Opening Panel Remarks At The FX Week Australia

Opening Panel Remarks At The FX Week Australia

Assistant Governor (Financial Markets)

Remarks at the FX Week Australia
Sydney – 27 March 2019

Thanks to FX Week for the invitation to discuss the FX Global Code.

When the FX Global Code was launched in 2017, the aim was that it would promote a robust, fair, liquid and transparent wholesale market. To do that, the Code sets out principles of good practice.

As awareness of the Code builds and more market participants commit to adhering to its principles, standards will no doubt improve across the market. The Code has already gained significant traction in the marketplace.

A recent survey of market participants by the Global Foreign Exchange Committee (GFXC) confirmed that awareness of the Code within the industry was now very high. Almost all of those surveyed had read part or all of the Code. Furthermore, the vast majority of respondents indicated that they expected or required their counterparties to adhere to the Code. Globally, there are now more than 800 firms that have signed Statements of Commitment to the Code and lodged them on public registers.

So what do we need to do from here? Globally, it is clear that the sell-side have embraced the Code. What appears to be missing is comparable take-up from the buy side. This is as apparent in Australia as it is in other jurisdictions. To some extent, this could be just a lag as buy-side participants take longer to complete the process of reviewing the Code and aligning their practices to it. Encouragingly, the GFXC’s survey showed that while current take-up from the buy-side was low, many of the buy-side respondents indicated that they did intend to adhere and some of those had already begun the process.

More broadly, though, the GFXC is conscious that greater take-up from the buy-side will be needed and the GFXC is actively looking at ways to achieve that end.

For those in the audience from the buy-side the question I would put to you is: can you justify to your stakeholders — whether they are your investors (if you are a fund manager) or shareholders (if you are a business) — why you have not adopted a set of principles which represent industry best practice when you are managing their money?

The widespread adoption of the Code will benefit everyone involved in the FX industry, regardless of where you sit in the market.

It is worth noting the Code is principles-based rather than rules-based. This is to encourage market participants to think about their practices and how their activities comply with the principles, rather than working narrowly to a set of rules. The Code’s application is also designed to be proportional to the FX business that a participant is involved in. Clearly, there are some principles that aren’t directly relevant to the buy-side. Most obvious are those principles that deal with handling client orders or client mark ups.

Ultimately, the Code’s principles are there to give market participants confidence in how the market is operating. There are numerous ways the Code can promote confidence. It can help to improve price competition as liquidity providers’ pricing practices become more transparent to clients. Market participants can also be more confident that good practices around information handling will result in a more level playing field for all.

So I encourage those of you who have yet to familiarise yourselves with the Code to do so. And then consider adopting it. It is a useful tool in many ways, not just to enhance your own practices but, for those on the buy side to gauge what you should expect from your brokers in terms of their execution, the type of market colour they provide and their market practices more generally.

Finally, I should mention the work of the Australian Foreign Exchange Committee (AFXC). This committee contributes to maintaining the Code and promoting it within the local market. Our membership comprises a diverse range of market participants, including those from both the sell-side and buy-side, and also those that provide infrastructure to the market, such as the platforms. So if you are interested to know more about the Code, you could contact any one of the members and ask about their own experiences with the Code.

Disclaimer:
Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. All CFDs (stocks, indexes, futures) and Forex prices are not provided by exchanges but rather by market makers, and so prices may not be accurate and may differ from the actual market price, meaning prices are indicative and not appropriate for trading purposes. Therefore Fusion Media doesn`t bear any responsibility for any trading losses you might incur as a result of using this data.

Fusion Media or anyone involved with Fusion Media will not accept any liability for loss or damage as a result of reliance on the information including data, quotes, charts and buy/sell signals contained within this website. Please be fully informed regarding the risks and costs associated with trading the financial markets, it is one of the riskiest investment forms possible.

Official Cash Rate Unchanged At 1.75 Percent

Official Cash Rate Unchanged At 1.75 Percent

The Official Cash Rate (OCR) remains at 1.75 percent. Given the weaker global economic outlook and reduced momentum in domestic spending, the more likely direction of our next OCR move is down.

Employment is near its maximum sustainable level. However, core consumer price inflation remains below our 2 percent target mid-point, necessitating continued supportive monetary policy.

The global economic outlook has continued to weaken, in particular amongst some of our key trading partners including Australia, Europe, and China. This weaker outlook has prompted central banks to ease their expected monetary policy stances, placing upward pressure on the New Zealand dollar.

Domestic growth slowed in 2018, with softness in the housing market and weak business investment contributing.

We expect ongoing low interest rates, and increased government spending and investment, to support economic growth over 2019. Low interest rates, and continued employment growth, should support household spending and business investment. Government spending on infrastructure, housing, and transfer payments also supports domestic demand.

As capacity pressures build, consumer price inflation is expected to rise to around the mid-point of our target range at 2 percent.

The balance of risks to this outlook has shifted to the downside. The risk of a more pronounced global downturn has increased and low business sentiment continues to weigh on domestic spending. On the upside, inflation could rise faster if firms pass on cost increases to prices to a greater extent.

We will keep the OCR at an expansionary level for a considerable period to contribute to maximising sustainable employment, and maintaining low and stable inflation.

Meitaki, thanks.

Disclaimer:
Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. All CFDs (stocks, indexes, futures) and Forex prices are not provided by exchanges but rather by market makers, and so prices may not be accurate and may differ from the actual market price, meaning prices are indicative and not appropriate for trading purposes. Therefore Fusion Media doesn`t bear any responsibility for any trading losses you might incur as a result of using this data.

Fusion Media or anyone involved with Fusion Media will not accept any liability for loss or damage as a result of reliance on the information including data, quotes, charts and buy/sell signals contained within this website. Please be fully informed regarding the risks and costs associated with trading the financial markets, it is one of the riskiest investment forms possible.

What’s Up (And Down) With Households?

What’s Up (And Down) With Households?

Assistant Governor (Economic)

Address to Housing Industry Association March Industry Outlook Breakfast
Sydney – 26 March 2019

Thank you to the organisers of this breakfast event for the opportunity to speak with you and share with you some of our thinking about current economic developments.

For a little while now, the team at the Bank has been grappling with how one might reconcile apparently weak national accounts figures with the noticeably stronger labour market data.

The disconnect can be traced to the household sector. Many other parts of the national accounts measure of output – gross domestic product (GDP) – are actually doing reasonably well. Outside the mining sector, where some large projects are still winding down, business investment is growing at a solid pace. Transport and renewable energy projects have been quite important. Public demand, both consumption and investment, is supporting growth.

There are also some areas of weakness outside the household sector, such as the drought-affected rural sector, which is weighing on exports at the moment. Droughts and other recent natural disasters clearly pose difficulties for those directly affected. But the underlying trends in the broader economy are not determined by these events. So in the main, outside the household sector, the economy is not doing too badly.

The Labour Market has Unambiguously Improved

This makes sense, because employment has been strong and someone must be hiring all those extra workers. Over the past year, total employment has increased by more than 2 per cent. The unemployment rate declined by ½ percentage point over 2018, reaching the level of 5 per cent before our forecasts implied it would (Graph 1). This is a good outcome. Youth unemployment has declined and most measures of underemployment have also come down a bit.

Graph 1

Labour market

Labour market

Some industries are doing better than others, but overall the strength in employment has been across a diverse range of sectors (Graph 2). We can see this either by looking at the industry that people say they work in, or we can use the ABS’s new Labour Account to triangulate this information with what firms say their industry is. Either way, we see jobs being added in a range of industries. Employment in health care and social assistance has been increasing for a while; the rollout of the NDIS is an important driver of this, but not the only one. More recently, we have also seen employment increase in a number of business services industries. Construction employment had also been strong for a while, reaching the highest share of total employment in more than a century of records.

Graph 2

Employment by sector

Employment by sector

One can be reasonably confident in the steer the labour market data are giving us, because it is coming from multiple, independently collected data sets. The employment and unemployment data come from the ABS’s survey of households. But a survey of businesses, also from the ABS, tells us that the number of job vacancies has been a very high share of the total jobs available. Separate private-sector surveys of businesses tell us that many firms plan to hire more workers. Many of our own liaison contacts also tell us that they are hiring.

And as the labour market gradually tightens, we are beginning to see the effects in wages growth. This has been low for some time, but is gradually trending up now, especially in the private sector (Graph 3). Part of this shift is that fewer workers are subject to wage freezes than was the case a year or so ago. Minimum and award wage rises have also increased. Along with other countries, it’s taking longer and a lower unemployment rate to start seeing faster wages growth than historical experience might have suggested. Indeed, we still think Australia is a little way off the levels of the unemployment rate that would induce materially faster wages growth. But as the experience of other countries has also shown, if the labour market tightens enough, wages growth does eventually pick up.

Graph 3

Wage price index growth by sector

Wage price index growth by sector

Household Consumption Spending is Slowing

In contrast to the positive picture implied by the labour market, growth in household income has been slow, and growth in consumption has weakened recently (Graph 4).

Graph 4

Household consumption and income growth

Household consumption and income growth

If we drill down to see which kinds of spending have slowed the most, we can see that spending on cars and household goods has been particularly affected (Graph 5). Spending on less discretionary items like food has been less affected.

There has been a deal of talk about the possibility that ‘wealth effects’ from declining housing prices might be weighing on spending. It’s important to remember, though, that people’s reaction to a fall in prices is likely to depend partly on how far prices had increased previously.

Graph 5

Consumer spending growth

Consumer spending growth

Some recent work by colleagues at the Bank suggests that the link is a bit more subtle than simply that increases in wealth boost spending directly (May, Nodari and Rees 2019). It isn’t so much that people wake up one morning, realise their home is worth more, and decide to go out shopping. Rather, if their home is worth more, they can borrow more against it, which matters for some people’s decisions to buy a car. And because rising housing prices usually occur in the context of high rates of transactions in the market, spending on home furnishings tends to rise and fall with housing prices. So when housing prices decline, turnover also declines. This means there are fewer people moving house and realising their old couch doesn’t fit or they need new furnishings in the extra bedroom.

Slow Income Growth is a Drag on Household Spending

Beyond this specific link to housing turnover, some slowdown in consumption spending is not entirely unexpected. For several years now, we have been calling out the issue of weak income growth and how it might test the resilience of household consumption spending. This is a particular issue in the context of high household debt and the need to service that debt.

One aspect of economic theory that actually works in practice is the observation that people try to smooth their consumption in the face of fluctuating incomes. Income growth is noticeably more volatile than consumption growth. So the usual pattern is that gaps between the two resolve with shifts in income growth, not shifts in consumption growth.

