Australia: Contraction ahead

Concern about rising household debt and house prices prompted Australian regulators to crack down on bank lending, with APRA introducing limits on interest-only loans.

Australia: Household Debt and Housing Prices

China is also making it more difficult for Chinese nationals to purchase real estate offshore. The combined result is a slow-down in Australian bank credit, with credit and broad money growth falling below 5% for the first time since the global financial crisis.

Australia: Credit and Broad Money Growth

Currency in circulation may be more volatile but a sharp fall in currency growth over the last two years confirms tighter monetary conditions.

Australia: Currency and M3 Growth

The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry recently kicked off with intense media coverage. Airing of banks’ dirty laundry in public is again likely to lead banks to further tighten lending standards. Falling housing prices as a result of fewer offshore purchases and restrictive lending practices will in turn fuel a more negative lending outlook, creating a negative feedback loop.

While a credit contraction can still be avoided, it may be difficult for the RBA and APRA to reverse course. Given that their objective is to avoid a full-blown banking crisis, caused by a collapse of the housing bubble, the current slow-down may appeal as the lesser of two evils.

Why Aussie banks are weakening

Australian banks are breaking primary support levels. There are two major reasons for this. One is the precarious level of household debt as a result of the housing bubble. The first graph below shows how housing prices have more than doubled compared to disposable incomes (after tax but before interest payments) over the past 30 years. And how household debt has risen, not as a result of, but as the underlying cause of, the housing bubble. Without rising debt there would be no bubble.

Australian House Prices and Household Debt to Disposable Income

Growth in Australian housing prices is now slowing, prompting fears of a correction.

Australian House Price Growth

The second reason is falling returns on equity. Banking regulators have increased pressure on major banks to improve lending standards and increase capital backing for their lending exposure. For decades banks were given free rein to increase lending without commensurate increases in capital, to the extent that the majors hold only $4 to $5 of common equity for every $100 of lending exposure. Low interest rates, increases in capital and slowing credit growth have all contributed to the decline in bank equity returns to the low teens.

Australian Banks Return on Equity

Australia: What housing bubble?

Some interesting comments from economist Saul Eslake regarding the Australian housing bubble:

“Rising house prices are not of themselves a reason for the market to drop. About two thirds of Australia’s household debt is owned by the top 40 per cent of households, by income distribution. There hasn’t been a lot of lending to people on low incomes,” explains Eslake.

Lending to people on small salaries is one of the reasons housing markets in other countries, such as the US in the sub-prime crisis, have come under pressure in the past.

There has also been a decline in the home ownership rate in Australia that also reduced the chance of a housing bubble popping. According to the 2016 census, home ownership is the lowest it has been since the census of 1954…..

Australia also never experienced the same extent of low-doc lending as happened in the US prior to the financial crisis, where “ninja loans” – no income, no job, no assets – were commonplace.

Similarly, very high LVR lending, another problem in the US, did not occur to the same extent in this market.

“In the US people of surprisingly modest means could get loans valued in excess of 100 per cent of the value of the property. But in Australia it’s very difficult to get a mortgage at more than 80 per cent LVR without mortgage insurance,” says Eslake.

…..An excess supply of housing, which impacted the US and Irish markets, is also missing in Australia.

“In countries housing supply ran a long way ahead of underlying demand. Builders kept building in the expectation of future demand. When the cycle changed, forced sales and excess supply crashed the market,” says Eslake.

For the last 15 years Australia has had a housing shortage. While that’s changing given a record numbers of apartments have been built in the last few years, supply has not yet outstripped demand.

While he does mention risks attached to interest-only mortgages, Saul’s view is that “a correction in the domestic residential property market, at this point in the cycle it seems unlikely.”

I believe there are further assumptions that he has not mentioned:

  • That banks continue to provide credit at the same rate as they are at present. A slow-down in new credit, precipitated by rising interest rates or falling prices, could cause a contraction.
  • That the inflow of foreign investment into Australian residential housing continues at the same rate as at present. There are three possible headwinds:
    1. Reluctance on the part of Australian banks to increase exposure to foreign investors.
    2. Tighter monetary policy in China.
    3. And a Chinese crackdown to restrict capital outflows.
  • That current low interest rates continue. Inflationary pressures are low, so this is not unreasonable at present, but circumstances can change. So can LVRs.

