Can Australia’s deflating property bubble deflate even further?

March 11th, 2007

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This is a question we have been asking ourselves. Currently, house prices in Sydney (the epitome of Australia?s housing bubble), which peaked in 2003, are stagnating. The general belief is that the stagnation has around one to two years to go before resuming its uptrend again. After all, the unemployment rate is at its lowest and inflation seems to be benign. The equity market is booming and consumer confidence is still strong. Perhaps the housing bust has bottomed and we shall see the return of wealth and boom soon? For those who truly believe that the ?good? old days of wealth attainment through property ?investment? is coming back soon, we suggest they take a dose of reality check.

Firstly, let us see the outcome of the ?prosperity? that this housing bubble (see The Bubble Economy) has brought about. According to this article in the Sydney Morning Herald (SMH), housing affordability in Australia is ?among the worst in the world.? Furthermore, thanks to the bust of the housing bubble, Sydney is now hit with a follow-on rental crisis (see Example of inevitable effect of monetary inflation). Thus, this is a very good example of how monetary inflation is of no eventual benefit to society?all it did was just a reallocation of wealth from the asset poor to the asset rich (see How to secretly rob the people with monetary inflation? and SMH?s Property set have never had it so good).

Next, let us take a look at the level of debt in Australia. Currently, the level of mortgage debt to GDP ratio in Australia stood at 82.2%. The level of total debt to GDP ratio is running at 152%. If we assume that the mortgage interest repayment rate stood at a generous 7.5% per annum, then 6.2% of GDP a year will go to servicing the mortgage debt’s interest payment only. If we assume that the rest of the debt requires an interest repayment of a charitable low rate of 6.25%, then another 4.4% of GDP a year will be consumed by that debt’s interest payment. In total, even given our incredibly generous hypothetical interest repayment rate, 10.6% of Australia?s GDP will have to go to service its total interest payments. What is Australia?s GDP growth rate? The latest report from the Australia Financial Review stated, ?Annual GDP jumps to 2.8%.? What this mean is that total Australian debt burden will grow at an exponential rate relative to GDP! Clearly, this is an unsustainable long run trend, which if continues, will one day lead to Australia?s debt burden exceeding its income (i.e. bankruptcy).1

For this reason, we still believe that Australia?s housing deflation is still vulnerable to even further deflation. The market?s view that the current house price stagnation will end in the near future and recommence its uptrend is based on extrapolating the status quo to the indefinite future. For us as long-term strategic thinkers, we do put much effort in trying to understand what may disrupt the status quo and then plan accordingly. In Australia?s case, with her towering levels of debt, any external shock can easily tip her over to a recession, which can lead to further asset (e.g. real estates and stocks) deflation. Indeed, from Bad debt rising among homeowners in the Daily Telegraph, we can glimpse a portent of what can happen in a much wider scale when a real recession hits.

The next question is, what external forces beyond Australia?s control may tilt her into a recession? There are many, of which we only have the time and space to list out only one:

  • A sustained uptrend in oil prices can have a damaging effect in any highly leveraged and indebted economies, Australia included. Should the Israelis strike Iran (see What if the Israelis strike Iran?), skyrocketing oil prices, if prolonged, will have a very devastating and disruptive impact on the global economy. Though such extreme events are unpredictable and its probabilities impossible to quantify, we have to bear in mind that a mere silent and relentless rise in oil prices, along with its macroeconomic implications, is enough to do the damage.

By now, it should be clear that whatever the external shock is not the issue?the point is that Australia is highly vulnerable.

How will a further house price deflation work out on the ground? It will start with mortgage repayment delinquencies, which will result in increased foreclosures. This will lead to lending institutions repossessing homes and having to urgently sell them to the market to recover losses incurred by bad mortgage debts. As we all know, such importunate sale rarely fetch a good price for the seller. When that happens, through the principle of imputed valuation (see Spectre of deflation on the concept of ?imputed valuation?), a minority of house sale will lead to a downward revaluation on the rest of the housing stocks. If the downward movement is strong enough, it may trigger a race among these sellers to get rid of their houses?a feedback effect.

Of course, we are not predicting that such a scenario will happen. It is just a possibility, which you will do well to understand so that you will know what to look out for and not be caught out asleep behind the wheel.