But there might be limits to how long households can continue expanding their consumption faster than their income is rising. People are still saving, and they can do so at a slower rate. But at some point they might conclude that this is not temporary and that low income growth will persist. At that point they would be likely to adjust their spending plans. Consumption growth would then slow.

So we need to establish how household income growth might indeed return back towards current rates of consumption growth or even higher. To do that, we need to understand why it has been so weak.

Labour Income Growth Has Recovered Somewhat

For some time, part of the story had been that labour income growth was weak. This has been true across several dimensions. First, the growth of wage rates for particular jobs has been slow (Graph 6). This is the measure of wages growth captured by the ABS’s Wage Price Index (WPI). It captures changes in wages paid for a fixed pool of jobs. As I already mentioned, growth in this measure has started increasing, though only gradually. It is still well below what one might expect in the longer run, if inflation is to average between 2 and 3 per cent and if productivity maintains a similar average growth rate to its average over the past decade or so.

People’s actual incomes include bonuses and other non-wage labour income, and average labour income depends on whether the mix of jobs in the economy is changing. For a number of years, these factors combined to make average earnings per hour, as recorded in the national accounts, increase much more slowly than the mix-adjusted WPI measure. It isn’t unusual for growth in this measure of earnings to differ from growth in the WPI. They are compiled on different bases. But in the years following the end of the mining investment boom, this gap was persistently negative, and quite large.

Graph 6

Labour costs

Labour costs

Some of the compositional change might have been because people were moving out of higher-paid jobs in mining-related activity, and had gone back to lower-paying work. It’s hard to pinpoint how important this effect was, because the weakness in average earnings growth was seen in some industry-level data as well. So at least some people would have had to be switching to lower-paid jobs in the same industry. Another factor that might have been at work was that fewer people were actually switching jobs than in the past. Surveys that track people through time, such as the HILDA survey, show that people who change jobs often see faster income growth in the year they switched, than people who didn’t change jobs (Graph 7).

Graph 7

Wages growth and labour market turnover

Wages growth and labour market turnover

This lower rate of job churn accords with some of the evidence we see in business surveys and the messages coming out of our business liaison program. Many firms report that they find it hard to find suitable labour, at least for some roles, and that this is a constraint on their businesses, though usually not a major one (Graph 8). But when we ask our contacts what they are doing about this problem, paying people more is not the first solution they think of. Even poaching someone from another firm by enticing them with higher pay is not that common. The evidence from our liaison program suggests that it has long been the case that firms first resort to other strategies to deal with labour shortages, and only turn to faster wage increases when the shortages are severe and persistent (Leal 2019).

Graph 8

Difficulty finding suitable labour

Difficulty finding suitable labour

But whatever the underlying drivers, the gap between the growth rates of the WPI and average earnings has closed more recently. Slow wages growth is still a concern, but in terms of its contribution to income growth, it is less of a puzzle than it was a few years ago. Instead we need to seek the source of the more recent weakness elsewhere.

Non-Labour Income Remains Weak

If we break household disposable income growth into its components, we can see the drivers of the more recent weakness (Graph 9). Labour income is not especially strong, but it no longer seems at odds with growth in employment and other information about wages growth. Rather, growth in other sources of income has been weak for some time, and this has continued more recently.

Graph 9

Household disposable income

Household disposable income

Within non-labour income, the main components are social assistance, rental income, other investment income, and the earnings of unincorporated businesses. It turns out that a confluence of factors has resulted in growth in most of these categories of income being weak recently. In some cases, this is a trend change that is likely to persist. Some others are driven by shorter-term factors that could reverse in coming years.

Social assistance payments have been relatively flat for a number of years (Graph 10). As the labour market has strengthened and unemployment has come down, it is not surprising that some forms of social assistance have not been growing. But there are a few other things going on at the same time. Firstly, the rate of growth of age pension payments has slowed, though it is still positive. There are a number of probable drivers of this, including the increase in the eligibility age, as well as more people above the (higher) eligibility age remaining in the workforce rather than drawing a pension. It is also possible that, as time goes on and the people who are retiring have had longer to accumulate superannuation balances, more people are receiving a part-pension together with an income stream from their superannuation.

Graph 10

Government spending growth

Government spending growth

Secondly, in recent years, growth in social welfare spending by the government has come from new programs (like the NDIS) that are counted as government consumption, not household income, in the national accounts. So while both disability payments and other payments to families with children have been broadly constant in dollar terms for several years, government consumption has been growing strongly over the same period. If we adjusted for this, the growth in the social assistance component of household income would look much closer to its average over the past, rather than well below average.

These factors all relate to the design of programs assisting households, and how they are classified in the national accounts. So we would not expect them to reverse all of a sudden. This implies that we should also not expect that measured household income from this source will bounce back strongly any time soon.

Rental income has also been a bit weak (Graph 11). This is not surprising considering that rents have been rising only slowly in most cities, and falling for a few years in Perth. But rental income is only earned by 15 per cent of taxpayers, and lower cash rental income for landlords is also lower rent paid by renters, leaving them with more money to pay for other things.[1] So the weakness in rental income is unlikely to be a large driver of any slowdown in consumer spending. Income from other kinds of investments has also been a bit weak, but has recovered a bit lately.

Graph 11

Sources of non-labour income

Sources of non-labour income

Unincorporated business income has also been weak of late. This can be a volatile type of income and sensitive to conditions in particular sectors. The farm sector represents a large share of unincorporated business income, compared with their share of the economy. So one reason this type of income has fallen has been the effect of the drought on farm incomes. A recovery here will depend on how soon normal seasonal conditions return. Much of the rest of unincorporated business income comes from sectors related to the property market, including building tradespeople and real estate agents. They are also seeing lower incomes, as both construction activity and the volume of sales of existing homes decline. Again, it can be envisaged that these sources of income might recover at some point, but not in the very near term.

Tax and Other Payments are Dragging on Disposable Income

When we think about household income available for consumption and saving, economists usually talk about household disposable income. This is income net of taxes, net interest payments and a few other deductions like insurance premiums. Income payable – the things deducted from gross income to calculate disposable income – increased by nearly 6 per cent in 2018. This was significantly faster than growth in gross household income.

Despite the relatively weak picture for household income growth, the tax revenue collected from households has grown solidly in recent years. It’s normal for growth in tax revenue to outpace income growth a bit: that is how a progressive tax system works. A useful rule of thumb is that, in the absence of adjustments to tax brackets to allow for bracket creep, for every one percentage point of growth in household income, taxes paid by households will on average increase by about 1.4 percentage points. That’s an on-average figure, though. The actual ratio can vary quite a bit.

In the past year, taxes paid by households increased by around 8 per cent, more than double the rate of growth in gross household income of 3½ per cent. So the ratio is more like a bit over two-to-one at the moment, rather than 1.4 to one. That is at the high end of the range this ratio reaches, but as this graph shows, it is not unprecedented (Graph 12). But this effect has cumulated over time, so that the share of income that is paid in tax has been rising (Graph 12, bottom panel).

Graph 12

Household income and tax

Household income and tax

What is noteworthy is that for all of the past six years, growth in tax paid has exceeded income growth by an above-average margin, at a time when income growth itself has been slow (Graph 13).

Graph 13

Household income and tax

Household income and tax

There are likely to be several things going on here. Aside from the usual bracket creep, some deductions and offsets have declined, boosting the overall tax take. Interest rates on investment property loans are now higher than for owner-occupiers, but overall the interest rate structure on mortgages is lower than it was a few years ago. So landlords will have lower tax deductions for interest payments on loans on investment properties. At the same time, the significant run-up in housing prices in some cities over the past decade will have increased the capital gains tax liability paid by investors selling a property. Turnover in the housing market has declined. But as best we can tell, the price effect has dominated the effect of declining volumes, and total capital gains tax paid has increased.

Compliance efforts and technological progress in tax collection have boosted revenue collected from a given income. The Tax Office reports that its efforts to raise compliance around work-related deductions have boosted revenue noticeably (Jordan 2019). The next wave of this effort, focused on deductions related to rental properties, could result in further boosts to revenue.

Some of these drivers boosting tax paid could persist for a while, but they aren’t permanent. For example, the earlier period of strong housing price growth will only increase capital gains tax revenue if the asset was owned during that period. It can be expected to become less important, the further into history it passes. Similarly, increased compliance increases the level of tax paid on a given level of income. It is not a change in the trend growth rate in tax paid. That said, the effect could last for a while as efforts shift to different aspects of compliance.

Some Recent Policy Changes Might Mitigate the Drag on Consumption

The net of all these effects is that household income growth has remained slow even as labour market conditions have been improving. Unlike slow wages growth, though, it is less clear how much weak non-labour income growth will weigh on consumer spending. As I already noted, slow growth in rental income for landlords means that tenants have more money to spend on other things. Some of the weakness in social assistance payments is because new programs are being delivered differently from existing ones, and so they are classified as government consumption. The net benefit to the recipients could be the same or higher.

So there might be reasons to think that weak non-labour income growth is less worrisome than weak wages growth. But you would not want to rely on that possibility to underpin your views on the outlook for consumption. So this is an area we need to watch closely. Household consumption spending is a large part of economic activity. A significant retrenchment there would lower growth and feed back into a weaker labour market, as well as into decisions to purchase housing.

Parting Thoughts

My talk today has deliberately not overlapped with what the Bank has recently said about the housing market. But I think it’s clear that conditions in the household sector more broadly are highly consequential for the housing sector and thus this audience. Whatever other forces might be affecting housing market developments, fundamentally demand for housing rests on the household sector’s confidence and capacity to take on the financial commitments involved in the purchase or rental of a home. Without enough income, and so without a strong labour market, that confidence and capacity would be in doubt. This is not the only reason we are watching labour market developments closely. But the nexus between labour markets, households and housing are crucial to our assessment of the broader outlook.

Thank you for your time.

Bibliography

Jordan C (2019), ‘Taxing times: positioning the ATO as an instrument of democracy’, Address to The Tax Institute 34th National Convention, Hobart, 14 March. Available at .

Leal H (2019),Firm-level Insights into Skills Shortages and Wages Growth’, RBA Bulletin, March.

May D, G Nodari and D Rees (2019),Wealth and Consumption’, RBA Reserve Bank of Australia Bulletin, March.

This speech uses unit record data from the Household, Income and Labour Dynamics in Australia (HILDA) Survey. For more information, see HILDA Survey Disclaimer Notice.

Endnotes

Thanks to Tomas Cokis for his invaluable help in putting together the material in this speech. [*]

The series in the graph shows total rental income, including both cash rents paid by tenants to landlords, and the rental income imputed to owner-occupiers. Owner-occupiers’ imputed rent is imputed using movements in cash rents as a guide, although the (slow-moving) relative quality of the owner-occupied housing stock relative to the rental stock also matters. Over shorter periods, changes in this series reflect developments in the rental housing market.

