OECD warns Australia on house prices, banking collapse

A severe collapse in house prices is the biggest threat to the Australian economy, the OECD has warned.

The OECD says the long period of low interest rates is leading to distortions in the economy.

A severe collapse in house prices is the biggest threat to the Australian economy and regulators should be drafting contingency plans now in case of “a crisis situation in one or more ­financial ­institutions”, the OECD has warned.

It says Australia’s 27-year run without recession is likely to continue, but the Reserve Bank should start raising interest rates as soon as possible to brace against economic shocks.

“Australia has demonstrated a remarkable capacity to sustain steady increases in material living standards and absorb economic shocks,” the OECD says in a comprehensive review of the Australian economy.

However, the Paris-based ­institution says the long period of very low interest rates is leading to distortions in the economy and there is a “risk of imbalances ­accumulating further if the low interest-rate environment persists”.

The OECD consulted with Treasury and the Reserve Bank while compiling its review and it says they believe they are “well equipped to handle shocks”. However, the OECD believes more needs to be done.

“The authorities should prepare contingency plans for a ­severe collapse in the housing market. These should include the possibility of a crisis situation in one or more financial institutions,” it says.

The OECD notes that “stress tests” by the banking regulator, the Australian Prudential Regulation Authority, show that banks would survive a downturn in the housing market without breaching minimum capital requirements, but too much comfort should not be drawn from this.

“The possibility of financial ­institution crisis should not be discounted entirely,” it says.

Josh Frydenberg seized on the warning to attack Labor’s negative gearing policy, which would limit the practice to new housing — while not affecting those with existing investments — while also halving the capital gains discount. “The OECD notes house ­prices have gradually cooled, ­stating ‘the current trajectory would suggest a soft landing’, but warns, ‘a large drop in house ­prices could cut household consumption, prompt collapse in the construction sector, increase mortgage defaults and freeze back lending to businesses’,” the Treasurer said.

“Labor’s housing tax policies will do just this. They will damage Australia’s housing market and destroy the equity that people hold in their homes, increasing the risk of financial instability and lower economic growth.”

The OECD’s central economic forecasts are slightly more subdued than those of the ­Reserve Bank and Treasury, predicting the recent fall in unemployment to 5 per cent will not be sustained, with the jobless rate ­averaging 5.3 per cent next year, while economic growth will slow to 2.9 per cent.

It says the 27 years of positive economic growth have brought rising living standards. “In the ­absence of a downturn, a gradual tightening should start as inflation edges up,’’ it says.

Although the OECD’s “early warning” indicators are flagging no signs of a downturn, it comments that “Australia faces economic challenges that, if not handled well, could see an end to its strong track record”.

“Financial supervisors and bank regulators should be prepared in the event of a hard landing in the housing market,” it says.

The OECD says the cooling of the housing market is welcome.

It says houses are not excessively overvalued, and the fall in house prices has so far been “modest”. However, it says its ­research into housing cycles shows that “soft landings” from housing downturns are rare.

The OECD notes that unlike the US and the EU, Australia does not have legislation that would automatically turn unsecured senior bonds and interbank deposits into equity in the event of a crisis.

“The absence of explicit bail-in provisions could slow down the speed of resolution and risk ­encouraging financial institutions to gamble for resuscitation,” it warns.

The report says that even if a financial crisis were averted, a downturn in the housing market could bring wider problems in the economy. “A likely route is via weakening household consumption ­demand and construction ­activity,” it says.

“Household consumption could be dented by negative wealth effects, precautionary ­saving responses and reduced ­expenditures related to the purchase and sale of housing, such as spending on renovation and interior decoration.”

This could lead to losses in business, putting stresses on ­financial institutions, and bring a slowdown in demand across the economy. The OECD echoes the comments of Reserve Bank deputy governor Guy Debelle that Australia has the scope to ­intervene in the event of a crisis.

“Room for monetary and fiscal support in the event of a shock, though smaller than might ­ideally be the case, is larger than in many other OECD economies,” it says.

“The speed and strength of the rebalancing processes in response to the global financial crisis and the end of the commodity boom indicate the economy has good capacity for absorbing shocks.”

The OECD says that while economic growth continues, the government should press ahead with efforts to return the budget to surplus.

It says discipline on spending should not be relaxed just because revenue is showing stronger growth, noting that “an upswing in revenues can prompt increased pressures to expand public spending”.

It says that if the government stuck to plans for surpluses of 1 per cent of GDP from 2022 onwards, it would bring a rapid ­reduction in the debt, which would be back to pre-financial crisis levels by 2029-30.

However, the OECD report says that once the budget is back in surplus, there should be a ­review of fiscal strategy. It says there is a trade-off ­between building a buffer against adversity and lowering tax burdens or targeted increases in spending.