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Household indebtedness a key theme

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22 Jan 2013

Expect the topic of household sector indebtedness to be a key theme in 2013.

While links between indebtedness and social unrest may be tough to prove, there is little doubt that over-indebtedness can do a lot of harm to households, and should be kept in check.

Over the years, perhaps fuelled by the consumer boom of last decade, we have seen a seemingly increasing obsession among many households over consumption and credit.

This seems to be a common phenomenon in societies where things have gone well for long periods of time, and it can be argued that middle and upper income South Africa has “had it good” for a very long time, with no major wars, recessions or depressions (the 2008/9 recession being relatively short-lived when one compares it to for instance the early-1990s recession of over two years).

But even the relatively recent 2008/9 3-quarter long recession, and the interest rate peak of 15.5 percent prime rate in 2008, is fading in the memory of many.

A long period of “abnormally low” interest rates by South Africa’s standards has led to a major improvement in household debt repayment performance, and this can be seen in large declines in numbers such as total insolvencies.

Home loans bankers, for one, sleep a lot easier at night these days with non-performing loans well down from the highs of 2008/9.

And in the area of non-mortgage household sector credit, the growth in borrowing has steadily accelerated since early-2010 in response to renewed happier economic and interest rate times.

But “all is not well”. If low interest rates lead to improved repayment performance this does not mean that the underlying household financial frailties no longer exist.

Increasingly, certain commentators are expressing alarm at the huge growth rates in certain categories of household credit.

Total household sector credit growth moved to above 10 percent as at November, the first month of double-digit year-on-year  (y/y) growth since late-2008.

The reasoning behind lower real interest rates pointing to greater household vulnerability is that certain households that borrow during low interest rate times tend to be more vulnerable, due often to a lack of forward thinking and planning for the inevitable interest rate hiking cycles.

But the discussion broadened late last year. Whereas the debate had typically focused on what the level of bad debt could become should household indebtedness get too high, allegations emerged that high levels of indebtedness may be linked in part to social unrest.

While links between indebtedness and social unrest may be tough to prove, there is little doubt that over-indebtedness can do a lot of harm to households, and should be kept in check.

Certain studies in the UK have even started to draw a link between levels of indebtedness and mental illnesses such as stress and depression.

How at risk is SA’s household sector? Relative to what is the question, I guess.

At least by our own historic standards, though, I would say that the answer is “very high”, given that the household sector debt-to-disposable income ratio is at 76 percent, not far lower than the 2008 historic high of 82.7 percent, which caused much pain when interest rates hit their peak in that year.

Furthermore, 2012 saw some renewed rise in the debt-to-disposable income ratio, after a few prior years of mild decline, and further household credit growth acceleration in the fourth quarter makes it likely that further increase took place in the debt-to-disposable income ratio as 2013 approached.

Our Household Debt Service Risk Index, rose for the fifth consecutive quarter in the Q3 2012, to a level of 6.68 (scale of 1 to 10), a very high level compared to the long run average of 5.3.

This, therefore, suggests that SA’s household sector is still at a relatively high level of vulnerability by our own historic standards.

Driving the Index higher was a higher debt-to-disposable income ratio of 76 percent in the second and third quarter, up from late-2011, while abnormally low interest rate levels have also helped to sustain high risk levels (very low real interest rates being viewed as a greater risk than high ones, the reasoning being that rate hiking risk is higher at the lower real levels, as well as because households tend more towards “over-borrowing” the lower the interest rates are).

The high level of household vulnerability has introduced a key policy dilemma.

Vulnerability of borrowers who qualify for loans at the peak of the interest rate cycle should thus on average be less than many of those who can only qualify at the low points in the cycle.

Arguably the most effective way to curb overall household borrowing growth is to hike interest rates.

However, given the high level of household indebtedness, the initial effect of rising interest rates is to exert severe pressure on many of those households with high levels of debt, not an attractive policy option in a time when the economy is battling and unemployment is a real problem.

A key challenge is to find a way to reduce the household sector’s propensity to borrow, and increase its desire to save, preferably without having to have painfully high interest rates such as those experienced at certain times in the 1990s.

Households tend to make poorer borrowing decisions, on average, when money is cheap, and far better ones when interest rates are relatively high.

That’s a common human weakness, and hence an additional part of the logic of viewing low interest rate periods as higher risk ones, especially when rates are “abnormally low” by a country’s standards, as is currently the case.

In recent years, interest rates have moved to abnormally low levels by SA’s historic standards, given that “structural consumer inflation appears to be somewhere near to 6 percent.

This decline is due to an abnormal global and domestic economic situation requiring significant monetary policy support.

The reasoning behind lower real interest rates pointing to greater household vulnerability is that certain households that borrow during low interest rate times tend to be more vulnerable, due often to a lack of forward thinking and planning for the inevitable interest rate hiking cycles.

Vulnerability of borrowers who qualify for loans at the peak of the interest rate cycle should thus on average be less than many of those who can only qualify at the low points in the cycle.

This may seem a strange statement to make, as payment performance on debt by the household sector has improved significantly in recent years, and this is seen in publicly available numbers such as insolvencies, which have fallen dramatically.

Home loans bankers, for one, sleep a lot easier at night these days with non-performing loans well down from the highs of 2008/9.

However, for this improved credit performance, the household sector has been relying heavily on the Reserve Bank (SARB) to maintain interest rate levels that are very low by SA’s standards, instead of building more significant financial buffers.

With a rising debt-to-disposable income ratio, the debt-service ratio will also start to move higher should interest rates not decline further.

Indeed, it has been the SARB’s huge reduction in interest rates from 15.5 percent prime as at late-2008 to the third quarter’s 8.5 percent in 2012 that has been the major contributor to bringing down the all-important debt service ratio (cost of servicing the household debt, interest + capital, expressed as a percentage of household sector disposable income) from a painful all time high of 16.3 percent to a far more comfortable level of 11.4 percent.

This, in turn, significantly improved household credit performance.

The “low risk” way of reducing the debt-service ratio, and the more desirable way, would be through lowering the debt-to-disposable income ratio of the household sector.

Some mild decline of this ratio did contribute to the lower debt-service ratio up until the end of 2011, but the resumption of a rise in the debt-to-disposable income ratio in 2012 required a further half-of-a-percentage-point interest rate cut by the SARB in the third quarter to prevent the debt-service ratio from rising.

Should interest rates not decline further, and currently accelerating household sector credit growth does push the debt-to-disposable income and debt-service ratios higher, this recent level of debt-service ratio could represent the bottom turning point of the current cycle.

Should this be the case, it would be the highest bottom turning point in recorded history.

Given that the debt service ratio is a fairly good predictor of household credit performance that is a cause for concern.

Looking at it another way, I am of the admittedly subjective opinion that a 13 percent debt-service ratio represents an acceptable maximum at the peak of the cycle.

When this ratio rises higher than 13 percent that would appear to be where matters become unacceptably painful for the household sector as well as lending institutions.

That was the case around 2007/08 as well as in the late-1990s.

The risk is, therefore, that the next interest rate hiking cycle could be of a bigger than normal magnitude as opposed to expectations from some quarters of it being more mild than normal. –John Loos

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