Expectations and the term premium in New Zealand long-term interest rates

Expectations and the term premium in New Zealand long-term interest rates

As a small, indebted economy, it is important to understand how financial market shocks in the rest of the world transmit to New Zealand. A key channel is long-term interest rates, which are highly correlated across countries. A sharp increase in international long-term bond yields would affect a range of New Zealand interest rates, including mortgage rates.

I use a term structure model to analyse the drivers of long-term interest rates in New Zealand. Movements in long-term interest rates can be decomposed into a component that reflects expectations about the future path of short-term policy rates, and changes in the term premium. The term premium is the compensation investors require for the risk of holding interest rate securities.

The term premium in New Zealand 10-year bond rates has trended down since the 1990s. Stable inflation, a strong domestic economy, and low global bond market volatility are likely to have contributed to a low term premium in recent years.

The New Zealand term premium is highly correlated with foreign yields, which may present some challenges for domestic monetary policy. Specifically, an increase in the term premium, even if driven from overseas, would be associated with a fall in domestic inflation and activity over the following year. Monetary policy may sometimes need to offset term premium shocks to achieve domestic macroeconomic objectives.

The model presented in this note provides estimates of the drivers of long-term yields that can be monitored at a high frequency, and a framework for thinking about movements in long-term interest rates and their implications for policymakers.

Disclaimer:
Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. All CFDs (stocks, indexes, futures) and Forex prices are not provided by exchanges but rather by market makers, and so prices may not be accurate and may differ from the actual market price, meaning prices are indicative and not appropriate for trading purposes. Therefore Fusion Media doesn`t bear any responsibility for any trading losses you might incur as a result of using this data.

Fusion Media or anyone involved with Fusion Media will not accept any liability for loss or damage as a result of reliance on the information including data, quotes, charts and buy/sell signals contained within this website. Please be fully informed regarding the risks and costs associated with trading the financial markets, it is one of the riskiest investment forms possible.

Property, Debt and Financial Stability

Property, Debt and Financial Stability

Michele Bullock
Assistant Governor (Financial System)

Urban Development Institute of Australia (WA)
Perth – 20 March 2019

Thank you for the invitation to speak to you today. It is great to be here and to hear your perspectives.

As Assistant Governor (Financial System) I oversee the Bank’s work on financial stability. But what is financial stability and what is the Reserve Bank’s role in it?

The wellbeing of households and businesses in Australia depends on growth in the Australian economy. And a crucial facilitator of sustained growth is credit – flows of funds from people who are saving to people who are investing. Credit provides households and businesses with the ability to borrow on the back of future expected income to finance large outlays, for example, the purchase of a home or equipment to establish or grow a business. A strong and stable financial system is important for this flow of funds.

There is no universal definition of financial stability but one way to think about it is to consider what is meant by financial instability. My colleague Luci Ellis suggested that this is best thought of as a disruption in the financial sector so severe that it materially harms the real economy.[1] This leaves unsaid where the disruption might come from, but we would all recognise the outcomes of financial stability when we see it. For example, while Australia was spared the worst impact of the global financial crisis, internationally it demonstrated the impact that financial instability can have on growth and hence the wellbeing of households and businesses in the economy.

Most of you will know about the Reserve Bank’s role in conducting monetary policy. But another key role of the Reserve Bank that you might be less familiar with is promoting financial stability. In this area, we share responsibility with the Australian Prudential Regulation Authority (APRA). But it is APRA that has responsibility for the stability of individual financial institutions and the tools that go along with that. So how does the Bank contribute to financial stability?[2]

There are a number of things we do. We undertake analysis of the economy and the financial system through the lens of financial stability, looking for financial vulnerabilities that could result in substantial negative impacts on the economy, or economic vulnerabilities that could result in risks to financial stability. We work with other regulators to identify signs of increasing risks in the financial system and measures to address these risks. Where appropriate, we provide advice to government on the potential implications for financial stability of policies. And we talk about the risks we are seeing to help inform other regulators, participants in the financial system, businesses and the general public of the potential risks that might have an impact on the economy.

This last action – communicating the risks – is the key purpose of our six-monthly Financial Stability Review (the Review). While any individual financial institution, business or household might think the risks they are taking on are appropriate, they may not be adequately taking into account the risks that are arising at a systemic level from everyone’s actions. The Review attempts to bring this system-wide view.

Our most recent Review was published in October last year and we are currently in the process of drafting the next one, which will come out in April. So, for the remainder of my talk, I am going to cover some of the key risks that we see at the moment. Given the audience, I am going to focus on risks related to residential and commercial property. First, I will give an update on recent developments in these areas. Then I will talk a little about recent concerns around tighter lending standards. And I will finish up with a few observations on the property market in Western Australia.

Household Debt

Six months ago in the Review, we noted that global economic and financial conditions were generally positive and that the Australian economy was improving. At the same time, housing prices were declining. In this context, we highlighted a number of vulnerabilities – issues that, were a shock to occur or economic conditions take a turn for the worse, could manifest in a threat to financial stability. At that time, we highlighted two domestic vulnerabilities that are relevant to my talk today – the level of household debt, and the slowdown in housing and credit markets. Six months on, these vulnerabilities remain. If anything, they are a little more heightened.

The Bank has highlighted the issue of household debt as a potential threat to financial stability many times over the past few years. Although it does not capture all the important information about household indebtedness, the ratio of household debt to disposable income is one summary indicator. This ratio is historically high (Graph 1). The household debt-to-income ratio rose from around 70 per cent at the beginning of the 1990s to around 160 per cent at the time of the GFC. The ratio steadied for a few years before starting to rise again around 2013 (around the same time that housing price growth began to accelerate) and is now around 190 per cent.

Graph 1

Household debt

Household debt

I have talked previously about some of the reasons why the debt-to-income ratio has risen so much over the past few decades.[3] In particular, a structural decline in the level of nominal interest rates and deregulation have eased credit constraints and increased loan serviceability. And as households have been able to borrow more, they have been able to pay more for housing. One important driver of high household debt in Australia is, therefore, housing. There is very little debt related to non-housing loans such as credit cards or car loans.

Just as housing costs have been an important driver of household debt, so has the ability to borrow more influenced the price of housing. Over the past decade, housing prices in many parts of Australia have risen but the rise has been particularly sharp in Sydney and Melbourne, which account for around 40 per cent of the housing stock (Graph 2). More recently, housing prices have fallen. Since the peak in mid 2017, housing prices Australia-wide have declined by around 7 per cent. The falls in Sydney and Melbourne have been larger. The question we are asking ourselves is, given the high levels of debt and falling housing prices, are there any significant implications for financial stability?

Graph 2

Housing prices by dwelling type

Housing prices by dwelling type

The answer would be no at this stage – the impacts are not large enough to result in widespread problems in the financial sector. This is not to downplay the financial stress that some households are experiencing. But most of the debt remains well secured against property, even with the decline in housing prices. Total repayments as a share of income remain steady and a large number of indebted households have built up substantial prepayments over the past few years. Broadly, the debt is held by households that can afford to service it. Arrears rates, while increasing a bit over the past few years, remain low. Banks are well capitalised and work over recent years to improve lending standards has made household and bank balance sheets more resilient. Loans at high loan-to-valuation (LVR) ratios and interest-only loans are less common than they were and most households have not been borrowing the maximum amount available.

Apartment Development

One area that we have focused on in recent years in our analysis of financial stability risks is apartment development. There has been a substantial increase in apartment construction since the start of the decade in the largest Australian capital cities (Graph 3). In Sydney there have been more than 80,000 apartments completed over the past few years adding roughly 5 per cent to housing stock in Sydney. Melbourne and Brisbane have also seen relatively large additions to the supply of apartments and, while the number of apartments being built in Perth has been small by comparison, this has been in the context of a fairly small apartment stock.

Graph 3

Estimated apartment completions

Estimated apartment completions

Our main concern with this from a financial stability perspective is the potential for this large influx of supply to exacerbate declines in housing prices and so adversely impact households’ and developers’ financial positions. By its nature, high-density development can tend to exacerbate price cycles. Large apartment developments have longer planning and development processes than detached housing. Purchasing the land, designing the development, getting approvals through relevant government bodies and then actual construction of the apartment block all take time. In a climate of rapidly rising prices, developers are willing to pay high prices for land on which to build apartments. Households, including investors, are willing to purchase apartments off the plan, confident that the apartment will be worth more than they paid for it when it is finally completed. This continues as long as prices are rising. This large increase in supply, however, ultimately sows the seeds of a decline in prices which, if large enough, results in development becoming unattractive, new supply falling and the cycle starting again.

This presents two risks. The first is to household balance sheets. A decline in apartment prices could negatively impact households that purchased off the plan and are yet to settle. They might find themselves in a situation where the value of the apartment in the current environment is less than they contracted to pay for it. And as market pricing falls, lenders will revise their valuations down and so will be willing to lend less. Households will therefore have to contribute more funds, either from their own savings or loans from other sources.

The second risk is to developers who are delivering completed apartments into the cooling market. If people who had pre-purchased are having difficulty getting finance, or decide it is not worth going ahead with the purchase, there would be increasing settlement failures. Developers would be left holding completed apartments, reducing their cash flow and their ability to service their loans, and impacting banks’ balance sheets.

Currently, the risks here appear to be elevated but contained. The apartment market is quite soft in Sydney; apartment prices have declined since their peak, rental vacancies have risen and rents are falling (Graph 4). In Melbourne and Brisbane, however, apartment prices have so far held up. Liaison suggests that settlement failures have not increased much and, to the extent that they have, some developers are in a position where they can choose to hold and rent unsold apartments. Further tightening in lending standards might, however, impact both purchasers of new apartments and developers – I will return to this in a minute.

Graph 4

Retail vacancy rates

Retail vacancy rates

Commercial Property

A final area worth touching on is non-residential commercial property.

Commercial property valuations have, like housing, risen substantially over the past decade, and much more than rents so that yields on commercial property have fallen to very low levels historically (Graph 5). This is particularly the case for office and industrial property. One reason for this is that yields, although they have been historically low in Australia, are high relative to overseas and to returns on other assets. Furthermore, some markets, such as the Sydney and Melbourne office property markets, are experiencing strong tenant demand and vacancy rates are low. But the rapid increase in commercial property prices over the past decade does pose risks. If transaction prices and valuations were to fall sharply, for example, in response to a change in risk preferences, highly leveraged borrowers could be vulnerable to breaching their LVR covenants on bank debt. This could trigger property sales and further price falls, exacerbating the cycle.

