The Australian payments system is evolving, both in terms of some innovative new payment instruments that are on their way and the declining use of some of our older or legacy payment instruments. Tony Richards RBA Head of Payments Policy Department RBA, spoke at the Payments Innovation 2016 Conference on this evolution.
There is a lot happening in the payments industry at present, so my sense is that it would be premature to have a serious discussion about possibly phasing out cheques before the implementation of the New Payments Platform (NPP), which is scheduled to begin operations in late 2017. But if this conference was to revisit this issue in early 2018 with the NPP up and running, it should find significant new payments functionality in place. This will include the ability for end-users to make real-time transfers with immediate availability of funds, to make such transfers on a 24/7 basis, to attach data or documents with payments or payment requests, and to send funds without knowing the recipient’s BSB and account number. These are all aspects that match or exceed particular attributes of cheques.
In addition, by early 2018 another two years will have passed and there will no doubt have been a significant further decline – based on current trends, a further 30 per cent or so – in cheque usage.
By that point, more organisations and individuals will have further reduced their cheque usage. The Bank has recently been doing some liaison with payment system end-users in our Payments Consultation Group and has heard some impressive accounts about how some of the major Commonwealth government departments and some large corporates have largely moved away from the use of cheques. Cheque usage in the superannuation industry has also fallen very significantly as part of the SuperStream reforms.
A shift away from the use of bank cheques is also underway in property settlements. On average, there are around 40 000 property transactions in Australia each month, plus a significant number of refinancings, with most of these requiring at least a couple of cheques for settlement. However, starting in late 2014 and after much preparatory work, electronic conveyancing and settlement is now feasible. This is being arranged by Property Exchange Australia Ltd (an initiative that includes several state governments and a number of financial institutions), with interbank settlement occurring in RITS, the Reserve Bank’s real-time gross settlement system. Volumes have risen steadily and by late 2015 the number of property batches settled in RITS – each batch typically corresponds to a single transaction or refinancing – had reached nearly 4 000 per month. This trend is expected to continue.
In addition, the Bank’s Consumer Use Survey indicates that usage of cheques is falling rapidly for households of all ages. Our survey from late 2013 confirmed that older households continue to use cheques more than younger ones. However, older households are also reducing their use of cheques significantly. And with more and more older households now using the internet, their use of cheques is likely to continue falling. Indeed, I’m sure we all have a story about an older family member or friend who has recently bought or received a tablet or notebook and discovered the benefits of being online.
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We will get a further reading on households’ use of cheques and other payment instruments in the Bank’s next Consumer Use Survey, which – if we follow the timetable of recent surveys – will be published in the first half of next year based on data collected late this year.
More broadly, as the industry starts to think about options for the cheque system, it will be important to make sure that those parts of the community that still use cheques are fully consulted so that we can be sure that their payment needs are met by other instruments. This is likely to involve consultations with organisations representing older age groups, the non-profit sector and those in rural Australia.
Cash
Discussions about the declining use of cheques sometimes also touch upon the declining use of cash.
Because transactions involving cash typically do not involve a financial institution, data for the use of cash are actually quite limited. However, one good source of data on the use of cash by individuals is the Bank’s Consumer Use Study. Our most recent study, in late 2013, showed that cash remained the most important payment method for low-value transactions (around 70 per cent of payments under $20). However, it confirmed that the use of cash had declined significantly, with the proportion of all transactions involving cash falling from 70 per cent in the 2007 survey to 47 per cent in 2013.
More recent data on the transactions use of cash are not available, though the ongoing fall in cash withdrawals from ATMs and at the point of sale suggest that it has continued. In addition, the continuing strong growth of contactless transactions and the growing acceptance of cards for low-value transactions are also suggestive of a further decline in the use of cash.
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However, that is where the parallels with cheque usage end. While the use of cash in transactions has been declining, the demand to hold cash has continued to grow. This is the case for low denomination banknotes as well as high denomination ones. Indeed, in recent years there has been a modest increase in the rate of growth of banknotes on issue, to an annual rate of around 7 per cent over the past couple of years. More broadly, over the longer term, growth in banknote holdings has been largely in line with nominal growth in the overall economy.
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The growing demand for holdings of cash suggest that it continues to have an important role as a store of value and there is some evidence – from demand for larger denomination notes – that this increased following the global financial crisis. So, despite the decline in use in transactions, cash is likely to remain an important part of both the payments system and the economy more broadly for the foreseeable future. In particular, significant parts of the population appear to remain more comfortable with cash than with other payment methods in terms of ease of use for transactions or transfers, as a backup when electronic payment methods may not be available, or as an aide for household budgeting.
