Statement on Monetary Policy – November 2008 Domestic Financial Markets
Money market and bond yields
The escalation of pressures in international markets in recent months has been reflected in Australian markets, although generally to a lesser extent. Term funding rates for banks increased toward the middle of September, as the US authorities intervened to support Fannie Mae, Freddie Mac and AIG, and Lehman Brothers filed for bankruptcy. The spread between 3-month bank bills and the expected cash rate increased sharply, doubling from 40 to 80 basis points. This rise in spreads occurred following the Reserve Bank's reduction in the target for the cash rate by 25 basis points in early September to 7.0 per cent, and despite the market's anticipation of further policy easing. The strains on the domestic market were amplified when offshore commercial paper markets effectively closed.
The Board's decision to reduce the cash rate by 100 basis points in early October – double the market's expectation – resulted in some reduction in bank bill rates, but the global rise in risk aversion limited the decline in money market yields, with the 3-month spread increasing to over 100 basis points (Graph 56). More recently, as authorities (including those in Australia) have announced more aggressive measures to support financial markets and economic activity, bill spreads have narrowed considerably. After the cash rate target was reduced to 5.25 per cent in early November, the 3-month bill rate declined to 5.15 per cent, more than 200 basis points below its level of three months ago.
The reductions in the cash rate by the Reserve Bank and the market's expectations of further falls to come have seen longer-term interest rates decline significantly. The 10-year swap rate has fallen from 7.0 per cent in early August to be around 5.8 per cent. This decline has exceeded that in government bond yields, as the swap spread has fallen in line with those in most currencies.
In its market operations, the Bank has continued to encounter heightened demand for funding from banks and other financial institutions. Given the increased size of central bank operations – including the US dollar swap discussed below – and to give institutions greater flexibility in managing their liquidity in this period of distressed markets, the Bank announced in early October that ‘related-party’ residential mortgage-backed securities (RMBS) and asset-backed commercial paper (ABCP) could be pledged as collateral on repurchase agreements with the Bank. The Bank also began offering 6- and 12-month funding terms each day in its operations – previously such long terms had only been offered sporadically. Since then, a combined value of around $20 billion of liquidity has been injected at these longer terms. To improve liquidity in markets more broadly, the pool of eligible collateral was expanded further to include highly-rated commercial paper, most ABCP and AAA-rated securities in early November. These arrangements will remain in place until June 2009.
In accommodating the market's demand for funding, the Bank has significantly expanded the size of its balance sheet. When tensions amplified in mid September, the Bank increased aggregate exchange settlement (ES) balances from $1½ billion to reach a peak of more than $11 billion in mid October. More recently, as conditions have stabilised somewhat, the Bank has acted to reduce settlement balances to around $6 billion. The reduction in ES balances has in part been achieved by the Bank commencing in late September to offer term deposits to its counterparties. Under this facility, institutions can bid to hold short-term deposits at the Bank (generally, for periods of up to two weeks). Offering term deposits enables the Bank to expand its demand for private-sector securities, so assisting banks' funding, and to satisfy financial institutions' demand for risk-free, liquid assets, without increasing ES balances too far which might impede the efficient operation of the cash market.
In September, the Bank also began auctioning US dollars to domestic market participants, taking Australian dollar-denominated securities as collateral. These operations were funded by a US$30 billion swap facility with the Federal Reserve, similar to those the Fed has arranged with other central banks (see Box B). To date the RBA has held three auctions. These facilities are designed to alleviate the shortage of US dollar funding for institutions that usually rely on the foreign exchange swap market (through which they exchange one currency for another, with an agreement to unwind the flows at a later date). Foreign exchange swap markets had become quite dysfunctional during September, with the implied cost of borrowing US dollars rising sharply against all other currencies. The co-ordinated central banks' actions were effective in lowering the cost of US dollar funding, including against Australian dollars. As noted in the chapter on ‘International and Foreign Exchange Markets’ and in Box B, this improvement in foreign exchange swap markets was particularly noticeable after a number of central banks began providing unlimited US dollars at a fixed price under these facilities.
