Banks Tightening Credit: The Knock Down Effect on the Economy

Property in Australia has seen some insane price increases in recent years.

Yes, Australia has seen high immigration.

But we do see two other explanations for these exorbitant property price rises. One has been easy access to credit.

The other is the belief that property will keep rising and that property owners will be able to sell later on, at a more expensive price.

That’s why households in Australia have been taking on more debt, to jump into property…which in turn has fuelled property prices.

But recently, regulators have been putting on the brakes.

They have introduced measures — mainly aimed at investors — to curve household debt.

Economist Warns: Overvalued Housing Market Set to Implode. Download the free report now.

As you may already know, they have introduced a 30% cap on the share of interest-only loans, and have put a 10% cap on investor lending growth.

The Reserve Bank of Australia’s (RBA) Deputy Governor Guy Debelle recently gave a speech on how these measures are affecting housing.

It gives an interesting insight into what the bank is thinking.

As the Bank explained:

The motivation for implementing these various measures was to address the mounting risk to household balance sheets arising from the rapid growth of certain forms of lending, in particular lending to investors and interest-only (IO) lending. The strong growth in investor borrowing was increasing the risk that investor activity could be excessively boosting housing prices and construction and so increasing the probability of a subsequent sharp unwinding.

With IO (Interest Only) loans, the borrower doesn’t pay any principal during the interest-only period, only interest. This makes monthly repayments cheaper…initially. Yet, once the IO period expires, the monthly mortgage repayment increases.

This is great for when property prices are increasing, but quite risky if they are decreasing.  The borrower risks ending up owing more than what the property is worth.

The measures have been quite successful.

The share of interest only lending has decreased. As the bank reported, it has gone from 40% in March 2017, to 17% by September 2017 and has stayed at 15% since.

Borrowers are also having a harder time rolling over their interest-only mortgages multiple times once the interest only period expires.  This means that borrowers are starting to pay principal, which can make the loan monthly payments 30-40% more expensive.

As the bank explained:

As a result there has been a sizeable shift in the composition of the stock of housing lending. In addition, in response to both measures, a sizeable number of borrowers switched from an investor and/or IO loan to a principal and interest (P&I) owner-occupier loan reflecting the now significant interest differential. As a result of switching and weaker growth of investor lending, we estimate the share of housing loans to investors has declined by 5 percentage points to around one-third. Interest-only loans currently comprise 27 per cent of the stock, having been as much as 40 per cent. These changes decrease the riskiness of the stock of housing lending.

Interest-only Lending

Source: RBA

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Banks are also lending less.

Most LVR loans over 90% have decreased as the bank estimated, about 20% less on average. 

Overall, the bank doesn’t see that the measures have greatly affected credit.

Yet we have seen property prices start to slide down, especially in places like Sydney and Melbourne, where there was a lot of investor activity.

People are having a harder time accessing credit, and they are not that sure they will be able to sell their property at a higher price later on.

The two dangers from high household debt

One is higher interest rates. With so much household debt, this would make all that debt more expensive.

The other is a rise in unemployment.

From what we heard from Debelle’s speech, the RBA isn’t worried about the first one. But it is worried about the second one.

As Debelle continued (emphasis mine):

I don’t see the riskiness of the borrowing as being the source of the negative shock. My concern is for its potential to be an accelerator to a negative shock from another source. To put it another way, I don’t regard it as likely that household borrowing will collapse under its own weight. Rather, if a negative shock were to hit the Australian economy, particularly one that caused a sizeable rise in unemployment, then the risk on the household balance sheet would magnify the adverse effect of that shock…

And they see a risk in this if there is a slowdown in construction as banks start to lend less to developers. The bank is forecasting construction could slow down in about a year.

As Debelle continued:

‘[B]anks are less willing to lend given the fall in prices. To the extent that the housing policy measures have contributed to the decline in investor demand and prices, they have indirectly affected developers’ access to finance. There is a risk that this process overshoots leading to a sharper or more protracted decline in activity than we currently expect.

Construction has been one of the big drivers of employment. It is not only employing in construction, but real estate and retail like furniture shops…

But there is an even higher risk. As Debelle continued (emphasis mine):

‘The effect of a tightening in lending to developers seems to me to be a higher risk to the economic outlook than the direct effect of the tighter lending standards on households, which has ameliorated risk. Relatedly, there may also be a bigger impact on lending to small business given the extensive use of property as collateral for small business loans. This would be further exacerbated if the banks’ risk appetite for small business lending declines for other reasons.

According to the Australian Bureau of Statistics, about 70% of employing businesses have between 1 and 4 employees. That is, small businesses are the main drivers of Australian employment.

With many small business loans backed by property as collateral, falling property prices could mean that small businesses struggle to access credit.

We think it’s great that regulators are trying to reign in household debt. Australia’s household debt is too high and as we have been contending, all that debt has been driving growth.

If credit tightens too much it could have a knock down effect on the economy.


Selva Freigedo,
Editor, Markets & Money

PS: Author and economist Harry Dent predicted Japan’s 1989 collapse, the 2000 dotcom bust and the 2008 subprime flop. He now has a chilling warning for Australian property.  To read more about it click here.

Selva Freigedo is an analyst with a background in financial economics. Born and raised in Argentina, she has also lived in Brazil, the US and Spain. She has seen economic troubles firsthand, from economic booms to collapses and the ravaging effects of hyperinflation, high unemployment, deposit freezes and debt default. Selva now writes from her vantage point here in Australia. She is lead Editor at the daily e-letter Markets & Money. And every week, she goes through each report and research note produced by our global network of trusted advisors to find the best investment opportunities for you in Australia and overseas. She packages these opportunities for you in Global Investor.

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