The International Monetary Fund has cautioned that the recent surge in Australian property prices and rising investor expectations could cause values to “overshoot”.

While the IMF does not point to a a property bubble in the hot markets of Sydney, Melbourne and Brisbane, it is urging regulators to scrutinise property investment to ensure banks maintain strict lending standards.

“Attention should be paid to the risk – as in any situation where asset price inflation accelerates – that a prolonged period of rapid price growth could give rise to expectations-driven, self-reinforcing demand dynamics and price overshooting,” the IMF said in a statement.

“A sudden house price decline, were it to occur – possibly triggered by a shock to household incomes and borrowing costs – could reduce consumer confidence and impact overall economic activity.

“The authorities would need to be prepared to take preventative actions if household credit growth, transactions volume, and prices accelerate.”

Australia ‘performing favourably’

The advice comes in the IMF’s latest report card on the Australian economy, which says it has “performed favourably” compared with other advanced economies.

However, the IMF says the Reserve Bank is well equipped to manage any potential price bubble, as it did in the early 2002 when the cash rate increased from 4.5 per cent to cool property speculation.

The IMF also believes Australian households are also better prepared having “built up large mortgage buffers” because of lower interest rates and consumer caution.

The IMF’s deputy managing director Min Zhu, who is visiting Australia, told AM that while there is no sign of a housing bubble, regulators need to ensure strict lending standards are maintained.

“The real risk is a financial risk,” Dr Zhu said.

“You have to see the qualifications of borrowers, you want to see the quality of the mortgage loan. I think this is the most important things. We need to carefully manage it.

“Particularly if expectation driven investments, you got to be very careful. So once again, the financial sector play a very important role to make sure the quality for long, to make sure the lending standards is there.”

Dr Zhu repeated warning from regulators, including the RBA governor Glenn Stevens, that investors should not expect instant capital gains from property.

“No, you don’t want to jump into the market and expect to see a huge return. It will never happen,” he said.

Banks facing risks from offshore lending

The IMF has also endorsed the strength and stability of Australia’s “big four” banks, but warned that “vulnerabilities remain”.

“The four major banks are systemic with broadly similar business models and their reliance on wholesale offshore funding, although falling, still represents a risk,” the statement says.

The IMF says that while stress tests show Australian banks “could withstand a number of sizeable shocks”, the effects would “make major inroads into their capital buffers.”

The IMF says that in the event of an shock – similar to a Lehman Brothers collapse – banks would possibly require intervention from the Reserve Bank.

“Banks would also likely require RBA help to withstand an extreme funding shock,” the IMF says.

“Banking sector vulnerabilities should be assessed on an ongoing basis to manage the risk that systemically important banks pose to the economy.”

Dr Zhu says while the reliance on offshore funding by banks is declining, it still poses a risk but one that can be managed.

“The whole banking sector still relies on the offshore funding. The one thing is that Australian banks have a good reputation and good quality ratings so they will be able to maintain a sustainable funding flow.”