Graph 5

Commercial property

Commercial property

Lending Standards

With that background, I want to turn to an issue that has attracted a fair bit of attention in recent months – the role that tightening lending standards might have played in the downturn in credit and the housing market. We published a special chapter in the October 2018 Review on this issue and the Deputy Governor discussed it in a speech in November last year so I will only cover it briefly here.[4]

Lending standards have been tightening since late 2014, well before housing prices in the eastern states started to turn down. The initial tightening occurred in December 2014 in response to very fast growth in lending to housing investors and an assessment by APRA that banks’ lending practices could be improved. APRA required banks to tighten their lending practices in a number of areas, including interest rate buffers, verification of borrower income and expenses, and high LVR lending. The measure that got the most attention at that time, however, was the ‘investor lending benchmark’ in which APRA indicated that supervisors would be paying particular attention to any institutions with annual investor credit growth exceeding 10 per cent. The idea was that it would be temporary while APRA worked with the banks on addressing lending standards.

The benchmark and the tightening of standards didn’t have an immediate impact on the pace of investor lending. It didn’t really start to bite until the middle of 2015 when banks introduced higher interest rates for loans to investors. And at that point, growth in lending to investors slowed sharply (Graph 6).

Graph 6

Investor housing credit growth

Investor housing credit growth

Once things settled down, however, and banks were comfortable that they were well below the benchmark, the growth in lending to investors started to pick up again. Then, in March 2017, APRA introduced restrictions on the share of new interest-only lending as part of its broader suite of measures to strengthen lending practices. As part of this, APRA reinforced its investor benchmark. While the interest-only measure was focused on reducing the volume of higher-risk lending rather than lending to a particular type of borrower, there was a noticeable impact on the growth in lending to housing investors since interest-only loans tend to be the product of choice for many investors.

Both the investor lending benchmark and the interest-only lending benchmark have been removed for banks that have provided assurances on their lending policies and practices to APRA. But the improvements in lending practices implemented by the banks over the past few years have resulted in credit conditions being tighter than they were a few years ago. Application processes have been taking a bit longer as lenders are being more diligent about verifying borrower income and expenses, borrowers are generally being offered smaller maximum loans and some borrowers are finding it more difficult to obtain a loan. Banks are more closely adhering to their lending policies, resulting in fewer exceptions being granted and there are fewer high LVR and interest-only loans being approved.

There have been some concerns expressed that these developments have been a key reason for the slowing in credit growth over the past year. Coupled with possibly some increased risk aversion of front-line lending staff in the wake of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, the concern is that this has been impacting housing credit growth and, by extension, housing prices. As concluded in the Banks’ February Statement on Monetary Policy, and noted by the Governor in a recent speech, tighter credit conditions do not appear to be the main reason for declining housing credit growth.[5] The evidence points towards declining demand for housing credit as being a more important factor.

Nevertheless, it is possible that tighter lending standards could be impacting developers of apartments. This could be direct, reflecting banks’ desire to reduce their exposure to the property market, particularly high-density development. But it could also be indirect by banks tightening their lending standards for purchases of new apartments, hence impacting pre-sales for developers and their ability to obtain finance. The Deputy Governor noted this in a speech in November 2018 and concluded that this was of potentially higher risk to the economy than household lending standards.

From a financial stability perspective, prudent lending standards are a good thing. They ensure that households and banks are resilient to changes in circumstances. But there needs to be a balance. The regulators are not proposing any further tightening in lending standards. And the appropriate amount of credit risk is not zero – banks need to continue to lend and that will inevitably involve some credit losses.

Western Australia

Finally, I want to turn my focus to developments in Western Australia. As you will have seen from some of my earlier graphs, the Western Australian circumstances are somewhat different to those of the eastern capital cities. There are two aspects I would like to focus on – household resilience and the commercial property sector.

Housing prices in Perth have been declining for some years (Graph 7). The peak in housing prices in Perth was in the middle of 2014. This followed a period of strong housing price growth as the population of Western Australia increased strongly during the mining investment boom and housing construction took longer to ramp up. When housing construction did respond, however, population growth had slowed markedly and housing prices started to fall. Median housing prices have fallen by around 12 per cent since 2014.

Graph 7

Perth median house prices

Perth median house prices

This has clearly been a difficult time for many homeowners in Western Australia. There are some households that are having difficulty meeting repayments, as evidenced by a rising arrears rate in Western Australia (Graph 8). At this stage, however, the losses are not large enough to threaten the stability of the financial sector. We nevertheless continue to monitor the situation for any potential systemic impacts.

Graph 8

Securitised mortgage arrears rates

Securitised mortgage arrears rates

Finally, office property in Western Australia has also been experiencing oversupply. Valuations have fallen over the past decade (Graph 9). Rents have also fallen reflecting a sharp increase in office vacancy rates in Perth’s CBD over the past few years (Graph 10). This makes for a challenging environment for owners of these buildings, particularly for owners of older or lower quality office buildings as tenants have taken the opportunity to move into newer buildings as rents have come down. But again, while a difficult time for developers and owners of office buildings, the financial stability implications seem limited.

Graph 9

Perth CBD office property

Perth CBD office property

Graph 10

Office vacancy rates

Office vacancy rates

Conclusion

Vulnerabilities from the level of household debt, the apartment development cycle and the level of non-residential commercial property valuations continue to present risks for financial stability. While so far, the financial sector has remained resilient, we continue to monitor developments in household debt and in property markets for signs that these might have more broad ranging effects on the financial system.

Endnotes

I am grateful to Nicole Adams and Cathie Close for assistance with this speech. [*]

https://www.rba.gov.au/speeches/2014/sp-so-fs-040614.html [1]

While the Bank’s objective for monetary policy is low and stable inflation, in setting monetary policy to achieve this it takes into account its financial stability objective. See for example https://www.rba.gov.au/speeches/2016/sp-gov-2016-10-18.html. The September 2016 Statement on the Conduct of Monetary Policy between the Treasurer and the Governor also notes that the Bank takes into account financial stability in conducting monetary policy. [2]

https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-10.html [3]

https://www.rba.gov.au/publications/fsr/2018/oct/assessing-effects-housing-lending-policy-measures.html
https://www.rba.gov.au/speeches/2018/sp-dg-2018-11-15.html [4]

See https://www.rba.gov.au/publications/smp/2019/feb/ and https://www.rba.gov.au/speeches/2019/sp-gov-2019-03-06.html

Bonds and Benchmarks

Bonds and Benchmarks

Christopher Kent[*]
Assistant Governor (Financial Markets)

KangaNews DCM Summit
Sydney – 19 March 2019

Introduction

It’s wonderful to be back at the Debt Capital Markets Summit.

The past year in Australia was a bit of a mixed bag in terms of issuance of fixed income securities. Banks’ issuance of bonds was high in net terms. Issuance of Residential Mortgage Backed Securities (RMBS) by the non-banks was also high.[1] However, in the second half of 2018 issuance by Australian corporations outside of the financial sector was low. Today I’m going to discuss some of these trends.

I’ll also discuss trends in yields. When I was at this event last year, I noted that spreads between corporate and government bonds had declined to be around their lowest levels since the global financial crisis (Graph 1). Over 2018, spreads on Australian bonds widened in line with global developments. The sharp rise in spreads around the end of 2018 reflected a greater concern regarding downside risks.[2] While spreads have narrowed a little in early 2019, they remain wider than when I spoke here a year ago.

Graph 1

Investment grade corporate bonds

Investment grade corporate bonds

In the second half of my presentation I want to address the risks relating to interest rate benchmarks. These are directly relevant to many of you here and it’s good to see that they will be discussed later today. These benchmarks are right at the heart of the plumbing of the financial system and, if they were to stop suddenly, this could generate significant financial instability. The clock is ticking for institutions with exposures to the London Inter-Bank Offered Rate (LIBOR) benchmarks. However, a path for transition away from LIBOR has been cleared, and we encourage all users to be taking the necessary steps to prepare for this change. And while bank bill swap (BBSW) rate benchmarks remain robust, there are still some issues that users should be addressing, which I will discuss today. If we work collectively, we can significantly reduce these risks.

Bonds

Let’s start though by considering developments in some key Australian bond markets.

Bank Bonds

Australia’s largest corporate fixed income market is that for financial corporation debt, of which bank bonds form a large part. Bank bond spreads widened in line with global developments over the past year or so. Nonetheless, yields remained relatively stable at a low level as benchmark rates edged down (Graph 2). Over 2019, thus far, both spreads and benchmark rates have fallen. So there has been an appreciable decline in the cost of issuing unsecured debt in this form to very low levels by historical standards.

Graph 2

Major banks' bond pricing

Major banks’ bond pricing

Issuance of bank bonds was quite high in 2018 in net terms. In fact, net issuance was the highest for almost 10 years (Graph 3). That high level of net issuance reflected gross issuance around the average we have seen over the past few years at the same time that maturities in 2018 were at a low level.

Graph 3

Bank bond net issuance

Bank bond net issuance

In addition to strong net issuance, over the past year the banks have been issuing a larger share of their bonds domestically (Graph 4). The banks have not just issued less paper overseas. They have also issued a higher value of bonds in the domestic market.

Graph 4

Banks' bond issuance

Banks’ bond issuance

Often the perception of the domestic market is that it has limited capacity to absorb sizeable increases in issuance. However, it appears that the banks were able to issue the extra bonds domestically at a price that was at least as, if not a little more, favourable for the banks than the price of bonds issued offshore (after accounting for hedging costs; Graph 5).[3]

Graph 5

Major banks' primary market bond pricing

Major banks’ primary market bond pricing

This raises the question of who was buying this domestically issued paper? Comprehensive data (from the Financial Accounts) show that the domestic issuance over the year to September 2018 was widely held across different sectors. But pension funds bought a disproportionate share of the issuance over that period – almost 25 per cent compared with the 5 per cent share that they had typically held.

In recent months, another notable feature has been the relatively high value of issuance of covered bonds (Graph 6). This may have been related to the rise in volatility around the turn of the year in domestic and global financial markets. Liaison with banks suggested that the tighter conditions in funding markets at the time did push banks to issue more covered bonds, since these are viewed as a good option for funding at such times. Having said that, there is still plenty of capacity for the banks to tap their covered bond lines if they have the need.

Graph 6

Covered bond issuance

Covered bond issuance

Non-Financial Corporations

Over 2018, non-financial corporation spreads followed those of financial corporations, and by extension, spreads in global markets (Graph 7). Issuance in the second half of 2018 was quite low, and the market is off to a slow start in 2019. However, with yields still low, this doesn’t appear to be a story about companies finding it difficult to obtain funding in bond markets. Moreover, the growth of business debt more generally – which includes bonds and credit issued by banks – has picked up over the past year or more (Graph 8). This quarter has seen some issuance among resource related corporations. Notwithstanding that, this is likely to remain a relatively quiet corner of the market for some time given that the resources sector in general has been deleveraging following the end of the mining investment boom.

