Should household debt be a worry?

Westpac had a note out the other day under the heading “Household debt levels now higher than before the financial crisis”.  Using December data for household and consumer debt (including debt used to finance residential rental businesses) and comparing it with household disposable income, they calculated that household debt was 162 per cent of income, compared to 159 per cent at the previous peak in September 2009.

Using slightly different numerators or denominators alters the picture only a little. Debt to income ratios fell back during and after the 08/09 recession, and have been increasing quite a bit in the last couple of years.  Credit growth has picked up and income growth has slowed.  I prefer to focus on debt to GDP measures, and here is my version of the chart.

household debt to gdp

The ratios haven’t yet reached the previous peaks, but aren’t that far away, and may well go past the previous peak this year.  One gets much the same picture looking at broader credit aggregates relative to GDP.

One could look at these trends in a variety of ways. I’d tend to emphasise the fact that over the last 7.5 years there has been no growth at all in the ratio of household debt to GDP, whereas over the previous 15 years that ratio had increased by around 60 percentage points.   Westpac seems much more worried than that.

But there are a couple of important things we know (or know we don’t know):

  • that we have no idea what any sort of “equilibrium” ratio of household debt to income is.
  • that when household debt levels were first at these sorts of levels, around the time of the 08/09 recession, it didn’t lead to any serious stresses on the financial system –  we had a pretty serious recession, mostly reflecting global developments, and yet there was never any question about the soundness of the New Zealand financial system.
  • that vanilla household debt has very rarely been at the heart of serious financial system problems in this or other countries  –  the Reserve Bank drew our attention to that in an article only a couple of years ago. Lending on speculative commercial (and residential) developments, and other (typically unsecured) business lending, has usually been the presenting source of financial system problems.

But I’m also puzzled by two points about the Westpac piece –  one presence, and one absence.

Westpac talks of high house prices boosting consumption.

household C to GDP

But household consumption as a share of GDP is currently just slightly below the average ratio for the last 30 years or so.  This shouldn’t be very surprising –  higher house prices don’t make New Zealanders as a whole any better off.  A longer discussion of this issue is contained in this Reserve Bank Bulletin article from a few years ago.

The “absence” is any sense that changes in household debt to GDP (or income) ratios are not mostly some exogenous phenomenon of reckless banks and households taking on new debt with gay abandon.  I discussed this issue a couple of weeks ago.  If there are shocks to the population, and land supply restrictions exist, then house prices will rise.  New purchasers will typically (and probably rather reluctantly) need to take on more debt than their predecessors did.  As a result, debt to income ratios will rise. Since the housing stock turns over only quite slowly, an initial shock boosting house prices will go on boosting debt to income ratios for many years.

In the chart below I’ve done a very simple exercise.  I’ve assumed that at the start of the exercise, housing debt is 50 per cent of income, house prices and incomes are flat, and people repay mortgages evenly over 25 years.  Only a minority of houses is traded each year, but each year the new purchasers take on new debt just enough to balance the repayments across the entire mortgage book.

And then a shock happens –  call it tighter land use regulation –  the impact of which is instantly recognized, and house prices double as a result.  Following that shock, house purchasers also double the amount of debt they take on with each purchase, while the (now rising) stock of debt continues to be repaid in equal installments over 25 years.

In this scenario remember, house prices rose only in year 1.  There is no subsequent increase in house prices or incomes.  But this is what happens to the debt to income ratio:

debt to income scenario

In this particular scenario, 100 years after the initial doubling in house prices, the debt to income ratio is still rising, solely as a result of the initial shock, converging (ever so slowly by then) to the new steady-state level of 1.  One could play around with the parameters, but a permanently higher level of real house prices will, in almost any of them, produce a permanently higher level of gross housing debt, and it will take many years to get to that new level.  The flipside, which I could also show, is the deposit balances of the other parts of the household sectors – the young who have to save for a higher deposit (even for a constant LVR) and the older cohorts who extract more money from the housing market when they downsize or exit the market.  Higher house prices do not, of themselves, require banks to raise more funding offshore.

This is deliberately highly-stylized, but it is designed to illustrate just two main points: higher debt ratios can be primarily a symptom of higher house prices (rather than any sort of cause) and the adjustment upwards in debt levels following an upward house price movement can take many years to work through.

Given the huge population pressures, especially in Auckland, and the lack of much material progress in easing land use constraints, it is hardly surprising that real house prices have increased quite a lot further in some places. If anything, it might be a little surprising that debt to income ratios have not increased more. But these things take time – the point of the chart above.

Westpac has long been of the view that low interest rates have been a major factor explaining rising house prices.  I’ve never found that story particularly persuasive.  We’ve had a 600 point cut in the nominal OCR since 2008 (and a bit more in real terms).  If all else was equal and the Reserve Bank had not cut the OCR as much no doubt house prices would be lower (and quite a lot of other aspects of the economy would be doing even less well).  But the OCR cuts have been done for a reason: the economy hasn’t been performing that well, and inflation has persistently surprised on the downside. In Wicksellian terms, it looks a lot as though the natural interest rate has fallen quite a bit.  Westpac worries about what happens when (if) interest rates rise, but they are only likely to rise much if the economy is performing much better, and is generating much stronger income growth (which would support the existing debt).

