Ric Battellino: An update on household finances
Speech by Mr Ric Battelino, Deputy Governor of the Reserve Bank of Australia, at the 7th
ITSA Bankruptcy Congress, Sydney, 30 October 2008.
* * *
The extraordinary developments in global financial markets over the past couple of months
have, understandably, undermined households' confidence in their finances. This has
occurred around the world.
•
Households have seen incredible volatility in financial prices. Daily movements in
share prices of several percentage points have become the norm.
•
Share prices have fallen sharply around the globe. In Australia, the share market is
down about 40 per cent in 2008, resulting in negative returns in most individuals'
superannuation funds.
•
The difficulties in global interbank markets which had existed since August 2007
took a dramatic turn for the worse last month. The crisis, which had until then been
largely confined to wholesale markets, spilled over into a severe loss of confidence
among retail investors in financial institutions. Governments around the world have
been forced to offer wide-ranging guarantees on banks' liabilities.
•
And, to top it off, some commentators are predicting sharp falls in house prices here
in Australia.
Given the daily barrage of gloom and doom, it is easy for households to lose perspective, so
I thought it would be useful to take an objective look at the state of household finances. In
doing so, I will focus on three key areas:
•
household income;
•
household balance sheets; and
•
the housing market - in particular, is the Australian housing market going to go the
same way as the US market?
Household income
The first thing to say about household income is that the past five years have been an
extraordinarily favourable period. Real disposable income of the household sector grew on
average by 6.1 per cent per year, resulting in a cumulative increase over the five years of
more than 30 per cent. One has to go back more than thirty years to find a bigger increase
over a five-year period.
Table 1: Real Household Disposable Income
Average annual percentage change
Before interest After interest
1963-1968 4.6 4.5
1968-1973 5.8 5.6
1973-1978 3.1 2.7
1978-1983 2.6 2.2
1983-1988 2 1.8
1988-1993 1.7 2.1
1993-1998 3.1 3
1998-2003 3.2 2.9
2003-2008 6.1 4.8
Deflated using the household consumption deflator; dates refer to financial
years.
Source: ABS
Periods of strong income growth tend to be periods of strong spending and it is the job of
central banks to try to keep a lid on this, to prevent excessive inflation. The past five years
were therefore also a period of rising interest rates. Some commentators would have us
believe that this had a crippling effect on the finances of the household sector. While some
households were no doubt severely affected, the facts show that this was not the case for the
sector as a whole. Even after allowing for higher interest payments, real household
disposable income over the five years still increased by more than 25 per cent. This
increase, too, was the largest since the early 1970s. Put another way, over the past five
years, the amount of money that Australian households had left over to spend, after paying
taxes and interest on all their loans, grew in real terms at the fastest rate in over 30 years.
What contributed to this surge in incomes? As usual, there were a number of factors at work:
•
wage and salary income grew strongly, at about 71⁄2 per cent per annum on average;
•
income from investments grew by 17 per cent per annum on average. This was due
to high dividends on shares and interest on deposits. This figure does not include
the very strong capital gains on shares, which I will come to later;
•
taxes payable grew less than income because we were given a series of tax cuts.
This meant that disposable income grew more quickly than gross income (8.3 per
cent per annum on average); and
•
inflation (as measured by the consumption deflator) ate up 2.2 per cent per annum
of this income growth, leaving growth in real disposable income at the figure of
6.1 per cent mentioned earlier.
This growth in household incomes in Australia greatly exceeded that in any other developed
economy. In the US, for example, growth in real household disposable income was only
about half that in Australia.
It is also interesting to note that the growth in income in Australia was fairly evenly distributed
through the household sector. The percentage increase in real income was very similar
across all the income quintiles.
In short, the boom in income in Australia was very strong by world standards and a high
proportion of Australian households shared it.
These facts help us to understand how we got to where we are, but the more relevant
question for households is: where are we heading over the coming five years?
I think it is now widely accepted that growth in real incomes over the next year or two will be
more subdued than over the past five years. How subdued will depend importantly on the
effects of the financial turmoil. Nobody knows how significant they will turn out to be but it
would be reasonable to assume that income growth for the household sector will be
noticeably below average over the next year or two.
Beyond the next couple of years, the future is harder to predict, but there is no reason at this
stage to doubt that past patterns will be repeated and that growth will pick up again. Australia
remains, after all, a very dynamic economy.
The outcomes in Australia will, as usual, be influenced to some degree by global
developments. At present, the major developed economies seem to be moving into
recession, as they tend to do every seven to ten years. The last such recession was in 2001,
so the one that is emerging at present seems to be pretty much on cue.
The Bank has been factoring weaker global economic growth into its policy assessment for
much of this year. Throughout this period, we have been forecasting lower growth than the
major international forecasters. Even so, the events of the past couple of months have
caused us to revise our forecasts down further.
Australia managed to sidestep the 2001 global recession. Can it do that again?
That is certainly what we are aiming for, and there is nothing in the data to date to suggest
that we are off track. But the economy is being affected by powerful forces from different
directions, and it is unclear what the net effect will be. The impact of global developments is
particularly uncertain.
