Australia, compared to other advanced nations, has enjoyed a stellar economic run over recent decades. Riding on the coattails of China’s rise to economic prominence, the nation has enjoyed a quarter century of uninterrupted economic growth.
Wage growth, up until recently, has been strong, unemployment has stayed low and wealth has increased substantially. While an envious record, one of the side effects from the nation’s astonishing economic run has been a substantial increase in household debt.
According to analysis conducted by Wells Fargo Securities, Australia’s household debt-to-GDP ratio increased from 108% to 122% in the seven years to Q2 2015, largely as a result of a sharp increase in housing debt.
Compared to other nations which saw household’s deleverage aggressively over the same period, Australian households did the opposite, using lower interest rates to lever up even further.
In what is a symbiotic relationship, as house prices increased, so too was the amount of debt required to purchase them. The chart below reveals the sharp increase in housing debt seen in Australia over recent years.
While the level of household indebtedness has increased sharply, Australia’s household debt servicing ratio (DSR) – simply debt repayments expressed as a percentage of disposable household income – has fallen substantially in recent years courtesy of a substantial decrease in mortgage interest rates.
With around 90% of all Australian mortgages floating, as the RBA reduced the cash rate, the cost of servicing debt fell.
As revealed in the chart below, provided by Wells Fargo, from its peak of 18.1% of disposable income in 2008, Australia’s household DSR has fallen to around 15%, courtesy of the RBA reducing the official cash rate to a record low level of 2.00% in May last year.
Essentially, lower interest rates have allowed households to take on more debt while reducing the cost of servicing it.
While it has provided a short-term win for the economy, allowing more money to be spent (or saved) in other parts of the economy, the tailwinds it has created for household consumption can only last so long.
Even if interest rates are reduced further in the months ahead, it’s unlikely to reduce the debt servicing costs for households by any significant margin unless they choose to pay down debt or receive a major, and unlikely, boost to household incomes.
It’s a tricky scenario that the RBA now has to juggle.
On one hand, if interest rates are reduced further it may simply lead to households choosing to take on even greater levels of debt, essentially mitigating the effect of lower debt servicing costs on households.
On the flip side, increasing interest rates will reduce the amount of disposable income households can spend in other areas of the economy, crimping their ability to spend on goods and services at a time when it is required to help offset weakness in other areas of the economy such as mining sector investment.
Neither situation seems palatable, particularly at a time when Australia’s economy is already growing below trend.
In recent months the RBA have adopted a mild easing bias in its monetary policy statements, noting that “the outlook for inflation may afford scope for further easing of policy, should that be appropriate to lend support to demand.”
The word “appropriate” is deliberately used, and points out exactly why the board is reluctant to cut interest rates further given the risk households will simply lever up even further.
However, with stronger consumption also required to help power Australia’s economic transition, it also suggests that interest rates are unlikely to increase for the foreseeable future.
If higher debt servicing costs quash consumption – be it through higher debt loading or higher interest rates – it’ll likely take economic growth with it.