A global indicator that correctly picks four out of five financial crises says Australia's OK -- for now

Photo: Getty / File.
  • Research from Capital Economics explains how a moderation in house prices can assist broader financial stability.
  • The findings are based on threshold tests used by the Bank of International Settlements, to determine financial crisis risks for a given country.
  • Economist Paul Dales said risks still remain if house prices could fall sharply or if domestic banks tighten lending standards.

The downturn in Australia’s housing market has been one of the central economic themes of 2018.

But research from Capital Economics shows that for a given point in the market cycle, a moderation in house prices can help to assist economic stability.

The findings are outlined by CE’s chief economist Paul Dales in a research report on whether Australia faces a looming financial crisis.

Dales highlighted three indicators used by the Bank for International Settlements — known as the “central bankers’ central bank” — to determine whether a country is at risk of a financial crisis.

The most important indicator is defined as the share of disposable income used to meet principal & interest repayments on all types of home loans.

The other two indicators used by the BIS are:

  • Private sector credit, calculated as the debt-to-GDP ratio of total household debt plus corporate leverage (excluding banks); and
  • The speed at which domestic banks are borrowing money overseas in foreign currencies.

All three measures use a threshold, calculated via growth rates compared to trend.

When the thresholds are breached, it spells danger. And the BIS analysis has a pretty strong success rate with only one false call for every five correct ones.

But there’s a fourth indicator which effectively forms the basis that the other three measures are calculated from.

Quite simply, it’s defined as “the change in real residential property prices relative to the long-term trend”.

Here’s Dales on why it’s so important:

On its own this isn’t as good a warning sign as the others. But because of the way property prices interact with the banking system and the economy, when its danger threshold is breached it lowers the danger thresholds for the other indicators. So a large boom in house prices isn’t necessary to cause a financial crisis, but it does increase the chances of one.

The multi-year rise in prices pushed the house-price indicator close to its threshold, but the recent declines have seen it ease back:

Source: Capital Economics

“Interestingly, had the property threshold been breached last year, then all the other indicators would now be flashing red as they would be above their lower thresholds” Dales noted.

The results are perhaps reflective of how a slowdown in house-price growth can help to offset the risks factors that lead to a more systemic financial crisis.

Of course, if house prices fall too far it presents a different set of financial risks.

“A large fall in house prices could plausibly trigger a recession or a financial crisis if it meant that banks’ assets were hit by a rise in mortgage defaults,” Dales said.

“That could happen if the soft housing market resulted in the economy being weaker and unemployment being higher or if lower prices led some homeowners in negative equity to walk away from their loans.”

Dales pointed to previous Capital Economics research which said that if the housing downturn becomes more entrenched, home values in Sydney and Melbourne could see price falls of 25-30%.

He also cited potential triggers in the form of a credit crunch stemming from tighter bank lending standards, and the risks posed by rising interest rates.

However, based on the findings from the BIS ratios, “if there was going to be a financial crisis, it should have happened during the GFC. And it appears that the risk isn’t as grave now”.

He attributed the relative stability to actions taken by domestic regulators in recent years, such as last year’s cap on interest-only lending which served to tap the brakes on property markets — notably in Sydney and Melbourne — that were in danger of overheating.

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