Graph 7

Australian non-financial corporate bond pricing

Australian non-financial corporate bond pricing

Graph 8

Business debt

Business debt

Despite 2018 being somewhat quiet, a diverse range of corporations have issued bonds. Last year, I showed some graphs of Herfindahl-Hirschman indices, which is a standard way of measuring concentration. The lower the index, the lower the level of concentration and the more diverse is the set of issuers.[4] In 2017, the index for non-financial corporations hit its lowest – most diverse – levels for some time (Graph 9). There was an uptick in concentration in 2018, but it is still at relatively low levels.

Graph 9

Non-financial corporations

Non-financial corporations

RMBS

In 2018, non-banks issued the second largest amount of RMBS since the GFC, only narrowly eclipsed by 2017 issuance (Graph 10). This was associated with strong growth of non-bank housing loans, as they gained some market share from banks. Spreads widened in line with other markets, although spreads for non-conforming deals appear to have widened a little more than for other deals.

Graph 10

Australian RMBS

Australian RMBS

The noticeable rise in the share of new mortgages extended by non-banks over recent years reflects, in part, earlier regulatory actions limiting the growth of banks’ investor and interest-only mortgages. Banks’ tighter lending standards in light of the Royal Commission have also had an effect on their lending activity over the past year.

Not only did this change in the banks’ behaviour contribute to the strong growth of non-bank lending, it may also have contributed to the shift in the nature of the collateral underlying the non-bank securitisation deals. We can use the Reserve Bank’s Securitisation Dataset to see three key changes.[5] First, the share of investor loans in non-bank securitisations has increased over the past few years (Graph 11). Second, their share of interest-only loans has remained relatively high, in contrast to the share of interest-only loans in banks’ securitisations. Third, the level of seasoning in non-bank deals has also fallen (Graph 12). In other words, their loans are newer than in the past and newer than for the bank securitisations. The fact that non-banks are bundling up mortgages more quickly into securities suggests that they are writing loans more quickly and, therefore, reaching the limits of their warehouse facilities.

Graph 11

Share of loan pools

Share of loan pools

Graph 12

Weighted average seasoning

Weighted average seasoning

In summary, over the past year or so, well-rated corporations – both in and outside of the financial sector – have been able to source funding in bond markets. While spreads on corporate bonds are higher than a year ago, yields remain low. That is a reflection of the effect of the expansionary setting of monetary policy, which is providing support to the economy more generally.

Interest Rate Benchmarks

I’ll change tack now by discussing the reform of interest rate benchmarks. Because these are intertwined with much of the financial system’s ‘plumbing’, the issue has been a longstanding focus for the global regulatory community.[6] Increasingly, it needs to also become a key focus of financial market participants, including many of you here today. With that in mind, I’d like to provide a brief update on the work underway to strengthen interest rate benchmarks, both internationally and in Australia.

The end of LIBOR

The various LIBORs have long been the key interest rate benchmarks for the major currencies. However, given that they are not supported by a sufficient volume of transactions in wholesale short-term funding markets, it is now widely recognised that these will come to an end. The UK Financial Conduct Authority (FCA), which regulates the LIBOR benchmarks, has made it clear that it will not support LIBOR beyond the end of 2021.[7] This is an important issue for Australian financial institutions, which have substantial exposures to LIBOR through derivatives, bonds and syndicated lending.

To replace LIBOR, regulators have worked closely with industry participants to develop alternative risk-free rates, such as the Secured Overnight Financing Rate (SOFR) for the US dollar and the Sterling Overnight Interbank Average Rate (SONIA) for the British pound.[8] The transition to risk-free rates is accelerating internationally across derivatives and bond markets. It is encouraging to see that Australian banks have recently issued sterling floating-rate notes (FRNs) referencing SONIA rather than LIBOR.[9]

New products can reference these new benchmarks. But when LIBOR comes to an end, there could be disruptions for many existing products referencing LIBOR unless their contracts contain robust ‘fall-back’ provisions. ISDA (International Swaps and Derivatives Association) has been taking the lead on this work at the request of the Financial Stability Board (FSB). This will involve using the risk-free rates as fall-backs for LIBOR, but with an appropriate adjustment for the historical spread between them. ISDA is expected to finalise these fall-back provisions by the end of the year. We strongly encourage all users of LIBOR in the Australian market to be ready to adopt these new fall-back provisions in their contracts.

BBSW remains robust

The BBSW rates are important interest rate benchmarks for the Australian dollar. A lot of work has already been done to ensure that these remain robust. This market – where banks raise short-term funding by issuing bills to wholesale investors as a liquid asset – is a longstanding one.[10] The bank bill market is considerably larger as a share of the Australian major banks’ balance sheets than equivalent markets in the US and Europe (Graph 13). As a result, unlike for LIBOR, there are enough transactions in the Australian bank bill market to support a benchmark.

Graph 13

Short-term papaer issued by banks

Short-term papaer issued by banks

Around a year ago, a new methodology was put in place for BBSW. This has made it possible to calculate BBSW rates directly from transactions in the bank bill market between banks and wholesale investors. This required the ASX, market participants and regulators to work together to develop new infrastructure and market practices. The new methodology has performed very well, with much more trading activity now underpinning BBSW during the ‘rate set window’, which is from 8.30am – 10am (Graph 14).[11]

Graph 14

Turnover in bank bill market at the daily rate set

Turnover in bank bill market at the daily rate set

Strengthening contractual fall-backs for BBSW

While BBSW is a robust benchmark, we shouldn’t take this for granted. The bank bill market is expected to have a secure future, since the assets of managed funds continue to grow, supported by superannuation contributions. These managed funds need to hold some liquid assets such as bank bills to be able to meet unexpected redemptions. Despite this, bank bills have been slowly declining both as a share of managed funds’ assets and the major banks’ liabilities (Graph 15). This is partly due to the liquidity standards introduced over recent years, which reduced the value that banks place on short-term wholesale funding. Given these trends, we cannot be certain that the bank bill market will always be large enough to sustain the BBSW rates as viable benchmarks.

Graph 15

Bank bill market

Bank bill market

If BBSW were ever to cease, the existing fall-back provisions in many contracts would be cumbersome to apply and could generate significant market disruption. The Australian Securities and Investments Commission (ASIC) is the regulator of licensed benchmark administrators. To protect financial stability, ASIC also has the power under the new benchmarks legislation to compel the banks to make submissions so that BBSW can still be calculated. However, if the bank bill market no longer existed, this would clearly not be a long term solution.

This is why we have been working with ISDA to strengthen the contractual fall-backs for BBSW at the same time as LIBOR. This will involve using the cash rate – which is the risk-free rate for the Australian dollar – as the fall-back, with an adjustment for the historical spread between BBSW and the cash rate. Once ISDA has finalised the fall-back provisions, we expect all users of BBSW to adopt them where possible. For new securities referencing BBSW, the RBA will make it a requirement that these fall-back provisions be adopted before the securities can be eligible in the RBA’s market operations. Currently, this would affect FRNs issued by banks, securitisation trusts and the state governments.

Users of 1-month BBSW should consider alternative benchmarks

Meanwhile, users of BBSW should also be aware that the market underpinning the 1-month tenor is not as liquid as for the 3-month and 6-month tenors. Unlike for these longer tenors, banks have no incentive to issue 1-month bills. This is because under the liquidity standards, they would be required to hold an equivalent amount of high-quality liquid assets.[12] The few transactions that do occur are mainly ones where investors are selling their bills back to the banks. While there are enough transactions to directly measure 3-month and 6-month BBSW on most days, this has only happened about half the time for 1-month BBSW.[13] Since the new calculation methodology was introduced, 1-month BBSW has also been more volatile than 3-month BBSW. This was particularly evident in mid January (Graph 16). So the lack of liquidity in the underlying market for 1-month bills appears to be affecting the benchmark.

Graph 16

BBSW rates

BBSW rates

Given these issues, users of 1-month BBSW should be preparing to use alternative benchmarks.[14] This is particularly relevant to the securitisation and derivatives markets, which frequently reference the 1-month rate. Consistent with this, the Reserve Bank is thinking about this issue given that it is relevant to a number of securities that we hold via our market operations.

One option would be for issuers to instead reference 3-month BBSW; another option is to reference the cash rate. It will be important for market participants to evaluate the best options and make progress towards these in a timely manner.

The cash rate is the alternative risk-free rate for the Australian dollar

The cash rate is best known as the Reserve Bank Board’s operational target for monetary policy. But it is also a significant benchmark in Australian financial markets. The cash rate is administered by the RBA and calculated directly from transactions in the interbank overnight cash market.

With the transition from LIBOR to risk-free rates internationally, we would expect there to be some corresponding migration away from BBSW towards the cash rate. This is particularly the case for financial products where it makes sense to reference a risk-free rate instead of a credit-based benchmark. For instance, FRNs issued by governments and securitisation trusts could instead tie their coupon payments to the cash rate instead of BBSW. The South Australian Financing Authority recently announced its interest in issuing a FRN linked to the cash rate. This would be a first for Australia.

We know that there is also demand from investors for term risk-free rates with similar tenors to LIBOR and BBSW. Some benchmark users value having more certainty about their cash flows, since a term rate would be known at the start of the relevant interest period, rather than being calculated at the end of the period by compounding the cash rate. It could be possible to generate a term rate using the overnight indexed swap market or the repo market. We are supportive of efforts by the private sector to develop such term rates. However, there would need to be significant effort to develop the appropriate market infrastructure and practices before these could be considered robust benchmarks. Given this, we encourage market participants to consider using the cash rate rather than waiting for the development of a term rate.

In conclusion, there are three main points I would like to leave you with concerning interest rate benchmarks:

  • It is widely recognised that LIBOR will come to an end. Market participants in Australia should continue preparing for this by moving to alternative risk-free rates and adopting more robust fall-back provisions in their contracts.
  • While BBSW remains robust, it would be prudent for all users to also adopt more robust fall-back provisions for BBSW in their contracts.
  • Users of 1-month BBSW should be considering alternative benchmarks given the illiquidity in the underlying market. We would suggest that participants consider using other robust benchmarks that are already available rather than waiting for the development of a term risk-free rate.