Equities
The past couple of months have been the most volatile for the Australian share market since 1987, as has been the case in share markets in most countries. Over the past month, aggregate daily share price movements have averaged just over 3 per cent – about five times above the pre-crisis average of 0.6 per cent (Graph 57). Volatility has been elevated since late 2007. This is an exceptionally long period of heightened volatility, with almost one-half of the 40 largest daily price movements since 1980 occurring this year.
The ASX 200 has experienced a substantial decline since the last Statement, falling by 16 per cent to be 39 per cent below its peak in November last year and its lowest level since June 2005 (Graph 58). The fall in Australian equities from their peak last year is of a similar magnitude to those in international equities, despite the fact that profits have held up much better than in most other countries.
In response to the volatile market conditions and similar actions by international regulators, ASIC temporarily banned short selling of all listed stocks for 30 days from 22 September. The initial ban has been extended until 18 November 2008 for non-financials and 27 January 2009 for financials; other aspects of the original ban remained unchanged, including the exceptions for market-makers and hedging of existing positions. Once these bans are lifted, disclosure of short sales will be required. ASIC noted that while short selling ordinarily plays a valuable role, recent market conditions and extensive short selling of stocks created the risk of unwarranted price fluctuations which, if left unchecked, could threaten the operation of fair and orderly stock markets.
While all three broad sectors of the Australian share market have fallen over the past three months, there have been particularly large falls in resource companies' share prices on sharp declines in commodity prices and expectations of slower economic growth in developing economies. Since the last Statement, resource companies' share prices have fallen by 32 per cent, to be 44 per cent below their peak in May this year (Table 9). In contrast, financials have fallen by 7 per cent over the past three months, less than the 35 per cent falls in equivalent indices overseas. The relatively sound capitalisation and profit outlook of Australian banks, as well as a range of domestic policy announcements – including the Australian Government's broad guarantee of deposits and wholesale funding, and the larger-than-expected falls in the cash rate – contributed to the relatively good performance of Australian financials.
Profits announced by listed Australian companies in the recent reporting season were broadly in line with expectations so there was little aggregate impact on share prices. Underlying profit – which excludes significant items and asset revaluations/sales – increased by just 1 per cent in the most recent half year compared to the corresponding period in 2007. This compares with average profit growth of 23 per cent over the previous three years.
By sector, the increase in profits was driven by resources and other non-financial companies. The profits of resource companies rose 21 per cent, reflecting strong growth in production volumes and high commodity prices. For other non-financial companies, profits increased by 36 per cent. This was offset by losses for real estate investment trusts (REITs) and diversified financials, and a lower level of profits for insurance companies, reflecting increased debt funding costs and a decline in revenue associated with falls in asset markets. The credit market strains have seen entities with complex financial structures and high leverage come under pressure, with many of these entities looking to deleverage their balance sheets.
The impact of the credit market turmoil was evident in companies' latest profit results. For many companies, interest payments increased sharply, reflecting the higher cost of borrowing. Announced buybacks were limited, with companies choosing to retain cash. Some companies scaled back dividends, particularly REITs that were previously borrowing against appreciating asset values to fund part of their dividend payments.
The large Australian banks continue to be less affected by the financial market turbulence than the large banks in other countries. The five largest banks' 2008 full-year underlying profits were little changed from the previous year at $17 billion, though profits in the second half were 15 per cent lower than in the first half. The banks' after-tax return on equity declined, but remains in line with its decade average at 16 per cent. Strong growth in net interest income, reflecting solid asset growth, was partially offset by a decrease in non-interest income (wealth management, insurance, trading and fee income) and a sizeable rise in the bad and doubtful debts expense. The Australian operations typically performed better than the UK and NZ operations, mainly reflecting the stronger Australian economy. The banks remain well capitalised, with all five banks reporting capital adequacy ratios that are well above regulatory minima.
