S&P warns on China risk to house prices

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By Leith van Onselen

From S&P comes the following warning on Australian house prices:

Australian house prices could decline by more than 5% in 2012 if China’s economy experiences a soft landing with GDP growth at about 8%, according to Standard & Poor’s.

But in the event of the less-likely scenario, under which China’s economy slows to 5% GDP growth, Australia could be sent into recession.

China’s hard landing likely flow-on effect of higher unemployment could trigger a sharp decline in Australian house prices of 20% or more, according to S&P who rate the prospect of a hard landing happening at 10%. The other scenario – a medium landing – would trigger a 10% price fall, it envisaged with the prospect of a medium landing happening given at 25% chance.

S&P analysts Craig Parker and Vera Chaplin see a soft landing as the most likely scenario.

So S&P gives it a 35% chance that Australian home prices could fall by 10% or more in 2012, with 5% falls the most likely outcome. Back to S&P.

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The report noted the insatiable demand for commodities from China and other Asian trading partners has kept Australia in good stead relative to most other Western economies during the current global economic slowdown.

While China’s growth slowed to 9.2% in 2011 from 10.4% in 2010 due to a weaker global economy and efforts by the Chinese government to control inflation, Standard & Poor’s expects China to experience a soft landing in 2012, with forecast GDP growth of 8%.

8% growth seems optimistic to me. China’s authorities have already lowered the country’s growth target to 7.5%. And according to Michael Pettis, China’s growth is set to slow even further over coming years, although maybe not in 2012:

…the consensus has been slowly moving down towards 5-6% annual growth over the next few years. That’s better than the crazy numbers of 8-9% most analysts were predicting even two years ago (and some still are), but it is still too high. GDP growth rates will slow a lot more than that. I still maintain that average growth in this decade will barely break 3%. It will take, however, at least another two or three years before a number this low falls within the consensus range.

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Let’s hope Pettis is wrong. Back to S&P:

“Based on this scenario [a soft landing in China], we expect the Australian economy to continue its moderate growth path and that the performance of the Australian housing market will soften further but not experience a sharp decline given the sound economic outlook,” Parker and Chaplin say.

“In this scenario, we expect the impact on both mortgage defaults and loss-given default to be muted and remain at relatively low levels as we expect the unemployment rate to increase marginally and property price decline to continue its recent softness.”

The report indicated that although Australian residential property prices have softened with Australian capital city dwellings losing about 4.8% of their value in 2011, a supply shortage and demand-side factors (such as falling mortgage interest rates, government assistance to first-home owners, strong labour market conditions and population growth) have prevented a more precipitous decline in asset prices.

But any increase in the unemployment rate and weaker or negative growth in household disposable income are likely to be the key drivers of mortgage default in the coming years.

“Sharp increases in unemployment will be likely if Australia experiences a significant economic slowdown,” the report says.

“Rising unemployment has been a strong precursor to mortgage defaults as evidenced in the early 1990s recession.”

It notes mortgage default rates can be masked in a strong economic environment with vibrant property prices, as borrowers have more options to refinance or adjust their financial position by downsizing their debt exposures.

In my opinion, the single most important factor holding up the economy and house prices is that incomes have been heavily supported by the terms-of-trade (ToT), which are near 140-year highs on the back of the China-led commodities boom (see below chart).

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The distributional effects of the high ToT are a bit of a mystery but the investment boom and its jobs is the most important. If the TOT deflates as China slows, we’ll see projects cancelled and slower investment growth, fewer jobs and lower house prices more quickly.

Interestingly this is the second time in recent weeks that S&P has warned on the risk to Australia of a China landing. We shouldn’t forget that this is a ratings agency we’re talking about. Presumably, they’re setting up downgrades if the landing gets bumpy.

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About the author
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.