One of the key themes amongst a lot of the comments on any given real estate related piece here at MB is the discussion about how and when there is some form of correction (if we set aside the spruik of endlessly elevated, or foreign or investor demand into the stratosphere) in Australian real estate prices, about how this comes about, and about how the economy manages that.
At one point earlier this week I found myself chewing over the Australian economy with the Oz analyst of an investment bank (in the UK – we mulled it by skype) and in particular the experiences of the UK/Eire (he is Irish) and Australia now. I found myself generally agreeing with the idea that currently we have a body politic in Australia which not only doesn’t want to address real estate prices but which seemingly wants to bring about austerity (to some degree) and implement measures to try and boost domestic economic performance around a central idea of real estate prices not coming down from their elevated heights. It seems to me that mapping out my thoughts (as I do below) may be worthwhile for some people – even if they think what I write is rubbish, then at least thinking about why they think so is will help them, and if they add their thoughts then maybe all of us can flesh out the game plan.
At essence the question is fairly simple and has been put to me this week as …….
‘Can Australia craft a productive economy, and generate income with a competitive exposed sector, with house prices, and the debt to support those house prices, where they currently are?’
The answer to that is universally a ‘No’ – I haven’t seen anyone anywhere contend that Australia can, or should try to, create an economy revolving around endlessly high real estate prices.
So then the question becomes one of ‘Does Australia need a productive economy with an income generating competitive exposed sector?’ along with maybe How soon will it need one?
The answer to that is ‘depends’ – maybe it can get away without a competitive exposed sector if mining revenues hold up, or if the population ponzi continues to juice nominal GDP and there is no political fallout from cramming more people in to existing infrastructure. Maybe it can get away with just these in play for a while (which to me seems to be the line of both mainstream political parties). I don’t think anyone would think it can get away without a competitive sector per se, but if there is a plausible next boom on the horizon then maybe mining revenues and the population ponzi buy us the time to get there.
That then brings me to ‘Is there a next boom somewhere on the horizon? A year ago people were touting LNG. Anybody still doing that now probably needs to ease off on the magic mushrooms. So, at some point I tend to the view that….
1. Australia will need a competitive externally exposed sector in the domestic economy.
2. Australian politics will reflect this need in a way it currently doesn’t.
That said, there is a line of thinking suggesting that even the most competitive economy in the world is not going to be doing all that well at the moment as the global macro is basically stuffed. So that could well lend itself to not doing much and playing for time (as it were) and supporting real estate prices in that context may make sense.
From there I come back to the question of does Australia create a competitive globally exposed sector with house prices where they are – with mortgage debt to GDP where it is, with wages needing to support that debt, and with the external facing sector needing to accommodate those wages? For me the answer is no.
So from that point the next thought I come back to is How do Australian real estate prices (and the debt supporting them, and the wages required to make that debt supportable) get transitioned back to a level where that competitive external facing sector can develop?
The short sharp shock
One thesis posited often enough (including by me – not that I think it necessarily desirable, but rather where the narrative I am seeing is leading) is the short sharp shock or crash school. For mine this would involve real estate prices rising sharply, supported by credit (we have had these), with that credit becoming progressively less justifiable (do we have this?), with the finance market invariably overshooting (in terms of credit extension) and arriving at an ‘oh no’ moment from which some people attempt to exit, and which leads to other people becoming concerned, exiting, and prices potentially dropping sharply (how far off is this?). A lot of the discussion I see tends to revolve around whether interest rates should be allowed to go lower to sustain aggregate demand (or bring the lower AUD about) when all that seems to be happening is the feeding of property speculators, as opposed to the possibility of raising interest rates (with a view cathartically frying some over leveraged property speculators – but to my mind adding to the Dutch disease problem Australia already has and I would expect the utter traumatisation of the Australian financial system, and from there the wider economy [that isn’t to say I don’t agree in many ways with the desirability of giving property speculation and the banking sector the knee in the nuts it deserves, but that I think very few people espousing the view actually get the nuance of what it is that idea entails. There were comments in the press in the wake of the Financial System Inquiry to the effect that real estate prices arguably represent the major financial system risk to Australia, and I tend to agree with that.])
