A lucky country rich with pessimists
Australia has a tendency towards a glass half empty view, but the Chinese economy, house prices and bank funding suggest our economy will weather the global storm, and the challenges that lie beyond the current crisis.
It is slowly becoming better recognised that the Australian economy's relative performance, against a very turbulent international background, has been remarkably good. Many foreign visitors to Australia comment on this relative success and I have noticed an increase in the number of foreign companies interested in investing in Australia as a result, notwithstanding our domestic tendency towards the ‘glass half empty’ view.
But some observers – admittedly not the majority – still harbour concerns about the foundations of recent economic performance and question the basis for confidence about the future. There are several themes to these doubts, but the common element is that recent relative success owes a certain amount to things that will not continue – to luck – and that our luck may be about to turn.
Rapid growth in Chinese demand for resources, for example, has been of great benefit to date, but what if the Chinese economy suffers a serious downturn? Another potential concern is dwelling prices. Australia saw a large run up in dwelling prices and household borrowing until a few years ago. Some other countries that saw this subsequently suffered painful corrections and deep recessions, associated with very stressed banking systems. Can Australia escape the same outcome?
A further theme is the focus on the funding position of Australian financial institutions, insofar as they raise significant amounts of money offshore. Could this be a weakness, in the event that market sentiment turns?
The Reserve Bank gives a lot of thought to these issues.
To begin, I shall re-state some key metrics.
These charts really require no exposition (Graph 1, 2 and 3). The message is clear. It is fair to conclude that, given the circumstances internationally, the Australian economy has exhibited more than acceptable performance over recent years.
Let us then take a look at some of the potential pressure points that people sometimes worry about. The first is the Chinese economy.
One of the data series people pay a lot of attention to is the Chinese version of the so-called ‘Purchasing Managers' Index’. The usual commentary surrounding such indexes invariably refers to the ‘50’ level as the threshold between growth and contraction in the sector of the economy being examined.
But what have these PMIs actually been saying about the Chinese economy? Properly calibrated, as in this chart, they suggest that growth in China's industrial production has been running at about 5 percentage points below average, which means it is just under 10 per cent (Graph 4). But it is a long way from a contraction. We did actually see Chinese IP contract for several months in 2008; we are not seeing that at present.
The conclusion I draw is that the Chinese economy has indeed slowed over the past year or so. It was intended that a slowing occur. But the recent data suggest that, so far, this is a normal cyclical slowing, not a sudden slump of the kind that occurred in late 2008. The data are quite consistent with Chinese growth in industrial output of something like 10 per cent, and GDP growth in the 7 to 8 per cent range.
To be sure, that is a significant moderation from the growth in GDP of 10 per cent or more that we have often seen in China in the past five to seven years. But not even China can grow that fast indefinitely and there were clearly problems building from that earlier breakneck pace of growth. Inflation rose, there was overheating in property markets and no doubt a good deal of poor lending. It is far better, in fact, that the moderation occur, if that increases the sustainability of future expansion.
Moreover, the Chinese authorities have been taking well-calibrated steps in the direction of easing macroeconomic policies, as their objectives for inflation look like being achieved and as the likelihood of slower global growth affecting China has increased. Prices for key commodities are lower than their peaks, but are actually still high.
So far, then, the ‘China story’ seems to be roughly on course.
Next I turn to dwelling prices.
Scaled to measures of income, Australian dwelling prices on a national basis have in fact declined and are now about where they were in 2002 (Graph 5). That is, housing has become more ‘affordable’. Four or five years ago we supposedly had a housing affordability ‘crisis’. Now it seems that the problem some people fear is that of housing becoming even more affordable.
