+ About Christopher Joye
About Christopher Joye
Christopher is the founder and Managing Director of the award-winning research and investment group, Rismark International, having established the business in 2003 on the basis of a landmark report he produced on affordable housing for the Australian Prime Minister's Home Ownership Task Force (read his blog here). Rismark has pioneered the development of the world’s first mass market, private sector shared equity finance program in which the lender participates in both the capital gains and wears the losses associated with home ownership without charging any interest. Since that time the initiative has won numerous industry awards and served as the basis for government-sponsored programs in Australia, New Zealand and the United Kingdom. In February 2009, Christopher was invited by the Rockefeller and MacArthur Foundations to present innovative policy solutions to America’s housing market woes based on Rismark’s experience at the privateTransforming America’s Housing Policy summit for Obama Administration officials in New York. In 2009 The Australian newspaper selected Christopher as one of Australia’s top 10 “Emerging Leaders” in its economic/wealth category. In 2007 Christopher was selected by The Bulletin magazine as one of Australia's "10 Smartest CEOs" and by BRW Magazine as one of "Australia's Top 10 Innovators". He previously worked with Goldman Sachs' Investment Banking Division in Europe and Australasia. Christopher was formerly a member of the Special Projects team within the Reserve Bank of Australia's Domestic Markets Division. In 2008, the Australian Government embraced a radical policy proposal developed by Christopher and Professor Joshua Gans of Melbourne University to provide liquidity to the Australian securitisation market to mitigate the adverse effects of the 2007-2008 credit crisis. This idea was also endorsed by the Government’s 2020 Summit. Christopher served as a Director of The Menzies Research Centre, which is a leading Australian think-tank, from 2003 to 2007. He is an experienced financial economist with expertise in investments and the dynamics of the residential real estate market. He has published widely on policy matters relating to housing and financial economics. Christopher received Joint 1st Class Honours (Economics & Finance) and the University Medal in Economics & Finance from the University of Sydney, where he was a Credit Suisse First Boston Scholar, SIRCA and University Honours Scholar. He studied for a PhD at Cambridge University in 2002 and 2003, where he was a Commonwealth Trust scholarship recipient. Christopher is also a Research Affiliate with the Centre for Ideas and The Economy (CITE) at Melbourne University.
Friday, June 01, 2012
The hard capex spending data in Q1 combined with the investment intentions survey over the next two years smacked-down those claiming the capex boom is over. TD Securities comments:
Had mining capex expectations been scaled back dramatically in this report, it was clear that the RBA would need to aggressively cut the cash rate. However, since the 1 May RBA meeting, mortgage rates are now accommodative, the consumer is growing at trend, and the labour market has been more robust than expected. Where is the urgency to cut except for being priced into the OIS curve?
March qtr capex better than expected: March qtr real capex jumped +6.1%/qtr (prior -0.7%/qtr, mkt +4%) confirming that private business investment will likely add around ¾%pt to Q1 GDP growth.
However, expectations are far more important: A strong 2011/12 is all-but locked in: +31% over 2010/11 (slightly downgrade from the prior survey) where businesses overall expect to spend nearly $A160b, or around 12% of GDP. The manufacturing sector plans to increase by +8% to over $A13b, unchanged; while mining remains the most aggressive sector, reflecting the resource boom, where this year’s plans are all-but unchanged at +72% to $A81b. The second estimate of 2012/13 did not disappoint: Mining capex set to expand another +50% to $A121b (or nearly 10% of GDP) defying pessimistic noises of investment cancellations from Australia’s major miners; Manufacturing capex to fall -12% to nearly $A12b and Services capex now set to decline slightly (was +4%) to $A59bn.
Monday, May 28, 2012
By Christopher Joye
A couple of weeks ago the Deputy Governor of the RBA, Dr Phil Lowe, revealed that the “biggest surprise” for the central bank in 2011 had been the very low level of “home building.” I laughed when I read this because I had debated exactly this issue with the RBA in 2009 and 2010. It was entirely predictable.
Pondering how the RBA had misjudged the level of new building activity over 2011, Lowe said he thought that “a lowering of expected capital gains on housing…has made developers, financiers and households less willing to commit to new construction despite rising rental yields, lower prices relative to income and ongoing growth in population.”
In 2009 and early 2010 I publicly and privately expressed anxiety that high-profile “jaw-boning” of house price rises by Glenn Stevens, Phil Lowe, and Tony Richards would exacerbate the supply-side problems that these same individuals claimed they were concerned about. I also warned economist buddies of mine that there was no way building approvals would recover to the levels they forecast while the RBA left the community with the impression there was a house price bubble. Here’s what happened to building approvals after the RBA’s “open mouth operations.”
On the one hand, the Bank has frequently argued via its bi-annual Financial Stability Review that the housing market’s fundamentals are solid, with an inelastic supply-side (something I had highlighted back in 2003), internationally low default rates, healthy population growth, a reasonable price-to-income ratio, and low vacancy rates. The Bank has also regularly said it would welcome more developer activity.
On the other hand, the Bank was worried that the rapid house price appreciation in 2009-10 could lead to future financial stability complications. It was a forward-looking critique: if asset price growth continued it could feed back into credit growth, which is something the Bank wanted to avoid. In March 2010 the Governor, Glenn Stevens, famously gave an unprecedented, and widely covered, interview to Sunrise’s David Koch warning home buyers that house prices were not a one-way bet.
Several months earlier, the RBA’s Tony Richards had offered the argument, which also got wide media airtime, that “[A]s a nation, we are not really any richer when the price of housing rises, but the more vulnerable tend to be hurt.”
The net result of the RBA’s posturing was that many commentators reported that the central bank thought Aussie housing was expensive. In truth, the RBA was trying to deliver more nuanced messages. One of these was that we should not expect to see a repeat of the 7-8% capital gains home owners realised over the last 30 years. A second was a reminder that house prices can go up and down.In abstract, this was wise advice. Indeed, I had myself regularly argued that the risk of an individual family home was much higher than many people understood. In this May 2010 column, I revealed research by Rismark that had, for the first time in Australian history, quantified precisely how risky an individual home is.
Before diving further into this issue, it is useful to get some context. After three years of relatively low house price growth in 2004, 2005, and 2006, capital gains accelerated by 13% in 2007. The coincidence of rising variable mortgage rates, which peaked at a scorching 9.6% in August 2008, and the onset of the GFC saw prices drop by about 4% that year.
Yet the unwinding of the RBA’s tight monetary policy in 2008 together with fiscal stimulus from the government helped the market recover quickly in 2009. That year prices rose 13.7%.
In October 2009 the RBA started to normalise monetary policy again with four quick rate hikes. The Bank was keen to do so in part because of worries it had about the effects of leaving rates too low for too long.
It was clear to Rismark in the first half of 2010 that there was no risk of a repeat of the previous year’s boom. In fact, we forecast zero capital growth in the second half of 2010, and started warning prices could fall if the RBA kept on pushing rates into restrictive territory. In November 2010 the RBA complied with a de facto double rate hike, which was amplified by a barrage of RBA rhetoric in the first half of the following year implying more hikes were coming. Unsurprisingly, prices fell by 3-4% in 2011.
Since the end of 2007 Australian house prices have risen by 2.5% per annum. That is, they have tracked the RBA’s inflation target. Notwithstanding two years in which house prices deflated, they are still around 8-10% higher than their early 2008 peak.
This is awkward news for the University of Western Sydney’s assistant professor, Steve Keen. Many will recall that Keen sensationally predicted a 40% drop in Aussie house prices. The gap between Keen’s 2008 prediction and current house price levels is over 80%.
With the 2009-10 rate hikes neutralising the relief bequeathed by the RBA during the GFC, I thought the high-profile jaw-boning of prices by RBA officials was fraught with danger. Specifically, I warned that these actions could end up stifling the supply-side. I outlined this thinking in April 2010:
“Back in 2008 and 2009 we had the RBA enthusiastically defending the integrity of housing market conditions and casting doubt on the many predictions for steep price falls.
What is problematic here is that Stevens and Lowe's statements [about the cost of housing] are only going to seriously spook lenders. Rightly or wrongly every credit officer in the country thinks the RBA believes Australia is suffering from an unproductive house price bubble. (We even had NAB’s Chairman criticising CBA and Westpac for ramping up mortgage finance.) The headlines on the front pages of newspapers conveyed the story this week: "RBA worried about bubble risks".
The RBA’s jaw-boning is going to exacerbate the supply-side problems. Ironically, rising prices are the best possible thing to stimulate investment in new supply. This is, after all, what free markets are there to do: signal where scarce economic resources should be allocated via the price mechanism.
It also pays to remember that property "investors" provide rental accommodation for lower income families. According to the RBA, rental vacancy rates are currently very tight. So surely we want to be encouraging, not discouraging, investment in new rental shelter?
Finally, if people are going to argue that fundamentals-based house price rises are bad for society, they also have to explain to us why rising share prices are bad too. Rising house prices simply reflect an increase in the value of productive assets that supply 10.9 million Australian workers with shelter. It is usually the market signaling that we need more investment in shelter. Likewise, the rise in the value of, say, farms that produce food for us to consume (food and shelter are the two essential inputs for a functioning economy) reflects an increase in the market value of its assets.
For clarity's sake, I am a big opponent of individual consumers gearing heavily into residential property or shares, which, contrary to popular opinion, have similar levels of risk at the individual asset level. It makes little economic sense. And I have argued longer and harder than anyone that we need to deleverage household balance-sheets [via greater use of “equity” as opposed to “debt” finance] and elastify the supply-side.”
In addition to jaw-boning house prices in 2009 and 2010, the RBA regularly signaled via its media proxies that it was prepared to put a break on housing returns if it deemed them to be problematic from a financial stability viewpoint.
Given these interventions, one wonders whether it really was that “surprising” that investors have downgraded their return expectations with direct ramifications for the amount of capital being committed to producing new housing supply.
This article was originally published on Christopher Joye's blog.
Sunday, May 13, 2012
In an interview a few weeks ago, Sky's Peter Switzer kindly introduced me as a "great friend of the RBA." In light of the many criticisms I have aired over the years, I couldn't help but laugh at this characterisation. I subsequently mentioned it to an RBA executive. Almost as amusingly, this person retorted: "yeah, 60% of the time."
Unfortunately, today may be one of those 'forty percenters'. What I am going to write about you will likely never read in an Australian newspaper. The journalists in question cannot report on these issues for fear of breaching confidences given to their sources.
Because I have one foot directly in financial services, and another in the media as a public commentator, I am a little different. Unlike most other RBA watchers, I never speak to the Bank, its board, or its political masters about monetary policy. I don't get the benefit--or, as we shall see, suffer the costs--of receiving the all-important private telephone and in-person briefings that senior correspondents secure after important RBA statements, and before major decisions.
I do speak to the Bank about abstract policy issues, such as whether they should use interest rates to lean against asset prices, or technical data matters, like how house prices movements should be measured.
I've also asked the Bank to set me straight if I ever make an objective mis-step. As one example, the Bank has a habit of frequently emphasising the "mid-point" of its 2% to 3% per annum inflation 'target' as its policy goal. I've previously written that this can lead one to infer that the RBA's 'implied' inflation target is actually a more specific 2.5 per cent. Core inflation outcomes materially above or below this point estimate could, therefore, be judged as misses.
It was, however, pointed out to me that Guy Debelle and Glenn Stevens had published a paper in 1995 arguing that the RBA's monetary policy aim is a deliberately "thick point", or wide, band most accurately described as "two point something". It is not an artificially precise 2.5%.
Long story short, anywhere in the band satisfies the inflation objective because the RBA knows that it cannot over-engineer its inflation targeting outcomes--the standard errors associated with its forecasts are just too high. That, by the way, is one reason why there is nothing wrong with consistently punching out 2% per annum core inflation, as is currently the case. (Most developed world central banks consider 2% normal.)
The motivation for today's remarks derive from questions I received last Friday. A senior interest rate trader asked me what I thought the RBA's closely-read Statement on Monetary Policy might say (it was to be published that day). I felt the lethargy mount inside me before I mustered a shallow response. All I could offer was, "dovish mate--they'v gotta rationalise the 50 points, ex post facto." But then I quickly added that I had not thought about it much.
After the Statement came out--which was dovish--Aussie government bond prices jumped a bit. Another experienced market participant called me and queried my views. I said I hadn't even read it aside from a quick glance at the housing section, which was in line with my priors (ie, the RBA is pushing a stabilisation meme, now couched as a deceleration in house price losses). I said I'd get back to him when I had some thoughts (I still don't).
Over the weekend I started reflecting on why I had so little interest in what is supposed to be the RBA's premier publication. It slowly dawned on me: it was more-or-less meaningless for rates. It would be part exercise in justification of a decision the RBA staff did not recommend, and part hazy and contradictory glimpses of their view of the world.
Rather than telescope in on a central set of projections that the staff actually believed in, the chastened executives would likely be obscuring any sharper messages with insurance and obligatory acknowledgements of how they had purportedly 'misread' the economy. (Yesterday's 4.9% unemployment print combined with the low core inflation over the last three quarters tells us that the RBA had, in fact, set monetary policy almost perfectly.)
As it transpired, the RBA did indeed make its views even fuzzier in this particular Statement by more-or-less giving up on forecasting. The projections the RBA delivered for year-ended GDP growth and core inflation were so wide that any real-world results at the limits of these ranges could have diametrically different consequences for policy. Beyond a year or so, the RBA has now formally embraced Glenn Stevens's 'first rule of forecasting': don't forecast; or, if you do have to forecast, hedge your bets.
My main idea before the last RBA board meeting was that no matter what happened we would learn a lot about how the Bank thinks and operates. You see, after the stunningly low first quarter inflation numbers, the RBA's 50 basis point cut was not a surprise, per se.
Before the inflation data, I had published a 'cheat sheet' with a table claiming that if core inflation came out at 0.3-0.4% one could expect the RBA to cut by 25-50 points. I also quickly attached a 40% probability to 50 basis points after the release. And by the time the Board meeting came around, the financial markets had converged to roughly this same estimate.
To be sure, 50 basis points before the CPI release was very low probability. Only one person in Australia was pulling for it: Stephen Koukoulas (or "Koukie" to friends). And with the benefit of hindsight, Koukie made a majestically timed call. The only wrinkle is that he had also called 25 and 50 basis point cuts in February and April too. So May was more about getting the medium term right, although this week's unemployment data arguably call this into question.
The surprising thing about the RBA's May meeting was that the senior staff only recommended 25 and went to considerable lengths to resist a larger cut. The surprise was that the once all-controlling RBA executive had again had their central recommendation--which would have been strategically hedged--rejected by the RBA's dovish, and increasingly powerful, board.
That's what happens when the "insiders" hold only two of the nine board seats, stakeholders with a vested interest in lower rates dominate all the others, and when the Governor is an open-minded consensus builder who has hitched his legacy to enhancing governance and transparency.
On the morning of the board meeting, a very senior economics correspondent for Fairfax, Peter Martin, published the following remarks in the Sydney Morning Herald:
"The staff recommendation sent to board members on Friday is believed to recommend a cut of 25 points, arguing that the economy is not weak enough to demand anything larger and that rates can be cut again if needed."
As a seasoned journalist with impeccable RBA and Treasury contacts, Martin would never make this statement unless he believed it to be true on the basis of a primary source. The day before, David Uren, another senior and instinctively cautious senior economics correspondent with The Australian, offered these predictions on both what would happen at the meeting, and, more curiously, what specific GDP growth numbers the RBA's Statement on Monetary Policy would include:
"People speculating that the Reserve Bank may cut by 50 basis points tomorrow are hyperventilating. The downgrade in the bank's growth forecast is unlikely to be dramatic. National Australia Bank's business survey shows conditions are still in line with the long-term trend and unemployment has remained steady for about two years. The March quarter inflation report was soft, but there is nothing to suggest that the economy is entering a recession. The Reserve Bank's monetary policy statement, which will be published on Friday, will still show growth over 2012-13 of at least 3 per cent. The bank will not be badgered into repeated slashing of rates by those parts of the economy that are on the wrong side of the structural change which the high value of the Australian dollar is forcing. It is unlikely that the bank judges that its cash rate is far from where it needs to be."
Like Martin, Uren would likely never write this and, more pointedly, dismiss the prospect of a 50 basis point cut, unless he had been guided by the RBA staff to do so. While he obviously got the rate call wrong, he was, perhaps unsurprisingly, spot-on with his even more difficult-to-anticipate Statement on Monetary Policy forecasts. Of course, the RBA staff determine the numbers included in the Statement without interference from the board in contrast to the cash rate decision.
Just as the staff are inclined to advocate their positions via preferred media proxies (universally accepted as a common, if awkward, practice), it's possible that some of the seven remaining board members do so too. This may be the reason why News Limited's leading columnist, Terry McCrann, (confidently) missed the RBA's February and April decisions to pause. At both meetings, the staff evidently managed to hold the line against a board agitating for rate relief.
But in May, McCrann was uncannily on-the-money well before any other analyst, or the market, save Koukoulas. On April 25th, after the CPI report but a week before the board meeting, Terry called a 50 basis point cut yet went one step further to, remarkably, describe a standard cut as a "most unlikely circumstance." Terry's smart, but he's not that smart. I am guessing that the reason he could effectively rule-out 25 is because either someone on the board (likely), or someone at the Bank (unlikely), told him it wasn't going to happen:
"TWO things are now absolutely beyond doubt. There will be an official interest rate cut next Tuesday, and the official rate will be cut by at least 50 points over the next five weeks. Somewhat less certain, is when the 50 points will be delivered. I suggest in one hit on Tuesday. But in the most unlikely circumstance that Tuesday turned out to be only 25 points, that would simply make a further 25 points absolutely certain at the next Reserve Bank board meeting in June."
On April 29 McCrann affirmed this projection:
"ON Tuesday, the Reserve Bank will cut its official interest rate...It should start with a 50-point cut and I suggest there's a better than even chance it will."
Now just think for a moment. If it is possible for this information to leak out from the RBA's board, and from senior staff, is it conceivable that there are folks around the world who might seek to profit from it? I would venture so. Indeed, there was some rather unusual trading on the day of the RBA's last meeting.
At exactly the same time the RBA board meeting finished--at 12:30pm--through until the time the policy decision was announced at 2.30pm, the Aussie dollar commenced a slide from circa 1.0422 US cents to as low as 1.0388 cents. There was also a slightly odd spike in 3 year government bond prices, which directionally has the same meaning (Koukoulas tweeted about it), although they pulled back on low volumes just before the release. Maybe it was noise. Maybe not. I honestly don't know.
Bruce Kovner, the founder of one of the world's biggest and most successful hedge funds, Caxton Associates, has said that in the 1980s the best traders of currencies were the Russians because of the KGB's ability to pick up economic intelligence. We have many private companies with intelligence gathering capabilities, and foreign intelligence agencies, functioning in Australia today. It is well documented that sourcing non-public economic intelligence, and pro-active industrial espionage, are key aims of any sovereign intelligence entity, including Australia's. I am not saying anything more than that.
As a hypothetical, you've got a full two hours between the 2:30pm release date and the time when seven of the nine RBA board members drift out from its Martin Place headquarters to monitor communications and collect one solid indication of what might have happened. The RBA takes precautions, of course, including sweeping its board-room for bugs. But if you are successful, you could make tens, if not hundreds, of millions of dollars. It is hardly unimanginable. The technology certainly exists. The self-interest is a given.
With this in mind, I would note that Dow Jones's Enda Curran highlighted this ABS media release during the week revealing that the surprisingly strong, and price sensitive, retail trade data had been leaked to six clients 20 minutes before it was communicated to the market. One assumes this was just a technical glitch.
Any long-time policy analyst knows that there is more than enough soft-corruption, influence-peddling, and subjugation of taxpayers' interests embedded in Australia's public sector decision-making processes for one to be worried. I have regularly hammered on about the wealth-destroying biases ingrained in our saving system's asset-allocation decisions and the manifold unpriced taxpayer subsidises bequeathed to our too-big-to-fail banks. Yet remedies appear hard to implement when even the nation's political leaders argue in private that the bureaucracy is pathologically resistant to change.
This article was originally published on Christopher Joye's blog.
Thursday, September 22, 2011
I had a bizarre experience while sitting in my car the other day. I had pulled over in Bligh Street, in Sydney's CBD, and was finishing up a call. In the space of only three minutes, I saw a multi-billionaire plodding up the road, a hedge fund guy worth a couple of hundred million crossing it, another younger fella who runs a Liberal Party think tank, and who will become a Federal Minister one day, going the other way, and, finally, the former leader of the NSW Opposition, who would be Premier today had he avoided certain indiscretions. It was kinda freaky.
Anyhow, it turns out that one of these blokes called me about an hour later and asked me what the RBA had meant by this curious, and market-moving, statement in their Board Minutes (emphasis added):
"Members were informed that, in Australia, market pricing prima facie pointed to expectations of large cuts in the cash rate by the end of the year, but a range of technical factors meant that market pricing might not be giving an accurate reading of expectations in the current circumstances."
The Deputy Governor of the RBA, Ric Battellino, reiterated this view in a speech he gave in New York overnight (emphasis added):
“[F]inancial markets seem to have concluded that the risks are weighted towards the Australian economy weakening sharply and, taken literally, seem to be pricing in a reduction in official interest rates towards the unusually low levels reached after the GFC. There are technical reasons why current market pricing may not be giving an accurate picture of interest rate expectations. Nonetheless, markets do seem to have reached a pessimistic assessment and this appears to be based mainly on the assumption that weakness in the US and Europe will flow through to Australia.”
So what gives? Are the RBA and the considerable weight (and knowledge) of financial markets at loggerheads? Yes and no. While the RBA is an economically conservative institution, you tend to find that alumni have a healthy disrespect for the ‘efficient markets’ doctrine, and the sanity of markets more generally. The Lowy Institute’s Stephen Grenville, who was previously Deputy Governor of the Bank, exemplifies this attitude in his writings.
To understand the RBA’s skepticism for markets you need to reflect on its role: the RBA is a non-democratically elected institution that unilaterally sets the price of credit in the economy, and less directly, the price of money. In its own way, the RBA is constantly seeking to ‘correct’ markets and their expectations. Another good example of this is when the RBA (rarely) intervenes in the currency market by buying or selling Australian dollars. It says, quite explicitly, that it only does so when financial markets become disorderly and over- or under-shoot reasonable estimates of fair value. Once again, this is a central bank opining that the markets have got it wrong. Interestingly, the RBA has thus far resisted the temptation to sell Aussie dollars during the recent episode primarily because the appreciation of the currency has only served to validate its medium-term view of the world (and is, to some extent, saving it from having to hike rates).
In responding to my friend’s question about the RBA’s back-hander to the financial markets apropos interest rate expectations, I offered the following explanations.
First, the RBA is very likely subtly pointing out that market pricing for interest rate changes is not a forecast or a prediction, as is commonly believed: it is, more precisely, a 'probability-weighted price'.
Imagine you had three potential contingencies for interest rates over the next year in your mind, and assigned each a probability. The market price would be equivalent to your 'expected value', or your probability-weighted interest rate estimate.
Now, if I asked you to supply a specific prediction, you would nominate your most likely outcome. Note that this will be different to the expected value. It will be especially different if the expected value is being influenced by a reasonable probability around some catastrophic event, as it is today.