I would describe the situation as reasonably stable at present but increasingly precarious in the long-term as the ratio of household debt to disposable income continues to climb.

Source: Opinion: What if the housing market crashed?

RBA stuck

Great slide from the NAB budget presentation:

RBA Interest Rates in a Cleft Stick

The RBA is in a cleft stick:

  • Raising interest rates would increase mortgage stress and threaten stability of the banking system.
  • Lowering interest rates would aggravate the housing bubble, creating a bigger threat in years to come.

The underlying problem is record high household debt to income levels. Housing affordability is merely a symptom.

There are only two possible solutions:

  1. Raise incomes; or
  2. Reduce debt levels.

Both have negative consequences.

Raising incomes would primarily take place through higher inflation. This would generate more demand for debt to buy inflation-hedge assets, so would have to be linked to strong macroprudential (e.g. lower maximum LVRs for housing) to prevent this. A positive offshoot would be a weaker Dollar, strengthening local industry. The big negative would be the restrictive monetary policy needed to slow inflation when the job is done, with a likely recession.

Shrinking debt levels without raising interest rates is difficult but macroprudential policies would help. Also policies that penalize banks for offshore borrowings. The big negative would be falling housing prices as investors try to liquidate some of their investments and the consequent threat to banking stability. The slow-down in new construction would also threaten an economy-wide down-turn.

Of the two, I would favor the former option as having less risk. But there is a third option: wait in the hope that something will turn up. That is the line of least resistance and therefore the most likely course government will take.

3 Headwinds facing the ASX 200

The ASX 200 broke through stubborn resistance at 5800 but is struggling to reach 6000.

ASX 200

There are three headwinds that make me believe that the index will struggle to break 6000:

Shuttering of the motor industry

The last vehicles will roll off production lines in October this year. A 2016 study by Valadkhani & Smyth estimates the number of direct and indirect job losses at more than 20,000.

Full time job losses from collapse of motor vehicle industry in Australia

But this does not take into account the vacuum left by the loss of scientific, technology and engineering skills and the impact this will have on other industries.

…R&D-intensive manufacturing industries, such as the motor vehicle industry, play an important role in the process of technology diffusion. These findings are consistent with the argument in the Bracks report that R&D is a linchpin of the Australian automotive sector and that there are important knowledge spillovers to other industries.

Collapse of the housing bubble

An oversupply of apartments will lead to falling prices, with heavy discounting already evident in Melbourne as developers attempt to clear units. Bank lending will slow as prices fall and spillover into the broader housing market seems inevitable. Especially when:

  • Current prices are supported by strong immigration flows which are bound to lead to a political backlash if not curtailed;
  • The RBA is low on ammunition; and
  • Australian households are leveraged to the eyeballs — the highest level of Debt to Disposable Income of any OECD nation.

Debt to Disposable Income

Falling demand for iron ore & coal

China is headed for a contraction, with a sharp down-turn in growth of M1 money supply warning of tighter liquidity. Falling housing prices and record iron ore inventory levels are both likely to drive iron ore and coal prices lower.

China M1 Money Supply Growth

Australia has survived the last decade on Mr Micawber style economic management, with something always turning up at just the right moment — like the massive 2009-2010 stimulus on the chart above — to rescue the economy from disaster. But sooner or later our luck will run out. As any trader will tell you: Hope isn’t a strategy.

“I have no doubt I shall, please Heaven, begin to be more beforehand with the world, and to live in a perfectly new manner, if — if, in short, anything turns up.”

~ Wilkins Micawber from David Copperfield by Charles Dickens

Australia: Housing slowdown

From Westpac’s Red Book:

….the situation around housing does appear to be shifting. We highlighted a sharp fall in the ‘time to buy a dwelling’ index as last month’s most significant development, warning that unless there was an equally sharp reversal in Aug it would likely mark the beginning of a further leg to the housing slowdown. The Aug update posted a solid but insufficient reversal. Home buyer sentiment does appear to be breaking lower and a further weakening in activity is now likely towards year end…..

Irrational Exuberance Down Under | Bloomberg View

From William Pesek:

Lindsay David’s new book on Australia deserves a medical disclaimer: Reading this will greatly raise your blood pressure.

