Australian house prices are "the best"

Our cricket team might be hopeless, but when it comes to house prices, Australia is the "best in the world" The Australian says today, restoring a bit of Aussie pride. This is a curious headline, since most of us who don't already own 12 investment properties would think that having the most unaffordable housing in the world is not exactly cause for celebration. But never underestimate the ability of Australian newspaper editors to put a positive spin on anything property related. In any case, house prices rose 9.4% in 2010, the article says, citing a report from Canada's Scotiabank. Here's what Scotiabank had to say:

"Australia is the clear front-runner in 2010. Housing demand is being supported by low unemployment, while tight supply is adding to the upward pressure on prices. Nonetheless, consecutive interest rate increases by the Reserve Bank of Australia (RBA), totaling 175 basis points since October 2009, alongside the expiry of the enhanced First Home Owners Grant in January 2010, have succeeded in cooling its red-hot property market to some degree...

We anticipate a further slowing in sales and price appreciation in 2011. While Australia’s close trade ties with Asia and resource wealth will continue to underpin a solid pace of domestic activity, higher interest rates will worsen already strained affordability. The RBA has recently taken pause, but we expect the resumption of a gradual policy tightening path in 2011, with short-term rates rising an additional 75 basis points by year-end."

So here's the problem. Let's say you're an optimist about the economy and you expect that China keeps growing at 10-11% a year. Australia keeps digging stuff out of the ground and the mining boom continues. In this case, the RBA will almost certainly be forced to raise interest rates further to control inflation. Scotiabank is not alone in forecasting multiple interest rate rises next year. But higher interest rates will force already tapped out consumers to devote a greater share of their disposable income to mortgage repayments, making housing even more unaffordable.

Remember that a huge volume of first homebuyers took out their mortgages in late 2008 and early 2009 (see chart below), when interest rates were more than 1.5% lower than today. In addition to the impact on recent homebuyers, higher rates are bad for the retail sector, which is reporting the worst Christmas sales since the early 1990s. Further rate rises could also push the Australian dollar even higher, strangling tourism and other industries that are becoming increasingly uncompetitive because of Australia's high costs.

On the other hand, if the bears are right about China and the commodity boom goes bust, the biggest impetus to economic growth in Australia in recent years would suddenly disappear, sharply slowing the economy. Unemployment would rise, and many homeowners could default on their mortgages. This is an ugly scenario for the economy and the housing market.

Source: RP Data

In other words, we are walking on a tightrope with respect to the housing market, and it's very hard to envision a scenario in 2011 that's good for house prices. And with personal debt at record levels, Australian households are very vulnerable to any economic turmoil. As the RBA's Ric Battelino warned in a speech in late 2007:

...the household sector is running a highly mismatched balance sheet, with assets consisting mainly of property and equities, and liabilities comprised by debt. This balance sheet structure is very effective in generating wealth during good economic times, but households need to recognise that it leaves them exposed to economic or financial shocks that cause asset values to fall and/or interest rates to rise. 

Meanwhile, there are troubling reports that foreign investors are growing cautious about holding the debt of Australian banks, which are reliant on offshore markets for nearly a third of their funds. Since Australian house prices continue to outpace growth in incomes, the only way they can rise further is for households to assume more and more debt. And until recently, overseas investors have been willing to indirectly fund much of this housing credit, having been sold the line that "Australia is different". But what happens when the music stops?

Put simply, despite The Australian's rosy headline, there is nothing good about rising house prices driven by massive increases in household debt. We are now in a very precarious situation, as Morgan Stanley's Gerard Minack said last August.

It was a major error by policy-makers to let this bubble inflate, in my view.  There is no value to society from rising house prices.  It is simply a wealth transfer to existing owners from potential buyers.  Pumping up house prices creates no more wealth than the RBA printing an extra six zeros on every piece of currency.  Worse, by increasing the leverage in the household sector and financial system, it increases the financial risks in the economy, as the last two years have demonstrated elsewhere.

You would think our political leaders would be urgently addressing these risks: the increasing debt levels of households, the chronic unaffordability of housing, and the dangerous reliance of our banks on overseas funding. Unfortunately, at present we have "two parties led by two political pygmies" -- as Laurie Oaks recently put it -- who continue to ignore the real issues facing our economy. And that puts us all at risk.