The Australian property market could reliably withstand an ‘extreme’ scenario of dropping 40 per cent in value at a time of high unemployment, a discussion paper issued by the country’s central bank has found.
The paper, titled ‘How risky is Australian household debt?’, examined the risks posed by the housing market’s increasing indebtedness, the stress a strong downturn would place on the banking system, and the effects it would have on people’s everyday spending.
How would we cope with a dire economic scenario?
A scenario where property prices dropped by 40 per cent and unemployment rose to 8 per cent was simulated using detailed household-level data -- data that predates the COVID-19 pandemic -- to stress test the banking system and consumer spending.
“We believe this is an extreme but plausible scenario, which is broadly in line with the shock experienced by some countries during the global financial crisis,” the discussion paper said.
“...(It) is comparable to (property) falls experienced in countries that were heavily affected by the (global financial) crisis, including the United States (32 per cent fall), Spain (37 per cent fall) and Ireland (55 per cent fall).”
Due to the COVID-19 pandemic, Australia’s unemployment rate is forecast to hit double digits before settling at 7 per cent for a few years, according to the Reserve Bank of Australia, but government stimulus payments have been introduced to subsidise a loss of income for many.
The simulation aimed to identify the households that would throttle their spending and default on their mortgage repayments.
Well enough, it seems
Banks are well positioned to handle “a severe downturn in the economy”, the stress tests revealed.
“The main reason for this is that they have maintained strong lending standards: most of the debt is held by households that have significant equity backing their loans and that are less likely to become unemployed than others in a downturn,” the discussion paper said.
“Nonetheless, we show that these households could still significantly curtail their consumption in response to a severe recession, especially if they react more strongly to declines in housing prices than they do to rises.”
The paper noted spending fell by modest margins since the GFC, while household indebtedness rose.
Australian household debt has risen
Australia has high levels of household debt relative to many other countries, the Reserve Bank said, but the results of the stress tests were positive for two reasons.
The first has to do with income levels: although household debt is higher in Australia, so too is income levels. This, coupled with falls in interest rates and inflation, means households have more money to spend on servicing the debt, the discussion paper said.
The second concerns home ownership. The property market in Australia is privately owned -- between people, banks, and at times, businesses -- while in overseas countries, a ‘significant’ share of rental properties belong to the government and corporate sectors.
Interestingly, the discussion paper, which used data predating the COVID-19 pandemic, said its findings cannot explain changes that have occurred from 2015. “(Our) model cannot explain the increase in debt over the past four or five years”, it said.
Three conclusions were drawn from the discussion paper.
The paper found it misleading to describe Australian households being more vulnerable than those overseas due to their higher levels of debt. Rather, it contends conditions in Australia make it easier for households to service greater debt.
The debt of households poses real management challenges for banks, the paper said.
And in turn, this indebtedness would affect consumer spending in “a larger-than-otherwise fall”, rather than they are to result in defaults and bank failures.
The paper credited Australian banks and policies by the Australian Prudential Regulation Authority in “mostly (doing) a good job” in making sure credit is issued to the people who can afford it.