In “Australia: Boom to Bust” David sounds the alarm about an Australian housing bubble he argues makes the 12th-biggest economy a giant Lehman Brothers. His thesis can be boiled down to the number 9 — the ratio of home prices to income in Sydney. The multiple compares unfavorably to 7.3 in London, 6.2 in New York and 4.4 in Tokyo. Melbourne is 8.4.

Read more at Irrational Exuberance Down Under – Bloomberg View.

Amir Sufi: Who is the Economy Working For? The Impact of Rising Inequality on the American Economy

Amir Sufi, professor of Finance at the University of Chicago, testified before the U.S. Senate Committee on Banking, Housing and Urban Affairs Subcommittee on Economic Policy. His statement titled “Who is the Economy Working For? The Impact of Rising Inequality on the American Economy” makes interesting reading.

“Only 76% of Americans aged 25 to 54 currently have jobs, compared to 80% in 2006 and 82% in 1999…..How did we get into this mess?”

The gist of his argument is:

“Richer Americans save a much higher fraction of their income, ultimately holding most of the financial assets in the economy: stocks, bonds, money-market funds, and deposits. These savings are lent by banks to middle and lower income Americans, primarily through mortgages.”

…And collapse of the housing market caused disproportionate harm to the middle and lower-income groups.

It is true is that middle and lower-income groups have a higher percentage of their wealth invested in their homes and are also far more exposed to mortgages than richer Americans. The source of funding for these mortgages, however, is not the wealthy — who are primarily invested in growth assets such as stocks — but the banks who create new credit out of thin air. The collapse of the housing market caused disproportionate hardship to middle and lower-income Americans because their wealth is concentrated in this area. The rich suffered from a collapse in stock prices, but the market has recovered to new highs while housing remains in the doldrums. That is one of the causes of rising wealth inequality.

Where I do agree with Amir is that credit growth without income growth is a recipe for disaster.

“A tempting solution to our current troubles is to encourage even more borrowing by lower and middle-income Americans. This group of Americans is likely to spend out of additional credit, which would provide a temporary boost to consumption. But unless borrowing is predicated on higher income growth, we risk falling into the same trap that led to economic catastrophe.”

The graph below compares credit growth to growth in (nominal) disposable income:

Credit and Disposable Income

The ratio of credit to disposable income rose from 2:1 during the 1960s to almost 5:1 in 2009.

Credit to Disposable Income

There is no easy path back to the stability of the 1960s. A credit contraction of that magnitude would destroy the economy. But regulators should aim to keep credit growth below the rate of income growth over the next few decades, gradually restoring the economy to a more sustainable level.

The worst possible policy would be to encourage another credit boom!

GOLDMAN: Here’s The Simple Reason We’re Probably Not About To Have Another Huge Crash | Business Insider

From Joe Weisenthal:

Historical analysis of past big busts done by top economist Jan Hatzius and Sven Jari Stehn shows that while there is growing risk of a stock market drop because of the big rally we’re missing one of the key preconditions needed for a true bust: high credit growth.

They write: “[C]redit growth is the most important predictor of house price busts, especially when we focus on busts that involve a recession. House price busts have also tended to follow periods of high inflation, high equity volatility and large current account deficits, although all of these effects become less pronounced when we focus on recessionary busts….”

via GOLDMAN: Here's The Simple Reason We're Probably Not About To Have Another Huge Crash | Business Insider.

Deflating Australia’s land bubble

ScreenHunter_18 Jul. 05 10.22

Great post by Leith van Onselen
Reproduced with kind permission from

Prosper Australia has provided a submission to the Senate Inquiry into Housing Affordability, which is well worth a look. The submission first provides nine metrics illustrating Australia’s residential property bubble, which include the following:

ScreenHunter_1461 Mar. 03 14.43

It took forty years from 1950 to 1990 for housing prices to double, but only fifteen years between 1996 and 2010 to double again. The surge in housing prices is driven by the tremendous growth in household debt, as owner-occupiers and investors take out ever larger mortgages to speculate on housing. The household debt to GDP ratio reached a record high of 98 per cent in 2010, the same year real housing prices peaked. In 2013, the mortgage and personal debt ratios were 86 and 9 per cent, respectively, for a combined household debt ratio of 95 per cent.

