The minutes of the Reserve Bank board’s monetary policy meeting of September 2 have raised the level of concern that the bank is now signalling around Australia’s residential property boom. Specifically the board notes: “policy also needed to be cognisant of the risks to future growth that could accompany a large further build up in asset prices, particularly if that was associated with an increase in leverage;” and: “Credit growth for investor housing was running at around 10 per cent per annum. Housing prices were continuing to increase in the larger cities and members considered that the risks associated with this trend warranted ongoing close observation.”
With the bank forecasting growth momentum in the economy at a woeful 2 per cent (annualised pace) in the second half of 2014 and a below trend 3 per cent in 2015, raising interest rates in the near term hardly looks like a viable policy option. Furthermore, the exchange rate complicates the decision-making with the carry trade support to the Australian dollar stifling the ‘rebalancing’ effect that the RBA is looking for from that quarter.
This is a not a new problem for commodity bloc countries, who have struggled to achieve the appropriate financial conditions mix. Low interest rates boost asset prices but are still attractive to global investors when compared to those in the core G-3 economies, where interest rates have been reduced and maintained at effectively zero.
Does this mean that we should be considering the possibility of the authorities introducing some form of macro-prudential policies? The fact that macro-prudential policies were recently adopted in New Zealand adds to the possible case.
Here we review the arguments in this sphere and conclude that, given our outlook for credit growth and leverage, and our assessment of the preferences of the policy makers, there is no imminent prospect of macro-prudential policies being introduced in Australia.
It must also be stressed that this note is not referring to recent initiatives being considered by the Financial Stability Board and the Basel Committee on proposals for global systematically important banks to have an additional layer of “loss absorbing capacity” in addition to their higher regulatory capital. Further, it is not proposed to comment on the recent interim report of the financial system inquiry.
First a little bit of background. What are ‘macro-prudential’ policies? One way of clarifying the term is to define it with reference to its antonym, ‘micro-prudential’, as the BIS does. In this sense, “the term refers to the use of prudential tools with the explicit objective of promoting the stability of the financial system as a whole, not necessarily of the individual institutions within it.” (Clement, BIS, 2010).
The term became fashionable in the wake of the global financial crisis, as it became clear that systemic risks that had built up unchecked in the global financial system added greatly to the severity of the crisis. The initial focus in the wake of the GFC was on the ‘pro-cyclicality’ of credit fuelled risk taking through the shadow banking system. The response to this has in some ways been incorporated into the design of the Basel III capital framework. This style of policy attempted to constrain the activities of lenders, with the ‘counter- cyclical capital buffer’ one of the most discussed tools in this group.
A different family of ‘macro-prudential’ controls is regularly practised in emerging markets but disdained until very recently by inflation targeting central banks in the advanced world. These impose variable constraints on borrowing and lending activities in specific sectors, notably housing. Here the major tools have been loan-to-value ratio and debt-to-income ceilings on loans, quantitative limitations on investor purchases, and fiscal measures such as tax (dis)incentives related to property holding periods. This group of measures can be viewed as a complement to conventional counter- cyclical monetary policy.
Back to the current situation in Australia. The September board meeting minutes note, in the section covering financial stability, that “additional speculative demand could amplify the property price cycle and increase the potential for property prices to fall later”. Risks were seen to be focussed on the real economy, rather than on the financial system itself, as fluctuations in house prices would be expected to impact upon wealth and thus spending. The minutes also noted that: “Members were also updated on some of the recent actions by the Australian Prudential Regulation Authority (APRA)”.
Whereas the macro-prudential policies which were adopted in New Zealand were implemented by the Reserve Bank of New Zealand, the responsibility for such policies in Australia falls to APRA as the supervisor of financial institutions in Australia. In a joint paper issued in September 20121 the RBA and APRA state that: “The main tools for macro prudential supervision in Australia are only exercisable by APRA”. To date, the main tool APRA exercises is to vary through the cycle the intensity of supervision backed up by prudential tools (particularly capital) and in extreme cases its direction powers which are applied to individual entities.
There is a precedent for this current official concern around the build up in investor housing. It is instructive to revisit APRA’s actions during the investment property boom of 2000-2003. In the same joint paper it was noted that: “in response to stress testing of housing loan portfolios of authorised deposit taking institutions (ADIs) in 2003, APRA made some significant adjustments to risk weighting of housing loans as well as the capital regime for lenders’ mortgage insurers.”
The 2000-03 period bears some comparison with the current situation. In that earlier period annual growth in credit to investors peaked at 30 per cent and overall housing credit growth peaked at 22 per cent. The household debt to income ratio – a standard measure of aggregate leverage across the household sector – had risen over 26 percentage points in just two years and there were signs that lending standards had been eased.
Contrast that with today. Currently annual credit growth for investors is running at 8.9 per cent with the six month annualised pace at 9.5 per cent. Overall housing credit is running at a steady 6.7 per cent annual pace. The household debt to income ratio has risen 4 percentage points over the last year and remains below its peaks in 2010 and 2007. Moreover, while the level of the debt to income ratio is considerably higher than it was
in 2003 we believe this understates the degree to which Australian households have deleveraged since 2007 as it excludes the substantial accumulation of funds in mortgage offset accounts (these funds are considered deposits rather than a reduction in principal).
In considering possible non-standard policy responses to the current situation, both the RBA and APRA have a clear preference for the tools deployed in 2003. The aforementioned joint paper also notes that APRA believes that the type of response to systemic or industry wide concerns, which was used in 2003, “is more likely to be effective than a narrow focus on a particular aspect of lending standards such as the loan to valuation ratio” (i.e. the RBNZ model).