Given the important ongoing role of cash in the payments system, the Bank is currently undertaking a major project to upgrade the existing stock of notes. Counterfeiting rates of the current series of banknotes remain low by international standards but have been rising and there are some signs that the counterfeiters are getting a bit better with new and cheaper scanning, printing and image manipulation technology. Accordingly, the program for the next generation of banknotes includes major security upgrades that should ensure that Australia’s banknotes remain some of the world’s most secure. The first release of the new banknotes will occur in September this year, with the release of the new five dollar note.
Australia is not alone in continuing to invest to ensure that the public can continue to have confidence in its banknotes. The United States has also done so recently, and Sweden – which is often cited as being furthest along the path to a cashless or less-cash society – is also in midst of introducing a new series of notes.
Digital currencies and distributed ledgers
As the use of cash and cheques continues to fall, the Bank will – subject to there not being any overriding concerns about risk – be agnostic as to what payment methods replace the legacy systems, consistent with its mandate to promote competition and efficiency.
In the short run, it is likely that we will see further growth in the existing electronic payment methods, including payment cards in their various form factors. In the medium term, it is likely that we will see growth in new payment methods and systems, including those that will be enabled by the NPP.
Let me stress that the Bank has not reached a stage where it is actively considering this, but in the more distant future it is even possible that we may we see a digital version of the Australian dollar. As the Bank has noted in the past, it seems improbable that privately-established virtual currencies like Bitcoin, with its significant price volatility, could ever displace well-established, low-inflation national currencies in terms of usage within individual economies. Bitcoin has, however, served to stimulate interest in the potential offered by distributed ledgers, extending to the possibility of central-bank-issued digital currencies. A plausible model would be that issuance would be by the central bank, with distribution and transaction verification by authorised entities (which might or might not include existing financial institutions). The digital currency would presumably circulate in parallel (and at par) with banknotes and other existing forms of the national currency.
A few countries have explicitly discussed the possibility of digital versions of their existing currency. Both the Bank of England and Bank of Canada have indicated that they are undertaking research in this area. And a recent announcement from the People’s Bank of China indicated that it has plans for digital currency issuance, though few specifics were provided.
The Bank will be interested to see what proves to be possible and what proves to be problematic, as countries consider going down the path of digital currency issuance. Given the various cybersecurity and cryptography risks involved, my personal expectation is that full-scale issuance of digital currency in any country, as opposed to limited trials, is still some time away. And I think it remains to be seen if there is real demand for a digital equivalent of cash and what it might offer end-users relative to what will be offered by the various forms of real-time payments that are being developed in many countries through projects like the NPP.
I should also touch briefly on another potential application of blockchain or distributed ledger technologies, namely in the settlement of equity market transactions. As the overseer of clearing and settlement facilities licensed to operate in Australia, the Bank obviously has a keen interest in the plans of the ASX Group to explore the use of distributed ledgers. Along with the Australian Securities and Investments Commission and other relevant public sector organisations, we will be working closely with ASX as it considers whether a distributed ledger solution might be the best way to replace its existing CHESS infrastructure.
Review of Card Payments Regulation
I will conclude with a few comments on the ongoing Review of Card Payments Regulation.
The Bank issued a consultation paper containing some draft changes to standards in late 2015. It has received substantive submissions from 43 different stakeholders, with a number of parties providing both a public submission and additional confidential information. 33 non-confidential submissions have been published on the Bank’s website.
The submissions indicate that most end-users of the payments system are broadly supportive of the Bank’s reforms over the past decade or more. Some submissions have indeed suggested that the Bank could have gone further in its proposed regulatory changes. Financial institutions and payment schemes have expressed a range of views. For the most part they have recognised the policy concerns that the Bank is responding to. In some cases there is a fair bit of common ground in areas where they have made suggestions for changes to the draft standards, but in others there are conflicting positions that correspond to the different business models of the entities that have responded to consultation.
The Payments System Board discussed the Review at its meeting last Friday, focusing on issues that stakeholders have highlighted in submissions. As we always do when regulatory changes are proposed, Bank staff will be meeting with a wide range of stakeholders to discuss submissions. Indeed, we have already had a significant number of meetings, sometimes multiple meetings with particular firms as they were preparing their submissions.
Some of the issues to be explored in consultation meetings include: the treatment of commercial cards and domestic transactions on foreign-issued cards in the interchange benchmarks; the proposed shift to more frequent compliance to ensure that average interchange rates remain consistent with benchmarks; and the calculation of permissible surcharges for merchants (such as travel agents or ticketing agencies) that are subject to significant chargeback risk when they accept credit or debit cards.
One other issue that I would like to flag ahead of our consultation meetings relates to the proposed reforms to surcharging arrangements. The Bank’s proposed new surcharging standard has been drafted to be consistent with amendments to the Competition and Consumer Act 2010 which were passed by the House of Representatives on 3 February and by the Senate yesterday.