ScreenHunter_1462 Mar. 03 14.45

As mortgage debt escalated, investors’ net rental losses increased rapidly from 2001 onwards. In that year, net rental income losses were just over $1 billion, rising to $9.7 billion in 2008 as the cash rate peaked at 7.2 per cent. By 2010, when mortgage debt reached its historical peak relative to GDP, investor losses eased to $5.1 billion as the cash rate fell to a then historic low of 3 per cent in 2009 following the global financial crisis (GFC). The latest data shows income losses rose to $8.2 billion in 2011, the second largest absolute loss on record…

The housing market meets economist Hyman Minsky’s definition of a Ponzi scheme, as gross rental incomes minus expenses are clearly insufficient to meet principal and interest repayments. As 67 per cent of property investors are negatively-geared as of 2011, investment decisions are predicated upon expected rises in land values, not rents. This strategy will inevitably fail, as the escalation in real housing prices can only be sustained by a continual acceleration or exponential rise in mortgage debt.

The price to income (P/I) ratio, otherwise known as the median multiple, is another measure of residential property valuation…

ScreenHunter_1463 Mar. 03 14.49

From the mid-1990s onwards, housing prices outpaced household incomes, and the P/I ratio increased from 4 to 7 nationwide. It is impossible for household incomes to match the rise in housing prices during the boom phase of a property bubble, as wages grow more slowly, usually just above the rate of inflation…

Land is the largest tangible market in Australia… Our housing bubble is actually a residential land bubble, as the total land values to GDP ratio doubled between 1996 and 2010, when it reached a record high of 298 per cent ($4.1 trillion). In real terms, residential land values rose from $895 billion in 1996 to a peak of $3.2 trillion in 2010, a relative increase of 262 per cent. This ratio is closely matched by a similar rise in the value of the residential housing stock. The rise in residential land values, rather than structures, is responsible for almost all of the increase in the value of the housing stock…

ScreenHunter_1464 Mar. 03 14.51

Prosper then places the blame for Australia’s expensive housing on convergence of factors, with Australia’s inefficient tax system front-and-centre:

A convergence of factors are responsible: a large cohort of irrational investors gambling on housing prices, a FIRE sector willing and able to facilitate a credit boom, and low property and land taxes attracting speculators to this asset class…

A positive feedback loop has emerged between housing prices and mortgage debt, with rising prices prompting the take-up of more debt in an upwards spiral…

An inefficient taxation system, comprised of low property and land taxes, allows landowners to expropriate ‘geo-rent’ (economic rent derived from land) by capturing the uplift in land values generated by taxpayer-funded infrastructure and rising economic productivity… Government willingness to tax wages and business ahead of land has elevated its privileged status, resulting in larger capital sums being paid by owner-occupiers and investors.

It also advocates land tax reform, which it claims would significantly improve incomes, affordability, and productivity:

Counter-intuitively, reducing wage and business taxation and increasing land tax would not necessarily lower fundamental land prices, given the offsetting boost to disposable wages, profits and hence rents, but it would certainly lower bubble-inflated land prices. Land tax reform – urged on government by every independent tax review in living memory – would firmly correct the price to rent and income ratios. If Australia wishes to escape or ameliorate the profound financial destruction of a bursting land bubble, the solution lies in this equation…

Prosper also slams housing-related tax expenditures, which undermine the integrity of the tax system:

The generous scope of tax expenditures relating to the housing market has served to further increase prices. Tax expenditures are defined as a deviation from the commonly accepted tax structure, whether it is a tax exemption, concession, deduction, preferential rate, allowance, rebate, offset, credit or deferral. Australia has the highest rate of tax expenditures among our OECD peers, at more than 8 per cent of GDP. Tax expenditures are vulnerable to lobbying, and often compromise the fairness and efficiency of the tax system. Lavish tax expenditures for both owner-occupied and investment property has significantly worsened housing affordability because they allow landowners to capture greater amounts of geo-rent and prioritise unearned wealth and income over what is earned. Existing home owners capture the most benefit, ahead of first home buyers, investors and tenants.