We also have to recognise that the task of managing the economy this time will be more
difficult than in 2001 because we are starting with a bigger inflation overhang. The Bank has
for some time thought that inflation would peak in the second half of 2008 and then fall;
accordingly, we have acted pre-emptively in reducing interest rates. Nonetheless, there is
still a big task ahead to bring inflation down and this could limit room for manoeuvre on
monetary policy.
Many people will be disappointed and unhappy with a year or two of below-average
economic performance. But the truth is that the economy cannot always grow above average
and it certainly cannot maintain the pace of the past five years. If we attempted to make it do
so, we would be repeating the mistakes of our predecessors in the 1960s, whose attempts to
maintain a never-ending boom laid the foundations for the subsequent two decades of
severe economic difficulties.
One of the factors that helped keep Australia from following the developed economies into
recession in 2001 was our increasing links to Asia, and China in particular. These links have
strengthened further since 2001, with China now Australia's largest trading partner.
It would be naïve to assume that China will not experience an economic cycle, so we should
expect its demand for our resources to fluctuate. However, China's strong long-term growth
potential must be a source of optimism about our own long-term prosperity, given our role as
one of its most important suppliers of raw materials.
Household balance sheets
I would like to turn now to household balance sheets.
Australian households have much bigger holdings of financial assets than financial liabilities.
Financial assets at 30 June averaged around $275,000 per household while liabilities
averaged $150,000 per household. Since then, we estimate that average assets have fallen
to around $245,000 per household, though this is still quite a strong position.
Graph 1
The composition of assets and liabilities is very different.
•
The liabilities consist mainly of borrowings from banks and other lenders where the
value is fixed and on which regular interest has to be paid.
•
Household financial assets, however, consist mainly of market-linked investments.
This balance sheet structure is very favourable in terms of maximising long-run accumulation
of wealth, because the return on these assets over long terms exceeds the cost of debt by a
substantial margin. The returns do not, however, accumulate evenly from year to year. Some
years produce very strong returns while others produce negative returns.
We are currently going through one of those periods of negative returns. As I mentioned, the
Australian share market has fallen sharply this year. Largely because of this, the typical
balanced superannuation fund experienced a negative return of about 8 per cent last
financial year. Returns are again negative so far this financial year.
Naturally, people find this very distressing. But it is not the first time this has happened. Over
the past 100 years, the share market on average has had negative returns every 5 years.
Graph 2
While the sharp fall in share prices since late last year is confronting, the thing that needs to
be kept in mind is that it was preceded by four years of extremely strong returns. As such,
even after this year's fall, anybody who has held shares over the past five years would still
have earned 8 per cent a year on average. That is still more than the return on government
bonds or bank deposits over the period.
Graph 3
The uneven pattern in share market returns partly reflects the economic cycle and partly
reflects the influence of human behaviour. As investors, we find it difficult to distinguish the
cycle from the trend. In particular, after a few years, a cyclical upswing starts to look like a
trend and more of us try to jump aboard. Eventually this pushes asset prices to levels that
are higher than can be justified by the income produced by the asset, and prices correct
down.
Investments in shares tend to compensate the holder for the short-run volatility in returns by
producing higher returns over the long run. If they did not, nobody would invest in them.
These higher returns can compound to very large amounts over time.
Graph 4
As an illustration of this, assume somebody had $100 (in today's money) to invest 100 years
ago:
•
If they put this in government bonds, and assuming all the interest was re-invested
in bonds along the way, the investment would today be worth about $800. This is an
annual real return of 2 per cent.
•
If they put it in the Australian share market, and again assuming that all dividends
were re-invested in shares, it would today be worth about $130,000. This is an
annual real return of 7 per cent.
The difference between these two rates of return - 5 percentage points per year - is the risk
premium that investors have received for investing in the share market.
At present, the risk premium is higher than this because investors have become very
nervous. The increase in the risk premium demanded by investors has been an important
factor causing share prices to fall in recent months. The one-year forward earnings yield on
Australian shares has risen to 11 per cent, well above the long-run average. This is a very
attractive yield. When the yield has risen to these levels in the past, the return on shares over
the subsequent 10 years has almost always been well above average.
The housing market
Finally, I would like to make a few comments about the housing market.
Some commentators who have looked at the US housing market feel they have seen the
future for the Australian market. In some ways, this is understandable because economic
developments in Australia have in the past often mirrored those in the US.
As you know, the ratio of housing costs to income has been unusually high in recent years
and it is not unreasonable to expect that it will decline over time. But this ratio can adjust in
several ways: lower house prices, rising incomes or falling interest rates. In the US, falls in
house prices have been a big part of the adjustment. I think there are reasons, however, to
believe that the Australian housing market will not follow the US market to the same degree.
Let me run through some of these reasons.
First, the cycle in the Australian housing market, rather than following the US market, is in
fact at a more advanced stage; it is probably leading the US market by three years or so. The
Australian housing market was at its hottest in 2003, whereas the US market peaked in
2006.
