With these cities accounting for the bulk of Australia’s housing market it is unsurprising that a sustained price decline over the past year has generated some alarm.

However, a closer look reveals a market that likely needed a correction to ease growing risk from home-loan serviceability – and in which regulators set out to curtail credit growth in areas perceived as risky, in the full knowledge that doing so would likely put downward pressure on prices.

One remaining question is whether recent price action will continue to represent the hoped-for soft landing or accelerate into something more worrying. The answer is likely to rest on whether wider economic factors turn more substantively against the housing market.

Whatever the overall market direction, the analyst community appears relatively comfortable with the robustness of Australian lenders. Frank Mirenzi, vice president and senior credit officer at Moody’s Investors Service (Moody’s) in Sydney, points out that regulatory moves that have helped spark the house-price correction were implemented to ensure financial-system stability rather than directly to drive house prices.

“Restrictions on investment and interest-only lending have certainly played a part in slowing house-price growth, which is likely good from a macro financial-stability point of view. People who can no longer get credit from the banking sector can go to the nonbank sector, so credit is still available. The fact that house prices are still coming down therefore suggests people are making rational decisions about whether assets are fairly valued,” says Mirenzi.

The need for a soft landing is readily apparent. The years prior to the current downturn were characterised by a rapid escalation in credit growth and house prices as borrowers exploited historically low mortgage rates. As a consequence, household debt and house prices reached record highs (see chart 1).

Rising household debt was starting to be perceived as a systemic credit risk. Guy Debelle, deputy governor at the Reserve Bank of Australia (RBA), said in a speech in May 2018: “In past decades, the debt level declined quite rapidly relative to a household’s income when incomes were growing quickly. Household income growth has been subdued for a number of years, which means a number of households may be carrying a larger mortgage for longer than they expected when they took out the loan.”

Regulators’ goal thus became closing the gap between household debt and income. Sally Auld, Sydney-based chief economist at J.P. Morgan, says: “The ideal way for household income and debt levels to rebalance is for it to happen organically, through higher income growth. That has not occurred in Australia, so the adjustment had to happen through slower credit growth.”

The traditional way to suppress credit – raising the cash rate – has not been palatable due to sluggish inflation and wage growth. Credit tightening therefore fell into the regulatory rather than the monetary realm. The Australian Prudential Regulation Authority (APRA) took measures to rein in credit growth in the specific areas where risk was perceived to be building.

In 2014, APRA capped banks’ investor-lending growth at 10 per cent. In March 2017, the banking regulator placed a 30 per cent cap on interest-only lending as a proportion of new housing loans by authorised deposit-taking institutions (ADIs). Furthermore, ADIs were required to place internal limits on the volume of interest-only lending at loan-to-value ratios (LVRs) above 80 per cent. The cap on investor-loan growth was discontinued as of July 2018 but the other measures remain in place.

The regulatory drive has been a major cause of eased credit growth, as have higher capital charges applied to mortgages written by banks using the internal risk-based approach to risk weighting. This environment in the banking sector has created the opportunity for nonbank lenders to grab market share. Meanwhile, market participants agree it has also been a major cause of the house-price correction.

To get a clearer view of the housing outlook, it is necessary to understand the horizontal and vertical slices that make up the Australian market. Geographies and market segments are behaving differently through the cooling period, as they did through the expansion.

Furthermore, how regulation might conspire with factors such as the economic and political environment to have longer-lasting, and perhaps deeper, consequences is also up for debate. So too is how policymakers might react to more dramatic price softening, given the use of macroprudential policy rather than the traditional cash-rate lever to tighten conditions has left monetary policy with even less room to move.

House-price growth in the last five years was concentrated in Sydney and Melbourne. Dampened lending conditions have had the most affect in these cities, too. An encouraging sign for those hoping for a measured correction is the fact that the top echelon of the market has taken the biggest hit.

RBA data suggest three-month annualised credit growth in investor loans was just 0.4 per cent to August 2018. Owner-occupier credit growth was 6.8 per cent in the same period.