The proposed framework envisages that merchants will retain the right to surcharge for expensive payment methods. However, the permitted surcharge will be defined more narrowly as covering only the merchant service fee and other fees paid to the merchant’s bank or other payments service provider. Acquirers would be required to provide merchants with easy-to-understand information on their cost of acceptance for each payment method, with debit/prepaid and credit cards separately identified. The draft standard would require that merchants would receive an annual statement on their payment costs which they could use in setting any surcharge for the following year. The information in these statements should allow the Australian Competition and Consumer Commission (ACCC) to easily investigate whether a merchant is surcharging excessively.
The objectives of the proposed changes to the regulation of surcharging received widespread support in submissions. However, a number of financial institutions have argued that it would be difficult to provide statements to merchants on their average acceptance costs for each payment system. Some have said that their billing process draws on multiple systems within their organisations (and sometimes from third parties), so that it is not straightforward to provide the average cost information proposed by the Bank. Some have indicated that they do not currently provide annual statements to merchants, so this would be a significant change. Accordingly, a number have suggested that they would prefer a significant implementation delay before they are required to provide merchants with the desired transparency of payment costs. Bank staff will be testing these points in our consultation meetings with acquirers. In doing so, we will be looking to see what might be done to ensure that the standards can take effect as soon as possible, in order to meet community expectations about the elimination of instances of excessive surcharging.
More broadly, the Board also discussed a possible timeline for concluding the Review. The Bank’s expectation is that a final decision on any regulatory changes should be possible at the May meeting. It is too soon to give much guidance on the date when any changes to the Bank’s standards might take effect, but the Board recognises that an implementation period will be necessary for the industry.
The principal interest rate benchmark in Australia is the bank bill swap rate (BBSW), but there are questions about its accuracy (and we know overseas, other benchmark rates – such as LIBOR – have been rigged). So Guy Debelle RBA Assistant Governor (Financial Markets) spoke at the KangaNews Debt Capital Markets Summit and both discussed domestic reforms around the benchmark, and mentioned the possibility of introducing a ‘risk-free’ interest rate for the domestic market, as a complement to BBSW. He did not talk about the investigations that ASIC is currently undertaking into conduct around BBSW.
Given its wide usage, BBSW has been identified by ASIC as a financial benchmark of systemic importance in our market. It is important there is ongoing confidence in it. Without that, we have a serious problem, given its integral role in the infrastructure of domestic financial markets.
As you may know, BBSW was calculated for a number of years by, each day, asking a panel of banks to submit their assessment of where the market was trading in Prime Bank paper at a particular time of the day. While it was a calculation based on submissions, it differed from LIBOR in that BBSW submitters were asked about where the market for generic Prime Bank paper was trading that day. In contrast, LIBOR submitters were asked about where they thought their own bank’s cost of funds was that day.
In response to the prospect of a large number of the participants on the submission panel no longer being willing to provide submissions, the calculation of BBSW was reformed in 2013 in line with the IOSCO Principles for Financial Benchmarks, which were issued in July 2013.
Since 2013, the Australian Financial Markets Association (AFMA) has calculated BBSW benchmark rates as the midpoint of the (nationally) observed best bid and best offer (NBBO) for Prime Bank Eligible Securities, which are bank accepted bills and negotiable certificates of deposit (NCDs). Currently, the Prime Banks are the four major Australian banks. The rate set process uses live and executable bid and offer prices sourced from interbank trading platforms approved by AFMA, These platforms are currently ICAP, Tullett Prebon and Yieldbroker. The bids and offers are sourced at three points in time around 10.00 am each day.
Trading activity during the daily BBSW rate set has declined over recent years to very low levels. There are quite a number of days where there is no turnover at all at the rate set. The low turnover in the interbank market raises the risk that market participants may at some point be less willing to use BBSW as a benchmark. This is the motivation for the CFR’s consultation to ensure that BBSW remains a trusted, reliable and robust financial benchmark.
The likely key change to the methodology proposed is to calculate BBSW directly from market transactions – that is, calculating BBSW as the volume-weighted average price (VWAP) of market transactions during the rate set window. Given the objective is to better anchor BBSW to transactions in the underlying market, the RBA supports moving the calculation methodology to the VWAP.
With regards to the risk-free benchmark:
Next I would like to briefly raise some issues around whether the use of BBSW needs to be quite as widespread as it is. In a number of instances, BBSW has become the default reference rate without much thought being given as to whether it is the most appropriate reference rate. BBSW is a credit‑based reference rate. It is based on the borrowing costs of the major banks, with the credit risk that entails embodied in the rate.
For a number of purposes, a credit‑based rate is completely appropriate. However, for other purposes, a rate that is closer to risk‑free may be more appropriate. For instance, in recent years, market participants have moved to use overnight-indexed swap (OIS) rates more often when discounting the cash flows in their swaps. The FSB, through its official sector steering group (OSSG) on benchmark reform, is encouraging market participants to contemplate switching from credit‑based benchmark rates like BBSW or LIBOR to risk‑free rates, where appropriate.