For example, you might say that you think in your ‘base-case’ there is a 70% chance rates will stay on hold until December. But then you add the rider that if, say, the Eurozone were to break-up, an event to which you assign a 30% probability, the RBA would be compelled to slash rates by, say, 100 basis points as it did in October 2008.
Observe how this gives you a ‘probability-weighted expectation’ of slightly more than one rate cut by the end of the year (if you multiply 70% by the cash rate and 30% by a 100 basis point lower cash rate), which is markedly divergent to your ‘base-case’ of no-change.
The second thing the RBA is likely canvassing is that the short-end of the yield curve, which people use to infer ‘market forecasts’ for rate changes over the next 1-2 years, is being artificially buoyed by the very high demand for cash (eg, bank bills) and other near-term, liquid securities. In the currently turbulent environment, many institutions, such as banks and pension funds, are parking their money in cash until the dust settles. This demand for cash has the effect of driving up prices and reducing implied yields. The net result is lower interest rate expectations for the period covered by the securities in question.
The other technical distortion we are seeing is in middle (or ‘belly’) and long-ends of the yield curve, which are dominated by the 3 year and 10 year Australian government bond prices. These prices are being artificially boosted for reasons I have explained before: viz., central bank and institutional portfolio diversification of their sovereign investment risks.
As is now well known, Australia is one of the few remaining AAA credits in the world, and has by far the strongest and healthiest balance-sheet of any country in the OECD (including Switzerland). We are pretty much the only developed country that has generated 20 years of uninterrupted growth and avoided recessions during both the 2001 'tech wreck' and the 2007-08 GFC. Furthermore, Australia offers growth diversification away from the North Atlantic economies, which, according to the IMF, account for less than one-third of the global growth pulse. In particular, 65% of Australia’s exports go to developing nations, while 75% go to Asia. The chart from the IMF below shows the expected growth gap between emerging and developed countries over the next two years. Australian investments give you exposure to the top yellow line.
Here is interesting to observe that notwithstanding the extreme media pessimism we are greeted with every day about North America and Europe, the global economy should be chugging along at a trend rate of growth in 2011 and 2012 even assuming very poor conditions in the advanced economies.
Given their high debt-to-GDP ratios, political dysfunctions, ageing populations, and the absence of leverage to emerging economies, many central banks are, at the margin, trying to quite rationally reduce their exposures to the traditional ‘safe haven’ currencies (eg, the US greenback, Yen, Sterling, and Swiss Franc). And since there are few alternatives in view of the pegged Chinese currency, there has been a tremendous increase in the demand for untainted Aussie sovereign debt with the likes of the Russian central bank announcing that they will start buying it for the first time.
Similar logic applies to global fixed-income investors that hold sovereign credits: in the current climate, safe yet high yielding Australian government bonds are at the top of their shopping list. When buying Aussie bonds, you buy Aussie dollars, so this also explains the currency’s (relative) strength.
A related wrinkle here is that many offshore buyers of Aussie government bonds are ‘price indifferent’ because the yields are so high and they can hold these assets ‘to maturity’ on their balance-sheets. That is, central banks don't necessarily need to worry as much about 'mark-to-market' risks.
The rise in the price of Aussie government bonds as a structural artefact of global investor and central bank portfolio diversification has in turn reduced their implied yields (given the actual interest payments on the bonds are fixed). And so longer-term Australian interest rates also appear to be very low, which would normally insinuate dismal growth prospects. This is exactly what has enabled the major banks to cut the cost of their fixed-rate home loans to more than one percentage point below the headline variable rate.
Within the yield curve, the 3 and 10 year government bonds provide the ‘benchmark’ prices. If the 3 year price surges, it will tend to bleed out through the rest of the curve. More specifically, the shorter 1 and 2 year interest rates have very high correlations with 3 year rates. In this way, short-term interest rate expectations can be pushed down further as a technical function of the global appetite for Australian sovereign credit.
Taking all of the above factors together, the RBA is basically saying that market expectations are giving you a bum-steer on the likelihood of rate cuts. Sure, we may get them. But absent a total meltdown, they are unlikely to come as quickly or generously as market prices imply.
Tuesday, September 20, 2011
I heard the other day that the CIA has inducted exposure to Australian equities as an unofficial form of torture. Since January 2009 I have warned of the risk of painful "dead-cat-bounces" in the sharemarket. In May 2010, I argued that there was every chance the 2007-08 crash would resemble its 1987 predecessor, and be followed by a protracted period of poor and volatile returns:
"2007 is looking eerily similar to 1987, at least judging by the equities market performance thus far...The bad news for equities investors is that it took until almost 1997 for the market to consistently recover its post-crash peak. Here's to hoping it does not take 10 years for the ASX to breach 6,800pts. (Note the 'dead-cat-bounce' in 1994.)"
In 2011 the Aussie sharemarket is still 37 per cent below its 2007 apogee with countless false dawns heralded by stock spruikers as the beginning of a new year of double digit returns. It is an instructive exercise to troll back through either Business Spectator or the Australian Financial Review's "annual predictions" of where the sharemarket will be in 12 months hence. It does not look pretty: according to the All Ordinaries Price Index, shares have delivered no net capital returns since 2005 (see chart).
Global shares have not been much better, and super funds, with their unnecessarily high weights to all forms of equities, have not protected investors. In fact, according to Super Ratings, the average "balanced" or "conservative balanced" super fund has underperformed inflation over the last five years--that is, they have delivered negative "real" returns. The numbers look even worse if you allocated to any of the "growth" options offered by your super fund. Before inflation, the average five year return has been 0.5 per cent to 1.3 per cent per annum (after inflation, returns are substantially negative).
Australian cash and fixed-income have been safe harbours during this turbulent time. Yet as the European sovereign debt crisis continues to rock the world, the risk is that the RBA temporarily "looks past" brewing inflation pressures, as many are calling on them to do, and cuts interest rates.
In this respect, US investors have the worst of all possible outcomes: high inflation; low growth; low interest rates; and an extraordinarily volatile equities market. Many smart observers are recommending investors seek out "inflation hedges" in our increasingly stagflationary world, such as gold, commodities and even bricks and mortar. After years of selling their gold reserves, central banks are back buying again. And only yesterday Bloomberg published an article with the headline "London Home Prices Surge as Investors Turn to Property Amid Market Turmoil."
The inversion of the yield curve that I have been talking about regularly here has started reducing the term deposit rates offered by Australian banks. The concomitant benefit is that the price of fixed-rate home loans has also declined. If the RBA loses its nerve and cuts its official cash rate, I think we will see more capital shifted back into housing given its demonstrated value as a (relatively) safe store of wealth. This is one of the internal inconsistencies the extreme bears face: a recession means home loan rates are going to plunge, which will only help house prices in the unique Australian market where almost all debt is variable-rate.
While the Aussie sharemarket is still nearly 40 per cent below its 2007 peaks, Australian house prices are about 10.3 per cent above their pre-GFC highs. Notwithstanding this, we have had effectively no house price growth in nearly one-and-a-half years while household disposable incomes have, according to the ABS, raced ahead at an 7-8 per cent per annum rate.
As other wise-heads have observed as we bounce from one crisis to the next, bad news sells and many cannot help themselves when it comes to peddling the end of the world. The online editors at the Sydney Morning Herald are a case in point, and especially fond of promoting doom-and-gloom.
For example, last month RP Data-Rismark reported that house prices in Australia's largest city, Sydney, had risen despite national values falling. The SMH nevertheless focussed on the national findings and subordinated the Sydney results, running with the headline "Prices fall faster in July" when, in fact, Sydney prices had actually appreciated slightly.
If I search out "housing" or "house prices" on the SMH's website, recent headlines include, "Sydney housing in dire trouble", "Housing out of reach for many", "Housing shortage a myth, bears claim", "Domino effect shows as gloom spreads to housing", "House prices to stagnate as debt binges end", and "House prices to slide further in 2012".
Now contextualise these claims against the hard fact that Australian capital city dwelling prices are merely 2.9 per cent lower than their level of 12 months ago. That is substantially less than some of the more savage daily swings in the sharemarket. Including rents, total gross returns realised by property investors have been positive!
A more balanced analysis is that while the housing market is certainly soft, it is not collapsing, and, if truth really be known, we are seeing some partial, leading indicators that imply the market may be finding a base.
The near-term outlook is, as I have been at pains to emphasise for the last 12-18 months now, heavily dependent on the course of interest rates, and, it would more recently appear, community perceptions of such.
The conviction households have held that they would be smashed with at least 2-3 rate hikes this year has exacerbated the subdued conditions. But the hikes have not materialised, and economists, the financial markets, and journalists are all talking about the prospect of cuts, or at least rates remaining on hold for an extended period.
Combined with a falling currency (currently down nearly 10 per cent from its recent highs at just 1.018 US cents), which will help exporters and ex-pat demand for local homes, it is plausible that Australia's housing market is rapidly approaching a turning point.
The final judge of this matter will, of course, be the house price data. But today it is instructive to review some of the aforementioned leading indicators. I would highlight three in particular.
The first chart below shows the monthly number of AFG housing finance applications, which in August hit its highest level in 19 months. (AFG is Australia's largest mortgage broker and accounts for about 10 per cent of the market.) The three month moving average is also trending up solidly following the flood-induced trough in January.
The second chart of interest illustrates the share of first time buyers as a proportion of all borrowers. According to AFG, this hit a low of 9.5 per cent in June 2010 and has gradually increased since to 13.8 per cent in August 2011 (the enormous protrusion in the middle of the chart depicts the stimulatory effects of the government's first time buyer boost). That is to say, there is some early evidence that first time buyers are returning to the market given the improvement in housing affordability (ie, lower house prices in concert with robust disposable income growth).
The final chart shows weekly auction clearance rates for Sydney, Melbourne and a weighted-average of all capital cities (noting that the auction sales mechanism is more common in the two biggest conurbations). What we can draw from this is that since the second quarter of 2011 clearance-rates have stabilised at slightly above 50 per cent in Sydney and Melbourne, and slightly below this level across the combined capital cities. That is, there is no sign of a continued deterioration.
The housing market probably needs a little more time to get accustomed to the striking change in interest rate expectations (ie, from several hikes to no hikes, or even cuts, if you believe AMP, Deutsche Bank, Goldman Sachs, Westpac or Macquarie). For what it is worth, I have not altered my own views, and still expect the next move to be up. But set against the cacophony of voices calling for easier monetary policy, my own opinions are likely irrelevant for overall consumer behaviour (having said that, consumers have had similarly hawkish perspectives to this point).
The next major marker will be the August house price index data. This will be a crucial guide to whether Australia's housing market is experiencing an accelerating decline, as folks like the perennial doomsayer Steve Keen would have us believe, or treading water, as I think is much more likely.
Friday, September 02, 2011
Every man and their dog has been shifting interest rate forecasts from hikes to cuts of late. Not me. Goldman Sachs, Deutsche Bank, Westpac and Macquarie are all forecasting that the next move will be a cut having previously predicted hikes this year. UBS have shifted the next cash rate change to Q3 2012, having also been in the hike camp. NAB have similarly moved the next change into the middle of 2012 after calling 2011 hikes. So, what do I think?
1. I believe Australia has an inflation problem that is only going to get worse over time. In fact, the inflation risks have significantly escalated following recent statements by leading developed world central banks that they intend to keep rates lower for longer, and will entertain further quantitative easing. The fact that the RBA's Board has forced the staff to drop or fudge its inflation target in 2011 only loads the dice in favour of more inflation in 2011, 2012 and 2013. I could go on about this, but I will save you the pain.
2. I think the next move in interest rates is up, and I think there is a decent chance that the RBA hikes after the Q3 inflation numbers come out in late October. The RBA staff and the (few) sane Board members believe they should have hiked in May. We know that they would have hiked in August were it not for the US debt ceiling crisis and problems posed by a majority of conflicted Board doves.
3. We have been bearish on 2011 house prices since early 2010. If my interest rate case proves out, I remain bearish on housing until the RBA starts normalising rates again, which I think will happen in the second half of 2012. If I am wrong, and the RBA starts cutting rates, I would be bullish on housing. Unlike almost any other housing market in the world, Australia is unique insofar around 90 per cent of all mortgage debt is purely adjustable-rate and priced off the RBA's target cash rate (most other countries, such as the UK, US, and NZ, have a preponderance of fixed-rate mortgage debt). Even the tiny minority of fixed-rate debt that exists out there is fixed for short periods of time (eg, 1-5 years). In sum, this is a very interest rate sensitive sector of the economy. Wages and incomes in 2011--unlike the December 2009 ABS disposable income data reported by some yesterday--are growing rapidly. Unemployment is low. Interest rates are not high. If the RBA gets all dovish on us and cuts rates, house prices are gonna rise.
4. The most interesting dynamic in the housing market right now is that consumers are acting as if they are getting slugged by rate hikes, even though the last change was in November 2010 (admittedly a double hike). In August they still expected two more hikes according to the Westpac-Melbourne Institute survey, with an amazing 29 per cent of all people budgeting for more than four hikes. It is this 'hawkish Australian consumer' that is depressing housing demand, for the time being. As soon as that attitude changes, housing conditions will promptly improve.
Friday, September 02, 2011
Since 2003 I have argued that the future of Australia’s cities more likely lies in ‘Manhattanisation’ rather than sprawl, while noting that the two dynamics are not mutually exclusive. We will increasingly build up rather than build out.
The great Australian dream of a quarter acre block will gradually morph into a more convenient ‘attached’ form of housing—be that a duplex, semi, terrace, townhouse or apartment—that, critically, is situated in relatively close proximity to important amenities and places of work.
As I explained in last week’s column, Australia will likely have to absorb 2.3 million additional households over the next 15 years alone. BIS Shrapnel estimates that this translates into a new home building requirement of about three million properties once you account for demolitions and the historical share of unoccupied homes (eg, holiday houses, etc).
Sydney and Melbourne are individually expected to have 5-6 million residents (see chart). This begs the question as to where all these people are going to live. Will we build new cities, allow existing metropolises to expand ever-outwards, permit Manhattan-like densities, or embrace all of the above?
The history of our urban development offers a guide. Over the last century, Australia’s urbanisation rate has increased inexorably. In 1921 only 42 per cent of us lived in metro areas. By 2011 that share had risen to 63.9%, and is projected by the ABS to increase to nearly 65 per cent by 2026.
Paradoxically, Australia is one of the most urbanised countries in the world, notwithstanding our large and mostly untapped land mass. Our federated structure combined with the socio-economic power of ‘agglomeration’ has led to a single city in each state attracting most of the immediate region’s residents. Indeed, Australia has more of its total metro population living in its two largest cities, Sydney and Melbourne, than any other country save Switzerland.
Yet if you fly into Australia’s major metropolises you will find a common characteristic: with the exception of the CBD pockets, they tend to resemble flat towns. With its much higher inner-city densities, hilly Sydney, by way of contrast, offers a vision of the urban future that awaits contemporary conurbations.
Continuing to build out poses a number of problems. Every marginal addition of new land on a city’s periphery necessitates accompanying investments in roads, electricity, water, transport, and sewerage. Up to a point, densification can leverage off existing infrastructure.
The further we spread our residents, and the workers living in these households, the more we typically have to transport them back to their places of work (and thus the higher their carbon foot-print). Densification holds out hope of truncating commute times.
And in order to build out, we are, by definition, taking fresh greenfields land away from the natural environment, in order to use it for the urban one. Building up does not exhaust any new land.
Los Angeles County is a great example of a metro area that has sprawled inefficiently. The population of 9.8 million is spread across great distances with an incredibly low density of just 798 persons per square kilometer. Unfortunately for LA’s residents, the public transport system is near nonexistent. If you don’t have a car in LA, you find it hard to function. This has historically resulted in serious traffic and pollution issues, in addition to undermining the city’s sense of community. In fact, LA is more like a basket of smaller cities, which have little in common.
New York City sits at the opposite end of the density spectrum. There are 8.2 million people co-habitating in attached forms of housing with a density of 10,194 persons per square kilometer (an order of magnitude more than LA), which makes it the densest municipality in the US.
Manhattan's density is two and a half times higher again. This is, in turn, more than ten times greater than Sydney and Melbourne’s densities of 2,058 and 1,566 persons per square kilometer, respectively.
To best service its conveniently contiguous residents, New York has developed a world-class public transport and taxi system that most of its population harnesses. While it is a qualitative observation, New Yorkers also appear to possess a stronger and more homogenous sense of community. You don’t live in Hollywood or Santa Monica; you simply live in the Big Apple.
One insight from these two case-studies is that Australia’s cities clearly have scope to boost the supply of accommodation in existing urban areas (see chart). While densification has the above-mentioned advantages, it also comes with obvious costs. In particular, existing residents, who are fond of their land-rich blocks, are often resistant to change. In their defence, this may be rational: stymieing supply can inflate prices. This dynamic is exacerbated by the fact that incumbent owners typically control local councils, which regulate the zoning and building approval processes.
In my 2003 report to the Prime Minster I presented several policy solutions to the conflict of interest between existing owners, who want to choke supply, and the next generation of buyers, who would like to see it liberated. One of these ideas involved giving local governments new housing supply quotas tied to public funding. This remains an option worthy of further discussion.
In contrast to a country like Japan, which will see its population contract by one-quarter over the next four decades, Australia’s is expected to expand by 60 per cent based on the Treasury’s projections.
With our rich endowments of natural resources that are conditions precedent for China and India to industrialise, we are lucky to be leveraged to the developing (as opposed to developed) world. This prosperous economic outlook combined with an ageing population implies that our demand for skilled labour will grow over time.
One way or another, we are going to have to find ways to accommodate 5.7 million new people in the next 15 years, around half of whom will be hard-working immigrants under the age of 40.
With this challenge in mind, it is interesting to note that perceptions of the ‘preferred’ form of tenure choice differ markedly across cities and societies. Community attitudes to housing types appear to vary according to the city’s geographic, economic and urban needs. Households in Los Angeles, Beijing, London, New York, Singapore and Sydney have quite divergent expectations with respect to the category of accommodation they hope to obtain.
I think that Australian’s understanding of tenure preference will continue to evolve. And here the data tells us an important story: whether you like it not, our cities are stealthily densifying before our eyes.
My final two charts show the share of Sydney and Melbourne building approvals accounted for by apartments, semis, and detached houses over the last 20 or so years.
In 1992 only 24.1 per cent of all building approvals in Sydney were for apartments. By 2011 that number had risen to nearly half (or 48.4 per cent). An even more striking story of densification is in evident in Melbourne. Twenty years ago just 4.6 per cent of all new approvals were apartments. Today that share has rocketed to 34.8 per cent.
Over the next 50 years our cities will densify much more than most can currently imagine. As a community we should prepare for that future today by investing in the supply-side infrastructure required to support it.
Friday, August 12, 2011
You often hear that Australian housing is more expensive than, say, UK or US housing, if not the dearest in the world.
Wild fluctuations in currencies make international comparisons hard, to say nothing of profound differences in house price data, household formation and population growth rates, the availability of new housing supply, the urban structure of nations, interest rates, and the legal, tax and institutional features of housing markets around the world.
By way of example, the rate of home ownership in Germany is around 40 per cent compared to circa 70 per cent in Australia, the UK, Canada, and New Zealand.
In the US there is capital gains tax levied on the owner-occupied home while mortgage repayments are tax deductible. In contrast, the owner-occupied home is CGT exempt in Australia, the UK, Canada, and New Zealand, but this comes with a cost: mortgage repayments are not tax deductible, as they are in the US.
One country Australia does share strong commonalities with is, naturally, the UK. The UK also has the benefit of very good housing data that is not plagued by “sample selection biases” (ie, when you only get a fraction of the total population of home sales, as you do with US house price indices).
So today I wanted to address two simple questions.
First, have Australian housing costs risen more rapidly than their UK equivalents over the last couple of decades?
And, second, how far did UK house prices fall during the GFC given the near complete disintegration of its banking system, with the whole or partial nationalisation of many of their largest lenders. (UK taxpayers ended up owning 100 per cent of Northern Rock, 83 per cent of RBS, and 41 per cent of Lloyds.)
I ask this question because the correspondence between the Aussie and UK banking systems, which are both dominated by a small number of big institutions, and their housing markets (both have near-identical approaches to tax and similar demand and supply fundamentals), makes a study of the UK downturn a credible guide in the event that something—god forbid—catastrophic were to happen here.
That is, it gives us a reasonable indication as to how far Australian house prices might decline if our banking system imploded, the economy careened into an acute recession with soaring unemployment and default rates.
For the purposes of this analysis we have taken the broadest possible UK house price measure, which is produced by a group called Academetrics. We then compare this to our standard RP Data-Rismark Hedonic Combined Capital Cities Index.
The results, which are illustrated in the two charts below (click to enlarge), are fascinating.
First, in the 15 or so years prior to the GFC, UK housing costs actually increased at a substantially greater rate than their Antipodean counterparts.
Of course, the cataclysmic economic and financial collapse subsequently experienced in the UK in 2007-08 resulted in a very significant contraction in UK dwelling prices.
Specifically, on a peak-to-trough basis, UK home values fell by 13.6 per cent. This compares with a smaller 3.9 per cent peak-to-trough decline in Australian dwelling values, which did not have to contend with big increases in unemployment (or arrears).
Monetary policy also works differently in Australia, with almost all borrowers on “adjustable rate” loans. In the UK, the split between variable and fixed rate loans has historically been around 50:50. This makes it harder for the UK central bank to deliver cash-flow relief to borrowers in the event of a crisis.
The circa 14 per cent drop in UK house prices is noteworthy but perhaps not as big as some might have expected. For example, the Aussie sharemarket (as measured by the ASX/S&P200) has fallen further in the last month or so.
And based on a far less-accurate benchmark for US housing costs, the S&P Case Shiller Index, which unfortunately excludes about 40 per cent of all US homes, the correction on the other side of the Atlantic was twice as steep. This might be partially explained by the fact that US default rates were nearly three times higher than comparable UK arrears (and about 10 times higher than Australian defaults).
A more interesting finding speaks to relative value. Because of the much stronger run-up in UK house prices prior to the GFC, the overall change in housing costs over the last 18 years has been virtually identical to Australia’s notwithstanding the sharp recent correction.
This can be seen in two ways. First, the levels in the charts are similar after accounting for a couple of decades worth of value changes. Second, the compound annual growth rates between 1993 and 2011 are statistically indistinguishable (7.3 per cent in the case of Australia, and 7.0 per cent for the UK).
If we plot the two house price benchmarks on a so-called “logarithmic scale” we can also evaluate their changes on a truly like-for-like basis. A log scale transforms the first chart such that movements in the two lines represent the same percentage change. As you can see in the second chart, the two lines look like one.
As a final test, we can compare house price-to-income ratios. Thankfully the economists at ANZ, which happens to have a British CEO, have done this for us (see the third chart below). It turns out that the UK house price-to-income ratio is actually higher than Australia’s, which suggests that Aussie housing may actually be better priced.
Based on the analysis above, residential property in Australia looks to be just as good value as UK housing today. Indeed, with demonstrably superior economic and household income prospects, and faster household formation rates, one might reasonably project superior returns going forward.
Thursday, August 04, 2011
A friend, Dominic Stevens, who is CEO of the annuity provider Challenger, shot me a chart of Australian house prices compared with US house prices over the long-term. This particular chart seemed to suggest that there was an enormous difference in the growth rates. Dom asked me whether it was right.