Given the linkages between the Australian banking system and the real estate sector (and one really must be aware that we really do have the only banking system in the world that lends 60% for mortgages and 40% for something productive, and that that banking system sources about 20-25% of what it lends in global wholesale capital markets because Australians don’t save enough) that line of thought brings me back to What are the implications of a decline in Australian real estate prices for Australian banks and the wider economy?
The first thing I think is that the mortgages the banks hold are ultimately assets against which they borrow. If Australian banks were to mark-to-market and reduce the implied value of the mortgages they hold then they would need to provide more assets as ‘collateral’ [and the process by which this occurs is far from straightforward – I would point to some of Deep T’s writings for more on the ins and outs] for their borrowings and probably face higher borrowing costs. From there that leads me to the view that a decline in Australian real estate prices may actually act in a similar way to an interest rate rise for Australian banks – insofar as it makes their cost of capital more expensive. In the current environment, with demand where it is, my guess would be that this presents major problems for the Australian economy – though if the minor portion of bank lending in Australia is for something productive then the impact may be muted (likewise if the bulk of lending is for real estate investors [as opposed to owners] – seen as exhibiting a lesser flow on effect in terms of spending – or not otherwise leading to a flow on effect through the economy sufficient to support aggregate demand) – with likely negative system feedback impacts though employment and spending.
The question for the banks of course is their profitability at this point, or (in the worst case) their underlying viability (if we assume that their mortgage lending is such a significant proportion of their operations, that a correction could be significant, that their deposits are such that they have considerable reliance on wholesale funding). Raising funding is not an issue in a circumstance where the rest of the world is printing money, where yields here are significantly higher than those on offer elsewhere, and where they benefit from the government deposit guarantee and where they are fairly overtly backed by the federal government which has (and provides them) a AAA rating. But once the government loses the AAA (which backstops the banks two ratings points: est) – presumably in a worsening economy and/or global macro event – it is not inconceivable this could occur when international credit to the banks becomes more problematic, which again represents a dangerous feedback loop – bearing in mind that this [post 2008] economic cycle is rapidly approaching the sort of end-of-cycle moment traditionally accompanied by major volatility and market collapse. That feedback loop gains even more substance in the shape of risk provisioning and NPLs likely to be encountered in a deteriorating economy. I assume too that anything large enough to disconcert the financial system will be communicated to and felt within wider society (though with the Australian commercial business media one could not be sure) with concurrent negative impacts on sentiment and spending.
Essentially the short sharp shock would be likely to be exceptionally painful in an economy which has not experienced a significant downturn in a generation.
The slow melt
The alternative real estate transition mechanism to a level supporting a globally competitive sector of the economy is what is generally referred to as the slow melt thesis. This appears to be the model which the RBA holds to, and which most regulatory agencies commentators and politicians (insofar as they comment on house prices at all). It revolves around the idea that house prices can continue growing, but that the level of growth being experienced decreases over time to a level less than wider economic growth and that the underlying house prices to [rental] yield, and house prices to credit [and thence to wages] ratios come back over time.
For mine, the risks to this theory are all too apparent.
It relies on house price growth being contained. Currently there is minimal scope for house price growth being contained because that section of society with access to debt sees key features about housing (when it looks at housing as an asset class) which make it the one sure fire speculative position to have exposure to if the economy is to go into recession (or near recession) but also if there is to be any economic growth going forward because:
- There is widespread belief there is a housing shortage.
- It is generally recognised that post 2008 immigration (running at more than 300 thousand per annum, against a 30 year average of approximately 70 thousand per annum) is generating immediate need for considerably more housing.
- The demand by foreign (predominantly Chinese) investors in Australian real estate (Estimated by Treasury at approximately AUD$25 Billion in the first 9 months of 2014, cf circa AUD$13 Billion for the whole of 2013) is expected to continue and to continue being encouraged by Australia (recognising that increased immigration supports aggregate demand, and that real estate purchases are seen as supportive of immigration rights, and that Australian real estate purchases by foreign national are barely monitored or regulated in any way by Australian regulatory authorities, with this situation expected to continue).
