the historical standards of the survey.

Repayment obligations, in combination with uncertainty about future labour income, are an important consideration for homeowners. According to liaison with banks, one consequence of this environment is that an increasing share of owner occupiers is opting for interest-only loans to increase repayment flexibility.

A reluctance to trade up homes might also stem from increases in effective stamp duty rates. In some states, including New South Wales and Victoria, the nominal housing price thresholds at which higher rates of stamp duty apply have not changed for a number of years. As housing prices have risen, more buyers have fallen into the higher stamp duty brackets, acting as a disincentive to purchase housing. In New South Wales, for instance, the stamp duty paid on a median-priced home has grown to around 25 per cent of annual disposable income per household, from close to 10 per cent in 1991.

Finally, the relationship between turnover and housing prices can be affected by developments in housing supply. Additions to the housing stock have been relatively low in some states over recent years, which would weigh on the rate of turnover as it is currently measured, while low supply relative to demand would also put upward pressure on prices.


Household Income Trends Show Strongest Growth At The Top

The ABS today released their Distribution of Household Income, Consumption and Wealth data for the years from 2003 to 2012.   According to the ABS, the average gross disposable income of Australian households grew 58 per cent in the period 2003-04 to 2011-12. However, the highest income quintile grew at a rate above average, at 62 per cent. All other income quintiles grew above 50 per cent , but below the average rate of 58 per cent. We see that older Australian’s income has been growing faster than younger ones.

GrossIncomesBy-AgeBandsThe relative share of gross income is gravitating towards older households. This is a function of the growing number of older households, thanks to the demographic shifts, and the fact they hold the lions share of investments yielding income.

RelativeShareGrossIncomesBy-AgeBandsWe can also look across the income quintiles (20% bands). We see stronger income growth in the higher income groups. This is stated in perecentage terms, but in doller terms the relative amounts are significant.

GrossIncomesPCQuintilesWe can see that growth in incomes for the richest quintile is stronger than the lower ones.

GrossIncomesQuintilesThe ABS says growth in wages and salaries was by far the largest contributor to this increase, except for the lowest income quintile, where social assistance benefits were the largest contributor to their income growth.

This is an important data-set and is the first time data for household groups has been released under the framework of the national accounts. We can look at which household groups are driving the growth in income, consumption, savings and wealth in the national accounts.

For example, households with two adults and dependent children were responsible for about one-third of the growth in household gross disposable income.

Households where the reference person was aged 35 to 44 years had an increase in income tax of $9,000 – with their payments going from $17, 000 in 2003-04 to $26,000 in 2011-12 – which was above the average increase of $4,500.

Of course this data stops in 2012, so we cannot yet see the impact of falling incomes in real terms, which we have discussed previously.

RBA On Housing Lending in Financial Stability Review

The RBA just released their Financial Stability Review for September 2014. They made a number of comments on Housing Lending, which I have collated in a more digestible form here.


Household credit growth has picked up, almost entirely driven by investor housing credit, which is growing at its fastest pace since late 2007. The willingness of some households to take on more debt, combined with slower growth in incomes, means that the debt-to-income ratio has picked up a little in the past six months. The increase in household risk appetite is most evident in the continued strength of investor activity in the housing market. The momentum in investor housing activity has been concentrated in Sydney and (to a lesser extent) Melbourne. Investor housing loan approvals are almost 90 per cent higher in New South Wales than they were two years ago and are 50 per cent higher over the same period in Victoria. As a share of approvals, both are back around previous peaks. By contrast, the momentum in the owner-occupier market appears to have slowed over the past six months or so, with loan approvals to owner-occupiers little changed. Some potential first home buyers are likely to have been priced out of parts of the market by investors, who typically have higher incomes and are therefore able to bid up prices. The broad-based reduction in grants to first home buyers for established housing since late 2012 has also contributed to reduced demand from these buyers.

Financial-Stabiliity2-Sept2014Strong investor demand can be a sign of speculative excess, with the risk that additional speculative demand can amplify the cycle in housing prices and increase the potential for prices to fall later. This is particularly the case if that demand is largely based on unrealistic expectations of future price growth, perhaps extrapolated from recent experience. A speculative upswing in demand can also be damaging if it brings forth an increase in construction on a scale that leads to a future overhang of supply. This risk is more likely to arise in particular local markets than at the national level. Nationally, Australia is a long way from an oversupply of housing and some increase in supply is to be expected in response to higher prices, which should also help to temper those rising prices.