To understand how this came about, it is necessary to look back to the second half of the
1990s. The tremendous shift in the global savings/investment balance that followed the
Asian crisis generated a surplus of funds in global markets. The financial sectors in the
English-speaking countries, being more dynamic and responsive than in many other
countries, were quick to take advantage of this. In the US, the early part of this period
coincided with a surge in technological innovation, and the initial wave of money in that
country went to the technology sector. This resulted in the "tech" bubble, which eventually
collapsed in 2000.
Australia did not have much of a technology-producing sector so our financial institutions
sought out other investment opportunities. What Australia did have was a conservative
household sector with relatively low gearing. As such, the financial sector saw opportunities
for financial innovation aimed at encouraging households to make greater use of their
borrowing capacity. Most of this was focused on housing lending.
The result was that the boom in housing in Australia got underway well before that in the US
the latter did not really get going until after the tech bubble collapsed.
A second difference relates to the dynamics of the housing markets in the two countries. In
the US, the rise in house prices elicited a very strong supply response so that, by the end of
2007, there was almost one-year's supply of newly built unsold houses overhanging the
market. US house prices stopped rising essentially because the supply of houses overtook
demand.
Graph 5
Here in Australia the rise in house prices did not elicit such a strong supply response. There
were pockets of overdevelopment in apartments in 2003/04 but, by and large, there was
never a serious oversupply of unsold new houses in Australia. In fact, the consensus is that
there is currently a shortage of dwellings.
The Australian housing boom ended because prices rose to levels that severely strained the
financial capacity of buyers to pay higher prices, not because too many houses were built, as
in the US.
The overhang of unsold houses in the US has created downward pressure on house prices
as builders and developers have been forced to sell. This is absent in Australia. Rather, the
shortage of housing here means that there are buyers waiting for better circumstances - e.g.
lower interest rates or rising incomes - to facilitate their entry to the market. This latent
underlying demand for housing is a factor that will support the market.
A third important difference between Australia and the US is in the groups that the lenders
targeted, and in the loan terms on offer. In Australia, the lending boom was concentrated on
existing home owners who traded up to bigger and better houses and bought investment
properties. Many of these were people in their 40s and 50s who previously had low levels of
debt. At the end of the boom, the home ownership rate in Australia was no different to that at
the start; in both cases about 70 per cent.
While one could argue that no socially productive purpose was served by this increased
lending to middle-aged existing home owners, it did mean that the loans largely went to
those who had a strong capacity to service and repay them. As a result, whereas most other
countries with housing booms have experienced a strong rise in arrears on housing loans
once the boom ended, in Australia the arrears rate is today no higher than it was at the start
of the boom in the mid 1990s. And, of course, it is low by international standards.
Graph 6
In the US, in contrast, a lot of the lending found its way to more marginal borrowers who
previously could not afford a loan, or it took the form of aggressively structured mortgages
which allowed people to borrow much more than they previously could. The home ownership
rate in the US continued to rise during the first years of the boom. One could argue that this
was a good thing, but one consequence was that a significant proportion of this group ended
up having trouble servicing their loans; hence, the sharp rise we have seen in US loan
delinquencies.
In setting out these differences, I don't want to leave the impression that the Australian
housing market is without its problems. There is no denying that there is a significant number
of people who are facing difficulties with housing loan repayments, especially in western
Sydney where arrears rates are significantly higher than in other parts of Australia.
While lending standards in Australia did not deteriorate to anywhere near the same extent as
in the US, loans sourced from new, non-traditional lenders have ended up with higher rates
of arrears than those of traditional lenders. The arrears, even on prime, full-doc loans made
by this new group of lenders are three times higher than those on similar loans sourced from
the major banks. In addition, a higher proportion of loans granted by these lenders were
lowdoc or non-conforming, the arrears rates on which are significantly higher than those on
prime loans. One can only conclude that these lenders had lower credit standards than
traditional lenders, and while this may have benefited some borrowers, it has ended up
causing significant hardship for others.
Graph 7
One of the issues that has been highlighted by events in the US is the importance of having
adequate regulation of lending and loan brokers. In Australia, all lenders were covered by the
Uniform Consumer Credit Code but loan brokers were much more lightly regulated, until very
recently. The Council of Australian Governments earlier this year recognised that regulation
needed to be strengthened and agreed to transfer responsibility for the regulation of all
consumer credit to the Commonwealth. This is due to take effect by the middle of next year
and should ensure that regulation of this very important financial activity is put on an even
sounder footing.
Conclusion
We are going through some uncertain financial times at present, which is leading some to
question whether the period of prosperity that has been running for almost two decades has
come to an end.
While nobody can predict accurately all that lies ahead, it is important not to become too
pessimistic because, fundamentally, household finances and the economy more generally
remain in good shape. The main problem that had built up - inflation - is manageable and is
being dealt with.
The next couple of years will be noticeably more subdued than the past five. We should not
be surprised by this as the income and wealth generated over the past five years were
simply extraordinary.
By definition, the economy must grow at a below-average pace for some of the time. These
periods provide the economy with the breathing space to sustain the expansion. There is no
reason to assume that the next year or two will not do the same.