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Australia's bubbly conundrum

By Samantha Grenville and John Watling

Australia's reputation for being a lucky country has certainly been polished to a high gloss over the past few years. Its buoyant economy contrasts mightily with the gloom and doom dominating the headlines in Europe and the U.S. But the country is abuzz with concerns about housing and whether or not the country is about to face the consequences of a busted bubble. The argument is vociferous but evenly matched, with partisans on both sides variously claiming imminent disaster or fevered imaginations. One thing seems certain though: the politicians are unlikely to intervene, even though in most such cases they would be falling over themselves to soothe the population's jagged nerves.

The arguments in favor of a bubble depend in large part on the meteoric rise in housing prices over the past decade and a half (by some estimates they were up about 150 percent between 2004 and the recent peak in 2010). Much of this increase was driven by higher household debt, which had many economists clucking in concern. Demand for housing has also been propped up by the soaring economy. China's gigantic appetite for the country's minerals and other primary resources has spurred strong growth in Australia's mining and allied sectors (including reports of unskilled mine workers earning six-figure salaries and attendant health and social issues), boosting the currency in the process. Other parts of the economy, such as tourism and domestic manufacturing have not been so lucky and are suffering because of the Australian dollar's surge. The recognition of the two-speed economy combined with elevated housing prices have spurred considerable popular fear among Australians that the country is on the brink.

Doomsday forecasters argue that the bursting of the housing bubble will cause the economy to implode, with the banks acting as the transmission mechanism. Collapsing home prices would destroy bank balance sheets, forcing the banks to raise capital in volatile markets, or to deleverage and withdraw credit from the real economy. That move would further depress home and other asset prices in a negative feedback loop.

So then why does Australia's government seem unwilling to intervene? Prime Minister Julia Gillard and Treasurer Wayne Swan have quietly deflected questions about housing with gentle bromides and urgings to the private sector to talk up the economy. They have likely made the wise decision, politically at least.

First, there may not be a housing bubble. Policymakers at Australia's Reserve Bank certainly seem to believe there is no danger. Reserve Bank assistant governor Guy Debelle speaking at a recent mortgage industry conference claimed he was more worried about the EU and that housing risk is not something that keeps him awake at night. Home prices have been declining steadily over the past year or so, and if that continues, household debt ratios may drop even further, freeing up the central bank to ease rates. In the meantime however, the Reserve Bank is clearly concerned that lowering rates would boost the wrong sort of confidence, encouraging still relatively indebted households to continue borrowing.

Second, there may be no need to act even if there were a dramatic decline in housing prices. Australian banks are considerably stronger than they were before the 2008/09 crisis. The IMF recently stress-tested the major banks by hypothetically invoking an Ireland-style housing bubble and bust, and found that banks would be buffeted but remain solvent. In perhaps the strongest vote of confidence in the local economy, Germany's Bundesbank -- arguably one of the world's most conservative central banks-is considering buying Australian dollars, signaling the country's emergence as a true safe haven.

Gillard may also be disinclined to tackle the issue lest it add to her burdens. Authorities are already facing a tough battle over the incoming carbon tax, which opposition Liberal Party leader Tony Abbot has used as a cudgel against the incumbent Labor Party government. Any misstep on housing would have the unfortunate side effect of giving Abbot another target.

All of these considerations argue in favor of a gentle hand on the tiller and against dramatic action until it may be absolutely necessary.

Samantha Grenville is an associate with Eurasia Group's Comparative Analytics practice, John Watling is a senior editor with Eurasia Group.

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