ScreenHunter_1465 Mar. 03 15.09

These tax expenditures provide a strong incentive to speculate on housing prices, and are reinforced by already low property taxes. Investors perceive rental income as secondary to expected rises in capital prices, while first home buyers over-leverage themselves to enter a bubble-inflated market…

Tax expenditures, combined with the ongoing deregulation of the banking and financial system, has transformed the housing market into a casino. Residential property is commonly viewed as a speculative asset to flip, rather than shelter to raise a family in…

Finally, Prosper provides two recommendations to the Senate Inquiry:

Recommendation 1: Reform Land Value Tax. The ideal tool to moderate land bubbles and properly fund infrastructure already exists in the hands of state and territory governments: state land tax (SLT). Unfortunately, this tax has been so riddled with exemptions and concessional treatments it must be considered dormant…

We suggest the current government introduce a nationwide one per cent federal land tax (FLT) – fully rebatable on SLT paid – to oblige the states and territories to use their taxing powers properly. State governments could adjust their tax rules and keep every dollar the FLT raises, to the benefit of all Australians. The Commonwealth Parliament would be entitled to argue this intervention is for sound economic reasons and dissipate the political fallout. Placing state and territory finances on sound bases would vastly improve the federal system mandated by Australia’s Constitution. Transitional arrangements would need to be considered. Rebating all stamp duty paid against a hypothetical past SLT obligation would address concerns of fairness and equity…

Recommendation 2: Macroprudential Regulation. A range of macro-prudential tools are needed to moderate housing price inflation and subdue credit growth in a pro-cyclical financial system, such as those affecting the loan to value, (LVR), debt servicing (DSR) and debt servicing to income (DSTI) ratios.26 Quantitative restrictions should be placed on the share of new mortgages with moderately high LVRs…

To reduce systemic risk, a large rise in capital and liquidity ratios (buffers) is required to ensure banks can withstand a future economic downturn, bank run or large fall in the value of collateral. Research suggests the probability of a banking crisis can be reduced to a 1 in 100 year event by raising core equity (Tier 1) capital ratios to 11 per cent in isolation or raising core equity to 10 per cent with an addition rise in liquid assets of 12.5 per cent (the rise in liquid assets over total assets). For the Big Four banks, this would represent a rise of around 3 per cent in core equity…

The full submission is available here.

Household Debt to Income ratio

Barry Ritholz highlights the alarming debt to income ratio for Canada compared to the USA:
Household Debt to Income ratio

How does Australia compare?
Australian Household Debt to Income ratio
Australian household debt to income is similar to Canada’s. There has been discussion recently about whether Australia is in a housing bubble. As Anna Schwartz (joint author of A Monetary History of the United States, 1867-1960 with Milton Friedman) pointed out: there is only one kind of bubble and that is a debt bubble. It may manifest through rising real estate, stock or other asset prices, but the underlying driver is the same: a rapid expansion of the money supply through easy credit.

Crawling, not walking, to non-mining led growth | MacroBusiness

Leith van Onselen quotes the latest JP Morgan report on the Australian economy:

…risk of a recession is “inevitably higher now than usual; the economy has built up vulnerabilities over time that have been masked by the continued growth in output and national income… the downside of avoiding recession is that Australia has carried these excesses through a succession of growth cycles”.

Households are particularly at risk from expensive house prices and high levels of household debt. Which brings me back to the unnecessary risks bank regulators are taking by condoning low bank capital ratios of between 4.0% and 4.5% of total credit exposure. Risk-weighting of bank assets provided a smokescreen, inflating perceived ratios to around 10%, while encouraging over-exposure to (low risk-weighted) residential mortgages.

Read more at Crawling, not walking, to non-mining led growth | | MacroBusiness.

Imbalances in the Australian housing market | Chris Joye

Chris Joye from the Financial Review warns on Radio National that imbalances that may be developing in the Australian housing market:

Hat tip to Leith van Onselen at who comments:

“My only observation is that governments of all persuasions have for too long abrogated their responsibilities for housing policy to the RBA – allowing affordability concerns to be addressed via continuous lowering of interest rates, rather than addressing the underlying causes of poor affordability through supply-side and taxation reform.”

