Econosights - The turnaround in the Australian housing market and implications for macroprudential policy

Introduction

Monetary and fiscal policy are the two main levers used by policymakers to influence the economy. But, macroprudential policy has also been gaining popularity as an additional policy tool to offset some of the risks created by low interest rates.

Macroprudential policy deals with managing financial stability risks which usually means limiting credit and debt growth, tightening lending standards and increasing bank regulation. In this Econosights, we look at the main issues related to macroprudential policy in Australia.

Australia and macroprudential policy

In Australia, the Australian Prudential Regulation Authority (APRA) is in charge of administering macroprudential regulation, with the RBA also involved in consultations. From 2013 to 2016, interest rate cuts and housing undersupply (predominately in New South Wales and Victoria) were fuelling rapid home price growth. The regulators were concerned about the huge lift in investor lending and the sharp rise in interest only loans. From late 2014 onwards, APRA introduced various macroprudential tools to combat these risks in the housing market including: limiting banks’ investor loan growth, introducing a minimum 7% interest rate when assessing new loan serviceability, more scrutiny on loan applicants expenditure based on average household expenditure and overall debt levels, increasing capital buffer requirements for banks and limiting interest-only lending. The progressive use and tightening of macroprudential policy over 2014-2017 was a significant contributing factor behind the slowing in housing prices and credit growth (especially for investors) – see chart below.

Macroprudential tightening significantly reduced the proportion of “risky” interest only loans which fell from around 40% of total loans at their peak in 2015 to around 24% (see chart below).

In 2017, APRA started to remove some of the limits on investor lending limits and moved more towards more sustainable qualitative lending controls through scrutinising household expenditure and total debt holdings. In May, APRA removed the minimum interest rate serviceability measure (which increased borrowing capacity for households by ~10-15%). Despite this change, lending standards are still tighter than a few years ago.

The recent housing cycle in Australia

Australian home prices bottomed in June this year following RBA interest rate cuts, some softening in lending standards and the re-election of the Liberal government which removed the risks around changes to capital gains tax and negative gearing. Since then, home price growth has accelerated in Sydney and Melbourne (see chart below) and is currently running at an annualised pace of around 20%, which has led to concerns of another unsustainable housing upswing and a further build-up in household debt. Home prices are likely to continue rising while the RBA is cutting interest rates (and probably starting quantitative easing next year). But, tight lending standards, low foreign demand for housing and a weaker economic environment (we expect the unemployment rate to rise) should limit home price growth. Our view is of national home price growth of around 5% after this initial bounce has run its course.

What types of macroprudential tools could be used down the track?

Macroprudential policies used over recent years in Australia have mitigated risks associated with lending to investors. Investor-dominated lending tends to be considered risky because investors are generally more leveraged, more likely to take out interest-only loans and are more likely to exit the housing market in times of stress which can exacerbate housing downturns. However, to offset these risks, Australian housing investors generally have higher incomes and wealth positions and use interest-only loans for their tax strategies. The current upswing in home prices does not appear to be driven by investors yet (see chart below).

At the moment, the more worrisome part of the Australian housing market is overall high household indebtedness (which is mainly housing debt) currently at 190% of household disposable income, which is extremely high compared to global peers (although it has been high relative to the rest of the world for a while – see next chart). This level of housing indebtedness has raised concerns that APRA could introduce debt-to-income (DTI) caps or even restrictions around high loan-to-value ratio (LVR) loans. The highest risk loans with debt levels six times or more above incomes make up a small amount (around 15% of new loans) while less than 10% of new loans have an LVR ratio above 90% and the proportion of these risky loans has generally been declining over the past few years.

We think APRA imposing specific DTI or LVR caps is unlikely. High household debt is an issue if home loan serviceability is unsustainable. But this is not really an issue in Australia (see chart below). Interest payments as a share of disposable income have been stable at 9% for years and are unlikely to rise while interest rates are being cut.

Imposing restrictions for DTI or LVR levels would help to reduce housing debt levels but it would also create unnecessary distortions in the market by excluding first home buyers (who are already facing enough difficulties), single person households and buyers who are trading up. Inequality issues could also be created as borrowers with means to draw on funds get around the rules. Tightening lending standards further (by additional analysis over borrower expenses and total debt holdings) or bringing back a minimum interest rate measure for serviceability would benefit financial stability, as much as DTI or LVR cap with less market distortions. The risks for financial stability from here are mainly down to household serviceability and how it would react to a deterioration in the economic environment, particularly given that wages growth is low (at just over 2% per annum), the unemployment rate is likely to drift a little higher (to around 5.5% over the next few months) and a high proportion of the labour force is still underemployed (at around 13.5%). While housing arrears are currently low at less than 1% of all loans, they could drift up if the employment market (and related wages growth) deteriorates. APRA should focus on further strengthening lending standards when assessing individual borrower serviceability as its main macroprudential instrument.