Australia: As Rates Rise, Focus Shifts to Real Estate Sector

In many respects Australia’s economy resembles those of its peers in North America and Europe.  Since the pandemic began, unemployment rates have plunged to record lows and inflation has surged (Figure 1).  The Reserve Bank of Australia (RBA) has been raising rates roughly in line with the Federal Reserve (Fed) (Figure 2), but its policy rate is still far below the rate of inflation, like those of many other central banks (Figure 3). 

Figure 1: Australia’s unemployment rate has fallen and inflation has soared since the pandemic

Figure 2: The Reserve Bank of Australia’s rate hikes have been largely keeping pace with the Fed

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Figure 3: The RBA still has rates far below the rate of inflation

While there are strong parallels between the Australian economy and those of Europe and North America, there are a few features that set it apart.  Firstly, Australia’s exports are dominated by commodities, which exert a strong influence on its currency.  Secondly, Australia’s domestic economy is closely tied to real estate, which in turn may be at risk given extremely high levels of household leverage and a dependence on adjustable-rate mortgages (ARMs).

AUD Decoupling from Commodity Prices?

From 2011 to the end of 2020, the Australian dollar (AUD) closely tracked an index of commodity prices weighted to reflect their economic value among Australia’s exports.  However, from early 2021, AUD and the Australian weighted commodity index began to diverge.  Commodity prices soared in 2021 while the AUD generally trended lower versus the U.S. dollar (USD).  The divergence appears to have been isolated to 2021 and may have been related to the nearly complete closure of Australia’s borders that halted foreign tourism – a major source of revenue. Thus far in 2022, AUDUSD and the commodity index have resumed their usual parallel movement, with both commodity prices and the AUD heading lower (Figure 4). 

Figure 4: Except for 2021, AUDUSD has typically followed commodity prices

Australia’s Real Estate Market

Australian real estate prices have far outpaced the general rise in values over the past several decades and this was especially true between the late 1990s and the end of 2021 when real estate prices tripled in inflation-adjusted terms (Figure 5).  Among the reasons for this was the sharp decline in interest rates.  Government bond yields, which averaged around 7% during the late 1990s, fell below 1% between late 2019 and late 2021.  Mortgage rates also fell sharply. 

Figure 5: Residential property prices tripled in inflation-adjusted terms between 1996 and 2021

Lower rates allowed for households to borrow much larger sums of money than had been possible in the past.  Between 2000 and 2021, Australian household debt rose from 69% to 120% of GDP, fuelling residential investment.  A 120% household debt-to-GDP ratio is extremely high compared to Australia’s peers: 106% in Canada, 77% in the U.S. and 59% across the eurozone.

The problem for Australia, however, is that bond yields are now rising sharply, having increased by 300 basis points (bps) in the past year, and the RBA is rapidly tightening policy.  Adding to concerns is the fact that adjustable-rate mortgages in Australia are the norm.  Higher home payments could impact consumer spending and add downward pressure on housing prices, while raising default risk across the sector and depressing home construction activity.

The good news for Australia is that the country’s overall debt levels are not especially high owing to relatively lower non-financial corporate and government debt ratios.  For example, public debt in Australia stands at 53% of GDP compared to ratios close to 100% in most peer-group nations.  This implies that if the Australian economy does slow down as a result of rising mortgage servicing costs, increased public borrowing could be used to support economic growth. That said, it may be difficult to justify fiscally expansionary measures as long as inflation remains elevated (Figure 6).

Figure 6: Australian household debt rose from 69% to 120% of GDP between 2000 and early 2022

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