Australia's 'irrational exuberance' to borrowing is risky, says study

by Julia Corderoy17 Jun 2015
Australia’s “irrational exuberance” about borrowing money to invest in property will increase the economy’s vulnerability to a more severe downturn.

According to a study conducted by PIMCO, which compares Australian borrowers to those in other countries, lower mortgage rates and house price appreciation have driven a “herd mentality” that assumes continued capital price appreciation and creates the fear of “missing out.”

However, this sort of irrational exuberance will leave the Australian economy more exposed in the face of an economic downturn.

“The problem is that expected future capital price gains may become unrealistic when extrapolated from recent history, leading to excess borrowing, which, when unwound, can lead to large negative externalities,” the study noted.

“Based on data from the OECD (2014), two commonly used valuation metrics place Australian house prices at the higher end of international comparisons. With this starting point, it seems questionable to embed expectations of continued high price growth.”

The study also claims that Australian households appear to respond too hastily, needing only two quarters of favourable changes in asset prices and mortgage rates to increase leverage. This hastiness to react could result in a feedback loop where falling asset values induce even further deleveraging.

“Based on our model for household leverage alone, if an exogenous shock sparked a deleveraging cycle in Australia, it would be expected to be quite severe given the larger co-efficient for asset prices and the quicker household response,” researchers said.

To mitigate potential risk, PIMCO says it would be wise to strengthen macro-prudential policies and reduce the reliance on monetary policy.   

“We believe macro-prudential measures should be strengthened to address financial stability risk and give the RBA maximum flexibility when setting policy for the aggregate economy.”

However, given the sensitivity of households to mortgage rates, PIMCO expects the cash rate peak in the RBA’s next hiking cycle to be much lower than in previous cycles.