By contrast, an ANZ research note points out that the average size of first-homebuyer mortgages has actually continued to grow – which the bank’s analysts argue suggests these buyers are not facing tighter credit conditions. They conclude that there is a low likelihood of dramatic price reduction spreading across the full spectrum of the Australian market, in the near term at least.

Kitson says the larger middle tier of the market – which includes most owner-occupiers – still has sound fundamentals. In fact demand factors – such as land availability, and population and employment growth – are still outweighing supply.

Another positive sign is in the apartment sector, which had been fingered as the most likely to experience a full-scale crash given the so-called “apartment boom”. A plethora of construction in Sydney and Melbourne was seen as an inevitable precursor to oversupply.

“There was considerable angst around the high-density sector because there was a lot of supply and investor participation with interest-only loans. It is an area that appeared to be more vulnerable but, so far, the adjustment is not worrying. It does feel as though the supply-demand imbalance is continuing, though,” says Auld.

The best-case scenario would be macroprudential measures succeeding in cooling the riskier parts of the market while causing minimal collateral damage in other segments. So far, analysts generally seem to believe that this outcome might be possible.

The challenge for the market lies in the potential for price action to become contagious. Hassan says a correction initially concentrated in the premium end of the market filtered into other market segments in the second and third quarters of 2018.

Lawless adds: “Although values are still rising at the most affordable end of the market, the rate of growth has slowed substantially. If the current trend continues, it is likely to slide into negative annual growth over the coming months.”

The answers to the big questions likely lie in the direction of the Australian economy as a whole. Long-term strong headline GDP growth and an ongoing low unemployment rate are clearly positive factors. But they are countered by chronic wage stagnation and declining disposable incomes which, some analysts say, would put many Australian borrowers in a precarious loan serviceability position in the face of even modest rate rises.

Gareth Aird, Sydney-based senior economist at Commonwealth Bank of Australia, says: “The cash rate hit a floor in 2016 and has remained on hold ever since, so the upward effect of low rates on dwelling prices was always going to wane. The various pieces of regulation played a part but they came at a time when the market was likely to cool organically anyway.”

While a higher RBA cash rate seems as distant a prospect as ever in late 2018, tougher conditions in credit markets – and an elevated Australian base rate – have started to put upward pressure on mortgage rates. Mirenzi says there could be an impact at the margin, for instance on the amount of debt new borrowers are willing to take on.

What’s more, some observers believe the Australian household’s long love affair with real estate may be easing – albeit at the margin and perhaps only on a temporary basis. Hassan says: “A growing number of consumers is nominating to pay down debt with savings rather than invest in real estate. This tells us that consumers do not consider it to be a good time to buy.”

This speaks to an environment of low wage growth and consequent depressed household confidence. Ilya Serov, Sydney-based associate managing director at Moody’s, says nominal GDP has actually gone backwards on a per-capita basis, further denting households’ borrowing comfort.

The risk is of a negative feedback loop developing, in which low confidence and flat wages suppress housing demand, which reduces the wealth effect and thus further pushes down on household confidence. There is little doubt that the wealth effect is now in reverse in Sydney and Melbourne. Serov adds: “How this plays out will come down to how gradual the correction is. At the moment, it looks like there will be some negative affect but it is unlikely to be sharp.”

Another question here is whether households are just being cautious or actually experiencing stress right now. Mortgage prepayment rates have fallen, which suggests there is at least some stress. However, some analysts point out that prepayment has come down from a high level on a global basis.

Kitson says prepayment rates are often a leading indicator of the general trend in arrears. “Slower prepayment rates can be an indicator that refinancing is slowing, which is one of the ways by which borrowers can manage their way out of mortgage stress.”

Like the overall housing market, though, a single prepayment rate can be too crude a measure to provide really useful data. Serov says: “From a credit perspective, average prepayment rate does not tell us much because it is not the average borrower who is at risk of default. According to the RBA, 30 per cent of borrowers have not prepaid at all. These are the ones at risk.”