In the local market, there appears to be growing interest in using risk-free rates as benchmarks. Such a rate could be backward looking, like the cash rate, or forward looking, like OIS rates. As a first step, some market participants have indicated that a total return index of the cash rate would be a useful backward-looking benchmark. Implementing this would be straightforward, since the RBA already calculates and publishes the cash rate. Some market participants are also interested in referencing a forward-looking rate with equivalent tenors to BBSW, and we will continue to work with AFMA on the development of such a benchmark.
One example where a change in reference rate could be contemplated is for floating rate notes (FRNs) issued by governments. FRN coupon payments are typically priced at a spread to BBSW. While referencing BBSW makes sense for FRNs issued by banks, it is less clear why governments should tie their coupon payments to a measure of bank funding costs.
That is one example worthy of consideration. There are a number of others. I know this is not necessarily an issue you may have thought that much about until now. At the very least, I would encourage you to at least ask the question whether the product you are issuing or holding is using the most appropriate reference rate.
In a Speech “The Evolving Risk Environment”, Malcolm Edey RBA Assistant Governor (Financial System) discussed some of the risks to financial stability, both globally and locally.
Much of the story has been told before, the economic uncertainties surrounding oil, China, Europe, high debt levels and locally the risks (and how they have been controlled) in the housing market, and potential risks in the commercial property sector.
One specific issue he covered was the potential international exposures Australian banks may face. He focussed specifically on the assets Australian banks hold overseas.
Direct exposures of Australian banking institutions to the risk factors I have been describing are quite limited Exposures to the euro area have been scaled back in the wake of the crisis and now represent only around 1 to 2 per cent of Australian banks’ consolidated global assets. Although exposures to the Asian region have been growing quite rapidly over recent years, they are still a relatively small share of consolidated assets – around 4 per cent. Many of these exposures are shorter-term and trade-related, factors that should lessen credit and funding risks. That said, operational and legal risks around these exposures could be relatively high, particularly given the rapid expansion of these activities in recent times.
Fair point. However, there are two other exposures to also consider. First banks here are funding their lending partly via capital markets overseas, because there is a gap between the value of deposits held and loans made. Different banks have different footprints. But this means if the international capital markets froze for any reason this would be a significant risk locally. This was demonstrated during the GFC. In any case, in the current environment, spreads are rising, and funding is becoming more expensive. To an extent, given limited competition here, they can just raise rates to customers. But there will be some limits. Recently we have seen a number of lifts in some mortgage rates and to the SME sector.
The other exposure is from international investors and fund managers who invest in the shares of the banks here, and who are also thinking about risk profiles, local economic performance and other factors. We often get asked to provide a picture of things here by such investors. They will consider levels of returns and risks implicit in these returns. Given that going forwards, it is likely banks will find it harder to maintain current dividends than in the past, we may see a change in the wind here too. If international investors were to jump ship, expect market prices to fall.
So, my simple point is that banks are exposed to global forces, well beyond those risks of default on loans, and these additional should be factored into discussions of financial stability.
I would also highlight that not all banks are equally exposed, as underscored by the batch of results declared in the past couple of weeks.
In the latest minutes, released today, there was interesting commentary on their perspective of household consumption growth, savings ratio, and housing activity. They are expecting a growth in household consumption. However, this does not necessarily jive with DFA’s Household Finance Confidence Index, which reported a fall in the most recent results.
Turning to developments in the household sector, members noted that growth in household consumption had increased in the September quarter to be close to its decade average in year-ended terms. Growth was expected to be similar in the December quarter, based on recent retail sales data, indications from the Bank’s retail liaison that trading conditions had improved in the Christmas and post-Christmas sales period, and surveys suggesting that perceptions of households’ own finances remained above average. Household consumption growth had been supported by low interest rates, lower petrol prices and increasing employment, despite relatively subdued household income growth. These factors were expected to support a further increase in consumption growth over the forecast period.
Members observed that although the saving ratio had been declining, recent revisions to national accounts data suggested that this decline was not as pronounced as previously thought. As a result, the saving ratio had remained close to 10 per cent over the past five years, which was a significant step up from its average over the previous two decades but not particularly high from a longer-run perspective.
Dwelling investment had increased strongly over the year to the September quarter and further growth was anticipated, albeit at a gradually declining rate. This was consistent with building approvals, which were at a high level, although lower than in early 2015. Members noted that some other indicators of dwelling investment, including loan approvals for new construction, had been more positive in recent months. Information from liaison contacts indicated that demand for high-density housing in Sydney, Melbourne and Brisbane had been sufficient to absorb the increase in the supply that had come onto the market, whereas demand had been somewhat weaker in Perth, which had experienced a decline in prices and rents for apartments over the past year. To date, there had not been any substantive signs of financial distress from developers, but there had been an increasing number of projects put on hold, particularly in areas where there were concerns about potential oversupply. Conditions in the established housing market more generally had eased in recent months. Housing prices had declined a little from September 2015 and auction clearance rates had fallen from very high levels to around their long-run averages.
