HOUSEHOLD SECTOR CREDIT RISK

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1 HOME LOANS DIVISION HOUSEHOLD SECTOR CREDIT RISK While household sector credit quality may well be improving, risks remain high. PROPERTY MARKET ANALYTICS John Loos: Strategist john.loos@fnb.co.za September 9 SUMMARY: CREDIT QUALITY IMPROVING, BUT IT REMAINS A HIGH RISK IMPROVEMENT RELYING HEAVILY ON INTEREST RATE CUTS, WITH ND QUARTER SARB DATA SHOWING LITTLE IMPROVEMENT IN HOUSEHOLD SECTOR FUNDAMENTALS. The release of the September SARB Quarterly Bulletin makes the economic and household sector picture for the nd quarter of 9 more complete. But Household Debt Service Risk Index this is not to say that the picture is a good one. Real disposable income showed even more extreme negative growth than in the first quarter despite 7 slightly less real economic contraction in the quarter, and it remains clear that the result of severe pressure on incomes is that the household sector is battling to de-leverage despite a sharp cut-back in new borrowing. Indeed, we have seen an improvement in household sector credit quality in the nd quarter, with insolvencies declining by -1 year-on-year and FNB Home Loans own arrears having started to decline. However, when examining the nd quarter household numbers one gets the impression that this improvement has little to do with any improvement in the household sector s fundamentals and almost everything to do with a sharp decline in interest rates in the year to date. This rate reduction has led to a significant reduction in the household debt-service ratio (the cost of servicing debt, interest+capital, as a percentage of household sector disposable income), which is the cause of improved debt repayment performance. Therefore, the recovery in households ability to service debt remains a high risk recovery, because it depends almost solely on interest rate cuts while the overall level of indebtedness remains near historically highs. Admittedly, after previous quarters of rise in the household debt-to-disposable income ratio, the nd quarter did show a slight reduction in the ratio as the quarter-onquarter credit growth slowdown slightly outstripped the disposable income slowdown, but the ratio remains at a very high level. For as long as interest rates are relatively low, the high debt-to-disposable income ratio shouldn t be problematic. But we wouldn t want to go into the next interest rate hiking cycle with indebtedness levels still so high, as this could quickly return the pressure to the household sector. At present, inflation risks appear benign, but with services inflation in SA remaining downwardly sticky, and the high base effects of last year s commodity price spike set to exit the year-on-year inflation figures late-9 or early-1, causing a possible CPI inflation turning point, the scope for further interest rate cuts looks limited at best. Further improvement in credit quality will increasingly rely on the household sector s ability to reduce its debt ratio, therefore. Our Debt-Service Risk Index therefore remains at high levels as a result of the ongoing high level of overall indebtedness, and has actually risen mildly over the past quarters. The most recent quarter s rise was due to the diminishing scope for further interest rate reduction. The most recent nd quarter reading of.3 is still lower than the 7.1 risk peak reached in early-, but it is nevertheless on the high side, given a multi-decade average of near. So, while interest rate cuts have helped improve the household financial and debt servicing situation somewhat, it is a HIGH RISK improvement in credit quality Composite Debt-Service Risk Rating LT Average Insolvencies - year-on-year change (Right axis) KEY HOUSHOLD SECTOR AND RELATED INDICATORS Real Disposable Income q/q annualized chge. (Q) Real GDP q/q annualized change (Q) SARB Leading Indicator Indicator Value (Jun) SARB Leading Indicator y/y change (Jun) Prime Overdraft Rate monthly avg. - (Aug) Consumer Price Inflation y/y change (Jul) Debt-to-disposable Income Ratio - (Q) Most Recent Prev. Year ago Debt-service Ratio - (Q) Net Saving to disposable income ratio - (Q) The information in this publication is derived from sources which are regarded as accurate and reliable, is of a general nature only, does not constitute advice and may not be applicable to all circumstances. Detailed advice should be obtained in individual cases. No responsibility for any error, omission or loss sustained by any person acting or refraining from acting as a result of this publication is accepted by Firstrand Group Limited and / or the authors of the material. First National Bank a division of FirstRand Bank Limited. An Authorised Financial Services provider. Reg No. 199/1/

