The outlook for the global economy has improved following the peak in inflation, but global financial stability risks remain elevated.

Financial market participants have been increasingly optimistic about the prospects for a soft landing in the global economy. A substantial easing cycle in monetary policy is expected over the next two years or so, with inflation returning to central banks’ targets and unemployment rising only modestly. Although pressures from high inflation and tight monetary policy continue to weigh on many households and businesses, a number of developments – including the resolution of supply chain disruptions, declines in energy prices, continued strength in labour markets, strong household balance sheets and solid corporate earnings – have contributed to the global economy’s resilience to date. The capital position of large international banks leaves them well placed to weather a decline in asset quality and/or worsening macroeconomic conditions. However, several economies, including the United States, have a sizeable tail of smaller banks, some of which are more vulnerable due to asset quality and profitability concerns.

Although risks to the outlook for the global economy have become more balanced as inflation has eased, risks to global financial stability remain. These risks have the potential to spill over to the Australian financial system, via their impact on the local economy through trade channels and/or an increase in risk aversion that results in tighter global financial conditions. This would add to the financial pressures experienced by domestic borrowers and, to the extent this puts significant strain on financial institutions’ balance sheets, limit access to credit in the Australian economy.

Among the global risks, several stand out as having the potential to adversely affect financial stability in Australia:

  • Further weakness in the Chinese property sector could interact with longstanding macro-financial vulnerabilities there. If stresses in the Chinese economy and financial system intensified or broadened, they could spill over to the rest of the world (including Australia) through trade channels and an increase in global risk aversion.
  • Conditions in global commercial real estate (CRE) markets could deteriorate further. High interest rates and ongoing weak demand, particularly for older or lower quality offices, continue to put pressure on borrowers. While the direct risks are largest in those international banking systems highly exposed to CRE lending, conditions in Australian CRE markets could be affected by the repatriation of foreign investment, following a decade or so where foreign investment in Australian CRE increased notably.
  • Worse-than-expected macroeconomic outcomes, coupled with fragilities in market functioning, could result in a disorderly adjustment in financial asset prices. Market participants’ expectations for a soft landing in the global economy, as seen in low risk premia and volatility, could leave financial markets vulnerable to an adverse shock. Possible triggers for an abrupt repricing in market risk premia include global inflation proving more persistent than expected or a severe adverse geopolitical event. Disruptions to the functioning of global financial markets could be amplified by shortcomings in the management of leverage and liquidity mismatches, including by non-bank financial intermediaries (NBFIs) in key financial centres as seen on several occasions in recent years.
  • Threats originating outside the global and domestic financial system continue to build. These include cyber-attacks, risks associated with climate change and geopolitical tensions.

Most Australian households and businesses remain able to service their debt and meet essential expenses.

Conditions will remain challenging for many households and businesses in Australia this year. This is especially true for lower income households, including many renters, and the indebted households already facing acute budget pressures. Under the economic outlook presented in the February Statement on Monetary Policy, these pressures are expected to gradually ease over the next few years as inflation declines and real incomes rise.

However, most households have continued to service their debt. Strong conditions in the labour market, the large savings buffers accumulated by many borrowers during the pandemic and rising housing prices are helping households to adapt to challenging economic conditions. Many households have made adjustments, including reducing their discretionary spending and saving, increasing their hours of work, and some have drawn down on saving buffers.

The strong financial starting position of many businesses should help to limit risks to financial stability. While the profit margins of many businesses are around pre-pandemic levels, some businesses are likely to remain under financial pressure over the coming period as sales growth remains subdued; in addition, strong growth in the costs of labour and other inputs is expected to moderate only gradually. This is particularly true of discretionary sectors, as many households have pulled back on non-essential consumption, and conditions remain challenging in parts of the construction sector. Yet, the overall level of profitability and strong balance sheets among businesses reduce the risk of widespread financial stress, and arrears on bank loans to businesses are low.

Conditions remain challenging in domestic CRE (in particular, office) markets, though there is little evidence to date of financial stress among owners of Australian CRE. Prices continue to ease and transaction volumes remain subdued, though there have been few signs of distressed sales. One key risk to conditions in the domestic CRE market stems from the possible withdrawal of foreign lenders and investors owing to a further deterioration in international CRE markets. Some domestic NBFIs also have material exposures to CRE, though some (including superannuation funds and unit trusts) use little or no leverage and most have measures in place to manage the effects of investor redemptions. The limited size and more conservative nature of bank lending to CRE in Australia than in the past means the systemic risks to the banking system are lower than in previous downturns in CRE markets.

Overall, the risks to the financial system from lending to households and businesses remain contained based on the current economic outlook. While banks expect loan arrears to pick up further, most Australian households and businesses appear positioned to manage the pressure on their finances from inflation and interest rates. However, the expected easing in labour market conditions and subdued growth in activity are likely to present further challenges for some households and businesses this year. These challenges would intensify if economic conditions were to deteriorate by more than expected or if inflation is more persistent than forecast in the February Statement.

The Australian financial system has a high level of resilience and is well positioned to continue to support the economy.

Australian banks are well prepared to handle an expected increase in loan losses in the period ahead. This expected increase in loan losses would be coming from a very low base. Banks’ overall capital levels are high, profits are healthy and the very low percentage of borrowers in negative equity on their loans further protects banks against credit losses. The recent stress test conducted by the Australian Prudential Regulation Authority concluded that large banks could continue to make credit available to borrowers even in a severe (but plausible) economic downturn. Banks also have strong liquidity positions, which should assist them if there were to be temporary funding market disruptions.

Risks to financial stability posed by Australian NBFIs are relatively contained. Around half of the Australian NBFI sector is comprised of prudentially regulated superannuation funds, which have low leverage and the ability to pass on investment risks to their members (in contrast to the greater risk profile of NBFIs in global financial centres). While the overall risks in the Australian NBFI sector appear to be contained, data gaps (including in relation to CRE activities) prevent the identification of potential vulnerabilities in less-regulated NBFIs. As a result, member agencies of the Council of Financial Regulators continue to pursue work aimed at strengthening the visibility and monitoring of NBFIs’ activities in Australia.

Strengthening institutions’ operational resilience to threats emanating from outside the financial system remains a regulatory priority.

Financial institutions’ operational resilience is critical to the overall resilience of the Australian financial system. The adoption of new technologies, including artificial intelligence and cloud infrastructures, brings many benefits but also risks, particularly in an environment of escalating cyber threats, geopolitical risks and increasing use of third-party providers. Strong governance and operational risk management practices by financial institutions are critical to maintaining operational resilience in a high-threat environment. This will continue to be a key area of focus for financial regulators in Australia.

Source – In Brief: Financial Stability Review – March 2024 | RBA