Housing credit growth overall had stabilised at around 7½ per cent, following a period of rising growth since late 2012. Growth in credit to investors in housing had declined, offset by an increase in growth in credit to owner-occupiers. This was consistent with the larger increase in mortgage rates for investors and the strengthening of banks’ non-price lending terms in response to earlier supervisory actions.
The Governor’s remarks to the House of Representatives Standing Committee on Economics highlight some of the global uncertainties, the continued adjustment of the Australian economy, lower GDP, and mentions the issue of whether stronger employment is a just temporary event in the light of weaker GDP or something more permanent.
Since the Committee’s previous meeting in September, we have continued to see evidence that economic activity outside the resources sector has been gradually improving. The pattern observed six months ago whereby business surveys were suggesting improving conditions by and large continued through to the end of the year.
Inevitably, this expansion is not uniform across the country or across industries. Areas that led the growth dynamic a few years ago are on the trailing edge now. Conversely, some that were subdued for a few years are among those leading growth today.
But few, if any, expansions are completely even, either geographically or by industry. Given the nature of the economic events through which we have been living, moreover, it is not surprising that there are differences. The good thing is that there are strong areas to counteract the weak ones.
The available information suggests that real GDP is expanding at pace a bit lower than what we used to think of as normal. Our estimate is that growth over the four quarters of 2015 was about 2½ per cent. This continued expansion has occurred in the face of a very large contraction in capital spending in the mining sector, restrained public final spending and the reduction in national income coming from the declining terms of trade. It has been helped by easy monetary policy and the lower exchange rate.
Notwithstanding below-average GDP growth, the demand for labour increased at an above average pace in 2015. The number of people employed, as measured, increased by well over 2 per cent, participation in the labour force picked up and the rate of unemployment declined, to be below 6 per cent. That is a noticeably better outcome than we expected a year ago.
This poses the obvious question of how, with apparently still somewhat below-trend GDP growth, the rate of unemployment has fallen. And whether the pattern will continue. Of course, it may be that the labour force data overstate the strength. Alternatively they may be telling us something not yet apparent in the GDP estimates. More data may shed light on this question over time.
Part of the reconciliation appears to be that growth has been concentrated somewhat in labour-intensive areas, like certain household and business services.
Another part of the reconciliation probably lies in the very modest pace of growth of labour costs. At any given rate of unemployment, wages growth appears to have been lower than would have been expected based on historical relationships. In fact, at an economy-wide level, unit labour costs – that is, wages per unit of aggregate output – have not risen for four years. This has surely helped employment.
This same phenomenon is also important in understanding the behaviour of inflation, which has been quite low. As measured by the Consumer Price Index, inflation was 1.7 per cent over 2015. This was affected by falling prices for petrol and utilities, the latter in part due to government policy decisions. But even the underlying measures, which remove or down‑weight such effects, at around 2 per cent, are low. Price rises for non-tradeable items are at their lowest for many years, and this reflects, among other things, the modest growth of labour costs.
In summary then, the economy is continuing to grow at a modest pace, in the face of considerable adjustment challenges. It has apparently been generating more employment growth and lower unemployment than we expected, while inflation has remained quite low.
Turning then to the rest of the world, there have been some key developments since we last met with the Committee.
In December, the United States Federal Reserve raised its policy interest rate for the first time in 9½ years. The last time the Fed actually started an upward phase in rates was as far back as 2004. The Fed’s rationale for this change was that the US economy had sufficient strength that a zero interest rate was no longer needed – and, as such, it is a welcome development. The change had been very well telegraphed and was absorbed by financial markets without any immediate disruption.
That said, US dollar funding costs are important to many financial strategies around the world and when they start to increase, however gradually, investors adjust their positions. This had already been happening in anticipation of the Fed’s decision, with funds seeking to lessen their exposures to emerging markets, high-yield debt instruments and so on.
These adjustments continued subsequent to the Fed announcement. For some emerging market economies, facing lower commodity export prices, things have become more challenging.
At the same time, some other major jurisdictions have sought to ease their monetary policies further. Both the European Central Bank and the Bank of Japan have pushed rates on some deposits at the central bank below zero. In other words, policy trajectories among the major jurisdictions are diverging, which creates the potential for market movements, not least in exchange rates.
Meanwhile, the Chinese economy has become more of a concern for many observers. It is not that the actual data on the Chinese economy are all that different from what we had been seeing. They paint a picture of softness in growth – but they were already saying that some time ago. The more recent anxiety is probably best described as greater uncertainty over the intentions of Chinese policymakers and over whether they will be able to carry off the economic transition China needs. This anxiety has been reflected in capital flows.