Analysts' forecasts for resource companies' earnings growth – formed after the profit reporting season – remain strong. The strength in forecasts of resource companies' profits in 2008/09 reflects large increases in iron ore and coal contract prices and the depreciation of the Australian dollar. The recent falls in spot commodity prices and expectations for weaker world growth suggest that these forecasts are likely to be revised down. Forecast profit growth for non-resource companies was scaled back a little on expectations of a slowing domestic economy. The most recent report of analysts' expected profit growth for the ASX 200 is 27 per cent in 2008/09, slowing to 9 per cent the following year.
The falls in the share market over the past three months have resulted in a continued decline in the trailing P/E ratio, which is based on earnings for the past year. The forward P/E ratio, which is based on expected earnings for the coming year, has experienced a similar decline but would pick up somewhat if earnings expectations are revised down (Graph 59). Both the forward and trailing P/E ratios remain well below their long-run averages and around the lowest levels since 1991. P/E ratios for all three broad sectors of the share market are also below their long-run averages.
Net equity raisings in the September quarter were $14½ billion, well above the average of $11 billion (Graph 60). Equity raisings by financials were above average, in part due to banks increasing their capital levels through underwritten dividend reinvestment plans and hybrid conversions; equity raisings by non-financial companies were also solid, as these companies used equity to fund investments (including M&A activity) and pay down debt. Buybacks weakened further and remain well below average, with companies preferring to retain cash to strengthen balance sheets given the uncertain outlook. IPOs also remain weak given volatile equity markets.
Despite the volatility in markets, M&A activity has been solid with $43 billion of deals announced since end June. M&A activity over the past year has been driven by a number of large deals, including BHP Billiton's bid for Rio Tinto (in February), Westpac's bid for St. George (May), ConocoPhillips’ 50 per cent acquisition of a subsidiary of Origin Energy (September) and BG Group's bid for Queensland Gas (October). M&A activity has been increasingly equity-funded with little debt financing.
The falls in share prices continue to weigh on superannuation fund returns. Australian superannuation funds had an average return of –8 per cent over the 2007/08 financial year, the lowest annual return in at least two decades, and returns are estimated to be around –10 per cent in the 2008/09 financial year to date.
Financial intermediaries
The ongoing turbulence in capital markets continues to affect the cost and composition of financial intermediaries' funding, with smaller, lower-rated financial institutions, and institutions that rely relatively heavily on capital market funding – particularly securitisation – being most affected.
Reflecting the dislocation in markets and the announcement of similar schemes in other countries, in October, the Australian Government introduced a range of measures designed to ensure that most financial intermediaries have ongoing access to funding. The Government will guarantee deposits held at eligible authorised deposit-taking institutions (ADIs) for a period of three years. There will be no fee on the guarantee for deposits less than $1 million. The Government has also offered to guarantee wholesale funding, and large deposits, for these institutions in return for a fee, which will vary depending on the credit rating of the borrower.[1] Subject to certain conditions, branches of foreign banks are also covered in these arrangements, thereby minimising any potential disruptions to the short-term money markets and to corporate lending. The Government guarantee on wholesale funding will be withdrawn when market conditions normalise. The guarantee scheme will commence on 28 November; up until that date, eligible deposits and wholesale funding will be guaranteed without charge.
Although bond issuance by the five largest banks remained strong in August, it slowed sharply in September and October amid the severe disruption to global markets (Graph 61). In September, just $1.7 billion was raised by the five largest banks, with a further $1.6 billion raised in October, well down from the $4½ billion monthly average before the credit crisis. The lower issuance in September and October, combined with around $7½ billion of maturing bonds, has seen the outstanding value of banks' bonds fall slightly. Despite limited issuance over the past couple of months, the five largest banks remain well ahead on their funding plans because of the strong net issuance early in the year. Lower-rated banks have had more limited access to the bond market.
About one-half of bond issuance by the five largest banks over the past couple of months has been into the domestic market, with little participation by non-resident investors in these transactions. There was no bond issuance overseas in October, the first month in which this has occurred since December 1999, reflecting the extreme risk aversion among many investors.