So we took up the challenge of answering his question. In Australia, all home sales data is collected by State Government land titles or valuer generals’ offices. However, none of these agencies make comprehensive sales data available prior to around 1975. We therefore view any indices purporting to rely on data before the 1970s as quite suspect, and certainly a very poor representation of the national market. It also turns out that reliable US house price data starts in about the mid 1970s too.
The two most respected indices in the US, produced by S&P Case-Shiller and the Federal Housing Finance Agency (FHFA), begin their benchmarks in 1987 and 1975, respectively. Robert Shiller has tried to construct a longer-term house price series, but relies on a “five-city” median price proxy between 1934 and 1952, and presumably poorer data prior to that. It is hard to fathom how one could legitimately argue that a sample taken from five US cities is somehow a decent representation of 50-100 cities spread across the US.
For Australia, we used RP Data’s information to construct a comparable “all regions” median price index (ie, as broad as possible) based on the criterion that we needed at least 12,000 dwelling sales per quarter. This begins in 1975 and by the end of that year we are including nearly 20,000 sales per quarter.*
The results of our analysis over this 36 year period are shown in the chart below. The first interesting insight is that Australian house prices grew no faster than US house prices right up until the late 1980s. And even during the next one and a half to two decades, the growth rates were similar. It is only the recent financial markets’ crisis and ensuing recession that has caused a noticeable disconnect. (Click to enlarge chart.)
Over the 32 year period stretching between 1975 and 2007 (ie, just before the GFC), the inflation-adjusted compound annual capital growth rate (“CAGR”) for Australian dwelling prices was 2.6 per cent. In contrast, the inflation-adjusted compound annual capital growth rate for US dwellings was 1.7 per cent.**
That is, there was only a 0.9 per cent per annum differential in the real house price growth rates realised in Australia and the US in the three-plus decades before the US sub-prime crisis materialised (of course, cumulatively this gives rise to a material divide in house price levels).
Since 2007, or the advent of the GFC, the differences between the two countries have widened considerably given the strongly divergent economic circumstances.
The US had its worst recession since the 1930s depression with the unemployment rate surging to 9.2 per cent. Australia, in contrast, suffered only one quarter of negative GDP growth and today has an unemployment rate of 4.9 per cent. Within the housing market, US mortgage default rates are more than 11 times higher than Australian equivalents (8 per cent compared with 0.7 per cent) notwithstanding our far steeper interest rates.
The effects of the crisis, and the 15 per cent to 30 per cent peak-to-trough fall in US dwelling values, led the US market’s real CAGR to fall from 1.7 per cent to just 0.5 per cent. Since default rates and the unemployment rate only ticked up mildly, Australia’s real CAGR has remained relatively stable at 2.5 per cent.
One question is whether the long-run differences between the two markets have been driven by per capita incomes. We find that real per capita national incomes have been nearly identical over the last 36 years.
There has, however, been a substantial disparity in inflation rates, with consumer prices in Australia growing at about a 1.2 per cent per annum higher pace than the US. This may be related to the fact that the RBA has a substantially higher inflation target than the Federal Reserve.
In addition to the underlying economics, a range of institutional, regulatory and tax factors have likely conspired to cause divergent outcomes.
For example, US home owners get the benefit of tax deductible mortgage interest payments, whereas Australians do not. This has led US borrowers to use more leverage, and hold it against their homes for longer (resulting in higher and more volatile default rates).
Australians, in comparison, typically pay down their mortgage debt quickly (because it is expensive) over a 15 year period, well in advance of the normal loan’s 25 year term.
In the US, households also pay capital gains tax above a certain threshold, whereas Australians (and those living in Canada, the UK, New Zealand, France and Germany) do not.
Finally, Australia has a much denser urban structure, with 61 per cent of our population residing in urban areas with more than 750,000 people, whereas the US is far more decentralised, with a comparable rate of just 47 per cent.
As always, the devil is in the detail!
* For the technical boffins, we use a simple median price index because it includes the maximum amount of data. An hedonic index would not be possible because we don’t have sufficient property attribute information in the 1970s and a repeat-sales index excludes too many observations for our liking.
**Again, for the boffins, our analysis of all alterations and additions data collected by the ABS implies that you should probably knock about 0.5 per cent to 0.6 per cent per annum off the CAGR to account for capital improvements to homes when using median prices.
Thursday, July 28, 2011
This is from my Property Observer column.
What’s the chance of losing money when you buy a home? Or, put another way, what percentage of all people who buy and sell suffer losses before accounting for costs? As simple as these questions may sound, they are not easy to answer. There are only a handful of organisations with the data and capabilities required to run this type of analysis.
Addressing this question is also important if you want to better understand individual property level risk, which is something that I have written about for years. In this column, I showed that the volatility of a home is akin to that of the share market, and three to five times riskier than a broad-based house price index.
Commencing our analysis in 1990, Rismark’s team of PhDs collected 3.7 million purchase and sale pair transactions pertaining to the same home. We call these ‘repeat-sales’. In total, there were 7.3 million transactions. Of course, there are going to be many people who bought homes during this period, but who have yet to sell. They are, by definition, excluded.
The team then calculated the buy-and-hold annual compound capital return (excluding imputed or explicit rents). These are, to be sure, gross returns and do not account for the many transaction costs associated with holding a home. They also do not control for alterations and additions (viz., renovations), which are undertaken to offset the physical depreciation of the asset, or simply to improve it.
A number of years ago we took the ABS’s alterations and additions data and tried to estimate its impact on annual capital growth. The number we arrived at was about 0.55 per cent per annum, which has been confirmed by other analysts.
The results of the first cut of our research are illustrated in the chart below. The median capital return to property owners since 1990 has been 7.8 per cent per annum.
This is interesting for a couple of reasons.
First, it is exactly the same compound annual growth rate we get when we look at RP Data-Rismark’s hedonic house price index over the last 10 years, which is a completely different methodology.
Secondly, it just happens to accord with the return we get if we calculate the compound annual growth rate attributable to a very simple ‘median’ house price index over the last 28 years.
Observe in the chart above that the distribution of buy-and-hold returns looks to be right skewed: more people are realising high returns relative to very low returns.
In particular, 9.3 per cent of all homeowners traded their property for a loss (note that these are pure capital returns, and ignore the rental income that you would have got along the way). This is also gross of all transaction costs, so you can be sure that the net number is higher. Ipso facto, around 90 per cent of owners realise positive gross capital returns on their homes before accounting for rents and costs.
The next diagram breaks-out this analysis by capital city so that we can get a feel for relative performance over the last two decades. And the results are fascinating. Perth and Adelaide are the two best performing cities, generating compound annual capital growth rates of 10.3 per cent and 9.5 per cent, respectively. The worst performer was Sydney, which has yielded about one per cent per annum less than the national average of 7.8 per cent per annum.
Two other things to think about.
First, these returns reflect the change in the capital value of a home over time. What they do not tell us is what the homeowner’s actual equity, or geared return, would have been. We can comfortably assume that the equity returns are far higher (likewise the losses for the one in ten folks that get unlucky).
Second, as discussed, this analysis excluded gross rents, which are currently around four to five per cent per annum. It also ignores all transaction costs, which sum to around one to two per cent per annum for the average homeowner who stays in their property for seven to eight years.
In closing, what are reasonable growth expectations going forward? A simple benchmark is national disposable incomes. If we take the ABS National Disposable Income estimates, and divide by the number of households to control for population growth, we get a useful per household growth estimate.
Based on this measure, Australian disposable incomes per household have risen by 4.9 per cent per annum since 1993, which is about 25 per cent higher than wages growth. The differential could be attributable to the advent of multiple-income households, the tendency for marginal tax rates to decline, stimulatory government subsidies, such as middle class welfare, and as a result of the better portfolio diversification households are getting via superannuation.
Looking ahead, one might reason that disposable income growth will be a bit lower. This in turn implies that house price growth might be less than the circa seven to eight per cent annual rate that it has compounded at over the last three decades.
Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.
Friday, July 22, 2011
Housing at crucial crossroads
There is mounting evidence to suggest that Australia’s housing market rests at a critical juncture. The first two charts below show the evolution of Australian dwelling values since 2000 and 2006, respectively. You can clearly see the latest innovation in the housing cycle, wherein overall Australian home values (blue line) have tapered by a modest 2.3 per cent. The question on everyone’s lips is, What lies in wait?
Before I address this, it is interesting to inspect the charts more carefully. Observe, in particular, how Sydney dwelling values have massively underperformed the rest of the Australian market over the last circa 11 years (black line, first chart). It is also fascinating to note that notwithstanding the Perth and Brisbane housing markets have suffered 7.5 per cent and 5.9 per cent declines in the past year, they have actually been our two best performing conurbations over the last 11 years.
In my opinion, the near-term destiny of Australia’s housing market very much depends on next week’s second quarter inflation numbers. If inflation is low, the RBA will likely be on the sidelines for the rest of the year. It can argue that it was vindicated for not responding to the very high first quarter results, and will in any event be downgrading its economic growth forecasts for 2011, which were always on the high side.
Talk in the media will galvanize more firmly around rate cuts. Consumers will start to scale back their still-extraordinarily-hawkish interest rate views (see chart below), with 84 per cent anticipating rate hikes. Given the average Australian thinks they will be hit by two or more rate hikes in the next 12 months, it is no surprise that underlying economic conditions have been so soft.
In this low inflation scenario with no future hikes and the prospect of cuts, our forecasting models predict that Australia’s housing market has the ability to start grinding out very modest capital growth, which, of course, should be complemented by healthy rental returns (see next chart).
In the less favourable alternative, where inflation next week prints high—at say 0.8 per cent for the quarter or more—it saddens me to say that our beloved central bank will be very much on the interest rate warpath. That means the likelihood of a rate hike, or hikes, before the year is out. And the half-nelson that the RBA currently has Australia’s housing market in will only tighten.
These cross-roads are best illustrated by the divergence of beliefs between economists and the financial markets. The following chart shows ANZ’s interest rate forecasts contrasted against the futures market’s expectations. Whereas the futures market is predicting rate cuts, ANZ thinks we will get hikes.
Who is right? We cannot tell at this point. It all depends on inflation. So, if you are looking to buy, but have not found a place yet, I would be hoping for a high inflation outcome, which will inevitably result in persistent, interest rate-induced pressure on prices. If, on the other hand, you are looking to sell, you should be praying for a low number next week.
Tuesday, June 28, 2011
Are Australia’s banks overexposed to housing vis-à-vis business lending, as so many pundits claim? Does the regulator madly tilt the odds in favour of the former? And should banks have a softer, social objective to extend more finance to businesses as opposed to residential borrowers, since, it is argued, the latter are ‘unproductive’? I hope to address all these questions today.
Australia’s banking regulator, APRA, is regarded as being a far-sighted and prudent agency in comparison to many of its overseas peers. (I’ve previously made the case that there was as much providence as prescience in Australia.). It is certainly true to say that over the years APRA has placed Australian banks under tremendous pressure to adjust practices it considers to be unnecessarily hazardous.
APRA works hand-in-hand with Australia’s central bank, the RBA, which until 1997 also had responsibility for banking supervision. Following the findings of the Wallis Inquiry, APRA was created, and the prudential supervisory responsibility previously held by the RBA transferred to it. The idea was that the RBA had too much on its plate—too many objectives once one accounted for its central role of keeping prices stable via management of economy-wide interest rates. There is much to be said for this logic, which is actually a rather unique regulatory set-up in a developed world context (most of our contemporaries have their central banks, like the US Federal Reserve, do pretty much everything).
Having said that, the RBA does, in fact, continue to exercise regulatory responsibilities in the banking domain through two chief means: first, the RBA controls the so-called “liquidity facilities” that all Australian banks and building societies have access to, and tap from time-to-time. These facilities allow them to “put” their assets to the RBA in a liquidity crisis and obtain funding from it (ie, the RBA lends to them against this collateral).
The second way the RBA exercises influence over the banking system is through its so-called “financial stability” remit. Inside the RBA there is a team of very highly qualified economists—led by Assistant Governor-in-waiting, Dr Luci Ellis—who spend all their time monitoring the manifold risks that have the potential to threaten the viability of Australia’s financial system.
Since most of this system is dominated by the banks, the RBA’s team does an enormous amount of analysis on different credit risks, default rates, the exposure of banks to the housing and commercial property sectors, and so on. All of this work comes to fruition bi-annually in a detailed, 100-plus page study known as the Financial Stability Review.
Neither APRA nor the RBA get rewarded for banks making big profits. They are typically only recognised when they help us avoid some catastrophe, such as during the GFC. This tends to make both institutions exceedingly conservative.
With that background in hand, we can turn to my first question: what do APRA and the RBA consider to be riskier—housing or business lending? This is actually easy to answer through the formal “risk-weights” that APRA forces banks to apply against different types of loans. The risk-weights in turn determine how much capital, or money, a bank needs to hold against every dollar of residential or business credit they extend. These weights are, therefore, a proxy for the probability of loss when you get into the lending game.
For all non-major banks, business loans attract a 100 per cent risk-weight whereas residential credit gets half this amount (ie, a 50 per cent risk-weight). APRA applies a much lower risk-weight to residential credit precisely because the proven empirical risks associated with this form of finance indicate that it has lower probabilities of loss than conventional business lending. If the opposite were true, and home loans were a more hazardous credit, then the risk-weights would work the other way around.
The major banks get the benefit of even lower risk-weights (and, thus, a lower cost of capital) compared to their competitors because they are permitted to use an “internally-determined” risk-weighting system under what is known as the “Advanced Route”. This means that APRA allows them to set their own risk-weights subject to a range of sophisticated rules.
You can see in my first chart, which was extracted from the RBA’s latest Financial Stability Review, the various risk-weights the major banks apply to different credits. On average, the risk-weight on home loans is around one-quarter the risk-weight on business loans to large companies. Since banks can hold less capital against a home loan, this is, in theory, a relatively more profitable activity for them to undertake. That last statement ignores, however, the impact of bank margins. Margins on business loans tend to be much higher than residential loans (as seen in higher business lending rates) in recognition of the former’s risks and the relatively greater labour intensity associated with assessing business credit risk. When all is said and done (ie, adjusted for margins), the actual returns on the two forms of finance are likely to be similar.
A second powerful quantification of business versus residential risk is supplied by examining bank default rates (ie, “non-performing” loans) and associated losses (or impairments). Once again, the Financial Stability Review delivers in spades here.
The next two charts cast into sharp relief the fundamental problem bank regulators have with business lending. In the right-hand-side panel of the fist chart, the RBA has broken-out Australian banks’ non-performing loans by type. Non-performance (ie, loans in arrears) is expressed as a percentage of the total loans in that category.
So, we can see that over 3.5 per cent of all business loans (blue line) are non-performing (ie, in default). In comparison, only around 0.7 per cent of all residential borrowers (orange line) are materially behind on their repayments. That is, default rates on home loans are a fraction of arrears on business loans.
Yet the real clincher is in the total dollar value of these non-performing loans. Today Australian banks tend to have a rough 60:40 split in favour of residential/business lending. Before the 1991 recession, the ratio was the reverse, with the majority of bank credit going to businesses. These exposures almost caused the collapse of two of the majors, ANZ and Westpac. Since that time, the majors have acknowledged the higher risks inherent in their business portfolios, and reversed course, with the encouragement of regulators.
Even so, look what once again happened during the GFC. Compare, in particular, the first two panels of the next chart. The far left-hand-side panel shows the dollar value of impaired housing loans (ie, red line). It looks like impairments are a little higher than $2 billion in total, which is trivial when you consider that there are well north of $1 trillion worth of residential mortgages out there. Now contrast this against the middle panel, which shows the banks’ impaired business loans based on the latest data. Total business impairments look to be over $22 billion, or a remarkable 10x higher than residential impairments.
Now ask yourself this question: would you have Australian banks ramp up their exposures to the middle column (ie, business lending) in preference to the first column (ie, residential lending), as folks like Steve Keen suggest would be a smart idea? I don’t think so.
For what it is worth, exactly the same phenomenon asserted itself during the much more acute 1991 recession. My final chart shows the loss rates across CBA’s different credit portfolios in that downturn, when unemployment peaked at close to 11 per cent while mortgage rates hit 17 per cent. Notwithstanding the serious difficulties households were having at the time, the losses on home loans (bottom red line) were a tiny fraction of the losses CBA realised on all other forms of credit.
I want to conclude with some words on the question of whether housing investments are ‘unproductive’. Notionally respected critics employ this argument to suggest that policymakers should discourage it by changing the negative gearing and/or capital gains tax rules. This logic is, however, flawed.
In standard economics theory, the two most basic necessities for a functioning economy and, more specifically, productive labour, are: food and shelter. We can interpret ‘shelter’ as covering both residential property, which is the accommodation required by a functional labour force, and commercial property, which is the accommodation needed for productive businesses.
You can either be a ‘producer’ of food and shelter by investing in, and owning, the underlying assets that supply these services/products by owning farms, homes, or commercial buildings; or, alternatively, you can just ‘consume’ these services/products and not invest in the assets by simply buying food from the supermarket, renting a home, or leasing space in a building.
There is a final option where you can both consume and invest by living on a farm (and eating its produce), owning and occupying your home, or owning and occupying the building in which your business operates as some companies do.
As an investor in agriculture, housing, or commercial property, you derive returns as you would with any other productive asset: via a mix of both growth in the capital value of the asset and income from the sale of the products/services (ie, food, residential accommodation, and commercial accommodation).
In addition to its innate productivity as a form of shelter for workers, academic researchers have shown that housing investments positively impact both labour and business productivity. That is, the higher the quality of housing, the more productive workers and businesses can be. The ABS has also demonstrated that investments in new housing have a very high, 2.9 times economic multiplier. This means that every dollar committed to building homes generates another 2.9 dollars of extra spending across the wider economy.
Finally, the housing market is increasingly fulfilling a new economic purpose: with the advancement of technology such as the NBN, supplying accommodation for businesses as more people work from home. The home is no longer an office for just the self-employed individual, or for secondary employment activity. It is increasingly the workplace of professional service employees in their primary job, who don’t wish to commute long hours to their labour market.
Tuesday, June 28, 2011
The RBA's Dr Guy Debelle has given another solid, albeit legally flawed, speech today on the liquidity of the banking system and the central bank's role in supporting such. He raises, and then seeks to address, several issues that I have brought to public attention in my writings for Business Spectator over time.
First, Dr Debelle acknowledges that the RBA's liquidity services represent a direct subsidy from taxpayers to the banking system:
"[I]n a stressed situation, that [RBA] rate is still likely to be less than the market rate, as otherwise there would be no need for recourse to the central bank. Thus the rate is penal relative to the normal cost of liquidity provision but not necessarily relative to the stressed market price of funding."
Second, he acknowledges that in acting as "lender of last resort" to banks that cannot fund themselves in the private markets--which Dr Debelle fails to observe meets the legal definition of insolvency--the central bank performs a very odd social function indeed.
In short, the central bank lifts itself above the ordinary operations of the Corporations Act and decides in its unilateral judgment which banks are insolvent and which banks are having what is euphemistically known as a "liquidity" as opposed to "solvency" crisis. I have written about this many times before. Under Australian law, there is no distinction: if you cannot meet your current liabilities, you are trading insolvent. Period.
I am not sure whether either Dr Debelle or the RBA understand this nuance. I am pretty sure I am the only person who has highlighted it, at least publicly in this country. To the extent they do understand this very significant legal and economic distinction, they should at least acknowledge it.
According to the RBA's narrative, the central bank is endowed with tremendous analytical powers--powers superior to all the participants in the market itself, which, it should be noted, have decided to deny reasonable finance to the institutions in question--and, by discriminating between good and bad credits, can offer these same institutions sub-market interest rates and terms. To quote Debelle:
"If a bank is experiencing a problem of illiquidity, the state of its asset portfolio is even more paramount. This relates to one of the fundamental tenets of central banking, most famously associated with Walter Bagehot. Writing in Lombard Street in 1873, Bagehot states that central banks should lend freely (ie, liberally) at a high rate to solvent but illiquid banks that have good collateral."
The third point Debelle makes, but glosses over, is that banks get this taxpayer subsidy because they are engaged in what is known as 'maturity transformation'. That is, they convert our short-term savings into long-term loans, and thus provide the fabric of liquidity upon which the economy so crucially relies. This produces a fundamental business flaw: if we ever demand those savings back, the bank may not be able to repay us. Hence the need for 'central banks', which have been established in developed countries around the world to furnish public sector liquidity support to failing private banks.
As a final point, Dr Debelle makes the case that "the central bank's provision of liquidity can be regarded as a 'public good'" referencing a 2008 paper by two RBA economists. This seems symptomatic of an RBA tendency of avoiding appropriate referencing of third-party work if that material does not originate from within its central banking orbit.
The policy concept of liquidity as a public good was first outlined formally in Australia in a Melbourne Business School paper published by Professor Joshua Gans and myself in early 2008. Fortunately, this paper was referenced by the two RBA economists that Dr Debelle footnotes.
In summary, Dr Debelle, the RBA and other central bankers would do well to drop the historical fiction that a central bank can distinguish between "illiquid" and "insolvent" institutions. Under the law by which all corporations and the RBA must abide, there is, in fact, no such distinction.
The Corporations Act is crystal clear in this respect: you are an insolvent institution if you cannot pay your debts "as and when they become due and payable." Put more bluntly, if you cannot pay them without recourse to the RBA's liquidity facilities, you are insolvent.
The RBA would have us believe that even if a bank cannot repay all of its depositors, or all of its short-term creditors, the bank may not be insolvent if the RBA (an unelected independent statutory authority) deems that the bank has sound assets, and could, potentially, meet its obligations if the RBA supplies that bank with taxpayer-underwritten bridging finance.
Let's call a spade a spade. Banks have business models encumbered by asset-liability mismatches that during liquidity shocks may require taxpayer subsidies. That is one key reason why we have a central bank in the first place: to bail private banks out of financial crises.
Legally and factually flawed central banking spin is only likely to encourage private bankers to believe that they are indeed government guaranteed, and able to tap the RBA's liquidity facilities so long as they remain too big to fail.
Wednesday, May 18, 2011
For some time now, I have argued that the RBA's decision-making ability is likely being compromised by the five business people that sit on its Board. These professionals are clearly conflicted when it comes to raising interest rates. That's not to say there's been any form of questionable behaviour by any of them. It's just that the private businesses they represent – to say nothing of their own personal investments – are in most cases some of the worst affected by tighter policy.
Jillian Broadbent is a Director of our largest retailer, Woolworths. Roger Corbett used to be CEO of Woolworths, and is now Chairman of Fairfax, which is heavily dependent on the cyclical advertising industry. Graham Kraehe is Chairman of BlueScope Steel, which is one of the more currency-sensitive exporters. Catherine Tanna runs British Gas in Australia, which presumably suffers when the exchange rate appreciates. And then we have the example of former Board member, Frank Lowy, whose wealth derived from the nation's biggest shopping centre empire. You don't need a PhD to figure out the impact of higher rates on retail consumption.
The number one rule that members must abide by when they agree to serve on the RBA Board is that they never, ever make comments on the conduct of monetary policy that could adversely impact the community's perception of it, or betray Board disunity. Public communications are the Governor's responsibility, as Chairman of the Board, and the face of the Bank. Roger Corbett appears to have fallen foul of these protocols.