- Real estate ‘investment’ is actively encouraged by the taxation system (Negative Gearing, Capital Gains Tax concessions, Superannuation Concessions for high net wealth individuals [more inclined to invest in real estate] greater scope for investment vehicles to borrow for wealthier individuals [SMSFs]).
- Real estate investment is the single most heavily promoted form of investment in the media.
- Real estate is the most extensively encouraged investment class by the banking system (investing in almost anything else is far more difficult – indeed investment in productive endeavours such as small business is often dependent on real estate ownership).
- Real estate (the PPR) is the only asset class excluded from asset calculations leading to social welfare support mechanisms.
Beyond this there is..….
- Widespread awareness that it is effectively policy that the Australian government and RBA is cultivating an environment where housing construction is the mainstay of demand support while the investment phase of the commodity boom declines from about 7.5% of GDP to its long term average of about 1.8% of GDP in the absence of other plausible demand supports (i.e. a competitive externally exposed sector of the economy).
And beyond that again there would be some awareness that preventing real estate price falls and prompting real estate inflation has been the strategy pursued in the United Kingdom to generate an economic turnaround of sorts, as well as the experience of places like Eire which have been socially catastrophic in many ways.
When all is said and done these factors make real estate the preeminent ‘investment’ class for most Australians. It is the investment they seek first and in the largest numbers, with the most regulatory and institutional support. In this it, more than any other investment class, would be representative of the national sentiment. The only way I could see it growing by less than the national economy would be if it was realistically replaced by something else as an asset class attraction, but this would require such an asset class in existence together with considerable cultural expectation change.
With mortgage debt at approximately 90% of GDP, the only limit to exposure of many people to real estate is the limit to the amounts they can borrow to expose themselves to real estate or concern about their employment being supportive of their continuing to support their exposure – in circumstances where mortgage lending is what the banks do mostly, where the banks make the largest margins, which banks see as being least risk, and with banks having most accurate and reliable historical data. At a certain level neither the banks nor the borrowers can help themselves, the same as state governments are effectively addicted to real estate stamp duties and local councils to developer charges. Expecting Australians to ease back and into something more productive would be broadly akin to expecting wildebeest on the Serengeti to hold back on the grass while it grows a bit.
Beyond that there is the underlying economy, which needs to grow faster than real estate prices for the slow melt to occur (supporting real wages growing faster). It is dependent on real estate prices rising currently, and other drivers are not on the radar.
This brings me to the point that the reason they are not on the radar is because of real estate prices having been pushed to where they are. Where they are represents …..
- Mortgage debt to GDP having been pushed towards (beyond) its reasonable limit (90% of GDP).
- The expansion of credit availability in the period since the early 1990s to the point where debt to disposable income in Australia has never really declined from about 150% in 2008.
- A mining boom since the mid 2000s which has provided a century high in terms of trade, incomes (therefore borrowing capacity), and sentiment (and spending sentiment).
- A period post 2008 where the rest of the world has had ultra loose monetary policy (if not straight out money printing) which has flooded to Australia seeking a yield and AAA rating (a lot of which has made its way into house prices), which has in turn pushed the AUD far higher than it might otherwise have been and enabled considerably greater spending power by Australians for a long period of time.
This situation has led to a current economic position where a potential investor in some form of productive endeavour in Australia would see:
- Future domestic demand crimped by a need to repay existing debts.
- Potential employees needing to maximise their labour costs to support mortgage repayments.
- A current AUD held higher than it may otherwise be via the banks accessing large volumes of capital from international wholesale markets (issuing bonds providing greater access for international capital to access AUD) – diminishing any potential competitive position.
- A government fiscal policy stance not conducive to supporting business (approaching and threatening austerity).
- Land costs being a significant factor for any business.
- A general labour cost which sees quite menial functions in Australia currently paid more than more specialised functions in other developed economies.
For these reasons (and others just not coming to mind as I sit here and type) I don’t really see any form of slow melt actually happening. What I do tend to see as happening is that real estate prices will be held in place by any means available for as long as possible, and that ultimately the objective of preventing real estate price falls will only be let go of at the point where the objective is no longer sustainable.
