Australians are being “irrationally exuberant” and borrowing too much to invest in housing, exposing the economy to financial shocks, global bond fund giant PIMCO says.
In a detailed statistical study that compares Australian borrowers to those in other countries, PIMCO researchers found that Australians’ decision to borrow is driven by falling interest rates and rising house prices – not economic fundamentals that reflect the health of the economy like employment.
In the US wages and other measures of economic health drive people’s decisions to borrow.
The world’s biggest bond investor said Australians’ focus on capital gains and cheap credit “may not be sustainable or linked to the productivity of the asset.”
Australians also appear to be ‘trigger happy’ about debt – they respond far quicker than other borrowers to changes in interest rates and asset prices. They start borrowing more after only six months of increases in house prices compared with a year in the US.
“Households are exhibiting irrational exuberance because they are placing little weight on broader fundamentals like unemployment that may be more representative of future incomes or asset price returns, increasing the likelihood of asset price bubbles,” the report released by the bond fund on Wednesday said.
Australians react faster and “more vigorously to a shock in asset prices or mortgage rates” which makes the economy more vulnerable to an external shock, such as a sharp slow down in China’s economy or another financial market sell-off, the report said.
The conclusions may bolster those who believe parts of Australia’s property market are into a bubble, including Treasury secretary John Fraser, and put pressure on regulators to take action. A sharp fall in property prices could hit the big banks, which borrow billions each year from overseas investors like PIMCO.
“The key point is that the speed which Australian households reacted to changes in housing assets and mortgage rate was much faster,” the researchers said.
Rising Household Leverage
That high responsiveness to changes in interest rates and prices “statistically highlights the potential vulnerability of high and rising household leverage incurred on the basis of past asset price movements,” the report said.
Co-author Laura Ryan, a PIMCO quantitative research analyst, said that when modelling the factors that driving in borrowings “wages didn’t predict any variation”
“Wages didn’t even show up [at all as a factor] after we included house prices and mortgage rates,” she said.
The 24 per cent rise in Australian house prices in three years driven largely by a 39 per cent gain in Sydney prices and a 22 per cent rise in Melbourne has reignited fears among Mr Stevens and other policymakers of a housing bubble.
The PIMCO paper said that the end of the resources boom had hit income and slowed wage growth that could lead Australians to pay off more debt and save more.
It warned about the possibility that falling interest rates and rising house prices could “drive a more irrational response relative to the macro fundamentals, a ‘herd mentality’ that assumes continued capital price appreciation and creates the fear of ‘missing out.'”
PIMCO portfolio manager and co-author Aaditya Thakur said there was a risk that people build unrealistic and unsustainable expectations that house prices could continue to rise given prevailing conditions.
“If you think about why people lever up its because they expect further income or price appreciation or a combination of both, but if they are extrapolating from past history, it might not be a true reflection of future productivity of the asset.”
Data from the OECD showed Australia is just one of four out of 19 developed countries with house price to rent ratios greater 25 times and one of six countries with price to income ratios greater than 120 times.
PIMCO showed using official data Australian household debt to net worth had increased from below 15 per cent in the early 90s to a peak to almost 30 per cent in 2009 but still remained above 25 per cent. By contrast US households had cut the ratio from a peak of 25 per cent to less than 17 per cent.
Elevated Household Debt
The elevated levels of household debt have become a key concern for the Reserve Bank with several senior officials including Mr Stevens discussing its impact on the path and effectiveness of monetary policy and the potential threats to financial stability.
In a speech delivered on Tuesday in Canberra, RBA assistant governor Christopher Kent said conservative households had used lower interest rates to reduce their debts however he said households with spare funds may have been prompted to take on new debt and invest in property in a “a search for yield”.
Treasury Secretary John Fraser told a Senate committee last month that there was “unequivocally” evidence of a Sydney property bubble however Treasurer Joe Hockey downplayed concerns about housing affordability by commenting that “If housing was unaffordable in Sydney nobody would be buying it.”
The PIMCO findings point to further complications for the RBA that may find further interest rate cuts could dial up risks in the financial system by encouraging more household leverage.
PIMCO, which manages $US1.6 trillion of assets globally and $35 billion in Australia undertook the extensive study to better understand the drivers of household borrowing decisions in the context of how the Reserve Bank would likely respond to economic conditions and risks to financial stability.
The findings helped to validate the fund’s thesis of a “new neutral” which suggested Australian interest rates would be held lower for longer by a number of factors – such as increased sensitivity of households to higher interest rates.
PIMCO’s Australian head of portfolio management Rob Mead said the findings added weight to calls to introduce so-called macro-prudential measures that pose restrictions on bank lending to manage the risks associated with rising house prices.
“The role of macro prudential policy is a blunt and unpredictable tool and there are different ways to approach it” he said
“We suggest protecting the ‘left tail [extreme risk]’ through better capitalised banks as the preferred course of action and fine tuning through macro-prudential policy as a secondary course.”
In May deputy governor of the RBA Phil Lowe listed high household debt an property prices coupled with slow income growth and a rising unemployment rate as a concern.
“– all those things would suggest there has been an increase in the level of risk, particularly as people have bought property for investment purposes,” he said.