Endnotes

I thank Leon Berkelmans, Ellis Connolly and other staff in the Domestic Markets Department for excellent assistance in preparing these remarks. [*]

Non-banks refers to financial institutions that are not authorised deposit taking institutions, or non-ADIs. [1]

See Kent (2019) ‘Financial Conditions and the Australian Dollar – Recent Developments’, Address to XE Breakfast Briefing, Melbourne 15 February. [2]

Graph 4 accounts for hedging costs using cross currency basis swaps and interest rates swaps. The calculations assume that banks swap their issuance into fixed rate Australian debt at the time of issuance, however in reality they can execute the swap at a later date depending on the pricing. [3]

If the market is accounted for by only one industry, this index is 1. If, on the other hand, n industries each have an equal share of the market, the index is 1/n. [4]

For more information on the Dataset, see Fernandes K and Jones D (2018), ‘The Reserve Bank’s Securitisation Dataset’, RBA Bulletin, December. [5]

See: Debelle G (2018), ‘Interest Rate Benchmark Reform’, Keynote at ISDA Forum, Hong Kong, 15 May; Debelle G (2017), ‘Interest Rate Benchmarks’, Speech at FINSIA Signature Event: The Regulators, Sydney, 8 September; Debelle G (2016), ‘Interest Rate Benchmarks’, Speech at KangaNews Debt Capital Markets Summit 2016, Sydney 22 February; Debelle G (2015). ‘Benchmarks’, Speech at Bloomberg Summit, Sydney, 18 November. [6]

Schooling Latter, Edwin (2019), ‘LIBOR transition and contractual fallbacks’, speech delivered at the International Swaps and Derivatives Association (ISDA) Annual Legal Forum, 28 January 2019. Available at: . [7]

SOFR is a broad measure of the cost of borrowing US dollars under repurchase agreements collateralised by US Treasury securities; SOFR is administered by the New York Fed. SONIA is a measure of the cost of borrowing British pounds in the wholesale unsecured overnight market; SONIA is administered by the Bank of England. [8]

The Commonwealth Bank issued a FRN referencing SONIA on 3 December 2018 and ANZ issued a covered bond referencing SONIA on 11 January 2019. [9]

The instruments traded in the Australian bank bill market are bills of exchange and negotiable certificates of deposit (NCDs). Historically, bills of exchange were the main instrument, although in recent years issuance of NCDs has dominated the market. [10]

For more details, see Connolly E and S Alim (2018), ‘Interest Rate Benchmarks for the Australian Dollar’, RBA Bulletin, September. [11]

Under the liquidity coverage ratio (LCR), banks are required to hold sufficient high-quality liquid assets (HQLA) to be able to cover their net cash outflows in a 30-day stress scenario. In this scenario, bank bills maturing within the next 30 days are treated as a cash outflow, so the bank issuing them would be required to hold an equivalent amount in HQLA. [12]

To improve the stability of 1-month BBSW, the ASX has announced a change to the methodology that is expected to result in a significant reduction in the proportion of days when 1-month BBSW can be directly calculated using transactions. See ASX (2019), “Consultation on changes to 1 month BBSW VWAP Methodology”, Available at: . [13]

The RBA has highlighted this issue in previous speeches: Kent C (2018), ‘Securitisation and the Housing Market’, Address to the Australian Securitisation Forum Conference, 26 November; Debelle G (2018), ‘Interest Rate Benchmark Reform’, Keynote at ISDA Forum, Hong Kong, 15 May

The Housing Market and the Economy

The Housing Market and the Economy

Philip Lowe – Governor

Address to the AFR Business Summit
Sydney – 6 March 2019

Thank you for the invitation to address this year’s AFR Business Summit. It is good to be back here again.

As you would be aware, the Reserve Bank Board met yesterday and left the cash rate unchanged at 1.5 per cent. I would like to use this opportunity to highlight some of the issues we discussed at the meeting. Before I do that, though, I would like to focus on the housing market and its implications for the economy. Readers of the monetary policy minutes would have noticed that at its February meeting the Board discussed a special paper taking a deep dive into this topic. My remarks today draw from that paper. I will first focus on the current state of the housing market. Then, I will discuss the main drivers of recent movements in housing prices, before turning to the implications for the broader economy and the financial system.

The Current State of the Housing Market

Australians watch housing markets intensely, perhaps more so than citizens of any other country. Over the five years to late 2017, they saw nationwide housing prices increase by almost 50 per cent (Graph 1). Since then, prices have fallen by 9 per cent, bringing them back to their level in mid 2016.

Graph 1

National housing prices

National housing prices

Declines of this magnitude are unusual, but they are not unprecedented. In 2008 and 2010, prices fell by a similar amount, as they did on two occasions in the 1980s. In the 1980s, the rate of CPI inflation was higher than it is now, so in inflation-adjusted terms, the declines then were larger than the current one.

These nationwide figures mask considerable variation across the country (Graph 2). The run-up in prices over recent years was most pronounced in Sydney and Melbourne, so it is not surprising that the declines over the past year have also been largest in these two cities. In Perth and Darwin, the housing markets have been weak for some time, affected by the swings in population and income associated with the mining boom. By contrast, the housing market in Hobart has been strong recently. In Adelaide, Brisbane, Canberra and many parts of regional Australia, conditions have been more stable. Given these contrasting experiences, it is pretty clear that there is no such thing as the Australian housing market. What we have is a series of separate, but interconnected, markets.

Graph 2

Median house prices

Median house prices

Another important window into housing markets is provided by rental markets. Over recent times, the nationwide measure of rent inflation has been running at a bit less than 1 per cent, the lowest in three decades (Graph 3). As with housing prices, there is a lot of variation across the country. Rents have been falling for four years in Perth and are now around 20 per cent below their previous peak. By contrast, in Hobart rents have been rising at the fastest rate for some years.

Graph 3

Rent inflation

Rent inflation

As is well understood, shifts in sentiment play an important role in housing markets. When prices are rising, people are attracted to the market in the hope of capital gains. At some point, though, valuations become so stretched that demand tails off and there is a shift in momentum. When prices are falling, it’s the reverse. The prospect of capital losses leads buyers to stay away or to delay purchasing. At some point, though, the lower prices draw more buyers into the market. First home owners find it easier to buy a home, investors are attracted back into the market, and trade-up buyers take the opportunity to upgrade to the home they have always wanted. These shifts in sentiment and momentum are seen in most housing cycles, but their precise timing is difficult to predict.

Some of these shifts in sentiment are evident in consumer surveys (Graph 4). Over recent times, the number of people reporting that an investment in real estate is the wisest place for their savings has fallen significantly. So, it is not surprising that there are fewer investors in the market. At the same time, the number of people saying it is a good time to buy a home has increased. Lower prices draw more people in and, eventually, this helps stabilise the market. So it is worth closely watching these shifts in sentiment.

Graph 4

Housing market sentiment

Housing market sentiment

Explaining the Recent Cycle

An obvious question to ask is what are the underlying, or structural, drivers of the large run-up in housing prices and the subsequent decline?

There isn’t a single answer to this question. Rather, it is a combination of factors.

Before I discuss these factors, it is worth pointing out that the current adjustment is unusual. Unlike the other four episodes in which housing prices have declined in recent decades, this one was not preceded by rising mortgage rates. Nor has it been associated with a rise in the national unemployment rate. Instead, in New South Wales, where the recent decline in housing prices has been the largest, the unemployment rate has continued to trend down. It is now at levels last seen in the early 1970s. The unemployment rate has also trended lower in Victoria.

So, the origins of the current correction in prices do not lie in interest rates and unemployment. Rather, they largely lie in the inflexibility of the supply side of the housing market in response to large shifts in population growth.

It is useful to start with the national picture (Graph 5). Australia’s population growth picked up noticeably in the mid 2000s and it took the better part of a decade for the rate of home building to respond. It took time to plan, to obtain council approvals, to arrange finance and to build the new homes. Not surprisingly, housing prices went up. Eventually, though, the supply response did take place. Over recent times, the number of dwellings in Australia has been increasing at the fastest rate in more than two decades. Again, not surprisingly, prices have responded to this extra supply.

Graph 5

Population and dwelling stock growth

Population and dwelling stock growth

The population and supply dynamics are most evident in Western Australia and New South Wales (Graph 6).

During the mining investment boom, population growth in Western Australia increased from around 1 per cent to 3½ per cent. This was a big change. The rate of home building was slow to respond. When it did finally respond, it was just at the time that population growth was slowing significantly, as workers moved back east at the end of the boom. This explains much of the cycle.

In New South Wales it is a similar story, although it is not quite as stark. The recent rate of home building in New South Wales is the highest in decades. At the same time, population growth is moderating, partly due to people moving to other cities, attracted by their lower housing prices and rents. By contrast, in cities where population patterns and the rate of home building have been more stable, prices, too, have been more stable.

Graph 6

Population and dwelling stock growth

Population and dwelling stock growth

Another demand-side factor that has influenced prices is the rise and then decline in demand by non-residents.

One, albeit imperfect, way of seeing this is the number of approvals by the Foreign Investment Review Board (Graph 7). In the middle years of this decade, there was a surge in foreign investment in residential property, particularly from China. This was apparent not just in Australian cities, but also in ‘international’ cities in other countries. In Australia, the demand was particularly strong in Sydney and Melbourne, given the global profiles of these two cities and their large foreign student populations. More recently, this source of demand has waned, partly as a result of the increased difficulty of moving money out of China as the authorities manage capital flows.

Graph 7

Foreign investment in residential real estate

Foreign investment in residential real estate

The timing of these shifts in foreign demand has broadly coincided with – and reinforced – the shifts in domestic demand. However, making a full assessment of their impact on prices is complicated by the fact that international property developers were also adding to supply in Australia at a time of very strong demand. More recently, these developers have scaled back their activity.

Domestic investors have also played a significant role in this cycle. This is especially the case in New South Wales, which was the epicentre of strong investor demand (Graph 8). At the peak of the boom, approvals to investors in New South Wales accounted for half of approvals nationwide, compared with an average of just 30 per cent over the five years to 2010. More than 40 per cent of the new dwellings built in New South Wales recently have been apartments, which tend to be more attractive to investors.

Graph 8

Investor housing loan approvals

Investor housing loan approvals

The strong demand from investors had its roots in the population dynamics. Low interest rates and favourable tax treatment added to the attraction of investing in an appreciating asset. The positive side to this was that the strong demand by investors helped underpin the extra construction activity needed to house the growing population. But the rigidities on the supply side, coupled with investors’ desire to benefit from a rising market in a low interest rate environment, amplified the price increases.

As I discussed earlier, there is an internal dynamic to housing price cycles, and this one is no exception. By 2017, the ratio of the median home price to income had reached very high levels in Sydney and Melbourne (Graph 9). Finding the deposit to purchase a home had become beyond the reach of many people, especially first home buyers if they did not have others to help them. At the same time, the combination of high prices and weak growth in rents meant that rental yields were quite low. So, naturally, momentum shifted. Given the big run-up in prices and the large increase in supply, a correction at some point was not surprising, although the precise timing is nearly impossible to predict.