Until that point I tend to see the political and economic imperative as being to support real estate prices at their elevated levels, maybe even to push them higher, and to try something, or anything else, which may conceivably position the nation better for economic growth. Indeed I would argue that currently the imperative to support real estate prices (amongst those in power – who have been demonstrated to have real estate portfolios worth millions, and for which they are personally responsible) has greater primacy than even economic performance (which can easily be blamed elsewhere when it doesn’t happen, and is easy to countenance when the individual circumstances have been looked after).
Given the large volume of support already lent to real estate prices by factors above (population ponzi, planning and development restrictions, credit extension, taxation concessions, the government backing of the banking system’s credit rating etc) it is difficult (for me) to see what else could be done to prop up real estate prices – allowing superannuation to be used for a deposit for younger home buyers would be one, but it would only be an effective transfer from one generation to another [given the preponderance of the 55+ cohort in property investing] and would doubtlessly undermine the effective functioning of the superannuation system (which may have its own unknown unknown financial system impacts), or maybe the reverse mortgage of entire investment property portfolios by the government for real estate ‘investors’ by a government prepared to hold and manage those portfolios with a portfolio specific profit maximisation strategy.
The macroeconomic outlook is pretty ugly. Australia has a heavily indebted, expensive labour force without a discernible competitive economic sector apart from natural resources (for which we are past the once in a century boom) and reliant on selling off national economic assets to fund a generations worth of current account deficits (in addition to agricultural land sales equal to double the landmass of Victoria – presumably all higher quality agricultural land – there has been a long period of corporate asset sales and takeovers – particularly noticeable in sectors which are either heavily influenced by natural monopolies [eg airlines, telecoms] or represent choke points on potentially competitive economic sectors [particularly agriculture, port facilities, electricity]. The mining investment boom is waning, Australia has offloaded manufacturers, and it is waving goodbye to car manufacturing (a significant employer in VIC/SA) over the next 18 months. The government (at all levels) is looking to pare outlays, there is no macro driver in place to support Australian demand. The workforce to retiree tipping point has passed and the bulk of the baby boomer retirement phenomena is ahead of us. If I put a tinfoil hat on we are due a major drought.
The scope for continuing to support real estate prices
In that environment, as others (notably HnH and UE) have written the lack of a competitive sector and the sharp fall in national incomes is now transforming into an incomes shock, which will go some way to bringing about an extended period of economic under performance if not a technical recession (almost impossible with immigration running at the levels it currently is). Current policy is to stimulate housing construction to offset this, and it is a widespread sine qua non, that existing real estate supports could not be touched while this unstated policy is in play (without questioning whether the same outcome – more house building – could be far more cheaply and effectively be stimulated by other policy means – easing development restrictions, limiting capital gains and negative gearing to new construction only etc).
Currently the budget is running at circa 21% of GDP – very low by international standards – justifying an AAA rating for the sovereign. Historical precedent (admittedly now old) suggests that in the event of a downturn the automatic stabilisers (increased social welfare, etc) will push that beyond 30% of GDP (as HnH points out regularly). At that point (or at the point where the balanced budget over the budget cycle is no longer plausible) the AAA rating goes for the sovereign, which means that the ratings support it lends to the banks balance sheets goes, which means their ratings go and which means their funding costs rise.
In the pursuit of retaining that AAA rating the government will try to reduce outlays, and the revenue projections experienced this year can be expected to be typical of those to come with declining commodity prices likely to undershoot projections on which the federal budgets are made (though the experience of the West Australian state budget this year is illuminating also) and lending an imperative to reduce outlays beyond that known to be required.
The experience of the 2014 budget (which has still not passed the Senate) in trying to impose greater fiscal austerity on the provision of pensions and social welfare support (and has politically failed) is likely to lead to pressure to curtail budget outlays in other areas, as well as reduce taxation concessions. Superannuation concessions and negative gearing of existing residential real estate [as opposed to new construction], in their current forms, may be difficult to ignore in this context, as well as a range of other phenomena which support real estate sentiment (including the exclusion of the PPR for pension access purposes, access to superannuation lump sums etc) . I tend to assume that removing any of these will be pretty tough politically, with impetus to do so only shaping when the national economic agenda moves from trying to preserve that we (as a nation) currently have (as opposed to who has it) back to (as pre-late 1990s) creating that which we want.