Canadian housing bubble looks ripe for popping | Toronto Star

Adam Peterson writes the Canadian housing bubble is headed for a “slow-motion” crash:

My gravest concern is that Canada is fast approaching a 5:1 home-price-to-income ratio, a benchmark achieved by the U.S. at the peak in 2006. Since the correction, the U.S. ratio now hovers at approximately 3:1.

To compound the problem, household debt in Canada has breached 150 per cent of income and continues in the wrong direction; households are not cushioned against a blow.

Australian household debt is also hovering around 150% of disposable income.

Australian household debt to disposable income

While the price-to-income ratio varies between 4 and more than 6 depending on whether you use national averages or median data.
Australian house price-to-income ratio

Read more at Canadian housing bubble looks ripe for popping | Toronto Star.

Rudd? Gillard? Australians have bigger problems | IOL Business

“Australia is a leveraged time bomb waiting to blow,” Albert Edwards, Société Générale’s London-based global strategist, said. “It is not just a CDO, but a CDO squared. All we have in Australia is, at its simplest, a credit bubble built upon a commodity boom dependent for its sustenance on an even greater credit bubble in China.”

From William Pesek at Rudd? Gillard? Australians have bigger problems – Columnists | IOL Business |

Has Australia hit the floor with interest rates?

Izabella Kaminska made a strong argument on FT Alphaville last year for the RBA to lower interest rates and weaken the Australian Dollar to protect manufacturing and export industries:

Australia’s current account deficit coupled with a deeply negative net external debt position both provide strong fundamental impetus for currency weakening. Should the RBA want to engineer currency depreciation, lower interest rates are likely to be more than enough. Indeed, even if interest rates decline only gradually to reflect a structurally slowing economy there are plenty of fundamental reasons for the Australian dollar to weaken.

The case for lower interest rates still holds true but the RBA is obviously concerned by signs of recovery in housing prices that could exacerbate the existing property bubble. Robert Gottliebsen at Business Spectator reports:

In less than three months the market price of a bottom of the range Meriton inner-Sydney apartment has risen 6 per cent from about $500,000 to around $530,000……According to Meriton’s Harry Triguboff, local buyers have jumped from 15 to 40 per cent of the market.

There is a solution. The RBA can lower interest rates provided it simultaneously introduces macroprudential steps similar to those being considered by the RBNZ: increase the amount of capital banks must set aside to cover potential losses from high loan to valuation ratio (LVR) home loans. That would make high LVR loans more expensive and discourage property speculation, taking some of the heat out of the housing market.

Clinton’s Spending Cuts—Not His Tax Hikes—Worked

EDWARD MORRISSEY writes about Clinton-era nostalgia:

In his eight years as President, Clinton reduced federal spending to 18.2 percent of GDP from 22.1 percent, thanks in large part to a Republican-controlled Congress that forced the issue……. Barack Obama managed to hike it 3.5 points in just one term, with 3.2 points going to non-defense spending. Under Obama, federal spending now exceeds 25 percent of GDP, and his has been the biggest increase of any of his predecessors over the last 60 years – even for two-term Presidents.The real debate over deficits isn’t over whether to go back to Clinton-era tax rates. It’s how to get back to Clinton-era spending levels, and then create a tax system that will adequately fund it. The 18.2 percent level of federal spending is one piece of Clinton-era nostalgia worth recalling – as well as the bipartisanship that eventually produced it.

Nostalgists should also remember that the housing bubble started in this era — as did the internet boom — followed by the dot-com bust just as Clinton left office. This article is definitely worth reading.

via Clinton’s Spending Cuts—Not His Tax Hikes—Worked.

Australia: Hard or soft landing?

Browsing the latest charts from the RBA.

Despite record low 10-year bond yields…..

Housing Finances

Credit growth is subdued and likely to remain so for some time.

Credit Growth by Sector

After a massive credit bubble lasting more than a decade.

Housing Finances

Households are saving close to 10 percent of Disposable Income in anticipation of a contraction.

Housing Finances

While banks are reluctant to lend when their margins are being squeezed.

Housing Finances

Borrowing offshore is not an option. That is how we got into such a fix in the first place.

Housing Finances

Makes me believe we are unlikely to see another housing boom for some time.

There are two possible outcomes: a soft landing and a hard landing.

It all depends on whether Wayne Swan and the RBA know their jobs.