In an interview given to Dow Jones last night, Mr Corbett seems to have contradicted the RBA's positions on inflation and interest rates, and described Australia's two-speed economy, which is something the RBA has worked hard to play down as a formative influence on policy, as a ‘major problem’.
He also sympathises with the consumers the RBA is deliberately seeking to suppress via higher interest rates, alleging, “The consumer is definitely feeling the pinch in New South Wales and Victoria … This ongoing debate about the economy, and the obvious implication that if things continue there will be further increases in interest rates, is very sobering for most Australians.”
It is, however, Mr Corbett's comments on inflation that are most remarkable. On the same day that the RBA released its Board Minutes with projections that core inflation in Australia will hit an unacceptably high (top of its target band) three per cent annualised rate by the end of this year, and stay there until 2013 at which point the RBA believes it will breach its two to three per cent band, Mr Corbett has tendered a very different perspective:
“But despite the rise in utilities, Australia isn't suffering a wider breakout in price pressures. We haven't got inflation. We have got very moderate inflation. Are there issues which Australia will have to face going forward? Undoubtedly.”
It is difficult to see how one can argue that Australia doesn't have inflation, only “very moderate inflation”, when the year-on-year headline inflation numbers printed at an above-target 3.3 per cent in March, and the annualised pace of core inflation in the March quarter was 3.4 per cent. This is to say nothing of the fact that the RBA's own analysis suggests Australia faces a serious inflation challenge between 2011 and 2013 even if it allows for two more rate hikes.
The ABS's cost of living indexes, which were released this week, paint an even more worrying picture, with the average working family experiencing a 4.9 per cent rise in its cost of living over the last year, which likely explains why consumer inflation expectations have been drifting up since the GFC.
Mr Corbett also highlights the Aussie dollar as "one of the most constraining influences across this country" with the implication that it is doing some of the RBA's work for it. This is being portrayed as a subject of considerable Board debate.
For the avoidance of any doubt, financial market participants last night took Mr Corbett's comments to conflict with the RBA's more hawkish stance, and believe they lend direct credence to rumours that the business members of the RBA's Board are at loggerheads with the executive. The media too has started picking up on this dynamic. Today, The Australian’s headline reports, ‘Interest rates to rise despite RBA board concern’. The opening paragraph continues:
“THE Reserve Bank will push ahead with an interest rate rise … despite growing concerns from its corporate board members … that the economy is troubled outside the powerful mining sector … The decision will anger the nation's chief executives, who are stepping up a campaign for the RBA to keep rates steady … One of the RBA's board members, the prominent retailer and Fairfax chairman Roger Corbett, yesterday said the economy was remarkably weak outside of the mining sector.”
Corbett's dovish remarks shed light on the market's recent complaints about the RBA's ostensibly confusing communications. The market interpreted the one page statement following the May Board meeting as being more dovish than it had expected.
A few days later, the market raised the probability of rate hikes after a “surprisingly hawkish” Statement on Monetary Policy, which is produced by the RBA's internal executive. There was active talk of a disconnect between RBA insiders and their more rate-sensitive Board members. Today The Australian reports one strategist as observing, “the board membership contains many industry people who may feel that the margin pressure on non-commodity exporting businesses resulting from the strong dollar is a sufficient constraint on business that additional interest rate hikes are not yet justified”.
To serve as a member of the RBA Board, one must, as a minimum, always abide by the crucial principles of (a) public solidarity with the Governor, and (b) never undermine perceptions of the Bank's commitment to price stability. More particularly, Board members are simply not permitted to make remarks that can be regarded as statements (god forbid, conflicting ones) on the current stance of monetary policy.
For years I have argued the RBA needs a strong, independent Board. But like Professors Warwick McKibbin and Adrian Pagan, a current and a former Board member, I believe we need specialists not lay business executives. The only credible claim in favour of the conflicted business people is that they give the RBA access to good information. I've previously made the point that this view is redundant given the RBA's unparalleled access to corporate Australia, and its direct monthly business surveys of hundreds of individual companies. If they want insights, they can get it in a heartbeat.
One possible indication of the RBA's diluted inflation-fighting respect in financial markets is the fact that investors have hardly altered the probability of rate hikes despite the RBA's belaboured attempts to set pricing right. These flaws in current market pricing were a consistent theme referred to in yesterday's Board Minutes.
The RBA's Board woes are also another reminder of why it is such a shame that its one truly unconflicted and most technically adroit member, Professor Warwick McKibbin, is being removed from it because of his comments on public policy. Ironically, McKibbin, who is universally regarded as Australia's leading macroeconomist, has been excoriated for engaging in debate on non-RBA related policy matters, but has always been careful to avoid opining on rates.
All told, this state of affairs is very disappointing. The poor folks inside the RBA have given their careers and lives to this wonderful institution. Taxpayers could not ask to be served by a more talented or ethical bunch of people. Without a shadow of doubt, they have the toughest job in the economic bureaucracy today.
Contrary to some absurd suggestions, Glenn Stevens deserves every cent of his well-below-market pay packet. A few commentators have made farcical comparisons to back their view that Stevens is paid too much. Let me objectively lay that debate to rest.
Glenn Stevens runs Australia's central bank, which is our single most important financial institution. It is the backstop for the entire banking system, and exerts a decisive influence over the path of Australia's $1.4 trillion economy. Stevens gets paid about $1 million per annum.
In its 2010 Annual Report, the CBA discloses that its top 12 executives are all paid, on average, $5.4 million per annum. Assuming that broadly similar pay benchmarks are used across the other three major banks, that tells us that there are at least 48 bank executives, setting aside all their smaller bank peers, who receive, on average, more than five times as much total annual compensation as Glenn Stevens. (If we ignore Ralph Norris's 2010 remuneration of $16.1 million, the average/median pay for the 11 other CBA executives is still $4.2 million to $4.4 million per annum.)
A conservative assumption is that Stevens could get at least a second-tier job at one of the major banks. The precedents set by David Morgan (Westpac), Andrew Mohl (AMP) and John Fraser (UBS) imply he could actually run one. This, therefore, is his opportunity cost. Even supposing he could only pick up a subordinate position, Stevens is, in fact, very poorly paid if one accepts the principle of market-competitive benchmarks.
My own figuring is that the criticisms of his paltry pay are more a function of relative justice concerns on the part of those making the claims.
Thursday, May 12, 2011
As I have explained here before, a June hike was crucially dependent on two things: the labour market and wages data, with the Budget posing a curve-ball in the event that it was surprisingly austere (no problems there).
The jobs numbers today were weak. While March was revised up to 43.3k jobs created in the month (from 37.8k), and the UE rate held steady at 4.85 per cent (slightly off from 4.92 per cent), a total of 22k jobs were lost in the month, with 49k full-time jobs going and 26.9k part-time ones created. The saving grace for the UE rate, which technically declined, was the participation rate, which fell from its near all-time record high of 65.8 per cent to 65.6 per cent. As you can see from the chart below, the Aussie dollar/USD pair shaved more than a full cent.
To see a large version of this image, click here.
The truth is that the monthly UE data are a crap-shoot with a wide 95 per cent confidence interval for total jobs created of between -77k and +32.5k (the actual number was -22k). The more telling point is that the UE rate has been bobbing along around 5 per cent since May 2010. So one school of thought would be that there is no real smoking gun yet for the RBA in terms of extreme labour tightness. The bullet is loaded, their finger is on the trigger, but it has yet to arguably fire. A structural break below 5 per cent and wages growth will be the two catalysts for genuine concerns, according to this view of the world.
And there is no doubt that this new information puts the prospects for a June rate hike on the back-burner for the time being (pun intended). All eyes will now turn to the wages numbers. While in theory the RBA should not have trouble hiking in June given the recent inflation results and its outlook, the optics of June are getting harder. They will face a chorus of cries that the high exchange rate is cruelling the tradeable sectors of the economy. They will have a very ugly Q1 GDP number to contend with. And they will have the seemingly compelling argument that they should wait for Q2 CPI to be certain that core inflation is on the loose.
You know my view: I think they should have gone in May, just like I thought they should have gone in October last year. One major tactical advantage of going before Q2 CPI is that the RBA can argue that its tightening in November, and, say, June/July, has kept a lid on price pressures. More simply, the analogy they should be trotting out is this: if you are trying to keep a car within the 60km/hr speed limit, it is much easier to break and decelerate at 80km/hr than it is at 120km/hr. The same is true of price stability.
In summary, this is looking more and more like September-November all over again. Scores of people said they were mad to do a de facto double rate hike in November last year. After the Q1 CPI data, the November hike looked like a belated necessity, and the RBA had suddenly got 'behind the curve'.
The risk, again, is that the RBA waits until August, Q2 CPI prints on the high side, and then suddenly they are once more behind the eight ball. If, and it is an "if", Q2 does print high, Australia would have been running above-target core inflation for over half a year, with the outlook much worse. This in turn risks undermining the tenability of the RBA's overall inflation-targeting regime, which is not something I believe the Bank can afford.
Now before the doves get overexercised, which they almost certainly will, there is every possibility that the May labour data puts them back in their box. Leading indicators imply future jobs growth of 20-30k per month. However, economists thought the April numbers could print low as a function of two things: (1) an unusually long Easter break; and (2) statistical pay-back for a super strong March result, which has actually been revised up further from 37.8k to 43.3k new jobs. The UE data tends to be a bit autoregressive in this respect.
The key is the participation rate (and, of course, jobs growth). If the participation rate stays low, or continues to decline, we could easily see a 4.6-4.7 per cent UE rate next month. So don't count your doves while the hawks are still in the sky...
Wednesday, May 11, 2011
First some thoughts from me and then the economists:
- Fiscally responsible, which is the least one should expect, but not tough enough.
- Initiatives to improve the supply of labour to Australia's fully-employed labour market, the participation rate, vital spending on national infrastructure (exclusive of the NBN waste), long overdue support for mental health, a rolling back of middle-class welfare, and maintenance of the liquidity of the government debt markets are all commendable measures.
- Having said that, I don't think this Budget will give any comfort whatsoever to a policy-challenged RBA, and a rate hike in June/July remains very much a 'live' possibility. If anything, the Budget disappointed in the austerity stakes. And the ramp-up in public spending on infrastructure, combined with tax incentives to encourage private investment, will only exacerbate supply constraints in the near-term (although these are much needed programs given Australia's infrastructure deficiencies).
- The chief problem is that public sector spending as a share of total economy-wide spending remains too high post the GFC-induced binge.
- The economy is operating close to its capacity, with a fully employed labour market and clearly emerging wage and inflation pressures.
- The nation is embarking on one of the biggest private capex booms in post-war history, and the public sector is consuming too many scarce resources.
- The Government has avoided making tough decisions on spending, and is leaving the (capacity-liberating) hard yakka to the RBA's blunt monetary policy instrument.
- Depositors will benefit from higher returns; expect to see seven per cent plus term deposit rates before too long. Cash will be king.
- House prices are going nowhere, as we have forecast since early 2010, although investors will benefit from robust rental growth.
- The share market will face significant headwinds as the RBA turns the monetary policy screws over 2011-12. Don't expect the Aussie equities market to recover its 2007 peak until perhaps 2013-14 or beyond.
Now over to the economists. Here's JP Morgan:
“A potential source of disappointment is the lack of ‘big-ticket’ expenditure savings – real bell-ringers, rather than bits and pieces all over the place – that would have signalled that the Government is really serious about cutting the spending that blew out during the GFC. While the Government is promising to do its bit in tightening conditions in the economy by delivering a surplus, the heavy lifting still will be left to the Reserve Bank – the cash rate is headed up, most likely within the next few months. This Budget has moved in the right direction, but has not done enough to prevent interest rates from rising.”
“The markets and analysts, however, will likely be disappointed by the very small size of projected budget surpluses in the years beyond 2012-13 and the return to stronger rates of spending growth (albeit still below the self-imposed two per cent per annum real cap), though to be fair this does include a very mild assumption about a decline in the terms of trade of 20 per cent over a 15-year projection period. The challenge over coming years will be to continue to improve the structural position of Australia's fiscal accounts in case the terms of trade weakens more substantially. The structural position was substantially weakened between 2004-05 and 2007-08, principally as the main benefits of the once in 150-year surge in the terms of trade were returned to the electorate in the form of tax cuts and middle-class welfare. This budget takes some useful steps in this direction in spite of the Government's minority status, but is likely to be criticised for not going far enough…
“What distinguishes this budget is the extent of focus on microeconomic matters and arguably a relatively smaller focus on the broader macro aspects of policy. This is not to say that the micro aspects are not important, just that a greater emphasis on improving the structural budget position over the full four-year budget forecast/projection period would have been welcome. Good examples of some of the positive micro aspects (albeit with a macro bent) include the wind back/pausing of some welfare payments and the increase in skilled migrant visas (to a record 125,850)…
“The markets are likely to view the stance of the Budget as not sufficient to dissuade the RBA from further interest rate hikes in the months ahead.”
“There's no unique measure of fiscal stimulus, but the Reserve Bank often uses the forecast change in the Budget balance as a share of GDP as a shorthand indicator. On this basis, the Budget is a 2.1pp drag on growth in 2011-12, with a further drag of 1.7pp in 2012-13.
“This is substantial turnaround and would be one of the biggest improvements in the Budget balance in the post-WW2 period. On our rough calculation, it would only be surpassed by the "horror" Budget of 1951-52, when tight fiscal policy saw a three pp turnaround in the Budget bottom-line.
“Whether or not fiscal policy actually turns out to be such a drag on growth is hard to judge, largely because history shows that it is very difficult to accurately forecast the Budget balance, especially two years into the future…
“Although the Government did run a large deficit during the global financial crisis, it pales in comparison with the deficits seen in the US and the UK, where deficits exceeded 10 per cent of GDP.
“If all goes to plan it should return to surplus much earlier than other countries and its challenge remains dealing with the resources boom. After all, the time for fiscal stimulus is well behind us even as the Government tilts its policy mix towards dealing with some the regional and industry inequality created by the boom.
“Another unusual problem is that a return to surplus will create tension between a strong demand for bonds - the product of strong offshore demand and tougher prudential regulations that will encourage banks to hold more Commonwealth bonds as liquid assets - and insufficient supply.
“The Commonwealth faced a similar problem in 2003 when surpluses meant that it could have paid down the bond market. Instead it decided to keep enough bonds on issue to maintain the liquidity of the futures market (c$50-55 billion of stock) and used some of the surpluses to establish the Future Fund to finance the unfunded pension liabilities of Commonwealth employees.
“As Skye Masters discusses in her note on the Government's plans for the bond market and issuance, this time it has decided to keep bounds outstanding at around 12 to 14 per cent of GDP (by way of comparison, the OECD average for public debt to GDP is 100 per cent!).
“It will consult with the market, but this is a very welcome development and raises the broader issue of whether the Government should set up a standard sovereign wealth fund – by perhaps broadening the mandate of the Future Fund – or establishing a macro stabilisation fund. While we are very positive on the long-term outlook for Asian commodity demand, the inevitability of the business cycle means either option would be a good one.”
Wednesday, May 11, 2011
While it has not always got it right, this RBA takes its communications policy very seriously. The recent appointment of Vanessa Crowe, the former head of PR at the Bank of England, to run the RBA’s media relations is one reflection of this. Governor Stevens’ transformation of the RBA’s governance, transparency and communications approach – including fostering genuine debate at Board level in comparison to his much more controlling predecessor – is another important illustration.
I also believe that the RBA wants to avoid a repeat of the ‘Shadow Governor syndrome’ whereby one journalist (that is, Terry McCrann) obtains mythical status in financial markets, with his every utterance moving them materially. The problem for the RBA is that this can lead to the journalist overplaying his or her hand. It is similar to the RBA’s desire to avoid the financial markets focusing on specific syntax – such as, “for the time being” – which was very clearly replaced by the equally meaningful final sentence in Tuesday’s Statement (that is, every meeting is live).
The most vivid example of the RBA’s recent media ‘rotation policy’ was David Bassannese last week. Two days before the SoMP, Bassannese predicts, without any equivocality, that the RBA would print 3.25 per cent in December 2013. Because of his imperfect track record in anticipating RBA outcomes, many people ignored him after the initial shock of the report.
The key point that I think folks miss is that the RBA simply cannot afford to irreversibly blow-up its media relationships by misleading contacts. If the RBA words a journalist up, and effectively compels that journalist to communicate a very specific message on their behalf, it is awfully difficult for the Bank to turn 180 degrees and do the complete opposite. The media would lose all faith in the RBA, and much more hesitantly communicate its view of the world, which would in turn make managing inflation expectations more difficult.
McCrann in October last year was different. He had arguably become an issue for the Bank with every article moving interest rate expectations. Whether the Bank had to deliberately head-fake him once is open to question. My own view is that the RBA meant to raise rates in October, but the missing three times independent directors at that particular Board meeting (critically, one of them was McKibbin), plus some genuine debate led to them to delay until November, which had the helpful ancillary benefit of demonstrating that McCrann cannot always correctly forecast every Board decision before the Board has had the opportunity to meet.
So to the question of a June hike. On Saturday, Fairfax's Peter Martin and News Ltd's David Uren – two experienced journalists with impeccable contacts – independently reported that the RBA would ignore the content of the Federal Budget and hike interest rates in June. Martin stated this categorically – without caveat and condition, which is unusual.
“The Reserve Bank will raise interest rates within weeks of Tuesday's federal budget – regardless of its content… The Reserve has held its official cash rate steady at 4.75 per cent since Melbourne Cup Day last year. The next opportunity to move will be at its board meeting on 7 June – four weeks after the budget.”
Uren in The Australian:
“Australians face an interest rate rise as early as next month after the Reserve Bank warned that a tough federal budget next week would not be enough to curb the inflation being driven by accelerating economic growth… Traditionally, the Reserve Bank does not lift rates in June, for fear it will be interpreted as a comment on the inadequacy of the federal budget released in May. The only time it has done so was in June 2002 when rates were returning from very low levels. However, having lifted rates during the 2007 election campaign, governor Glenn Stevens is unlikely to be restrained by political perceptions.”
It is highly unlikely that Martin and Uren would separately report the same thing (which both News Ltd's Terry McCrann and yours truly had forecast a week ago) unless they had been given express instructions by our Central Bank to do so.
So, in my opinion, barring a bad employment result, and a shock deceleration in wages growth, the RBA is likely to seriously consider going in June. Another reason why they will contemplate going in June is because it is somewhat illogical to do anything else. The RBA has told us that Australia will have a core inflation problem in 2011 given their three per cent SoMP forecast. They have further made a very big deal about this core inflation problem deteriorating out to 2013 despite assuming two further hikes, a high exchange rate/TWI, and high oil prices that crimp global growth.
As Glenn Stevens reminded us recently, if the Bank waits until it is absolutely certain it has an inflation problem (such as, in August after the Q2 print), it will almost certainly be too late.
After wording up countless journalists about Australia’s inflation challenges, it does not seem overly credible for the RBA to then wait, say, another full two months (that is, until July) for its next hike. This would be tantamount to saying there is no pressing problem.
Moving in June also reiterates the RBA’s political independence, and is consistent with Stevens’ tendency to break precedent.
Finally, we know that the RBA’s executive thinks that the Government’s fiscal settings have been far too expansionary (via McKibbin and Bloxham), and delaying until July gives the impression that the RBA thought the Budget was doing some of the work for it, which is not something they necessarily want to convey.
Friday, May 06, 2011
Despite Australia’s first quarter core and headline inflation numbers printing at stunning 3.4 per cent and 6.4 per cent annualised rates last week, following on from the ABS’s estimate of producer prices expanding by a stonking 4.8 per cent annualised rate, the interest rate futures markets are still not fully pricing in a single rate hike in 2011. That is to say, financial markets are not certain we will see the RBA move until 2012. The foreign exchange market has tracked in lock-step, with the Aussie dollar shaving nearly three US cents from its recent high of over 1.10 to plunge back to a low of 1.073 in overnight trade. The Aussie dollar continues to fall as I write this, and could well slip back to 1.06 US cents. This firmly reinforces the thesis I outlined earlier this week that it would be mad for the RBA to rely on the exchange rate--as many argue they should--as a secondary monetary policy tool.
Or, put differently, to take the view that it does not need to lift interest rates today because the exchange rate is doing the work for it. Of course, since the Aussie equities market has consistently underperformed (as we predicted) since its 50 per cent crash in November 2007, and a small number of export sectors, such as tourism and education, are being hurt by the currency, there is the 'appearance' of vast swathes of economic discontent. This is naturally contradicted by our 4.9 per cent unemployment rate. I also have little doubt that the five businessmen that sit on the RBA's Board, which lend it an inherently 'dovish' tilt, would be feeling the pinch via their public company responsibilities and direct equities exposures. Surely things must be tough if the sharemarket is getting smashed...
In summary, many billions of dollars of capital, and the world's smartest investors, have collectively concluded that Australia's central bank is not overly worried about core inflation running 100 basis points above its official 2.5 per cent per annum target (ie, the mid point of its mandated 2-3 per cent range), and headline (and cost of living) inflation rising higher again.
Based on all the feedback the RBA has supplied to investors this year, and the formal Statement released by the Board on Tuesday this week, the smart money has inferred that Glenn Stevens basically thinks everything is 'you beaut' down under.
The prevailing consensus is that notwithstanding the RBA’s currently ‘mildly restrictive’ monetary policy and evidence of scorching core and headline inflation pressures emerging (the annualised rates I quote above are consistent with US conventions), this RBA Governor will wait at least until the second and third quarter inflation results come out. He is in no rush. You can just hear investors imagining a dry Australian drawl from Glenn Stevens: "no dramas, mate."
Never mind that if the April through June core inflation figures once again print way above target, the RBA will have ignored one of the highest core inflation rates in the OECD for over half a year, just like it did in 2006-07.
Never mind that if inflation starts also building in the US, and US interest rates begin to rise off their all time historical lows, there will likely be very significant downward pressure on the Australian exchange rate, which will then start acting as a source of domestic inflation, rather than disinflation, in its own right at the same time as the economy is exhausting all its spare capacity .
Never mind that the labour market is already fully employed at the start of the biggest private investment boom in Australia’s history, and that many of our major trading partners—China, India and South Korea—have inflation problems they are beginning to export to us.
One gets the sense that the attitude of investors is partly driven by the fact that the RBA has overshot both its core inflation and headline 2.5 per cent target by about 20 per cent per annum for the last decade.
Indeed, one of the largest fixed income investors in the world recently argued that the RBA's target was not, in fact, 2.5 per cent per annum, and that long-term Australian core inflation equal to 3.0 per cent would, in theory, be consistent with its mandate. I beg to disagree. That would mean that Australia's central bank is comfortable tolerating inflation at least 50 per cent higher than almost other developed world central banks. The RBA itself has made clear that its aim is to keep inflation at 2.5 per cent per annum. The wider 2-3 per cent range simply gives the RBA room to move over the course of the business cycle.
The behaviour of financial markets and the RBA’s long-term performance starts to lend a lot of credence to the expectations of Australian consumers, which, as I have illustrated here many times before, have drifted up over the last 20 years to the point where they are now averaging around 3.5 per cent per annum. The man on the street is basically saying that they don’t believe the RBA will keep inflation at 2.5 per cent per annum over the long-run. And they have been right thus far.