Graph 9

Housing price-to-income ratios

Housing price-to-income ratios

No discussion of housing prices is complete without touching on interest rates and the availability of finance. The low interest rates over the past decade did increase people’s capacity to borrow and made it more attractive to borrow to buy an asset whose price was appreciating. But the increase in housing prices is not just about low interest rates. The variation across the different housing markets indicates that city-specific factors have played an important role.

Recently, much attention has also been paid to the availability of credit. This attention has coincided with a noticeable slowing in housing credit growth, especially to investors (Graph 10).

Graph 10

Housing credit growth

Housing credit growth

It is clear there has been a progressive tightening in lending standards over recent years. The RBA’s liaison suggests that, on average, the maximum loan size offered to new borrowers has fallen by around 20 per cent since 2015. This reflects a combination of factors, including more accurate reporting of expenses, larger discounts applied to certain types of income and more comprehensive reporting of other liabilities. Even so, only around 10 per cent of people borrow the maximum they are offered. Sensibly, most people borrow less than what they are offered, so the effect of this reduction in borrowing capacity has not been particularly large.

It has also been apparent through our liaison that some lenders became more cautious last year. There was a heightened concern by some loan officers about the consequences to them and their career prospects of making a loan that might not be repaid if the borrower’s circumstances changed. So, lenders became more risk averse. This, along with greater verification of expenses and income, led to an increase in average loan approval times, although some lenders have invested in people and technology to address this. Our liaison suggests that application approval rates are largely unchanged.

Overall, the evidence is that a tightening in credit supply has contributed to the slowdown in credit growth. The main story, though, is one of reduced demand for credit, rather than reduced supply.

When housing prices are falling, investors are less likely to enter the market and to borrow. So too are owner-occupiers for a while. Consistent with this, the number of loan applicants has declined over the past year. There is also strong competition for borrowers with low credit risk, which is not something you would expect to see if it were mainly a supply story. This competition is evident in the significant discounts on interest rates on new loans compared with those on outstanding loans.

Even though the slowing in credit growth is largely a demand story, we are watching credit availability closely. It is perhaps stating the obvious to say that we want lenders who are both prudent and who are prepared to take risk. As lenders recalibrated their risk controls last year, the balance may have moved too far in some cases. This meant that credit conditions tightened more than was probably required. Now, as lenders continue to seek the right balance, we need to remember that it is important that banks are prepared to take credit risk. And it’s important that they have the capacity to manage that risk well. If they can’t do this, then the economy will suffer.

Impact on the Macroeconomy

This brings me to the issue of how developments in the housing market affect the broader economy.

Movements in housing prices affect the economy through multiple channels. They influence consumer spending, including through the spending that occurs when people move homes. They also influence the amount of building activity that takes place. Changes in housing prices also have an impact on access to finance by small business by affecting the value of collateral for loans. And finally, they can affect the profitability of our financial institutions.

Today, I would like to focus on the effect of housing prices on household consumption. My colleagues at the RBA have examined how changes in measured housing wealth affect household spending.[1] They estimate that a 10 per cent increase in net housing wealth raises the level of consumption by around ¾ per cent in the short run and by 1½ per cent in the longer run. They have also examined how this wealth effect differs by type of spending. They find that it is highest for spending on motor vehicles and household furnishings and that for many other types of spending the effect is not significantly different from zero (Graph 11). Part of the effect on spending on furnishings is likely to come from the fact that periods of rising housing prices are often associated with higher housing turnover, and turnover generates extra spending.

Graph 11

Wealth effects by consumption category

Wealth effects by consumption category

Over recent years, spending by households has risen at a faster rate than household income; in other words, the saving rate has declined (Graph 12). The results that I just spoke about suggest that rising housing wealth played a role here. If so, falling housing prices, and a decline in measured household wealth, could have the opposite effect.

Graph 12

Household consumption and income

Household consumption and income

The more important influence, though, is what is happening with household income. For many people, the main source of their wealth is their human capital; that is, their future earning capacity. As I have discussed on previous occasions, growth in household income has been quite weak for a while. It is plausible that, for a time, this didn’t affect people’s expectations of their future income growth; that is the value of their human capital. So they didn’t change their spending plans much, despite their current income growth being weak, and the saving rate fell. However, as the period of weak income growth has persisted, it has become harder to ignore it. Expectations of future income growth have been revised down and it is likely that this is affecting spending.

My conclusion here is that wealth effects are influencing consumption decisions, but they are working mainly through expectations of future income growth. Swings in housing prices and turnover in the housing market are also having an effect, but they are not the main issue. This assessment is consistent with the data on housing equity injection (Graph 13). Over recent years, households have been injecting substantial equity into housing and have not been using the higher housing prices to borrow to support their other spending. This is in contrast to the period around the turn of the century, when households were withdrawing equity.

Graph 13

Housing equity injection

Housing equity injection

Given this assessment, developments in the labour market are particularly important. A further tightening of the labour market is expected to see a gradual increase in wages growth and faster income growth. This should provide a counterweight to the effect on spending of lower housing prices.

Taking these various considerations into account, the adjustment in our housing market is manageable for the overall economy. It is unlikely to derail our economic expansion. It will also have some positive side-effects by making housing more affordable for many people.

A related issue that the RBA has paid close attention to is the impact of lower housing prices on financial stability.

In 2017, APRA assessed the ability of Australian banks to withstand a severe stress scenario, in which housing prices declined by 35 per cent over three years, GDP declined by 4 per cent and the unemployment rate increased to more than 10 per cent.[2] The estimated impact on bank profitability was substantial, but importantly, bank capital remained above regulatory minimum levels. This provides reassurance that the adjustment in our housing market is not a financial stability issue. We have not experienced the very loose lending practices that were common in the United States before the housing crash there a decade ago. Nor have we seen significant overbuilding around the country.

Non-performing housing loans in Australia have risen recently, but they remain low at less than 1 per cent (Graph 14). The increase is most evident in Western Australia, where the unemployment rate has risen.

Graph 14

Banks non-performing household loans

Banks non-performing household loans

The national experience has been that low levels of unemployment and low interest rates allow most people to service their loans, even if weak income growth means that household finances are sometimes strained. Our estimate is that currently, less than 5 per cent of indebted owner-occupier households have negative equity, and the vast bulk of these households continue to meet their mortgage obligations. One factor that has helped here is that the share of new loans with high loan-to-valuation ratios (LVRs) has declined substantially (Graph 15). The nature of Australian mortgages – in which there is an incentive to make prepayments – has also helped.

Graph 15

Banks high LVR lending

Banks high LVR lending

Monetary Policy

I would like to conclude with some words about monetary policy and highlight some of the issues we focused on at yesterday’s Reserve Bank Board meeting.

As you are aware, the current setting of monetary policy has been in place for some time. A cash rate of 1.5 per cent is very low historically and it is clearly stimulatory. It is supporting the creation of jobs and progress towards achieving the inflation target.

Looking forward, a key issue is the labour market. Achieving full employment is an important objective in its own right. But, in addition, a strong labour market is the central ingredient in the expected pick-up in inflation. We are expecting that as the labour market tightens, wages growth will increase further. In turn, this should boost household income and spending and provide a counterweight to the fall in housing prices. The pick-up in spending is, in turn, expected to put upward pressure on inflation. Of course, it is possible that inflation could move higher for other reasons, although the likelihood of this at the moment seems low. This means that a lot depends upon the labour market.

The recent data on this front have been encouraging. Employment growth has been strong, the vacancy rate is very high and firms’ hiring intentions remain positive. The latest reading of the wage price index also confirmed a welcome, but gradual, pick-up in wage growth, especially in the private sector.

Other indicators of the economy, though, paint a softer picture. We will receive another reading on GDP growth later this morning, but growth in the second half of 2018 was clearly less than in the first half. This is similar to the picture internationally. In a number of countries, including our own, there is growing tension between strong labour market data and softer GDP data. We are devoting significant resources to understanding this tension.

The Board will continue to assess the shifts in the global economy, trends in household spending and how the tension between the labour market and output indicators resolves itself. We have the flexibility to adjust monetary policy in either direction as required. There are plausible scenarios under which the next move in interest rates is up. There are also plausible scenarios under which it is down. At the moment, the probabilities appear reasonably evenly balanced. Given these various cross currents, the Board’s judgement remains that the most appropriate course is to maintain the cash rate at its current level.

Thank you for listening and I am happy to answer your questions.

Endnotes

I would like to thank Iris Day, Penny Smith, Andrew Staib and Andrea Brischetto for assistance in the preparation of these remarks. [*]

May D, G Nodari and D Rees (forthcoming), ‘Wealth and Consumption’, RBA Bulletin. [1]

APRA (2018), ‘Testing resilience: The 2017 Banking Industry Stress Test’, APRA Insight, Issue 3.

Financial Aggregates January 2019

Financial Aggregates January 2019

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Fusion Media or anyone involved with Fusion Media will not accept any liability for loss or damage as a result of reliance on the information including data, quotes, charts and buy/sell signals contained within this website. Please be fully informed regarding the risks and costs associated with trading the financial markets, it is one of the riskiest investment forms possible.

Safer banks for greater wellbeing

Safer banks for greater wellbeing

Increasing the amount of capital banks hold will improve the safety of New Zealand’s financial system and economic wellbeing, Reserve Bank Deputy Governor Geoff Bascand said today.

The Reserve Bank is currently consulting on a proposal to raise the minimum amount of capital that banks must hold. In a speech today Mr Bascand explained the proposal and the implications for banks and society. The speech was hosted by the Institute for Governance and Policy Studies at Victoria University, in Wellington.

“Ensuring the soundness and efficiency of New Zealand’s banking system is a core responsibility of the Reserve Bank. The proposal aims to make bank failures less likely, ensure that bank shareholders have a meaningful interest in their bank’s business, and are able to absorb a greater share of any loss if they occur” Mr Bascand said.

New Zealand has already experienced two banking crises in its modern economic history, and a wide variety of finance company failures and near misses. There has also been more than 140 banking crises around the world since the 1970s. The social and economic costs of these failures is severe, in terms of unemployment, health and the quality of life.

“We are proposing to make New Zealand’s banks safer by requiring them to use more of their own money to manage through good times and bad. More shareholder equity reduces the costs and risks for depositors and taxpayers, should something go wrong. This change goes a long way to improving the wellbeing of current and future generations of New Zealanders.”

“Capital is the single most important feature of the financial sector’s regulatory tools. Other tools such as disclosure and transparency requirements, governance and risk management practices, and regulator supervision all work better when bank owners have more skin in the game.”

