This is an extract from a post back in May. I’m bringing to the front analysis that was hidden in the original piece. The basic story: the credit contraction in Australia was much deeper than we’ve originally thought, but now the expansion is running much stronger than the ABS has told us. UBS has published a piece that goes to the heart of this story, presumably it will be picked up by the media. A quote from the UBS piece:
Mortgage redraws, accrued interest and fees are another significant part of mortgage credit growth which is rarely seen. Across the banks this accounts for around one-third of all mortgage extensions. However, we believe that these mortgage extensions are not picked up in the ABS housing commitment statistics.
Household savings are crucial to understanding the shift to lower growth in the Australian economy. The rise in the Australian savings rate has been well above expectations and has occurred at a time of globally low interest rates. It is well above the savings rate in the United States, UK and Canada where conditions have been worse. Between 2002 and 2007, a time of a rising dollar but low savings, growth averaged 3.5% per annum. In the period since, with a rising dollar but savings at 10% of disposable income, growth has averaged just 2.7%. Savings is the smoking gun in slower growth. It has forced the leakage from the economy.
The big question for me though has been where have all these savings gone?
Deposits is an obvious place to start. The chart below shows deposits and deposits as a share of nominal GDP. Deposit growth has averaged 11% since 2007 and 9% since 2010.
This rise in deposits has dramatically improved the Australian financial system’s vulnerability to a withdrawal of support from international financial markets. Effectively, Australia is closer to the point where it can fund itself. But the bigger, and more important question, is whether the rise in savings has improved the balance sheets of indebted households?
Well, officially, the answer is no, not really. The chart below shows debt to household disposable income and interest paid. It highlights that there has not been a significant fall in debt to income ratios amongst Australian households, despite all the savings. This argues that the wrong groups are saving.
But an interesting chart appeared in the RBA’s recent Financial Stability Reviewthat seemed to suggest that the chart above might not tell the full story. According to the chart below, Australians hold about 14% of outstanding home loans in offset or redraw facilities. This is equivalent to about 21 months of interest payments. This is new data that I don’t believe the market has previously been made aware of. Previous Financial Stability Reviews have not provided this statistic. The redraw and offset account facilities are an important feature of the Australian housing market. Apparently, such mortgages are known as Australian mortgages in the United States. They allow households to pre-pay their mortgage. Their popularity in Australia is due to the preponderance of variable rate mortgages (about 80-90% of mortgages in Australia are variable rate. The ratio is inverted in the United States.) as fixed rate mortgages tend to not allow pre-payment.
From a household perspective, these accounts represent savings or less debt. From a statistical perspective, however, the value of savings in offset or redraw accounts are not subtracted from the level of outstanding debt because the line of credit remains open. By including the pre-payments in the household debt to income ratio, the numerator falls by $200bn, putting the ratio at 127%, some 20ppts lower than the current level. The cost of debt servicing falls to around 8% of disposable income.
The implications of such a fall in the effective household debt to disposable income are twofold.
First, Australian household balance sheets have improved more substantially than many have thought. Debt to income ratios are closer to the levels seen in 2002 despite much lower interest rates. It’s not just the national economy but also its households that are now much stronger. It’s also the case, however, that credit might have contracted for much of the last four years which makes the growth outcome very positive for Australia.
Second, there may be an increased likelihood that the market and RBA misinterprets credit statistics if recent shifts to purchase higher yielding assets (equities and property) continue. Recently, credit growth has been subdued at less than 5% annual growth. But, this analysis would suggest that while new credit growth may be subdued, net credit growth could be rising more quickly.
Consider this example. A householder bought a home with an interest only loan of $500,000 in 2003. This home has since appreciated 20% and the householder has paid $100,000 into an offset account. This year the householder upgrades to a $1,000,000 home. The householder now holds $200,000 in cash or equity and $800,000 in debt. According to the RBA and ABS, the householder has increased credit by 60% ($800,000 over the $500,000 line) but to the householder, credit has doubled ($800,000 over $400,000).
Like the rise in the Australian dollar, the dramatic increase in the Australian household savings rate and retained earnings funding the mining boom (or alternatively an unrecognised but substantial credit contraction) has contributed to slower economic growth through lower consumption and less financial intermediation. It has also, more importantly, led to a much stronger economy with corporations and households now in better shape to handle any substantial downturn. Much of the excess of the early 2000s has been taken from the economy through the discipline of Australian households and the strength of commodity prices.
As we look forward, however, low interest rates do pose a risk to the medium-term sustainability of this outcome. Households, increasingly, seem keen to have savings earn more than the current cash rate. This has seen a strong bid in Australian equities and to a lesser extent house prices. Effectively, the RBA seems to be happy with the following trade-off: higher activity levels as savings are transformed into equity and housing with some weakening in household balance sheets.
The rise in the Australian savings rate has been the stand-out feature of the last five years in this economy. It has weighed on growth but made the economy stronger, it would be a shame to see it unwound. Either Australia maintains current savings levels and becomes a capital exporter through a current account surplus, or Australia transforms its savings to invest heavily in productive capacity.