It is also consistent with the break-even inflation rates bond market investors impute to Australia, which are among the highest in the world at 3.08 per cent per annum.
I have recently argued that in order to actually get the RBA to hit a 2.5 per cent inflation target we might have to consider reducing its otherwise high goal back in line with other central banks to, say, 2.0 per cent per annum. At the very least, this would mean that regularly delivering 3.0 per cent core inflation would look a helluva lot worse. That is, it would have a sharper disciplining influence on Australia's central bank.
If for some reason I am wrong, and there is a case to accept past outcomes, and use them as a guide for the future, as both investors and consumers are presently doing, let’s just bite the bullet and raise the RBA’s inflation target to 3.0 per cent per annum, and not try to pretend otherwise.
If the collective intelligence of financial markets is right, and the RBA does not raise rates in 2011, then the credibility of the RBA’s current inflation target will, I believe, be very much open to question. The next 12 months thus loom large as a true test of our central bank’s independence and commitment to price stability.
Friday, April 29, 2011
Since the start of 2011, the RBA has accompanied its monthly interest rate decisions with the following bold statement, which I always thought would leave it with egg on its face given the distribution of risks: "The Bank expects that inflation over the year ahead will continue to be consistent with the 2–3 per cent target." The RBA can no longer credibly make this claim.
Before I explain why, note that both the RBA and the markets interpret the RBA's monetary policy mandate as meaning that it has a 2.5 per cent per annum through-the-cycle inflation target, which, as I have noted here many times before, is actually the highest of any central bank in the developed world with the exception of Norway. Also remember that over the last decade or so, the RBA has consistently missed its (already high) 2.5 per cent per annum target, with both core and headline inflation averaging around three per cent per annum. This has in turn led to upward drift in long-term consumer inflation expectations, which have averaged 3.5 per cent per annum since 2000.
Based on the RBA's inflation forecasts released in its last Statement on Monetary Policy, the Bank was expecting a 0.6 per cent core inflation result in the first quarter of this year. Instead it got a 0.9 per cent outcome (unrounded 0.85 per cent). Even the most dovish economists believe that this will now force the RBA to upgrade its 2011 calender year forecast for underlying inflation from 2.75 per cent to 3.0 per cent. The key point is that this 3 per cent outcome for core inflation is materially above the 2.5 per cent mid-point implied by the RBA's 2-3 per cent per annum range. In even worse news, the RBA may also need to upgrade its headline inflation forecast, which was already at an above-target 3.0 per cent in 2011.
So it is awfully difficult for the RBA's Board to now claim when it meets on Tuesday next week that "the Bank expects that inflation over the year ahead will continue to be consistent with the 2–3 per cent target" given the long and variable lags associated with monetary policy movements. It will now be projecting significantly above-target underlying inflation at a time when its cash rate setting is only generating lending rates that are "a little above average".
And I have not mentioned anything here about the mounting risks of importing more inflation from an urbanising China, a fully-employed labour market, rapidly increasing wage growth, a much more rigid industrial relations environment, and a mad slowing of population growth (care of the xenaphobic debate at the last election, which, as I correctly predicted at the time, is now leading to more acute skills shortages and the need for higher rates).
Some argue that the Australian dollar buys the RBA time. But does it? These same folks maintained that the Aussie dollar's surge over Q4 and Q1 should have given us a benign core inflationary outcome in the first three months of this year. But it did not, and the discounting was not as sharp as many had anticipated. More importantly, the exchange rate is a monetary policy 'circular reference', or a causal result of global interest rate differentials.
The rise in the Aussie has been partly based on the view that the RBA was going to increase rates. If the RBA does not increase rates, the Aussie will face downward pressure.
Another motivator of Aussie appreciation has been central bank diversification away from the USD into commodity currencies, like the AUD and CAD, which I have flagged here before.
But there is a very important constraint on this activity that UBS recently highlighted: when foreign central banks buy the Aussie they need to do so via highly rated and liquid government debt instruments. Australia has a very small government debt market, which is likely to shrink further over time as the Commonwealth seeks to reduce its stock of outstanding obligations. (Foreigners already own nearly three-quarters of all government securities.) In sum, UBS's FX strategists don't think that the Aussie government debt market is large or liquid enough to permit sustained central bank diversification over the long-run.
Yet the major downside risk for the Aussie is, of course, the US dollar. The recent surge in the Aussie/USD pair has been a USD depreciation story. That is, the USD has been falling against all major currencies. This has has been driven by the maintenance of incredibly low US interest rates in contrast to almost all other central banks.
However, as both core and headline inflation in the US now accelerate, and activity gradually recovers, the Federal Reserve has made it clear that it is stopping QE2 and will start thinking about contracting its balance-sheet. This will represent a normalisation of monetary policy and result in higher US interest rates. Put another way, if you think the US is going to have an inflation challenge going forward, you have to be bearish on the Aussie/USD pair.
In summary, over the next 12-24 months, there are likely to be strong headwinds faced by the Aussie. More significantly, the RBA would be silly to rely on continued appreciation in the AUD as a reason for forestalling monetary policy tightening. The risks here are quite the reverse: a substantial 10-20 per cent depreciation in the Aussie over the next 12-24 months care of rising US yields could produce strong domestic inflationary pressures at just the time that the capex boom is taking off. And to the extent that the RBA substitutes currency action for interest rate action, this could be self-fulfilling given the exchange-rate is priced off global interest rate differentials.
A word on the market reaction. All economists were caught-out by yesterday's 0.85 per cent core CPI print (nearly 3.4 per cent annualised) with the exception of RBS and ICAP, which both pencilled in 0.8 per cent outcomes. UBS also canvassed upside risks given the producer price index results last week, which I also drew attention to here. Perhaps the most curious response was the attempt by dovish analysts to then rely on the 'year-on-year' inflation numbers. To be clear, that means bizarrely giving as much weight to Australian inflation in March through June 2010 as March through June 2011! Indeed, it means 75 per cent of your inflation result derived from 2010, not 2011. This is clearly flawed, especially when the economy is experiencing a turning point in the inflationary cycle. What matters most is what Glenn Stevens recently described as the ABS's "accurately measured" inflation pulse over the last three months, which is telling us that both headline and core price pressures are running well above the RBA's target. And cost of living measures, which crucially determine consumer inflation expectations, are even higher again.
Some participants like to ignore the recent increase in consumer inflation expectations, and emphasise investor expectations derived from the government bond market. For what it is worth, these are also very high, with the Australian 10 year rate about 3 per cent per annum. But the key point is that investors don't determine consumer price inflation. Consumers do. We are seeing this same dynamic in the US right now, with 5-10 year consumer inflation expectations surging while investor expectations have remained anchored. The latter is largely irrelevant for monetary policy, despite what some would have us believe. What central bankers should be worried about is consumer expectations feeding into cost of living views and then wage claims. Prioritising bond market break-even rates over consumer beliefs is a total furphy.
As a final comment, why wouldn't the RBA wait for the second quarter inflation results? Simply because they cannot afford to. If the Q2 numbers print high again, which is where the risks lie, the RBA will be confronting a situation whereby core and headline inflation have been running materially above target for half a year at the beginning of a cyclical recovery. They will be forced again to revise up all their inflation projections (damaging for their credibility), and will be reacting to a serious, six month old inflation problem in the third quarter. Given the RBA's spotty track-record over the last 10 years, and fluid inflation expectations, this is just not a tenable situation for a credible inflation-targeting central bank. So the RBA needs to take out insurance today, via one hike prior to the Q2 CPI, against the risk that it is once again behind the curve.
Friday, April 15, 2011
How incredibly boring. It seems around once a year, every year, we have this silly debate about the cost of Australian housing cleaved by extreme pessimists on the one hand forecasting devastation and precipitous price falls, juxtaposed against, well, a range of more sensible views spanning the spectrum of positive to negative. For some reason, Australians seem to lap this stuff up even though it is typically the same old tosh recycled every 12 months. And, of course, once in a blue moon the extremists will look like they called it right.
Well, let me help you out: as Rismark has very accurately predicted for a long time now, there is nothing happening in Australia's housing market. We've been projecting weak building approvals for years. Why economists ever anticipated a surge in supply we will never know given the parlous returns on equity currently offered to developers care of local and state government taxes and charges driving up the marginal cost of housing to above its market clearing price.
Since late 2009 we forecast a soft landing in 2010 with little to no capital growth, and the risk of some nominal falls if the RBA hawked up over 2010-11. As incomes continue their inexorable rise, housing valuations will improve until the RBA starts cutting rates again, which will likely trigger a return to above trend capital growth.
Until that time, the housing market is not going to be doing a great deal, and should be boring the pants off most of us. Interestingly, if commodity prices collapse, resources investments get iced, and the China/India story ends, the one Australian sector that will probably fare well is housing. Since it is the most interest rate sensitive area of the economy, it will benefit most if the RBA slashes rates, just as it did during the GFC.
Wednesday, March 09, 2011
The RBA targets 2.5 per cent per annum pa inflation through the cycle. The Bank of England targets two per cent over a two-year horizon. The key to hitting these targets is credibility.
The two charts below show the break-even inflation rates in 10-year government bonds in Australia and the UK between 2003 and 2011. The red line shows each central bank's inflation target.
The Aussie expected inflation rate over the next 10 years is about three per cent, almost exactly in line with what has happened over the last 10 years (and nowhere near 2.5 per cent). The UK inflation expectation is even higher at 3.25 per cent, way above the two per cent target.
Observe how both lines were trending up before the GFC, and how after some recent turbulence they are trending up again. Long story short, financial markets do not believe that either the RBA or the Bank of England will hit their inflation targets on average over the next decade. A worrying thought.
My best guess is that central banking in 10 years’ time will look a little different to the central banking of today.
Tuesday, March 01, 2011
So the RBA Statement today was deadpan neutral aside from this: “After the significant decline in 2009, growth in wages has returned to rates seen prior to the downturn.”
For the record, wage growth before the GFC was too high for the RBA. That's them ringing the labour market alarm bell, albeit softly for the time being. The other thing the RBA added was the fact that policy was now “mildly restrictive” in the last line of the Statement. I took this to be emphasising that they potentially have a way to go to get to really restrictive. Others no doubt thought that it was a dovish remark. People tend to read what they want to see.
Now the Governor was complaining the other day in parliamentary testimony about how much media attention interest rates get in Australia, which he claimed was unusual by international standards. I was surprised by this, since the Governor had previously been the first to highlight the fact that around 90 per cent of all mortgagors (not mortgagees!) – mortgagees are lenders – have variable rate home loans in Australia. The Governor brought this to our attention because it meant that during the GFC the RBA could deliver massive cash-flow relief to around four to five million households by cutting its target cash rate. In contrast, most US borrowers are on long-term fixed rate loans, which makes life hard for the Fed, and in the UK the split is about 50/50 between fixed and variable. Fixed also dominates in NZ.
It is not, therefore, surprising that interest rate decisions capture so much attention back home. They are much, much more relevant for the hip pockets of Australian households than borrowers in most other developed countries.
Nonetheless, you got the distinct impression today that the RBA was trying to kill off media speculation on the next rate move. While it could easily come in May, they gave absolutely nothing away.
In terms of its communications, the RBA has a delicate balancing act. On the one hand, it is very worried about external inflationary pressures combined with internal inflation expectations. On the other hand, it does not want to 'talk-up' inflation, otherwise it will become a self-fulfilling prophecy.
In fact, the RBA is doing everything possible to 'talk-down' inflation, which the market is misinterpreting as dovish commentary. This is wrong. The RBA ain't remotely dovish. Their number one concern is brewing global inflation. In a small, open economy, domestic inflation is to a significant degree determined by offshore inflation. So if you have rising capacity constraints internally combined with price pressures externally, it makes for a potent mix.
And then the RBA wants to give allegedly risk-averse Australian households every opportunity to remain parsimonious – that is, to stay thrifty with their finances. To date, it has not yet received any really hard evidence that the consumer caution that it has sought to attract so much attention to, and to reinforce as a positive behaviour that will reduce the probability of future hikes, is abating. But if rates remain on hold, that time will come. For now, the RBA is data-dependent. The first clear sign that consumer purse strings are opening wide will trigger an almost immediate whack with the rate stick.
Finally, to the RBA's latest analysis of commodity prices:
“Preliminary estimates for February indicate that the index rose by 2.2 per cent (on a monthly average basis) in SDR terms, after rising by 5.3 per cent in January (revised). The largest contributors to the rise in February were increases in the estimated prices of iron ore and coal, reflecting some further adjustment towards the higher contract prices in the March quarter. Increases in the prices of crude oil and wheat also contributed to the rise, while beef and veal prices fell. In Australian dollar terms, the index rose by 1.9 per cent in February. Over the past year, the index has risen by 48 per cent in SDR terms. Much of this rise has been due to increases in iron ore, coking coal and thermal coal export prices. With the appreciation of the exchange rate over the year, the index rose by 32 per cent in Australian dollar terms.”
Friday, February 18, 2011
I've debated old Steve Keen twice in the last couple of weeks. Lovely guy. Not so good with his facts. In the last debate, my penultimate slide was the one enclosed immediately below.
As you can see, Steve has a terrible forecasting record. And I mean truly terrible. His latest prediction, announced in the middle of last year when the RP Data-Rismark house price index first started tapering, was that the rate of house price falls would "now accelerate". Unfortunately for Steve, nothing like that has come to pass. House prices have basically flat-lined.
When I ran through this slide, Steve jumped (cat-like for someone in his final years!) up out of his seat and screeched that he was "living in the wrong country", and that if only he had been based in the US he would have been right (until he was scolded by the moderator). I am truly sorry Steve, but you were wrong, and repeatedly so. And not by a small margin – you were off by miles, as in from Perth to Sydney.
In the second chart, I show our national dwelling price to income ratio estimates stripping out the imputed owner-occupied income that the quarterly ABS National Accounts include (these are the only regular disposable income estimates the government produces). Again, contrary to what Steve claims, the impact is trivial. The benchmark ratio rises from 4.4 times to 4.8 times. My old pal Steve would do his credibility wonders by sticking to what he knows and understands, and not trying to twist facts to suit his fictions. If he does, any legacy that he leaves when he departs this world will be judged much more fondly by history.
Monday, February 14, 2011
The markets quite rightly think the RBA has a case of multiple-personality disorder. From what I have read so far, Adam Carr, one of the more iconoclastic commentators, gets closest. For mine, the situation is pretty straightforward.
Prior to the Governor's testimony yesterday, the bank bill futures market was pricing in another two rate hikes. But remember that these are probabilistic, or risk-adjusted estimates. That seems pretty fair, and it is, in fact, rare for the market to price in more once you are in restrictive territory.
This RBA seems to like to use these parliamentary testimonies as a bit of a PR exercise, where they showcase the softer/kinder face of the central bank. The RBA thinks raising rates is hard yakka. It is not easy bringing the community along. From a pure PR vantage (Vanessa Crowe's influence perhaps?), there is little upside in projecting the impression that you want to crush households with higher rates.
There is also an element of the RBA's decision-making process being a 'monthly model'. So when the Governor says that rates are 'appropriate for the outlook', to some extent his statement could be read to expire at the next Board meeting. This is important to bear in mind.
The RBA is clearly worried about inflation expectations (more so than economists appreciate), which alongside unemployment and wages will be another rate trigger. Yet there is no upside in emphasising their concerns about expectations, since this will become a self-fulfilling prophecy (the headlines the next day would read, 'RBA worried about inflation'). In fact, they went to great lengths on Friday to talk downconsumer inflation expectations – that is, they really tried hard to explain, in a very explicit fashion, why all these price shocks (floods, Yasi, commodity prices, utilities, etc.) are one-off events. The problem here is there are a lot of them. And the pre-GFC experience suggests expectations can drift up.
In terms of intrinsic hawkishness, Glenn Stevens probably sits a little behind Phil Lowe (number one) and Ric Battellino (number two). (As an aside, the Deputy Governor really gives you the sense that he is the banking system's best friend! I bet he ends up on one of the majors' boards, like big Ian Mac did.) So when Stevens speaks, you probably get a more neutral assessment of the inflation risks.
“Listening to the question- and-answer session at today’s parliamentary hearing, I can see a lot of people doving up and that’s probably fair. Stevens’ comments were much more dovish than I had initially believed after the Statement on Monetary Policy. Certainly, one of the newswires reckons the RBA has told us ‘rates were on hold for some time’. Bearing in mind that he didn’t actually say that, I don’t think the Bank is truly of that view. Stevens specifically made reference to market pricing, which was, prior to the testimony, 57 per cent priced for July and 64 per cent by August, and suggested that this was a reasonable assessment. That’s different to saying it is the right assessment – or the assessment. Indeed having made that comment, Stevens also said that rates could move earlier. In truth, I don’t think he was really giving much away. They are happy where they are for now, and that is fair, but I also think they are a little perplexed at the moment.
What we know is that; 1) the RBA is optimistic on the global and domestic economy and sees the need to hike rates at some point, assuming this base case scenario plays out. Yet and 2) they think they are ahead of the game, that consumers are cautious at the moment and have noted that inflation currently is contained. This is where I think they are confused and while it’s for these reasons that they believe rates are appropriate “at the moment”, they can’t be that dovish, truly that dovish, with the outlook they have got.
Realistically, they need to either change their outlook or rates are going up sooner than markets think. It can’t be both - it would be inconsistent to have a barely restrictive monetary policy setting, or to be overly reactive, when you are facing the largest hit to the terms of trade in a generation and an unemployment rate below five per cent. When you are talking about robust domestic economic growth and core inflation approaching the top of the band by year-end, it is bad policy to get there after the fact.
Wednesday, February 09, 2011
First, the RBA's reference to a forecast unemployment rate of 4.5 per cent by mid 2013 is apparently a new innovation (Paul Bloxham and Kieran Davies pointed this out to me). So why include it, especially when you are near-100 per cent certain to get the forecast embarrassingly wrong, with the probabilities tilted strongly in favour of hitting it by the end of this year?
The answer is pretty obvious to my mind – the RBA is setting a non-inflationary rate trigger. The most important variable it uses to forecast inflation is unemployment. But the issue, as I observed yesterday, is that the RBA might face some lowish core inflation prints at the same time as unemployment is rapidly trending down, and wages rising. The seemingly absurd 4.5 per cent unemployment rate forecast in mid 2013 gives the RBA a target that it can use to prospectively rationalise a rate hike (that is, “Oh dear, the economy's capacity constraints are much worse than we last forecast!”).
The second thought that jumps to my mind is this. The RBA is basically saying today that market pricing of just one further rate hike was well wide of the mark. By using market pricing, and getting forecast outputs with core inflation at the top of the target for the final two years of the horizon, and GDP running way above trend for a sustained period, the RBA is telling us that it is going to hike more than the market thinks if its central case proves out. If the RBA's central case is going to present so many policymaking challenges, and rate changes today don't have their full effect for another two years (as the RBA's research shows), why wouldn't you start the process now? What is stopping hikes in March or April?
By the time March comes around, the RBA will have January unemployment data and Q4 wages. It will also have further visibility on February inflation and inflation expectations data from the Melbourne Institute. If the US and Chinese economic flows are still strong, and there is no evidence of additional European discord, can you really say that the current stance of monetary policy is appropriate for the outlook? I don't think so.
My final idea is this, which I have shared with one journo. There may be a little game theory at play here between the RBA and the government. You can make the case that there is every incentive for the RBA to hawk up as much as possible, and even fire off a rate hike, before the government's May budget. The more the RBA can scare the life out of Gillard/Swan about the spectre of a spate of rate hikes (prior to the 2013 election), the more likely we are to get austere fiscal policy outcomes. Lifting rates is never easy for a central bank, and it is tough to bring the community along. The RBA would ideally like fiscal policy to do some of the heavy lifting for it. At the very least, the government can do a lot more to lubricate labour supply (that is, via skilled migration). I would venture, however, that no matter how much sabre-rattling the RBA might be engaging in, its highest probability view of the world still implies a few more rate hikes even given more accommodating fiscal policy settings.
Monday, January 31, 2011
The much stronger-than-expected US economic recovery (relative to the priors 12 to 24 months ago), which, critically, means that both the world's number one and number two economies are now expanding at or above historical trend, with the former likely to accelerate further, is a real curve-ball for Australian monetary policy.
The RBA was relying on weak US growth over the next couple of years as the deleveraging process gripped. Instead, the US has rejected the European austerity approach and decided to try and bootstrap its way out of its quagmire via policy-induced growth.
The Chinese authorities are similarly hell-bent on avoiding anything resembling a subdued expansion for fear of the social instabilities that this might stimulate (read: The Party's plutocracy is not the best available economic model).
This means that in the medium term, the global economy will likely grow significantly faster than the RBA had expected. Combined with the spectre of unanticipated inflation problems in all of Australia's major trading partners (bar Japan), which, with the guts of the currency appreciation behind us, Australia risks importing, the RBA is going to have a major monetary policy challenge on its hands.
The RBA's task is made all the more awkward care of the floods-imposed inflation spike, which has already had an immediate impact on domestic inflation expectations (the latter of which had persistently drifted upwards in the years before the GFC). Together with a labour market that is already fully employed prior to the start of the biggest private investment boom in history (much of which has already commenced), it is hard to see how the RBA is not going to surprise the financial markets with a spate of earlier-than-projected hikes. Rest assured here that the US economic rebound is the joker in the pack that the RBA had not banked on.
Monday, January 31, 2011
If you believe the interest rate futures market, we will get less than one rate hike in 2011. That will be a huge boon for Australia's housing market, if it actually comes to pass.
Our forecasts assume three rate hikes, which would make generating capital gains heavy-going indeed. But if savvy fixed income investors are correct, and we don't get a rate hike in 2011, then the housing market could very much surprise on the upside with nominal price rises.
We will have booming national incomes, strong employment and wages growth, and a cost of capital that is only marginally higher than the historical average. Throw in very strong economic growth in the US and China to boot. That means consumer spending should bounce back firmly by the middle of the year, and credit growth will also recover (pushed along by all the financial institutions trying to drive their credit books). Great news for the banks and housing investors … If you believe the futures market, that is, which, for the record, I don't!
Monday, January 24, 2011
While international comparisons of housing markets are fraught with difficulties, the OECD’s analysis, which was released today provides Australia with a mixed report-card.
The OECD validates Rismark’s analysis that Australia has one of the highest transaction cost housing markets in the world. On the basis of round-trip transaction costs, Australia is the fourth most expensive market in which to transact in the OECD with total costs of more than 13 per cent of the value of a home. If we just look at vendor costs, Australia has the highest expenses in the OECD. This eviscerates the notion that Aussie housing is tax-advantaged vis-à-vis the rest of the world.
The chief transaction costs are obviously stamp duties and real estate agents’ fees. The OECD’s findings accord with the Henry Review’s recommendation that governments should dump stamp duties in favour of a more efficient tax base. There is also an argument here that we need to look at the efficiency of the real estate agent industry.
Since my 2003 report to the Prime Minister’s Task Force on housing, I have argued that one of the principal drivers of the escalating cost of housing in Australia has been increasingly inelastic supply. This was not a fashionable analysis at the time, and was explicitly rejected by the RBA. The RBA has, however, subsequently accepted that Australia’s inert supply-side plays a very important role in our housing cost story.