Are dwelling prices overvalued? It's very hard to be definitive on that question. There are two aspects to the claim that they might be. The first is that prices relative to income are higher than they were 15 or 20 years ago. If this ratio is somehow mean-reverting, then either incomes must rise a lot or prices must fall. It could be that this analysis is correct, but the problem is that there is no particular basis to think that the price to income ratio 20 years ago was ‘correct’. There are reasons that might be advanced for why the ratio might be expected to be higher now than then – that the mean has shifted – though again there is little science to any quantification for such a shift. In any event, arguments that appeal to historical averages for such ratios lose potency the longer the ratio stays high. In Australia's case the ratio of prices to income on a national basis has been apparently at a higher mean level – about 4 to 4½ – for about a decade now.
The second support for the claim that dwelling prices are overvalued is the observation that they seem high in comparison with other countries. In seeking to make such comparisons, though, there are serious methodological challenges. The key difficulty is in sourcing comparable data on the level of prices across countries. Such data are, at best, pretty sketchy. With that caveat very clearly in mind, consider the following two charts.
Simply comparing Australia and the United States, it is hard to avoid the impression that gravity will inevitably exert its influence on Australian dwelling prices. But if we put these two lines on a chart with a number of other countries with which we might want to make comparisons, the picture is much less clear (Graph 6) To the extent that we can make any meaningful statements about international relativities, the main conclusion would be that Australian dwelling prices, relative to income, are in the pack of comparable countries. In this comparison, the United States seems the outlier.
None of this can be taken to say definitively that Australian dwelling prices are ‘appropriate’, or that there is no possibility they will fall. It is a very dangerous idea to think that dwelling prices cannot fall. They can, and they have. The point is simply that historical or international comparisons, to the extent they can be made, do not constitute definitive evidence of an imminent slump. At the very least, the complexity of making these comparisons suggests we ought to look at some other metrics in thinking about the housing market.
One would be the performance of the associated mortgages. Here, the main story is that not much has changed. Arrears remain low and if anything have been edging down over the past year. That in turn is not altogether surprising given that debt servicing burdens have declined (Graph 7).
It has to be said that the housing market bubble, if that's what it is, seems to be taking quite a long time to pop – if that's what it is going to do. The ingredients we would look for as signalling an imminent crash seem, if anything, less in evidence now than five years ago.
What then about funding vulnerabilities?
The pre-crisis period saw too much ‘borrowing short to lend long’, and too much reliance on the assumed availability of market funding. Banks everywhere have been adjusting away from that model over recent years, Australian banks among them. The share of offshore funding has fallen, and its maturity has been lengthened (Graph 8).
The flip side of this is of course the rise in domestic deposit funding, which has occasioned such competitive behaviour in the market for deposits.
Interestingly enough, while we have been told over the years how Australian banks were doing the country a favour by arranging the funding of the current account, they have stopped doing this over the past year without, apparently, any dramatic effects. As measured in the capital account statistics, there has been a net outflow of private debt funding over the past two years, offset roughly by increased inflow of foreign capital into government obligations (Graph 9). This has occurred with a net decline in government debt yields and a net rise in the exchange rate. The current account deficit has, in other words, been easily ‘funded’ without the assistance of banks borrowing abroad – in fact, while they have been net re-payers of funds borrowed earlier.
A reasonable conclusion is that the degree of vulnerability to a global panic of any given magnitude appears to have diminished, rather than grown, over the past few years. It hasn't completely disappeared, and it would not be sensible to expect it would, unless we were pursuing a policy of financial autarky. But there is little reason to assume that Australian institutions are somehow unusually exposed to these risks compared with most of their counterparts overseas.
In the end, of course, any bank's ability to maintain the confidence of its creditors is mainly about its asset quality. That brings us back to lending standards, the macroeconomic environment, and so on. One would think that, overall, things look relatively good in Australia, compared to the world's trouble spots. Think for just a moment about the holdings of government debt on the books of banks in any number of other countries, and about the state of public finances of many of those countries.
The arguments I have presented amount to saying that some necessary adjustments have been occurring gradually and reasonably smoothly. China's growth had to moderate. It has slowed, but it hasn't collapsed. Housing values and leverage in Australia couldn't keep rising. They haven't. Dwelling prices have already declined, relative to income, and it is in fact not obvious that they are particularly high compared with most countries. Housing ‘affordability’ has improved significantly; over 99 per cent of bank-held mortgages are being serviced fully.
