The search for yield and risky lending may be a natural consequence of persistently low interest rates, but that environment “can lead to the development of new financial vulnerabilities” if left unchecked, according to Reserve Bank of Australia (RBA) deputy governor Philip Lowe.
The combination of low volatility -- at least until recently -- high asset prices, compressed credit spreads and rising leverage leaves the financial system more vulnerable to surprises.
In Sydney yesterday, Lowe spoke at length regarding the financial system and investing in a low interest rate world. This follows RBA assistant governor Guy Debelle’s excellent speech on financial market vulnerabilities last week (The market stillness before the storm; October 14).
Lowe notes that investors and savers have three basis choices. They can leave their savings in the bank; they can purchase existing assets; and they can invest in new capital -- whether that be equipment, buildings or even intellectual property.
The low interest rate environment has rendered the first method of investment rather unsatisfying. Deposits in many developed countries remain at around zero per cent and even in Australia where rates are higher the returns are hardly appetising.
Investment strategy post-crisis has instead been dominated by the purchase of existing assets – property prices and shares have boomed. However, despite central banks injecting trillions into the global financial system very little of it has made it to the real economy. The post-crisis recovery remains slow in the likes of the United States and United Kingdom, and in Europe it hasn’t even begun.
The G20 this year has produced an agenda that attempts to address this issue and seeks to usher in a range of structural policies to boost trade and productivity and enhance competition. Promoting infrastructure investment is another method. Growth and productivity has been a key tenant of Australia’s G20 presidency.
Lowe notes that “now is a favourable time to undertake such investment”. Not only are interest rates at a low level -- and expected to remain that way -- but many developed countries are suffering an infrastructure deficit. Existing infrastructure is ageing or underdeveloped and may in some cases impede future growth.
A key stumbling block remains financing. Many infrastructure projects are huge and when pursued privately almost always require businesses to take on additional debt. Despite low interest rates, many businesses are understandably reluctant to take on such risk after the past six years.
Governments find themselves in the same boat, though their failure is more of their own choosing. Many states borrowed heavily in the aftermath of the global financial crisis, putting pressure on bond yields and threatening in some cases to default on their debt.
But as I noted last Friday, the public sector had one remaining option available that was largely costless. In the presence of a liquidity trap, governments can simply print more money to finance fiscal policy without running the risk of higher inflation (Fund fiscal policy, not greedy banks; October 17). Had that approach been taken the post-crisis recovery may have been far swifter.
In Australia the search for yield has played out in a similar fashion, albeit to a lesser extent. Low interest rates exist, but safe haven assets such as term deposits still have some modest appeal. Property prices have boomed but the share market has not increased to the same extent as the Dow Jones or S&P 500.
Productive investment -- outside the mining sector -- has been subdued for a number of years. Speculation in existing property has been rampant but new residential investment has only recently begun to improve. Foreign investment flows have arguably left our housing market more susceptible to foreign shocks than ever before.
An issue of increasing importance in Australia – and echoed internationally -- “is whether the recent increases in prices of the existing housing stock, together with pockets of higher borrowing, is generating increased financial and macroeconomic risk?”
Lowe alludes to investor activity in the property market, which is currently at its highest level in history. As a result, there has been “some increase in overall risk”. Lowe is quick to add that he is “not saying that this will end badly, or even that it is likely to end badly -- just that, on average, recent loans are probably a bit more risky than those made earlier”.
In addressing these issues, the Council of Financial Regulators, including the RBA and the Australian Prudential Regulation Authority (APRA), have held meetings regarding the merits of introducing macroprudential policies to curtail the recent rise in financial risk.
Lowe maintains that APRA is working with the banks to ensure that they maintain “appropriate lending and risk-management standards”.
My fear is that on this issue the horse has already bolted, with Australian banks far more leveraged than their international counterparts and the average mortgage size far above those of other developed countries.
The alternative to macroprudential policies is simply to raise rates. Lowe says that in Australia “low rates are entirely appropriate”. He is completely right, although I’d go further and say that lower rates are entirely appropriate. Faced with a range of economic headwinds -- including a federal government more interested in austerity than stimulus -- low interest rates are the only way for the RBA to pursue its dual mandate of moderate inflation and full-employment.
Low interest rates are having some desirable effects on the domestic and international economy. But the longer they persist -- and we’re at six years and counting -- the greater the risk of financial imbalances, systemic risk and toxic lending.
The RBA has been slow to act on the systemic risk posed by Australia’s property market but Lowe’s speech -- combined with speeches by Luci Ellis and the RBA’s Financial Stability Review -- indicate that they finally accept the reality of Australia’s $5 trillion property market. The RBA and APRA are all but certain to intervene in lending markets before they year is out and not a moment too soon.