The OECD’s research confirms my 2003 analysis, and finds that housing supply becomes less responsive as land use regulations rise and land scarcity increases. This can lead to imbalances that perpetuate strong price growth that can be ultimately punctuated by unnecessarily sharp price declines if and when the supply-side is finally liberated.
In international terms, Australian housing supply appears to be middle-of-the-road in terms of its price elasticity. However, Rismark’s analysis has found that the elasticity of Australian housing supply has declined appreciably over the last seven years. New starts are running well below almost all independent assessments of demand.
The OECD argues that governments should seek to remove subsidies that favour housing investment over other asset-classes. This is true by definition. Yet recent research by the RBA’s Dr Luci Ellis found that the tax treatment of Australian housing is not, in fact, anomalous compared to most peer countries. For example, most nations allow negative gearing on investment properties. In many ways, the most anomalous country from a tax perspective is the US where home owners get deductible mortgage interest repayments, but are also taxed on capital gains. This encourages borrowers to gear up by taking out higher LVR loans, and using longer pay-down periods. It also likely stimulates higher default rates.
In comparison, Australia has one of the lowest mortgage default rates in the world despite the fact that mortgage rates here are higher than pretty much any developed country on earth. One explanation for this dynamic is the fact that holding non-deductible debt is expensive: it makes sense to pay-down the loan quickly.
People tend to forget that Australians pay a massive price for the CGT exemption on housing: the debt repayments are not tax deductible, as they are in all other asset-classes. When you combine this with the huge transaction costs associated with home ownership, as identified in this OECD analysis, and local government levies that represent a land tax of around one per cent per annum of the value of a home, it is not at all clear how owner-occupied housing is a more tax-efficient vehicle than, say, shares.
On a more positive note, the OECD concludes that Australia has the second-highest residential mobility in the developed world notwithstanding our heinous transaction costs. This is likely an artifact of the structural changes taking place in the economy care of the resources boom, which has necessitated shifts of labour across conurbations, and our stunning population growth over the last decade.
Australia also ranks comparatively well in the context of the efficiency of our rental market, as defined by the extent of price and landlord regulation. This should be further encouraged.
Friday, January 21, 2011
The strength of the inflationary pulse that seems to be emerging around the world is striking, albeit that one can argue it is being driven by an external commodity price shock, which is a once-off, relative price shift that will not perpetuate ongoing inflationary effects (this is a possibly heroic interpretation). The other claimed mitigant is the significant surfeit of excess labour supply in some countries, which would appear to rule out wage-price spirals.
Of course, Australia does not have the luxury of a large 'output gap' like the US and UK. On the inflation front, we face the worst of all worlds: positive external price shocks combined with budding internal price pressures.
So in those developed countries with output gaps, is one then left with a repeat of the 1970s 'stagflation' in the event that central banks face stubbornly sticky inflation resulting from secular food price rises, feeding (no pun intended) back into consumer inflation expectations, and imported inflation via, say, higher Chinese input (labour and raw materials) costs and strategic currency depreciation by the countries in question (such as, the US and UK)?
The much more interesting question is arguably this: will developed world central banks that have for the last two decades hailed the success of their 'inflation targeting' regimes have the stomach to normalise their interest rates in an environment when fiscal policy is working in the other direction, and growth may slow and unemployment remain at uncomfortably high levels? Will monetary policy in these nations remain truly independent of the polity, or will it continue to be co-opted into this process of 'budgetisation' (such as, wherein the Fed and BoE print money and effectively engage in fiscal policy)?
A crude survey shows that, at the very least, the following countries are currently struggling with worrying (to varying degrees), above-target headline inflation problems, which, in some cases, are feeding back into consumer expectations of future price rises. We are already starting to see some evidence of this in Australia, as I noted in the posts below. This is the central banker's nightmare: a once-off inflationary shock results in permanently higher inflation due to a rise in people's expectations of future period price increases:
- South Korea
- The Eurozone
- The UK
It also pays to remember that in the 'inflation-targeting' world, central banks have to deliver 'headline' inflation within target, not the 'core' analytical measures that conveniently strip out high growth inputs.
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Friday, January 14, 2011
It has been interesting watching the interest rate futures market over the last few weeks. Prior to the floods and the advent of the upward price pressures that the destruction of the supply-side will inevitably induce, the bank bill futures market was comfortably pricing in at least two hikes before the end of 2011.
Care of the Queensland disaster one and a half of these hikes disappeared. That is, the bank bill – not interbank – market was pricing less than one cash rate increase by the end of the year.
There was an instant and quite dramatic reaction in the hour or so following the Brisbane evacuation with futures prices surging. The unemployment data confused investors.
Immediately after the release yesterday the market rallied presumably because of the low total employment number, which it took as a sign of weakness even though there are huge monthly standard errors associated with this data. But an hour or so later the market sold off solidly when it worked out that it was the unemployment rate that is far and away most important for forecasting inflation, and that had fallen to less than the crucial five per cent threshold associated with the Non-Accelerating Inflation Rate of Unemployment (NAIRU).
With some suggesting that the Queensland rebuild will add another $20 billion worth of investment to the economy, and the US recovering much better than the RBA expected, the risks to rates and inflation lie well and truly to the upside. Aloha from Honolulu airport!
Wednesday, January 12, 2011
Okay, it is not easy to keep on top of this stuff from Hawaii (where I’m vacationing at the moment), but a few comments on the question of whether Treasurer Wayne Swan should reappoint Professor Warwick McKibbin to the Board of the RBA.
First, McKibbin is far and away Australia's best and most respected academic macroeconomist, and should be reappointed without question. The fact that he has had the fortitude to say what he thinks about public policy – on fiscal policy, the GFC, and climate change, to name a few – only reaffirms his outstanding independence. It is also well known that McKibbin is a hawk when it comes to holding RBA policymakers to account for positions that are not backed by credible analysis.
Second, if McKibbin is not reappointed, which, to be clear, would be a public disgrace should he make himself available for a further term at what is a critical policymaking juncture for the RBA (given the extraordinary uncertainty our central bank currently faces), then the Treasurer should look to appoint talented young monetary economists who can truly represent taxpayers interests in policy debates with the RBA and Treasury staff. This is, after all, the central purpose of the Board.
For the avoidance of doubt, Ross Garnaut is not a monetary economist, nor a currently practicing academic. Yet Australia does have two exceptional candidates in Professors Mardy Dungey and Renee Fry, who I hope will be considered in the event that McKibbin does not make himself available for some reason.
Professor Fry’s research focuses on issues surrounding international financial market and economic linkages, with an emphasis on financial market contagion and crises. Professor Dungey’s interests concern measuring the effects of international shocks on small open economies, and the transmission of financial crises and contagion across asset types and geographical borders. Both have world-class analytical skills.
Aside from the fact that these two young professors are the best available candidates, and in many ways substantially superior to Garnaut, they would also improve the diversity of the RBA's leadership by adding a second female to a currently male-dominated Board.
C'mon Julia – kick Swannie into line. I know you guys read this stuff.
Monday, January 10, 2011
Hailing from mining heartland, UBS's Matthew Johnson is notorious for calling a one carat diamond nothing more than a tonne of compressed coal. And on Thursday he proclaimed that the probability of an RBA rate hike in Q1 was "almost zero". This seems too aggressive from my Hawaiian vantage: while the likelihood of them going is clearly low – perhaps now sub 20 per cent – there is way too much important data between now and March to scratch a hike altogether. The real question is this: have the floods changed the timing of the RBA’s two-year inflation forecast? I very much doubt it. Do they shift the inflation probabilities to the upside or downside. If pushed, I would guess the former.
So from a decision-making standpoint, why write off Q1 hikes completely? We get the monthly unemployment reads in January and February, and Q4 inflation in January. The unemployment data is indisputably most significant. So while the base-case might be for steady or even modest increases in unemployment given the falling capacity utilisation data, employment growth has consistently surprised on the strong side. What happens if UE prints below five per cent in both January and February, and core CPI is a little higher than folks expected? These are material probability events (say somewhere between 25-50 per cent likelihoods). You would have to think a forward-looking and hawkish RBA worried about its inflation-fighting credibility has a decent chance of going in March if these things come to pass. The near-term upside risks are also heightened by the stronger than expected recoveries in the world's two largest economies, the US and China.
Friday, December 17, 2010
Boy, I got bored with this banking debate a while ago. The word ‘debate’ does not do it justice, however, since the different stakeholders are talking at cross-purposes. I thought I might try, one last time, to break this down so folks can avoid some common mistakes.
1. The RBA is NOT the ACCC, and does not give a rat’s bum about competition
First, as I have pointed out for years, the RBA has no regulatory responsibility for ‘competition’ in the banking sector. In fact, its one regulatory objective – financial system stability – directly conflicts with any notion of enhancing competition. That is, the RBA sees an explicit trade-off between more competition and maintaining system stability. This is why in the middle of the GFC the RBA:
- Initially opposed efforts by the government to support the securitisation sector relied upon by smaller lenders.
- Relentlessly defended the competitive characteristics of the system despite an obviously enormous increase in its concentration (as the non-conflicted Treasury submission to the Senate Inquiry acknowledges).
It is, therefore, quite silly--disingenuous even--to think that you are going to get any objective or worthwhile statements from the RBA supporting higher levels of competition in the banking system. There is just no upside for the central bank advocating this stuff (it would be like asking the ACCC to champion reduced competition). Furthermore, the RBA knows that there are a vast number of participants out there – including politicians – that can do the vocal heavy lifting on the industry’s behalf.
The RBA’s only interest is in ensuring that any increase in competition does not undermine the stability of the financial system, which, in effect, means the stability and market power of the major banks.
2. The ‘competition’ debate is about risk and return, not interest rates
The RBA ultimately sets the level of interest rates, not the banks. If, for example, better competition ends up contributing to lower lending rates, the RBA will increase its cash rate to force banks to lift rates back up again. It is not quite that simple, and there is no doubt that the advent of bank ‘top-ups’ to the RBA's cash rate changes has made monetary policy more complex to set in the near-term. The Governor conceded as much in recent parliamentary testimony, remarking that:
- The RBA does not know exactly what banks will do (contrary to some claims in the media).
- To the extent that the banks do more than the RBA anticipates, that will have an effect on future monetary policy decisions, which may need to reverse-out the banks' actions.
Having said that, the RBA was clearly frustrated by the major banks jawboning on funding costs and net interest margins earlier in the year on the basis that they did not really need to further increase RoEs, which is why in the October minutes it made the otherwise unnecessary observation that NIMs were “well above” pre-crisis levels. Politicians latched on to this point, which the RBA also made in other publications. I suspect the central bank got a little spooked about the public furore their statements caused, and the manner in which the RBA had been dragged into the debate. This probably explains the recent RBA backtracking and reversion-to-type, which has puzzled some journos.
To be clear, the debate about ‘out-of-cycle’ rate hikes is not about getting rates lower. It is about the question of whether we are seeing oligopolistic profiteering or margin expansion by the majors. It is about the acceptable trade-off between the returns generated by explicitly taxpayer-backed institutions, which cannot be compared to other private sector industries, and the risks they take. This is the nub of the debate raging globally. This is also precisely the issue that the Chairman of Bendigo & Adelaide Bank is talking about when he states (as reported by AAP):
“Return on equity (ROE) was a measure of profitability and the Australian banks delivered ROE of 20 per cent or more prior to the global financial crisis, he said. A return to that level was still anticipated by bank analysts, but historically such returns were "unusually high and beyond what one would expect of a privileged, government guaranteed utility", Mr Johanson said.”
NAB’s Cameron Clyne also gets it when he told the Senate Inquiry yesterday, “What we are is a solid, dividend-paying stock. Not everything has to be a high ROE if you are able to pay a strong dividend.”
To his credit, this is the heavy-duty policy matter that the Shadow Treasurer has been concentrating on for some time now.
Of course, the two things that the government can do to reduce the level of interest rates paid by borrowers in the community are:
- Make further cuts to the fiscal stimulus, which the Governor of the RBA recently acknowledged has resulted in rates rising faster than they had to.
- Minimise inflation pressures by fostering a flexible labour market and investments in the supply-side of the economy. As the 12-year veteran of the RBA, Paul Bloxham, argued in the AFR the other day: “[B]y choosing not to tighten fiscal policy sooner, the government has implicitly chosen higher interest rates than might otherwise have been the case.”
3. Swannie's policy package does have some bite
The Treasurer’s package does contain several important reforms, including:
- Making the taxpayer guarantees of deposits permanent (but what price will banks pay for this service?).
- Undertaking a Bernie Fraser-led inquiry into establishing my idea of a national electronic credit register, which could facilitate true account portability.
- Creating a listed exchange for the trading of government debt, which will help retail investors access these AAA-rated securities and foster liquidity in the thinly traded corporate debt market.
- Giving the ACCC new price signalling powers, which, interestingly, Graeme Samuel argued last night on Sky News was a tool required by the regulator, citing a specific example of local bank price signalling last year.
- The advent of covered bonds, although this will almost certainly benefit the major banks most, as evidenced by their share price action following the announcement.
There is also, unsurprisingly, a lot of fluff, and some bad ideas, like banning exit fees.
4. But the meaty policy issues are too-big-to-fail and moral hazard, not competition
On the policy front, the really big issues are how the taxpayer guarantees of the financial system have fundamentally reduced the risk profile of banks, the policy measures one needs to now put in place to minimise the probability that this will, in the future, induce moral hazards similar to those that propagated problems in the US, and what, from a regulatory perspective, it means for us to have a significant number of too-big-to-fail institutions. Unfortunately, Swannie’s package does not even acknowledge these concerns.
Wednesday, December 15, 2010
On Sunday, Treasurer Wayne Swan announced a series of reforms to promote a “competitive and sustainable banking system” following an intense debate initiated by the Shadow Treasurer, Joe Hockey.
The package has significant strengths and weaknesses, and is somewhat undermined by much superficial padding (that is, allowing building societies to change their name, getting taxpayers to fund lenders’ marketing campaigns, and claiming private sector initiatives as government policy).
The government has explicitly accepted three of Joe Hockey’s “nine points” on:
- New price signalling powers for the ACCC.
- Measures to enhance the liquidity of the residential mortgage-backed securities market relied upon by smaller lenders.
- The introduction of covered bonds, which is an historical first for Australia.
Curiously, the government made no efforts whatsoever to open up Australia Post’s latent 3800 branches for use by smaller lenders, which is an initiative supported by the former CEO of CBA, David Murray, and many industry minnows.
And the government persists in peddling the popular myth that competition will reduce interest rates. As the RBA has belaboured of late, the central bank sets prevailing lending rates, not the banks. If rates are too high, the RBA will cut the cash rate until it gets the lending rate it wants.
The two things that the government can do to reduce interest rates are:
- Make further cuts to the fiscal stimulus, which the Governor of the RBA recently acknowledged has resulted in rates rising faster than they had to.
- Minimising price pressures by fostering a flexible labour market and investments in the supply-side of the economy.
A 12-year veteran of the RBA, Paul Bloxham, who recently left to become chief economist of HSBC, put it this way: “[B]y choosing not to tighten fiscal policy sooner, the government has implicitly chosen higher interest rates than might otherwise have been the case.”
Perhaps the package’s single biggest deficiency is the complete absence of any acknowledgement or discussion of the two major policy issues that are front-and-centre in all banking debates raging around the world today: moral hazard and too-big-to-fail. These are also the principal policy focuses for the global Basel Committee on Banking Supervision, the global Financial Stability Board, and the G20.
Joe Hockey has also relentlessly raised these issues in his own advocacy. But for some reason the government has been missing in action from the global debate. Indeed, they have apparently negotiated an exemption for Australia’s four major banks from new higher capitalisation standards that will be applied to the world’s 25 most systematically important banks, even though three of the four majors rank, by market capitalization, in the top 25. The basis of this exemption is understood to be the assumption that the major banks will stay domestically focused in the prosecution of their business models. But what ensures that this will indeed be the case?
The crux of post-GFC policy challenge is getting a better understanding of the crucial role banks play in the community, and the risks that they should be permitted to take given the presence of explicit taxpayer guarantees. The CFO of NAB recently described this tension best: “The [taxpayer] guarantee has underlined the privileged position that banks have in the economy and that at the end of the day the state will step in to support them. It has shined the light on the obligations on banks not only to act in their own self-interest but to keep in the front of their mind they have obligations to all stakeholders.”
1) Whether banks will be asked to pay for taxpayers insuring nearly $1 trillion worth of customer deposits, which he today confirmed will become a permanent feature of Australia’s financial system following their unveiling for the first time during the crisis (that is, will this continue to be provided by taxpayers for free?)
2) Whether taxpayer guarantees of the bank’s wholesale liabilities, which peaked at just under $200 billion, will be made available in future crises, as the banks themselves have said they expect to be the case (in conflict with the Governor of the RBA’s stated preferences in recent parliamentary testimony).
3) What policy measures the government proposes to put in place to mitigate the “huge moral hazard” risks that the RBA Governor identified have now been embedded in the financial system following the shift to explicit taxpayer guarantees.
1) The government has appointed former RBA Governor, and current Chairman of Members Equity Bank, Bernie Fraser, to examine the bottlenecks to moving to a financial system that has full account portability, which is not currently the case. This is a very welcome development.
2) The government has seemingly embraced a radical idea that I have outlined on several occasions in the past, which I termed a “National Electronic Credit Register” (NECR), which would provide the architecture necessary to establish electronic linkages between all lenders and deposit-takers throughout Australia. NECR would, I believe, revolutionise the ability of the RBA and APRA to manage financial stability risks, and furnish the connections that would permit seamless account portability. I explained how this would work in detail a while ago here.
3) The government has endorsed Joe Hockey’s proposal to empower the ACCC to prevent anti-collusive price signalling by institutions, which seems like a sensible idea (they also suggest some mitigants to quell industry concerns).
4) The government has announced that it will make the deposit guarantees permanent, which was likely to happen in any event. It has not, however, disclosed whether institutions will be required to a pay premium for this taxpayer-supplied insurance service, as would ordinarily be the case.
5) The government has extended by $4 billion its existing $16 billion commitment to the RMBS market, which is an idea that Joshua Gans and I first came up with in March 2008 that does not increase net government debt and which has generated positive cash-flows for taxpayers.
It has to be said that this is a fairly trivial additional and represents just eight per cent of the annual volume of RMBS securitisations prior to the crisis. More disappointingly, the government has not announced any pro quo for the taxpayer quid. There is no new licensing regime for securitisation, which I have advocated. That is, lenders benefit from this taxpayer injection of cash at zero cost.
Recall that securitisation in Australia remains completely unregulated. You would have thought that governments had learnt the lessons of the last crisis (that is, self-regulation does not work), yet Australia seems distinguished by its ability to be blinded by hubris. Obvious policy reforms here include establishing a common set of securitisation standards for all participants, and a formal licensing regime overseen by APRA.
6) The government has accepted Joe Hockey’s suggestion to permit banks to issue covered bonds, which I understand is not something that regulators support. This will help diversify the ADIs’ funding sources, and brings Australia in line with other developed countries. But it is not clear that this will do anything to support competition. In fact, one smaller bank executive has argued the majors would likely be the biggest beneficiaries of this innovation.
7) Finally, the government will establish a centralised exchange for the trading of government debt securities. It claims that this will in turn help improve the liquidity of the corporate bond market. While this may prove true, the first beneficiary will be the government itself, since it will effectively be seeking to raise funds directly from the retail market. As I have noted on countless occasions before, mums and dads are massively underweight fixed-income investments (and overweight equities) in their superannuation portfolios. If a listed exchange increases the probability of self-managed superannuants, individuals and even institutions investing in AAA-rated government debt, then that is probably a good thing. And insofar as it allows more transparent pricing of corporate debt securities, it could help to boost liquidity in this underdeveloped market, which I consider to be a worthy policy aim.
Regrettably, there is also considerable fluff in the government’s package:
1) Banning exit fees is a terrible idea that is likely to most adversely affect smaller lenders, and actually undermine their ability to compete. Smaller lenders, which operate on wafer thin margins that are substantially lower than the major banks need to charge exit fees to mitigate early repayment risks and recover their costs. This proposal has been widely opposed by smaller lenders and I am surprised to see it get off the ground.
2) The idea of a ‘mandatory fact sheet’ for all new loans is already required by the existing NCCP laws. All lenders have to detail in plain English upfront all of the fees and charges associated with a new loan in standardised, industry-wide formats.
3) The government is going to allow building societies and mutuals that already meet APRA’s banking capitalisation guidelines to call themselves a ‘bank’. This is hardly revolutionary policy that will lead to a ‘fifth pillar’ in banking, but rather just offering the option to these institutions to change their name. Given the stigma associated with the word ‘bank’, it will be interesting to see how many actually take it up. The one benefit of calling yourself a bank is the perception of safety and security. Yet the government’s decision to make taxpayer guarantees of deposits permanent addresses this issue.
4) The government appears to be asking taxpayers to underwrite a marketing (or ‘awareness’) campaign for smaller banks, mutuals and building societies, which looks like a waste of public money.
5) The government will establish a ‘taskforce’ with the RBA, which is the payments system regulator, to see whether there are any further ways to improve ATM competition. Since this is already the RBA’s regulatory responsibility, and the central bank has recently completed substantial reforms to the sector, it is hard to see what more will be achieved.
6) The government claims it will work to develop a ‘bullet-bond’ structure for the RMBS market. Yet this is, in truth, a private sector initiative that has little to do with the government. The package states, for example, that “The AOFM recently announced its support for the issuance of a new RMBS transaction by Bendigo and Adelaide Bank, which includes a significant bullet tranche.” That is, an Australian bank has already successfully launched this innovation.
Wednesday, December 08, 2010
In good news for prospective home owners, the valuation of Australia’s housing market has improved over the third quarter of 2010. And there is more deflation likely to come.
Drawing on the September quarter ABS National Accounts data combined with Australia’s most comprehensive residential sales database, which captures 100 per cent of all home sales across the country, Rismark finds that Australia’s dwelling price-to-disposable household income ratio has fallen from 4.6 times in June to 4.4 times in September 2010.
Subject to the course of interest rates, Rismark projects that disposable household incomes will continue to grow more rapidly than dwelling prices over the next 6-12 months.
In the 12 months to September 2010, disposable incomes per Australian household rose by 6.8 per cent while the cost of the median dwelling across all Australian regions increased by 6.6 per cent. Australian disposable household incomes have also out-run median dwelling prices over the preceding three years with compound annual growth rates of 5.0 per cent and 4.2 per cent, respectively.
Since September 2003, which roughly coincides with the end of the last housing boom, the cost of housing and incomes have moved almost exactly in lock-step. In particular, the compound annual growth rate in the median Australian dwelling price has been 6.5 per cent compared with 6.3 per cent annual growth in disposable incomes per household.
Australia’s dwelling price-to-income ratio in the September quarter is exactly in line with its average of 4.4 times since the end of the last cycle seven years ago. On this basis, there appears to be little evidence that housing market valuations have become more stretched in recent years, as is commonly claimed.
Unlike other estimates, Rismark’s national dwelling price-to-disposable household income ratio includes:
*Dwellings across all Australian regions (not just capital cities);
*All property types (not just detached houses); and
*The ABS’s quarterly National Accounts measure of average disposable household incomes (not just average weekly earnings), which captures income earned from all areas (eg, labour and investments) and reflects the fact that there is typically more than one income earner per household.