Commodity prices have generally fallen further over recent months. Most prominent was the further fall in crude oil prices to about US$30 per barrel. While this level of oil prices is not especially low in a longer-run historical context, it is a large decline from prices prevailing in recent years and is bringing considerable adjustment. Oil-producing companies and nations are seeing a decline in their incomes, and yields on debt issued by corporates in the energy sector have increased sharply. Exploration expenditure and investment in new capacity is being rapidly curtailed. Sovereign asset managers for some key oil producers are liquidating some assets to help manage the effects on fiscal positions.
As with most price changes, there are gainers as well as losers. The fall in energy costs is a windfall to energy users and represents a terms of trade gain for countries that are net importers. Importantly, it does not appear to be the case that the fall has predominantly been caused by weak demand for oil. Indications are that oil demand has still been rising, albeit not as quickly as it had been. Supply increases appear to have been more important than demand factors in explaining the large price fall, at least thus far. Hence, we should not interpret the decline in oil prices as uniformly negative. On the contrary, a fall in oil prices resulting from additional supply has usually been seen clearly as a bonus for consumers and many businesses in advanced economies, including Australia.
In financial markets, as investors and traders have sought to make sense of all these conflicting currents, we have seen a period of volatility recently. This has been apparent in equity and bond markets, as well as foreign exchange markets. Equity markets are lower, yields for core sovereign obligations are lower, spreads for lower-rated corporates and emerging market sovereigns are wider. Exchange rates have seen more variability, with currencies for many emerging market countries weaker. The Australian dollar is around the same level now as when we last met with the Committee, though commodity prices are lower.
Looking ahead, forecasters expect a bit less growth in the global economy this year than they did a few months ago. Expectations for Australia’s trading partner group itself are for growth to be a bit below average, little changed from six months ago. Inflationary pressures globally look quite subdued. Global interest rates will still be very low, even if short-term rates move up a bit further in the United States.
For Australia, the adjustment we have been experiencing for a couple of years now will most likely continue. The terms of trade are still falling. The fall in mining investment spending will continue for at least one more year, though it is probably having its most significant effect on the rate of growth now. Other areas of demand are expected to add to growth. The net effect of all this is likely to be continuing expansion at a moderate pace.
One key question will be whether the recent financial turbulence itself will have a material negative effect on aggregate demand – in Australia or abroad. I don’t expect that we will be able to answer that question for a little while yet.
Another question is what the recent unexpected strength in the labour market means for the outlook. If it turns out that the strength is just temporary, then the outlook is still for moderate growth, but no near-term acceleration. If, on the other hand, recent trends were to continue, the income gains coming from higher employment may start to feed into stronger demand growth, which would probably lead in due course to higher levels of investment. Alternatively, if demand growth were to be in areas that require relatively little capital to support the labour employed, then the apparent weakness in capital spending outside mining could be of less concern anyway.
As usual, there are many questions regarding both our current circumstances and the outlook. At its recent meetings, the Reserve Bank Board has kept the stance of policy unchanged, with the cash rate at 2.0 per cent. We will be examining new information over the months ahead as we try to discern the answers to these and other questions. With inflation unlikely to cause a problem by being too high over the next year or two, the statement after the recent meeting indicted that the Board retains the flexibility to ease further, should that be helpful.
The latest Statement of Monetary Policy, released today, continues to tell the now well rehearsed story. Resources down, China under pressure, local growth slowish, and transitioning from mining, sort of working, whilst home lending continues to grow at above 7% annually. But they kick around two interesting issues. First, why is the unemployment rate so good when growth is sluggish, and second why is the household savings ratio lower now?
Looking at employment first:
…strong employment growth has also been supported by a protracted period of low wage growth which, along with the exchange rate depreciation, may have encouraged firms to employ more people than otherwise. At the same time, growth in the supply of labour has increased through a rise in the participation rate, notwithstanding lower population growth. The unemployment rate declined to around 5¾ per cent in late 2015, having been within a range between 6 and 6¼ per cent since mid 2014. Nevertheless, there is evidence of spare capacity in the labour market, as the unemployment rate is still above recent lows, the participation rate remains below its previous peak and wage growth continues to be low.
Also, the low growth of wages is likely to have encouraged businesses to employ more people than otherwise. Measures of job vacancies and advertisements point to further growth in employment over the coming months. In response to this flow of data, the forecast for the unemployment rate has been revised lower. The fact that the improvement in labour market conditions has occurred against the backdrop of below-average GDP growth raises some uncertainty about the economic outlook. It is possible that the strength in the labour market data contains information about the economy not apparent in the national accounts data, or that the strong growth in employment of late will be followed by a period of weaker employment growth. Alternatively, the strength in labour market conditions relative to output growth may reflect a rebalancing of the pattern of growth towards labour intensive sectors and away from capital intensive sectors.