2 DESPITE MORE GREEN ON THE SCREEN, THE HOUSEHOLD SECTOR FINANCIAL AND DEBT POSITION REMAINS FRAGILE AND RISKY AT BEST Still more green appears on the screen for the nd quarter, suggesting a mildly more positive environment from a household sector financial and credit quality point of view. Most important was the return to decline in the household debt-to-disposable income ratio in the nd quarter after quarters of increase. However, while this is a step in the right direction, the ratio remains near historic highs, and we will need to see a substantial improvement in disposable income growth in the second half of 9 if we are to see significant progress in reducing this ratio. In the mean time, one shouldn t be fooled. Household sector fundamentals remain extremely weak. This raises questions as to the sustainability of any improvements that we may be starting to see in consumer confidence and household sector credit quality. Household Sector Financial Conditions and Determinants Thereof Q- Q3- Q- Q1-9 Q-9 Q3-9 to date Real Disposable Income Growth (q/q ann.) Declining positive growth Negative Growth Declining negative growth Declining negative growth Declining negative growth N/A Employment Growth Declining positive growth Declining positive growth Negative growth Accelerating Negative growth N/A N/A Average Real Wage Growth Negative Growth Zero growth Positive growth Positive growth N/A N/A SARB Leading Economic Indicator Growth - qtly avg. (q/q ann.) Accelerating negative growth Accelerating negative growth Accelerating negative growth Diminishing Negative Growth Positive m/m growth N/A Real Economic Growth (q/q ann.) Rise in positive growth Decline in positive growth Negative Growth Declining negative growth Diminishing Negative Growth N/A Debt servicing costs and main drivers thereof Interest Rates on debt (quarterly average) Rising Rising Declining Declining Declining Declining Consumer Price Inflation Rising Rising Declining Declining Declining Declining Household debt-to-disposable income ratio Declining Declining Rising Rising Declining N/A Household debt-service ratio Rising Rising Rising Declining Declining N/A Drivers of household wealth Household Net Saving-to-GDP Ratio Slightly less dis-saving Slightly less dis-saving Slightly less dis-saving Slightly less dis-saving Unchanged dis-saving N/A Real house prices (y/y) Accelerating negative growth Accelerating negative growth Accelerating negative growth Accelerating negative growth Accelerating negative growth De-celerating Deflation JSE All Share Index monthly average Positive growth Negative Growth Deterioration in Neg. Growth Less negative growth Positive growth Positive growth Indicators of household confidence Consumer Confidence Index (FNBBER) Declining Declining Declining Rising Rising N/A of total residential property sellers selling to emigrate Rising Rising Declining Declining Declining N/A

3 HOUSEHOLD SECTOR DISPOSABLE INCOME GROWTH CONTINUED ITS SHARP SLOWDOWN IN ND QUARTER Gap between Nominal Disposable Income and Consumer Inflation Percentage point gap between nominal disposable income growth and consumer inflation Nominal household disposable income - y/y change Consumer Inflation (using HCE Deflator) - y/y change Real Disposable Income Growth Real Household disposable income - Estimated y/y change Real disposable income growth - quarter-on-quarter annualised change The arrival of last year s commodity price slump after mid-year set the scene for a significant decline in domestic consumer price inflation. It had been the huge inflation surge prior to that that had exerted pressure on real disposable income growth, eating into households nominal disposable incomes, and we had already seen a steady drop in real disposable income growth since early-7. Under a normal more mild economic slowdown, this decline in inflation may well have translated into improving real disposable income growth in 9, but alas, this was no normal economic slowdown. It was a deep recession, and the pressure that the economy has exerted on nominal disposable income growth (through job loss, declines in discretionary rewards for employees, and weak investment incomes), has overridden the positive impact of a decline in consumer price inflation. It is not only the economic growth rate that must be blamed, but also the stickiness of services inflation, which has led to a disappointing rate of decline in overall consumer inflation. And so, nominal disposable income growth declined to.3 year-on-year in the nd quarter from 7 previous, outstripping the pace of decline in consumer price inflation from.9 in the 1 st quarter (Household consumption deflator) to 7.7 in the nd quarter. The net result has been a further acceleration in the rate of negative growth in real disposable income. Negative growth in Real household disposable income accelerated further to -.7 quarter-on-quarter annualised (-3.1 year-on-year), from -. in the previous quarter, an extreme situation by most standards. THE HOUSEHOLD SECTOR S RESPONSE TO DISPOSABLE INCOME PRESSURE Residential Fixed Investment remains the major victim, although pace of consumption decline is also accelerating - Real Residential Fixed Investment Growth vs Household Consumption Expenditure 199 Real Residential Fixed Investment - year-on-year change Real household consumption expenditure - y/y change The response of the household sector to declining real disposable income remains one of significant cutbacks in residential fixed investment. However, whereas real residential fixed investment s rate of year-on-year decline remained unchanged at -7.7 in the nd quarter, the cutback in real household consumption expenditure was still gathering momentum, with a -3. decline which was an acceleration on the -1. year-on-year decline of the previous quarter. So although households are more reluctant to cut consumption as opposed to fixed investment in tough times, the harsh economic realities have driven cuts in both.