There is a still a strong sense around that, when it comes to housing, what goes up must come down.  But when a market is so heavily influenced by regulatory factors, there is no such natural adjustment.  As a loose parallel, we have plenty of people who find it hard to get a job, but the minimum wage keeps on being increased.  Urban residential property prices, especially in Auckland, are a disgrace –  the responsibility of the choices (active and passive) of a succession of central (and local) government politicians. They are hard to defend under any conception of justice or fairness. But there is little sign that they are any sort of macroeconomic risk.  Debt to income is little higher than it was a decade ago, consumption to GDP has not gone crazy, there is nothing of the sort of debt fuelled speculative construction boom seen in, say, Ireland, and there is no sign of reckless behaviour by lenders.  And the banks are very well-capitalized.  It is awful for the many adversely affected, but there is no reason why things should necessarily change much for the better any time soon,

Finally, one of the points of the Westpac note seemed to be to foreshadow the risk of new layers of regulatory controls (so-called “macro-prudential” measures) being imposed on the banking system by the Reserve Bank.  Perhaps they are right about what might be coming. But there would be no good (financial system soundness) basis for further intrusions on the ability of borrowers and lenders to freely arrange finance.    There is simply no evidence that the soundness of the financial system is at risk –  or would be even if, say, the population pressures reversed and land use restrictions were freed up.  Then again, the last two sets of LVR restrictions, undermining the efficiency of the financial system and the wider economy in the process were unwarranted, but that didn’t stop the Reserve Bank charging ahead then.


6 thoughts on “Should household debt be a worry?

  1. The LVR restrictions are working very well in maintaining bank discipline and therefore big plus in bank stability. Between 2002 to 2007 banks got very aggressive with high LVR loans and very aggressive with low documentation loans as interest rates increased.

    Currently, even though interest rates are falling, savings deposits are still rising to record levels, which means that banks liabilities(savings are a liability to banks) are rising which puts banks under increasing pressure to lend out(lending are assets on a banks books). Our interest rates falling is still higher than most of our trading partners which does put upward pressure the NZ as funds around the world seek higher yields.

    Contrary to what people believe, NZ household savings are running ahead of NZ household debt. I do not believe that Wheeler needs to do anything goes at this point. The banks are under severe pressure to drop interest rates even if Wheeler chooses a do nothing approach.

    A RBNZ do nothing approach would force banks to divert the increased levels of savings to more high risk areas eg, small businesses and perhaps we start to see increased lending towards commercial activities like the budding Gisborne space industry.


  2. The problem with Westpac economists is that they fail to look at the assets side of the equation. That seems to be a common problem with economists in that they forget that even though debt is rising, savings deposits is rising even faster plus also the value of the housing assets. If we add the $300 billion invested in business plus savings of $152 billion in savings plus the value of houses. The assets of NZ households is in excess of $1.3 trillion dollars with a tiny amount of debt(including student loans) of $163 billion.


  3. Economists are now predicting a new round of limits that could include reducing the Auckland LVR threshold for investors from 70% to 60% and/or extending the LVR limits for investors beyond Auckland to the rest of the country. Other options include increasing the amount of capital banks have to hold against mortgage lending, or lending generally, and banning the use of interest-only loans to landlords.

    The problem with the RBNZ pushing too far with the LVR threshold is that it interferes with the banks profitability and therefore creates bank instability as they have to seek higher returns in more risky lending.

    The other option of banning interest only loans also interferes with banks profitability and is also difficult to administer as you can opt to borrow from your own home and have a mix of lending. Some against your own home and some against the investment property.


  4. I have a problem with debt to income ratios. It has no meaning. NZ household disposable income as a measure is hugely distorted because it does not factor in that 25% of New Zealanders are migrants, thats roughly 1 million people. They may have overseas income not factored in. There are also around a million New Zealanders that do not reside in NZ that do borrow and buy NZ property. That means that there are potentially as many as 2 million people that may borrow in NZ using possibly an overseas income.

    Eg 29/11/2013 Auckland’s most expensive house, the seven-bedroom mansion on exclusive Paritai Drive partly financed by former Hanover Finance director Mark Hotchin, has been sold to businessman Deyi Shi for $39 million.

    Deyi Shi would likely borrow $20 million but may only pay tax on an income of say $400k. The bank is prepared to loan him $20 million because his overseas businesses run into hundreds of millions of dollars in terms of income and net worth.NZ Stats for debt to income is awfully skewed from just one migrant as his overseas income is not considered.


  5. Thanks for link. I did notice that there was no reference at all to town planning law etc and the resulting regulatory restrictions on urban land supply. They don’t have these problems in Atlanta, or Nashville or……despite low interest rates, a greater role of govt in promoting the supply of credit, and faster-growing populations.


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