Rismark’s preferred ratio also compares average dwelling prices with average disposable incomes on a per household basis.
The chart below illustrates the change in Rismark’s national dwelling price-to-disposable household income ratio since 1993. For completeness, this analysis compares both average and median dwelling prices across all metro and non-metro regions with average Australian disposable incomes per household.
Rismark estimates that the national median dwelling price based on sales in all regions throughout Australia, and encompassing all detached houses, semis, terraces and units, fell from $418,000 to $405,000 between June and September 2010. The average* dwelling price also declined from $447,994 to $432,954 during this same period.
Rismark has documented a remarkably robust and statistically significant relationship between Australian housing costs and disposable household incomes since 1993 (on a per household basis). The chart below highlights this relationship.
There has only been a brief period between 2000 and 2003 during which Australian dwelling prices have outpaced disposable incomes. Rismark and Australia’s central bank, the RBA, believe this reflects the once-off valuation impact of the structural downward shift in inflation and nominal interest rate expectations after the RBA established a credible inflation-targeting regime in the late 1990s (this regime was practically implemented in 1993 but did not fully anchor long-term inflation expectations until the latter half of the decade).
To demonstrate this point, the next chart depicts the change in Australia’s headline variable mortgage rate since 1980. Observe how the ‘level’ of mortgage rates did not stabilise until the early 2000s. It was presumably around this time that Australian home buyers had greater confidence that the future path of interest rates would remain relatively stable around a much lower 6-8 per cent average rate compared to the far higher rates that prevailed in the 1980s and early 1990s.
Because of the boom in the prices of Australia’s key commodity exports, such as iron ore and coal, the nation is benefiting from a large income shock. This is reflected in the striking differential in the real gross national income (GNI) and real gross domestic product (GDP) growth rates over the last year. In the 12 months to September 2010 real GNI rose by 7.2 per cent compared with just 2.7 per cent growth in real GDP (see chart). The RBA believes that this positive income shock is more likely than not to persist for a number of years as China and India continue to undergo their steel-intensive urbanisation processes.
Rismark’s analysis draws on Australia’s largest residential sales database, which is supplied by RP Data and captures 100 per cent of all homes sales transacted across the country. In total, RP Data has more than 150 million real estate records and spends over $9 million each year collecting new data.
The income proxy employed in the analysis above is the ABS National Accounts disposable household income estimate before interest payments and excluding unincorporated enterprises divided by the total number of households. It represents the total disposable wage and investment income generated by all members of the household and should not be confused with simpler estimates of average wages or median incomes.
On an annual basis, one can quantify the impact of excluding the ‘net imputed owner-occupied rents’ that the ABS includes in its National Accounts numbers. Rismark estimates that in the September quarter this would have reduced average disposable income per household from $98,859 to $90,476. Regrettably, the ABS’s Survey of Income and Housing measure of median disposable household income is not produced on a regular basis (the last available estimates were surveyed between August 2007 and June 2008).
*The ‘trimmed mean’ is similar to the measure used by the RBA when estimating inflation. A simple average results in very volatile estimates due to extreme outliers that may reflect occasional valuer general data entry errors. The trimming process results in the truncation of only the top and bottom 5 per cent of prices within the price distribution.
Friday, December 03, 2010
Last weekend, Australia’s housing market declared it had arrived in the dead-zone, with RP Data’s national weighted auction clearance rate slipping below the crucial 50 per cent threshold for the first time since 2008 (there was actually a one-weekend blip below this benchmark in February 2009). Consistent with our long-held projections, there has been a monotonic decline in the national clearance rate following its 75.5 per cent apogee in March this year (see chart).
Australia’s housing market looked to have stabilised after a soft patch over June, July and August. Dwelling prices were flat lining and credit growth had begun building momentum. I expect this to be reflected in our October house price index results, which will be published next week.
Yet the surprise decision by the RBA to lift rates in November having resolved not to do so in October, combined with the major banks’ hefty top-ups, was akin to a surgical ‘double-tap’ from a Special Air Service Regiment operator’s Browning 9mm. It has suffocated any nascent recovery and stopped the market dead in its tracks. As the next chart below shows, sustained rate rises have a habit of doing that.
The headline variable mortgage rate, which sits at 7.8 per cent today, has now moved beyond its recent historical average of 7.4 per cent (for example, since the advent of the RBA’s inflation targeting regime) into genuinely restrictive territory for the first time since November 2008. Household interest repayments as a share of disposable income are similarly creeping back towards the mid 2008 highs when the headline variable mortgage rate hit a gut-punching 9.6 per cent.
And all of the ‘partial’ indicators that RP Data and Rismark carefully track in real-time, including the stock of unsold homes available for sale (supply), the average time between listing and sale, the amount by which vendors have to discount their homes below the list price in order to effect a sale, and auction clearance rates imply that more soggy price conditions lie in wait (see charts).
In this respect, it is interesting to note that the third quarter GDP numbers, which are released next week, are likely to come in well below Q2’s above-trend 1.2 per cent pace. In fact, it is possible that Australia’s economy experienced little-to-no growth in the three months to September.
This does not, however, mean a great deal. The RBA’s objective has always been to put households and other interest rate sensitive areas of the economy into the central banker’s half-nelson in order to make room for the unprecedented investment stimulated by our once-in-a-century terms of trade boom.
One sneaky dividend yielded by this strategy is that the RBA also gets to engineer a gradual deleveraging of household balance-sheets as the incentive to save increases while the higher cost of gearing dissuades credit growth. Here I was wrong to question earlier in the year the RBA’s ‘cautious consumer’ thesis. I should have realised that the Bank was telling us that this was not a matter of choice: if households did not play-ball and pull their horns in, the Bank would force them to do so via its interest rate whip.
For those that would question the sanctity of the RBA’s high-growth ‘central case’, consider that the domestic investment that has already commenced but which has not yet been completed (for example, projects currently underway) represents an extraordinary 20 per cent of GDP. And this will be further amplified by the stunning pipeline of planned projects that have not begun.
To my mind, the third quarter was always going to be an economic air pocket. We had the unusual conjunction of a European sovereign debt crisis, scaremongering by US deflationistas, an election in which the RSPT/MRRT tax was on the line, a hung parliament, and uncertainty about the integrity of the Chinese and Indian growth stories.
With Australia’s economy so heavily reliant on one sector (given the RBA’s commitment to cruelling everything else), we will experience more volatility than in days past, as the RBA itself has repeatedly warned. But with a lot of this turbulence ostensibly behind us, I am expecting the fourth quarter and 2011 data flows to start once again providing positive surprises (with the exception of those deriving from the interest rate sensitive sectors).
The RBA believes that the fundamentals underlying Australia’s housing market are exceedingly firm. On the demand-side, household incomes will benefit from the income shock delivered by the terms of trade boom, which will help mitigate higher interest rates. The unemployment rate will also slowly drift back towards its 4.5 to five per cent full-employment threshold while population growth will remain healthy to staunch our enduring labour shortages.
In contrast, every credible economist agrees that housing supply in Australia is a serious policy problem with new starts running well below the rate of household formation. Public and private sector estimates of the theoretical housing shortage tend to range from 150,000 to 250,000 homes and growing at circa 40,000 to 50,000 per annum.
For the time being, these structural drivers are being thwarted by restrictive monetary policy settings, which, perversely, will only serve to reinforce the severity of the underlying shortage by further disincenting new housing investment.
To be clear, this is not what the RBA wants: at a recent event, the RBA was asked by an analyst whether it would like to see less housing investment across the economy. The RBA responded that, on the contrary, it is now convinced that Australia suffers from a very substantial housing investment deficiency, and that policymakers should work to foster much higher levels of supply-side production (this was not the RBA’s position back in 2003-04 when it underestimated the extent of the inherent supply-side rigidities that were increasingly constraining the market’s ability to seamlessly accommodate new demand). Yet with dwelling prices tapering and interest rates escalating, no developer is going to be brave enough to ramp up their activities in the near-term.
Once the RBA’s current tightening cycle ends, these fundamentals will rapidly reassert themselves via an unprecedented housing construction boom underpinned by solid, through-the-cycle capital gains.
We are nevertheless forecasting weakness over the next 12 months if the RBA fulfils the consensus economists’ expectation of three to four cash rate hikes. This would likely lead to nominal and real dwelling price declines, which is no bad thing and would help eviscerate the myth that asset prices always rise. We also think that Rismark’s June quarter national dwelling-price-to-income ratio estimate of 4.6 times will compress somewhat over the third and fourth quarters, which will assuage valuation concerns.
Rismark has a team of four full-time PhDs dedicated to analytics and forecasting. We got 2008 right by projecting only trivial national nominal dwelling price declines. According to our market-leading hedonic index, the actual peak-to-trough correction was slightly less than four per cent. In late 2008 we stated that we thought the 2009 recovery would surprise on the upside, as it did. And we got a little ahead of the curve with our projected 2010 soft-landing, which we thought would come near the start of 2010 rather than in the second quarter.
Since the beginning of the year we’ve argued that we were not expecting national dwelling price growth of more than four to five per cent, which is why we have been bearish on the second half outcomes. Looking ahead, we think 2011 will afford astute investors some attractive buying opportunities as stress levels rise.
Some bears like to typecast us as very bullish because of our efforts to dispel the many myths peddled by doomsayers during the GFC. But as a matter of record, we have never publicly projected dwelling price growth beyond that realised by disposable household incomes. And in contrast to those who are genetically negative, we have been able to consistently pick cyclical changes.
Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.
Wednesday, December 01, 2010
One of the more fascinating disclosures coming from the RBA's testimony to Parliament on Friday was the repeated assertions by Glenn Stevens that the central bank has got behind the interest rate curve – that is, had to play catch up – far more frequently than it has been able to pre-emptively anticipate inflation with rates. This was all, of course, rationalisation of the RBA's move in November, which followed a very low 0.5 per cent third-quarter CPI number.
It nevertheless fits well with the thesis I regularly outlined here in September and October regarding the need for the RBA to be even more forward-looking in its monetary policy approach. In fact, I think that following the mistakes made by Stevens et al in 2006-07, which the Governor seems happy to now acknowledge, this RBA has changed the way it conducts policy.
With such a large investment and income shock looming – and, in the RBA's words on Friday, very little spare capacity – it will be much less focussed on contemporaneous data (like the Q3 CPI), and more willing to take risks with the conduct of policy by backing its medium term inflation forecasts. This has big consequences: it means that the RBA runs the risk of making mistakes, which is, by the way, okay, since it can always reverse its decisions. It also means that monetary policy will be much harder to predict day in, day out.
But it fits perfectly with my asymmetric reaction function thesis: that is, having observed the mistakes it made in the recent past, and the disturbing upward drift in both core and headline inflation, and even more worryingly, increases in all measures of future inflation expectations, the RBA would much rather CPI undershoot rather than overshoot the target.
This also explains the other very interesting anecdote coming from the testimony: the RBA's repeated references to changing interest rates when you are uncertain that this is the right thing to do. To the RBA's mind, this is because when you are certain, it is much too late.
"As each month goes by, you are closer to those impacts coming through the economy. So you are in a period where you are waiting to see how certain things resolve one way or the other – but you know that you cannot wait forever…
But, having been involved in this process one way or another for quite a long time, I cannot think of very many cases in history where we looked back and thought, ‘Yep, we tightened too soon.’ I can think of several times where we looked back and thought we should have tightened a bit earlier. I think that if we are doing it right the decisions will be finely balanced most of the time – that is where we should be – and we will probably move a little bit earlier than the moment when it is clear that you have to. That is if we are doing it well. There is some risk that you do things you do not need to do – I agree with that. We have to balance that risk, obviously, against the risk of getting behind the game. Historically, for many central banks, including us, that has tended to be the mistake that we made."
"The truth is we could have delayed a month until December and then have done it without maybe making a material difference to the course of the economy. It is very hard to say that it would. The problem is that any month you can say, ‘Let’s just wait a bit longer.’ You kept waiting and then eventually what typically tended to emerge when that was the case in the past was that you thought, ‘Now we have to get motoring and catch up.’ I think it is better really to move in a reasonably timely fashion to a point where you might be able to rest for a while. That is a better position to be in. As I said earlier, yes, we will be criticised for being trigger-happy."
"...having observed this or having taken part in it for a long time, I do not think I can recall too many occasions when with an early rise we looked back and thought we wished we had not done it. I can think of occasions when we wished we had moved more quickly or sooner, and I think there have probably been occasions when you can look back and wish you might have started coming down sooner. It is easy for the process to have a lot of inertia, ‘Let’s just get a bit surer before we do anything.’ The problem with doing that is that once you are sure, you are late, almost certainly."
Friday, November 19, 2010
Consistent with our forecasts for around 12 months now, the second half of 2010 looks like it will see little-to-no capital growth. Last weekend's auction clearance rates were weak. Rismark successfully projected the modest downturn in 2008, the robust rebound in 2009, and the cooling in 2010 (albeit that we were anticipating a slowdown a little earlier – in Q1 2010 as opposed to Q2 2010 – than actually transpired).
This can be contrasted against the lunatic housing fringe, who forecast 20 to 40 per cent house price falls in 2008 (confer with realised dwelling price declines of just three to four per cent), and, amazingly, the same again in 2009 and 2010. It must get awfully frustrating when you are proven relentlessly wrong by real world outcomes. Going forward, we are bearish on asset price growth over 2010-11 as a function of the RBA's base-case interest rate story.
As an interesting aside, the housing nutters out there used to criticise the best-in-class RP Data-Rismark Hedonic Dwelling Price Indices, which in 2008 reported slightly lower dwelling price declines than the simpler – and less representative – ABS measure. Unsurprisingly, this practice ceased when the market recovered and RP Data-Rismark reported far and away the most conservative capital growth rates over 2009-10. Indeed, the loonies started relying on RP Data-Rismark's numbers when we were the first to disclose dwelling price declines in the month of June 2010, well in advance of the ABS and APM.
Wednesday, November 10, 2010
This is the keynote address I gave on Thursday morning to the Annual LIXI Forum:
Today I am going to talk about a policy idea that has the potential to revolutionise regulatory risk management and help facilitate the otherwise intractable ‘switching’ of customer account information between financial intermediaries. This is obviously germane given the current political atmospherics.
One of the problems with managing the Byzantine nexus between extreme asset price and credit cycles, and the ordinarily adverse ramifications of these events for our real economy, is that policymakers have historically had very poor credit data.
As the RBA spent considerable time highlighting in its September 2009 Financial Stability Review, the measurement of seemingly simple statistics like mortgage default rates is an exceedingly complicated exercise both within countries and across nations. While this might sound esoteric to some, getting an understanding of the risks accompanying the $1 trillion worth of outstanding Australian mortgage debt is vital to all of our welfare.
Yet even these default rates are an ex-post expression of duress. That is to say, you only find out about it after the risk has already materialised. In fact, the probability of default on a home loan tends to peak a full two to three years after the date on which a loan is originated. A more valuable leading indicator of financial stress that could be used to predict changes in default rates over time would be ‘live data’ on the quality of the assessment standards employed by all lenders when they extend credit.
To the best of my knowledge, it has been awfully difficult for policymakers to get access to this critical real-time information. This is also true of investors in the residential mortgage-backed securities (RMBS) market, where issuers (that is, lenders) do not normally provide investors with data on the debt serviceability ratios underpinning the individual loans that they are vending into the market. They too are stuck with after-the-event default rates.
Getting data on dynamic changes in lending standards over time is crucial precisely because these standards are not static. History tells us that credit rules can be highly pro-cyclical – money is easy to access during the good times, and hoarded by suddenly risk-averse lenders during the bad.
In many ways, the GFC was simply an echo of the coincident asset price and credit boom (and subsequent bust) that occurred during the late 1980s with the distinguishing characteristic that twenty years’ hence global capital markets are much more interdependent due to the profound information and communications technology revolutions that have literally changed our way of life (aka the Internet). Oh and substitute in sub-prime loans for that 1980s innovation, junk bonds.
Another important difference this time around is that consumer, business and institutional investor confidence appears to be even more fickle and volatile than in days gone by because of the mind-boggling speed with which information in transmitted around the globe.
So when in the 1980s households had to wait for information to slowly percolate its way through the print and television news cycles, today consumers are fed this content in shockingly voyeuristic fashion. It’s like capitalism has become a perverse version of reality TV. And the velocity of this process means that the editorial and diligence standards that were previously applied to interrogating information have been frequently diluted (or, at the very least, consumers absorb much more ‘raw’ content than they have ever before).
The tyranny of distance is long gone – today we face the tyranny of virtual proximity. And so we had the butterfly effect that was US households defaulting on their loans quickly causing chaos around the world, including, but not limited to, the first run on a UK bank since 1866, the partial nationalisation of many private banking systems, and wholesale changes of government.
These new dependencies between economic events, the release of information, consumer and business sentiment, and their feedback into real behaviours warrant detailed study by academic researchers. They also mean that policymakers and politicians have arguably higher duties of care to faithfully communicate with the nation as opposed to seeking to mercenarily exploit these relationships for short-term gain (for example, by exaggerating the nature of problems we face).
All of this is a rather roundabout way of saying that regulators also need to think more creatively about how they monitor, measure and ultimately manage risk. And in this context, I have a policy proposal. I have put this to government economists and industry participants, and they have, without exception, enthusiastically embraced it. Thus the only thing preventing us from implementing this policy is political will.
Moving from the general to the specific, I would propose that the Commonwealth establish a central electronic ‘clearinghouse’ of all residential, personal and business credit originated in Australia. For simplicity’s sake, let’s call it the National Electronic Credit Register (NECR).
If you think about it, credit is effectively an over-the-counter (OTC) contract. There is no centralised exchange novating the relationship between the parties as we see, for instance, with companies listed on the stock exchange, or with listed derivatives and futures contracts. In the latter cases, the ASX acts as a both a contractual and informational intermediary. NECR’s role would be purely around the aggregation and transmission of information between parties.
As we discovered during the GFC, one of the profound shortcomings associated with OTC markets is that they effectively eviscerate transparency. The only people who know what is going on are the counterparties themselves. This causes significant ‘information asymmetries’ that destroy confidence, and is one of the principal explanations for the evaporation of liquidity in many markets during the crisis.
In Australia, APRA and the RBA do collect a great deal of ex-post facto credit data. But this is normally aggregated information and does not tell them much about the individual loan-by-loan risks. It also does not necessarily furnish them with any insights into the ex ante, or before the event, credit assessment standards employed by lenders.
The establishment of NECR would presumably be very straightforward. All Australian lenders have electronic lodgement processes and there are standardised communications formats that allow lenders to communicate with one another (in the mortgage market this is known as LIXI or the ‘language of lending’).
APRA, the RBA, and ASIC (to cover the non-banks) could, therefore, simply insist that any licenced entity involved in the creation of personal, residential or business credit sends NECR a simple data packet upon the settlement and, notably, discharge (that is, repayment) of every single loan. The lender’s transmission to NECR would contain, amongst other things:
- A unique loan identification code (so that NECR can track the loan).
- The loan amount.
- The loan type (for example, three-year fixed).
- The interest rate.
- The settlement/discharge date.
- The collateral value (for example, property value).
- The collateral address.
Importantly, a nationally-defined debt serviceability standard measuring the ability of the borrower to meet the repayments on the loan (all lenders use these in one form or another, so it should be easy to define a standard metric that they have to supply, which in turn would allow us to make cross-sectional comparisons of ex-ante credit quality for the first time).
NECR might also provide the architecture required for the transmission of broader customer information between counterparties. That is, it might help resolve the current bottlenecks around customers ‘switching’ accounts between institutions, the manifold difficulties associated with which stifle competition. I am told that one of the chief obstacles to switching is the absence of the necessary electronic linkages between institutions involved in the deposit-taking and/or credit creation business. NECR could be employed as a centralised hub that any institution could use to transfer customer data to another once they are instructed to do so by a customer.
My good friend Professor Joshua Gans has suggested something similar in the context of switching with his proposal for a universal customer ID.
NECR would also revolutionise the RBA and APRA’s approach to risk-management. Allow me to illustrate a few examples. In the shadow of the GFC, regulators are understandably worried about system-wide debt levels (or ‘leverage’) and the rate of change in credit over time (such as, the process of gearing up, or, conversely, deleveraging).
These concerns are made all the more acute given the recent tapering in national house prices combined with the spectre of further rate rises. But what arguably gets regulators most energised is the so-called ‘distribution’ of these risks. That is, those borrowers sitting in the far tails of the distribution that carry the highest hazards. But disaggregating this information when banks are sending you summary statistics is an arduous task (obviously the regulators insist on some disaggregated data).
So rather than simply calculating a system-wide loan-to-value ratio (LVR) by dividing the total amount of mortgage debt (that is, circa $1 trillion) by the total amount of residential property outstanding (around $3.5 trillion), or for the pedants, the amount of property with mortgage debt held against it (about half based on the 2006 Census), the regulators would be able to measure the individual LVRs of every single loan in the country. And they would get live updates on changes in those LVRs as loans were regularly refinanced, which they are.
Since the average home loan’s life is only around four years (due to refinancing), it would not be long before they had individual records on all outstanding debt.
More significantly though, real-time information on the specific lending criteria employed by institutions (as proxied by, for example, LVRs and a standardised debt serviceability metric, which does not currently exist) would allow authorities to act assertively in the upswing of concurrent asset price and credit booms rather than picking up the pieces after the bubble has burst.
A more expansive iteration of NECR would have all institutions report monthly changes in account balances and default rates during the life of their products.
Regulators could then make anonymised variants of this information aggregated at a granular, say, suburb level available to institutions that participate in the exchange. And so, if lender A was concerned about the volume of lending, serviceability standards, LVRs and/or default rates associated with housing credit in, say, Perth, they could request this data from NECR, and modify their own approach as appropriate.
As a final observation, today there is technology available that enables lenders to revalue every single home in Australia on a daily, weekly or monthly basis. These Automated Property Valuation Models (AVMs) are highly accurate on a ‘portfolio’ basis. Armed with this weaponry, regulators could literally quantify the LVRs and equity held in every home in the country as frequently as they desired in order to compute the fallout associated with multi-standard deviation property price falls (aka ‘black swans’). Now that’s what I call 21st century policymaking.
In a world in which the relationship between the state and the various institutions it regulates is more intertwined, NECR seems like a reasonable aspiration. It would also make an important contribution to helping insulate Australia’s financial system from the next crisis, which could originate much closer to home.
Important information:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.
Thursday, November 04, 2010
UBS’s rates strategist Matt Johnson has just thrown a massive spanner into the Australian monetary policy debate. In short, he argues that, contrary to both the RBA’s and popular economist received wisdom, Australia could be set to experience a prolonged period of low, as opposed to high, inflation.
Over the past few years, the narrative among most economists, which remains the general consensus to this day, has been that the RBA got ‘head-faked’ by a brace of low inflation prints in December 2006 and March 2007, which led them to delay future rate hikes. These inflation outcomes were almost exactly the same size – 0.5 and 0.6 per cent, respectively – as the results in the second and third quarters of 2010.
The argument then goes that the RBA was forced to play catch-up in 2007 and 2008 as domestic inflation spiked to extremely high levels of up to five per cent (in September 2009), which has cast a question over the inflation-targeting performance of the Stevens RBA.