Growth in banks’ domestic lending has lifted over the past six months, after a few years of modest growth (Graph 2.5). Housing credit expanded at an annualised rate of around 7 per cent over the six months to July 2014; growth in investor credit continued to strengthen and at nearly 10 per cent reached its fastest pace since 2007, well above the rate for owner-occupiers. Business credit growth also picked up, although it continues to be weighed upon by subdued non-mining business investment. The pick-up in credit growth has been accompanied by stronger price competition in some loan markets. The ongoing improvement in bank funding conditions, including for smaller banks, has aided price competition. It will be important for banks’ own risk management and, in turn, financial stability that they do not respond to revenue pressures by loosening lending standards, or making ill-considered moves into new markets or products. Banks need to ensure that loans originated in the current environment can still be serviced by borrowers in less favourable circumstances – for instance, at higher interest rates or during a period of weaker economic conditions. Furthermore, banks should be cautious in their property valuations, and conscious that extending loans at constant loan-to valuation ratios (LVRs) can be riskier when property prices are rising strongly, as is currently the case in some commercial property and housing markets.




In the residential mortgage market, price competition for new borrowers has intensified. Fixed rates have been lowered in recent months. According to industry liaison, a number of lenders have also extended larger discounts on their advertised variable rates and broadened the range of borrowers that receive these discounts. Banks are offering other incentives to attract new borrowers, including fee waivers, upfront cash bonuses or vouchers. In addition, some banks recently raised their commission rates paid to mortgage brokers. However, reports from banks and other mortgage market participants suggest that, in aggregate, banks’ non-price lending standards, such as loan serviceability and deposit criteria, have remained broadly steady over recent quarters. This seems to be supported by APRA data on the composition of banks’ housing loan approvals, which suggest that the overall risk profile of new housing lending has not increased. It is noteworthy that the industry-wide share of ‘low-doc’ lending continues to represent less than 1 per cent of loan approvals, while the share of loans approved with an LVR greater than 90 per cent has fallen over the past year (see ‘Household and Business Finances’ chapter). That said, strong investor activity in the housing market has meant that the share of investor loans approved with LVRs between 80 per cent and 90 per cent has risen.


The shares of interest-only loans for both investors and owner-occupiers have also drifted higher, and average loan sizes (relative to average income) have increased.  The increase in interest-only share of banks’ new lending, which has continued to increase for both investors and owner-occupiers in 2014, might be indicative of speculative demand motivating a rising share of housing purchases. Consistent with mortgage interest payments being tax-deductible for investors, the interest-only share of approvals to investors remains substantially higher than to owner-occupiers. According to liaison with banks, the trend in interest-only owner-occupier borrowing has been largely because these loans provide increased flexibility to the borrower. It does not necessarily mean that borrowers are taking on debt that they may not be able to service if both interest and principal repayments are made. Rather, some of these borrowers are likely to be building up buffers in offset accounts. In any case, APRA’s draft Prudential Practice Guide emphasises that a prudent authorised deposit taking institution would assess customers’ ability to service principal and interest payments following the expiry of the interest-only period. More broadly, consumer protection regulations require that lenders do not provide credit products and services that are unsuitable because, for example, the consumer does not have the capacity to meet the repayments.

Future housing loan performance is likely to at least partly depend on labour market performance. Although forward-looking indicators of labour demand have generally improved since last year, they remain consistent with only moderate employment growth in the near term.