DFA is of the view that the growth in lower-paid non-wealth producing jobs at the expense of productive jobs is the key – more are now working in the healthcare and services sector (in response to growing demand thanks to demographic shifts), but it just moves the dollar around the system, and does not create new dollars. There is difference between being busy, and being productively (economically speaking) busy.
Turning to the savings ratio:
… after falling for more than two decades, the aggregate household saving ratio in Australia increased sharply in the latter half of the 2000s. While it has since remained close to 10 per cent – which implies that, collectively, households have been saving about 10 per cent of their incomes – the saving ratio has declined modestly over the past three years or so.
Understanding developments in the saving ratio is important because changes in household saving behaviour can have implications for the outlook for aggregate consumption. Trends in the household saving ratio in Australia over recent years are likely to reflect a range of factors, including the effect of the boom in commodity prices and mining investment on household incomes, behavioural changes stemming from the global financial crisis, and the current low level of interest rates. Longer-term factors such as financial deregulation and population ageing have also played a role. Households’ expectations about future income growth and asset valuations, and the uncertainty around those expectations, are also relevant to their saving decisions. Many households accumulate precautionary savings to insure against an unanticipated loss of future income or unexpected expenditure (such as on a medical procedure). At the macroeconomic level, precautionary saving is likely to be particularly important if households are very risk averse or constrained in their ability to borrow to fund consumption when their incomes are temporarily low. For example, the financial crisis is likely to have made households more uncertain about their future employment or income growth and/or led them to reassess their tolerance for risk, which would have encouraged them to increase their rate of saving. Surveys at that time showed an increase in the share of households nominating bank deposits or paying down debt as the ‘wisest place for saving’, although this may have also reflected lower expected rates of return on other financial assets following the financial crisis.
The level of interest rates can also influence the saving ratio. On the one hand, the current low level of interest rates reduces both the return to saving and the cost of borrowing, which encourages households to bring forward consumption; this might explain some of the recent decline in the aggregate household saving ratio. Low interest rates also support the value of household assets, which increases the amount of collateral households can borrow against, and potentially reduces the incentives for households to save. On the other hand, the household sector in aggregate holds more debt than interest-earning assets, so cyclically low interest rates provide a temporary boost to disposable income through a reduction in net interest payments, some of which may be saved. Households also need to save more to achieve a given target level of savings when interest rates are low.
Structural changes to the Australian financial system have been important longer-term drivers of changes in household saving behaviour. Financial deregulation in the 1980s and a structural shift to low inflation and low interest rates in the 1990s allowed households that were previously credit constrained to accumulate higher levels of debt for a given level of income. This rise in indebtedness was accompanied by strong growth in housing prices and a reduction in the household saving ratio to unusually low levels. In this way households were able to support consumption via the withdrawal of housing equity. Innovation in financial products – such as credit cards and home-equity loans – also gave households much better access to finance. The adjustment to these structural changes in the financial system appears to have largely run its course by the mid 2000s.
The ageing of the population is another longer-term influence on the saving ratio. If shares of younger and older households in the population were constant over time, the different saving behaviours of these households would not affect the aggregate saving ratio. However, Australia’s baby-boomer generation is a larger share of the population now and has been entering the retirement phase since around 2010. Because households save less in their later years, this is expected to have a gradual but long-lasting downward influence on the aggregate household saving ratio. However, a potentially offsetting influence is rising longevity, which may lead households to save more during their working years to finance a longer period of retirement.
The amount that each of these drivers have contributed to recent trends in the aggregate household saving ratio is unclear. It is also uncertain how they will evolve over the next few years, although the Bank’s central forecast embodies a further modest decline in the saving ratio, that reflects, in part, the unwinding of the impact on saving from the earlier boom in commodity prices and mining investment.
Using data from the DFA household surveys, we note three factors in play. First, household confidence levels still below long term trends, so we would expect households to continue to save, if they can, against perceived future risks. Second, older households hold the bulk of the savings, and they are indeed growing as a proportion of the total, so again we would expect to see a rise, not a fall in the ratio. But, the third factor, is in our view, the most significant. That is that many are relying on income from savings, and as deposit interest rates have fallen (and alternative investment options become more risky), some have switched savings into investment property and others are having to eat into capital to survive. The RBA’s policy settings of low interest rates, and high house prices are being reflected back in lower savings ratios.
At its meeting today, the Board decided to leave the cash rate unchanged at 2.0 per cent.
Recent information suggests the global economy is continuing to grow, though at a slightly lower pace than earlier expected. While several advanced economies have recorded improved growth over the past year, conditions have become more difficult for a number of emerging market economies. China’s growth rate has continued to moderate.
Commodity prices have declined further, especially oil prices. This partly reflects slower growth in demand but also very substantial increases in supply over recent years. The decline in Australia’s terms of trade, which began more than four years ago, has therefore continued.