If anything, these pressure points provide an even greater reason for curtailing risky lending practises. Kitson says: “When there is sluggish wage growth and high household indebtedness, the prudence of debt-serviceability assessments to ensure borrowers can absorb interest-rate increases become very important.”

The key consideration raised by market participants is that while regulators and the central bank cannot radically change economic fundamentals they can help promote a system that will be resilient to cyclical shifts. The consensus of Australian housing-market analysts is that the base case is a continued moderate house-price decline rather than an acceleration.

The macroprudential regulations likely provided the initial trigger for house-price decline by slowing credit growth, while economic fundamentals played into the shift in direction. But there are also factors providing a parachute for the market.

“We can’t lose sight of the fact that Australia has good growth, falling unemployment and strong population growth fuelling underlying demand. We don’t see interest rates rising materially so it is unlikely that we will see a hard landing in the housing market,” Aird tells KangaNews.

Like most developed economies, Australia used a lot of policy bullets in the wake of the financial crisis. While it never had to institute full-blown QE, the combination of declining credit growth and house prices while the cash rate is at a historically low level does not leave much wiggle room for monetary policy in the event of a greater economic downturn.

Auld says: “This is an unusual scenario for the RBA to be in. It may pose some policy challenges in future if a downside risk causes a steeper decline in house prices, which could affect confidence, consumption and the broader economy.”

It will be hard for the RBA to build a monetary-policy arsenal in the medium term. Despite steady growth, robust employment and an inflation rate that is slowly creeping into the RBA’s target band, a rate hike seems unlikely while house prices are declining. Lenders have also increased mortgage rates in response to elevated base rates, which will likely further stay the RBA’s hand.

“If you raise the cash rate it flows throughout the financial system. This is why macroprudential regulatory measures were targeted at specific areas where risks were building in the system,” says Hassan.

Market watchers highlight looming political risks as ones to watch when it comes to predicting potential downside surprises. The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry released its interim report in October 2018. While recommendations were vague, the commission uncovered sufficient evidence of poor conduct on the part of banks to make many believe further constraints on bank lending may be inevitable.

Meanwhile, a federal election is also on the horizon in Australia and Hassan says property-related tax policy is shaping as a battleground – especially in the form of the opposition Labor Party’s promise to reassess tax incentives for residential property investment. This adds further uncertainty to the market, especially as opinion polls have long favoured Labor to win.

The inward migration that has helped prop up property demand is also a growing political issue, as headlines and commentary around overcrowding and poor infrastructure in Sydney and Melbourne are feeding a political echo chamber.

Foreign investment into the Australian property market, which was a large contributor to demand in recent years, has already waned, with major drivers being state-government stamp duties implemented in New South Wales and Victoria and Chinese restrictions on residents deploying capital offshore.

Meanwhile, Serov identifies the conversion of interest-only loans to principal-and-interest format over the next two years as a potential risk. “We are monitoring this carefully, as delinquencies for people who have converted are twice those for borrowers that have not.”

Where the chips land is still unclear, but most forecasts project another 12 months or so of moderate house-price decline. Auld says: “There have been periods in the last decade where house-price growth has slowed but they have always been followed by a quick pickup. This likely won’t be the case this time as it is not what regulators want to happen.”

For now, it appears the desired soft landing of the Australian property market is being achieved and well managed. There are several pressure points for the property market and some question marks about political and economic fundamentals. But the underlying drivers of demand and the fact that credit has not been constrained across the whole system – including growth in the nonbank share of the market – provide a baseline for prices in most segments.

“There will always be doomsday predictions about the housing market, but the reality is there would have to be a fundamental change in the economy, such as recession, before we see prices come off sharply. We assign a low probability to this over the foreseeable future,” Aird tells KangaNews.

Hassan adds: “APRA and the RBA are trying to enact a tightening in lending standards and conditions while the consumer and the economy generally are in good shape. It is better that the adjustment happens now rather than at a time when interest rates may be higher and the economy shaping into a downturn.”