Although, in aggregate, bank housing lending standards do not appear to have eased lately, a crucial question for both macroeconomic and financial stability is whether lending practices across the banking industry are conservative enough for the current combination of low interest rates, strong housing price growth and higher household indebtedness than in past decades. Moreover, lending to investors is expanding at a fast pace, which could be funding additional speculative activity in the housing market and encourage other (more marginal) borrowers to increase debt. Lending growth is varied across geographical markets and individual lenders, which may suggest a build-up in loan concentrations and therefore correlated risks within the banking industry. The Reserve Bank’s assessment is that the risk from the current strength in housing markets is more likely to be to future household spending than to lenders’ balance sheets. However, the direct risks to banks will rise if current rates of growth in investor lending and housing prices persist, or increase further. In light of the current risks, APRA has increased the focus of its supervision on banks’ housing lending. Specifically, it has:

• begun a regular supervisory survey of a broader range of risk indicators for banks with material housing lending

• released a draft Prudential Practice Guide (PPG) for housing lending that outlined expectations for banks’ risk management frameworks, serviceability assessments, deposit criteria and residential property valuations.1 By way of example, prudent serviceability assessments are seen to involve: an interest rate add-on to the mortgage rate, in conjunction with an interest rate ‘floor’, to ensure the borrower can continue to service the loan if interest rates increase; a buffer above standard measures of household living expenses; and the exclusion, or reduction in value, of uncertain income streams. While much of the guidance in the PPG is already common practice within the industry, it is nonetheless important that practices are not deficient at even a minority of lenders

• written to individual bank boards and chief risk officers asking them to specify how they are monitoring housing loan standards and ensuing risks to the economy

• assessed the resilience of banks’ housing loan (and other) portfolios to large negative macroeconomic shocks, including a severe downturn in the housing market, as part of its regular stress testing of banks’ balance sheets.

In addition, the Reserve Bank is discussing with APRA, and other members of the Council of Financial Regulators (CFR), further steps that might be taken to reinforce sound lending practices, particularly for lending to investors.


The proportion of disposable income required to meet interest payments on household debt has stabilised accordingly, at around 9 per cent. Households continue to take advantage of lower interest rates to pay down their mortgages more quickly than required. The aggregate mortgage buffer – balances in mortgage offset and redraw facilities – has risen to be around 15 per cent of outstanding balances, which is equivalent to more than two years of scheduled repayments at current interest rates. Prepayment rates and the proportion of borrowers ahead of schedule on their mortgage repayments are also high according to liaison with banks. Part of this prepayment behaviour has been due to some banks’ systems not automatically changing customer repayment amounts as interest rates have declined, while in many cases households have not actively sought to reduce their repayments. This might be a sign that household stress is currently limited. The household saving ratio, although trending down a little lately, remains high at just under 10 per cent. Households’ aggregate balance sheet position has continued to improve in recent quarters: real net worth per household is estimated to have increased by 4 per cent over the year to September 2014.


One area of shadow banking activity in Australia that warrants particular attention is non-bank securitisation activity, given strengthening investor risk appetite as well as the connections between this activity, the housing market and the banking system (through the various support facilities provided by banks). As discussed, RMBS issuance has picked up since 2013 and spreads have narrowed, including for non-bank issuers (i.e. mortgage originators). Mortgage originators tend to have riskier loan pools than banks; this is partly because they are the only suppliers of non-conforming residential mortgages, which are typically made to borrowers who do not meet the standard underwriting criteria of banks. These originators currently account for about 2 per cent of the Australian mortgage market (not all of which is non-conforming), and so have limited influence on competition in the mortgage market and the housing price cycle. Even so, it is useful to monitor any signs of greater non-bank activity, as this could signal a broader pick-up in risk appetite for housing.


Lenders mortgage insurers (LMIs) are specialist general insurers that offer protection to banks and other lenders against losses on defaulted mortgages, in return for an insurance premium. LMIs’ profitability improved in the first half of 2014, with the industry posting a return on equity of about 14 per cent, up from an average of around 10 per cent over the preceding few years. The number and average value of claims on LMIs has declined recently in response to the buoyant housing market, as well as previous improvements in underwriting standards. In addition, some LMIs have recently increased their premium rates. In May, the largest LMI, Genworth Australia, successfully listed on the ASX, with around one-third of the company now independently owned. Also, in August QBE announced plans to partially float its subsidiary, which is the other major LMI in Australia. Share market listing will subject the relatively concentrated Australian LMI industry to greater market scrutiny and increase its access to domestic capital markets; such developments could be beneficial to financial stability given the LMI industry’s involvement in the credit creation process and linkages to the banking system.