Reserve Bank of Australia governor Phil Lowe has warned Australian banks have been issuing too many loans “where the borrower has the skinniest of income buffers”, in a speech that highlighted increasing concern among the nation’s top financial policymakers about household debt levels.
Lowe said that while households “are coping reasonably well with the higher debt levels”, the low levels of wages growth are making it hard for people to get ahead on their mortgages, stretching household budgets.
He said the foundations of the surge in house prices had been laid by supply shortages and a failure to invest in infrastructure, but that this had been exacerbated by the offering of interest-only loans to investors and by the tax treatment of such investments.
as is often the case in economics, it largely comes down to supply and demand. On the demand side, population growth in Australia – especially in our largest cities – picked up unexpectedly in the mid 2000s and it is only in the past couple of years that the rate of home building has responded. This imbalance was compounded by insufficient investment in the transport infrastructure needed to support our growing population. Nothing increases the supply of well-located land like good transport links. Underinvestment in this area is one of the factors that has pushed housing prices up. Put simply, the supply side simply did not keep pace with the stronger demand side. The result has been higher prices.
Not surprisingly, the rising prices have encouraged people to buy residential property as an investment in the hope of ongoing capital gains. With global interest rates so low, many investors have found it attractive to borrow money to invest in appreciating residential property. This has reinforced the upward pressure on prices.
Lowe revealed the combination of higher debt levels and rising house prices had been “discussed at length” by the Council of Financial Regulators, the high-powered committee which Lowe chairs as the RBA governor and also includes the heads of Treasury, the banking regulator APRA, and the corporate regulator, ASIC.
“The concern has not been that these developments have posed a risk to the stability of our financial system. Our banks are resilient and they are soundly capitalised,” Lowe said. “Instead, the concern has been that the longer the recent trends continued, the greater the risk to the future health of the Australian economy. Stretched balance sheets make for more volatility when things turn down.”
The remarks indicate mounting concern about the economic risks of the debt build-up on household balance sheets.
It gives some of the clearest insight we’ve seen yet about how the central bank sees the risks in the economy given the explosive house growth in Sydney and Melbourne over recent years.
Lowe’s speech, to a dinner hosted by the RBA in Melbourne last night, came hours after the RBA’s monthly interest rate statement noted the labour market has been showing signs of weakness recently, while also noting the increased focus of the banking regulator on lending standards.
Setting out how the RBA sees household debt levels, Lowe said:
The level of household debt in Australia is high and it is rising. Over the past year the value of housing-related debt outstanding increased by 6½ per cent. This compares with growth of around 3 per cent in aggregate household income. The result has been a further rise in the ratio of household debt to income, from an already high level.
In aggregate, households are coping reasonably well with the higher debt levels. Arrears rates remain low and many households have built up sizeable buffers in mortgage offset accounts. At the same time, though, slow growth in wages is making it harder for some households to pay down their debt. For many people, the high debt levels and low wage growth are a sobering combination.
While Australia’s economic growth rate has been relatively healthy, there have been some recent signs of strain in the consumer sector. Official data from the Australian Bureau of Statistics showed retail sales volumes contracted slightly in February, for example, and the unemployment rate has ticked up from 5.7% to 5.9%.
Lowe went on to comment on what he said was Australia’s “unusual” environment for property lending and its associated tax incentives. Explaining some of the rationale for APRA’s recent crackdown on interest-only lending, he said:
There are two parts of APRA’s announcements that I would like to draw your attention to.
The first is the need for lenders to have a very strong focus on serviceability assessments. Despite the focus on this area over recent times, too many loans are still made where the borrower has the skinniest of income buffers after interest payments. In some cases, lenders are assuming that people can live more frugally than in practice they can, leaving little buffer if things go wrong. So APRA quite rightly has said that lenders can expect a strong supervisory focus on loans with a very low net income surplus.
The second area is interest-only lending. Over the past year, close to 40 per cent of the housing loans made in Australia have not required the scheduled repayment of even one dollar of principal at least in the first years of the life of the loan; only interest payments are required. This is unusual by international standards. In some countries, repayment of at least some principal is required on all housing loans for the entire life of the loan. In other countries, interest-only loans are available only if the borrower has already contributed a fair degree of equity. So this is one area where Australia stands out. We are not unique in this area, but we are unusual.
There are a couple of factors that help explain the popularity of interest-only loans in Australia. One is the flexible nature of Australian mortgages. Many people with interest-only loans make significant payments into offset accounts rather than explicitly paying down principal. This flexibility, which is of value to many people, isn’t available in most countries. A second factor is the taxation arrangements that apply to investment in residential property in Australia.