For the major banks, bond spreads at issuance have picked up a little in recent months. One bank issued 2- and 3-year bonds into the domestic market in early October at spreads above swap of 75 basis points and 100 basis points respectively. This is about 10 basis points higher than comparable issues in August. Secondary market pricing indicates that spreads are up 10 basis points since the last Statement; however, with swap rates falling 205 basis points, banks' bond yields have fallen sharply to around 6 per cent – around 270 basis points below the peak in June (Graph 62).
Rating agencies downgraded several smaller Australian financial institutions, or negatively revised their outlook. These changes largely reflected their reduced funding options resulting from the heightened market turbulence, lower forecast earnings, and – in the case of some foreign-owned banks – poor performance of their parents. S&P affirmed the credit ratings of the five largest Australian banks, citing their ‘conservative stance’ and limited exposure to the US sub-prime crisis. The four largest banks in Australia are rated AA; of the world's largest 100 banks, only a few have higher ratings (Graph 63). Unlike some of the large financial institutions abroad and a couple of the foreign-owed banks operating in Australia, no Australian-owned bank has had its rating downgraded since the onset of the credit turmoil.
Activity in securitisation markets continues to be limited, with only a few public RMBS deals taking place. Since mid 2007, quarterly RMBS issuance has averaged around $2 billion compared to an average of $18 billion in the year prior to the credit crisis (Graph 64). The average deal size remains small ($400 million compared to $1.6 billion pre-credit turmoil), with deals frequently tailored to specific investors. All RMBS issuance has been onshore since the onset of the credit turmoil. As a result, the stock of Australian RMBS outstanding offshore has fallen by substantially more than the stock onshore since mid 2007 (36 per cent versus 10 per cent). Aggregate Australian RMBS outstanding has fallen 25 per cent since its peak in June 2007.
The little RMBS issuance there has been in recent months suggests that spreads have edged higher. RMBS spreads at issuance are around 130–160 basis points over BBSW for the AAA-rated tranche. At these spreads and current mortgage rates, RMBS are unlikely to be a viable funding source for many lenders. The Australian Government announced a program for the Australian Office of Financial Management (AOFM) to purchase new RMBS directly from issuers. The AOFM will invest a total of $8 billion in AAA-rated RMBS, with half of this amount to be directed to mortgage managers; the first purchases are to be made later this year.
Recently issued RMBS have been structured with sufficient subordination so that the senior tranche is independent of lenders' mortgage insurance (LMI). QBE recently acquired PMI Australia, which provides LMI to around 40 per cent of securitised mortgages in Australia. The rating agencies have affirmed PMI's AA− rating, as QBE has stated it will ‘quarantine’ PMI from the rest of QBE to maintain its capitalisation. As a consequence, there are not expected to be any flow-on effects to RMBS ratings.
Losses on RMBS picked up in the June quarter, though remain low as a share of outstandings at around 5 basis points on an annual basis. Investors in prime Australian rated RMBS have never borne any losses of principal; losses after the sale of property have been covered by LMI and excess spread. In September, a non-conforming RMBS suffered a small loss on its lowest-rated tranche ($600,000 on a tranche of $7.7 million). This is the first time a rated tranche in Australia has experienced a loss. The loss resulted from the poor performance and high rates of delinquency of the loans in this pool, and disputed LMI claims.
Developments in global financial markets led to some tightening in short-term securitisation markets, with spreads on Australian ABCP widening a little after remaining steady, albeit elevated, in recent months. The total stock of outstanding paper remained flat over the past few months to August – the latest data available. Total outstanding ABCP is 30 per cent below its peak in mid 2007 (Graph 65).
Deposit growth remained strong in the September quarter, aided by ongoing demand for low-risk assets from households and non-financial corporates and robust competition for deposit funding from financial institutions. This has contributed to strong growth in M3 and broad money.
The average interest rate on the major banks' 3-, 6- and 12-month term deposits has fallen by 165 basis points since end July, primarily reflecting the marked decline in bank bill rates – which are a pricing benchmark for term deposits – but also some unwinding of ‘special’ rate offers (Graph 66). The average rate on financial intermediaries' at-call deposits – including online savings, cash management and bonus saver accounts – has fallen by 114 basis points over the three months to end October, a little less than the decline in the cash rate over this period.
