The Reserve Bank of Australia (RBA) has released its latest assessment of financial stability risks, acknowledging mounting uncertainty in the global economy and the threat to Australia.
The central bank referenced periods of instability throughout 2023, underpinned by high inflation and aggressive monetary policy tightening.
This has included banking stress in the United States and Switzerland back in March, which led to the collapse of three US banks and Swiss-based Credit Suisse.
Looking ahead, the Reserve Bank said three main headwinds could re-aggravate tensions – ongoing weakness in the Chinese real estate market; a credit crunch and persistently high inflation; and a sharp deterioration in labour market conditions.
Chinese property market
The Reserve Bank said it fears property sector stress and broader structural issues in the Chinese economy could worsen and “reverberate globally”.
“The property sector is a key part of the Chinese economy and could negatively interact with long-running macro-financial imbalances in China through interlinkages with local government financing, shadow banking activities, and banks,” the RBA stated.
Observers had expected a “V-shaped” recovery in China after Beijing eased COVID-19 restrictions, however, this has not materialised.
According to the latest figures, the Chinese economy grew 0.8 per cent in the second quarter of 2023, below market expectations, and is unlikely to grow by up to 6 per cent over the course of the year, as initially anticipated by some economists.
Credit crunch and sticky inflation
The Reserve Bank has noted concern over a protracted battle against inflation, resulting in further “substantial tightening in global financial conditions and disorderly repricing in financial asset markets”.
The RBA said this could lead to “significant deterioration” in credit quality, exposing vulnerabilities among financial institutions, particularly non-bank financial institutions (NBFIs), and resulting in a subsequent credit crackdown.
“There could also be declines in asset prices that are sufficiently disorderly to disrupt financial system functioning,” the RBA said.
“Vulnerabilities in NBFIs in key global financial markets, including shortcomings in the risk management of leverage and liquidity mismatches, could significantly amplify these abrupt adjustments in financial markets.”
The RBA also flagged risks of a sharper-than-anticipated deterioration in labour market conditions as aggregate economic demand softens.
“While most banks are well placed to withstand a sharp economic slowdown, higher-than-anticipated loan losses resulting from rising unemployment could lead to a tightening in lending standards, amplifying the downturn,” the central bank noted.
The RBA made specific reference to vulnerabilities in the commercial real estate (CRE) market, with slowing economic conditions threatening to add to structural headwinds in the retail and office space.
“In some jurisdictions, weak conditions in commercial real estate (CRE) markets are likely to exacerbate banks’ losses and impair credit provision,” the RBA added.
“This is especially true for smaller US banks whose exposure to CRE loans is particularly large (around one-quarter of assets).”
These triple-pronged risks could filter through to the Australian economy via a spike in domestic fundings costs, diminished access to credit, and weaker trade flows.
“The nature of the underlying shock to global growth would determine the speed and magnitude of adjustment in Australia (which could play out unevenly for different sectors of the economy), though overall, it is likely that nominal incomes would be lower and unemployment higher,” the RBA warned.
“This would challenge the debt-servicing capacity of the more vulnerable borrowers among Australian households and businesses.”
But ultimately, the RBA believes Australian households and businesses “remain well placed” to absorb shocks.
“A strong labour market and sizeable savings buffers have played a key role in Australian households’ ability to adapt to a difficult economic environment,” the RBA noted.
“Most borrowers have been able to make adjustments to their finances as required, including by restraining their discretionary consumption, reducing their savings rates, or even drawing down their stock of savings, and increasing hours worked.
“Incidences of severe financial stress are expected to increase but remain limited to a small share of housing borrowers.”
More broadly, the RBA touted the strength of the local financial system, supported by regulatory oversight and a strong prudential framework.
“Overall, Australian banks are in a strong position to raise provisions and absorb loan losses if economic conditions worsen more than expected,” the RBA observed.
“The very low share of borrowers in negative equity on their loans further protects banks against credit losses. Banks’ funding sources are relatively stable, with a large share of domestic deposits, which are less susceptible to flight risk.
“This would leave them well placed if there were to be disruptions to international funding market conditions.”
The RBA concluded by stressing the importance of investment in operational and financial resilience to threats “outside the financial system”.
This includes cyber-related incidents, a potential escalation in geopolitical tensions resulting in severe disruptions to trade and international capital flows, and climate change impacts.
“These risks may also interact, adding to the uncertainty around how they might transmit through the financial system,” the central bank observed.
“In response to this escalating threat environment, Australia’s regulatory agencies have increased the intensity of their supervision of operational resilience among key financial institutions.
“It is important that Australian financial institutions continue to invest the time and resources required to enhance their operational defence and recovery plans in light of the heightened risk environment.”