Banks have reduced their need for the sort of funding that might be difficult to obtain in a crisis situation. The current account deficit is being funded by a combination of direct equity investment, and flows into high-quality Australian dollar-denominated assets, the latter at costs that have been falling. In fact, the Commonwealth of Australia, and its constituent States, are at present able to borrow at about the lowest rates since Federation.
Markets do not, then, seem to be signalling serious concerns about Australia's solvency or sustainability. But markets can be wrong sometimes. They can sometimes be too optimistic (and other times too pessimistic).
So even though we don't face immediate problems, we should ask: what if something went wrong?
If the thing that goes wrong is a major financial event emanating from Europe, the most damaging potential transmission channel would be if there were a complete retreat from risk, capital market closure and funding shortfalls for financial institutions. Let me emphasise, importantly, that this is not occurring at present and if it did occur it would be a problem for a great many countries, not just Australia. But in that event, the Australian dollar might decline, perhaps significantly. We might find that, in an extreme case, the Reserve Bank – along with other central banks – would need to step in with domestic currency liquidity, in lieu of market funding. The vulnerability to this possibility is less than it was four years ago; our capacity to respond is undiminished and, if not actually unlimited, is not subject to any limit that seems likely to bind. An alternative version of this scenario, if it involved the sort of euro break-up about which some people speculate, could be a flow of funds into Australian assets. In that case our problem might be not being able to absorb that capital. But then the banks would be unlikely to have serious funding problems.
If the thing that goes wrong is a serious slump in China's economy, the Australian dollar would probably fall, which would provide expansionary impetus to the Australian economy. But more importantly, we could expect the Chinese authorities to respond with stimulatory policy measures. Even if one is concerned about the extent of problems that may lurk beneath the surface in China – say in the financial sector – it is not clear why we should assume that the capacity of the Chinese authorities to respond to them is seriously impaired. And in the final analysis, a serious deterioration in international economic conditions would still see Australia with scope to use macroeconomic policy, if needed, as long as inflation did not become a concern, which would be unlikely in the scenario in question.
If dwelling prices in Australia did slump, then there would be obvious questions about how that dynamic could play out. In such circumstances people typically worry about two consequences. The first is a long period of very weak construction activity, usually because an excess of stock resulting from previous over-construction needs to be worked off. But we have already had a fairly protracted period of weak residential construction; it's hard to believe it will get much weaker, actually, at a national level. The second potential concern is the balance sheets of lenders. This scenario is among those routinely envisaged by APRA's stress tests over recent years. The results of such exercises always show that even with substantial falls in dwelling prices, much higher unemployment and associated higher levels of defaults, key financial institutions remain well and truly solvent.
Of course, it can be argued that the full extent of real-life stresses cannot be anticipated in such exercises. That's a reasonable point. But we actually had a real life stress event in 2008 and 2009. The financial system shows a few bruises from that period, but its fundamental stability was maintained
Most Australians I encounter who return from overseas remark how good it is to be living and working here. We are indeed ‘lucky’ in so many ways, relative economic stability being only one of them.
But what matters more is what we do with what we have. Not every good aspect about recent performance is down to luck. By the same token there are things we can do to improve our prospects – or, if you will, to make a bit of our own future luck. Some of the adjustments we have been seeing, as awkward as they might seem, are actually strengthening resilience to possible future shocks. Higher – more normal – rates of household saving, a more sober attitude towards debt, a re-orientation of banks' funding, and a period of dwelling prices not moving much, come into this category.
The years ahead will no doubt challenge us in various ways, including in ways we cannot predict. But what's new about that? Even if the pessimists turn out to be right on one or more counts, it doesn't follow that we would be unable to cope. Acting sensibly, with a long-term focus, has as good a chance as ever of seeing us through whatever comes our way.
This is an edited version of a speech given by Reserve Bank Governor Glenn Stevens at the Annika Foundation Luncheon on July 24.