Is an Australian financial crisis on the cards?
Following on from yesterday’s article about the Aussie economy we thought it worth sharing a recent Australian Financial Review article titled “Is an Australian financial crisis on the cards?” which was off the back of comments from respected economist Paul Dales. In 2016 the very same AFR awarded him ‘Economist of the Year’ ranking him as the top forecaster in 2016 for Australia’s ‘highly competitive local economic prediction market’ praising him for making ‘all the right calls in a market that most chief economists found hard to read’. So his is an opinion worth listening to. With that introduction, here is the article if you missed it:
“Household leverage may have peaked, house prices are falling, and credit conditions are tightening. The combination of the three should have all of us asking: what next?
The question is crucial because Australia is one of the few economies to have increased its debt burden since the global financial crisis. Household debt to GDP has tailed off a touch of late, but sits at record highs of around 120 per cent. The next nearest is Canada, at 100 per cent. We also have one of the highest household debt-to-income ratios in the world: 190 per cent. Five years ago it was 160 per cent.
"Economic history shows that there is usually a consequence of a prolonged period of rapidly rising debt, the only question is: how bad will the consequence be", Capital Economics chief Australia economist Paul Dales writes in a provocatively titled new report "Is a financial crisis looming?".
Yet the Reserve Bank remains stubbornly upbeat about the prospects for the Aussie economy. The central bank forecasts above trend growth that will facilitate a lift in inflation towards the middle of its target range, which will, in turn, allow the next rate move to be up, rather than down.
Economic history teaches us that years of rapidly rising debt usually carries consequences.
These predictions smack Dales as being too "perfect" to be real. He believes there is a level of complacency around how the legacy of years of climbing leverage can act as a drag on potential growth once the cycle turns. As he says, there are "consequences" to a decade of super-charged debt growth.
"The most likely consequence is a number of years of softer GDP growth and lower interest rates than expected," Dales says.
The best way to work your way out of debt is for years of household incomes growing at an appreciably faster pace than debt levels. Unfortunately, wages are barely moving higher.
Indeed, RBA governor Philip Lowe on Wednesday warned the current pace of wages growth is not compatible with his goal of keeping inflation at 2.5 per cent.
Lowe expressed the hope that a steadily improving economy will provide the growth in pay packets needed. This is also what is needed for households to run down debt. But as long as the consumer is focused on improving their finances, then domestic demand will suffer, weighing on overall economic activity, which holds down wages. That starts to sound like a debt trap.
Weaker than trend growth in coming years is not a disastrous outcome, but nor is it one baked into official forecasts.
Meanwhile, the risks of something worse are on the rise, Dales says.
"Six months ago I didn't think this risk [a financial crisis] was worth talking about," Dales says. In such a scenario, credit conditions tighten significantly, credit falls outright and the resulting major falls in house prices weakens the economy and brings into question the quality of the banks' assets. You can have a recession without a financial crisis, but Dales assumes not vice versa.
"There's always a chance of something horrible happening, but the risk of a bad outcome has risen due to two things."
The first of those is that house prices are now falling, and its unclear how far they still have to go. The latest CoreLogic? figures show Sydney house prices are down 4.2 per cent over the 12 months to May. A year earlier, and values had been shooting higher at an annual pace of 17 per cent.
Melbourne house price growth has flattened. Auction rates have dropped sharply in the major east coast cities, and there are concerns around a potentially over-supplied Brisbane housing market.
"The bottom line is no one really knows whether house prices will fall by 5 or 10 or 20 per cent," Dales says.
The timing is important, too. A 15 per cent fall in house prices is OK if it happens over five years, but a similar fall over 18 months is potentially much more problematic.
Significantly tighter credit conditions is the other potential trigger for a worse work-out of Australia's debt burden by sparking further steep falls in house prices, and potentially climbing defaults. The royal commission is the wildcard here. Longer term it should shore up the financial system by rooting out poor and unethical practices. In the short term there is the potential for overreach that leads to a "credit crunch".
"There's no way knowing for sure what the actually triggers are" for a disorderly deleveraging, Dales says. Higher mortgage rates looms as an overarching risk, but there is the potential, in all these scenarios, for the RBA to cut rates to ease the pressure.
Dales now puts a 20 per cent chance of a recession in the coming years, and an additional 10 per cent chance of a financial crisis – a total 30 per cent probability that the years of boom turns bust.
"All of the risks are pushing in this direction," Dales says. "Even if you think these risks are fairly small, I think it's worth thinking about."”