Household financing
At the time this Statement was finalised, the November decrease in the cash rate had only just started to flow through to borrowing rates. Nevertheless, interest rates on loans to households have fallen markedly since end July, with financial intermediaries passing on most of the cash rate reductions to their variable housing loans (Table 10). Variable indicator rates on prime full-doc housing loans have fallen by an average of 120 basis points in the three months to end October to 7.74 per cent. On average, banks have reduced their interest rates by considerably more than mortgage originators, credit unions and building societies (CUBS). Interest rates on prime low-doc loans have decreased by 117 basis points.
The five largest banks' average 3-year fixed rate on prime full-doc housing loans has fallen by 213 basis points since the end of July 2008, and is currently 7.29 per cent. The share of owner-occupier approvals at fixed rates has continued to decline over recent months; it was 3½ per cent in September, the lowest share in at least 17 years and well below the decade average of 12 per cent.
There has been little pass-through of the cash rate cuts to personal loans. Since the end of July, average variable interest rates on unsecured personal loans and margin loans have decreased by 6 basis points and 43 basis points respectively, while rates on standard and low-rate credit cards have risen by 8 basis points and 34 basis points respectively. As with housing loans, the banks have tended to reduce their rates by more than other financial institutions. The incomplete pass-through of recent cash rate cuts has seen the spreads to cash for personal loan indicator rates widen by about 175 basis points since July 2007, compared with the 55 basis point widening in the spread on housing loans (Graph 67).
Overall, we estimate that the average interest rate on outstanding household loans has fallen by about 73 basis points over the three months to end October 2008, and is about 35 basis points above its post-1993 average.
Reflecting the earlier increases in borrowing costs and some tightening of lending standards for riskier borrowers, the value of housing loan approvals has fallen sharply over 2008 to date, and in August, was around 26 per cent below the peak last year. The share of owner-occupier loans approved by the five largest banks has risen by a further 5 percentage points to 72 per cent over recent months; the market shares of the smaller banks, CUBS and mortgage originators have fallen (Graph 68).
The decline in housing loan approvals is in line with the easing in housing credit growth over the year. Over the September quarter, housing credit grew at an average monthly pace of 0.5 per cent, down from an average monthly growth rate of 0.9 per cent in 2007.
Personal credit fell significantly in the September quarter, as continued stock market volatility weighed on investors' appetite for margin debt and credit card lending slowed (Graph 69). In annualised terms, personal credit fell by 5.1 per cent over the September quarter, compared with average annual growth of 11.3 per cent over the past decade.
The number of margin calls rose to 4.3 calls per day per 1,000 clients in the September quarter, the highest frequency since March 2003 (Graph 70). The frequency of margin calls increased even further in October. Sustained falls in share prices over the past year have pushed up investors' gearing levels, and this, combined with the extreme market volatility, has increased the frequency of margin calls.
Business financing
The cost of business borrowing has also fallen since the last Statement. Variable interest rates on large business loans – which are mostly priced off bank bills – are estimated to have fallen by 80 basis points since end July, while variable indicator rates for small business loans have declined by around 70 basis points. These rates are currently 60 and 110 basis points higher than their mid-2007 levels respectively, despite the cash rate declining by 25 basis points over this period.
Rates on new 3-year fixed small business loans have decreased by 185 basis points since end July, broadly in line with the fall in the 3-year swap rate. At 7.60 per cent, the 3-year fixed small business rate is currently at its lowest level since early 2006.
Overall, we estimate that the average interest rate on all outstanding business loans has fallen by 70 basis points in the three months to end October, but at 8.15 per cent, remains around 30 basis points above its post-1993 average (Graph 71).
Growth in total business debt has slowed sharply over 2008, as a result of the higher cost of borrowing as well as tighter lending standards for some businesses (Graph 72). Total debt slowed to an annualised growth rate of 7½ per cent in the six months to September, compared with 18 per cent in the same period in 2007. The slower growth in business debt over 2008 largely reflects an easing of growth in intermediated business credit. However, business credit growth picked up in the September quarter, to an average monthly rate of 0.9 per cent from an average monthly pace of 0.3 per cent in the June quarter. The stock of non-intermediated debt is little changed over the past year, partly reflecting reduced access to capital markets. Commercial loan approvals have levelled out in recent months, following significant declines earlier in the year.