Consultation closes on 3 May 2019.The Reserve Bank will consider all feedback before issuing final decisions in the third quarter of 2019.

Disclaimer:
Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. All CFDs (stocks, indexes, futures) and Forex prices are not provided by exchanges but rather by market makers, and so prices may not be accurate and may differ from the actual market price, meaning prices are indicative and not appropriate for trading purposes. Therefore Fusion Media doesn`t bear any responsibility for any trading losses you might incur as a result of using this data.

Fusion Media or anyone involved with Fusion Media will not accept any liability for loss or damage as a result of reliance on the information including data, quotes, charts and buy/sell signals contained within this website. Please be fully informed regarding the risks and costs associated with trading the financial markets, it is one of the riskiest investment forms possible.

Opening Statement to the House of Representatives Standing Committee on Economics

Opening Statement to the House of Representatives Standing Committee on Economics

Philip Lowe
Governor


Sydney – 22 February 2019

Chair

Members of the Committee

My colleagues and I welcome this opportunity to share our views on the Australian economy and the RBA’s important policy responsibilities. These hearings are an essential part of the accountability process.

Two weeks ago, we released our latest forecasts for the Australian economy. Our central scenario is for GDP growth of around 3 per cent this year and around 2¾ per cent in 2020. The outcome for the year just past is expected to be a bit below 3 per cent. These numbers are lower than the ones we were expecting at the time of the previous hearing in August.

By contrast, the labour market outcomes have been better than we earlier expected. When we met six months ago, we were not anticipating the unemployment rate to reach 5 per cent until 2020, but it has already been around that level for some months. The number of jobs created has also exceeded our earlier expectations. We continue to expect the unemployment rate to move lower over the next couple of years to around 4¾ per cent.

In terms of inflation, the recent outcomes have been a bit lower than we had been expecting. In the September quarter, childcare costs declined substantially due to government policy changes. And in the December quarter, petrol prices fell due to global developments, and a further decline is expected in the March quarter. In underlying terms, inflation is above its trough of a couple of years ago, but the pick-up is more gradual than we previously expected. By the end of 2020, inflation is forecast to reach 2¼ per cent.

Putting this together, our central scenario for 2019 is for growth of around 3 per cent, inflation of around 2 per cent and unemployment of around 5 per cent. In the broad sweep of our economic history, this is not a bad set of numbers. Indeed, in many years in the past four decades we would have welcomed such an outcome. It is important that we do not lose sight of this. The economy is benefiting from increased spending on infrastructure and a pick-up in private investment as capacity utilisation has tightened. The strong growth in jobs is also supporting spending, as is the sustained low level of interest rates.

Globally, the central scenario also remains a reasonable one. Inflation is low and unemployment in many advanced economies is the lowest in many decades. Recently, however, the focus has not been on this, but rather on the downgrading of forecasts for global growth by the International Monetary Fund and others. What sometimes gets lost, though, is that the latest forecast is for global growth to be around average, not below average. We need to remember that average growth at a time when unemployment is low is a reasonable outcome.

What is of more concern is the accumulation of downside risks.

There are two major areas of risk globally that the Reserve Bank Board has been keeping an especially close eye on.

The first is what I will broadly label as political risk. Here the list includes: the trade and technology tensions between China and the United States; Brexit; the rise of populism; and strains in some western European economies. It is hard to be certain how these various issues will play out. But it is conceivable that one or more of these risks crystallises in a way that damages confidence and the global economy. It is, of course, also conceivable that political leaders respond to the mounting economic risks in a way that restores confidence. Time will tell.

In working through the various possibilities, one issue that many people have focused on is the resilience of the global economy to a severe shock, whether it is generated in the political sphere or elsewhere. In many countries, both public and private debt levels are already very high. Real interest rates are also already very low. This means that there are fewer buffers in the global system than there once were. So there is less room to manoeuvre, although in a number of important dimensions the global financial system is more resilient than it used to be.

The second international risk we are monitoring closely relates to the Chinese economy. Growth there has slowed, probably by more than the authorities had been expecting. The economy is feeling the effects of the tensions with the United States and the squeezing of finance to the private sector as the authorities seek to rein in non-bank financing. The authorities have responded by easing policy in some areas, but they are walking a fine line between supporting the economy in the near term and addressing the debt problem.

Turning to the Australian economy, the Board has recently been paying particularly close attention to the strength of household spending and to developments in the housing market.

Household consumption accounts for almost 60 per cent of total spending, so what happens on this front is important. Recently, determining the underlying strength of consumption has been complicated by volatility in the consumption data in the national accounts, as well as notable revisions to the history of both consumption and household income. On balance, though, the available data suggest that the underlying trend in consumption is softer than it earlier looked to be and this has affected the outlook for the economy.

There are a couple of important considerations here. The first is the protracted period of relatively low growth in aggregate household income. The second is the decline in housing prices in our largest cities.

Since 2016, aggregate household disposable income has grown at an average rate of around 2¾ per cent per year. This is down from an average of 6 per cent over the preceding decade. It is plausible that households have responded to this extended period of weaker income growth by progressively downgrading their spending plans. For many people, it has become harder to see the lower growth in income as just a short-term development that can be looked through.

On this front, we are expecting better news ahead, with growth in disposable income forecast to increase. Wages are rising more quickly in almost all industries and in all states than they were a year ago. This is good news and we expect this gradual lift in wages growth to continue. Disposable income will also be boosted by the announced tax cuts. Faster income growth will support household spending. From a longer-term perspective, though, the key to boosting the real income of households is lifting productivity. I encourage you to keep examining ways to do this.

Looking beyond income growth, developments in the housing market can also affect overall spending. Lower turnover means less of the spending that occurs when people move homes. Declining housing prices also make some people feel less wealthy, so they spend less, although this effect doesn’t look to be very large. Lower housing prices are also associated with less construction activity. So these are the areas we are keeping a close watch on.

We do, though, need to keep things in perspective. The adjustments in the Sydney and Melbourne housing markets are occurring at a time of low unemployment, low interest rates and strong population growth. What we are witnessing is largely the working through of shifts in supply and demand for housing due to structural factors. In both markets it took a long time for supply to respond to faster population growth, so prices went up. And now that supply has responded, some of the earlier increase in prices has been reversed.

I understand that these swings in housing prices are difficult for some in our community. We should, though, take some reassurance from the fact that our economy and our financial system are resilient. This adjustment in the housing market is not expected to derail the economy. It will put our housing markets on more sustainable footings and allow more people to purchase their own home. So there is a positive side too.

I would now like to turn to monetary policy. The Reserve Bank Board has held the cash rate steady at 1½ per cent since August 2016. This is a stimulatory setting of monetary policy, which has helped support job creation and a gradual lift in inflation.

When we met with the Committee six months ago, I said that if further progress on achieving our goals of full employment and returning inflation to target is made, you could expect the next move in interest rates to be up, rather than down. I also said that the Board did not see a strong case for a near-term adjustment in the cash rate, given that the progress towards our goals was expected to be only gradual.

Today, the probability that the next move is up and the probability that it is down are more evenly balanced than they were six months ago. This shift largely reflects the change in the outlook for consumption that I have spoken about.

It is important to point out that we are still expecting further progress towards our goals. The unemployment rate is forecast to decline further and inflation to increase, although only gradually. If we do make this progress, it remains the case that higher interest rates will be appropriate at some point. But it is also possible that the economy is softer than we expect and that progress towards our goals is limited. If there were to be a sustained increase in the unemployment rate and a lack of further progress towards the inflation objective, lower interest rates might be appropriate at some point. We have the flexibility to do this if needed. We are not on a predetermined course.

The Board maintains its strong focus on the medium term and is seeking to be a source of stability and confidence. As was the case six months ago, it does not see a strong case for a near-term change in the cash rate. With monetary policy already providing considerable support to the Australian economy, it is appropriate to maintain the current policy setting while we assess developments. Much will depend on what happens in our labour market.

I would like to turn to some other issues now.

Some years ago, this Committee held extensive hearings into the foreign bribery issues at Note Printing Australia (NPA) and Securency. The legal proceedings against former employees of these companies were finally completed last November. As a result, the Supreme Court of Victoria lifted longstanding suppression orders. This allowed the RBA to disclose that in 2011 NPA and Securency entered guilty pleas to charges of conspiracy to bribe foreign officials between 1999 and 2004. We were also able to disclose that the two companies paid substantial fines and penalties, including under proceeds of crime legislation.

The Reserve Bank has sought to deal with this difficult matter as openly and transparently as possible. The corrupt and unethical behaviour that was uncovered runs counter to everything that we stand for.

A number of years ago, we sold our half share in Securency, the manufacturer of the polymer material the notes are printed on. Securency is now owned by a Canadian firm. NPA remains a fully owned subsidiary of the RBA and it prints Australia’s banknotes in Melbourne. The company has undergone a top-to-bottom overhaul of its governance arrangements and its business practices. I am confident that the company is operating to the very high standards that we demand and that it will continue to do so.

On a more positive front, over recent months, NPA has been printing Australia’s new $20 banknote. We are today releasing the design of the new note and it will be issued into circulation in October. It will have the same world-leading security features as the other new notes. It will also have three raised bumps along each edge to assist people who are blind or have low vision.

The new $20 note will continue to recognise two significant Australians: Mary Reibey and the Reverend John Flynn. Mary Reibey was a remarkable woman. She arrived in the colony of New South Wales in 1792 as a 15-year-old convict. Then, through hard work and determination, she rose to become one of the colony’s most successful entrepreneurs. And John Flynn is best known for establishing what we know today as the Royal Flying Doctor Service. This service has helped countless Australians and is now the largest aero-medical service in the world. We are very proud to celebrate the enterprise and ingenuity of these two Australians on the $20 note.

The Reserve Bank also continues to work on the upgrading of Australia’s electronic payments system. We want to see a system that is reliable, secure and efficient, and meets the needs of Australians. It is one year now since the New Payments Platform (NPP) was launched. Over 2½ million Australians have registered PayIDs and the banks are progressively adding functionality to the system. Many people are already benefiting from faster and more flexible payments. We have, however, been disappointed that some of the major banks have not met the originally agreed timelines. This delay has, regrettably, slowed the pace of innovation in the overall system, given the substantial network effects that exist in payment systems. Late last year, I wrote to the CEOs of the major banks on behalf of the Payments System Board expressing our concerns and seeking a commitment that the updated timelines will be satisfied. It is important that these commitments are met. Notwithstanding these delays, I remain confident that the NPP will provide the backbone for substantial innovation in Australia’s payment system for years to come.

Thank you very much. My colleagues and I are here to answer your questions.