My guess would be that we will approach something of an inflection point as more people realise the costs preserving the economic ‘now’ imposes on the creation of the economy we want, with (I would have thought) something of a first mover reward for whichever mainstream political party identifies that the economic future facing demographic is more politically rewarding than the economic past, but that any political narrative moving too soon could be punished by the ‘now’ demographic if it moves too early.
The wild cards
There are some major potential risks even to that sort of transition which I would guess would have major implications for either the unemployment, the budget, the bank lending etc narratives.
The most obvious to me is the possibility of an end of market cycle breakdown globally. It isn’t altogether clear to me that this isn’t in play globally, and my suspicion is that some of the crude price breakdown reflects this (particularly when seen alongside the breakdowns of other major commodities – particularly those important to Australia, iron ore, gold, coal, and LNG). I find myself wondering how the world responds to a major downturn in expectation about the economic future – at the moment I have Japan gone, Europe gone, China looking very much like slowing more than anticipated, emerging markets gone, and only the US enjoying anything like buoyancy [and how sustainable is this if the crude price knocks out the alternative oil gain which has partly driven the US rebound – strong enough to drive a global upswing?].
In 2009 and 2010 Australia was one of the refuges of global capital because the mining boom and China stimulus made Australia a sure bet. It wouldn’t be this time around, and may effectively suck capital from Australia, pushing the banks to increase rates for lending (at precisely the time they wouldn’t be wanted) and reinforce the local impact.
The other wild card for mine is the political narrative. At the moment neither of the two major political parties will mention housing (particularly housing affordability) because they know the risks this entails of a political backlash from those who ‘own’ the houses. But continuing this position isn’t risk free and is opening up scope for another political outlet (independent?) for sentiment seeking to ask questions directly about housing, but also about other ‘no-go’ areas in national policy, including immigration, education and (plausibly) the economic narrative.
The longer they remain no go areas for current mainstream politicians the more substance they provide alternative politicians when they do get raised. In the current situation of a government becoming more profoundly unpopular by the day, facing an opposition which was equally reviled not 18 months ago (and with leadership which is viewed with a fair bit of suspicion) and has not sought to establish policy primacy anywhere, coming to an election within 2 years, anything which can seize a piece of the national limelight may conceivably get political influence out of all proportion to the actual number of votes involved, but may also conceivably get a surprising number of votes.
The disturbing degree of youth unemployment (we are now starting to look like Club Med) and the overt superiority of other nations for education (compare the costs in Europe with those here) and opportunities for those with good educations may be another source of social change driving a political imperative.
Preparing for the future
So I suppose from all this I see Australia and its management of real estate and the wider economy bumbling on as is until the point where doing so is no longer plausible – electorally or economically. I don’t see the slow melt happening. I don’t see the will to address the core issues until crisis has shaped the need to do so. So logic pretty much tells me that I wouldn’t expect anyone to invest in a venture in a globally exposed sector of Australia’s economy while that series of interlinked factors is frozen in play.
Ultimately as the parent of two kids I am pretty firmly of the view I will be taking them overseas for the sake of their careers and lives at some point, so I educate them with that thought in mind. The price of Australian real estate now will require long term repayments, and I don’t think these will prevent the correction of Australian real estate to levels required to sustain an effective economy over the longer term.
Indeed, I tend to the view that Australian real estate is right up there with about the worst long term investments one can make if one is going into debt to make that investment. Some young families are locking themselves into paying mega mortgages for a generation in the speculative hope the place will go up in value and they will be able to sell it for a gain. For the nation, Australia has locked itself into the current high real estate prices shaping its economy for some time to come (in the direction of becoming the holiday resort or retirement scene that parts of the Mediterranean have become rather than something productive? – and even in those places housing is cheap). For me it is a simple matter of when it realises this is the ‘investment’ it has made and the economic costs this entails.