The pick-up in business credit growth in the September quarter was most evident for loans greater than $2 million, although loans to small businesses also rose moderately. The growth in loans greater than $2 million was likely driven by mid-sized firms, with syndicated loan approvals data suggesting that lending to large corporates remained subdued. Syndicated loans for acquisition-related purposes remained especially low, with M&A activity continuing to be equity-funded instead (Graph 73). The pick-up in business borrowing in the September quarter appears to have been relatively broad-based across sectors.
Corporate bond issuance has remained low in recent months (Graph 74). Thirteen small bonds were issued in the September quarter, totalling around $1¾ billion. This is significantly lower than the average quarterly issuance of around $5½ billion before the credit turmoil. Two small corporate bonds were issued in October. As has been the case with most corporate issues in 2008, all of the recent deals were issued offshore.
Three non-resident institutions with bonds outstanding in the domestic market have defaulted over the past couple of months. Lehman Brothers had $600 million of Kangaroo bonds outstanding in the Australian market, and two Icelandic banks had a further $315 million outstanding; together these make up less than 1 per cent of all domestic bonds issued by non-residents. These are the first bond defaults in the Australian market since 2004, and the first defaults by Kangaroo issuers.
Secondary market bond yields for Australian corporates have fallen by around 65 basis points since the last Statement to be around the same levels as at the start of the year (Graph 75). This fall was driven by a sharp decline in the swap rate, offset by an increase in spreads. Market contacts indicate that the secondary market has become more illiquid during the recent heightened turbulence, with few trades taking place.
Australian businesses' balance sheets generally remain in good shape despite the strains in markets. Some companies, particularly those with complex structures and those that are highly leveraged or exposed to declining asset valuations, have come under pressure. The book value gearing ratio – the ratio of debt to shareholders' equity – of listed non-financial companies was broadly unchanged at 83 per cent in the June half 2008, after increasing sharply in the second half of 2007 due to Rio Tinto's debt-funded purchase of Alcan (Graph 76). Excluding Rio Tinto, gearing was unchanged at 71 per cent, a little above the long-run average but well below the levels reached in the late 1980s. Most of the highly leveraged companies are utilities and industrial companies that typically have fairly stable cashflows. By sector, resource companies reduced their gearing slightly, while non-resource companies' leverage rose slightly.
The market value measure of gearing (excluding Rio Tinto) – which incorporates expectations about future profits that can be used to service debt – increased, driven by a fall in share prices with debt outstanding being broadly unchanged.
Companies' response to the credit turmoil was evident in their balance sheets. Corporates that were highly geared reduced their leverage over the June half, and there was a fall in the relative use of short-term debt. Overall, there does not appear to be a significant risk to the Australian non-financial corporate sector, although there may be further instances of individual companies running into difficulties rolling over debt. The share prices of some companies with high gearing or reliance on short-term debt have already been marked down heavily. On average, companies with high reliance on short-term debt do not tend to be highly geared.
Aggregate credit
Financial conditions tightened in the first three quarters of 2008, reflecting both higher lending rates and tighter lending standards. As a result, average monthly growth in total credit has slowed from a peak of 1.3 per cent in the December quarter 2007 to 0.6 per cent in the September quarter (Table 11, Graph 77). Year-ended growth has slowed from 16 per cent over 2007 to 10 per cent over the year to September. All components of credit have slowed. The slowing in total credit growth is consistent with other domestic demand indicators as discussed in the ‘Domestic Economic Conditions’ chapter. The recent easing in financial conditions resulting from declines in interest rates is yet to be reflected in the lending data.
Footnote
For AA-rated entities, the annual fee is 70 basis points. For A-rated entities, the annual fee is 100 basis points. For BBB-rated and unrated entities, the fee is 150 basis points. [1]