On this latter subject, headline inflation has averaged three per cent since September 2006 (when Glenn Stevens was first appointed), which is at the top of the RBA’s target band. Macquarie’s Brian Redican highlights that using a through-the-cycle average rate of inflation is not, however, a fair benchmark. In particular, he quotes the RBA’s Guy Debelle, who argues, “the intent is that over the course of the business cycle, the bulk of the distribution of year-ended inflation outcomes should lie between two and three per cent, not that the annualised average inflation rate from the start of the business cycle to the end should necessarily lie between two and three.”
To meet Debelle’s standard, one should therefore use a median as opposed to average estimate on inflation. Since September 2006, median year-ended inflation has been 2.9 per cent while median ‘core’ inflation has been about 3.4 per cent. On any measure, the RBA’s recent inflation-targeting performance has not been great.
Johnson’s contribution is that he assaults the prevailing view that the principal driver of domestic price pressures was Australia’s terms of trade boom and a fall in the unemployment rate to sub-five per cent. Recall that in 2006-07 unemployment was at or below the all-important ‘full employment’, or ‘non-accelerating inflation’, rate of unemployment. This is the threshold beyond which any further declines in unemployment are thought to drive up labour costs and trigger price pressures.
The 2006-07 episode is relevant to the RBA’s deliberations because there are some commonalities with current circumstances: we are once again experiencing a terms of trade boom and strong employment growth (although the jury is out on whether the unemployment rate is actually declining, or whether it has stabilised around five per cent).
A further wrinkle here, which Johnson points out, is that the RBA recently released a research discussion paper that found that the single best predictor of changes in inflation over time was the domestic unemployment rate.
Johnson’s analysis turns some of this on its head by positing that Australian inflation is more a global, rather than local, phenomenon. More specifically, he argues that low unemployment and the first phase of the mining boom were not the principal explanations for the high inflation Australian experienced prior to the GFC. His thesis also fits with the intuition that as a small, open economy which is a price taker in global markets, Australian inflation is heavily influenced by the global ‘output gap’ – that is, how global economic output stands relative to global capacity. On this basis, if global output is running above (below) capacity, local and offshore inflation will rise (fall).
Johnson’s work has crucial consequences for Australia’s inflation and interest rate outlook: if global growth is expected to be below capacity for the foreseeable future, and the inflationary pulse weak, Australia could be set to endure a period of relatively benign price pressures. This would in turn suggest that the RBA may not need to lift the cash rate another four times to 5.5 per cent, as is currently believed by most market economists.
In his first chart below, Johnson compares Australia’s inflation path (blue line) with that of the US (red line) and an average of Germany, Canada, New Zealand and the UK (green line). The substantial rise in inflation in 2007-08 was clearly a global experience, although it is true that the very low prints in 2006-07 were somewhat indigenous to Australia, and not fully explained by the offshore dynamics.
The next two charts are fascinating. Johnson constructs a model of Australian inflation that is based purely on inflation in the US, Germany, Canada, New Zealand and the UK. He fits this model using data between the period 1994 and 2000, and then employs that historical analysis to forecast (out-of-sample) future Australian inflation between 2000 and 2010. As you can see, this global model of Australian inflation does a very good job of predicting changes over time. And where the local outcomes do diverge from the model’s expectations, they are patently attributable to idiosyncratic events, such as the GST and Cyclone Larry.
Based on these insights, the RBA still arguably made a mistake in 2006, since predicted and realised inflation in 2007-08 was way above target even when relying only on overseas inflation data. Here Johnson also notes that, “our conclusion that the inflation spike probably had little to do with idiosyncratic domestic policy is not (presently) shared by the RBA. Their most recent work on inflation modelling squarely takes the blame for inflation problem. The upshot of their modelling exercise is that the RBA is responsible for the lion’s share of the 2007-08 inflation problem, as they allowed the unemployment rate to fall too low”.
One risk to Johnson’s thesis is that structural changes in the composition of global economic output, with an increasing share of output generated out of emerging economies like China, India and Brazil, will mean that domestic inflation may be less influenced by the spare capacity in the US, UK, Germany, Canada and New Zealand. There is also a risk that globally low interest rates will stoke secular inflation pressures.
Nonetheless, Johnson has made an important contribution to our thinking on interest rates. He concludes, “Most forecasters presently expect wide global output gaps to depress global inflation for some time. If this is the case, the foregoing suggests there is a nontrivial probability that Australian inflation remains subdued, despite the capex/mining boom.”
Consumers remain risk-averse
In good news for the RBA, Westpac's Red Book shows that consumer risk-aversion remains at high levels, as illustrated by the charts below. Doubtless recent speculation around rate rises has helped the RBA's cause. Cash remains the 'wisest place for savings' followed by debt reduction and real estate. Shares have rightly suffered a systemic decline in their relative positioning after historic highs were reached in the late 1990s. I won't prattle on here any more about the volatility of equities, and their mediocre risk-adjusted returns, as we have done so too many times in the past ... If only super funds would listen!
Monday, November 01, 2010
In good news, Australian housing affordability has been improving for the last four months. In the month of September, Australian capital city dwelling values were effectively unchanged (0.1 per cent seasonally-adjusted or 0.4 per cent raw) based on results released by RP Data-Rismark today (the previous raw month of August results revised by a tiny margin from 0 per cent previously to -0.1 per cent).
Indeed, there has been no growth at all in capital city dwelling values since the end of May 2010. More specifically, dwelling values have actually fallen by around one per cent (or 0.8 per cent raw), which implies that affordability is getting better.
Over the September quarter, Australian capital city dwelling values declined by 0.4 per cent seasonally-adjusted (or 0 per cent raw). And in the 12 months to September, Australian capital city dwelling values grew by eight per cent.
The affordability situation is even better in the less supply-constrained ‘rest of state’ markets, which cover the 40 per cent homes not located in capital cities. House values in the rest of state areas registered a seasonally-adjusted decline of 0.9 per cent in September (-1.5 per cent unadjusted), according to RP Data-Rismark.
Perhaps more interestingly, rest of state house values have realised no capital growth at all in 2010, and are up by just 2.7 per cent in the 12 months to end September.
Over the September quarter, RP Data-Rismark’s Rest of State Index recorded a 1.5 per cent seasonally adjusted fall in house values (-2.4 per cent unadjusted).
These results are gratifying insofar as they accord with our long-term projection that Australia’s housing market would flat-line in the second half of 2010. It is also worthwhile highlighting here that the monthly RP Data-Rismark Hedonic Home Value Index was the first benchmark to report a big shift in housing conditions with a substantial fall in Australian dwelling values in the month of June. This followed annualised double-digit capital growth since the start of 2009.
Other house price measures, such as APM’s stratified median price index, are now starting to fall into line. We expect the ABS’s stratified median price index to report similarly negative results for the third quarter on Monday.
Nationally, the median Australian dwelling price (across all regions) in the three months to end September was $406,500 which is $9500 (or 2.3 per cent) lower than it was at the end of June 2010 (note: medians should not be used to measure changes in value over time).
After falling 1.7 per cent since the end of May, the 20 per cent most expensive (capital city) suburbs in Australia staged a comeback in the month of September by generating modest capital gains of 0.4 per cent. In contrast, the cheapest 20 per cent of suburbs fell in value by 0.4 per cent. The most resilient part of the market has been the middle 60 per cent of suburbs, which realised 0.7 per cent capital growth in September.
There has been much recent talk about housing bubbles, which appears to be a universal constant in the local landscape no matter what part of the cycle one finds oneself in. GMO’s Jeremy Grantham has sought to defend himself after coming in for a tonne of technical criticism for the questionable analysis he used to justify claims that Australia was in the grip of the mother of all bubbles. Unfortunately, Mr Grantham got it wrong again. The immediate clue in his latest response is the argument he tenders upfront: there must be a housing bubble because people have disagreed with him!
Grantham then reasserts the line that Australia’s dwelling price-to-income ratio is 7.5 times or higher, when many experts, including the RBA, have repeatedly demonstrated that this is wrong: the right ratio is about four to five times if you compare national dwelling prices with national incomes, or capital city dwelling prices with capital city incomes. Just this week, Westpac’s Matthew Hassan concluded, “A price-to-income ratio based on an all dwellings, all regions national median is 4.3 times and has ranged between 3.9 times and 4.4 times over the last seven years. This compares to an often quoted national price to income ratio from Demographia of 6.8 times, who view a ratio over five times as severely unaffordable.”
A final mistake is Grantham's claim that Australia has "accommodating monetary conditions", when, in fact, mortgage rates are exactly in line with their long-term averages, and among the highest in the developed world.
The biggest risk to Australia’s housing market is likely posed by the course of monetary policy. The consensus view is that the cash rate will rise another 100 basis points to 5.5 per cent. Banks are also likely to add another 25 basis points on top of this, leading to an effective increase in lending rates of 125 basis points. This means that the headline variable mortgage rate will rise to 8.65 per cent.
While household balance sheets will be supported by a strong labour market and robust income growth, our analysis suggests that a substantial increase in rates would put some downward pressure on dwelling prices. New borrowers taking out loans should, therefore, be sure that they can service mortgage rates that are a good 1.5 per cent higher than what they are currently paying.
RP Data-Rismark’s Hedonic Index is based on Australia’s largest real estate database, which has recorded 266,942 dwelling sales in 2010 alone, and is the preferred benchmark for most economists.
Important information:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.
Sunday, October 24, 2010
The Age is reporting today about 'David Murray's plan' to for Aussie Post to open up its circa 3,000 plus outlets as distribution channels for smaller lenders. This is exactly what I have suggested several times in the past.
Joye wrote the following on 5 January, 2010:
Today I am going to consider the political sensitivities surrounding the profitability of the major banks. I will also put the counterintuitive argument that simpler banks like Bendigo and Adelaide are, in many respects, safer than the majors despite what investors and the credit rating agencies say.
And I will conclude with some recommendations on what Ahmed Fahour can do with Australia Post in the context of the controversial debate regarding a so-called ‘People’s Bank’.
In short, I will propose that there is a case for a new public banking capability in regional and rural Australia. But in the metro markets, I would encourage Fahour to stick to much simpler third-party distribution and open up his 4000 outlets as commercial conduits for smaller lenders.
The commentariat has started serving up some high-quality fodder on these subjects. Indeed, Business Spectator’s own Stephen Barthomoluez has produced an excellent column in which he warns the big four banking ‘oligarchs’ (perhaps this will become a new descriptor in the local lexicon) from acting as pure profit maximisers:
“A sharp rebound in profitability would be contentious and politically sensitive. There are already calls for federal government intervention to create more competition for the majors. The appointment of former senior National Australia Bank executive Ahmed Fahour to head up Australia Post has sparked urgings for the creation of a post office bank.
While it is vital that the majors remain solidly profitable – the wreckage in financial sectors and fiscal settings elsewhere illustrates how destabilising and destructive an unprofitable system can be – it would be a sign of an unhealthily concentrated and uncompetitive system if the majors were too profitable. It would also almost inevitably lead to government intervention.”
Now although I have not always seen eye-to-eye with Bartho, he must rank among Australia’s best banking analysts (I think my previous divergences with him at least partly validate my capacity to make such an assessment). And I mean ‘analyst’ in the genuine sense of the word. The more conventional market analysts are not paid to critique public policy, or to reflect on abstract changes to the banking business model – they earn their crust by accurately valuing these companies and thus predicting how they will behave (or, put differently, forecasting their future cash flows).
This makes analysts rather useless when it comes to evaluating the actions of banks from a public policy perspective. I have noticed a similar phenomenon with economists. When I first started out, I thought that the market economists would make great sparring partners in debates about monetary policy. Yet they actually proved to be surprisingly unwilling and ill-prepared accomplices. I appreciate this might sound odd, but it is true. I am friends with many of these guys. And a very senior sage explained the problem to me one day. In response to a criticism I had levied against him about his disinclination to question the RBA, he averred, “Mate, it is not my job to think about what the RBA should or should not be doing—it is my brief to predict their behaviour; if anything, I need to spend more time thinking like them.”
Anecdotally, I have found an inverse relationship between the forecasting prowess of economists vis-à-vis monetary policy and their preparedness to critically appraise the RBA. This is no surprise, since the aforementioned analyst also opined that if he relentlessly questioned the RBA the central bankers would be less disposed to sharing their views. The concern is that if you take on the bank you will be removed from the informational flows. Dr Stephen Kirchner of the CIS and I have independently argued that exactly the same dynamic can be applied to journalists. And, of course, the principle is germane to banking analysts – can you imagine a leading analyst making the sort of statements one reads here and then expecting seamless access to the big four CEOs? I don’t think so. (As an aside, notwithstanding my regular questioning of the RBA I actually find them to be very open-minded – it has not appeared, for example, to impact on our professional relationship with them.)
Returning to Bartho’s recent column, he canvasses an important point, which is something I raised with him some time ago in a debate about the oligarchs. In previous posts I have presented RBA data that shows that the major banks’ return on equity declined only modestly during the GFC. That is, their RoEs have remained in solid double-digit territory and are no less than those experienced in the early 2000s. Leveraging off CBA analysis of its own cross-divisional returns, I (and others) have also belaboured the fact that their underlying businesses have been hugely profitable on a cash basis—it was the large expected losses in their business lending areas (aka ‘impairments’) which dragged down their reported profits. Naturally, if the anticipated economic Armageddon does not come to pass, these impairments will evaporate and future profits will soar. This is the origin of Bartho’s concerns given that the sustenance of such profits during the recent calamity has relied directly or indirectly on the public purse.
Yet whenever I have suggested that the majors should be able to absorb more of their funding cost pressures, I have met with the refrain, No we need to protect the banks’ profits or their ability to raise equity capital will suffer. This logic is, however, flawed.
One of the principal behavioural complexities we face today is the relentless focus on returns to the detriment of risk. If you are assuming a much higher probability of loss (viz., risk) in order to generate better returns, your risk-adjusted returns have not increased. This is why equities are not the wonderful investment class that many in the commentariat claim. I recently came across the statement that your best asset-allocation bet since the 1970s was Australian shares. This is certainly true on a raw return basis. But when you risk-adjust the historical returns using any standard methodology, such as a Sharpe Ratio, Australian shares stack up poorly against many fixed income alternatives. The commentariat’s pathological tendency to ignore risk and focus mums and dads on raw returns is a real problem: we seem to have this mental blind-spot where we erase from our minds the 40 to 50 per cent price falls seen in global equity markets in 1987, 2001 and 2007-08. Punters get lured into the market by commentators acting like casino promoters. The challenge is not just for retail investors: as I have regularly highlighted here, the same behavioural biases afflict many retail super funds’ asset-allocations, which have amazingly highly 60 to 70 per cent weights to global equities. And slowly but surely this is starting to attract the appropriate criticisms from regulators and asset consultants.
Coming back to our oligarchs, there is nothing wrong with a decline in the major banks’ return on equity (which is, in fact, likely to increase significantly in the next few years) if that is accompanied by a commensurate reduction in their expected risk. And that is precisely what we have observed since the start of the GFC. As is now well understood, taxpayers have effectively said that they will insure away the risk of bank failure. This is an incredibly important policy innovation since it fundamentally changes the perceived risk of these enterprises. Banks are clearly not just ‘private concerns’ as many would have us believe. At the first sight of mortal adversity, taxpayers were compelled to guarantee all of their funding sources at no price in the case of most deposits, and at an arguably sub-market price in respect of their wholesale liabilities.
Furthermore, a taxpayer-funded lender to the banks, the RBA, supplied them with cheap loans that were a vital lifeblood of liquidity during the darkest days of the crisis when extreme counterparty risk eviscerated liquidity for even the most creditworthy institutions. This is, in fact, one of the RBA’s key responsibilities—as a lender of last resort to private banks that are otherwise prone to fail.
Setting aside the significant new moral hazard concerns that have emerged from this crisis, what do these actions tell us? They clearly illustrate that bank shareholders get the benefit of a raft of (call-option like) protections that are not supplied to other private companies. Given taxpayers have revealed that they are willing to insure away much of the downside risk associated with catastrophic bank failure, these institutions have, by definition, significantly lower equity risk.
If the probability of loss associated with investing with the majors has declined care of these profound changes to our prudential system (APRA was founded in 1997 on the explicit basis that it would never, ever guarantee any institution), the expected returns should also fall. That is, investors should be more than happy to accept lower returns since the risks associated with putting your dough with the banks has also fallen.
This touches on another one of those rarely-discussed nuances. That is, the tension between CEOs and their shareholders, who are mostly focused on maximising raw returns in the short-to-medium term, and the much longer-term system-wide interests of taxpayers and policymakers who would like to see these institutions behave in a manner that minimises the prospect on them calling on our insurance (such as bank bailouts).
This now situates us at the heart of the regulatory questions that are being asked by some academics, politicians and policymakers: given their protected-species status, should the banks be subject to stricter regulatory constraints on what businesses they can and cannot operate? Should they just stick to their knitting and focus on savings and loans? Do they need to be stockbrokers, corporate financiers, investment bankers, proprietary traders, and bankers to businesses and home owners in, say, China? For some observers, and for Glass and Steagall way back in 1932, the answer to most of these questions was no.
These issues raise another incongruity. Everyone appears to agree that the oligarchs need to reduce their reliance on short-term wholesale debt and boost the funding they source from deposits (setting aside the fact that whether you use deposits or wholesale debt, you still have a profound asset-liability mismatch that is the source of the fragility that sits at the heart of the banking business model). From memory, the major oligarchs derive around 60 per cent of their funding from deposits, which is up from circa 50 per cent prior to the GFC.
In comparison, the much more lowly-rated Bendigo and Adelaide Bank sources around 93 per cent of its funding from deposits.
Even more importantly, Bendigo and Adelaide Bank very much conforms to the highly conservative ‘narrow banking’ model that Glass and Steagall, and some contemporary policymakers, aspire to see. That is, it sticks to the core business of providing safe-harbour for savings and redistributing that capital as credit to businesses and households throughout the economy. There is no investment bank. No proprietary trading desk. No stockbrokers. No certain-to-embed-much-higher-risk ‘pan-Asian’ banking designs (I have frequently drawn attention to the apparent contradiction of the major banks rushing to expand overseas following the GFC when it was the claimed absence of these exposures that many believe protected Australian banks from the crisis in the first place!).
Rather than being rewarded for its highly conservative approach (notwithstanding some minor missteps that originate from the Adelaide Bank legacy), Bendigo has been punished by investors, ratings agencies and even policymakers. Yet if you evaluated Bendigo’s business purely through the lens of the risk of catastrophic failure outside of the core savings and loan domain, you can mount the case that it is a demonstrably safer concern than the majors who have embedded so many other independent hazards into their activities (NAB reportedly acquiring a UK bank, Northern Rock, is just another example of this).
Now in the ‘base-case’ (aka the ‘good times’) it can be argued that these independent operations diversify bank earnings. But whether it be through investment banking operations, trading of stocks, currencies or commodities, or direct foreign banking exposures in the US, UK, Indonesia, or China, these non-core activities all boost the probability of catastrophic loss.
This is exactly what happened to the long line of once plain-vanilla banks during the GFC. A striking example is Royal Bank of Scotland (RBS), which morphed from a simple Scottish retail banking concern to a global trading and investment banking powerhouse. Yet it was precisely these investment banking exposures that brought it down. Today the UK taxpayer owns more than 84 per cent of RBS.
The experience during the GFC undermines the notion that private banks are inherently safer than publicly-owned enterprises. Indeed, if history tells us one thing, it is that private banks have a very high propensity for failure due to the asset-liability disconnect that is the source of so much of their instability.
This brings us to the question of the People’s Bank. I have spent much of the past two years arguing, with some success, that the Rudd Government should create more competitive neutrality in the banking and finance sectors by establishing a level playing field between deposits, wholesale debt and securitisation. And they have made some inroads here with the $16 billion of liquidity they’ve injected into the RMBS market.
To my mind, there does not seem to be a super strong case for a People’s Bank in the mainstream markets. As I noted last time around, we already have a strong second tier of smaller banks, credit unions and building societies outside of the oligarchs who, with appropriate public encouragement, could bring significant competitive pressure to bear. And a new non-bank model will inevitably emerge as securitisation spreads compress.
Yet even the most hardheaded of major bankers have privately confided to me that there would potentially be a role for Australia Post to deliver banking services in rural and regional Australia. To be sure, Bendigo and Adelaide Bank valiantly services part of this market. But with the retreat of the majors from rural Australia during the 1990s and 2000s there is an argument for a simple, low-cost banking service furnished by the state. Those living in rural Australia are members of the taxpayers I highlighted above who have supplied so much direct and indirect protection to the banking system throughout the GFC. And let there be no doubt that ‘banking’ is a necessary public good that all Australians require access to in order to make their way in life. This is why, for example, academic research has shown that micro-finance is crucial to pulling families out of poverty.
So Ahmed Fahour could secure his first banking mandate in rural Australia. This would also provide Kevin Rudd and Wayne Swan with a powerful political wedge. The Nationals would find it impossible to oppose empowering Australia Post to deliver banking services to their constituencies. At the same time, the 'dry' faction of the Liberal Party would presumably be opposed to any form of state intervention in the banking sector even though such opposition would be based on an ideological fiction (the fact is that the state already underwrites much of the industry). In short, this would be a policy that would either cleave the Coalition in two, or represent something they'd be forced to embrace if the ‘dries’ were rolled.
I recently had a long chat with Danny John at the SMH about all of this, and he subsequently published an outstanding piece on what to expect from Aussie Post. Danny notes that Aussie Post is effectively a monopoly in decline. Standard mail is a thing of the past. So the main test facing our chief postie, Mr Fahour, is how to reinvigorate the franchise while avoiding the adverse political spectre of closing non-economic post-offices.
Here it occurs to me that there is another reason why Australia Post could achieve these aims while further enhancing competition in the banking and finance sectors. Australia Post has the one thing that many smaller lenders do not: an extraordinarily strong national branch network. With over 4000 outlets nationwide they have a distribution capability comparable to the majors. So while Australia Post may not want to compete directly in the mainstream savings and loan markets in metropolitan Australia, they could develop a financial services distribution capability.
Imagine if in every post office you could find a dedicated professional who would have the capacity to offer you non-commission-based finance on behalf of the smaller banks, building societies and non-banks. Aussie Post could remunerate these professionals on a time-basis and avoid some of the conflicts associated with mortgage brokers. Concurrently, they could negotiate at the corporate level very lucrative distribution deals with all the non-major lenders in Australia on a volume basis. In time, it is easy to imagine this service being expanded to other staple products: for example, various forms of insurance, Australian government bonds, superannuation, and so on.
At the very least, this should be some food for Mr Fahour’s thoughts.
This brings us to the question of the People’s Bank. I have spent much of the past two years arguing, with some success, that the Rudd Government should create more competitive neutrality in the banking and finance sectors by establishing a level playing field between deposits, wholesale debt and securitisation. And they have made some inroads here with the $16 billion of liquidity they’ve injected into the RMBS market. Danny notes that Aussie Post is effectively a monopoly in decline. Standard mail is a thing of the past. So the main test facing our chief postie, Mr Fahour, is how to reinvigorate the franchise while avoiding the adverse political spectre of closing non-economic post-offices.
Important information:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.