EY Australian Financial Conditions Index

Introducing the EY Australian Financial Conditions Index - a tool for business to assess the environment for investment

In brief:

• The EY Australian Financial Conditions Index illustrates the state of financial conditions in Australia for businesses that wish to assess the macro investment environment.
• This inaugural edition (December 2023) of the index will be updated and published quarterly.
• The EY Australian Financial Conditions Index shows less restrictive conditions in the December quarter than in the second half of 2022, even though interest rates were tightened through 2023, including in November.
• The index illustrates the importance of examining a broader range of variables than just the cash rate to fully understand conditions impacting Australian business.

Why care about financial conditions?

Financial conditions are an important contributor to economic growth – an indicator of the stage of the business cycle and what’s ahead.

Tight financial conditions mean it is difficult for businesses to access funding and liquidity is hard to come by, while expansionary conditions mean it is easy for businesses to access capital for growth.

There is no easy way to assess financial conditions in the market other than by considering a very wide range of variables, many of which are not accessible to non-financial market participants. The purpose of the financial conditions index is to amalgamate these variables into one easy-to-interpret index for EY clients.

Expansionary conditions (a negative index value) indicate that the financial system is currently supporting the economy. If conditions are restrictive (a positive index value), the financial system is constraining the economy, indicating financial downside risks are present.

We note that as financial systems become more and more complex, the nature of the risks we face in the future differs from those experienced in the past1. The index will help EY clients consume this information, even as it is changing unobservably, and guide them as they make strategic investment decisions.

Financial conditions are dictated by more than just interest rates

The first and most important data point in guiding financial conditions is the cash rate, which the Reserve Bank of Australia sets to steer the economy. However, there are many more variables that are also important.

We draw on a broad number of variables, including asset prices, interest rate spreads, credit and money growth, debt securities outstanding, financial market risk and surveyed measures of consumers’ views on their household finances. We focus mainly on Australian variables, but also include variables from the US to capture the strong influence this economy has on Australia’s economy.

Constructing the Index

In line with previous work undertaken by the Reserve Bank, we use principal component analysis (PCA)2 to construct the EY Australian Financial Conditions Index.

The aim is to transform a large set of financial variables into a single data series – the Financial Conditions Index – that contains as much information from the large data set as possible. This basically means trading a bit of accuracy – as some level of information will inevitably get lost – for simplicity.

See the Technical Appendix for more details on how the index has been created.

The EY Financial Conditions Index provides frequent and timely information for EY clients, given that there are few publicly available estimates of financial conditions in Australia, and none that are updated for public use on a regular basis.

A Reserve Bank research discussion paper published in 2021 (Hartigan and Wright 2021) sought to construct a Financial Conditions Index, but the Reserve Bank does not provide updates on this, with the public data only available up to Q3 2020. Queensland Treasury Corporation developed a financial conditions index for Australia in March 2023; however, this has not been updated since.3

We will update the EY Financial Conditions Index quarterly to help ensure the most recent financial movements are captured, unless rapid changes are occurring in financial conditions, in which case we will provide more frequent updates.

The key differences between the Reserve Bank’s Financial Conditions Index and the EY Australian Financial Conditions Index is our start date of 1995 (when the monthly data sets we use began). The Reserve Bank index can be calculated back to 1976.

Our indicator incorporates 26 data series, aiming to provide one representative variable from each group of highly correlated variables in each category, and to avoid repetition of similar information. The Reserve Bank drew on 75 data series to create their index (including data on the banking sector, financial system complexity and leverage measures which are not widely available).

The direction of the two indicators (expansionary/restrictive) is almost always the same for the period where both are available. The amplitude of the Reserve Bank index is higher, probably due to the fact that their indicator incorporates a broader range of financial variables and is therefore capturing more information.

Improved resilience within the financial system

The EY Australian Financial Conditions Index starts in 1995 during the ‘Great Moderation’, a period when the business cycle in many economies became less volatile.4 Our index shows that financial conditions were expansionary in 1995, with the cash rate sitting at 7.5 per cent. Although a 7.5 per cent cash rate does not appear to be expansionary by today’s standards, five years earlier it was 14 per cent.

