Debt Deflation

Is this the start of debt deflation?

We’re focused on the Australian economy today. There won’t be much in the way of conclusions or actionable information. The focus is one thing in particular that has been consuming a lot of my attention. This chart:

I posted this earlier in the year. What we’re looking at is Australian household debt to GDP. I also posted this next chart:

To recap, Australia holds the record for having the highest household debt to GDP ratio for all developed nations that run a trade deficit.

What’s preoccupying my thinking is the understanding that private sector debt always has a limit – it can never increase indefinitely as there comes a point where that nation’s collective debt servicing capacity hits a limit.

To digress a moment, this is not necessarily the case for government debt – a government cannot reach a point where it cannot physically “service” debt that’s denominated in its own currency, although servicing a very significant burden can become problematic to a degree as the government assigns the cost of debt servicing to other parts of the economy (for example, a desire to cut University funding to allow for the added cost of servicing higher debt).

Back to household debt, what we know is that Australia is well within the range that has marked the peak for other nations in the past. For example, USA household debt peaked at around 100% of GDP prior to the GFC before experiencing a significant unwind. Of course, no two economies are the same but there are similarities across all developed nations and economic principles that are consistent across them.

As I’ve previously noted, to some schools of economic thought the business cycle is pretty much the credit cycle. This is because increasing debt boosts demand which will boost economic activity. However, we know from plenty of previous experiences that high household debt can cause significant debt overhang problems, especially if a country experiences a negative shock. This is one of the lessons we learned in the GFC – some nations with high household debt (e.g. Ireland) experienced a larger downturn and slower recovery than nations with lower debt.

Here’s a couple of findings the IMF had within their household debt and financial stability report that they published late last year:

“On average, an increase in household debt boosts growth in the short term but may give rise to macro economic and financial stability risks in the medium term. Real GDP initially reacts positively to increases in household debt, as do consumption, employment, and house and bank equity prices. However, after one or two years, the dynamic relationship between debt, GDP, consumption, employment, housing, and bank equity prices turns negative. Higher household debt is associated with a greater probability of a banking crisis, especially when debt is already high, and with greater risk of declines in bank equity prices.”

Here in Australia, it’s relatively easy to find what looks to be quite compelling evidence of the “positive” factors cited above. Take retail sales which have broadly been outpacing wage growth and gross national income in recent years. How can this be? Here’s an interesting chart that demonstrates that mortgage approvals have been a pretty handy proxy for retail sales (hat tip- Nikko Asset Management):

In light of this, the ABS’s latest monthly dwelling commitments release doesn’t paint a positive picture:

This leads us to what has consumed a lot of my attention lately…

It seems that nearly every time I go onto Australian-based financial news websites of late I’m greeted with more stories about how household debt (aka mortgages) are becoming harder to come by.

For example, Westpac announced the other week that they are exiting the SMSF lending business at the end of July. This will leave Commonwealth Bank as the last big lender making loans to SMSF’s for property (and I’m willing to bet that they will probably exit soon too).

Apparently, the move by Westpac left a lot of mortgage brokers and financial advisers shocked, not to mention a little worse-off if they can’t get their clients into lucrative SMSF property investment deals.

The other space that’s even more important is interest only loans. In recent years there’s been a flocking towards interest-only loans. Now it’s getting a lot harder to find an interestonly loan as banks pull back on this type of lending following the products being targeted by financial regulators.

But to make matters worse (or in fact the reason why regulators have targeted these products), most of the interest-only loans that have been made aren’t interest-only forever – most have a reset date, usually between 3 to 5 years where they either need to be rolled over for a new interest-only loan or they revert to principal and interest. There’s around $480 billion worth of loans to reset in the next 3 or 4 years.

And then there’s all the stories about how lending standards in general are being tightened. Many of those interest-only loans won’t even have a chance of refinancing to a new interestonly product and will face substantial repayment increases as the product reverts to principal and interest.

So in summary, even if Australia collectively hasn’t hit the limit of our private debt servicing capacity, it’s getting a lot harder to get yourself into debt. Thinking about this from another perspective, the fact that it’s getting harder to get into debt may in and of itself be a strong sign that the nation has hit its debt servicing limit.

So what happens if debt goes backwards? Well, that depends…

The big question is to what extent the Australian economy has become reliant on credit growth to fuel economic growth. Here’s how credit growth has been tracking for the last 20 years or so:

It’s interesting to see that with regard to year-on-year change, the rate of housing and personal credit growth peaked around 2005 to 2007. It’s worth comparing this to our chart of household debt to GDP from the beginning – this era corresponded with a significant acceleration in the debt to GDP ratio from around 70% to over 100%. The general concern with all of this is that outstanding credit has grown to a very large amount…and yet has still been increasing at a pace comfortably above the rate of GDP (aside from the Personal component).

Such a “levering” process can only really happen once per cycle. In other words, it’s pretty improbable that credit growth for any sector (except the government sector) is going to accelerate to any meaningful degree – this is because of our key concern being that aggregate debt (particularly households) has reached such a significant level relative to the size of the economy – an acceleration similar to that witnessed back in the 2000’s would see debt balloon to 140, 150, 160% of GDP – numbers never seen before for any nation. We all know we’re “special” down here, but its rather naive to expect us to set records like that.

A Bank of International Settlements paper from last year reported finding that a 1 percentage point increase in household debt is associated with lower GDP growth of 0.1% in the longerterm. So the last 20% increase in debt stands to act as a couple of percent drag on growth.

But I can’t help but feel that this is a little too simplistic. Debt is so high that recent annual increases in debt are huge (i.e. 5% of a big number is a big number). A slowing of credit growth will have flow-on effects – “pro-cyclical” drivers that will impact growth further. A simple example I’ve used in recent times – if the property developer can’t confidently sell the next development it doesn’t happen and all those jobs that would have been created by the project are lost.

My current obsession with household debt is based on an understanding that Australia has reached levels of debt that have acted as the limit for other developed nations in the past. If, like many other countries have experienced when they have reached similar levels, we see an outright decline in aggregate household debt, we know that the ramifications for the economy are quite profound. On top of this, we’re seeing banks and regulators pushing to deliberately make debt harder to get – I can’t help but think this is a bad recipe.

I expect that we will be revisiting this topic fairly regularly in the near future.

To be continued…