Financial markets have once again exhibited heightened volatility recently, as participants grapple with uncertainty about the global economic outlook and diverging policy settings among the major jurisdictions. Appetite for risk has diminished somewhat and funding conditions for emerging market sovereigns and lesser-rated corporates have tightened. But funding costs for high-quality borrowers remain very low and, globally, monetary policy remains remarkably accommodative.
In Australia, the available information suggests that the expansion in the non-mining parts of the economy strengthened during 2015 even as the contraction in spending in mining investment continued. Surveys of business conditions moved to above average levels, employment growth picked up and the unemployment rate declined in the second half of the year, even though measured GDP growth was below average. The pace of lending to businesses also picked up.
Inflation continues to be quite low, with the CPI rising by 1.7 per cent over 2015. This was partly caused by declining prices for oil and some utilities, but underlying measures of inflation are also low at about 2 per cent. With growth in labour costs continuing to be quite subdued as well, and inflation restrained elsewhere in the world, consumer price inflation is likely to remain low over the next year or two.
Given these conditions, it is appropriate for monetary policy to be accommodative. Low interest rates are supporting demand, while regulatory measures are working to emphasise prudent lending standards and so to contain risks in the housing market. Credit growth to households continues at a moderate pace, albeit with a changed composition between investors and owner-occupiers. The pace of growth in dwelling prices has moderated in Melbourne and Sydney over recent months and has remained mostly subdued in other cities. The exchange rate has continued its adjustment to the evolving economic outlook.
At today’s meeting, the Board judged that there were reasonable prospects for continued growth in the economy, with inflation close to target. The Board therefore decided that the current setting of monetary policy remained appropriate.
Over the period ahead, new information should allow the Board to judge whether the recent improvement in labour market conditions is continuing and whether the recent financial turbulence portends weaker global and domestic demand. Continued low inflation may provide scope for easier policy, should that be appropriate to lend support to demand.
The RBA Credit Aggregates for December, released today, shows a continued rise in lending for housing, up 0.7% in the past month seasonally adjusted by $10.6 bn to $1.52 trillion. This includes all lending, including non-banks, seasonally adjusted. There are no reported series breaks this past month, so no abnormal shifts between investment and owner occupied loans . This is a rise of 7.1% over the past year.
The splits between owner occupied and investment lending shows that loans for owner occupation rose $10 bn, up 1.1%, to $967.7 billion. Loans for investment purposes also rose – just 0.09% or $0.49 billion to $546 billion, so investors are still in the market. The proportion of loans on book relating to investment lending has fallen again, to 36.1% from a high of 38.6% last year. This is still a big number, and higher that the levels which were thought to be a concern (as expressed by the regulators) last year, before recent swapping between categories. Remember the Bank of England is worried by their 16% share of investment loans – in Australia it is much higher!
Personal credit has fallen again, down 0.2% to $148 billion. But lending for business was only up 0.11%, or $0.94 billion to $826 billion. This represents a low 33.2% of all lending, down from 33.3% last month, and down from 34.7% in 2012. This continues to highlight the lack of investment in the grown engine of the economy – business – as compared to the easy money going towards housing. Structurally, we continue to have a problem, as housing growth is not productive and cannot lead to the right economic outcomes. Remember this is with interest rates at rock bottom.
The latest RBA chart pack, to December 2015 was released today. Households remain under financial pressure, as shown by the updated data relating to household debt as a percentage of household disposable income continues to move higher, and well above 175% . Whilst interest rates are low, so interest paid is on average a little above 8%, this masks significant differences across household segments, and highlights the risks to households if interest rates were to rise.
We also see that income growth is as at the low-end of trend in the past 20 years, and the savings ratio continues to fall. Consequently consumption is on the low-side.
The RBA released their November Credit Aggregates. Total housing loans (SA) reached $1.51 trillion up 0.7%, thanks to growth of 1.05% in owner occupied loans, whilst loans for investment property grew by just 0.09%. Total owner occupied loans totalled $968 billion, and investment loans $548 billion, so investment loans now comprise 36.1% of all loans on book (from a high of 38.6% in July). We need to be a little cautious, as further adjustments were made in the classifications. The RBA tell us that “following the introduction of an interest rate differential between housing loans to investors and owner-occupiers in mid-2015, a number of borrowers have changed the purpose of their existing loan; the net value of switching of loan purpose from investor to owner-occupier is estimated to have been $32.5 billion over the period of July 2015 to November 2015 of which $1.9 billion occurred in November. These changes are reflected in the level of owner-occupier and investor credit outstanding”.
Of note is the relative movement in business lending, which was 33.2% of all loans, to $826 billion, up 0.11% in the month. Business lending is still restrained, compared with lending for property, the latter unproductive, and simply stoking household debt. Productive lending for growth is under pressure. Personal credit fell again to $147.9 billion, down 0.2%.
Looking at the 12 month growth figures, investment lending is now below the 10% speed limit, at 9.1%, whilst owner occupied loans are at 6.5%, the highest rate for 6 years (Feb 2011).