4 Savings improvements have stalled, and savings rate remains weak When greed turns to fear in the tough times, it can be expected that the savings rate will start to rise. However, there comes a point where pressure on income is too severe for such SA Household Savings Rate improvements to occur. This appears to have been the case in the nd quarter, where the rate of net dissaving remained unchanged at -.1 of disposable income (net saving refers to the saving that remains after gross savings levels has been adjusted for depreciation on fixed capital owned by the household sector). It is this ongoing low level of savings that continues to slow the residential mortgage market recovery, because many households fail to quality for loans where deposits are required. It also contributes to the risk that lending institutions face on an ongoing basis, because on top of the low savings rate being a constraint on long term fixed investment and economic - growth, it also renders SA s household sector Net household savings as of Disposable income vulnerable to external cash flow shocks. Household credit growth decline continues, but indebtedness level nevertheless remains near historic highs Year-on-year household sector credit growth declined further from.1 in the 1 st quarter to. in the nd quarter, a continuation of a long trend starting back in. However, this declining trend has been accompanied in more recent times by a sharp drop in nominal household disposable income growth (.3 in the nd quarter) implying very little headway to date in reducing the household debt-to-disposable income ratio. The household debt-to-disposable income ratio did decline somewhat from 7. in the 1 st quarter to 7.3 in the nd, but this comes after previous quarters of increase, and the level still remains not far from the record 7. level reached in the 1 st quarter of Household Disposable Income vs Total Household Sector Credit Growth Household debt - y/y change Nominal household disposable income - y/y change 7 Household Debt to Disposable Income Ratio vs Interest Rates Household debt-service ratio (Left Axis) Prime Rate In the absence of decline in the household debt-to-disposable income ratio, it has therefore been up to the Reserve Bank (SARB) to improve the strained household sector s ability to service its debt burden by cutting interest rates sharply. The debt-service ratio (the cost of servicing the household debt burden, interest + capital, expressed as a percentage of disposable income) is possibly the best single macro-indicator to predict the future path of home loan default rates, and possibly of household credit quality in general. The debt-service ratio has started to decline in 9, down to 13. in the nd quarter from a peak of 1 late last year. Plotting insolvencies on the same graph, insolvencies growth has turned negative to the tune of - year-on-year in the nd quarter, after a lengthy period of sharp increase. We are also seeing the value of arrears on home loans decline as of late. Household sector credit quality has thus started to improve. But a credit quality improvement that relies almost solely on interest rate cuts, as opposed to getting the indebtedness level back down to more manageable levels (essential given the magnitude of global and local economic weakness and uncertainty) is a high risk credit quality improvement, because as fast as interest rates go down they can go up again, depending on the global and local inflation picture.

5 1 1 1 Household Debt Servicing Costs vs Insolvencies Household indebtedness levels run in cycles, normally related to interest rate cycles. In lagged response to an interest rate hiking phase, borrowing growth pulls back and the debt ratio declines, building a solid platform for the next cyclical credit growth recovery when interest rates are once again at lower levels. The debt-to-disposable income ratio started that downward movement in the nd quarter of, but was thwarted by a recession so severe that the income growth slum began to keep pace with the credit slowdown. As a result, there exists a good possibility that we may enter the next interest rate hiking phase with a relatively high debt ratio, and that the solid platform for credit-driven spending will only be in place at the next interest rate cutting cycle, which is only anticipated at some stage beyond 1. BRINGING IT ALL TOGETHER THE HOUSEHOLD DEBT SERVICE RISK INDEX The graph below represents a rating of risks to the household sector s future ability to service debt, in which the Household Debt Service Risk Index has risen over the past 7 3 Household debt-service ratio (Left Axis) Insolvencies year-on-year change Household Debt Service Risk Index Composite Debt-Service Risk Rating LT Average Insolvencies - year-on-year change (Right axis) quarters back up to level of.3 after some decline since its high of 7.1. The last strong rising trend in Debt Service Risk Index, to a high level by historic standards, was indeed followed by a sharp lagged deterioration in credit quality. There are reasons for this recent increase in the Debt Service Risk Index. Firstly, the direction of the household debt-to-disposable income ratio, along with its level are key determinants in determining the level of risk, with the other driver being the level of real interest rates. The Household Debt-Service Risk Index (expressed on a scale of 1 to 1 with 1 being the highest level of risk) is an attempt at measuring the vulnerability of households when it comes to the future ability to service their debt. 3 variables play a role in its level: The level of the household debt-to-disposable income ratio (higher debt-to-disposable income ratio implies higher risk) The direction of the household debt-to-disposable income ratio (rising debt-to-disposable income ratio points to higher risk than declining trend), and The level of real interest rates. This measure of real interest rates is the difference between prime rate and the -year average consumer price inflation rate. The reason for using a -year average inflation rate is to get to more of a structural level of inflation, because periodically we will have extremely low levels of inflation which will could temporarily lead to low interest rate levels, but which could be unrealistic and could imply steep hiking and pain once inflation normalises. As prime rate moves nearer to the -year average inflation rate (i.e. declining in real terms as has recently been the case), the lower the scope for further rate cuts and the greater the chance that the next rate move is up. Should the SARB pursue with negative real rates al la US Federal Reserve, this too creates risks in terms of stimulating unsustainable credit growth. Either way, periods of low real interest rates are seen as ones where the risks to the household sector s debt service ability rise. The Household Debt Service Risk Index has begun to rise over the past quarters due largely to the sharp reduction in interest rates to levels nearer to the structural inflation rate, significantly lowering the probable scope for further interest rate reduction. Accompanying this, progress in reducing the debt-to-disposable income ratio has been limited and the ratio remains very high. So, while we are still at a lower risk level than the high peak in the risk index back in, the levels of debt service risk still remain high. This doesn t necessarily mean we should expect an imminent rise in household sector loan arrears. Rather, it suggests that the household sector remains highly vulnerable to any possible economic shock, because of high indebtedness and limited scope to ease monetary policy from here on, implying the need to proceed with caution from a borrower/lender point of view