Australia's medium term economic prospects have become increasingly uncertain.
There are any numbers of factors responsible for the current predicament including, but not limited to, the following:
- The failure to address systemic imbalances in the housing market
- The RBA's monetary policy conundrum
- The failure to adopt necessary structural changes in labour markets
- Changes in Government policy that fail to provide business with certainty
- Poor Government policy that has caused spiralling debt and falling taxation receipts.
In this quarterly update, we will focus on the first two issues. The remaining issues warrant a separate discussion in a future edition.
Failure to address systemic imbalances in the housing market:
Australians have a fixation on residential property. This fixation has created significant wealth for many investors who have capitalised on booming prices over the last few decades. But as in physics, every action has an equal and opposite reaction. With the winners come many losers. The average new mortgage in Australia is now $443,000, and in NSW $544,000. In Sydney the average property price now equates to around 9 times average household income, up from around 4 times 20 years ago. The sheer size of the new mortgages has meant that a disproportionate percentage of household disposable income is now allocated towards paying off a mortgage and therefore less is available to spend on other areas such as food, retailing and entertainment.
Of course while not everyone has a large mortgage, the percentage is not insignificant and this alone creates a powerful drag on economic growth. In theory this drag should only last until the net decrement from spending caused by the large mortgage is eroded by rising wages or falling interest rates. As we have seen in recent years, interest rates have fallen but instead of homeowners spending this windfall, the average mortgage holder has simply maintained their mortgage repayments rather than reducing them. This is largely why the string of interest rate cuts have not translated into much stronger retail sales figures and instead has kept the economic measure known as the Savings Ratio higher than it otherwise would be.
If we haven't seen any significant uplift in discretionary spending when interest rates have been falling and are at historic lows, it is not difficult to imagine the impact on heavily indebted household budgets if interest rates start to rise again.
Of course high mortgages are simply a by-product of high house prices, which is mainly a function of the lack of supply. The only way for household debt to fall to more manageable levels is for house prices to fall. This can only occur if we see a significant increase in supply of properties to offset demand so that we see both a fall in prices and rents. In theory market forces should solve this problem as developers take advantage of high growth (and high profits) by building more dwellings (typically apartments) until supply catches up with demand and prices settle back to more normalised levels. The good news is that this is finally beginning to happen in Melbourne and Brisbane where rampant apartment development has caused a sharp increase in supply. Unfortunately this is less evident in Sydney, in part due to the protracted planning approval process which blows out holding costs (if a developer buys a block of land it might takes years before they can start construction and they are losing money in the meantime by paying interest for no return). The other impediment has been the risk averse banking sector, which has often demanded a high level of pre-sales before it has been willing to commit funds to new developments (a legacy from the property development failures experienced in the late 80's/early 90's when interest rates (%) were in the mid–teens). Government policy that alleviates these issues would certainly help.
In summary, low interest rates have fostered a sharp rise in housing prices and mortgages that has led to below trend levels of household consumption, creating a drag on growth. Supply needs to continue to build, certainly in Sydney, to address the demand equation. Unfortunately there is no easy answer. In the long run, the economy would be better off with house prices 20% or lower than they are today. A sharp fall of that magnitude, however, would almost certainly cause a severe recession, so the best case scenario is a gradual fall (a soft landing) over an extended period of time.
The RBA's conundrum
The RBA continues to face a dilemma as it tries to encourage business investment by lowering interest rates and the exchange rate. At the same time the RBA is mindful of the property boom (chiefly in Sydney and Melbourne) and remain concerned that lowering interest rates will only fuel the bubble that has emerged. To date, it has decided to err on the side of business and ignore the potential perils caused by excessive household debt, but this approach may not end well (to be fair, the RBA was hoping that APRA would have required banks adopt more stringent macro-prudential measures to quell demand).
On a positive note the reduction in interest rates along with the sharp fall of commodity prices has helped the exchange rate fall, which has clearly been a boon for import competing manufacturers and service providers as well as tourism. In addition, the reduction in interest rates has forced investors seek higher yielding (and hence higher risk) alternatives such as property and shares. This has increased household wealth.
Unfortunately the succession of interest rate cuts has to date failed to stimulate any real improvement in business investment and this would be of concern to the RBA. Companies will only invest if they are confident that demand for their products or services will improve sufficiently to warrant the increase in productive capacity. This confidence clearly requires reasonable clarity about the outlook and stability on government policy, both of which are arguably lacking at the moment. Nevertheless, the historical correlation between low rates and higher investment is moderately high and so optimism remains that eventually an improvement will occur.
The most dangerous aspect of the abnormally low interest rate environment is the damage that it can do to future savings intentions. If individuals think that interest rates will stay lower for longer it can create two types of behaviours. The first behaviour of encouraging greater risk taking has been borne out by strength in domestic share markets. Investors are cashing in their term deposits and investing in higher yielding shares. This is the behaviour that the RBA wants to encourage but this is inherently dangerous as it causes asset bubbles (evident in the Sydney/Melbourne property markets and developing in pockets of the sharemarket). The second behaviour is potentially even direr as it encourages investors to save even more than they normally would. As an example, a household who spends $50,000 per annum will need to save about $1 million when interest rates are circa 5% before they retire. If interest rates are at 2%, that same household will need to save $2.5 million to generate the same risk free income stream. So low interest rates don't always generate more consumption, indeed, where individuals are risk averse, it actually encourages them to consume less. Just ask the citizens of Japan and much of Europe.
In the short term, the stimulative impact of low interest rates coupled with positive momentum in residential construction should remain broadly supportive of growth. Beyond 12 months, the outlook is very uncertain given the divergent forces at play. We will continue to monitor developments as they unfold.
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