by
Christopher Joye - AFR
With the world's leading credit rating agency warning this week that it will
potentially downgrade all Australian banks — and the nation's sovereign rating — unless the housing market's crazy momentum cools fast, it's beyond time for the Reserve Bank of Australia to reverse its 2016 mistakes.
If governor Philip Lowe ran money at a hedge fund, he would be forced to cut his losses and accept that the logic the RBA used to rationalise its May and August rate reductions was wrong (
as we warned ad nauseam).
The two main reasons the RBA felt it could further debase borrowing costs were: first, because it thought the housing market was already cooling (erroneously claiming house prices fell in July); and, second, that its rate cuts would not reignite the boom that it launched in 2013. Both assumptions proved faulty.
Between January 1 and April 31, 2016, Australian capital city home values appreciated at a frisky 8.1 per cent annual pace (after removing the April jump in CoreLogic's index when it upgraded its sales sample, which is the largest of any index provider). In the 10 months since April 2016 (or following the RBA's May cut), price growth has accelerated to 10.4 per cent a year. Strike one.
Just as the Australian Prudential Regulation Authority's 2015 constraints on credit creation were starting to mitigate the irrational exuberance, the RBA injected borrowers with another double dose of adrenalin.
And yet in September 2016, Lowe advised parliament that "the two interest rate cuts we have had this year do not seem to have stimulated a new round of house price increases".
The RBA's bubble-blowing is clearly borne out in auction clearance rates, which are one of the best proxies for real-time conditions. Last weekend the national clearance rate hit 79 per cent compared to 72 per cent at the same time a year ago. The weighted-average 74 per cent clearance rate across all capitals in the six months to February 2017 (since the RBA's latest cuts) is likewise materially above the 66 per cent average over the six months to February 2016 (before the moves). Strike two.
The final blow to the RBA's case has been the subsequent surge in speculative lending, which had been moderating before the May cut. This week Goldman Sachs highlighted that in January 2017 "investor housing credit continued to rise…with the sequential momentum reaccelerating sharply in recent months (the three-month annual rate is 8.8 per cent)".
"With house prices also reaccelerating, auction clearance rates in Sydney and Melbourne back to record highs, and investor finance approvals up 27 per cent in eight months, we believe investor credit dynamics are increasingly problematic from a financial stability perspective," Goldman said.
The boom's new lease on life coincides with an economy that is reaccelerating. In the December 2016 quarter, Australia recorded the biggest trade surplus since 1979 care of elevated export volumes and soaring commodity prices. On Wednesday the performance of manufacturing index leapt to its highest level in six years, one point away from an 18-year record. Capacity utilisation is also at an eight-year peak, implying wages growth has passed its nadir.
Finally, we learned this week that the economy has been expanding more rapidly than economists and the RBA assumed, with the 2.4 per cent GDP growth over 2016 significantly stronger than 2.0 per cent consensus forecast.
The odd man out is Australia's "emergency" 1.5 per cent cash rate, which is exactly half the 3 per cent trough the RBA thought appropriate during the darkest days of the global financial crisis.
While the 2016 cuts were predicated on analysis that has been invalidated by the passage of time, they have had deleterious consequences. Unsustainably strong property price and housing credit growth are the factors pushing Standard & Poor's to seriously consider downgrading both Australia's AAA credit rating and all our bank ratings, which would undermine the security and stability of our capital-importing nation.
The good news is that there is an easy fix.
The RBA can staunch the housing heat with a single rate hike by mid-year. Timed after the US Federal Reserve likely lifts its own cash rate in March, the RBA would not have to fret about excess currency appreciation. It is fond of moving in "double taps" on the presumption that one cash rate change does not do much. But this thinking is founded on research made redundant by the fact that Australia's household debt-to-income ratio (and the interest elasticity of consumer behaviour) was much smaller in the past than it is today (the ratio was 125 per cent in 2000 compared to 187 per cent in 2017).
The next monetary policy tightening cycle should, by definition, be more cautious. A single hike by mid-year would keep credit risks (and rating agencies) at bay and could be followed by another at year-end if borrowers need further convincing that the cost of capital has to normalise eventually.
A second hike might be unnecessary if banks top up the first, which would be justifiable given APRA is remaining vigilant in its efforts to reduce leverage in our financial system.
On Tuesday S&P warned that it thinks "there is a significant risk of continued build up of private sector debt and house price growth because several important factors driving growth in these two metrics are likely to persist — including low interest rates [and] a relatively benign economic outlook".
S&P threatened that it would downgrade the banks if it there is "a trend toward private-sector debt growth of more than five percentage points compared with GDP growth, or inflation-adjusted house prices growth of more than 4 per cent".
That is 6 per cent house price growth in nominal terms, which is well below the current double-digit pace. The decision will be made before October, which is why the RBA cannot waste time prevaricating.
S&P also said it believes APRA's "recent communications [are] indicative of a likely announcement in the short term of an increase in regulatory capital requirements for the banks".
Confirming this column's analysis, S&P stated that "for one or more of the major Australian banks, the increase in regulatory capital requirements could be enough to push their capital ratio under S&P Global Ratings' framework to greater than 10 per cent, which could be enough to alleviate...emerging pressures on...creditworthiness".
The capital shortfall S&P quantified was $16 billion, in line with our estimates. The task will, however, be made much more difficult — to the tune of an extra $24 billion — if S&P lifts Australia's economic risk score due to our house price growth quadrupling incomes.
Deleveraging the big four remains an important policy goal in light of the Basel Committee disclosing this week that the 75th percentile non-risk-weighted equity ratio among the top 100 global banks is now 7 per cent, way above the majors' internationally harmonised 5.75 per cent level.
Phil Lowe earned his reputation on research advocating that central banks use interest rates to lean against asset price bubbles that threaten financial stability. The RBA has done the exact opposite. It's time to back the rich rhetoric with action.
The author is a portfolio manager/director of Coolabah Capital Investments and Smarter Money Investments, which invest in fixed-income securities.
Read more:
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