While the paper seems to cede specific responsibility to APRA for the implementation of any macro prudential policies, the Reserve Bank is likely to have considerable influence. The RBA governor is the chair of the Council of Financial Regulators and the bank has a longstanding responsibility for financial stability as confirmed in its common understanding with the government in its statement of the conduct of monetary policy (2010).
The minutes emphasised the economic rather than financial stability risks: “Members further observed that additional speculative demand could amplify the property price cycle and increase the potential for property prices to fall later. The main risks in such a scenario would likely be to the stability of the macroeconomy rather than the financial system, particularly if households were to react to declines in their wealth by cutting back on their spending.” The implication is that the bank is less concerned about borrowing and lending decisions than the potential for rising prices and associated changes in price expectations to influence the broader economy.
The concentration of strength in investor activity poses additional challenges for a targeted policy response. In a July 2013 report to the Reserve Bank, Luci Ellis, head of financial stability department, discusses the effectiveness of various types of macro prudential policies that have been adopted in other countries2. The LVR model is generally assessed as being ineffective in an investor driven boom partly because investors generally have lower LVRs than owner occupiers – especially first home buyers. However, we note that in emerging markets, where LVRs tend to be much lower than in the advanced world, very onerous restrictions have been put in place at times – it is not the tool, but the degree to which it is willing to be applied that often determines its effectiveness. There is no precedent for such onerous policies being used in advanced economies.
The other issue around the effectiveness of such policies is around the risk of leakages to the unregulated sector. There is anecdotal evidence of such leakages in the New Zealand episode. Whereas NZ has a very limited non-bank sector, Australia has a much larger unregulated sector. For Australia the unregulated housing sector currently represents around 5 per cent of new loans, having peaked at 20 per cent of total loans in 2007.
A second form of regulation considered in this report was limits on debt servicing ratios although “recent research shows that higher income households can manage much higher ratios without falling into stress”.
Of most promise from the perspective of this study were changing “interest rate buffer guidelines”. In this policy, lenders are required to calculate allowable loan amounts using higher interest rates than those currently prevailing. The interest buffer could be counter- cyclical, increasing when rates fall, and could become an automatic stabiliser for the financial system. Of course such a policy would reduce the impact of monetary policy in one of its most important channels. Such a policy change would be subject to considerable implementation and regulatory lags particularly if, as appears the case, it is not necessarily favoured by APRA.
APRA has embraced the counter-cyclical capital buffer which has been built into the Basel III framework. However the Basel authorities do note that the capital buffer might not be effective in dampening booms mainly because the amounts of capital involved are unlikely to sufficiently raise borrowing costs in a speculative boom, where shadow banking is also likely to be a major part of the flow of new credit, and the implementation lags are too long.
Finally, some countries have introduced dynamic provisioning where higher provisions are required against over exuberant lending – such a policy reduces profits directly during the upswing. Banks may dispute a regulator’s assessment of the appropriate provision without clear evidence of the loss information in a comparable downswing. It is unlikely that such a policy would be imposed in Australia.
In conclusion the report finds: “The discussion above suggests that many of the suggested policy tools for dealing with property booms carry problems of their own.... Within the dimensions of lending standards, more focus should probably be given to serviceability and amortisation than LVR or low doc lending”.
A reasonable conclusion is that Australia is unlikely to introduce the New Zealand style of direct macro prudential controls. APRA may lift its intensity of communication to ADI boards and, possibly, even impose a further round of stress testing, although banks now regularly conduct stress testing. It seems unlikely that, at this stage, it would adopt the policies of 2003 where it raised the risk weighting on home loans and increased the capital requirements of mortgage insurers.
The Reserve Bank is likely to maintain or step up its public warning around house prices and investor activity.
Recall that even in the frenzy of the official concerns around the investment boom in the early 2000s, the increased capital charges on home loans were not introduced until 2003 – a year after the first two rate hikes in May and June 2002.
In taking the 2003 precedent further it is relevant to compare the current pace of growth of new lending to the peak in that earlier period. With current annual investor credit growth running at 10 per cent compared to the peak in that earlier period of 30 per cent it seems that we are probably some way away from any policy action be that either direct or through increased rates.
Westpac does not expect anything like that pace of build-up in investor credit in 2014 and 2015.
Our forecast for the RBA cash rate is that the next move is likely to be an increase in the September quarter 2015. That will be driven by an improving global outlook; a modest lift in the momentum of consumer spending and non-mining investment and a falling unemployment rate. House prices and credit growth are also likely to be rising but not of themselves at a sufficiently rapid pace to trigger a rate hike.
Consequently we see no reason to change our forecast for the first RBA rate hike next year.
Bill Evans is chief economist with Westpac.
1) ‘Macro prudential Analysis and Policy in the Australian Financial Stability Framework’, September,2012 (joint paper by RBA and APRA), http://www. rba.gov.au/fin-stability/resources/2012-09-map-aus-fsf/pdf/2012-09-map- aus-fsf.pdf.
2) ‘Macro prudential policy: what have we learned?’, Luci Ellis, Head of Financial Stability Department ,Reserve Bank of Australia, http://www.rba. gov.au/foi/disclosure-log/pdf/131413.pdf.
3) ‘The term “macroprudential”: origins and evolution’, Clement, BIS, 2010, http://www.bis.org/publ/qtrpdf/r_qt1003h.pdf.
4) ‘Statement on the Conduct of Monetary Policy’, October 2013, http://www.rba.gov.au/monetary-policy/framework/stmt-conduct- mp-6-24102013.html.