The Global Financial Crisis (GFC) between 2007 and 2009 led to a substantial tightening in financial conditions. The spread between the cash rate and 3-year government bond yields rose to 2 per cent, and corporate bond yield spreads peaked; credit growth slowed; the stock price index fell; financial market volatility spiked; and banks’ long-term debt became more costly. Financial conditions tightened despite swift monetary easing. The cash rate was quickly cut to 3 per cent by the Reserve Bank – an all-time low at the time.

The US Federal Reserve went further and cut the federal funds rate to 0.0-0.25 per cent and engaged in Quantitative Easing.5 Australia’s monetary policy response was rightly milder than in the US (and the European Union) as the GFC coincided with the mining boom in Australia, which provided substantial support to the Australian economy, and Australian banks having relatively small exposures to the US housing market and banks.

Over the next decade, starting in 2012, financial conditions in Australia became less restrictive before COVID-19 caused further fluctuations.

With the start of the pandemic, financial conditions deteriorated sharply, driven by falls in asset prices, a jump in government debt and elevated levels of financial market risk.

Moreover, the functioning of government bond markets was impacted by the high level of uncertainty and new risks to the outlook. The Reserve Bank stepped in, announcing a government bond purchase program; a 3-year Australian Government bond yield target of around 0.25 per cent; a term funding facility for the banking system, particularly supporting small and medium-sized businesses; and a change to the conditions of exchange settlement balances at the Reserve Bank.

In response, the 3-year Australian Government bond yield to cash rate spread narrowed to near zero. Credit growth and money supply growth accelerated, due to the unprecedented monetary policy response.

During the pandemic, financial conditions never became as restrictive as during the GFC. This likely reflected improved resilience within the financial system and also the extreme and rapid response of both monetary and fiscal policy to the crisis.

At the start of the GFC, an initially small shock to the economy was amplified by the financial system, leading to significant economic loss. In contrast, during the pandemic, the initial large shock was not amplified, but rather cushioned by the financial system. Banks performed well through the pandemic, continuing to lend and support businesses and households, and in some circumstances deferring loan repayments for borrowers impacted by the pandemic.

Although COVID-19 was a shock external to the financial system, it could have exposed weaknesses in the system. Instead, the financial system helped support the economy when combined with a speedy policy response from governments.6

The monetary policy response combined with unprecedented fiscal policy support –including cashflow assistance for businesses and individuals, and policies such as JobKeeper and HomeBuilder – pushed financial conditions into an expansionary phase by October 2020. Consumers’ perception of their family finances recovered, and corporate bond yield spreads narrowed.

In February 2022, financial conditions became restrictive again as inflationary pressures started to build. Shortly after, the Reserve Bank started hiking the cash rate from the all-time low of 0.1 per cent.

Financial conditions remain restrictive

In the December quarter of 2023, the thirteenth rate hike of the cycle was delivered and financial conditions remained restrictive, although eased slightly from a peak in August 2022. Markets became comfortable that the Reserve Bank was likely close to or at the end of the current hiking cycle, along with other central banks around the world. There was also a moderation in financial market volatility and consumers’ perception of their household finances improved, although it remained poor.

Conditions are still restrictive though as total credit growth was stagnant, and the money base started to come down as the Reserve Bank’s Quantitative Easing slowly unwound.

The fact that the EY Australian Financial Conditions Index shows less restrictive conditions than in the second half of 2022, despite the Reserve Bank continuing to tighten policy, illustrates why examining a broader range of financial variables than the cash rate is necessary to garner the true extent of financial conditions. It also helps business to determine in which direction financial conditions have been trending and, therefore, whether access to finance may be getting easier or harder as market conditions change.

The Reserve Bank’s current rate hiking cycle looks to have come to an end. However, as the Governor has warned, interest rates could remain around current levels or even increase if both domestic and international inflationary pressures remain high or fluctuate in 2024.

Financial conditions are likely to remain restrictive, at least in the first half of 2024.

The EY Australian Financial Conditions Index will give a timely update on the business investment environment via its consolidation of numerous variables.